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Future Shock

How can CFOs create value in uncertain times? Five experts offer fresh answers.
Ronald Fink, CFO Magazine
March 1, 2005

Five 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.


The question is whether this matters or not. Classic financial theory, as pioneered by Franco Modigliani and Merton Miller, says no, except during times of financial distress. So is this an example of such times? Only if companies can't pay their debts. And so the discussion goes in circles.

Enter Ivo Welch, who contends that markets are less efficient and investors less rational than classical theorists assume, and that CFOs echo this behavior by basing decisions about capital structure not by doing what they believe is right for their particular firms but by following the crowd. Welch's research, which he plans to publish in a new textbook, finds that corporate debt-equity ratios are primarily determined by how the stock market is doing, and that firms, for the most part, are passive participants. Says Welch: "If the stock market does well, firms' debt-equity ratios will go down dramatically. If the stock market does poorly, firms' debt-equity ratios will go up dramatically."

The lesson for CFOs, then, he says, "is that looking at the debt-equity structures of industry competitors as a 'smart target' to attempt to go to is not the smart thing to do." After all, if a CFO essentially ties a company's financial condition to the market, a company's stakeholders cannot help but wonder what value he or she is attempting to add.


Financial Management
Focus on the Long Run
Jeremy C. Stein
Harvard University

Jeremy Stein's work on what academics call internal capital markets envisions the role of the CFO as that of a banker making investment decisions within a particularly constrained environment. Such a view inevitably leads to questions of how CFOs can best distinguish "winners" from "losers" within portfolios of businesses or products, and how hurdle rates should and shouldn't be applied with that in mind.

But while success on that front may be an effective way for CFOs to add value to an organization, Stein contends that in the wake of the scandals that brought down Enron, WorldCom, and others, it has become equally important that CFOs "not use the finance function to destroy value." The challenge here, says Stein, and one he considers fundamental, is to move decisively away from the type of short-term decision making that characterized the late 1990s' bubble toward a longer-term, more sustainable perspective.

Says Stein: "In an ideal world, the CFO and the financial-management side of the business would be the servants of the real side of the business. Instead of saying, 'We can't do this, because we need to make this quarter's earnings,' they would then ask, 'What are the investments we need to make for the longer haul, and how do we mobilize the resources and explain what we're doing to the market?'"

Stein concedes that it's hard to do that during a bull market. "At a time when there's a lot of equity issuance and a lot of competition for external capital, it's difficult not to worry about short-term stock price," he says.

Ironically, however, the relatively aimless recent direction of the current capital markets may be a blessing in disguise, insofar as it makes it easier for CFOs to change focus. With less equity-raising being done, "maybe it's a little easier to get people to understand that you're not doing absolutely everything you can to deliver managed or smoothed earnings," says Stein. "If they know that, then when you fall short by a nickel, it doesn't carry the same stigma."

Still, he worries that while it may be more difficult to rely on traditional accounting tricks to manage earnings, CFOs may now be tempted instead to resort to means even more detrimental to their companies. "You can never really make it illegal for people to manage their earnings through bad economic decisions," says Stein. "If I have a huge inventory of some durable goods like refrigerators, and the right thing for me to do is sell them gradually, I may decide instead to cut the prices and sell every single one of them on the last day of the quarter to realize bigger earnings." He cites a recent research paper ("The Economic Implications of Corporate Financial Reporting," by John R. Graham et al.) that found most CFOs still concern themselves chiefly with quarterly earnings estimates and admit to engaging in such actions as cutting maintenance, advertising, and research and development to meet them.

Instead, Stein advises CFOs to make it clear to investors that they are not engaged in any kind of earnings management, saying to them in effect, "Don't expect me to have stable earnings. We're just going to focus on the business." And while that may mean investors have to take a hit in the short term, Stein points out that "if you have a lot of internal resources right now and are doing a lot of stock repurchases, you can weather that."


Sarbanes-Oxley Act of 2002
Get Ready for Risk
Robert A. Howell
Tuck School of Business at Dartmouth College

While many corporate managers bitterly complain of the compliance burden imposed by Sarbanes-Oxley, Robert Howell thinks the efforts ultimately can only benefit them. Might investors go so far as to pay a premium for better accounting, disclosure, and controls?

"Absolutely," answers Howell. "As a result of Sarbanes-Oxley, people have had to get back to basics in terms of accounting, financial reporting, and internal controls that can assure investors that what they're looking at represents what the company has done and what its condition is."


He acknowledges that a more immediate effect of the law may be to inhibit risk taking that's necessary for growth. But if companies are now compelled to pay more attention to the downside as well as the upside of their actions, "I say that's not so bad," says Howell. "During the go-go years, companies were stretching the rubber band pretty far, and maybe they should let it snap back a little bit."

Besides, Howell thinks that any such risk aversion will be short-lived. "I think once people have confidence that their systems are all that they need to be, then you'll be able to take greater risk and know that you can assess the impact of the risk that you're taking," he says. "In the long run, the re-creation of a strong underpinning of a corporation's finance and accounting system will permit companies to take well-judged risks, whereas before I think in some respects we were flying by the seat of our pants."

Howell adds that he's confident that once CFOs "get past all this blocking and tackling in internal auditing and getting the training and development to focus on those basics as well as ethics, they'll revert to focusing on top-line growth and investments for the future."

Ronald Fink is a deputy editor of CFO.




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