A Better Way to Measure Operating Performance (or Why the EVA Math Really Matters)

Most companies rely heavily on earnings to measure operating performance, but earnings growth has at least two important weaknesses as a proxy for investor wealth. Current earnings can come at the expense of future earnings through, for example, short‐sighted cutbacks in investment, including spending on R&D. But growth in EPS can also be achieved by investing more capital with projected rates of return that, although well below the cost of capital, are higher than the after‐tax cost of debt. Stock compensation has been the conventional solution to the first problem because it's a discounted cash flow value that is assumed to discourage actions that sacrifice future earnings. Economic profit—in its most popular manifestation, EVA—has been the conventional solution to the second problem with earnings because it includes a capital charge that penalizes low‐return investment. But neither of these conventional solutions appears to work very well in practice. Stock compensation isn't tied to business unit performance—and often fails to provide the intended incentives for the (many) corporate managers who believe that meeting current consensus earnings is more important than investing to maintain future earnings. EVA doesn't work well when new investments take time to become profitable because the higher capital charge comes before the related income. In this article, the author presents two new operating performance measures that are likely to work better than either earnings or EVA because they reflect the value that can be lost either through corporate underinvestment or overinvestment designed to increase current earnings. Both of these new measures are based on the math that ties EVA to discounted cash flow value, particularly its division of current corporate market values into two components: “current operations value” and “future growth value.” The key to the effectiveness of the new measures in explaining changes in company stock prices and market values is a statistical model of changes in future growth value that captures the expected effects of significant increases in current investment in R&D and advertising on future profits and value.     

How to Create Value Without Earnings: The Case of Amazon

Investors and commentators often equate GAAP accounting metrics, especially earnings per share, with financial success. The reality, however, is that there is no simple, linear relationship between GAAP earnings and intrinsic value, which is defined as the present value of expected future cash flows. And adjustments of GAAP metrics, though admittedly subjective, are often required to understand the economic reality of a business. http://Amazon.com Inc. provides a case study that throws into sharp relief the need to look beyond GAAP in order to analyze underlying fundamentals and value. In this paper, the authors argue that Amazon has done a superb job of building shareholder wealth, all the while reporting low and declining operating and net income margins. The article provides a framework for thinking about Amazon's underlying profitability that is based on the concept of return on capital in relation to the cost of capital, and shows how that profitability has been masked by GAAP accounting. The authors demonstrate that the company is now investing very large amounts of capital with the expectation of earning rates of return well above its cost of capital. And their analysis suggests that if such investment can continue over the long term, Amazon's current market value of $140 billion can be readily justified.     

Save the Buyback,Save Jobs

In response to a recent New York Times op‐ed by Senators Schumer and Sanders deploring the effects of stock buybacks on workers and the economy, the authors explain the role of buybacks in increasing corporate productivity and in recycling “excess capital” from mature companies with limited growth and employment opportunities to the next generation of Apples and Amazons. Some companies, as Schumer and Sanders charge, are guilty of repurchasing shares in the name of “shareholder value maximization” instead of pursuing job‐creating investments. But as the authors argue, well‐run companies increase shareholder value not by boosting EPS through buybacks, but mainly by earning competitive returns on capital and investing in their long‐run “earnings power.” And by paying out capital they have no productive uses for, such companies give their own shareholders the opportunity to reinvest in other companies with promising prospects for growth and jobs. But the authors go on to note the tendency of companies to buy back shares not when their stock prices are low, but instead when the companies are flush with cash and nearer the top than the bottom of the business cycle. The result of this tendency, as research by Fortuna Advisors (the authors' firm) shows, is that fully three quarters of companies doing large buybacks during the period 2013‐2017 failed to produce an adequate “Buyback ROI,” a metric developed by Fortuna that indicates management's effectiveness in “timing” its stock repurchases. Given the usefulness of buybacks in recycling capital, the authors conclude that the most reliable solution to the corporate short termism and underinvestment problem is for companies to adopt better financial performance measures—including Buyback ROI—to guide their capital allocation. And when management determines that it has significantly more capital than value‐adding investments, but wants to avoid committing to unsustainable dividend increases, it should consider buybacks—but only if management is convinced that its stock price has not outpaced performance.     

