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A visitor's stock toll is the clearest measure out of market expectations about its functioning. Notwithstanding in a 1984 Louis Harris poll of summit executives from more than 600 companies, fewer than 1-third thought the market fairly valued their company's stock. Tellingly, only 2% thought their stock was overvalued, while a dramatic threescore% said the market place undervalued their shares. My work with executives non but confirms the pervasiveness of the belief that the market place undervalues companies simply also demonstrates that it is generally unsupported by analysis.

While managers are interested in how the market values their companies, they are skeptical of a procedure that seems to depend on an unseen analyst'due south prophecies about a very uncertain future. If a visitor'due south management can't effigy out what's going to happen, how tin can the market? Moreover, managers contend that value is sensitive to different assumptions near the economy, the competitive dynamics of the industry, and the company's strategic position.

Information technology is time to reconcile management and market values. In an economic environment dominated past corporate takeovers and restructurings, managers tin no longer be concerned simply virtually whether the company's shares are over- or undervalued. Sophisticated managers take begun to realize that they should not continually contend over what the stock market has to say. They have found they tin can learn a lot if they analyze what the stock price tells them about the market place's expectations for their company's performance.

My research and consulting work has demonstrated that the market place tin can, for example, give management information on whether the company is valued as a going concern or on the ground of some predictable breakup value. By interpreting marketplace signals, management tin compare its expectations with the market'due south. More than important, management can better evaluate its operational and financial restructuring alternatives. I have brought together these findings into a "market signals approach" that provides a systematic manner to interpret marketplace expectations.

To illustrate what the approach tin can do, permit's await at one large company that was rumored to exist a takeover target and is currently undergoing significant restructuring. During the beginning half of 1986, the company'south stock outperformed the overall market by a wide margin. Direction was pleased but puzzled by this sudden enthusiasm.

To sympathise the market place's response, management gathered data from publications like Value Line most analysts' forecasts for the visitor's sales growth, operating turn a profit margins, income revenue enhancement rate, working majuscule investment, and fixed capital investment. (I call these indicators "value drivers" considering they are the basis for whatsoever analysis of shareholder value.) Management then corroborated these estimates with those of the three or 4 manufacture analysts it considered all-time at evaluating the company. Information technology used these figures to come up up with estimates of time to come greenbacks flows and to develop a consensus description of what the market thought was the company's nearly probable future.

To justify the $50 per share price enjoyed in early 1986, management constitute that the market place expected the company to perform at the levels projected for these value drivers for 10 years. Thereafter, the visitor was expected to invest at its cost of capital. (In other words, the $50 stock price represented the present value of a ten-year cash period projection using the value-driver forecasts plus the present value of the cash menstruum level reached at the end of x years.) Because the visitor's five-twelvemonth plan projections were very close to Wall Street's, management decided the marketplace had valued the company fairly at the offset of 1986, and that it was not in imminent danger of beingness more radically restructured past a raider.

Then, in mid-1986, the company's stock toll increased by 50%, to $75 per share, while the overall market went up past only 20%. Conspicuously, the market expected a much higher level of operating performance—something beyond management'south reach. The signals said the visitor would have to increase sales growth from 8% to slightly over 11% or raise operating margins from 12% to over 16%.

At the same time market expectations were shifting, interest rates were falling—a fall that also buoyed the company'south share cost. And so management extended its assay to encounter what portion of the increment (from $50 to $75 per share) was due to the drop in interest rates. The assay demonstrated that only about $5 of the $25 per share increase was due to the interest rate change. That meant that $20 was due to the marketplace's anticipation of a major restructuring. Further investigation showed that fifty-fifty though the stock was traded at about $75, street estimates of the company's breakdown value ranged from $85 to $100 per share.

The market was sending out two powerful signals. First, $20 of the $75 per share cost was due to predictable restructuring decisions bachelor to management. Second, the spread between the company's breakdown value and its electric current market value showed just how vulnerable the company was to takeover. To minimize this threat, management decided it had to increase the company'due south stock cost. The marketplace would respond just if management provided persuasive evidence that it had started to restructure, either by divesting or spinning off underperforming businesses or by repurchasing stock.

In short, management could estimate future corporate performance by comparison the expectations implied past the current stock price with its own expectations, identifying the shortfall in its corporate plan, and then ferreting out restructuring opportunities to minimize the shortfall. On the other paw, if market place expectations appeared unduly small-scale, management would have a good opportunity to communicate information that enables the market to heighten its expectations.

