12

News and Narratives

In the last chapter I looked at how the real world delivers surprises that alter narratives and affect value. In this chapter I will continue that discussion by looking at how corporate news announcements may (or may not) affect narratives and value, starting with earnings reports, perhaps the most ubiquitous and widely followed of these news stories, and then moving on to more infrequent but often more consequential announcements about new investments, financing (borrowing or new stock issues), and plans to return cash (dividends or stock buybacks) that can change your stories, and value.

The Information Effect

You don’t have to be a believer in efficient markets to accept the proposition that markets move on news. Stock prices are driven up and down by new information, and the only debatable issue is whether the price changes that you see are consistent with the news, both in terms of direction (good or bad) and in magnitude. Not surprisingly, news stories also have an effect on narratives, and as noted in the last chapter, they can alter the trajectory radically in some cases, change it marginally in others, and end it in extreme cases.

In this chapter I focus on how corporate news releases affect their narratives, starting with earnings reports, released quarterly in some parts of the world (including the United States) and semiannually or annually in others. I then look at more infrequent announcements that companies make about their investment decisions (acquisitions, in particular), financing (to add to or pay down debt), and dividends (initiated or suspended, increased or decreased, and defined broadly to also include buybacks) to see how these can change the story you tell about a company. The final section focuses on what is loosely categorized as corporate governance news and, in particular, how a corporate scandal can alter perceptions about a company (and its narrative) and why having a change in the investor base (especially the entry or exit of activist investors) can change the story for a company. As you go through the chapter, it is worth emphasizing that having the company as the source of your news is both a plus and a minus. The plus is that the company has access to information that most investors otherwise would not have. The minus is that the company is a biased source, especially when it is in the midst of a crisis.

Earnings Reports and Narratives

Each quarter, U.S. companies, in particular, go through a ritual called the earnings season, when they report their quarterly earnings. These announcements are among the most analyzed and awaited news stories about companies. Sell-side equity research analysts spend a considerable portion of their time estimating what the earnings will be, and the company’s top managers spend just as much time trying to get expectations under control. When the earnings report comes out, the announced earnings per share is measured against expectations and is classified as positive if it beats expectations and negative if it does not meet expectations.

Much of what happens in the period around the earnings report involves the pricing process. The price reaction to an earnings report is usually consistent with the surprise contained within it, with positive or negative surprises evoking positive or negative price reactions. As a consequence, companies have increasingly turned to using the discretion that is granted to them in the accounting for income and expenses to “manage” earnings and to beat expectations, and there is some evidence that as companies have learned to play the earnings game, market reactions to earnings reports have also become more complex. Thus, when a company consistently manages to beat earnings per share expectations by five cents per share every quarter, at some point in time the market raises the bar for measuring earnings surprises to five cents above the analyst expectations.

If you are an investor, uninterested in playing the pricing game and more concerned with value, you will look at earnings reports very differently than traders would. Rather than focus on whether the reported earnings per share meet or beat expectations, you will scan these reports for information that could change your narrative about the company and, by extension, its value. Figure 12.1 outlines how you can use the narrative framework to change your story to reflect the information from the earnings report.

Figure 12.1

Earnings reports and narratives.

As you can see, this assessment may cause you to have a very different reaction to a given earnings report than traders, who are more focused on earnings surprises. An earnings release that reports higher than expected earnings per share (good news on the pricing front) can cause negative changes in your narrative, leading you to reduce the value of the firm just as price increases. Conversely, an earnings report that reports worse-than-expected earnings can change your story in positive ways, again causing a deviation between price and value movement.

CASE STUDY 12.1: EARNINGS REPORTS AND NARRATIVE CHANGES—FACEBOOK IN AUGUST 2014

I valued Facebook just before its IPO in February 2012 at about $27/share and argued that the stock was being overpriced at $38 for the offering. The tepid response to the offering price made me look right, but for all the wrong reasons. The botched IPO was not because the stock was overpriced or because the market attached a lower value to the stock but largely due to the hubris of Facebook’s investment bankers, who seemed to not only think that the stock would sell itself but actively worked against setting a narrative for the company. My initial valuation, though it looked conservative in hindsight, was based upon the belief that Facebook would be as successful as Google in its growth in the online advertising business, while maintaining its sky-high profit margins. Table 12.1 shows the valuation, with the story embedded in it, at the time of the IPO.