Beyond EVA

A former partner of Stern Stewart begins by noting that the recent acquisition of EVA Dimensions by the well‐known proxy advisory firm Institutional Shareholder Services (ISS) may be signaling a resurgence of EVA as a widely followed corporate performance measure. In announcing the acquisition, ISS said that it's considering incorporating the measure into its recommendations and pay‐for‐performance model. While applauding this decision, the author also reflects on some of the shortcomings of EVA that ultimately prevented broader adoption of the measure after it was developed and popularized in the early 1990s. Chief among these obstacles to broader use is the measure's complexity, arising mainly from the array of adjustments to GAAP accounting. But even more important is EVA's potential for encouraging “short‐termism”—a potential the author attributes to EVA's front‐loading of the costs of owning assets, which causes EVA to be negative when assets are “new” and can discourage managers from investing in the business. These shortcomings led the author and his colleagues to design an improved economic profit‐based performance measure when founding Fortuna Advisors in 2009. The measure, which is called “residual cash earnings,” or RCE, is like EVA in charging managers for the use of capital; but unlike EVA, it adds back depreciation and so the capital charge is “flat” (since now based on gross, or undepreciated, assets). And according to the author's latest research, RCE does a better job than EVA of relating to changes in TSR in all of the 20 (non‐financial) industries studied during the period 1999 through 2018. The article closes by providing two other testaments to RCE's potential uses: (1) a demonstration that RCE does a far better job than EVA of explaining Amazon's remarkable share price appreciation over the last ten years; and (2) a brief case study of Varian Medical Systems that illustrates the benefits of designing and implementing a customized version of RCE as the centerpiece for business management. Perhaps the most visible change at Varian, after 18 months of using a measure the company calls “VVA” (for Varian Value Added), has been a sharp increase in the company's longer‐run investment (not to mention its share price) while holding management accountable for earning an adequate return on investors’ capital.     

SOME EVIDENCE THAT BANKS USE INTERNAL CAPITAL MARKETS TO LOWER CAPITAL COSTS

To the extent raising external capital is especially costly for banks (as the preceding article suggests), bank managers have incentives to manage their internal cash flow in ways that minimize their need to raise external equity. One way to accomplish this is to establish bank holding companies that set up internal capital markets for the purpose of allocating scarce capital across their various subsidiaries. By “internal capital market” the authors mean a capital budgeting process in which all the lending and investment opportunities of the different subsidiaries are ranked according to their risk-adjusted returns; and all internal capital available for investment is then allocated to the highestranked opportunities until either the capital is exhausted or returns fall below the cost of capital, whichever comes first. As evidence of the operation of internal capital markets in bank holding companies, the authors report the following set of findings from their own recent studies:

• ? For large publicly traded bank holding companies, growth rates in lending are closely tied to the banks' internal cash flow and regulatory capital position.
• ? For the subsidiaries of bank holding companies, what matters most is the capital position and earnings of the holding companies and not of the subsidiaries themselves.
• ? The lending activity of banks affiliated with multiple bank holding companies appears to be less dependent on their own earnings and capital than the lending of unaffiliated banks.

The authors also report that, after being acquired, previously unaffiliated banks increase their lending in local markets. This finding suggests that, contrary to the concerns of critics of bank consolidation, geographic consolidation may make banks more responsive to local lending opportunities.     

