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” that will appreciate as our earnings increase. This activist investor, our directors, and I share the same frustration with our current earnings multiple, which 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
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.
Sometimes outsiders have clearer eyes than insiders, and the market sees something you don’t.
You should take a long, hard look at two possible explanations for the stagnation of your share price. One is that the stock market is missing 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.