Table 12.1

Facebook, the Google Wannabe

The story
Facebook is a social media company that will use its giant user base to become an online advertising success story, almost as big as Google. Its growth path and profitability will resemble Google in its early years.
The assumptions
	Base year	Years 1–5	Years 6–10	After year 10	Link to story
Revenues (a)	$3,711	CAGR* = 40.00%	40.00% → 2.00%	CAGR* = 2.00%	Grow like Google
Pretax operating margin (b)	45.68%	45.68% → 35.00%		35.00%	Competitive pressures
Tax rate	40.00%	40.00%		40.00%	Leave unchanged
Reinvestment (c)	NA	Sales-to-capital ratio of 1.50		Reinvestment rate = 10.00%	Industry average sales/capital
Cost of capital (d)		11.07%	11.07% → 8.00%	8.00%	Online advertising business risk
The cash flows (in $ millions)
	Revenues	Operating margin	EBIT (1-t)†	Reinvestment	FCFF††
1	$5,195	44.61%	$1,391	$990	$401
2	$7,274	43.54%	$1,900	$1,385	$515
3	$10,183	42.47%	$2,595	$1,940	$655
4	$14,256	41.41%	$3,542	$2,715	$826
5	$19,959	40.34%	$4,830	$3,802	$1,029
6	$26,425	39.27%	$6,226	$4,311	$1,915
7	$32,979	28.20%	$7,559	$4,369	$3,190
8	$38,651	37.14%	$8,612	$3,782	$4,830
9	$42,362	36.07%	$9,167	$2,474	$6,694
10	$43,209	35.00%	$9,074	$565	$9,509
Terminal year	$44,073	35.00%	$9,255	$926	$8,330
The value
Terminal value		$138,830
PV (terminal value)		$52,832
PV (CF over the next 10 years)		$13,135
Value of operating assets =		$65,967
−Debt		$1,215
+ Cash		$1,512
Value of equity		$66,284
−Value of options		$3,088
Value of equity in common stock		$63,175
Number of shares		2,330.90
Estimated value/share		$27.07	The offering price was set at $38/share.

^* CAGR = Compound annual growth rate

^† EBIT (1 − t) = (Revenues* Operating Margin) (1 − tax rate)

^†† FCFF = Free cash flow to firm

Looking at Facebook’s nine earnings reports between its IPO in 2012 and late 2014, the market reaction shifted significantly over the period, as evidenced in table 12.2.

Table 12.2

Facebook Earnings Reports, 2012 to 2014

Report date	Revenues (in millions)			Operating income in millions/margin		Earnings per share (EPS)	Price reaction
	Actual	Estimate	% Surprise	Income	Margin	% Surprise	Week after
7/26/12	$1,184	$1,157	2.33%	($743.00)	−62.75%	54.02%	−25.35%
10/23/12	$1,262	$1,226	2.94%	$377.00	29.87%	−137.74%	8.77%
1/30/13	$1,585	$1,523	4.07%	$523.00	33.00%	25.00%	−7.01%
5/1/13	$1,458	$1,440	1.25%	$373.00	25.58%	16.88%	−1.13%
7/24/13	$1,813	$1,618	12.05%	$562.00	31.00%	47.73%	38.82%
10/30/13	$2,016	$1,910	5.55%	$736.00	36.51%	36.00%	0.22%
1/29/14	$2,585	$2,354	9.81%	$1,133.00	43.83%	1.01%	16.18%
4/23/14	$2,502	$2,356	6.20%	$1,075.00	42.97%	47.06%	−2.57%
7/23/14	$2,910	$2,809	3.60%	$1,390.00	47.77%	22.45%	4.75%

The botched public offering colored the market response to the very first earnings report, with the stock down almost 25 percent. In fact, I revalued Facebook after this report, when the stock price plunged below $20, and argued that there was nothing in the report that changed my initial narrative and that the company looked undervalued to me. I was lucky enough to catch it at its low point, since the company turned the corner with the market by the next quarter and the stock price more than doubled over the following year. I revisited the valuation after the August 2013 earnings report and with narrative changes came up with $38/share, leaving me with the conclusion that the stock was fully priced at $45 and that it was prudent to sell. Looking at the earnings numbers across the quarters, it is clear that Facebook mastered the analyst expectations game, delivering better than expected numbers for both revenues and earnings per share for each of the last seven quarters.

