Second, the late 1970s and late 1990s produced significant deviations from intrinsic valuations. In the late 1970s, when investors were obsessed with high short-term inflation rates, the market was probably undervalued; long-term real GDP growth and returns on equity indicate that it shouldn’t have bottomed out at P/E levels of around 7. The other well-known deviation occurred in the late 1990s, when the market reached a P/E ratio of around 30 — a level that couldn’t be justified by 3 percent long-term real GDP growth or by 13 percent returns on book equity.
Third, when such deviations occurred, the stock market returned to its intrinsic-valuation level within about three years. Thus, although valuations have been wrong from time to time — even for the stock market as a whole — eventually they have fallen back in line with economic fundamentals.
Focus on Intrinsic Value
What are the implications for corporate managers? Paradoxically, we believe that such market deviations make it even more important for the executives of a company to understand the intrinsic value of its shares. This knowledge allows it to exploit any deviations, if and when they occur, to time the implementation of strategic decisions more successfully. Here are some examples of how corporate managers can take advantage of market deviations.
- Issuing additional share capital when the stock market attaches too high a value to the company’s shares relative to their intrinsic value
- Repurchasing shares when the market under-prices them relative to their intrinsic value
- Paying for acquisitions with shares instead of cash when the market overprices them relative to their intrinsic value
- Divesting particular businesses at times when trading and transaction multiples are higher than can be justified by underlying fundamentals
Bear two things in mind. First, we don’t recommend that companies base decisions to issue or repurchase their shares, to divest or acquire businesses, or to settle transactions with cash or shares solely on an assumed difference between the market and intrinsic value of their shares. Instead, these decisions must be grounded in a strong business strategy driven by the goal of creating shareholder value. Market deviations are more relevant as tactical considerations when companies time and execute such decisions — for example, when to issue additional capital or how to pay for a particular transaction.
Second, managers should be wary of analyses claiming to highlight market deviations. Most of the alleged cases that we have come across in our client experience proved to be insignificant or even nonexistent, so the evidence should be compelling. Furthermore, the deviations should be significant in both size and duration, given the capital and time needed to take advantage of the types of opportunities listed previously.
Provided that a company’s share price eventually returns to its intrinsic value in the long run, managers would benefit from using a discounted-cash-flow approach for strategic decisions. What should matter is the long-term behavior of the share price of a company, not whether it is undervalued by 5 or 10 percent at any given time. For strategic business decisions, the evidence strongly suggests that the market reflects intrinsic value.
About the Authors
Marc Goedhart is an associate principal in McKinsey’s Amsterdam office, and Tim Koller is a principal in the New York office. David Wessels, an alumnus of the New York office, is an adjunct professor of finance at the Wharton School of the University of Pennsylvania. This article is adapted from Tim Koller, Marc Goedhart, and David Wessels, Valuation: Measuring and Managing the Value of Companies, fourth edition, Hoboken, New Jersey: John Wiley & Sons, 2005.