Rational exuberance
What is the value of your stock?
One reason the stock market has been so volatile is that active traders are applying vastly different models for setting the value of stock shares. Federal Reserve Board Chairman Alan Greenspan surfaced this issue, and began a firestorm of national debate, six years ago by asking the Fed: “How do we know when irrational exuberance has unduly escalated asset values?”
Negotiation of an actual sales transaction is the only effective way to reconcile buyer and seller valuations, and recent rapid shifts in perceived stock value have made it even more difficult for traders to reach a meeting of the minds. Nearly every value model relies heavily on stock “fundamentals,” but each emphasizes different performance metrics such as earnings, price-to-earnings ratio, profit growth, or return on assets.
One important distinction among valuation models is that some focus on historical trailing indicators and use them to assign a current value for a stock, and other models utilize more speculative leading indicators to assign a current stock value based on potential future returns. Within each of these two camps there are methods that set stock value on the basis of earnings, revenues, dividend yield, cash flow, asset equity, or value of a subscriber base. Given these substantial differences in assumptions and foundation data, it’s not surprising that we see dramatic swings in estimated stock values and selling prices.
Over the past several decades I’ve seen a series of shifts in valuation schemes employed by mainstream investors ranging from mutual funds to individual day traders. More and more frequently we see major bounces, up or down, in stock prices that are triggered by national events or by revelations from the investment guru of the day.
Almost immediately, investor sentiment becomes a hot-button issue for CEOs and corporate boards. They translate the resulting new priorities into company policies and incentives and then they realign the organization to maximize this season’s preferred metric. Any improvement in the target metric often comes at the expense of the other so-called fundamentals. The CTO may be compelled to absorb major impacts to R&D goals or to discretionary investments in R&D or even slowdowns in product development. Other C-level officers may see changing expectations in levels of oversight, productivity goals, or capital investment. The ripple effects eventually impact nearly every employee.
Just as we see in the stock market, there are major cycles and minor cycles in shifting valuation trends. The regulatory environment is a driving factor in major cycles, as we’re seeing now. New requirements for certification of corporate balance sheets by the CEOs of nearly 1,000 large companies are a direct response to the loss of investor confidence in corporate integrity. Related congressional legislation will require much more detailed reporting and reconciliation of earnings statements from all 14,000 publicly traded companies.
Clearly the regulatory pendulum has shifted from a climate of widespread deregulation back toward increased oversight. I saw a similar regulatory shift in the 1980s when the sitting director of NASA was indicted for improper R&D accounting in his prior position as a corporate CTO. (Never mind that the Federal trial judge eventually dismissed all charges several costly years after the CTO’s forced resignation.) Just as we’re seeing now, when the pendulum changed direction it caught a lot of executives off guard and rippled through all corporate levels. Bear in mind that your actions as a CTO today will have to withstand being measured against future standards that may be based on completely different values — quite different.
The minor cycles reflect the passing fashions in determining equity values. In recent years, CTOs have been repeatedly reoriented by their boards to maintain stock prices by contributing this year to forecasted growth, profit margins, price-to-earnings, return on net assets, profit after taxes, reinvestment, or even inventory turnover. When a metric-of-the-year emerges, it usually spawns a cottage industry of consultants who claim to be able to drive that metric to high values. Survival of a company can depend on how effectively we manage investor perceptions of current and forecasted company performance.
The longer-term challenge is to avoid sacrificing performance for the fundamental metrics that don’t happen to be popular this year. Besides satisfying the board and the investment community with excellent performance on their hot-button metric, balanced performance across the full set of fundamental metrics provides the strongest possible foundation for rational exuberance.
