What drives value in the stock market?

Long-term investors don’t really care about short-run price fluctuations, because when they invested their money, they saw long-lasting value in the companies they bought. However, investing this way is easier said than done: as investors, we should be able to distinguish between value-creating initiatives, and value-destroying ones. The key to success is to invest in the former, and discard the latter. Since share prices are determined by dividing the fair value of the company by the amount of shares outstanding, it’s important to be able to understand what drives value: by doing so, it will be easier to spot opportunities, better evaluate companies and understand price movements.

Basically, the way companies create value for their owners is by investing cash in the present, in the hope to generate more in the future. Then, the amount of value created isn’t anything more than the difference between expected future cash inflows and the investment cost, obviously adjusted to reflect the time value of money: in short, tomorrow’s cash is worth less than today’s. Therefore, we can conclude that the amount of value a company creates is ultimately determined by its return on invested capital (ROIC), revenue growth and the ability to sustain both over time. Newer investors may be tempted to think that as a company grows, it naturally improves its ROIC: however, that is true only for young, start-up businesses. It almost never happens for mature businesses.

In order to create value, a company must have its ROIC higher than its cost of capital: indeed, growth at lower returns reduces a company’s value. At any level of growth, an improvement in ROIC always increases the company’s value, as it reduces the investment required for growth. In other words, all else being equal, the higher the ROIC, the better. The same cannot be said for growth: indeed, when ROIC is high, faster growth increases value, but when ROIC is lower than the cost of capital, faster growth actually destroys value. When the return on invested capital is lower than the company’s cost of capital, growing faster means investing more at value-destroying returns. We can conclude that for high-ROIC companies, the best strategy to generate additional value is to increase their growth rate, while for low-ROIC companies, the best value-creation strategy is to focus on improving this metric.

It seems logical to expect some kind of agreement in the industry on something as fundamental as value, but this isn’t the case: indeed, many executives, board and financial media are still treating accounting earnings and value as if they were the same thing, focusing obsessively on improving that specific metric. That’s why prices move so much after the release of EPS results. However, while earnings and cash flows are often correlated, the former isn’t enough to understand the value creation process. If all companies in an industry earned the same ROIC, then earnings growth would be the differentiating metric, because in that case only growth would determine differences in companies’ cash flow.

Focusing too much on earnings growth often lead companies to actually stray from value creation. Basically, there are five kinds of growth strategies that a company can follow: introduction of new products, expansion of an existing business, increase in share of a growing market, competition for share in a stable market or acquisition of businesses. Typically, the strategy that creates the most value for shareholders is the introduction of new products, while acquisitions create the least. Indeed, strategies based on organic new product development don’t require much new capital and, furthermore, the investments to produce new products are not required all at once. By contrast, acquisitions require that the entire investment is made up-front, reflecting the expected cash flows from the target, plus a premium to beat other bidders. Therefore, even if the acquirer is able to improve the target so to generate an attractive ROIC, typically the rate of return is just slightly higher than its cost of capital.

Finally, the management has to consider the method by which it chooses to improve ROIC. Indeed, a company can increase ROIC by either improving profit margins or improving capital productivity: with respect to future growth, it doesn’t matter which of these paths a company emphasizes. However, for current operations, at moderate ROIC levels margin improvement will have a higher impact on value compared to capital productivity improvement. At high levels of ROIC, the effect of margin improvement will be even higher.

As we said at the beginning of this article, value is driven by discounted cash flows. Therefore, a corollary of this principle is that anything that doesn’t increase cash flows, doesn’t create value. That means that value is unchanged when a company changes the ownership of claims to its cash flows, but doesn’t change the total available cash flows: for example, value is conserved when the company substitutes debt for equity, or issues debt to repurchase shares. Similarly, changing the appearance of cash flows without actually changing them, for example by using accounting witchery, doesn’t change the value of the company. As smart investors are already well aware of this principle, they do not care if information is recorded, for example, as an expense or disclosed in the footnotes: they know what to do with that information regardless.

Out of the common ways to increase value easily, even though only apparently, there are share repurchases, acquisitions and financial engineering.

Starting with share repurchases, while it is often a good thing for management to do, a common fallacy is thinking they create value simply because, as a consequence, earnings per share (EPS) is increased. Unfortunately, this doesn’t square with the conservation of value, because the total cash flows of the business is remained unchanged. Moreover, it’s worth noting that the company could have invested the cash rather than returning it to shareholders: if the return on capital from the investment exceeded the company’s cost of capital, it’s likely that the longer-term EPS would be higher from the investment than from the share repurchases. Therefore, while share repurchases increase EPS immediately, they risk lowering long-term earnings. However, when the likelihood of investing cash at low returns is high, share repurchases make sense as a tactic for avoiding value destruction. Buying back shares when they are undervalued may be good for the shareholders who don’t sell. However, studies of share repurchases have shown that companies aren’t superb at timing share repurchases, often buying when their share prices are high rather than low.

Moving to acquisitions, they create value only when the combined cash flows of the two companies increase due to cost reductions, accelerated revenue growth, or better use of fixed and working capital. Many executives and bankers believe that once A buys B, the stock market will apply A’s P/E to B’s earnings. In the United States, this thinking is called “multiple expansion”, while in the United Kingdom “rerating”. However, that’s false. If it was true, all acquisitions would create value because the P/E on the lower-P/E company’s earnings would rise to that of the company with the higher P/E, regardless of which was the buyer or seller: sadly, there’s no data available to support this idea. Multiple expansion may sound great, but it is an entirely unsound way of justifying an acquisition that doesn’t have tangible benefits. Furthermore, if the acquirer’s management doesn’t specific the sources of increased revenues from the acquisition, the market won’t value the company differently than before.

Finally, financial engineering, that McKinsey describes as the “use of financial instruments or structures other than straight debt and equity to manage a company’s capital structure and risk profile”. Financial engineering can include the use of derivatives, structured debt, securitization, and off-balance-sheet financing. While some of these activities can create real value, most don’t. Even so, the motivation to engage in non-value-added financial engineering remains strong because of the short-term, illusory impact. As always, it’s important to remember that anything that doesn’t increase discounted cash flows, is not creating value.

This article was originally written by Matteo Marinelli, on Blackink Research’s blog on March 29th, 2022. You can find the original version here.