Profit vs. Value

To those few of you who read my blog on a regular basis, I want to apologize in advance for what will be a fairly technical blog.

As I read about the various arguments regarding how to revise the financial regulatory system, I am amazed at the fact that the discussions never seem to get to the basis of modern financial decision making. In the modern world we use the term “Value Creation” to describe the goal of maximizing shareholder value. This means keeping the price of a stock as high as possible. Almost all of the executive compensation packages are based upon the principle that maximizing the current price of a share of stock is the goal of all companies. This is based upon the assumption that we have perfect markets with perfect information. However, as we have found out, al la ENRON, the market often does not have the information necessary to properly value a company’s shares. In fact, the management has huge incentives to engage in long run value destroying activities because they appear to add value in the short run.

The whole value maximization approach is aimed at a trading rather than an investing mentality. This is an outgrowth of the work of Nobel Laureates Miller, Modigliani, and Sharpe. Miller and Modigliani establish that the value of a company is independent of the debt/equity ratio of the firm. They even establish that the optimal financial structure in the presence of taxes is 100% debt. Sharpe, through the Capital Asset Pricing Model establishes that a firm’s expected return is related to the variability of the returns a firm earns as compared to market returns and returns on risk free assets. For both of these systems to be applicable firms need to be traded in efficient markets and risk associated with specific firms can be diversified away. It appears that the people implementing value maximization forgot these underlying assumptions.

When we look at a firm’s capital structure, i.e. debt/equity ratio, we need to remember that higher debt leads to a wider variation in the returns available to the shareholder. Higher debt equals higher risk. As more and more firms follow the approach of increasing debt the less likely it becomes that risk can be successfully diversified. As a result, we demand higher and higher returns to off-set the higher risk. In an attempt to meet these higher expectations, managements increase the risk of the projects they undertake because higher risk usually results in higher returns. The whole system becomes subject to the types of risks that, in the past, had only been associated with specific firms (Specific Risk). The Financial System starts to rise on a spiral staircase that has a drop-off at the top. The financial meltdown of 2008 was the result of the system going over the top of the staircase just described.

Going back to Miller, Modigliani, and Sharpe we find that they appear to work under the assumption that managements look toward valuing a firm as the present value of the future stream of income. In the absence of Wall Street Analysts this might be true. However, analysts seem to have a trading mentality. As a result, the concept of investing in solid profit earning firms on a long term basis is lost. Even many of our institutions, such as pension plans, which should be long-term investment oriented have turn-over ratios nearing or over 100%. The resultant trading mentality combined with higher levels of specific risk leads to very high levels of risk for the entire system. We have turned into speculators and gamblers rather than investors.

Please do not misinterpret what I am saying:

1. I do not have the hubris to place my ideas on the level of Nobel Laureates. I am, however, criticizing those who have misused their works.
2. Speculators serve an excellent purpose in an economic system. Through arbitrage, they act to effectively stabilize the markets. However, this only works if we have markets dominated by investors. When speculation dominates the system we find that we are operating a casino instead of a financial market.

Our regulation writers have to take into consideration how we got where we are. I believe that they are spending too much time looking at specifics rather than the general approach which got us into trouble to begin with. “…We can’t see the forest for the trees…”