In past years when the stock market was booming, the “price-earning multiples" of many growth stocks were in the stratosphere. Without taking into account the yet-to-make-any-profit dot coms whose P/E multiples were infinite, it was common to see P/E multiples in the hundreds, which means investors were expecting significant future earnings growth from these companies. Employees with stock options became millionaires on paper when the market translated these lofty multiples into ever-rising stock prices.
No one wanted the party to end, and many truly believed that the “New Economy" would defy gravity rather than follow traditional economic principles. In September 1999, when the stock market kept breaking new records, James K. Glassman and Kevin A. Hassett published their book titled “DOW 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market". The amazing thing was there were many who actually believed their prediction that this would happen in just a few years! Not to be outdone, another author, Charles Kadlec, has predicted that the Dow will go to 100,000 by 2020.
Beneath all this optimism is the relentless pressure to push up the “E" element in the P/E formula since senior management realize that this is perhaps the only element that is somewhat “controllable" by them. They figure if management can show continuous growth in earnings, the lofty multiples will continue and stock prices will escalate. To make sure the market feels the multiples are justified, they routinely make brash predictions about earnings growth.
Companies Under Pressure
Things have become difficult. Sales have slowed down. Margins are squeezed. Targets are in danger of being missed. The pressure on reported profits is relentless – public companies have to face the public every quarter. In desperation, strange things happen:
* The Securities and Exchange Commission (SEC) is currently investigating Xerox and Citibank, whose Brazilian units may have entered into a series of bogus transactions to boost profits in 1999. It is alleged that in order to increase its sagging sales, Xerox worked out a deal with Citibank to enable it to immediately book $321 million in sales and $182 million in future rental profits from copiers that were leased out. The transaction made it look like Citibank was leasing these copiers from Xerox, thus enabling Xerox to book the profits. Actually Xerox guaranteed Citibank that if the true customers return the copiers, Xerox would make Citibank whole. These facts were never disclosed. A disgruntled former Xerox executive blew the whistle, which brought on the SEC investigation.
* Lucent Technologies, a darling of the stock market 18 months ago, has crashed. Its former CEO, Rich McGinn, went from being the genius who increased Lucent’s market capitalization to $285 billion after spinning-off from AT&T, to being fired in late 2000.
Two women, Carly Fiorina (current CEO of HP) and Nina Aversano (who was fired days before McGinn and is now suing Lucent) strongly advocated an aggressive growth strategy. I had first-hand experience dealing with Lucent when I was the CEO of a wireless telecommunications company in Hong Kong. My company awarded a large contract to Lucent in 1996 when Lucent was by far the most aggressive bidder (“We are selling below our cost", the sales executive from Lucent assured me at the time). Then things got tight, and Lucent began to sell equipment to small telecommunications companies on generous credit terms and to “stuff the channel" so as to pull future income into the present. Aversano’s lawsuit describes how McGinn had ruthlessly pushed everyone into producing increasing sales and profits at each quarter’s end. The result was a series of missed targets, substantial write-downs and profit restatements which put the company on the brink of being taken over.
* Carly Fiorina, now the head of HP, took the same aggressive style there. As soon as she arrived at HP, she began to make ambitious and optimistic predictions: “Revenue growth of 12% to 15% and earnings growth faster than that" (early 2000); “15% revenue growth and even faster earnings growth" (mid 2000); “15% to 17% for revenues (Fall 2000)". In fact, Carly Fiorina was so confident of HP’s earnings that when she was asked by an analyst whether or not it was really necessary to publicly give these targets, she said, “I wouldn’t be promising that if I wasn’t sure that it was in the bag". HP’s share price went to a historical high of nearly $140 before the 2-1 split in October 2000. Then things unraveled. On November 13, 2000 she had to disclose that HP was going to miss the targets “by a few cents". Even so, she still gave the same optimistic prediction: “For the 2001 fiscal year ending Oct. 31, 2001, HP expects to achieve revenue growth in the range of 15 to 17%, compared to 15% in FY 2000." But two months later on January 11, Ms. Fiorina announced: “…the company no longer expects to meet previous first quarter guidance. our revenue guidance for Q1 is in the low- to mid-single-digits and we’re not counting on improvement during the first half of our fiscal year." In April, Ms. Fiorina had to do away with the 15%-17% projection altogether. On May 16, HP announced that its net income had fallen 66%, and sales fell 4%. Ms. Fiorina’s prediction now: revenue from flat to down 5%.
I could go on and on citing cases where companies over-promised and under-delivered. The pressure to “show more profits" sometimes turned into “cooking the books" or “producing profits from thin air". There are a number of major companies (McKesson, Cendant, Tyco, etc.) which have suffered from acquisition of grossly over-inflated companies.
Quick “Fixes" and Long Term Consequences
What are the consequences of this ever-increasing pressure to show higher profits?
Such pressure has affected the behavior of corporate officials who normally follow sound business practices and generally accepted accounting principles. Financial statements used to be believable but pressure has caused many corporate executives to walk a thin line. The short-term mentality to “borrow from the future to show results today" may sacrifice the corporation’s long-term future. Companies which focus on the short term may take short cuts on research and staff development, which do not add to the bottom line immediately. Or they will take on excessive risks, such as credit risks, just to generate business. Such corporate myopia could be detrimental to the long-term viability of the corporations.
Such overreaching ambition is also bad for investors who are being presented with rosy predictions that must be revised downward over and over again. Investors must make their decisions on timely, accurate and relevant information, yet they often do not get it from these companies. When companies restate their results or miss their own aggressive targets, investors suffer loss in the value of their investment, sometimes as much as 30% in a single day! There are many class-action lawsuits by investors who want to fight back, but the only ones who gain from these lawsuits are the lawyers.
The negative impact on the employees also cannot be ignored. Executives who are under pressure to stretch or be economical with the truth face a constant moral dilemma. The pressure to achieve higher and higher profits every quarter creates so much stress that is unhealthy both physically and mentally. And of course when companies use massive layoffs as the way to improve short-term bottom lines, the lives of many families are affected.
Where Do You Stand?
Many believe capitalism is the best economic system this world has ever seen, and perhaps it is. But if there are no corporate ethics or controls to keep rampant greed in check, things will spin out of control. The examples above clearly show the detrimental effects on both individuals and businesses. Neither can survive long on lies or greed. Short term gains may be achieved by pure chance or deceptions, but long term gains must be based on something much more substantial.
Whether you are a CEO or just a regular employee, you too probably feel the tremendous pressure from running in the “rat race”. Are you driving your career and your life with unrealistic goals, over-ambition, greed, or lies? Do you believe the end always justifies the means? How do you distinguish right from wrong? When the going gets tough, where do you draw your inner strength and moral fortitude? For Christians, God’s Words provide the solid foundation for our careers and our daily living. In Matthew 7:24-27, Jesus said, “Therefore everyone who hears these words of mine and puts them into practice is like a wise man who built his house on the rock. The rain came down, the streams rose, and the winds blew and beat against that house; yet it did not fall, because it had its foundation on the rock. But everyone who hears these words of mine and does not put them into practice is like a foolish man who built his house on sand. The rain came down, the streams rose, and the winds blew and beat against that house, and it fell with a great crash."
林修榮談天說地 