Valuation, Capital Budgeting, and Value-Based Management
Spring 2006, Volume 18.2
Expectations-Based Management
The article argues that to create shareholder value, a business’s return on capital must exceed what investors are expecting. To guide expectations, management should provide investors a clear sense of the firm’s internal benchmark returns. Management incentive plans should not be based on options because prices reflect expectations, creating a temptation to manipulate earnings in the short term.
Financial Management Association Roundtable on Stock Market Pricing and Value-Based Management
A group of academics and practitioners note that despite the “fixation” of many investors on smoothly rising earnings per share, earnings provide at best a useful starting point for valuing companies. The most sophisticated investors consider far more when pricing stocks. The message to corporate practitioners is to avoid letting cosmetic accounting effects get in the way of value-adding investment and operating decisions.
Handling Valuation Models
Valuation models are useful tools, but need to be handled with care. Simple models should be built on the foundation of “what we know,” separating them from the speculative “components” of long-term growth rates that are inevitably part of any model. Models are to be used as much to identify the market’s current expectations about future performance as to discover the right price.
How Kimberly-Clark Uses Real Options
Kimberly-Clark (K-C) historically relied on ROIC and DCF to evaluate innovation, which can lead to undervaluation of projects with risky upside potential. This article discusses K-C’s adoption and use of real options, sharing lessons learned, and emphasizes the importance of simplicity and clarity in gaining organizational support for the introduction of an innovative valuation approach.
Incentives and Investor Expectations
An expectations-based EVA bonus plan is presented, demonstrating two key steps in designing such a plan: using a company’s “Future Growth Value” to calibrate the series of annual EVA “improvements” that are expected by the market; and determining the executive’s share of those improvements. A solution to the single-period focus of EVA is also proposed.
London Business School Roundtable on Shareholder Activism in the U.K.
The roundtable begins by reviewing a study of the Hermes UK Focus Fund, which actively engaged companies with the belief that it could bring about changes that would improve performance. The announcement of successful engagements resulted in positive stock price reactions that accounted for almost all of the fund’s excess return. An “insider’s” view of Hermes is offered, followed by a panel discussion.
Multinationals in the Middle Kingdom: Performance, Opportunities, and Risks
Many multinational companies entered China in the 1990s unprepared to operate in a developing economy with a foreign culture, resulting in poor performance. But recent adjustments have led to better returns. Case studies of Procter & Gamble, Anheuser-Busch, and Wal-Mart illustrate the substantial challenges that remain and provide some important lessons.
The Effect of Private and Public Risks on Oilfield Asset Pricing: Empirical Insights into the Georgetown Real Option Debate
Investment projects face both market risks (price of oil) and private risks (amount of oil in the field). For real options, it’s debatable whether it’s better to price the two risks separately or to combine them into a unified framework. This article sheds light on the debate with findings from an analysis of U.K. oilfield expansion options, with the conclusion contingent on the field size.
The Real Reasons Enron Failed
Popular accounts of why Enron failed point to the use of deceptive bookkeeping and off-balance sheet financing. The more fundamental causes appear to have been matters of organizational design and internal control—flawed incentives that rewarded growth in earnings and EPS at the expense of economic profit; mark-to-market accounting; and making finance a “profit center.”
The Role of Real Options in Capital Budgeting: Theory and Practice
A series of examples demonstrates that discounted cash flow (DCF) and real options valuation (ROV) methods, when done correctly, should provide the same answer. But when the project risk is expected to change over time, the “risk-neutral approach” used by real options may make it easier to implement than DCF. The key to success is understanding which method is best suited to the circumstances.
The views and opinions expressed in the Journal do not necessarily represent those of Morgan Stanley or its affiliates.
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For close to 20 years, the Journal of Applied Corporate Finance has distinguished itself as a unique forum for addressing the topics that drive corporate value. Featuring articles by top academic thinkers and financial practitioners, this quarterly publication presents the practical application of the best current research in finance.
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