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voluntary disclosure. Accounting rules usually prescribe minimum disclosure require-
ments, but they do not restrict managers from voluntarily providing additional infor-
mation. These could include an articulation of the company™s long-term strategy,
speci¬cation of non¬nancial leading indicators which are useful in judging the effective-
ness of the strategy implementation, explanation of the relation between the leading in-
dicators and future pro¬ts, and forecasts of future performance. Voluntary disclosures
can be reported in the ¬rm™s annual report, in brochures created to describe the ¬rm to
investors, in management meetings with analysts, or in investor relations responses to
information requests.6
One constraint on expanded disclosure is the competitive dynamics in product mar-
kets. Disclosure of proprietary information on strategies and their expected economic
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17-9 Part 3 Business Analysis and Valuation Applications

consequences may hurt the ¬rm™s competitive position. Managers then face a trade-off
between providing information that is useful to investors in assessing the ¬rm™s eco-
nomic performance, and withholding information to maximize the ¬rm™s product market
A second constraint in providing voluntary disclosure is management™s legal liability.
Forecasts and voluntary disclosures can potentially be used by dissatis¬ed shareholders
to bring civil action against management for providing misleading information. This
seems ironic, since voluntary disclosures should provide investors with additional infor-
mation. Unfortunately, it can be dif¬cult for courts to decide whether managers™ disclo-
sures were good-faith estimates of uncertain future events which later do not materialize,
or whether management manipulated the market. Consequently, many corporate legal
departments recommend against management providing much voluntary disclosure.
Finally, management credibility can limit a ¬rm™s incentives to provide voluntary dis-
closures. If management faces a credibility problem in ¬nancial reporting, any voluntary
disclosures it provides are also likely to be viewed skeptically. In particular, investors
may be concerned about what management is not telling them, particularly since such
disclosures are not audited.

Selected Financial Policies
Managers can also use ¬nancing policies to communicate effectively with external in-
vestors. Financial policies that are useful in this respect include dividend payouts, stock
repurchases, ¬nancing choices, and hedging strategies. One important difference be-
tween this type of communication and additional disclosure is that the ¬rm does not pro-
vide potentially proprietary information to competitors. The signal therefore indicates to
competitors that a ¬rm™s management is bullish on its future, but it does not provide any

DIVIDEND PAYOUT POLICIES. As we discussed in Chapter 16, a ¬rm™s cash payout
decisions can provide information to investors on managers™ assessments of the ¬rm™s
future prospects. This arises because dividend payouts tend to be sticky, in the sense that
managers are reluctant to cut dividends. Thus, managers will only increase dividends
when they are con¬dent that they are able to sustain the increased rate in future years.
Consequently, investors interpret dividend increases as signals of managers™ con¬dence
in the quality of current and future earnings.7

STOCK REPURCHASES. In some countries, such as the U.S. and the U.K., managers
can use stock repurchases to communicate with external investors. Under a stock repur-
chase, the ¬rm buys back its own stock, either through a purchase on the open market,
through a tender offer, or through a negotiated purchase with a large stockholder. Of
course a stock repurchase, particularly a tender offer repurchase, is an expensive way for
management to communicate with outside investors. Firms typically pay a hefty premi-
694 Management Communications

Management Communications

um to acquire their shares in tender offer repurchases, potentially diluting the value of
the shares that are not tendered or not accepted for tender. In addition, the fees to invest-
ment banks, lawyers, and share solicitation fees are not trivial. Given these costs, it
is not surprising that research ¬ndings indicate that stock repurchases are effective
signals to investors about the level and risk of future earnings performance.8 Research
¬ndings also suggest that ¬rms that use stock repurchases to communicate with investors
have accounting assets that re¬‚ect less of ¬rm value and have high general information

