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future will keep many firms honest, since the gains from any one-time wealth transfer are
likely to by outweighed by the reputation loss associated with such actions. These issues
will be considered in more detail later in the book.

The Firm and Financial Markets
There is an advantage to maintaining an objective that focuses on stockholder or
firm wealth, rather than stock prices or the market value of the firm, since it does not
require any assumptions about the efficiency or otherwise of financial markets. The
downside, however, is that stockholder or firm wealth is not easily measurable, making it
difficult to establish clear standards for success and failure. It is true that there are
valuation models, some of which we will examine in this book, that attempt to measure
equity and firm value, but they are based on a large number of essentially subjective
inputs on which people may disagree. Since an essential characteristic of a good objective
is that it comes with a clear and unambiguous measurement mechanism, the advantages
of shifting to an objective that focuses on market prices is obvious. The measure of
success or failure is there for all to see. Successful manager raises their firms™ stock price
and unsuccessful managers reduce theirs.
The trouble with market prices is that the investors who assess them can make
serious mistakes. To the extent that financial markets are efficient and use the
information that is available to make measured and unbiased estimates of future cash
flows and risk, market prices will reflect true value. In such markets, both the measurers
and the measured will accept the market price as the appropriate mechanism for judging
success and failure.
There are two potential barriers to this. The first is that information is the
lubricant that enables markets to be efficient. To the extent that this information is

hidden, delayed or misleading, market prices will deviate from true value, even in an
otherwise efficient market. The second problem is that there are many, both in academia
and in practice who argue that markets are not efficient, even when information is freely
available. In both cases, decisions that maximize stock prices may not be consistent with
long-term value maximization.

2.3. ˜: The Credibility of Firms in Conveying Information
Do you think that the information revealed by companies about themselves is usually
a. timely and honest?
b. biased?
c. fraudulent?

The Information Problem
Market prices are based upon information,
Public and Private Information: Public
both public and private. In the world of classical information refers to any information that
theory, information about companies is revealed is available to the investing public, whereas

promptly and truthfully to financial markets. In the private information is information that is
restricted to only insiders or a few
real world, there are a few impediments to this
investors in the firm.
process. The first is that information is sometimes
suppressed or delayed by firms, especially when it
contains bad news. While there is significant anecdotal evidence of this occurrence, the
most direct evidence that firms do this comes from studies of earnings and dividend
announcements made by firms. A study of earnings announcements, noted that those
announcements that had the worst news tended to be delayed the longest, relative to the
expected announcement date.17 In a similar vein, a study of earnings and dividend
announcements by day of the week for firms on the New York Stock Exchange between
1982 and 1986 found that the announcements made on Friday, especially after the close
of trading, contained more bad news than announcements made on any other day of the

17 Penman, S. H., 1987, The Distribution Of Earnings News Over Time And Seasonalities In Aggregate
Stock Returns, Journal of Financial Economics, v18(2), 199-228.

week.18 This suggests that managers try to release bad news when markets are least active
or closed, because they fear that markets will over react.
The second problem is a more serious one. Some firms, in their zeal to keep
investors happy and raise market prices, release intentionally misleading information
about the firm's current conditions and future prospects to financial markets. These
misrepresentations can cause stock prices to deviate significantly from value. Consider
the example of Bre-X, a Canadian gold mining company that claimed to have found one
of the largest mines in the world in Indonesia in the early 1990s. The stock was heavily
touted by equity research analysts in the United States and Canada, but the entire claim
was fraudulent. When the fraud came to light in 1997, the stock price tumbled, and
analysts professed to be shocked that they had been misled by the firm. The more recent
cases of Enron, WorldCom and Parmalat suggest that this problem is not restricted to
smaller, less followed companies and can persist even with strict accounting standards
and auditing oversight.
The implications of such fraudulent behavior for corporate finance can be
profound, since managers are often evaluated on the basis of stock price performance.
Thus Bre-X managers with options or bonus plans tied to the stock price probably did
very well before the fraud came to light. Repeated violations of investor trust by
companies can also lead to a loss of faith in equity markets and a decline in stock prices
for all firms.