With Facebook, the market also paid attention to the size and growth of its user base and the company’s success at growing its mobile revenues. In table 12.3 I list these numbers and Facebook’s invested capital each quarter (computed by adding the book values of debt and equity and netting out cash) and a measure of capital efficiency (sales as a proportion of invested capital) from the IPO to August 2014.

Table 12.3

The Changing Look of Facebook

Report date	Active users	Mobile active users	Percent of revenue from mobile	Net income	Capital	Trailing 12 month sales/capital
7/26/12	955	543	NR	($157)	$3,515	1.23
10/23/12	1010	604	NR	($59)	$4,252	1.09
1/30/13	1060	680	23.00%	$64	$4,120	1.24
5/1/13	1100	751	30.00%	$219	$4,272	1.28
7/24/13	1150	819	41.00%	($152)	$3,948	1.55
10/30/13	1190	874	49.00%	$425	$4,007	1.71
1/29/14	1230	945	53.00%	$523	$4,258	1.85
4/23/14	1280	1010	59.00%	$642	$4,299	2.07
7/23/14	1320	1070	62.00%	$791	$4,543	2.20

This table captures the heart of the Facebook success story during this period: a continued growth rate in a user base that was already immense, a dramatic surge in both online users and advertising, and improved capital efficiency (note the increasing sales-to-capital ratio). The August 2014 earnings report provided more of the same: continued user growth, increased revenues from mobile advertising, and improved profitability. Looking at that report, I had to conclude that I had been wrong about Facebook’s narrative, for the following reasons:

  1.  While my initial reaction to Facebook’s success on the mobile front was that it needed to accomplish such growth to sustain its narrative as a successful online advertising company, the rate at which Facebook grew in the mobile market was staggering. In fact, given its results through August 2014, I saw a very real possibility that Facebook would supplant Google as the online advertising king and continue to maintain its profitability. That is a narrative shift, which will translate into a larger market share of the online advertising market, higher revenue growth, and perhaps more sustainable operating margins (than I had forecast).

  2.  The inexorable growth in the user base, astonishing in light of the size of the existing base, was also surprising. It is Facebook’s biggest asset and a platform they could use to enter new markets and sell new products/services. Between 2012 and 2014, Facebook showed a willingness to spend large amounts of money on acquiring the pieces it needed to keep increasing its user base and to profit from it. The downside of this strategy is that growth has been costly, but the upside is that Facebook positioned itself to monetize its user base. While the revenue breakdown did not reflect this business expansion yet, I thought that Facebook was better positioned for a narrative change in August 2014 than it was a year or two prior.

My updated valuation for Facebook in August 2014 reflected these adjustments. Incorporating a higher revenue target ($100 billion, rather than $60 billion) and more sustained margins (40 percent instead of 35 percent), I valued the company’s operating assets at $132 billion, a little more than double my estimate of $65 billion at the time of its IPO and the stock at almost $70/share. Did I have regrets about selling the shares at $45? For a brief moment, yes, but then again, I considered it a reminder of why it is so important that I keep feedback loops open and listen to those who disagree with me on my valuations.

Other Corporate News Stories

In addition to earnings reports, companies make news for other reasons, some good and some bad. While these announcements are not as frequent as earnings announcements, they often contain news that has bigger consequences for value. Broadly speaking, almost all corporate announcements of consequence can be categorized into news about investments (adding new assets, divesting old ones, or updating existing ones), financing (raising new financing or paying down old financing), and dividends (decreasing or increasing cash returned to investors in dividends or buybacks).

Investment News

The best way to frame investment announcements is to structure them around a balance sheet and think about these announcements as a restructuring of the asset side of the balance (figure 12.2).

Figure 12.2

Investment news, narratives, and value.

Viewed from this perspective, companies can either add new assets (by taking on new projects or acquisitions) to the balance sheet or they can remove existing investments (by shutting them down, liquidating, or divesting). They can also provide information about ongoing investments that may lead to a reassessment of their values. In sum, they can reinforce or change an existing narrative for a company.