FINANCING CHOICES. Firms that have problems communicating with external in-
vestors may be able to use ¬nancing choices to reduce them. For example, a ¬rm that is
unwilling to provide proprietary information to help dispersed public investors value it
may be willing to provide such information to a knowledgeable private investor”which
can become a large stockholder/creditor”or a bank that agrees to provide the company
with a signi¬cant new loan. A ¬rm with credibility problems in ¬nancial reporting can
sell stock or issue debt to an informed private investor such as a large customer who has
superior information about the quality of its product or service.
Such changes in ¬nancing and ownership can mitigate communication problems in
two ways. First, the terms of the new ¬nancing arrangement and the credibility of the
new lender or stockholder can provide investors with information to reassess the value
of the ¬rm. Second, the accompanying increased concentration of ownership and the
role of large block holders in corporate governance can have a positive effect on valua-
tion. If investors are concerned about management™s incentives to increase shareholder
value, the presence of a new block shareholder or signi¬cant creditor on the board can
be reassuring. This type of monitoring arises in leveraged buyouts, start-ups backed by
venture capital, and in ¬rms with equity partnership investments. In Japanese and Ger-
man corporations, it may also arise because large banks own both debt and equity and
have close working relationships with ¬rms™ managers.
Of course, in the extreme, management can decide that the best option for the ¬rm is
to no longer continue operating as a public company. This can be accomplished by a
management buyout, where a buyout group (including management) leverages its own
investment (using bank or public debt ¬nance), buys the ¬rm, and takes it private. The
buyout ¬rm hopes to run the ¬rm for several years and then take the company public
again, hopefully with a track record of improved performance that enables investors to
value the ¬rm more effectively.

HEDGING. An important source of mispricing arises if investors are unable to distin-
guish between unexpected changes in reported earnings due to management perfor-
mance and transitory shocks that are beyond managers™ control (e.g., foreign currency
translation gains and losses). Managers can counteract these effects by hedging such
“accounting” risks. Even though hedging is costly, it may be valuable if it reduces infor-
mation problems that potentially lead to misvaluation.
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17-11 Part 3 Business Analysis and Valuation Applications

Example: Other Communications for FPIC Insurance Group
On August 12, 1999, FPIC Insurance Group announced that it would immediately begin
purchasing shares of its common stock. As many as 429,000 shares were to be repur-
chased under the program. The company argued that the dramatic drop in its stock price
was unwarranted and that its stock was now greatly undervalued. William R. Russell,
president and chief executive of¬cer of FPIC stated: “We believe the recent drop in our
stock price may be linked to certain changes in our reserving policy that were described
in our earnings release. We believe that our reserving policy is now and has always been
appropriate. We believe that the market has overreacted and that FPIC continues to be an
excellent long-term investment. Our repurchases . . . re¬‚ect our commitment to enhance
shareholder value.” (Reuters, August 12, 1999)
The repurchase temporarily arrested FPIC™s stock price slide. The price recovered
from $21 to around $26 during the repurchase period. However, this effect was tempo-
rary, and the price subsequently fell further to $14.25.

Key Analysis Questions
For management considering whether to use ¬nancing policies to communicate
more effectively with investors, the following questions are likely to provide a use-
ful starting point for analysis:
• Have other potentially less costly actions, such as expanded disclosure or ac-
counting communication, been considered? If not, would these alternatives
provide a lower cost means of communication? Alternatively, if management
is concerned about providing proprietary information to competitors, or has
low credibility, these alternatives may not be effective.
Does the firm have sufficient free cash flow to be able to implement a share
repurchase program or to increase dividends? If so, these may be feasible op-
tions. If the firm has excess cash available today but expects to be constrained
in the future, a stock repurchase may be more effective. Alternatively, if man-
agement expects to have some excess cash available each year, a dividend in-
crease may be in order.
• Is the firm cash constrained and unable to increase disclosure for proprietary
reasons? If so, management may want to consider changing the mix of own-
ers as a way of indicating to investors that another informed outsider is bull-
ish on the company. Of course, one possibility is for management itself to
increase its stake in the company.
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Management Communications

