Riding a Tiger Called the Market Capitalization

26 01 2009
 
 
 The valuation of wealth of individuals and companies is no longer done by adding up the value of the physical assets like land, property, jewellery or even bank balance. The valuation is done on the basis of market capitalization. Market capitalization is a simple multiplication of the share price with the number of shares owned by the individual.Forbes prepares its annual lists of the wealthiest businessmen in the world on the basis of market cap of the shares owned by them. They simply ignore all the other assets, because they consider them insignificant in comparison to the market cap of shares. In 2007, four Indian businessmen figured in the top 10 list of world’s wealthiest individuals. In 2008, none of them figure. In fact, Anil Ambani has the dubious distinction of having lost the largest wealth in the world in 2008, about US $ 30 Bn. Thus when the stock prices are high, the wealth is high, when the markets are down, the wealth is low.  If businessmen and companies start basing their identity and targets to the market caps of their companies, they have begun riding a tiger. Market cap is based on the share prices and number of shares. To increase market cap, the share prices have to keep rising constantly and or keep issuing more number of shares. Using the fundamental analysis principles, the share price is a function of earnings per share (EPS) and P/E multiple. Whereas EPS is based on profits, P/E multiple is a function of the perception the investors have about the company’s growth prospects and future margins.

In order to get a higher P/E multiple, companies and their managements make a lot of efforts to look progressive, transparent, growth oriented and put their best forward particularly with the analysts. If for some reason, they are unable to get a high P/E multiple with respect to the competitors, in order to keep their share price high, they have to get a higher EPS. Higher EPS is possible only if the business is generating higher profits.

If the business is not generating higher profits, then EPS will be low. In effect, the share price will not go up or worse it will go down. That is the point at which, the top managements are faced with the temptation of artificially cooking up the profits, so as to jack up the EPS.  The dilemma is whether to report the EPS honestly and face the prospect of share price going down and thereby personal wealth going down or cook the balance sheets and increase the market cap.Several managements resort to this occasionally, with the hope that they will make it up in future quarters. Even the legendary Jack Welch of GE was accused of smoothening the earnings occasionally.

The Chairman of Satyam, Ramalinga Raju.  when faced with such a dilemma, has confessed that he had chosen the path of cooking the balance sheets, not once or twice, but over several years. He mentions in his resignation letter that “It was like riding a tiger not knowing how to get down, without being eaten.” 

Businessmen and companies focussing on market cap are like batsmen batting with the eye on the scoreboard rather than the ball. Instead if they focus on their core business and satisfy their customers, they will be better off in the long run. Distributed dividend from profits earned in the core business should be the source of real wealth. The virtual wealth generated by increase in share prices is too fickle and a factor on which the company or the management have very little control. Focussing on controlling this virtual wealth can lead to disasters like Satyam. Satyam might well be the most recent and the most talked about case, but is certainly not the only one who met with this fate, in trying to ride the tiger of market cap.  

– G. Mohan

 

 

 

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2 responses

30 01 2009
Venkat Subramaniam

In the recent Businessworld there was an article that talked about parameters to measure whether a company is cooking up its Balance Sheet or not:

1. If difference the Cash Flow from Operations and Earnings before Interest, Tax, Depreciation and Amortization (EBITDA) : EBITDA minus Cash Flow is much higher as compared to the previous year, then the company is reporting much higher book earnings as compared to real Cash flow, which could be false

2. If the revenue from ‘Other Income’ is much lower as compared to previous year, that could mean that income from investments and other non core areas is being transferred to core revenues (to keep up the topline)

3. If loans to related parties is showing much higher than normal then there could be a discrepancy of money being siphoned out.

4. If depreciation expenses in the Profit and Loss account is much lesser than what it was in the previous year, then this is a indicator that profits (bootomline) is being shown higher at the cost of lower reserves for capital expenses.

The idea is to go beyond comparing the topline and bottomline figures, to assess the health of the company.

28 02 2009
Paloma Pentarian

Aren’t these people subject to annual audits and public reports done by outside firms?

Paloma Pentarian

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