Value‐Added Per Share (VAPS): A Value‐Relevant Corporate Performance Metric

The authors introduce Value Added Per Share (VAPS) as a value‐relevant metric that is intended to complement earnings per share (EPS) in helping corporate managers and analysts understand and overcome the limitations of GAAP‐based reporting. VAPS discounts a firm's past and projected cash flows at its “cost of capital,” allowing companies to avoid the subjective accounting accrual process and other practices that often make EPS misleading. A company's VAPS is calculated in three main steps: (1) estimate the change in the capitalized value of after‐tax operating cash flow by taking the net change (plus or minus) of the firm's operating cash flow after taxes and dividing that number by the firm's cost of capital; (2) subtract total investment expenditures; and (3) divide by the number of shares outstanding. By capitalizing the change in after‐tax operating cash flow, one finds the net change in a firm's current operations value. By subtracting investment expenditures from that change in current operations value, the analyst gets a clearer picture of the benefit to shareholders net of the funds used to create that benefit. Consistent with basic theory, VAPS is positive when a company earns a return at least equal to its cost of capital and negative otherwise. Because of their fundamental differences, EPS and VAPS are likely to send different signals, and VAPS is expected to provide greater insight into stock price changes. The authors provide the findings of statistical tests showing the superior explanatory power of VAPS and recommend that companies publish statements of VAPS along with standard GAAP results, especially since the former can be readily calculated using the available income statement, balance sheet, and cash flow statement data.     

Valuation with Market Multiples: How to Avoid Pitfalls When Identifying and Using Comparable Companies1

An important part of the market multiple valuation process is selecting companies for comparison that are really comparable to the company being valued. The goal of assessing comparability is to align the relevant value drivers—especially risk and growth—of the comparable companies with those of the company being valued. In this paper, the authors examine the relevant value drivers for commonly used market multiples such as EBIT and EBITDA. They show that, in addition to risk and growth, analysts doing market multiple valuations need to take account of differences in variables such as cost structure, working capital, and capital expenditure requirements when assessing comparability. The authors also show that the degree to which different value drivers are important for assessing the comparability of companies differs across commonly used market multiples. In other words, some multiples are more sensitive than others to changes in certain value drivers. For example, when using a multiple like EBITDA in which certain expenditures (such as capital investments, working capital investments, and some expenses) are not deducted in the calculation of the denominator, assessing comparability based on such expenditures is more important than when using a multiple like free cash flow that deducts that expenditure in calculating the denominator. Or to cite another example, since EBIT and EBITDA make no attempt to reflect income taxes, using income tax cost structures to assess comparability is more important for enterprise value multiples based on these measures than for enterprise value multiples based on “after‐tax” measures of income such as unlevered earnings or free cash flow. In addition, not all multiples control for differences in cost structure, such as cost of goods sold or SG&A. If a multiple is affected by differences in those value drivers, the comparable companies must be similar to the company being valued on that dimension. Finally, the authors show that differences in capital expenditure and working capital requirements can also have large effects on certain multiples; and as a result, such value drivers also must be considered when assessing comparability.     

Financial Management Association Roundtable on Stock Market Pricing and Value‐Based Management

A group of academics and practitioners addresses a number of questions about the workings of the stock market and its implications for corporate decision‐making. The discussion begins by asking what the market wants from companies: Is it mainly just steady increases in earnings per share, which are then “capitalized” by the market at the current industry P/E multiple to produce a higher stock price? Or does the market pay attention to the “quality,” or sustainability, of earnings? And are there more revealing measures of annual corporate performance than GAAP earnings—measures that would provide investors with a better sense of companies' future cash‐generating capacity and returns on capital? The consensus was that although many investors respond uncritically to earnings numbers, the most sophisticated and influential investors consider far more than current earnings when pricing stocks. And although the stock market is far from omniscient, the heightened scrutiny of companies resulting from the growth of hedge funds, private equity, and investor activism of all kinds appears to be making the market “more efficient” in building information into stock prices. The second part of the discussion explored the implications of this view of the market pricing process for corporate strategy and the evaluation of major investment opportunities. For example, do acquisitions have to be “EPS‐accretive” to be value‐adding, or is there a more reliable means of assessing an investment's value added than pro forma EPS effects? Does the DCF valuation method always offer a better guide to value than the method of comparables used by many Wall Street dealmakers? And under what circumstances are the relatively new real options valuation approaches likely to provide a significant advantage over conventional methods? The main message offered to corporate practitioners is to avoid letting cosmetic accounting effects get in the way of value‐adding investment and operating decisions. As the corporate record on acquisitions makes painfully clear, there is no guarantee that an accretive deal will turn out to be value‐increasing (in fact, the odds are that it will not). As for choosing a valuation method, there appears to be a time and place for each of the major methods—comparables, DCF, and real options—and the key to success is understanding which method is best suited to the circumstances.     

