Dare to Keep
Your Stock Price Low
By Joseph Fuller and Michael C. Jensen. Mr. Fuller is CEO of
the Monitor Group. Mr. Jensen is a managing director at the Monitor Group and a
professor emeritus at Harvard Business School.
Egged on by a buoyant economy and the pace of value creation set by
the market's best performers, over the past two decades securities analysts
challenged the companies they covered to reach for unprecedented earnings
growth. Too often managers collaborated in this fiction, either because they
had unrealistic expectations for their companies or, worse yet, because they
used analysts' expectations to set internal corporate goals. When the fiction
finally became obvious the results were massive adjustments in growth projections
and equity valuations, and in some cases bankruptcy and liquidation.
Enron is perhaps the most dramatic example. Wisely taking
advantage of a rapidly deregulating market and capitalizing on its deep
knowledge of the industry, Enron had seized a powerful, but probably
once-in-a-lifetime, opportunity to remake itself as a market maker in natural
gas and energy.
Wall Street responded to this and other genuine innovations with a
series of positive reports and ever-higher valuations, eventually labeling
Enron one of the best companies in the economy and comparing it to Microsoft
and General Electric. However, the aggressive targets that Wall Street set for
Enron's shares made the company a captive of its own success.
Enron's peak valuation of $68 billion in August 2001 required the
company to grow its free cash flow at 91% annually for the next six years, and
then to grow at the average rate for the economy. One analyst blithely
predicted that Enron would come to dominate the wholesale energy market for electricity,
natural gas, coal, energy derivatives, bandwidth and energy services on three
Enron, to its own detriment, decided to take up the challenge. In
seeking to meet expectations it expanded into markets in which it had no
specific assets, expertise or experience, like broadband and even weather
hedging -- and when this failed to deliver enough growth, it manipulated the
information it gave to Wall Street.
The story of Nortel is similar. In 1997 Nortel CEO John Roth
launched a strategy to transform the company from one dependent on voice
switching into one focused on data networking. Nortel acquired 19 companies
between 1997 and early 2001. As its stock price soared, reaching a total
capital value of $277 billion in July 2000, it came under pressure to do deals
to satisfy the analysts' growth expectations. The more it did, the more it was expected
to do. Ultimately, it paid over $32 billion -- using its own overvalued stock
as currency -- for these companies, most of which eventually had to be sold
off. Its stock has fallen by more than 99% from its peak. Some question whether
the company will survive.
It didn't have to be this way for either company. A few CEOs have
wisely and bravely decided to put an end to the expectations game by simply
saying no to what has euphemistically been termed earnings
"guidance." In a recent filing to the Securities and Exchange
Commission, Barry Diller, chairman of USA Networks, balked at the sophisticated
art form known as managing expectations, comparing it to a Kabuki dance and
saying publicly what many others have said privately: The process has little to
do with running a business and the numbers can become distractingly and
dangerously detached from fundamentals.
Indeed, an overvalued stock can be as damaging to the long-run
health of a company as an undervalued stock. The words of Warren Buffett in his
1988 letter to shareholders are instructive on this point: "We do not want
to maximize the price at which Berkshire shares trade. . . . We wish for them
to trade in a narrow range centered at intrinsic business value."
But in order for a stock to trade close to its intrinsic value
managers must work to make their organizations far more transparent to
investors. Mr. Diller has chosen to provide for analysts actual business
budgets broken down by business segments. While it is still too early to tell
how that will work, at the very least companies should state their strategies
clearly, identify associated value drivers, and report auditable metrics on
both. That must include addressing the "unexplained" part of their
firm's share price -- that part not directly linked to observable cash flows --
through a coherent description of the growth opportunities they foresee. They
must tell the markets frankly when they see their stock price as overvalued.
Stock prices are not simply abstract numbers. The price that Wall
Street puts on a company's securities increasingly affects the nature of the
strategies that firm adopts and, hence, its prospects for success. Stock prices
also drive a company's cost of capital, its borrowing ability, and its ability
to make acquisitions. A valuation that becomes unhinged from the underlying
realities of the business can rob investors of savings, cost people far more
innocent than senior management their jobs, and undermine the viability of
suppliers and communities.
In the long run, conforming to market pressures for impossible
growth leads to shortened careers, humiliation and damaged companies. Just ask
the folks at Enron, whose once-valuable company and pension fund are now in