Gordon Prime

At the moment, all of academic finance revolves around present-value logic. Every model starts this way. No one feels compelled to justify the choice. Researchers view the positive-NPV rule as the gold standard of financial decision-making. What would it be like to live on a world where everyone else felt the same way?

Life on Gordon Prime

On Gordon Prime, the whole civilization is organized around discounting and present-value logic. The positive-NPV rule is not an abstract idea that CEOs learn about in business school. It is what everyone does every day, as a matter of course. M&A press releases lead with the NPV surplus the deal creates. Gordian CEOs can quote every major project’s risk-adjusted discount rate and explain how they arrived at the number. NPV calculations are front and center in conference calls and Investor Day presentations.

The citizens of Gordon Prime are not clairvoyant. They cannot sum infinite series in their heads. They need computers to estimate multi-factor models. To cope, Gordian CEOs have developed many helpful shortcuts for picking reasonable discount rates. Like the rule of 72, but for choosing the right . Moreover, on Gordon Prime, CEOs routinely make long-term cash-flow forecasts. A CEO who discounts at can predict cash flows years in the future. For projects with lower discount rates, , it is not uncommon to see horizons of years or more.

Corporations on Gordon Prime announce quarterly cash flows. Income statements exist, but CEOs and shareholders treat them as a mere accounting convention. Earnings get reconciled to cash flows, never the other way around. Because everyone instinctively knows to set “price equal to expected discounted payoff”, Gordian children learn the two Modigliani-Miller irrelevance theorems in kindergarten. Many find the results obvious. Investors on Gordon Prime expect a firm’s leverage and dividend policy to be dictated by frictions. Absent such complications, nobody would think to ask a Gordian CEO about either.

Asset pricing on Gordon Prime is a solved science. It has to be. Everyone needs this input to perform the right NPV calculation. John Cochrane has a counterpart on this distant planet. There, he gave an AFA presidential address titled “Discount Rates: We Know How To Calculate Them.” A Gordian CEO expects her decisions to move her firm’s multiple right away. To choose a corporate policy she has to understand how the market will price the resulting change in her firm’s future payout stream.

Research on Gordon Prime

Now put yourself in the shoes of a Gordian corporate-finance researcher. What would your day look like? You certainly would never survey CEOs about whether they use the positive-NPV rule. Of course they do. CEOs on Gordon Prime won’t shut up about it. They talk about the positive-NPV rule incessantly. On Gordon Prime, the question would be as strange as asking whether CEOs perform arithmetic. Instead, you might run surveys asking CEOs how they pick the right discount rate for specific kinds of unusual projects.

Discount rates are a property of a project’s future cash flows, not a characteristic of the firm. So, on Gordon Prime, it does not matter which company is evaluating a project. A CEO who greenlights the investment at one company would make an identical call while running another. Thus, much of corporate-finance research on Gordon Prime would be done at the project level.

Gordian CEOs make decisions by discounting cash flows that are expected to arrive decades in the future. Current interest rates and market conditions play a minor role. The Gordon Prime version of IBES contains 20- and 30-year cash-flow forecasts for most firms because this is the horizon that matters when thinking in present-value terms. The positive-NPV rule compares the present value of a project’s cash flows against the upfront cost, so the funding source is treated as a minor detail. What matters is a project’s total cost, not where the company gets the money from.

Prestige on Gordon Prime would go to researchers who study how corporate investment moves over time in subtle ways. Gordian researchers treat capital structure and dividend policy as second-tier topics, which only matter due to frictions. When these frictions bite, the dose-response curve is the same for every firm. The documented effects are smooth and continuous. Constrained CEOs invest a little less than otherwise-similar unconstrained ones.

A strange little model

One slow afternoon, you (dear Gordian researcher) write down a strange little model where the CEO does not discount anything. Instead, she makes decisions aimed at increasing her firm’s short-term EPS forecast—i.e., expected earnings over the next twelve months divided by current shares outstanding.

What would follow?

Quite a lot! The EPS-maximizing CEO in your model does not use the positive-NPV rule. Instead of converting the project’s future cash-flow stream into an upfront valuation, she translates the upfront cost into an expense flow. Your EPS maximizer only invests in projects that generate enough income next year to cover their own added financing expense using the firm’s cheapest available source of capital. In other words, the CEO funds projects with income yields, , that exceed her firm’s cheapest financing yield, . This is the accretive investment rule.

One thing that immediately jumps out at you is the nature of this hurdle rate. It is a property of the firm, not the project. Equity would be cheapest for a firm whose earnings yield is below the riskfree rate, . Such a firm would fund investments by issuing stock even while sitting on cash. By contrast, a firm with would lever up, making cash by far the cheapest funding source if/when it ever appears. The line between the two types would fall at , and it would move around as the riskfree rate moved. The EPS-maximizing CEO in your model takes her firm’s current pricing as given, so her decisions track with market conditions rather than her beliefs about cash flows decades in the future.

It is a strange little model. No discounting. No present value. But sharp predictions, so you keep going.