“De‐risking” Corporate Pension Plans: Options for CFOs

Until the stock market bubble burst in 2000–2002, most CFOs viewed their defined benefit pension plans as profit centers and relatively risk‐free sources of income. Since neither pension assets nor liabilities were reported on corporate balance sheets, and expected returns on pension stocks could be substituted for actual returns when reporting net income, the risks associated with DB plans were masked by GAAP accounting and thus assumed to have no bearing on corporate capital structure. But when stock prices and corporate profits fell together, the risks associated with conventional stock‐heavy pension plans showed up first in reduced pension surpluses (or, in many cases, deficits) and then later in higher required cash contributions and lower reported earnings. As a consequence, today's investors (and rating agencies) are viewing pension and other legacy liabilities as corporate debt, and demands for transparency and increased funding have triggered accounting changes and proposed legislative reforms that will further unmask the economics. This article aims to provide both private‐sector and public‐sector CFOs with suggestions for reducing and controlling the cost of providing for the retirement of their employees. Profitable, tax‐paying companies with DB plans should consider (1) funding any unfunded liabilities (if necessary, by issuing debt) and (2) reducing pension equity and interest rate exposures by shifting some (if not all) pension assets into bonds and defeasing the pension liability (achieving a tax arbitrage in the process). And in cases where the expected costs of maintaining DB plans outweigh the benefits, companies should consider freezing or terminating their plans and switching to a defined contribution (DC) or some form of hybrid plan. The authors also propose similar changes for public pension plans, where underfunding and mismatch problems are greater, less transparent, and in some ways less tractable than those of corporate DB plans.     

An Unconventional Conglomerateur: Henry Singleton and Teledyne

Capital allocation involves decisions about raising and returning capital, and about acquiring and selling companies—all of which can have major effects on shareholder value. Rather than judging CEOs by growth in revenues or earnings, the author argues that they should be judged by increases in the per share value of the companies they manage and also in comparison with the returns generated by peer firms and the broader market. Successful CEOs have been able to overcome the “institutional imperative”—the tendency of managers to focus on the sheer size of their enterprises and to avoid doing things that might be seen as unconventional. In this chapter from his recent book, The Outsiders, which provides accounts of eight remarkably successful and long‐tenured CEOs, the author describes the successful management by Henry Singleton of the conglomerate Teledyne from 1963 to 1990, a period during which the company's shareholders enjoyed annualized returns of over 20%. During the 1960s, the company produced high returns mainly by making large acquisitions funded by new equity issues. During the 1970s and '80s, by contrast, Teledyne used massive share repurchases to return excess capital to shareholders. Thus, Singleton adjusted his capital allocation strategy in response to changes in product and financial markets—and to changes in the perceived difference between market and intrinsic values. When investors provided capital with relatively low required rates of return, as in the 1960s, Singleton was an aggressive buyer investor in a wide range of businesses. But when interest rates were high and equity valuations were low, as in the 1970s and early 1980s, Singleton used share repurchases to create value by reducing investment and limiting growth. The company's shareholders were well rewarded in both environments.     

