The Problems That Can Arise With Struggling Firms Facing Wall Street

The Baltimore Sun
Michael Hill
(Copyright 2002 @ The Baltimore Sun Company)

One essential element of the collapse of Enron is a theme of such downfalls in recent years - the pressure to maintain a high and increasing stock price.

The allegations at Enron are that large amounts of debt were essentially kept off the books, allowing the company to appear to be as profitable as Wall Street analysts wanted, ensuring that its stock continued to rise. After word of their accounting irregularities leaked, panicked Enron executives asked the White House to intervene, trying unsuccessfully to convince administration officials that the collapse of their inflated stock would take down a large chunk of the country's economy.

When Washington-based MicroStrategy's stock tanked two years ago, putting a large hole in what was then the huge dot-com bubble, the charge was that the company took money from one quarter and put it in the previous quarter, again to beat those Wall Street earnings projections and keep the stock soaring.

Albert Dunlap and other former executives of the Sunbeam Corp. agreed last week to pay $15 million to settle a shareholders' class action lawsuit that accused them of misleading investors to keep the stock selling.

"There's a lot of pressure on CEOs to keep the stock price up and have it increase," says Peter Cramton, a professor of economics at the University of Maryland, College Park. "This especially becomes a problem in periods of irrational exuberance when stock prices are unjustifiably high.

"It puts CEOs in a position that in order to justify that extremely high stock price, they have to have phenomenal growth, and maintaining that growth is really virtually impossible," he says.

Though the dot-com bubble collapsed, its hangover remains. For many, the way to make money in business is not to profitably produce a product people will buy, it's by hitting it big on the stock market.

That is exactly the way many executives make their money. As "maximizing shareholder value" became the accepted mantra of American business, more executives found their compensation tied to their company's stock price.

When William Clay Ford Jr. announced tens of thousands of layoffs at Ford Motor Company a few days ago, he said he would take no salary, only stock options.

"There has always been some kind of obsession with stock prices," says Nagpurnanand Prabhala, assistant professor of finance at UMCP's Smith School of Business. "It went up vastly more in the '90s. It is hard to say if the relationship is causality or correlation, but you can't ignore the fact that this happened at the same time more and more executives were getting option guarantees."

Many argue that executives' salaries should be tied to stock performance.

"There is no more important and appropriate job for a CEO than supporting the stock price," says Joel N. Morse, director of the division of economics, finance and management at the University of Baltimore.

Morse says that a high stock price means a company has access to capital to pursue its goals, short-term and long-term. When the system works correctly, he says, investors weigh the long-term prospects of a company as they decide on the value of its stock today.

But he agrees that the pressure in today's market to keep the stock price rising can lead to distortions.

"If you are an executive of a corporation and you know you'll lose your job and your fortune if your stock goes from $100 to $50, but you know you need to be cautious in a few areas of your business and you want investors to know that, it's hard to do," he says. "It's harder to call a spade a spade and the whole American market is based on calling a spade a spade."

Some tie the stock price obsession with the rise of financial analysis industry.

"The growth of this tremendous investment community and all the specialists who work in it and all the media that report on it, it seems to me, puts substantially more short-term pressure on management to keep the pipeline going, keep the growth rate going," says Louis Galambos, an economics historian at the Johns Hopkins University. "The external pressure has changed."

Galambos says company CEOs have few more important tasks than their presentations for Wall Street financial analysts whose projections have a tremendous impact on stock prices.

"The amount of preparation for these reports is awesome," he says. "That's because of the pressure they feel from the financial analysts and from the media. Sometimes this kind of pressure can distort things. It can distort prices."

J. Edward Ketz, an associate professor at Penn State's Smeal College of Business, says this exercise has gotten out of hand.

"What started out as a useful service to society by analysts when they collect and study the financial statements and other news about a corporation's welfare to predict its future earnings has become an insane escapade," he says.