Management can apply this kind of analysis in many facets of its piece of work to understand the level of accomplishment necessary for shareholders to earn their required charge per unit of return on visitor shares. Market place indicate analysis can help show the economic link betwixt internal functioning and likely returns to the company's shareholders. Agreement this relationship helps motivate managers and provides a focus for investor communications. Reconciling management and market expectations, particularly when there are significant disparities betwixt the two, is essential for corporate decisions on the issue of new shares, the repurchase of stock, possible divestments, and the financing of major investments including mergers.

Evaluating a Merger

In today'due south market, in that location is a limited supply of companies available at a price that would give the acquirer an adequate rate of return. To minimize the risks of buying an economically unattractive business or paying as well much for an bonny i, management must go across standard conquering analysis. Generally, the maximum acceptable cost for a target company is its stand-alone value plus the value of conquering benefits generated by operating, financial, and taxation synergies. Because of the doubt of value-driver forecasts (including the elapsing of the forecast period) direction sometimes justifies paying substantial premiums by applying a comfy qualitative label like "strategic fit," "market share opportunity," or "technological imperative."

This approach can be costly. Many of today's targets were yesterday's overly aggressive bidders. To found a maximum cost, management tin can apply market signal assay in conjunction with standard acquisition assay. Rather than beginning with forecasts to estimate the maximum adequate price, executives can get-go with a figure that'southward much easier to make up one's mind: the price it will have to brand a successful bid. Management tin use the required bid to establish the market'southward minimum expectations for the target visitor'southward postmerger performance.

To illustrate, let's look at the 1985 acquisition of General Foods by Philip Morris. General Foods traded for near $65 per share before the annunciation of the R.J. Reynolds-Nabisco merger in June 1985. The merger generated a flurry of speculative interest in other major food companies, and the price of GF'south stock jumped to nearly $80 per share. In October, Philip Morris acquired the company for $120 per share.

These stock prices tell us a bang-up deal about the market'due south expectations for GF's growth and profit-margin operation. Value Line's long-term projections for General Foods in the summer of 1985 called for half-dozen% sales growth and 7% operating profit margins. Coupled with estimates of investment requirements, revenue enhancement rates, and toll of capital, these projections suggested that to justify the $65 per share price, General Foods would have to perform at those levels for eight years; thereafter, the visitor would invest at its cost of capital rate.

Exhibit I shows the various combinations of sales growth and operating turn a profit margins needed to justify $65, $eighty, and $120 per share prices. It illustrates the trade-off between turn a profit margins and sales growth. It also shows the difference between what the market expected in terms of growth and profitability earlier the merger (shown at the $65 share cost) and the kinds of accomplishments GF would have to make to justify Philip Morris'southward final payment toll of $120 per share.

Showroom I Signals on General Foods

For case, to justify a $65 per share price, GF would need to combine a 6% sales growth rate with a 6.78% operating profit margin (this combination is marked with an ten). Interestingly, because GF invests at just to a higher place the price of capital (or economic break-even point), information technology must raise its sales growth rate considerably to offset even a small-scale subtract in operating turn a profit margin. For example, if the margins decreased from seven% to 6.5%, the sales growth rate would accept to go from 6% to 10% for the company's value to remain at $65 per share.

When GF'southward cost increased from $65 to $80 per share, the market signaled it wanted ameliorate performance. To justify that price, GF's 6% sales growth rate required that it increment its operating profit margin from seven% to almost eight%. Of course, the implied market expectations for an acquisition price of $120 per share are even more than dramatic. Bold no change in the vi% sales growth rate, GF's margin would have to exist over 10%. This kind of margin level is far above both GF's historical levels and securities analysts' near optimistic projections.

The acquisition cost curve translates the floor for value creation into operational terms like sales growth and profit margins. The buying company will create value for its shareholders only if the acquired company performs above the curve. Of grade, if the buyer intends to sell certain properties immediately after acquisition, it can subtract the proceeds from the acquisition price earlier plotting a bend, since such a sale would justify lower growth and margin requirements.

Hurdle Rate Analysis

For many managers, trying to decide what hurdle rates to fix for an investment is a nightmare.1 They know that even if a company successfully invests at a charge per unit higher than the toll of capital, the shareholders' rate of return may not be that high. Shareholders' returns depend on the difference between the expected level of company functioning (implied by the stock toll when shares are purchased) and subsequent operation. If the electric current stock price implies that the company can earn college returns than its cost of capital, and so lower subsequent performance will likely reduce market expectations and share toll, even if investments are fabricated above the cost-of-capital letter hurdle rate.

