Corporate Eye

The Role of Financial Theory in Investor Relations

past future prediction The Role of Financial Theory in Investor Relations

During their first year of business school, MBA students are taught that traditional financial theory holds that the value of a firm is equal to the sum of its future cash flows, discounted back to a present value.

While this is fairly simple to express, quite a bit of financial calculation goes into coming up with the final value, including making estimates of future cash flows, figuring a terminal value, risks to be considered in coming up with a discount rate, and other considerations beyond the scope of this essay. Note at this point that the financial theory does not make any mention of a firm’s past performance record. However, except in the case of a brand new venture with no history of operations, estimates of future cash flows and prospects do not occur in a vacuum but rather are examined through the lens of past performance in order to judge the likelihood of achieving the firm’s potential for future profits.

A common framework used to think about how this valuation is achieved is: Past Performance + Perception of Future Performance = Current Stock Price.

In other words, the valuation of future cash streams coming from the company is filtered through an examination of what the company has done in the past. This means that the investor relations officer of a company must be able to express to the equity market not only what a company has done in the past but also needs to be able to cogently frame up the company’s future prospects. And the weighting between the two should be fairly equal.

Yet when you look at the presentations of most companies, the bulk of discussion seems to focus on what has happened in the past. A couple of years ago I looked at a small sampling of presentations posted on the internet by large capitalization U.S. companies to try and determine how much of their presentation concerned forward-looking information. My methodology was simple – I counted the total number of slides in a presentation and then counted the total number of slides that contained information concerning future operations. I tried to be overly generous in what I counted as a slide concerning the future, and any slide that had even a little bit of information about what a company intended to do going forward or the outlook for their products and markets was counted as being about the future.

In examining the presentations, it became obvious that companies were much more concerned with talking about past performance than future opportunity. The percentage of forward looking slides in presentations ranged from a low of 6% to a high of 35%, with the average for all presentations being 20%. If we assume that the information being discussed generally follows in proportion to the slides in the presentation, this means that, on average, four-fifths of all information in the sample was about something other than future profitability.

I am somewhat at a loss to explain this behavior. Usually when you find this type of disconnect between theory and practice, a reason exists for it. I have lots of theories, such as management’s fear of being sued if forward-looking information proves incorrect, corporate conservatism, and an attitude that “we need only tell investors the minimum required by regulation”. Unfortunately, I have no data to back any of it up.

Financial theory is clear however: the more data a company can provide on future prospects, the closer estimates of the firm’s current market value will get to its intrinsic value.

 The Role of Financial Theory in Investor Relations

John Palizza

John recently retired as a Lecturer in Management at Rice University’s Jones Graduate School of Management, where he taught investor relations. Prior to that, John was in charge of investor relations for Sysco Corporation and Walgreen Co. He holds a MBA from the Kellogg Graduate School of Management at Northwestern University and a law degree from Loyola University of Chicago. You can learn more about John’s thinking about investor relations at his blog, Investor Relations Musings.

 
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