Usefulness of comprehensive income reporting in Canada

In January 2005 the Canadian Accounting Standards Board (AcSB) issued three new accounting standards that require Canadian firms to mark-to-market certain financial assets and liabilities and recognize the holding gains and losses related to these items as other comprehensive income or as part of net income. The Board’s objectives for issuing the new standards are (i) to harmonize Canadian GAAP with US and International GAAP, (ii) to enhance the transparency and usefulness of financial statements, and (iii) to keep pace with changes in accounting standards in other countries that are moving towards fair value accounting. This paper investigates empirically whether requiring Canadian companies to report comprehensive income and its components provides the securities market with incremental value-relevant information over the traditional historical-cost earnings approach.Previous empirical studies provide mixed evidence on the value relevance of other comprehensive income and its components. This mixed evidence may be attributed partially to the use of as if methodology to construct an ex-ante measure of other comprehensive income prior to the implementation of SFAS 130, which introduces measurement error. In contrast, this study uses actual data on other comprehensive income for a sample of Canadian firms cross-listed in the US in the period 1998–2003. We find evidence that available-for-sale and cash flow hedges components are significantly associated with price and market returns. We also find that aggregate comprehensive income is more strongly associated (in terms of explanatory power) with both stock price and returns compared to net income. However, we find that net income is a better predictor of future net income relative to comprehensive income. Our findings suggest that mandating all Canadian firms to adopt the new accounting standards is expected to enhance the usefulness of financial statements. Our findings, therefore, should be of interest to Canadian accounting policy makers as they provide ex-ante evidence on the potential usefulness of mandating firms to report comprehensive income and the components of other comprehensive income in their financial statements.     

Is Economic Growth Good for Investors?1

When measured over long periods of time, the correlation of countries' inflation‐adjusted per capita GDP growth and stock returns is negative. This result holds for both developed countries (for which the correlation coefficient is –0.39 using data from 1900–2011) and emerging markets (the correlation is –0.41 over the period 1988–2011). And this means that investors would have been better off investing in countries with lower per capita GDP growth than in countries experiencing the highest growth rates. This seems surprising since economic growth is generally assumed to be good for corporate profits. In attempting to explain this finding, the author begins by noting that economic growth can be achieved through increased inputs of capital and labor, which don't necessarily benefit the stockholders of existing companies. Growth also comes from technological advances, which do not necessarily lead to higher profits since competition among firms often results in the benefits accruing to consumers and workers. What's more, it's important to recognize that growth has both an expected and an unexpected component. And one explanation for the negative correlation between growth and stock returns is the tendency for investors to overpay for expected growth. But there is another—and in the author's view, a more important—part of the explanation. Along with the negative correlation between long‐run average stock returns and per capita growth rates, the author also reports a strong positive association between (per share) dividend growth rates and overall stock returns. Such an association is not surprising since unusual growth in dividends is a fairly reliable predictor of increases in future earnings. But another effect at work here is the role of dividends—and, in the U.S., stock repurchases too—in limiting what might be called the corporate “overinvestment problem,” the natural tendency of corporate managers to pursue growth, if necessary at the expense of profitability. One of the main messages of this article is that corporate growth adds value only when companies reinvest their earnings in projects that are expected to earn at least their cost of capital—while at the same time committing to return excess cash and capital to their shareholders through dividends and stock buybacks.     

Does Risk Management Add Value? A Survey of the Evidence

The fact that 92% of the world's 500 largest companies recently reported using derivatives suggests that corporate managers believe financial risk management can increase shareholder value. Surveys of finance academics indicate that they too believe that corporate risk management is, on the whole, a valueadding activity. This article provides an overview of almost 30 years of broadbased, stock‐market‐oriented academic studies that address one or more of the following questions:

• ? Are interest rate, exchange rate, and commodity price risks reflected in stock price movements?
• ? Is volatility in corporate earnings and cash flows related in a systematic way to corporate market values?
• ? Is the corporate use of derivatives associated with reduced risk and higher market values?