This chapter discussed ¬rms™ strategies for communicating with investors. Communica-
tion with investors can be useful because managers typically have better information on
their ¬rm™s current and expected future performance than outside analysts and investors.
By communicating effectively with investors, management can potentially reduce this
information gap, lowering the likelihood that the stock will be mispriced or volatile. This
can be important for ¬rms that wish to raise new capital, avoid takeovers, or whose man-
agement is concerned that its true job performance is not re¬‚ected in the ¬rm™s stock.
The typical way for ¬rms to communicate with investors is through ¬nancial report-
ing. Accounting standards and auditing make the reporting process a way for managers
to not only provide information about the ¬rm™s current performance, but to indicate,
through accounting estimates, where they believe the ¬rm is headed in the future. How-
ever, ¬nancial reports are not always able to convey the types of forward looking infor-
mation that investors need. Accounting standards often do not permit ¬rms to capitalize
outlays that provide signi¬cant future bene¬ts to the ¬rm, such as R&D outlays.
A second way that management can communicate with investors is through non-
accounting means. We discussed several such mechanisms, including: meeting with ¬-
nancial analysts to explain the ¬rm™s strategy, current performance and outlook;
disclosing additional information, both quantitative and qualitative, to provide investors
with similar information as management™s; and using ¬nancial policies (such as stock
repurchases, dividend increases, and hedging) to help signal management™s optimism
about the ¬rm™s future performance.
In this chapter we have stressed the importance of communicating effectively with in-
vestors. However, ¬rms also have to communicate with other stakeholders, including
employees, customers, suppliers, and regulatory bodies. Many of the same principles
discussed here can also be applied to management communication with these other

1. Apple™s inventory increased from $1 billion on December 29, 1994, to $1.95 billion
one year later. In contrast, sales for the fourth quarter in each of these years in-
creased from $2 billion to $2.6 billion. What is the implied annualized inventory
turnover for Apple for these years? What different interpretations about future per-
formance could a financial analyst infer from this change? What information could
Apple™s management provide to investors to clarify the change in inventory turn-
over? What are the costs and benefits to Apple from disclosing this information?
2. a. What are likely to be the long-term critical success factors for the following
types of firms?
• a high technology company, such as Microsoft
• a large low-cost retailer, such as Kmart
b. How useful is financial accounting data for evaluating how well these two com-
panies are managing their critical success factors? What other types of informa-
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17-13 Part 3 Business Analysis and Valuation Applications

tion would be useful in your evaluation? What are the costs and benefits to these
companies from disclosing this type of information to investors?
3. Management frequently objects to disclosing additional information on the grounds
that it is proprietary. Consider the recent FASB proposals on expanding disclosures
on (a) executive stock compensation and (b) business segment performance. Many
corporate managers expressed strong opposition to both proposals. What are the po-
tential proprietary costs from expanded disclosures in each of these areas? If you
conclude that proprietary costs are relatively low for either, what alternative expla-
nations do you have for management™s opposition?
4. Financial reporting rules in many countries outside the U.S. (e.g., the U.K., Austra-
lia, New Zealand, and France) permit management to revalue fixed assets (and in
some cases even intangible assets) which have increased in value. Revaluations are
typically based on estimates of realizable value made by management or indepen-
dent valuers. Do you expect that these accounting standards will make earnings and
book values more or less useful to investors? Explain why or why not. How can
management make these types of disclosures more credible?
5. Under a management buyout, the top management of a firm offers to buy the com-
pany from its stockholders, usually at a premium over its current stock price. The
management team puts up its own capital to finance the acquisition, with additional
financing typically coming from a private buyout firm and private debt. If manage-
ment is interested in making such an offer for its firm in the near future, what are its
financial reporting incentives? How do these differ from the incentives of manage-
ment that are not interested in a buyout?
6. You are approached by the management of a small start-up company that is plan-
ning to go public. The founders are unsure about how aggressive they should be in
their accounting decisions as they come to the market. John Smith, the CEO, asserts:
“We might as well take full advantage of any discretion offered by accounting rules,
since the market will be expecting us to do so.” What are the pros and cons of this
7. Two years after a successful public offering, the CEO of a bio-technology company
is concerned about stock market uncertainty surrounding the potential of new drugs
in the development pipeline. In his discussion with you, the CEO notes that even
though they have recently made significant progress in their internal R&D efforts,
the stock has performed poorly. What options does he have to help convince inves-
tors of the value of the new products? Which of these options are likely to be fea-
8. Why might the CEO of the bio-technology firm discussed in Question 7 be con-
cerned about the firm being undervalued? Would the CEO be equally concerned if
the stock is overvalued? Do you believe that the CEO would attempt to correct the
market™s perception in this overvaluation case?
9. When companies decide to shift from private to public financing by making an ini-


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