With new investments and divestitures of existing assets, you have to trace through the effect that these actions will have on the narrative for the company and hence its value. Thus, the announcement by Tesla that it would build a new battery factory, costing almost $5 billion, changed my story for the company from one that was built around it being a luxury auto company to one that incorporated an energy business. In the same vein, the news from GE that it would sell off GE Capital, its financing arm, in 2015, altered the story you would tell about the company by removing one if its biggest business pieces.

Acquisitions are among the biggest investment decisions that companies make, for two reasons. One is magnitude, since they tend to be much bigger (in terms of money spent) than internal investments. The other is that companies tend to do acquisitions for a wider range of reasons, and an acquisition can dramatically change the narrative arc in both good and bad ways. For instance, the acquisition of Jaguar Land Rover, a global luxury automaker, by Tata Motors, an Indian mass automaker, in 2009, changed the story that you would tell about the latter. Figure 12.3 provides some of the possible story lines that emerge from acquisitions tied to different parts of the narrative process.

Figure 12.3

Acquisition effects on narratives and numbers.

Note that almost every change that is listed in this figure tilts positive, which may lead you to the inexorable conclusion that acquisitions will always increase value. The reason that you should be cautious in this conclusion is that the effect of an acquisition on the acquiring company’s stockholders will be the net of the price paid for the acquisition. Thus, notwithstanding the potential for an acquisition to change the narrative (and value) in positive ways, the stockholders in the acquiring firm will be worse off if the price paid is too high.

CASE STUDY 12.2: AB INBEV AND SABMILLER—THE CONSOLIDATION STORY

On September 15, 2015, AB InBev, the largest beer-manufacturing company in the world announced its intent to buy SABMiller, the second-largest brewery globally, and the market’s initial reaction was positive, with the stock prices of both AB InBev and SABMiller increasing on the story. Figure 12.4 captures the key details of the deal, including the rationale and consequences.

Figure 12.4

The AB InBev–SABMiller deal.

As an investor in AB InBev, consider the effect this deal would have had on your narrative for the company. The company had built a reputation for aggressive growth, unmatched efficiency, and its capacity to wring cost cuts in a mature business, as manifested in its acquisition and turnaround of Grupo Modelo, a Mexican brewery. It was also run by a Brazil-based private equity group (3G) known for their skills at allocating capital. While the SABMiller deal was of much greater magnitude than prior acquisitions, it did fit into that pattern of AB InBev’s cost-cutting and efficiency.

In table 12.4, I summarize how bringing the AB InBev efficiency model to SABMiller would change the value of the combined company and the resulting value of synergy.

Table 12.4

Valuing Synergy in the AB InBev–SABMiller Deal

	AB InBev	SABMiller	Combined firm (no synergy)	Combined firm (synergy)	Actions
Cost of equity	8.93%	9.37%	9.12%	9.12%
After-tax cost of debt	2.10%	2.24%	2.10%	2.10%
Cost of capital	7.33%	8.03%	7.51%	7.51%	No changes expected
Operating margin	32.28%	19.97%	28.27%	(30.00%)	Cost-cutting and economies of scale
After-tax return on capital	12.10%	12.64%	11.68%	(12.00%)	Cost-cutting also improves return on capital
Reinvestment rate	50.99%	33.29%	43.58%	(50.00%)	More aggressive reinvestment in shared markets
Expected growth rate	6.17%	4.21%	5.09%	(6.00%)	Higher growth because of reinvestment
Value of firm
PV of FCFF in high growth	$28,733	$9,806	$38,539	$39,151
Terminal value	$260,982	$58,736	$319,717	$340,175
Value of operating assets	$211,953	$50,065	$262,018	$276,610	Value of Synergy = $14,591.76

Assuming that AB InBev would be able to bring its cost-cutting skills to SABMiller, I increased the operating margin for the combined company from 28.27 percent to 30 percent (translating into annual cost reductions of approximately $1.3 billion), and this in turn pushed up the after-tax return on capital that the company will be able to make on new investments from 11.68 to 12 percent. A higher reinvestment rate (50 percent, up from 43.58 percent) added in the possibility that the combined company would also be able to find more investment opportunities in its combined markets, increasing the expected growth rate from 5.09 to 6 percent. While these changes are small in percentage terms, it is worth remembering that when the largest brewery in the world buys the second-largest brewery, it is difficult to post dramatic changes in percentage market share or growth. I estimated the value of synergy in this deal at $14.6 billion, assuming it would be delivered instantaneously.