2.4. ˜: Reputation and Market Access
Which of the following types of firms is more likely to mislead markets?
a. Companies that access markets infrequently to raise funds for operations - they raise
funds internally.
b. Companies that access markets frequently to raise funds for operations

18 Damodaran, A., 1989, The Weekend Effect In Information Releases: A Study Of Earnings And
Dividend Announcements, Review of Financial Studies, v2(4), 607-623.

2. The Market Problem
The fear that managers have of markets over reacting or not assimilating
information well into prices may be justified. Even if information flowed freely and with
no distortion to financial markets, there is no guarantee that what emerges as the market
price will be an unbiased estimate of true value. In fact, there are many who would argue
that the fault lies deeper and that investors are much too irrational and unreliable to come
up with a good estimate of the true value. Some of the criticisms that have been mounted
against financial markets are legitimate, some are overblown and some are flat out
wrong, but we will consider all of them.
1. Financial markets do not always reasonably and rationally assess the effects of
new information on prices. Critics using this line of argument note that markets
can be volatile, reacting to no news at all in some cases; in any case, the volatility
in market prices is usually much greater than the volatility in any of the
underlying fundamentals. The argument that financial markets are much too
volatile, given he underlying fundamentals, has some empirical support.19 As for
the irrationality of markets, the frequency with which you see bubbles in markets
from the tulip bulb mania of the 1600s in Holland to the dot-com debacle of the
late 1990s seems to be proof enough that emotions sometime get ahead of reason
in markets.
2. Financial markets sometimes over react to information. Analysts with this point
of view point to firms that reports earnings that are much higher or much lower
than expected and argue that stock prices jump too much on good news and drop
too much on bad news. The evidence on this proposition is mixed, though, since
there are other cases where markets seem to under react to news about firms.
Overall, the only conclusion that all these studies agree on is that markets make
mistakes in assessing the effect of news on value.
3. There are cases where insiders move markets to their benefit and often at the
expense of outside investors. This is especially true with illiquid stocks and is
exacerbated in markets where trading is infrequent. Even with widely held and

19 Shiller , R. J., 2000, Irrational Exuberance, Princeton University Press, Princeton.

traded stocks, insiders sometimes use their superior access to information to get
ahead of other investors.20
Notwithstanding these limitations, we cannot take away from the central contribution of
financial markets. They assimilate and aggregate a remarkable amount of information on
current conditions and future prospects into one measure -- the price. No competing
measure comes close to providing as timely or as comprehensive a measure of a firm's
standing. The value of having market prices is best illustrated when working with a
private firm as opposed to a public firm. While managers of the latter may resent the
second-guessing of analysts and investors, there is a great deal of value to knowing how
investors perceive the actions that the firm takes.

2.5. ˜: Are markets short term?
Focusing on market prices will lead companies towards short term decisions at the
expense of long term value.
a. I agree with the statement
b. I do not agree with this statement
Allowing managers to make decisions without having to worry about the effect on market
prices will lead to better long term decisions.
a. I agree with this statement
b. I do not agree with this statement

Illustration 2.4: Interaction with financial markets “ A Case Study with Disney
The complex interaction between firms and financial markets is best illustrated by
what happens around earnings announcements. Consider, for instance, Disney™s earnings
report for the last quarter of 2002 that was released to financial markets on February 1,
2003. The report contained the news that net income at the company dropped 42% from
the prior year™s level. The stock price increased by about 2% on the announcement of this
bad news, because the reported earnings per share of 17 cents per share was higher than
the 16 cents per share expected by analysts.

20 This is true even in the presence of strong insider trading laws, as is the case in the United States. Studies
that look at insider trades registered with the SEC seem to indicate that insider buying and selling does
precede stock prices going up and down respectively. The advantage is small, though.

There are several interesting points that are worth making here. The first relates to
the role that analysts play in setting expectations. In early 2003, for example, there were
17 analysts working at brokerage houses and investment banks who provided estimates of
earnings per share for Disney.21 The lowest of the estimates was 13 cents per share, the
highest was 20 cents per share and the average (also titled consensus) estimate was for 16
cents per share. The second relates to the power of expectations. Any news that a
company reports has to be measured relative to market expectations before it can be
categorized as good or bad news. Thus, a report of a drop in earnings (as was the case
with Disney for the last quarter of 2002) can be good news because it did not drop as
much as expected. Conversely, Disney reported an increase of 12% in earnings for the
last quarter of 2003 (in February 2004) and saw its stock price decline slightly on the
news because the increase was smaller than expected.

