Fundamentals of Financial Management (Concise 6th Edition)

Chapter 1 An Overview of Financial Management 11

Many other legal but questionable accounting procedures have been used, all in an
effort to boost reported pro! ts and the stock price on the option exercise day.
Obviously, all this can make it dif! cult for investors to decide how much a stock is
really worth, and it helps explain why a! rm’s reputation is an important determi-
nant of its stock price.
Fortunately, most executives are honest. But even for honest companies, it is
hard for investors to determine the proper price of a stock. Figure 1-2 illustrates the
situation. The top box indicates that managerial actions, combined with the econ-
omy, taxes, and political conditions, determine stock prices and thus investors’ re-
turns. Remember that no one knows for sure what those future returns will be—we
can estimate them, but expected and realized returns are often quite different. In-
vestors like high returns, but they dislike risk; so the larger the expected pro! ts
and the lower the perceived risk, the higher the stock’s price.
The second row of boxes differentiates what we call “true expected returns”
and “true risk” from “perceived” returns and “perceived” risk. By “true,” we
mean the returns and risk that investors would expect if they had all of the infor-
mation that existed about a company. “Perceived” means what investors expect,
given the limited information they actually have. To illustrate, in early 2001, in-
vestors had information that caused them to think that Enron was highly pro! t-
able and would enjoy high and rising future pro! ts. They also thought that actual
results would be close to the expected levels and hence, that Enron’s risk was low.
However, true estimates of Enron’s pro! ts, which were known by its executives
but not the investing public, were much lower; and Enron’s true situation was ex-
tremely risky.
The third row of boxes shows that each stock has an intrinsic value, which is
an estimate of the stock’s “true” value as calculated by a competent analyst who
has the best available risk and return data, and a market price, which is the actual
market price based on perceived but possibly incorrect information as seen by the

Intrinsic Value

An estimate of a stock’s

“true” value based on

accurate risk and return

data. The intrinsic value

can be estimated but not

measured precisely.

Intrinsic Value

An estimate of a stock’s

“true” value based on

accurate risk and return

data. The intrinsic value

can be estimated but not

measured precisely.

Market Price

The stock value based on

perceived but possibly

incorrect information as

seen by the marginal

investor.

Market Price

The stock value based on

perceived but possibly

incorrect information as

seen by the marginal

investor.

Determinants of Intrinsic Values and Stock Prices

F I G U R E 1! 2

Managerial Actions, the Economic

Environment, Taxes, and the Political Climate

“True” Investor

Returns

“True”

Risk

“Perceived” Investor

Returns

“Perceived”

Risk

Stock’s

Intrinsic Value

Stock’s

Market Price

Market Equilibrium:

Intrinsic Value = Stock Price