It is worth noting that AB InBev paid a premium of almost $30 billion to acquire SABMiller, and that brings home the point I made earlier about how the price you pay is what determines value creation and destruction. If my assessment of deal synergy is on target, this deal created about $14.6 billion in value for AB InBev’s stockholders, but paying $30 billion for SABMiller made these stockholders worse off (by approximately $15.4 billion). If this deal does turn out to be value destroying, it will also lay siege to another part of AB InBev’s narrative: 3G’s reputation for shrewd capital allocation.

Financing News

When a company announces its intent to borrow more money or pay off debt, it is setting in motion actions that can alter your narrative for that company, both directly or indirectly.

Consider first the decision to borrow more money, which changes your narrative in both good and bad ways if you are an investor (figure 12.5). On the plus side, it allows the company to exploit the debt tilt in the tax code and increase the value of the business by the value of tax savings from debt. On the minus side, not only does it increase the chances of default (failure) but may also open the door to operating backlash if the company is perceived to be in financial trouble and customers hold back on buying its products. Consequently, a debt-increasing action by a firm can ripple through your story, altering the potential for growth and increasing the tax benefit component of value, while also altering the risk of the investment. The net effect can be either positive or negative.

Figure 12.5

Financing decisions and value.

A decision to reduce debt also affects your narrative. Not only does it reduce the potential for tax savings from interest expenses, but it can also be viewed by some investors (fairly or unfairly) as a signal that the management of the company feels less secure about future earnings and cash flows. It may be the precursor to other actions that the firm may take to make itself a business with a less risky story for investors.

CASE STUDY 12.3: APPLE’S DEBT DECISION

In April 2013 Apple announced its first bond issue, raising $17 billion from the market. Given its market capitalization at the time, which was more than $500 billion, the bond issue by itself was too small to have much of an impact on the value of the company. However, the decision to borrow in the bond market did have the potential to change the company narrative in ways that could create larger effects on value.

For those investors whose story of Apple had been based on the assumption that the management of the company, based on its history and culture, would never borrow money, the news that the company would borrow money was good news, insofar as it allowed the company to capture some of the tax benefits it was leaving on the table. At the same time, it was potentially bad news for the investors in the company, who were convinced that Apple could revert to its high-growth path from the previous decade with an endless stream of new products, since the debt issue suggested that managers did not share their optimism. Not surprisingly, the debt issue ended up being a wash in the financial markets, with Apple’s stock price barely budging on the announcement.

Dividends, Buybacks, and Cash Balances

Investors invest in businesses to generate returns, and cash returned to stockholders in the form of dividends and buybacks represents the harvesting of these investments. Thus, when companies announce changes in both the amount of cash they return to stockholders and the manner in which that cash is returned, it can lead to a reassessment of the stories that govern their value (figure 12.6).

Figure 12.6

Dividend decisions and value.

If a company decides to return more cash than it has historically, it can be either good or bad news for your narrative for the company, depending on your initial framing of the company. Thus, if your initial view of the company is that it is a high-growth business with significant investment opportunities, an initiation or increase in dividends may lead you to negatively reassess the growth potential portion of your story (and your value). If your initial perspective on the company is that it is in a mature business with few investment opportunities and that the existing management is not only holding back cash unnecessarily but also may waste that cash (by taking bad investments), a decision by the firm to increase cash returned may be an indication that the management has come to its senses, thus making your narrative more positive (and your value higher).

There are two ways of returning cash to investors, the first being dividends and the second being stock buybacks. When companies alter their conventional patterns of returning cash, there may be information in their actions that can affect your story and value. When a company that has historically paid only dividends initiates a stock buyback, you should consider the possibility that the firm feels less secure about future growth than previously. After all, one of the biggest benefits of buybacks, relative to dividends, is that you gain more flexibility in how much cash you return, and when. Conversely, when a firm that historically has returned cash only in the form of buybacks decides to switch back to dividends, there are story­telling implications that the firm perceives its earnings stream as less volatile than it was.

