The Most Important Thing About Contemporary Finance, part 2
With accounting earnings, we might use a somewhat complex term to explain what is meant. The concept at issue is epistemology. Epistemology is an understanding of the theory of knowledge and how and in what ways and degrees things are known. In some situations you have a very high degree of accuracy attached to a given dollar figure – for example, printed stock prices on the financial page. The degree of reliability of reported stock prices should be understood in relation to the reliability and accuracy of reported accounting earnings. With respect to reported accounting earnings, some companies apply very conservative, withdrawn, and limited accounting principles to recognize revenue in a very limited way and recognize expenses more rapidly. Other firms do precisely the opposite, recognizing revenue in an expansive fashion, while slowly writing off expenses. In the boom years of the 1990s, many firms (technology firms in particular) engaged in the latter practice of reporting current earnings at as high a level as possible through rapid revenue recognition and delayed expense write-offs. Thus, the reported net income figures of firms using greatly differing accounting principles are inherently dissimilar in a qualitative fashion and simply cannot be compared without adjustment.
Accordingly, we must apply a far lower level of reliability to reported accounting earnings (and the comparability of this figure across different firms using different accounting conventions) than we do to reported stock prices. In essence, there is a significant epistemological difference between these two concepts. And again, there are no rules: Two financial statements can have the same dollar per share of earnings and mean something very, very different in one case versus the other. So it’s hard to speak in terms of rules governing financial affairs.
If we had to list ten immutable rules with respect to finance, all ten of them would be, “Be skeptical.” Just as they say about real estate, “Location, location, location,” we should say, “Be skeptical of what you’re told” ten times. Look beneath the simplistic nature of things. There truly are no immutable rules other than obvious mathematical relationships. If you invest a dollar today, and you get two dollars back at the end of ten years, every financial analyst knows that your rate of return is 7.2 percent compounded annually. This financial relationship between inflows and outflows of funds will not change over time. To compute the present value of a financial commitment, once the inflows and outflows of funds on the commitment are known, every financial analyst will get the same answer. This is an unchangeable rule. You put the numbers in the computer and press a button, and everyone will agree as to the outcome. But it’s only those kinds of things that are hard and fast rules; everything else is highly changeable. The really important, significant, and interesting issues relate to the inputs (usually the inflows and outflows of funds). Once we can agree on these inputs, we will all get the same answers. But agreement on these inputs is not easy and depends on the many assumptions that are made in any such determination of project cash inflow and outflows.
Nevertheless, there are a few formulas, theories, and hypotheses that have risen to a high level of ascendancy in terms of understanding financial markets. Again, none of these models is believed in the sense of immutability.
CAPM, as noted, is simply a way of relating risks and returns. CAPM was originally developed as a means of valuing financial assets. However, it has been used less successfully in capital budgeting, which refers to the valuation of real assets.
There is also the Black-Scholes model, which is an options pricing model that has additionally been extended in terms of contingent liabilities and other areas. Black-Scholes has been found to be a very useful model with respect to many valuation problems.
But there have been a number of departures from both of these – the so-called arbitrage pricing theory is one. All of these models are fairly old and well used. There was a time, 20 or 25 years ago, when in the classroom we would use these terms and teach our students these things, and find that in executive development programs in the investment community, they weren’t widely used. Now they are. Beta and other measures of risk are as common in the contemporary investment community as blood pressure, PSA, and other measures of physical health are in the doctor’s office.
In essence, what were once purely academic models have now risen to the status of general acceptance in the professional business and investment communities, a development of the last 20 or 25 years. Before that time, these academic terms and concepts weren’t quite as popular as they now are in the professional world. One of the primary reasons for the adoption of these academic concepts by the professional business community is the trend for students to be trained in the academic world before entering business. The MBA is now virtually a necessary credential for entry at the highest levels into the business community. Executive training programs have become commonplace. And some of the highest-level academics are now going to work in the business world, either as consultants or as employees in some of the biggest Wall Street firms. Many academics have done that – and in so doing have fattened their pocketbooks considerably. But the overall result is a greater closeness over the past quarter century between the academic and professional business worlds.
A concept not yet developed in this chapter that has considerable current interest both in academic and professional business circles is the efficient markets hypothesis (EMH). EMH is the notion that information drives stock prices, comes to the market randomly, and is instantaneously impounded in these stock prices. A clear implication of EMH is the disutility of attempting to predict stock price movements. Many studies have tested the validity of EMH, and while some exceptions have been found to this concept, most of these exceptions are to be expected on the basis of institutional characteristics of markets and other such factors. In essence, while some inefficiencies have been found in major markets, such as the United States, this condition is somewhat unusual and rarely represents viable investment opportunities for the individual investor. In general, market inefficiencies are far greater in emerging markets than in developed markets. Yet, anyone who has lived through the last ten years understands that inefficiencies can plague developed capital markets, as well.
A word of caution: All models make assumptions. For example, CAPM assumes no transaction costs, no taxes, and, among other things, the stability of beta over time. You have to understand the assumptions behind these models, and all of them abstract and go into somewhat unrealistic assumptions to make reasonable projections of risk-return relationships. It’s not enough just to say, “I know the equation of CAPM.” That’s easy enough. You actually have to understand what’s behind the equations – basically the assumptions on which these equations have been built.
Tags: Finance