Home > Business > On Stock Market Valuations, some light to the recurring scandals

On Stock Market Valuations, some light to the recurring scandals

“There must certainly be a vast Fund of Stupidity in Human Nature, else men would not be caught as they are, a thousand times over, by the same Snare, and while they yet remember their past Misfortunes, go on to court and encourage the Causes to which they were owing, and which will again produce them.” – said Cato several thousand years ago (from The Battle for the Soul of Capitalism)

Here’s an interesting analysis from John C. Bogle‘s book “The Battle for the Soul of Capitalism

“When the S&P Index rose from 130 in March 1981 to 1,527 in March 2000, the return on investor capital, excluding dividends, was 13.8 percent per year. Earnings growth amounted to 6.2 percent annually, less than half of the return, with the remainder the result of a rise in the price-earnings ratio from eight times to thirty-two times. That increase alone accounted for 1,100 points of the 1,400-point gain, or 7.6 percent per year. If one were to attribute even a 5 percent corporate cost of capital as a threshold for stock option grant- a return a company might have earned merely by placing all of its assets in a bank certificate of deposit- corporate management could claim responsibility for an extra 1.2 percent per year.” (emphasis added)

So how does Wall Street manage to “meet” or “exceed” their generous quarterly guidance with such a high success rate? Here’s an example:

“In 2001, Verizon Communications reported a net income of $389 million and awarded its executives bonuses based on that amount. Net income would have been negative, however, had the company not included $1.8 billion of pension income. Thus, Verizon was able to use pension earnings to convert net income to profits, giving the firm cover to provide managers with higher bonuses [and meeting expectations, and keeping their stock options way high in the black]. It gets worse. It turns out that Verizon’s pension funds did not generate any real income in 2001; they had negative investment returns, losing $3.8 billion in value [What?!]. How then, could Verizon report income of $1.8 billion from its pension assets? The company merely increased its projection of future returns on pension assets to 9.25 percent, a move allowed under the accounting rules then in effect. Thus, the $1.8 billion in pension income used to move Verizon into the black did not even reflect actual returns generated by the pension funds. The pension income was simply the result of a change in the accounting assumptions. This certainly did not create any value for the firm or its shareholders.” (emphasis added)

OK, so lets do this simple math. They claim they made $389 million in net income, because of the $1.8 billion of magic pension fund money that doesn’t exist. This means they actually lost $1.4 billion, but that’s not it. They didn’t make $1.8 from pension, rather lost $3.1 billion in value for that fund.

Who ends up carrying those losses? The individual investors, fooled to believe a company is stable, holds the stock and takes the heavy losses when all the cards in the table are finally shown at once.

  1. Roberto Ortiz
    November 16, 2008 at 1:41 am

    It comes to mind that in a court of law the auditors would probably be liable if something went wrong. Indeed they are our only line of defense. They are supposed to ensure GAAP are followed but only as long as following accounting rules and principles don’t distort the fairness of the financial statements, like is the case here. It’s kind of hard to imagine big four accountans would miss this. 1.8 billion in the face of $389 million of Net Income is too much a material amount to assume careful procedures were not applied during the audit even if they were an aggregate. I think this case and many others, together with what has been happening in Wall Street recently will cause the market to require the PCAOB to be more aggressive. Due to the nature of how Net Income is calculated and reported on the financial statements a note should be added referring specifically to the liquidity of that particular amount. Because of it’s complexity the Cash Flow does not receive as much attention from investors as it should. Steps towards making it simpler to understand could be a good aid. Unfortunatelly my solutions are probably way too simplistic. But in the words of Jack Nicholson “At least I tried”. I also think the market has a problem with, financial instruments and accounting rules that are becoming too complex to follow. Leaving too much room for book playing which our markets love but it’s dangerous as we are so painfully learning. I don’t want to engage in the republicans v. democrats eternal economic battle but as is the case here, certainly more regulation is necessary.

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