Do Stock Prices Reflect Long Term or Short Term Events

Managers often complain that the stock market is shortsighted, and that it cares only about next quarter's performance. Let's use the constant growth model to test this assertion. MicroDrive's most recent dividend was \$1.15, and it is expected to grow at a rate of 8 percent per year. Since we know the growth rate, we can forecast the dividends for each of the next five years and then find their present values:

g)1 , Do(1 + g)2 , Do(1 + g)3 , Do(1 + g)4 , Do(1 + g)5

Do(1

(1.134)1 (1.134)2 (1.134)3 1.095 + 1.043 + 0.993 + 0.946 \$5.00.

Recall that MicroDrive's stock price is \$23.00. Therefore, only \$5.00, or 22 percent, of the \$23.00 stock price is attributable to short-term cash flows. This means that MicroDrive's managers will have a bigger effect on the stock price if they work to increase long-term cash flows rather than focus on short-term flows. This situation holds for most companies. Indeed, a number of professors and consulting firms have used actual company data to show that more than 80 percent of a typical company's stock price is due to cash flows expected more than five years in the future.

This brings up an interesting question. If most of a stock's value is due to long-term cash flows, why do managers and analysts pay so much attention to quarterly earnings? Part of the answer lies in the information conveyed by short-term earnings. For example, if actual quarterly earnings are lower than expected, not because of fundamental problems but only because a company has increased its R&D expenditures, studies have shown that the stock price probably won't decline and may actually increase. This makes sense, because R&D should increase future cash flows. On the other hand, if quarterly earnings are lower than expected because customers don't like the company's new products, then this new information will have negative implications for future values of g, the long-term growth rate. As we show later in this chapter, even small changes in g can lead to large changes in stock prices. Therefore, while the quarterly earnings themselves might not be very important, the information they convey about future prospects can be terribly important.

Another reason many managers focus on short-term earnings is that some firms pay managerial bonuses on the basis of current earnings rather than stock prices (which reflect future earnings). For these managers, the concern with quarterly earnings is not due to their effect on stock pricesâ€”it's due to their effect on bonuses.9