It's the Cash Flow, Stupid!

Interesting Article that I received as an email forward. A dot-com investor confesses to a fit of irrational exuberance. -SSS


ECONOMISTS ARE SOMETIMES defined as people who don't believe things work in practice until they can be proven in theory. Not surprisingly, during the dot-com bubble the behavior of investors befuddled these economists. Very few dot-com investors consulted their financial theory textbooks before making investments in the stock market. In fact, many did not even understand the businesses they were investing in. To understand the dynamics of valuations during the bubble, it is necessary to look at investor practice. Like many others, I had a rush of "irrational exuberance." With hindsight, my only regret is not that I joined in the gold rush but that I became exuberant at a time when the bull market was 95 percent of the way up the incline. Although it went against everything I ever learned in finance, I began to believe that I was missing the much-touted "New Era Economic Thinking."

During the boom, the stock market valued dot-coms that were incurring negative cash flows more highly than companies generating profits and positive cash flows. We had irrationally exuberant investors driving stock prices beyond what cash flows could justify and so-called professionals trying to rationalize why this was correct! Later, cash flows acted on valuations the way gravity acts on matter: The lower the cash flow, the greater the downward pull on valuation. The Bill Clinton mantra, "It's the economy, stupid," kept his people's focus on the central role that the U.S. domestic economy plays in American voting behavior. I could have done with an adviser reciting a mantra about the fundamentals of company valuation: "It's the cash flow, stupid."

In the aftermath of the roller-coaster ride, I returned to my finance books and re-learned the basics of how to value a business. According to "efficient markets" theory, the stock market valuation of a firm is the outcome of all available economic information about that firm. But the theory is based on the assumption that investors act rationally and therefore stock prices are always a reflection of value. The dot-com bubble presents a challenge to efficient markets theorists because of the obvious stock mispricing that lasted for quite some time without a correction by the market.

When the cash flow performance of Internet companies became clear and reliable estimates of cash flow became possible, two things changed that had an impact on stock market valuation: Investor enthusiasm for dot-coms collapsed, and valuations became aligned with the emerging reliable estimates of future cash flow performance.
In other words, in the aftermath of the dot-com crash, long-established valuation principles were restored, and a new generation of investors has learned old lessons in finance.

BY RONAN MCGOVERN, MS SLOAN '96
Ronan McGovern, MS (Management) Sloan '96, is associate director of the corporate finance division of Allied Irish Bank in Dublin, Ireland. The full text of this article was published in Ireland in the Jan. 13, 2002, Sunday Business Post.