A Discounted Cash Flow View of Investor Relations

Every now and again, it’s helpful to stop and think about the frameworks in which investor relations operates. From a finance viewpoint, traditional academic finance approaches the valuation of a company along the following lines: “the value of a company is based upon investors’ estimates of the sum of its future cash flows, discounted back to their present value”. (Investors will often use earnings per share and dividends per share as proxies for cash flows.) The confidence that investors have in those estimates is based largely upon: 1. A company’s past performance as a measure of its ability to continue to perform, and 2. The investors’ view of the economy and the markets as expressed by the discount rate they assign to the cash flows. In other words, what drives the equation are estimates about the future, using the past record of the company as a reality check.

When you think about it this way, several interesting things about investor relations pop up. First, the equation is predicated on what will happen in the future, yet most of investor relations is spent explaining what occurred in the past, i.e. last quarter. So it’s important that proactive investor relations officers spend much of their time discussing what the firm is doing to insure future revenues and where the markets for their products are headed. If investor relations can’t, or won’t, explain how the firm intends to grow revenues, earnings and cash flows into the future, they shouldn’t expect investors to make that leap of faith for them. Companies that have to sell products or services will almost always have better forward-looking market data than investors. Judiciously sharing that data with investors will help them make better estimates. And by removing some uncertainties, it can help lower the discount rate assigned to the cash flows, which results in a higher present value.

Secondly, management matters. How can investors be expected to place large bets on your company’s future performance through the ownership of stock, if they haven’t met and assessed management’s ability to continue to perform? Yet many investor relations departments view their roles as gatekeepers, only allowing access to management at limited times to favored investors. If you want to achieve fair valuation over the long haul, investors need to speak periodically with management. Investor relations departments can function to save management a lot of time by making sure investors understand the company before seeing management and by covering what I would characterize as “routine maintenance” questions, but eventually, investors need to hear directly from the management team to see if they have a grasp on strategy, details, customers and markets.

Third, consistent profitability over the life of the investment will be more valuable than big profits in the out years of the investment, because they will be discounted less and will help compound earnings projections in later years. Consistency will also help investors assign lower discount rates to future cash flows, as they are much more comfortable projecting based on visible trends than they are if your earnings are all over the map.

So why then does everyone make such a fuss about the most recent results, and why do the short-term results seem to have such an outsized influence on the stock price? The answer, quite simply, is “Because that’s the way the math works”. (When my kids were struggling with math in grammar school I used to tell them that all of life was a math problem – this is a perfect example.) If, based on recent results, an analyst reduces their estimate for the first year of a five year model, not only does the reduction count for more because it is almost entirely undiscounted, but it will reduce estimates in future years, as the models are constructed to build and compound on previous years. Further, if the model is taking dividends into account by estimating them as a percentage of earnings, it will reduce all subsequent dividends as well. Conversely, changes made to estimates in the later years of a model have a much smaller effect on estimated present value and the price investors will pay for a company’s stock.

To put all of this in perspective, smart investors are betting on your future success, and that’s where the bulk of investor relations communication should be. But don’t neglect to adequately explain current earnings because if you don’t, and estimates are too low in the early years of investors’ earnings models, the perceived value of your firm will wind up being too low.

In other words, the ability to adequately explain current and past performance creates the foundation necessary for investors to understand a company, but helping them understand the basis for future profitability is the structure they need for estimating a fair value for your stock.