CASE STUDY 12.4: SLOW-MOTION STORY CHANGES—IBM’S BUYBACK DECADE

For much of the twentieth century, IBM was one of the great growth companies in the world, able to post double-digit growth as the leading mainframe computing company in the world. The growth of personal computers in the 1980s put a damper on IBM’s growth, and the company had a fall from grace in the latter part of the decade. In an often-told comeback story, Lou Gerstner presided over the reinvention of IBM as a business services company in the 1990s, as the company rode the tech boom to growth again. After the tech bubble burst in the early part of the last decade, IBM found itself fighting for market share yet again.

While the narratives on IBM have spanned the spectrum, the company has behaved in a consistent fashion for much of the last decade, choosing to return most of its earnings in the form of dividends and buybacks. In table 12.5, I summarize the earnings and cash return numbers for IBM and the shares outstanding in the company.

Table 12.5

IBM’s Operating and Share Count History

During this period, the cash returned, in the aggregate, amounted to 128.43 percent of earnings, with buybacks representing the bulk of the cash returned. While IBM did report growth in net income over this period, that growth was accompanied by declining revenues and a sharp decline in shares outstanding.

While there are many who have criticized IBM for returning too much cash, there is an alternative story line that is consistent with the company’s behavior. Faced with a declining business and fewer investment opportunities, the company has adopted a strategy of partially liquidating itself each year, with the intent of making itself a smaller business. If you are an investor in IBM and you are investing in the expectation that it will revert to being a growing company, you are fighting not only the facts on the ground but a company that is not behaving in accordance with your story. Rather than blame the company for not adapting to your story (of high growth with reinvestment), would it not make more sense to adapt your story to the company’s behavior? With IBM, that would mean changing your story about the company to one of low or even negative growth over time, as the company becomes a smaller, leaner, and hopefully more profitable enterprise.

Corporate Governance Stories

The top management of a business plays a key role in setting, maintaining, and changing its narrative, and news stories about managers, good or bad, can have effects on narrative and value. In this section, we start with stories of misconduct and scandal about companies and how these can have significant effects on their values. We then move on to looking at how the entry or exit of a key investor or investor group can sometimes cause you to reassess your narrative for a firm (and its value).

Corporate Scandal and Misconduct

Companies sometimes get in the news for the wrong reasons, with stories about corporate or managerial misconduct, a failure to disclose material information, or stories of managerial incompetence. These stories have consequences at many levels. The first is that they cause a distraction, as the managers of a company that has been accused of misconduct spend a significant portion of their time doing damage control, thus delaying and deferring investment and operating decisions. The second is that these actions can result in fines and fees if the misconduct crosses the threshold of illegality. The third is that they can sometimes put the company in legal jeopardy, as aggrieved customers, shareholders, and suppliers sue the company for damages.

While all of the above can result in significant costs and value, there can be even more lasting damage if the corporate narrative changes as a consequence of the misconduct. This is due to several reasons. The first is that the scandal can unalterably change the reputation of the company, and to the extent that its narrative was built on that reputation, its story as well. Thus, the news in 2015 that Volkswagen, a company that built its reputation on German efficiency and reliability, had cheated on emissions controls for its diesel cars in the United States could have altered your story line for the company and had large consequences for value. The second is that a key component or components of the company’s business model may have been built on questionable business practices, which once exposed, can no longer be continued. The third is that large scandals often result in management turnover, with the new management perhaps bringing a different perspective to the company.

CASE STUDY 12.5: VALEANT’S DRUG BUSINESS MODEL AT RISK?

Lead-in Case Study 5.1: The Pharmaceutical Business—R&D and Profitability, November 2015

In an assessment of pharmaceutical companies in chapter 5, I argued that the conventional business model for these companies, built around R&D, had deteriorated. While pharmaceutical companies have been able to maintain hefty profit margins for the last decade, the payoff to R&D has been steadily declining, with little or no revenue growth coming from the pipeline. Investors have responded accordingly, scaling down the pricing of these companies, which has manifested in lower multiples of revenues and earnings.

It is in the context of this history that you have to consider the rise of Valeant, a Canadian pharmaceutical company that went from obscurity in 2009 to the very top of the ranks in 2015. In figure 12.7, I graph the meteoric increase in revenues and operating income at the company in the time period between 2009 and 2015.

Figure 12.7

Valeant’s operating history.

