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Valuation Workbook: Step-by-Step Exercises and Tests to Help You Master Valuation, 5th Edition by McKinsey & Company

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16

Markets Value Substance, Not Form

Return on invested capital (ROIC) and growth are the only drivers of value creation, yet managers often spend time and resources attempting to smooth earnings, meet earnings targets, stay listed in a stock index, and become cross-listed. The evidence shows that the stock market does not reward these efforts, nor do changes in accounting rules and stock splits have lasting effects. These issues do not have an effect on stock returns unless they reflect a change in fundamental value.

Firms that have a good record of beating earnings forecasts tend to have more favorable stock returns; however, this record is usually the result of the favorable earnings reflecting a positive fundamental change and not just that earnings were higher than the forecast. Thus, managers should not focus too much on meeting earnings expectations; in fact, the efforts of managers to pursue these goals may have detrimental effects on the firm (e.g., lowering advertising expenditures to increase revenue in a given period).

Listing and delisting from an index do not seem to have long-term effects for any given firm. Although there can be a negative effect initially from delisting, the effect usually reverses in a few months. Furthermore, cross-listing within developed markets does not have an effect; however, firms in emerging markets may benefit from cross-listing in a developed market.

Investors apparently see through accounting changes. If investors focused on earnings, ...

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