Ibexx,
Thanks for that link.
Here's another one. Both Intel & Microsoft are discussed in this excellent article:
Shareholder Scoreboard:
Three Ways Stock-Market Investors Can Stack the Odds in Their Favor
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By Alfred Rappaport
Special to The Wall Street Journal
Don't be lulled into complacency by the long-running bull market. Although
disciplined analysis may seem less important for investors now than when
prices are falling, just the opposite is true.
Of course, investors have enjoyed an unprecedented run in the stock market.
Despite periods of breathtaking volatility, the Dow Jones Industrial Average and
Standard & Poor's 500-stock index each had an annual average return of more
than 30% during the past three years.
But only those infected with irrational exuberance believe this level of
performance to be sustainable. Current stock prices already incorporate
expectations of a bright future consisting of low interest rates and robust
increases in corporate cash-flow generation. Stock-market returns are likely to
be closer to the historical average of about 11% a year for the next decade.
If you actively manage your own stock portfolio, you can't afford to relax.
Disciplined analysis that addresses the risk of unfavorable performance
surprises is always appropriate. But it is even more crucial when formidable
growth and operating-margin assumptions are needed to justify stock prices.
Here are three ways to improve your chances of owning stocks that will earn an
A or B rating on future Shareholder Scoreboards.
Investors seeking superior long-term returns should ignore the quarterly
earnings mating dance between management and analysts. It is best to
remember that cash is a fact, earnings an opinion.
Shareholder returns are driven by two fundamental factors: changes in investor
expectations about a company's future cash flows and changes in interest rates
that affect the appropriate rate for discounting those cash flows.
Reported earnings, on the other hand, measure a company's past performance
and can be misleading.
For one thing, earnings growth can take place at the same time shareholder
value is being destroyed because of excessive investment in fixed and working
capital.
Companies also have become adept at delivering quarterly earnings in line with
Wall Street expectations by guiding analysts' estimates before earnings are
announced or by "managing earnings" with alternative but equally acceptable
accounting methods.
The 29% plunge in Oracle Corp.'s stock price Dec. 9, following a disappointing
earnings report, has added to the belief among some managers and investors
that stock prices are strongly influenced, if not totally determined, by short-term
earnings. But a different picture emerges if the market's response to the Oracle
announcement is interpreted properly.
The determining factor is whether an earnings report provides new information,
negative or positive, about a company's long-term cash-flow prospects. When,
as in Oracle's case, a disappointing earnings announcement is seen as a
harbinger of the future, the stock price will sink.
In contrast, restructuring announcements disclosing management's intention to
cut its losses and exit from value-decreasing businesses are almost invariably
accompanied by significant write-downs in current earnings and increases in
share prices. The market responds not to the unexpected decrease in earnings
but to the favorable longer-term consequences of allocating corporate funds to
higher-valued uses.
The fact that earnings and shareholder returns don't necessarily move together
shouldn't come as a surprise in light of the fundamental differences between
reported earnings and economic value. In a study conducted with LEK/Alcar
Consulting Group LLC, we found 65 S&P 500 companies that reported
decreasing earnings per share during the past three years while achieving annual
shareholder returns as high as 40%. The same study also found 16 companies
with growing earnings per share and negative shareholder returns during
1995-97, a period in which the annual return on the S&P 500 was a remarkable
31%.
Most investors evaluate a company's past performance to estimate its future
performance. The most successful investors will take this a step further by
looking at how a company is likely to perform relative to how it is expected to
perform. Only the investor who correctly anticipates changes in a company's
prospects that aren't reflected in the current stock price will earn superior
returns.
Investing in companies with extraordinary growth records isn't the answer, nor
is investing in companies with last year's best Shareholder Scoreboard rankings.
After all, if the competitive advantages that these companies enjoy are
incorporated fully in their current stock price, one should expect to earn no
more than an average return. High-expectations stocks also leave little room for
disappointing performance.
Investing in a stock because it sells at a relatively low price/earnings ratio may
not be the answer either. A stock is no bargain if the market's low expectations
are warranted.
The key lies in determining the level of future performance implied by the stock
price and then assessing whether the company's performance is likely to trigger
an increase in market expectations. Take a look at two well-known favorites,
Intel Corp. and Microsoft Corp., whose shareholders earned average compound
annual total returns during the past five years of 45.7% and 43.4%,
respectively.
Both companies achieved these spectacular shareholder returns when the
growth of pretax operating profit substantially exceeded expectations. Because
tax and investment rates are generally stable, growth in pretax operating profit
serves as a good proxy for the fundamental driver of value, cash-flow growth.
At the end of 1992, Value Line Investment Survey forecast a 15% growth rate
for Intel. To justify Intel's share price at the beginning of 1993, the 15% growth
would have had to last eight years. In other words, buyers of Intel shares
essentially were betting that Intel's operating performance would persuade the
market to increase its expectations of 15% growth for eight years.
Shareholders were well rewarded when Intel's pretax operating profit achieved a
1993-97 growth rate of 43%. At the end of 1997, Intel stock implied an
expected growth of 16% for a period of seven years. Today's investor will earn
superior returns only if better-than-expected results cause the market to
increase its current expectations.
