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S+B BLOGS May 9, 2017

STRATEGY & LEADERSHIP

Strategy Talk:
sponsored
by

The Real
Reason Your Stock Price
Is Lagging
Ken Favaro
Dear Ken,

An activist investor has been after our


board to split the company’s common stock
into two classes — one that pays a dividend
stream to attract “yield investors” and
another designed for “growth investors”
Ken Favaro is a contributing
that will appreciate as our earnings
editor of strategy+business
and the lead principal of act2, increase. This activist investor, our
which provides independent
counsel to executive leaders, directors, and I share the same frustration
teams, and boards.
with our current earnings multiple, which
 EMAIL
is far below the market average and
materially less than our closest
competitors. Yet we have performed well,
producing two straight years of record earnings. I know we have
to pay attention to our shareholders, but is this a good strategy
for boosting our shareholder returns?

—Restless over Returns


Dear Restless,

This is financial engineering at its worst. The understandable


frustration with your share price is no reason to bow to an
investor’s hocus-pocus for conjuring a higher one out of your
company. Never mind the technical difficulties of making the
proposed stock split work in practice; it simply makes no
business or financial sense.

Your share price is the result of what different investors are


willing to pay for your dividend stream, future earnings growth,
or both. And your company’s equity value is, of course, the
number of shares multiplied by your share price. If you were to
issue the two classes of stock proposed by your activist investor,
what’s changed? Now your equity value is the sum of what
different investors are willing to pay for each stock. But your
company’s total value remains the same because the underlying
reasons for different shareholders to invest in your company
have also remained the same. Moreover, the ultimate
determinants of your dividend stream and future earnings —
namely, your business strategy, total capital claims, and ability
to execute — are all unchanged. In other words, the
fundamentals supporting your valuation have not been altered
just because you split your stock. This is why, to answer your
original question, it’s not a good strategy for boosting your
shareholder returns.

The real problem here is equating a company’s stock price with


its earnings multiplied by its earnings multiple. This is
mathematically correct, but fundamentally wrong. In the real
world, it’s the other way around: Your earnings multiple
depends on your stock price and ultimately on your
fundamentals. And that means you should be worried about
your anemic valuation. People with something real at stake
(their money) are unwilling to bet on your company’s future,
except at a very low stock price relative to your current
earnings. They have little confidence in either your strategy or
your ability to pull it off. That is what you need to fix. If you
don’t, in time, your options and freedom of action will become
limited enough that the market’s lack of confidence becomes a
self-fulfilling performance problem for you. This will further
encourage the activist investors — some with misguided
“advice” — to heap even more pressure on you and your board.

You should take a


Sometimes outsiders long, hard look at two
possible explanations
have clearer eyes than
for the stagnation of
insiders, and the your share price. One
market sees something is that the stock
market is missing
you don’t.
something. “The
market” is made up
of various actors
whose collective behavior is adding up to your languishing
earnings multiple. This includes investors who’ve chosen to hold
shares and others who decided to avoid them. Ask both sets of
investors what they think your strategy is and what barriers
they see to implementing it. Then ask yourself whether their
answers are compelling or ignorant. If the latter, your agenda is
to educate and convince.

But if you hear some compelling answers, you are facing the
second explanation: that the market sees something you cannot
ignore. It’s time to go back to the drawing board and objectively
consider whether developments in your market are making
obsolete the business definition, business composition, target
customer, value proposition, or capabilities that make up your
strategy. Sometimes outsiders have clearer eyes than insiders,
and the market is in essence saying that it sees something you
don’t. If the market is correct, whatever you are missing will
eventually weigh heavily on your dividend stream and future
earnings growth.

Whichever scenario explains your moribund valuation, fiddling


with your company’s stock structure is not the solution. In my
experience, leaders get the investors they deserve. Those leaders
 that try financial engineering to attract particular kinds of
investors mostly lack conviction in their strategies. Thus, they let
the market — often encouraged by bankers — become the tail
that wags the dog. A leader with strong conviction wants only
those investors who believe in the path she has set out for the
company and her ability to stay on it. And a self-assured leader
is willing to change her conviction if investors are unwilling to
bet on her company at an acceptable valuation. She is able to
acknowledge that perhaps the market’s low valuation of her
company is making a point. She’s willing to find out what that
point is, and then act on it.

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