WFU Law School
Law & Valuation
4.3.3 Stock Valuation Experts

4.3.4 Corporate Decision-Making and Stock Value

In making business decisions, it is often said that corporate managers are supposed to maximize shareholder value. How do managers know whether their business decisions are maximizing shareholder value?

New projects. Here's the rule. Managers generally should not invest in a new business project that offers a rate of return less than the company's capitalization rate. To do so would reduce the valuation of the business. If the new project has the same risk as the overall business, the "Gordon model" tells us that a new project with a rate of growth less than the company's capitalization rate (discount rate) will have negative value. If, however, the new project diminishes the overall risk of the business, undertaking it may result in a new capitalization rate and greater net value for the overall business.

Dividend policy. When faced with the choice of investing in a new project or payment of the dividends to shareholders, which should managers choose? That is, should managers re-invest earnings or pay them as dividends?

Here's the rule. Managers should reinvest earnings if the reinvested amounts will permit the business to earn more than its cost of capital - that is, the net present value of the reinvestment (using the company's cost of capital as the discount rate) is positive. But managers should pay dividends if reinvested amounts would not earn more than cost of capital. That is, if the reinvested amounts would have an internal rate of return less than the cost of capital, shareholders (not the company) should get the money to invest.

Example

[better for managers to pay dividends and have zero growth or retain earnings and have growth equal to cost of capital.

Answer: [indifferent - both are the same / show with table] If a company has excess cash and few worthwhile projects (that is, NPV<0 or IRR<the cost of capital), distributing that excess cash to stockholders as dividends is wise. However, when a firm is faced with many good projects (NPV>0 or IRR>cost of capital) and excess cash, more value will be created by investing in these projects instead of returning cash to stockholders.

If a company has earnings, won't some shareholders prefer to have cash now - rather than let the company reinvest the earnings? Perhaps so. But even if the company does not pay dividends, sharheolders can create "home made dividends" by selling some of their shares and obtaining capital gains that reflect the reinvested, unpaid earnings. These capital gains should reflect the increase in market value resulting from the reinvested earnings, and thus simulate the payment of a dividend. So long as the capital gains are at least equal to the unpaid dividend, even cash-hungry shareholders should be happy. (Under the current tax laws, shareholders should actually prefer taking their cash as capital gains, since income tax on cpaital gains is lower than on ordinary dividends.) This assumes that the stock market properly measures the present value of reinvestment projects and that the company does not sqaunder excess cash on bad projects or acquisitions.

A common policy among public companies is to maintain regular dividends over an extended period of time, no matter the actual level of cash flow. Even if the company suffers a loss for the year, the regular dividend will be paid out of accumulated earnings from prior years. Some describe this by saying dividends tend to be "sticky." The signaling effect of dividends explains this aspect of dividend policy.

In a market with assymetric information, dividends are seen as a way for management to "signal" positive information otherwise unavailable to the public. If a company has an extraordinary year and generates significant cash flows, the best move may not be to pay out a huge dividend. While paying out the dividend may send a positive signal to the market and result in a higher stock price, more than immediate consequences must be examined. Management must first determine if this dividend can be sustained for the long haul, because if it cannot, reducing the dividend the next year might eliminate the gain in the stock price from increasing the dividend (Evidence does indicate that the signaling effect of increases and decreases are not symmetric -- increases tend to raise stock prices more than decreases lower the price). Thus, only sustained increases in cash flows should prompt a dividend increase. The same is true on the other side as well -- only sustained decreases in cash flows--not a one-time dip in earnings -- should prompt a reduction in dividends. Texas Instruments has maintained steady and increasing dividends for the past twenty years, in spite of uneven cash flows.

Of course, firms do exist that pay no dividends at all. Warren Buffett's Berkshire Hathaway has never paid a dividend, as all cash is reinvested into the company. Many young or newly public companies need all available cash to sustain their growth and will not have any excess from which to pay dividends.

