Answer to Question #18917 in Finance for Traci Barker

Question

Discuss how senior management’s short-term focus on stock price in a publically traded company can lead to unethical behavior

Answer 1

Leaders receive much of the credit for success and also shoulder most of the blame for ethical failures in organizations. CEOs and other senior corporate executives concerned with their reputations and the company's stock price also focus on reported short-term performance measures, particularly earnings. As a consequence, investment and corporate managers have a mutually reinforcing obsession with short-term performance, with earnings the most widely accepted metric.Portfolio managers who are able to accurately and consistently forecast year-ahead earnings can earn extraordinary returns. It is easy for investors who observe sizable price responses to earnings surprises to conclude that using "irrational" earnings analysis is better than using the "rational" DCF model, which they view as theoretically valid but practically disconnected from expected returns.
Stock prices reflect information relevant to the models investors use. Investment managers have little incentive to pursue private information that con¬tributes to more efficient prices unless such information is also relevant to their decision models. Fundamental efficiency is not an empirically refutable hypothesis because in a sea of uncertainty and heterogeneous beliefs, the right price is indeterminate.
Corporate executives point to the behavior of market participants to justify their short-term focus and their belief that investing for the long term is not rewarded by higher stock prices. The idea that management's primary responsi¬bility is to maximize long-term shareholder value is widely accepted in principle but imperfectly imple¬mented in practice. Maximizing long-term value means that management's primary commitment is to continuing shareholders rather than to day traders, momentum investors, and other short-term-oriented market players. To maximize value to con¬tinuing shareholders, managers must develop and effectively execute strategies that maximize the company's long-term cash flow potential.
Spurred by the belief that investors mechanically apply a multiple to current earnings to establish value and the fact that management compensation is partially tied to earnings performance, some companies repurchase shares even when they believe shares are fairly valued or overvalued. There is no greater impediment to good corporate governance and long-term value creation than earnings obsession. There is no greater enemy of stock market efficiency than earnings obsession.