Why the Enron Scandal Matters to You

Why are the Enron (ENE - commentary - Cramer's Take) scandal and so many like it, involving phony accounting at public companies, so important? Because they will affect what a stock is and how it can be valued. This is vital stuff for anyone who has money invested in a public company.

The Way We Were

Long ago, the standard way of valuing a public company was to compute the discounted present value of its dividends unto some future date at what was supposed to be the agreed-upon long-term interest rate. This approach correctly likened stocks to bonds as interest- or dividend-bearing instruments, useful for the cash they paid to you in the future in return for the cash you paid for them now.

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With that model, there were two questions: What was the interest rate, and was the dividend secure? If you knew even a general answer to both, you knew the value of the stock.

At some point in the 1960s, for a variety of reasons, corporations started to greatly lower the amounts and percentages of dividends they were paying to stockholders. This trend accelerated dramatically in the 1980s and 1990s. Partly, this was due to a delayed reaction to the repeal of an "undistributed profits tax." There was no longer any need to pay out profits to avoid a tax.

Also, it became the fad to believe that managing a company's money in terms of putting it to work in bonds or arbitrage was as important as the company's main line of business. I can vividly recall studying this myself in grad school at Yale long ago. Then there was the belief among executives that they could deploy the money better than their stockholders, so they should really do their stockholders a huge favor by keeping their money and investing it for them.

The ultimate example of this is Berkshire Hathaway (BRK.A - commentary - Cramer's Take), which promises to never have a dividend, but just keep investing the earnings of the stockholders forever. If the stockholders need cash, they can sell shares.

With good managers, this strategy makes sense. You need only look at Berkshire Hathaway to see how well it can work at its best, although even its stock is reaching a point of fantastic valuation, along with so many others. (I own a very small amount of Berkshire Hathaway stock.)

Dividends as a percentage of stocks' prices also fell, partly because the prices rose so much, even when dividends stayed constant. Thus, valuing companies by their dividends became archaic, simply because dividends were so small.

But if you value a company without direct reference to its dividends, you have to value it on some other basis. You have to know its earnings, its revenue, its book value and its liabilities -- and have at least a good guess about its prospects. If actual dividend checks aren't getting mailed to you, you must have some other numbers to value the company. Usually, the main number is earnings.

Indeed, if you look at valuing a company with numbers, modern stock prices make no sense at all in terms of dividends and valuing them into the future.

The Bond Comparison

For a powerful example, try valuing stocks now according to their dividends. If you did so -- with today's dividend level of about 1.8% for the 30 stocks in the Dow Jones Industrial Average -- you'd never buy a stock. Bonds pay four times as much at the long end, so why buy a stock?

You can even assume really generous growth in dividends -- say, increases of about 5% a year (not 5 percentage points, but 5% of the prior year's dividends) -- while the bond coupon stays the same. You'd still start out so far ahead with the bond, and you can reinvest the bond coupon so lucratively, that it would take about 49 years for the stock with its growing dividends to exceed the bond's cumulative payments. And it's not at all clear that dividends of public companies are rising anyway, certainly not in recent years. If you assume lower growth for the stock's dividends, say 3% a year, you'd have to wait 80 years for the stock yield to cross the line of the bond yield. (These figures were computed by investment guru Phil DeMuth.)

But if you value the stock on the basis of its earnings, it starts out much closer to the bond yield (about 3.8% for the Dow stocks right now). It takes only about a decade for the earnings yield to exceed the bond yield if earnings grow at 6% a year, and only a few years after that for the stock's total earnings yield to exceed that of the bond. (This assumes that the stock dividend continues to rise, as noted, and that the buyer bought it at a 3.8% yield.)

Clearly, something like this calculation has to be holding up the stock market -- although market valuations are still stupendous until earnings have many years of growth. That is, earnings, not dividends, are underpinning the market both as an instinctive, common-sense matter that we all see and also as a matter of mathematics and finance theory. This is basic ... but it's also basic that we have to have a realistic number for earnings, at least for past earnings. (Future earnings guesses can be educated, but they are still guesses.)

So if we don't know the earnings, how can we take any stab at the present or future value of the stock? The dividend is open and available to view. The earnings are hidden. Management is supposed to tell us earnings, and sometimes they do with perfect fidelity. But if they don't, where are we?

Who Can You Trust?

We then have to rely on the stockholders' supposed sentries, the accountants. If they knowingly tell us false data about earnings, book value or liabilities, we're shooting blind. The markets simply cannot work with phony data about the most basic facts of corporate life. There can be no valuation, no investment discipline -- not even informed speculation -- without honest accounting. That's why Enron is so important and why the hiding of the truth by Arthur Andersen is so devastating.

The blow that the accountants at Enron and many other companies strike when they allow false earnings and other figures to come out under their imprimatur is a deadly attack on markets in general -- and on investors and their savings. Severe punishment is needed for people who attack and sabotage something as basic as the free market in investments by abusing investors' trust. I hope we can expect it from the Securities and Exchange Commission, but I have my doubts.

In the meantime, yet another immense uncertainty has entered an already dicey market. Besides issues of nosebleed valuations, economic uncertainties, interest rate changes, technological obsolescence and foreign woes, an even more troubling problem has emerged: We just can't tell for sure what a company earned, even last year.

This is getting scary. Correction. Scarier.

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Benjamin J. Stein has been a trial lawyer, a White House speechwriter for former Presidents Nixon and Ford and a campaign speechwriter for Reagan. He has been a columnist for The Wall Street Journal and written for publications including Barron's, New York magazine and Los Angeles magazine. He is a novelist, a nonfiction book writer and a screenwriter, and he has been an expert witness on financial fraud. He studied economics and finance at Columbia University, where he graduated with honors in economics in 1966. He studied finance at the graduate level at Yale while he was a law student there and served as an economist with the Department of Commerce before commencing his work as a trial lawyer. His work on ethical issues in finance has been widely published, especially as it related to the Drexel Milken junk bond scheme and to the problems inherent in management buyouts of public companies. He has also written frequently about the problematic nature of mergers and acquisitions of public companies and about the deep ethical problems of accountants of public companies. His book on Drexel, A License to Steal, addresses many of these issues. He speaks frequently to financial and lay audiences about issues in finance and ethics, usually from a humorous perspective. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. At time of publication, Stein was long Berkshire Hathaway, although positions can change at any time. While Stein cannot provide investment advice or recommendations, he invites you to send your feedback to Ben Stein.