Managing what you measure
Nobel prize-winning economist Joe Stiglitz has an interesting essay in the current Fortune about the deficiencies of gross domestic product as a measure of economic health. Lots of people have been criticizing GDP these days: Some focus on the inability of economic numbers to reflect true well-being. Others worry that our methods for measuring inflation are skewing real GDP growth either upward or downward.
Stiglitz takes aim at the failure of GDP to factor in the depletion of resources. A country can boost GDP by strip-mining with abandon or cutting down all its trees, even though both actions probably leave it less well-off. The alternative that Stiglitz endorses is "green net national income," a measure you can learn more about here. The idea is to incorporate financial and physical assets, and the depreciation thereof, into national accounting--as is already done in corporate financial accounting. The upshot is supposed to be better decisionmaking. As Stiglitz writes: "A government focused on GDP might be encouraged to give away mining or oil concessions; a focus on green NNP might make it realize that the country risks being worse off." Sounds reasonable. There would be a certain irony, though, in moving from cash-flow-based national economic accounts to a measure modeled on corporate earnings. It is, after all, pretty standard investing advice to ignore earnings and focus instead on cash flow, because earnings are so colored by estimates and assumptions and thus easy to manipulate. Would "green NNP" be any different? The lesson here is that any single measure of a country's or a corporation's well-being is bound to be deeply flawed. Since most of us are prone to fixating on just one, we should of course try to arrive at the best single measure possible. But truly intelligent economic decisionmaking will always require looking beyond it. "The lesson here is that any single measure of a country's or a corporation's well-being is bound to be deeply flawed"
The value of corporate stock is its ability to pay dividends, as the value of any investment is its return. The future value of any stock is its future ability to pay dividends. People who say stock is "hard to value" are probably selling or holding stock for prices higher than its value. Ultimately, once all bubbles are ironed out and capital expansion rates become decent rather than indecent, the value of stock will be the value of its dividends. It is an inevitable conclusion of the stock market, the current unrealistic situation is not stable, propped only by a vastly increasing supply of investment capital worldwide, which self-corrects as people come to judge capital at its true value. During periods of fantastic capital expansion, there is a misjudement towards overvalue, people's thinking can't keep up with the money supply expansion, but these things catch up. At that point, people will begin to require dividends from stocks before investing capital in them, making sound decisions rather than speculative ones. Yes, but one can only estimate what future dividends will be. Any single measure of current corporate performance (be it earnings or dividend yield or EVA or whatever) is going to miss some aspects of the real economic health of a company.
The comment on cash flow being better than earnings is not true, and the reason why supports Stiglitz's views. Earnings are better because they better describe CURRENT activity, which may generate cash flows in the future for many years. Current cash flows are likely mostly about past activity. Most financial companies cannot be reasonably valued using cash flow for this very reason. That earnings can be manipulated more easily is unfortunate but irrelevant. If cash flows were better, that's what accountants would use for GAAP, and they don't. Earnings force you to think about future cash flows now, and that's exactly what Stiglitz wants, which is a very good idea.
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