Capital allocation and project selection

What if the board is presented with more than one project, but has limited resources and cannot undertake all value-added endeavors? The three methods for assessing a project -- NPV, IRR, and PI -- suggest that the managers should simply take the project that produces the highest value.

But things in the real world are hardly ever that easy. In their article, "Why the NPV Criterion Does Not Maximize NPV" (SSRN), Berkovitch and Israel identify situations where exclusive use of the NPV method leads to inefficient capital allocations. Instead, they argue that while the method is proper for measuring the project's addition to firm value, it does not succeed in maxmizing shareholder value. The reason for this is not a fundamental flaw in the NPV formula but rather lies in the fact that NPV, compared to IRR and PI, is biased for large-scale projects.

Empire-building managers, bent on increasing their own stature, will submit the larger of two projects, assuming they both have positive NPVs, even though the smaller alternative might increase shareholder value more. However, IRR and PI eliminates these potential agency considerations. The authors find support for their argument in real-world business where many companies do not rely on NPV in their capital allocation process.

Use of market price to evaluate corporate law. It has become fashionable to evaluate corporate law rules according to whether they have an effect on public stock prices. Good rules should increase price, bad rules the opposite.

But is stock price a good criterion? Professor Lynn Stout argues no. Share Price as a Poor Criterion for Good Corporate Law, SSRN Paper 660622 (Jan 2005):

Academics, reformers, and business leaders all yearn for a single, objective, easy-to-read measure of corporate performance that can be used to judge the quality of public corporation law and practice. This collective desire is so powerful that it has led many commentators to grab onto the first marginally plausible candidate: share price.

Contemporary economic and corporate theory (as well as recent business history) nevertheless warn us against unthinking acceptance of share price as a measure of corporate performance. This Essay offers a brief reminder of some of the many reasons why stock prices often fail to reflect true corporate
performance, including the problem of private information; obstacles to effective arbitrage; investors' cognitive defects and biases; options theory and the problem of multiple residual
claimants; and the problem of corporate spillover effects that erode diversified shareholders' returns. These considerations argue against assuming there is a tight connection between stock prices and underlying corporate wealth generation. A corporation
or a corporate law system designed around the philosophy that anything that raises share price is good is likely to produce a firm that cooks its books; that avoids long-term projects that won't appeal to unsophisticated investors; that chases after
investment fads and fancies; that tries to opportunistically exploit creditors, employees, and customers; and that pursues business strategies that harm its diversified shareholders' other investment interests.

The Essay concludes that, if we allow our desire for a
universal performance measure to blind us to the fallibility of share price, we court costly error. The Essay examines three recent examples of just such erroneous triumphs of hope over experience: the rise and fall of the Revlon doctrine; the 1990s infatuation with options-based executive compensation; and
academics' current preoccupation with event studies, regressions on Tobin's Q, and other forms of empirical scholarship that attempt to judge the quality of corporate law and practice according to changes in share price.

Example

David Puddy, CEO of Arby's, has decided the restaurant needs to diversify its business into other areas. Puddy is not familiar with the idea of core competencies and proposes to the board of directors that the company begin selling a line of high-end automobiles, similar to a Saab.

Puddy has determined that such a venture would entail an initial outlay (including any change in working capital) of $300 million for market studies, design development, construction of an assembly plant, and advertising. Puddy has also determined the project will lose $25 million in year one and $3 million in year two. However, Puddy predicts sales will go up and "conservatively" estimates the project will net $75 million in year three, $150 million in year four, and $350 million in year five. Assuming Puddy's figures are reasonable, should the board approve his plan? Assume Arby's cost of capital is 15%. What if Arby's cost of capital is 12%?

Answer: An analyst will need to determine if undertaking the proposal will increase shareholder value. Among the more popular methods to conduct this evaluation are determining the project's net present value (NPV), internal rate of return (IRR), or profitability index (PI).

NPV. The NPV is just the present value of future cash flows of the project minus its initial investment.