The answer to the first question, at least in the case of financial institutions and interest rate risk, is a definite yes; all studies with this focus find that the stock returns of financial firms are clearly sensitive to interest rate changes. The stock returns of industrial companies exhibit no pronounced interest rate exposure (at least as a group), but industrial firms with significant cross‐border revenues and costs show considerable sensitivity to exchange rates (although such sensitivity actually appears to be reduced by the size and geographical diversity of the largest multinationals). What's more, the corporate use of derivatives to hedge interest rate and currency exposures appears to be associated with lower sensitivity of stock returns to interest rate and FX changes. But does the resulting reduction in price sensitivity affect value—and, if so, how? Consistent with a widely cited theory that risk management increases value by limiting the corporate “underinvestment problem,” a number of studies show a correlation between lower cash flow volatility and higher corporate investment and market values. The article also cites a small but growing group of studies that show a strong positive association between derivatives use and stock price performance (typically measured using price‐to‐book ratios). But perhaps the nearest the research comes to establishing causality are two studies—one of companies that hedge FX exposures and another of airlines' hedging of fuel costs—that show that, in industries where hedging with derivatives is common, companies that hedge outperform companies that don't.     

Explaining the accrual anomaly by market expectations of future returns and earnings

This study examines the accrual anomaly under the framework of the Campbell [Campbell, J.Y. (1991). A variance decomposition for stock returns. Economic Journal 101 (405), 157-179.] model. The Campbell (1991) model shows that realized asset returns are a joint function of 1) expected returns, 2) revisions in market expected future returns (i.e., return news), and 3) revisions in market expected future cash flows (i.e., cash flow news). The current study adopts the Easton [Easton, P. (2004). PE ratios, PEG ratios, and estimating the implied expected rate of return on equity capital. The Accounting Review 79 (1), 73-96.] model to estimate proxies for expected returns, return news, and cash flow news. The results show that firms with low accruals have lower expected returns than firms with high accruals, which is contradictory to prior research that argues that firms with low accruals are more risky. However, investors underestimate (overestimate) future earnings growth, a proxy for cash flow growth, for low (high) accrual firms. Further analysis demonstrates that earnings news (proxy for cash flow news) plays a major role in explaining abnormal returns associated with the accrual anomaly.     

Valuing Companies with Cash‐Flow@Risk

The classic DCF approach to capital budgeting—the one that MBA students in the world's top business schools have been taught for the last 30 years—begins with the assumption that the corporate investment decision is “independent of” the financing decision. That is, the value of a given investment opportunity should not be affected by how a company is financed, whether mainly with debt or with equity. A corollary of this capital structure “irrelevance” proposition says that a company's investment decision should also not be influenced by its risk management policy—by whether a company hedges its various price exposures or chooses to leave them unhedged. In this article, the authors—one of whom is the CFO of the French high‐tech firm Gemalto—propose a practical alternative to DCF that is based on a concept they call “cash‐flow@risk.” Implementation of the concept involves dividing expected future cash flow into two components: a low‐risk part, or “certainty equivalent,” and a high‐risk part. The two cash flow streams are discounted at different rates (corresponding to debt and equity) when estimating their value. The concept of cash‐flow@risk derives directly from, and is fully consistent with, the concept of economic capital that was developed by Robert Merton and Andre Perold in the early 1990s and that has become the basis of Value at Risk (or VaR) capital allocation systems now used at most financial institutions. But because the approach in this article focuses on the volatility of operating cash flows instead of asset values, the authors argue that an internal capital allocation system based on cash‐flow@risk is likely to be much more suitable than VaR for industrial companies.     

Liquidity,the Value of the Firm,and Corporate Finance

The theory of corporate finance has been based on the idea that a company's market value is determined mainly by just two variables: the company's expected after‐tax operating cash flows or earnings, and the risk associated with producing them. The authors argue that there is another important factor affecting a company's value: the liquidity of its own securities, debt as well as equity. The paper supports this argument by reviewing the large and growing body of evidence showing that differences—and changes—in liquidity can have major effects on the pricing of corporate stocks and bonds or, equivalently, on investors' required returns for holding them. The authors also suggest that the liquidity of a company's securities can be managed by corporate policies and actions. For those companies whose value is likely to be increased by having more liquid securities—which is by no means true of all companies (mature firms that don't need outside capital may well benefit from having more concentrated ownership and hence less liquidity)—management should consider actions such as reducing leverage and substituting dividends for stock repurchases as well as measures designed to increase the effectiveness of their disclosure and investor relations program and the size of their investor base.     

