VideoFive years into the new millennium, a cloud of uncertainty hangs over Corporate America. The lackluster economy, the war in Iraq, public and private fiscal imbalances, the Sarbanes-Oxley Act — all this obscures the financial landscape, inhibiting new investment, and with it, innovation and growth.
In this atmosphere of doubt, senior financial executives bent on creating value may not find reassurance from the conventional wisdom. Fresh thinking is needed to clear the fog. With this in mind, CFO sought out academic experts whose research suggests new, if unconventional, ways to create value. The work of the five experts we interviewed — Margaret Blair, Richard Roll, Ivo Welch, Jeremy Stein, and Robert Howell — centers on classic corporate-finance topics, from capital allocation and structure to accounting, governance, and risk and return. While much of their research may be theoretical, their observations surely will help CFOs struggling to find a profitable way forward.
Corporate Governance
Empower the Directors
Margaret Blair
Vanderbilt University Law School
Along with a handful of other iconoclasts, Margaret Blair has long argued that corporate law requires directors to be fiduciaries for the corporation, not just for shareholders. In practice, this places all stakeholders on an equal footing. Had the markets recognized this, she says, the scandals that destroyed so much shareholder value at Enron and other companies might have been avoided.
But until the interests of employees, customers, suppliers, and taxpayers are fully acknowledged, Blair warns, scandal will not diminish (Sarbanes-Oxley notwithstanding). Why? Her logic goes like this: other stakeholders help create value and have contractual rights that cannot easily be ignored. So if managers reward shareholders at the expense of other stakeholders, "they won't be able to enter into precommitments and irrevocable contracts that reassure the [stakeholders]," observes Blair. That would leave managers with fewer options, the most tempting of which may be to manipulate the stock price.
"For optimal wealth creation," concludes Blair, "both sides" — shareholders and stakeholders — "need to yield their authority to a board of directors."
But how is management to proceed in light of these competing interests? Make long-term decisions in the interest of the business, answers Blair, instead of focusing on the daily ups and downs of the stock price. A self-evident solution, of course, but by no means simple to implement, she admits. "You have to keep doing something new. If you don't, you're in a commodity business. And if you do, there is no formula."
Capital Allocation
Understand Your Options
Richard Roll
The Anderson School, UCLA
The most widely used method for estimating a company's cost of equity — the capital asset pricing model (CAPM) — has long been criticized for its reliance on beta, a standardized measure of risk. Beta makes no allowance for company-specific risk, say critics, and that effectively rules out the possibility that individual managers add or destroy shareholder value. "We don't really have a good risk-return model," says Richard Roll.
But Roll offers some reassurance for finance executives who may fear that the current environment makes it particularly risky to use the CAPM when setting hurdle rates for investments. "There is more uncertainty in the world than there was 10 years ago," he acknowledges. But all that means, he says, is that "the extra premium that you'd have to put into the discount rate would be higher."
In fact, Roll contends that changes in hurdle rates may be less meaningful at present. When discount rates are low, he explains, "a small change in the discount rate will make a big difference in which projects you undertake. But if discount rates are high, then the relative impact of a small change is low."
For those managers nonetheless looking for an alternative to CAPM, Roll recommends real-option-pricing models. The classic model, Black-Scholes, must be tweaked to measure value when options on a company's stock aren't publicly traded, but Roll says that's easy enough to do through the so-called binomial lattice method, which models value by taking into account a series of assumptions.
Just don't expect the use of option-pricing models to justify bolder spending. Says Roll: "If risk has increased, that means discount rates have gone up, and there are fewer projects that are going to have positive net present value." And he takes issue with those who contend that companies should become more aggressive anyway. "When there's more uncertainty," he says, "you should take on fewer projects."
Dividend increases and stock buybacks, anyone?
Capital Structure
Don't Follow the Crowd
Ivo Welch
Brown University
While companies have been boosting cash flow, their balance sheets may not be as strong as one might expect. That's because the reduction in leverage seen at many companies may have more to do with higher stock prices, thanks to equity repurchases, than reduced debt levels. That view is clearly supported by a recent study of Federal Reserve data by Smithers & Co. Ltd., an investment firm based in London.
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