n THE VALUE MANAGER who have gone through massive restructuring believe that it w 1 ve, as we discussed in the first chapter of this book, that restructuring and an active market for corporate control are now facts of corporate life. Con- managers need to ensure that they identify and act on value-creation opportunities regularly—not just once when the raider is knocking at the door, but on an ongoing basis. This is best done through fundamental changes in the way their bu: nesses are structured and operated. By acting now, value manag- ers can avoid the need to react under duress later. x - ca VaLv ation 3 Copeland Roller Morrin Cash Is King y “On October 1, 1974, the Wall Street Journal published an editorial “lamenting the widespread focus on earnings per share as an indicator of value: A lot of executives apparently believe that if they can figure out a ‘way to boost reported earnings, their stock prices will go up even if the higher earnings do not represent any underlying economic change. In other words, the executives think they are smart and the market is dumb. ‘The marke executive caug! smart. Apparently the dumb one is the corporate up in the earnings-per-share mystique. Unfortuni our experience shows that many corporate managers still worship earnings per share, and thus are still betting that the market is dumb. They do have good reasons for this belief. Earnings per share is a simple calculation that answers many business questions quite well. But the virtue of simplicity can also be a vice. Earnings per share ignores the effects of many natural or contrived peculiarities of accounting. It can therefore lead, or allow, managers to make choices that destroy value in the ong term, often without the short-term share price improvement they hoped for. ‘The key problem with maximizing accounting earnings can be demonstrated with an example of another common valuation B74 CASH IS KING, approach. Cable television companies are sometimes valued by placing a monetary value on each subscriber, say $2,000 each Using the number of subscribers as a comparable for share value suggests th. ter can be increased simply by signing up more subscribers. But if that is accomplished by slashing subscrib- er fees, for instance, value actually might be destroyed rather than increase The essential problem with the cable television dollars-per- subscriber approach is that it does not value what directly matters to investors. Investors cannot buy a house or car with subscribers. Nor can they use subscribers to make additional investments. Only the cash flow generated by the business can be used for consumption or additional investment. The price-per-subscriber approach is useful only when the number of subscribers is a good proxy for cash flow. That occurs only when all cable systems generate the same cash flow per subscriber. Similarly, accounting earnings is useful for valuation on) when earnings is a good proxy for the expected long-term cash flow of the company. Not all companies generate the same cash flow for each dollar of earnings, however, so earnings approaches are generally only useful for first-cut value approximations. They fail as a comprehensive management tool. As the Wall Street Journal editorial goes on to say, “To us the lesson is clear: If the manager keeps his eye on the long-run health of the enterprise, the stock price will take care of itself.” That message gives rise to a question: What valuation tool is most consistent with the goal of long-term value creation? We believe that the manager who is interested in maximizing share value should use discounted cash flow (DCF) analysis, not earnings per share, to make decisions. The DCF approach captures all the elements that affect the value of the company in a comprehensive yet straightforward manner. Furthermore, the DCF approach is strongly supported by research into how the stock markets actual ly value companies DCF CAPTURES ALL ELEMENTS OF VALUE Either explicitly or implicitly, all management decisions are based ‘on some valuation model. The manager tries to take those actions cf CAPTURES ALL ELEMENTS OF VALUE 75 that will increase the value of the company’s shares. Itis therefore to the manager's advantage to base his or her decisions on the model that most accurately reflects share value. We will show that the DCF approach—an economic model—provides a more so- phisticated and reliable picture of a company’s value than the }ecounting approach, although the latter is simpler and can be made to serve well in many instances. First, let's define the two competing valuation approaches that we will be comparing throughout this chapter. + In the accounting approach, all that matters is the accounting earnings of the business. Value is simply earnings times some multiple (the price-to-earnings or P/E ratio). In its extreme form, the accounting approach says that only this year’s or next year’s earnings matter. A more complex form discounts the future stream of earnings at some rate. + In the DCF approach, the value of a business is the future expected cash flow discounted at a rate that reflects the riskiness of the cash flow. A simple example will illustrate the difference between the two models. Exhibit 3.1 shows the projected income statements of two companies. Based on this accounting information, would you pay more for Longlife Company or Shortlife Company? Both the level and expected growth rates of earnings are identical, so most people would be inclined to pay the same price for both compa- nies. Exhibit 3.2 shows the projected cash flow statements for the two companies. Longlife Company uses manufacturing equip- ment that must be replaced every three years, while Shortlife Company uses equipment that must be replaced every year but costs one-third what Longlife’s equipment costs. In addition, Shortlife does a better job of collecting its receivables. Now which one would you pay more for? Most people would pay more for Shortlife, because most people prefer to have cash now rather than later. 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