Life on planet Accreton

To better understand your max EPS theory, you run a thought experiment. You imagine a crazy planet where accretive decision-making is the law of the land. You call it, “Accreton”. It must be a wild place, indeed. What would life on this hypothetical planet look like?

On Accreton, press releases would lead with EPS accretion. The deal’s NPV surplus would often go unmentioned, or even (**GASP**) uncalculated. EPS-maximizing CEOs would use rules of thumb, such as IRRs and payback periods, that avoid choosing a project-specific discount rate altogether. Accretonese companies would obsess over short-term earnings, not cash flows. Since the star of the show is next year’s EPS, no one on planet Accreton would bother making 20-year cash-flow forecasts. Maybe companies would talk about cash flows a bit… but only to reconcile why they differ from net income.

Unlike on Gordon Prime, leverage and payout policy would be first-order concerns on planet Accreton. CEOs would labor over these choices. Analysts would ask hard questions to make sure the values were correct. An Accretonese CEO would not need to know the correct asset-pricing model. It would not matter to her where the company’s PE ratio and marginal interest rate came from. All she would need to know is what the current values are. On planet Accreton, a CEO could take these numbers as given and evaluate corporate policies from there.

On planet Accreton, firms on either side of would pursue two different constellations of corporate policies. A growth stock () would see equity as cheap compared to riskfree debt. A value stock () would see equity as more expensive. The two kinds of firms could disagree about whether to fund the same project. If the Federal Reserve on planet Accreton cut rates, then the value stock might flip its verdict. Accretonese growth stocks fund investments by issuing equity even when cash is available. By contrast, value stocks would find it accretive to lever up until cash becomes their cheapest available source.

Accretonese research

This thought experiment has been fun so far. You decide to keep pushing. What would life be like for a corporate-finance researcher on planet Accreton? Golly gee willikers, you think to yourself as a proud Gordian citizen, the literature on that other planet sure must be different.

For one thing, you figure that no researcher on planet Accreton would bother running surveys asking whether CEOs use the positive-NPV rule. What would be the point? Every corporate statement on planet Accreton leads with EPS growth. The relevant metric there is obviously not NPV.

You imagine that Accretonese researchers would focus on yield spreads, not discount rates. When a CEO on that planet decides whether to fund a project, what matters is the income-vs-financing yield spread, . The discovery of the growth-versus-value divide at would be one of the foundational discoveries in the literature. On planet Accreton, capital structure and payout would not be sleepy backwaters. They would have a seat at the big boys’ table, right next to real investment. All three would be seen as ways for a CEO to generate value for her shareholders by increasing the firm’s EPS next year.

A firm’s PE ratio is just another way of writing its earnings yield, . You figure that Accretonese researchers would view IRRs and payback periods in a similar light. An IRR is a multi-period generalization of a project’s income yield, . A payback period is the same quantity expressed as a multiple, . If there’s a database like IBES on planet Accreton, then you have to imagine that it only contains 1- and 2-year EPS forecasts. Why would anyone there bother to forecast cash flows two decades into the future?

Stranger than fiction

Here is the crazy thing. That planet you dreamed up… (Q: You mean the one where accretive decision-making is the law of the land and most people never discount a cent?) Yes, that one. That planet is a pixel-perfect description of Earth. Every line of it. You did not invent Accreton. You described home.

Yet, corporate-finance researchers act as though they are living on Gordon Prime. They spend their days puzzled by the data that keeps arriving. Discount rates that barely move when the cost of capital does. Investment that lurches with cash flow it should not care about. CEOs quote payback periods even though textbooks call the method “stupid”. Researchers cannot tell CEOs which cost of capital to use because they cannot agree themselves. The literature contains a zoo of different factor models. None of it should be puzzling. It is Accretonese data read by researchers who insist they are somewhere else.

A sensible Gordian researcher would never run a survey asking whether CEOs use the positive-NPV rule or an IRR hurdle. On Gordon Prime the answer is plain, they discount, and everyone can see it. A sensible Accretonese researcher would never run that survey either. Here the answer is just as plain, they go by accretion, and every press release says so. The question only occurs to someone who cannot tell which planet she is standing on. It is the question of a lost interstellar traveler.

What regressions show

You can’t convince researchers that they live on Accreton by pitting the accretive rule against the positive-NPV rule in a horse race to see which one fits the data better. That contest is silly. The first Modigliani-Miller paper was published in 1958. Researchers have spent nearly 70 years adding ingredients to the same present-value framework: financing constraints, agency costs, behavioral biases, adjustment costs, etc. Collectively, all that machinery can be fine-tuned to fit almost any pattern. If we live on Accreton, then any explanatory power associated with the positive-NPV rule must come from either overfitting or these after-market add-ons. A comparison of predictive accuracy cannot separate those two stories.

That is the value of this thought experiment. It shows where the diagnostic evidence lives. It is not in the regression . It is in what CEOs say when they announce an M&A deal, in which numbers lead the press release, in how rarely CEOs mention discount rates. Only 1% of conference calls quote a discount rate. The fact that we have to ask CEOs whether they use the positive-NPV rule doesn’t prove we live on planet Accreton. But it sure is hard to square with the claim that Earth is Gordon Prime.