To ensure that the intrinsic value of a company is fully reflected in its stock price, the company should communicate intelligently with the investors. The actions of a company what it should do and not do in this respect can be appreciated by understanding how the stock market really works. Share prices are not determined by a polling process in which all investors have an equal say. Rather, they are influenced by the actions of influential investors or lead steers. Stock prices like all prices are set not by average investors; they are set at the margin by the smartest money in the game. The herd is led by influential investors, lead steers as we call them. They care about cash flow and risk and they are not fooled by accounting illusion.
Given the dominant role of lead steers the company should bear in mind the following guidelines while communicating with an efficient market.
Deemphasize Creative Accounting: he advocates of the disclosure view of financial communication believe that the stock market is influenced by investors who assess companies by their reported financial result. Hence they argue that a company must paint a picture of steady earnings growth and cover any deficiencies by resorting to creative accounting. As a Wall Street Journal editorial put it: A lot of executives apparently believe that if they figure out a way to boost reported earnings their stock price will go up even if the higher earnings do to represent a underlying economic change.
Empirical evidence on market efficiency, however strongly supports the view that the market is very intelligent in penetrating through the veil of accounting reports and seeing a company’s underlying economic performance. Hence efforts to artificially inflate reported earnings or creatively manage the bottom line are futile.
Avoid Financial Hype: Many managers believe that the securities of a company should be marketed like any other product. This implies that the company should hire a public relations firm, sell its story through imaginative advertisement, and hype itself in the best tradition of Madison venue. This approach is guided by the ‘demand and supply view’ which assumes that securities can be sold at higher process by stimulating their demand through high pressure selling tactics.
The ‘demand and supply view’ is not a valid view in a market dominated by rational lead steers. The ‘intrinsic value view’ prevails in such a market. If prices rise because unsophisticated investors are momentarily swayed by financial hype, lead steers will sell and align price with intrinsic value. They may even short sell. This means that in a market dominated by forward looking investors, shares can change hands without changing price.
Cut Lead Steers into Planning Process: Meaningful communication with lead steers calls for cutting them into the planning process of the company. This means that, interalia they should be provided information about the following: (1) average operating profit over a business cycle from capital already committed to the business, (2) new investments projected in the foreseeable future, (3) expected rate of return over the lives of investment, (4) target capital structure and financing policy, (5) acquisition / divestiture strategy, (6)international performance, and management compensation plan.
Corporate Governance: Corporate governance is concerned basically with the agency problem that arises from the separation of finance and management (or, in more popular terms, ownership and control). It refers to the constraints that managers put on themselves or that investors impose on managers to induce investors to provide funds ex ante and check misallocation of resources ex post facto by managers. More specifically, corporate governance covers issues like the legal rights of investors the role of large investors, the system of electing the board of directors, the composition of the board and its various committees, the ability of the board to maintain surveillance, the system of checks ad balances, the incentives offered to managers to protected investors from dissipation of resources the standards of financial reporting and corporate disclosures and so on.