Cash flow in millions
PV formula
PV
Initial Outlay
($300)
= -300/(1+.15)^0
($300.00)
Year 1
(25)
= -25/(1+.15)^1
(21.74)
Year 2
(3)
= -3/(1+.15)^2
(2.27)
Year 3
75
= 75/(1+.15)^3
49.31
Year 4
150
= 150/(1+.15)^4
85.76
Year 5
350
= 350/(1+.15)^5
174.01
   
NPV of project
($14.92)

The NPV of this project is below zero. Thus, the project will not increase shareholder value and should not be undertaken.

IRR. The IRR is the rate of return that discounts any future cash flows to an amount equal to the initial investment. In other words, the IRR is the discount rate that will produce an NPV of zero. This can be determined though trial and error or a quicker way, the IRR function in Excel. As we have already determined that the NPV is relatively close to 0, we know that the IRR for this series of cash flows can't be much less than 15%. The actual IRR on this series of cash flows is 13.75%. Thus, as the IRR is below the firm's cost of capital, this project will not increase shareholder value. Compare other secenarios on attached spreadsheet.

PI. The profitability index is simply the ratio of the present value of the project's cash flows to its initial cost. A project that adds value will have a PI of at least 1.0.

PV of Year 1
($21.74)
PV of Year 2
(2.27)
PV of Year 3
49.31
PV of Year 4
85.76
PV of Year 5
174.01
Total
$285.08
PI
= 285.08/300.00
PI = .95

Again, this technique shows the project will not increase shareholder value as the profitability index is less than 1.0.

Lowering the cost of capital to 12% will obviously have an impact on our analysis.

New NPV
$ 22.60
New PI
1.08

Changing the cost of capital will have no impact on the actual determination of the project's IRR. However, the change does bring the cost of capital below the project's IRR. Thus, with the adjusted cost of capital, all methods indicate that the project should be undertaken as it will increase shareholder value.

Business Judgment Rule

Suppose Puddy's great idea turns out poorly. The company loses money. Could you, as an Arby's shareholder, sue the board of directors for their negligence? Probably not. Corporate officers are afforded substantial protection under the business judgment rule. Judge Winter in Joy v. North, 692 F.2d 880 (2d Cir.1982), explained:

While it is often stated that corporate directors and officers will be liable for negligence in carrying out there duties, all seem agreed that such a statement is misleading. Where as an automobile drive who makes a mistake in judgment as to speed or distance injuring a pedestrian will likely be called upon to respond in damages, a corporate officer who makes a mistake in judgment as to economic conditions, consumer tastes, or production line efficiency will rarely, if ever, be found liable for damages suffered by the corporation. Whatever the terminology, the fact is that liability is rarely imposed upon corporate directors or officers simply for bad judgment and this reluctance to impose liability for unsuccessful business decisions has been doctrinally labeled the business judgment rule.

Judge Winter gives three reasons for the rule:

  • Shareholders voluntarily assume the risk of bad business judgment. In fact, a key determinant in choosing investments is the management ability of the underlying company. Investors have broad range of companies and investments, some of which offer less vulnerability to mistakes of management.
  • Litigation coming after the fact is not the best place to rehash corporate business decisions. Reconstructing the atmosphere and circumstances existing when the decision was made is not an easy task. Also, business decisions often are made without perfect information or long deliberation. Decisions made in the heat of the moment may seem totally irrational today, but at the time, such a decision was entirely reasonable.
  • Significant investment returns are not realized without risk. The law should not create incentives for entrepreneurs to not take risks. In addition and similar to the first point, investors have numerous options available to diversify their risk such that judicial intervention is unnecessary.

In conclusion, Winter states that the business judgment rule protects corporate decision-making unless the decision “lacks a business purpose, is tainted by conflict of interest, is so egregious as to amount to a no-win decision, or results from an obvious and prolonged failure to exercise oversight or supervision.”

How should the Arby’s board’s decision come out?

4.3.3 Stock Valuation Experts

©2003 Professor Alan R. Palmiter

This page was last updated on: March 2, 2005