"Accounting is simply not precise enough to allow people to predict that a company is going to have, for example, quarterly earnings of $1.23 per share and then actually expect the firm to meet the number exactly," he says. "Given those limitations, I cannot understand why anybody becomes troubled if the earnings number actually turns out to be $1.22 or $1.21 per share. But investors do react to a firm's missing its forecast even by one penny by punishing the company with a big drop in the stock price."

Walter Schubert, chairman of the finance department at Lehigh University, says too many investors have short attention spans.

"These guys are fascinated by the earnings statements every quarter," he says. "We have a lot more access to information. Cable TV has helped - or hurt, depending on your perspective. And everyone is looking for that 30-second sound bite on CNN or the Internet. Very few people read in-depth analyses."

One odd aspect of these analysts' work is that they tend to love layoffs. Schubert says he remembers his father's factory going on four-day shifts to avoid layoffs.

"They still do that in other countries, but not here," he says. "When a company announces it has laid off 3,000 workers, now it's, `Oh, boy! Isn't that great?' It's bizarre. You are saying you're performing poorly. If you were shaking up management, it might make sense, but you still have the same people who got the company into this trouble in the first place."

But since the word on Wall Street is that layoffs make stocks rise, people buy the stocks of companies that announce layoffs. It's a self-fulfilling prophecy. The same is true of making - or missing - earnings projections. Stocks are bought and sold on those benchmarks even if the projections are based on unreal assumptions about the accuracy of accounting.

Ketz, who teaches accounting, says the stock price pressure is felt by accountants.Enron's accounting firm, Arthur Andersen, has been implicated in its troubles.

"Given that so much real money is riding on meeting these forecasts, it is easy to understand - but not accept - why some managers lie about the actual results by the corporation," he says. "In turn these managers put pressure on auditors to allow them to book events and transactions in the manner that managers see fit."

Part of the blame here, Ketz says, is that the accountants work for firms that are making big bucks from the companies they are auditing.

"Most auditors in the field know the problems and risks of their clients and attempt to address the audit concerns," he says. "Yet the only message they hear from their bosses is that they must generate profits."

Gene Swanson, director of the MBA program at Johns Hopkins, notes another way the stock price pressure can affect these audits.

"The auditors themselves are not compensated in stock, but who oversees the auditors?" he asks. "That's usually a board of directors activity. The audit committee is a sub-committee of the overall board and many of them have shares and options on shares. That's a conflict of interest area that I think needs to be dealt with in a regulatory way."

Swanson recommends firewalls between those auditing a company and those making money from a company. He and Morse join many in suggesting similar barriers between the financial analysts recommending stocks and the financial firms that market those stocks.

Several say that companies like Enron that are involved in complex transactions should be required to report those in an understandable form. Others suggest that that pay packages tied to stock prices should be structured to make sure executives are looking after the long-term interests of a company not just the next quarter's results.

Cramton has one other piece of advice.

"When you get into a period when the stock price just doesn't make much sense, that's when the CEO is put in a most difficult position and has very strong incentives to make the wrong decision and sustain the bubble as long as possible rather than doing the right thing and letting the stock price drop down to where it should be and work on creating long-term values."

As Buddy Holly once sang, "That'll be the day ... "

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REPORTERS & EDITORS: For more information, please contact Wyatt DuBois in the Smeal College of Business Media Relations Office at 814-863-3798 or wed112@psu.edu .

Penn State's Smeal College of Business offers highly ranked undergraduate, MBA, executive MBA, Ph.D., and executive education opportunities to more than 5,500 students at all levels. Featuring academic departments of accounting, finance, marketing, insurance and real estate, management, and supply chain and information systems, the college is also home to major research centers such as the Center for Supply Chain Research, the Institute for the Study of Business Markets, the eBusiness Research Center, the Farrell Center for Corporate Innovation and Entrepreneurship, the Center for Global Business Studies, and the Center for the Management of Technological and Organizational Change.

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