What this means is that a company's investors and managers become involved in investment decisions. Both groups want to achieve a maximum economic render for a given level of risk. Ultimately, however, their interests diverge on the required rate of render for a given project because investors and managers differ in their assay of ii factors: the relevant amount of investment and the forecasted cash flows. (Taken together in discounted cash flow analysis, these factors govern the economic charge per unit of render.)

The investment for a prospective shareholder (or opportunity investment for a current shareholder) is simply the current stock market price, which represents the discounted present value of all cash flows from expected every bit well every bit by corporate investments.

Shareholders invest in rights to fiscal claims—that is, dividends and uppercase appreciation. Managers, in contrast, make real investments in fixed and working uppercase. Unlike the shareholder who makes his unabridged investment when he purchases shares, investments in corporate strategies are made over a period of time. The company's initial investment is the capitalized value of its currently sustainable greenbacks flow, or its "prestrategy" value. Unlike marketplace value, the prestrategy value does not anticipate the economical value of futurity investments. Shareholder value is then the sum of the prestrategy value and the value created during the forecast period.

The shareholder and the manager as well have unlike views on relevant cash flows. The shareholder has a merits to all cash flows—those due from by likewise as prospective investments. Since past investments are sunk costs for a company, the corporate director worries only about the incremental cash flows associated with prospective investments.

If direction and the market accept identical forecasts, then the market price equals the prestrategy value plus the value created by the company's strategy. When the marketplace price is college than the prestrategy value, the market place expects management to invest above the cost of capital or the investor-required rate of return. If, after the shareholder makes his investment, the market thinks direction volition invest at (rather than above) the cost of capital, share cost volition decline and the shareholder will earn less than the required rate.

Reading expectations

The movement of IBM's stock price in 1986 illustrates how management can "read" market expectations virtually hurdle rates. I used the Value Line Investment Survey Study of November 7, 1986 to approximate these expectations. This study presented the post-obit estimates for IBM for 1987 to 1991.

To simplify the instance, I accept assumed these rates volition be constant for the entire forecast menses.

IBM offset its total debt of about $iv billion by a similar amount of marketable securities. Because IBM is financed almost entirely past equity, its cost of equity and overall cost of capital are nearly identical.

IBM's share price in Nov 1986 was $128 per share. To justify that price, IBM would have to perform at the projected levels for a period of six years; thereafter the visitor could invest in strategies that would yield a 12% cost of majuscule.

For an investor to earn a 12% rate of return at a $128 per share price, IBM's corporate rate of return must be 23.six%. I call the departure in these figures (xi.6%) the market expectations premium. IBM's prestrategy value of $78 per share represents about 61% of its $128 market price. The remaining 39% represents expectations that IBM will be able to invest at a rate in a higher place the cost of uppercase over the next six years. In effect, y'all can remember of 39% of the market cost as an investment in a "value growth option."

Finding your hurdle charge per unit

Management can use the marketplace signals approach to prepare hurdle rates. A comprehensive survey of 177 major U.S. companies found that more than 87% of the companies' chief financial officers used a weighted average price of majuscule equally their hurdle rate.2 The majority likewise used target capital letter structure weights. The approach employed nigh oftentimes to summate the cost of debt and equity was the render required by investors.

If IBM sets its hurdle rate at its 12% price of majuscule, and if its investment projects yield something near that figure, management will not be able to justify its stock price. Investing in a higher place the cost of majuscule—even at a rate below the 23.six% corporate charge per unit of return implied past the market price—is better, however, than distributing the investment funds equally dividends, because shareholders investing in similar run a risk opportunities elsewhere tin expect to earn no more the cost of capital letter rate.

The disparity between the hurdle charge per unit and the required corporate rate of return poses a problem for management. Some might fence that a 12% hurdle rate is only likewise low for a company whose price implies investment opportunities yielding an boilerplate of 23.half dozen%. If y'all think of the hurdle rate equally the minimum acceptable return, even so—and if management believes investments will yield approximately the rate implied by the marketplace price—then the 12% hurdle rate becomes more than reasonable.

