Techno Finance and Executive Diary...

Tuesday, May 31, 2005

fundamentals—or emotions?

Do fundamentals—or emotions—drive the stock market?

Emotions can drive market behavior in a few short-lived situations. But fundamentals still rule.

Focus on intrinsic value

What are the implications for corporate managers? Paradoxically, we believe that such market deviations make it even more important for the executives of a company to understand the intrinsic value of its shares. This knowledge allows it to exploit any deviations, if and when they occur, to time the implementation of strategic decisions more successfully. Here are some examples of how corporate managers can take advantage of market deviations.
Issuing additional share capital when the stock market attaches too high a value to the company's shares relative to their intrinsic value
Repurchasing shares when the market under-prices them relative to their intrinsic value
Paying for acquisitions with shares instead of cash when the market overprices them relative to their intrinsic value

Divesting particular businesses at times when trading and transaction multiples are higher than can be justified by underlying fundamentals

Bear two things in mind

First, we don't recommend that companies base decisions to issue or repurchase their shares, to divest or acquire businesses, or to settle transactions with cash or shares solely on an assumed difference between the market and intrinsic value of their shares. Instead, these decisions must be grounded in a strong business strategy driven by the goal of creating shareholder value. Market deviations are more relevant as tactical considerations when companies time and execute such decisions—for example, when to issue additional capital or how to pay for a particular transaction.

Second, managers should be wary of analyses claiming to highlight market deviations. Most of the alleged cases that we have come across in our client experience proved to be insignificant or even nonexistent, so the evidence should be compelling. Furthermore, the deviations should be significant in both size and duration, given the capital and time needed to take advantage of the types of opportunities listed previously.

Provided that a company's share price eventually returns to its intrinsic value in the long run, managers would benefit from using a discounted-cash-flow approach for strategic decisions. What should matter is the long-term behavior of the share price of a company, not whether it is undervalued by 5 or 10 percent at any given time. For strategic business decisions, the evidence strongly suggests that the market reflects intrinsic value.

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Posted by "CPerformance" :: 5:56 AM :: 0 comments