EVA, ACCOUNTING PROFITS, AND CEO TURNOVER: AN EMPIRICAL EXAMINATION, 1985–1994

A growing number of companies use EVA or related measures of economic profits as metrics for corporate planning and executive compensation. Unlike traditional accounting measures of performance, EVA attempts to measure the value that firms create or destroy by subtracting a capital charge from the cash returns they generate on invested capital. For this reason, EVA is seen by its proponents as providing the most reliable year-to-year indicator of a market based performance measure known as market value added, or MVA. Although EVA and MVA have received considerable attention in recent years, there has been little empirical study of these performance measures—and what studies have been produced have provided mixed results. This study joins the debate over EVA vs. conventional accounting measures by asking a different question: Which performance measures do the best job of explaining not only stock returns, but the probability that a CEO will be dismissed for poor performance? Using a sample of 452 firms during the period 1985–1994, the authors report that EVA has a somewhat stronger correlation with stock price performance than conventional accounting measures such as ROE and ROA. But, of greater import, EVA appears to be a considerably more reliable indicator of CEO turnover than conventional accounting measures.     

Improving the Health of Healthcare Companies

The healthcare sector has been extremely effective in improving human health while at the same time delivering outstanding returns to shareholders, at least on average. But averages can hide a lot of poor performance, and careful examination of the sector shows a sizable disparity between the long‐run productivity and value added of the top companies and the rest. To better understand the reasons for this disparity, the authors undertook a comprehensive study of how differences in capital deployment strategies, financial policies, and measures of corporate operating performance such as sales growth and return on capital are associated with returns to shareholders. Perhaps the most striking finding is the strong positive correlation in the healthcare industry between higher rates of reinvestment, especially in the form of spending on R&D and acquisitions, and stock price performance. And given the importance of such reinvestment, it is not surprising that maintaining financial flexibility by paying down net debt and otherwise limiting corporate leverage—and even issuing significant equity—are all associated with higher stock returns. When it comes to operating performance, moreover, it's not enough just to be good; it takes growth and improvement in cash flow and earnings to drive share prices higher. Measures of changes in performance such as increases in EBIT and ROIC, and high rates of growth in sales, all show consistently strong and positive relationships with stock returns while measures of levels of performance, especially EBIT margins and EBITDA margins, demonstrate relationships that are weak and in some cases even negative. Last, and consistent with the findings reported above, despite often vocal investor demands to pay dividends and buy back shares, in the case of healthcare as a whole such distributions have a clearly inverse relationship with share price performance. That is to say, the larger the payouts to shareholders, the lower the shareholder returns.     

Terminal Value,Accounting Numbers,and Inflation

In a 2008 article published in this journal, Michael Bradley and Gregg Jarrell argue that the well‐known Gordon‐Shapiro (henceforth “GS”) model for calculating terminal values does not properly account for the effects of inflation. Bradley and Jarrell suggest modifying the growth factor in the standard GS model by adding an additional term to the nominal growth rate that reflects the positive effect of inflation on the value of existing assets. In this article, the authors support the original Gordon‐Shapiro method for calculating terminal values by showing what they believe to be an oversight of the Bradley‐Jarrell critique. According to the authors, the disagreement stems from the use of fundamentally different assumptions about the effect of inflation on the capital investment required to sustain a business. Although Bradley‐Jarrell agree with the authors that intrinsic value is the discounted value of future free cash flows, their assumptions about capital investment effectively lead them to conclusions similar to those practitioners who attempt to value companies on the basis of discounted future accounting earnings. Despite much common practice, the GS model was meant to be applied to free cash flows, not accounting earnings. And for companies with substantial capital investment, the differences between accounting earnings that involve accruals and free cash flows can be very large.