So, how did Valeant pull off this feat of growing in a sector where others were struggling? As shown in table 12.6, it took a path that was very different from other pharmaceutical companies, investing less in R&D than the typical drug company but investing far more in acquisitions and using those acquisitions to deliver not only high revenue growth but also high margins and earnings per share growth. The combination made Valeant a favorite of value investors and took its market capitalization to over $100 billion. In September 2015 Valeant’s business model came under assault for two reasons:

Table 12.6

Valeant versus Sector

	Valeant	All drug companies	Large drug companies
R&D/sales	2.98%	16.09%	15.19%
Revenue growth (last 5 years)	61.50%	16.75%	23.10%
Expected EPS growth (next 5 years)	22.80%	18.36%	14.42%
Operating margin	28.32%	26.09%	29.08%
(EBIT adjusted for R&D)/sales	30.32%	30.48%	33.00%
Return on equity	11.13%	15.55%	18.97%
Dividend payout	0.00%	23.36%	19.86%
(Dividends + buyback)/net income	8.26%	49.13%	41.73%
Effective tax rate	9.84%	38.89%	29.75%

  1.  The price increases in the drugs that the company acquired as a result of its acquisitions drew the attention and ire of politicians, health-care professionals, and insurance companies.

  2.  The company’s relationship to Philidor, an online pharmacy, came under scrutiny. Some argued that Philidor was being used by Valeant to pass through its high drug prices to the patients, insurance companies, and the government.

After initially attempting to defend itself as guiltless, Valeant cuts its cord to Philidor, but the damage had been done.

The spotlight on Valeant as a result of this crisis put at risk two pieces of its historically successful narrative: using acquisitions instead of R&D to grow and the repricing of old drugs as the basis for high profit margins. Analysts who had taken its financial statements at face value became more questioning of the acquisition debris in their financials, making it more difficult to continue on that path. The pricing hikes were not unique to Valeant, but being tagged in this crisis made it more difficult for them to continue increasing prices, at least for the near term. The company lost 70 percent of its value in the weeks following the scandal, perhaps reflecting the market’s view that if Valeant was forced to follow a more conventional path of investing in R&D and measured price increases, it would resemble other pharmaceutical firms in both its operating results and pricing.

Investor Composition

You would expect shareholders, as owners of publicly traded firms, to have a say in corporate narratives, but in most publicly traded firms in the world, they do not. One reason is that in big publicly traded firms, with thousands of shareholders, the splintering of shareholding means that most investors have only small stakes in the company, making their influence minimal. Even those shareholders who own larger stakes in companies, generally institutional investors, are passive investors with little or no interest in challenging existing business models, even if they disagree with them. There are, however, two groups of investors who have the potential to change business models (and the stories about businesses), and the entry of either into a company can cause narrative changes.

•  Activist investors, armed with capital and willing to fight over the long haul, target mature companies that they believe are investing badly or too much in bad businesses. They generally push these companies to invest less, borrow more, and return more cash to stockholders, and by doing so, they offer a counternarrative to managers who may be more intent on preserving the status quo. The appearance of a Carl Icahn or a Nelson Peltz, both well-known activist investors, in the investor ranks of a publicly traded company may be a signal that you should reassess the story you are telling about that company and, by extension, its value.

•  Strategic investors are those who invest in a company in the hope of using the investment to further other interests. In many cases strategic investors are other companies that have chosen to invest in your company because they believe they can generate side benefits from the investment. To the extent that the strategic investor has deep pockets and a different endgame, it is possible that the entry of that investor will change your corporate narrative. For example, the news story that General Motors had made a $500 million investment in Lyft, the ride-sharing company, could not only change the risk portion of your story (by making it less likely that Lyft will fail) but also the business portion of the story (by increasing the likelihood that Lyft will move from a pure ride-sharing business to one that has a driverless or electric car component).

Conclusion

A corporate story is not a timeless classic. It is a constantly changing, ever-shifting narrative that will be affected by news about the company, starting with earnings reports and financial filings but also extending to include corporate announcements about investment, financing, and dividend policy. The extent to which these announcements affect narrative and value will vary across the announcements and can change them in positive or negative ways. The market reaction to these announcements is more of a pricing game, and it is conceivable that a news story can cause large price changes without much change in value or large value changes with little price effect. To the extent that top managers in the company play a role in setting its narrative, news that is about them will also affect both value and price.