Previously, I wrote about the commonality between the product life cycle chart and corporate life cycles and some of the implications this has for investor relations.
To recap, where you are in terms of your corporate life cycle is a large determinant in whether you get Growth, Growth at a Reasonable Price (GARP), Value or Deep Value investors. As each of these different styles of investors is willing to pay differing amounts for your future earnings, the valuation you get in the stock market will in no small degree be influenced by where investors view you in your life cycle. To carry this one step further, we will now use the graph to look at how companies seek to avoid the point at which they transition into a mature, and then a declining company and how successful this is in avoiding a declining P/E ratio.
In product development, when a product threatens to become mature, the marketing people move in and try to rejuvenate and refresh the brand by introducing new product features and formulations or market applications. The idea is to boost sales volume and market penetration. Nobody wants to get to the point where a product is mature, verging on stale, and headed for inevitable decline. In graphical terms, what they do looks like this:
Companies do the same thing. A great example of a company continually reinventing itself via new products and markets is Apple. First Apple was a computer company. Then they introduced the iPod and iTunes. This was followed by the iPhone, Apps and the iPad. Apple has been incredibly successful in this approach—helped by great design and engineering—creating a tightly integrated suite of products that customers love. And the stock market has richly rewarded them for this, making Apple one of the most valuable companies on the planet.
In addition to new products, companies attempt to prolong their progress up the growth curve through acquisitions, entering new markets, entering new territories, going global, reengineering their work processes, expense initiatives and a raft of other things too numerous to mention. In doing this they hope to extend their growth and the premium investors will pay for their future earnings. The problem with all of this, from an investor’s viewpoint, is that the new products, programs and initiatives are exactly that, new, and they don’t have a track record. Therefore, the certainty with which future earnings from these programs can be predicted is less than it is for existing operations and the willingness of investors to pay up for the incremental earnings is less. Unless and until a company can establish a track record for successful entry into new products or markets or initiatives, investors will discount the future earnings at a greater rate than the old familiar type of earnings. Investors just don’t like uncertainty. So revenues may go up; earnings may in fact also go up, but P/Es will fall until a company can demonstrate that it has as one of its core competencies the ability to extend its growth with new initiatives. There is a zone of uncertainty that surrounds the new initiative until things resolve themselves, which graphically looks like this:
Again, if we look at Apple, the first iPod was introduced on October 23, 2001. Following the announcement of the new product, one that turned out to be revolutionary, Apple’s stock price didn’t do much for the next couple of years. Investors had a wait and see attitude.
This, of course, drives corporate management nuts. They have invested millions of dollars in a new initiative through design and engineering, consulting fees and countless meetings and studies. They are embarking on a bold new strategy to push their company forward for the next millennium. And yet, in their view, the market doesn’t get it. Usually, if you get them off in a quiet room with a scotch or two in them, they will blame this on “Typical Wall Street short-sightedness”. Yet in this case, investors are really taking a longer term view as they want future uncertainties to be resolved before buying the stock.
Investor relations professionals should learn to recognize this type of fact pattern and be ready to explain to management why the stock didn’t jump when the CEO’s latest initiative was announced. Much heartburn can be avoided if companies take a realistic approach to how the market values new corporate actions. There is no real way around this – companies have to prove themselves to investors on new initiatives to a far greater extent than for existing operations. But as witnessed by Apple, it can be done.
Lucy is Editor at Corporate Eye