Taking this disparity into account, direction should ask the post-obit questions: Are market expectations reasonable in low-cal of the company's long-term plans? At what level should hurdle rates exist gear up to maximize potential for value creation? If market expectations are unduly pessimistic or optimistic, the required corporate charge per unit of return implied by the market price volition exist correspondingly off. For example, analysis shows that if market estimates of IBM's sales growth rate and profit margin are besides high past 2% and 1% respectively, IBM's required corporate rate of return drops from 23.6% to 21%.

Once direction compares the corporate rate of return implied past the market with its ain forecast, it tin choose a target charge per unit of return. Then management must choose a hurdle rate that will both help the visitor accomplish the target charge per unit of return and maximize the company'southward potential for creating value.

An effective hurdle rate tin have a positive effect on management beliefs. Increasing a low hurdle charge per unit, for example, may encourage managers to seek investment opportunities in new products, additional capacity, and toll-reduction and replacement projects. Conversely, setting the hurdle rate at the toll of capital charge per unit may effectively limit motivation to seek new and riskier opportunities. Finally, setting the hurdle rate besides high may strength managers to exclude value-creating projects that are important to the visitor'due south time to come or may encourage them to exaggerate expected returns.

Understanding market expectations is essential to setting reasonable hurdle rates. Later on all, if investors are to earn their required rate of return, the overall rate of return on corporate strategies must be consistent with the expectations implied in the company's stock price.

Of class, only investing in projects that yield rates of return above the hurdle charge per unit does not guarantee corporate value creation, as capital letter budgeting projects business relationship for only a fraction of a visitor's expenditures. Direction should invest in strategies, not projects. Too ofttimes companies invest in high-yield projects that are embedded in economically unattractive strategies. Any appropriation requests coming from operating units should meet at to the lowest degree 2 tests. Beginning, each expenditure should exist consistent with a previously approved strategy. Second, the project should accept greater potential for value creation than any competing options. In brief, projects should back up strategies in the most productive fashion possible.

Evaluating Performance

The marketplace signals arroyo is besides useful in evaluating executive performance. Showroom Ii shows three rates of render that bear on the assessment of business: the cost of capital, the corporate rate of render implied by the company's stock price, and the corporate rate of return forecast by direction. The deviation between the price of capital and the corporate rate of return unsaid by the stock price represents a market expectations premium. In the IBM case, for instance, the difference between the 12% toll of upper-case letter and the market'southward implied corporate rate of return of 23.half dozen% produced a market place expectations premium of 11.6%. If IBM management were to forecast a 20% corporate rate of render based on its strategic plan, a "planning shortfall" of iii.half dozen% from market expectations would materialize.

Exhibit II Forecasts vs. expectations

By what standard should the business organization and its managers be evaluated? The cost of capital, the corporate charge per unit of return unsaid past the market price, and the corporate rate of return forecast by direction are all possibilities. One method is to evaluate and reward managers on the ground of value creation—for investing at a rate above the cost of capital. If the purpose of corporate strategy is to develop sustainable value creation, the company should advantage managers who contribute to this development.

If the corporate rate of render implied by the market price incorporates market place expectations, managers' and shareholders' interests volition coincide. If a visitor evaluates the executives by this standard, it should advantage them only when they see or exceed market expectations. One immediate problem is that managers may have proprietary data non bachelor to the market and may therefore believe that market expectations are either too robust or too small. In either case, they won't be happy with market expectations equally the basis for performance evaluation.

The company might besides use the corporate rate of return forecast past management as the standard of performance. Those who favor this approach fence that a sound plan emerging from a comprehensive competitive analysis is not only the well-nigh logical standard but also the i to which managers have made an organizational commitment.

In Perspective

Publicly held companies constantly interact with the stock market place through common signaling and monitoring. The company gives data to the market via published reports or investor relations campaigns. The market takes this and other data and incorporates its view of the company'due south futurity prospects in the stock price. The stock cost, in plough, is a bespeak to the company about the level of accomplishment expected if shareholders are to earn their required rate of render on the visitor'south shares.

Ultimately, there is no improve measure for corporate performance than stock price. Managements who ignore the important signals from stock toll—particularly in today'due south environment of corporate takeovers and restructurings—do so at their peril.

1. For a larger discussion of hurdle rates and performance, run into Creating Shareholder Value: The New Standard for Business Functioning (New York: Free Printing, 1986).

2. Lawrence J. Gitman and Vincent A. Mercurio, "Cost of Capital Techniques Used by Major U.S. Firms: Survey and Analysis of Fortune'due south thousand," Financial Management, Winter 1982, pp. 21–29.

A version of this article appeared in the November 1987 issue of Harvard Business organisation Review.