In Practice: Are markets short term?
There are many who believe that stock price maximization leads to a short-term
focus for manager - see for instance Michael Porter™s book on competitive strategy. The
reasoning goes as follows: Stock prices are determined by traders, short term investors
and analysts, all of whom hold the stock for short periods and spend their time trying to
forecast next quarter's earnings. Managers who concentrate on creating long-term value,
rather than short-term results, will be penalized by markets. Most of the empirical
evidence that exists suggests that markets are much more long term than they are given
credit for:
1. There are hundreds of firms, especially small and start-up firms, which do not have
any current earnings and cash flows, do not expect to have any in the near future, but
which are still able to raise substantial amounts of money on the basis of
expectations of success in the future. If markets were in fact as short term as the
critics suggest, these firms should be unable to raise funds in the first place.

21 These analysts are called sell-side analysts because their research is then offered to portfolio managers
and other clients. The analysts who work for mutual funds are called buy side analysts and toil in relative
obscurity since their recommendations are for internal consumption at the mutual funds and are not

2. If the evidence suggests anything, it is that markets do not value current earnings and
cash flows enough and value future earnings and cash flows too much. Studies
indicate that stocks with low price-earnings ratios, i.e., high current earnings, have
generally been under priced relative to stocks with high price-earnings ratios.
3. The market response to research and development and investment expenditure is not
uniformly negative, as the 'short term' critics would lead you to believe. Instead, the
response is tempered, with stock prices, on average, rising on the announcement of
R&D and capital expenditures.
Do some investors and analysts focus on short term earnings and not on long term
value? Of course. In our view, financial managers cater far too much to these investors
and skew their decisions to meet their approval, fleeting though it might be.

The Firm and Society
Most management decisions have social consequences, and the question of how
best to deal with these consequences is not easily answered. An objective of maximizing
firm or stockholder wealth implicitly assumes that the social side-costs are either trivial
enough that they can be ignored or that they can be priced and charged to the firm. In
many cases, neither of these assumptions is justifiable.
There are some cases where the social costs are considerable but cannot be traced
to the firm. In these cases, the decision-makers, though aware of the costs, may choose to
ignore the costs and maximize firm wealth. The ethical and moral dilemmas of forcing a
managers to choose between their survival (which may require stockholder wealth
maximization) and the broader interests of society can be debated but there is no simple
solution that can be offered in this book.
In the cases where substantial social costs exist, and firms are aware of these
costs, ethicists might argue that wealth maximization has to be sublimated to the broader
interests of society, but what about those cases where firms create substantial social costs
without being aware of these costs? John Manville Corporation, for instance, in the fifties
and sixties produced asbestos with the intention of making a profit, and was unaware of
the potential of the product to cause cancer. Thirty years later, the lawsuits from those
afflicted with asbestos-related cancers have driven the company to bankruptcy.

To be fair, conflicts between the interests of the firm and the interests of society
are not restricted to the objective of maximizing stockholder wealth. They may be
endemic to a system of private enterprise, and there will never be a solution to satisfy the
purists who would like to see a complete congruence between the social and firm

2.6. ˜: Can laws make companies good citizens?
It has often been argued that social costs occur because governments do not have
adequate laws on the books to punish companies that create social costs. The follow-up is
that passing such laws will eliminate social costs.
a. I agree with the statement
b. I do not agree with this statement

Illustration 2.5: Assessing Social Costs
The ubiquity of social costs is made clear when we look at the three companies
we are analyzing “ Disney, Aracruz and Deutsche Bank. These companies, in spite of
their many differences, have social costs to consider:
Disney was built and continues to market itself as the ultimate family oriented

company. When its only businesses were theme parks and animated movies, it
faced relatively few conflicts. With its expansion into the movie business and
television broadcasting, Disney has exposed itself to new problems. To provide an


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