While 16% growth is well below Intel's recent performance, this growth rate
must be achieved for a much larger company facing new challenges. With the
rapid growth of below-$1,000 personal computers, Intel will be selling cheaper
chips. Can the company increase volume enough to offset lower-margin chips?
Can Intel maintain its technological lead over its competitors? How soon and
how steep will the predicted slowdown in the computer industry be?
In Microsoft's case, can the 23% growth in pretax operating profit implied by
its share price be sustained in light of the company's continuing antitrust battle?
The prudent investor, recognizing that the past five- and 10-year returns for
Intel and Microsoft are unlikely to be repeated, will instead carefully assess the
reasonableness of expectations embedded in the current stock price.
Stock prices also are affected by changes in interest rates, which, in turn, affect
how investors price a company's expected cash flows. For many companies,
the decline in interest rates, rather than a positive change in performance
expectations, explains much of their recent stock gains. However, forecasting
interest rates for purposes of selecting individual stocks is a losing game. Shifts
in interest rates affect all stocks, albeit to different degrees.
To earn a competitive return, focus on performance expectations. Those who
feel strongly about the probable direction of interest rates can always rebalance
their current mix of stocks, bonds and cash.
No corporate decision can move the stock price as quickly or as drastically as a
major acquisition. Deregulation, excess capacity and the race for dominant
market share will continue to fuel industry consolidation via mergers and
acquisitions in 1998 and beyond. But shareholders won't necessarily benefit.
Indeed, with acquiring companies paying premiums averaging 40% to 50%
more than the market capitalization of the companies they buy, it comes as no
surprise that an acquirer's stock routinely falls upon the announcement of the
transaction. Mark L. Sirower, a professor of management at New York
University, found that since the late 1970s, the "synergy discount" -- the median
loss of market value at announcement date divided by the acquisition premium
-- has been close to 50%. For example, a company that pays a $2 billion
premium has, on average, seen its market value decrease by $1 billion.
Value is created for shareholders only if expected synergies are greater than the
acquisition premium. If investors come to believe that a large proportion of the
synergy expectations embedded in the premium are unlikely to be realized, the
acquirer's shares will correspondingly decrease.
The premium represents the shareholder-value-at-risk (SVAR), or the loss of
value if no synergies materialize. To estimate the relative magnitude of this risk,
divide the acquisition premium by the preannouncement market value of the
acquiring company to obtain the SVAR%. Think of the SVAR% as a
bet-the-company index. For example, the SVAR% for Starwood Hotels &
Resorts Trust's recent purchase of ITT Corp. is 58%, while WorldCom Inc. is
betting 28% of its value in its bid for MCI Communications Corp.
Synergies are easy to forecast but difficult to achieve. A high SVAR% doesn't
necessarily indicate a value-destroying acquisition. However, companies that
engage in SVAR%s of, say, 25% or more should be closely monitored or, for
the faint of heart, avoided.
What if one of your portfolio companies announces a high-SVAR% acquisition
and its share price falls before you can evaluate the situation? Say, for example,
the SVAR% is 25% and, upon announcement, the acquirer's shares drop by
5%.
This response suggests that investors expect the value of synergies to be 20%
less than the acquisition premium. If you believe that postmerger operating
improvements will more than offset the premium, then the shares are priced
attractively. On the other hand, if you believe the acquiring company will recoup
substantially less than 80% of the expected synergies, then selling before this
view is incorporated in the share price may be the best alternative.
There is no shortage of value-destroying acquisition examples. Quaker Oats
Co.'s purchase of Snapple Beverage Corp., AT&T Corp.'s acquisition of NCR
Corp. and Novell Inc.'s purchase of WordPerfect Corp. are three familiar to
many investors. Investors can't avoid bad acquisitions, but they can minimize
their damage by making the synergy bet explicit with SVAR% analysis. Better
yet, institutional investors with market clout should insist that management
conduct this analysis before committing to any major acquisition.
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Expectations vs. Reality
Annual growth in pretax operating income forecast at the end of 1992 and
number of years that growth rate would have had to continue to justify each
company's stock price at the beginning of 1993, vs. actual growth in
1993-1997. Also shown is growth rate and duration of that growth rate implied
by each company's stock price at the end of 1997.
INTEL MICROSOFT
'92 growth forecast 15% 20%
Growth duration (years) 8 7
Actual '93-'97 growth 43% 38%
Current growth forecast 16% 23%
Growth duration (years) 7 11
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Alfred Rappaport, Leonard Spacek professor emeritus at J.L. Kellogg Graduate
School of Management, Northwestern University in Evanston, Ill., conceived
the Shareholder Scoreboard. He is co-founder of Alcar Group Inc., whose
consulting and education practices are now part of LEK/Alcar Consulting Group
LLC. LEK/Alcar, an international strategy-consulting firm specializing in
corporate shareholder-value creation, performed the calculations for this special
section. Dr. Rappaport is the author of "Creating Shareholder Value: A Guide for
Managers and Investors" (Free Press, 1998). He lives in La Jolla, Calif. |
