Call it ticker shock. For more than a generation, senior executives everywhere have been obsessed with corporate share prices. During the US leveraged-buyout craze of the 1980s, the mere scent of an undervalued stock would bring corporate predators circling around. Over the past decade, as the ranks of investors have grown and increasing numbers of companies have used shares as the currency for M&A, share prices have assumed an ever larger role in strategic planning. And what senior executive has never claimed that the stock market undervalues or "doesn't appreciate" his or her company? If only it had different investors or if analysts understood it better, the complaint goes, its share price would be higher.

To push it higher, CEOs and CFOs spend more and more time communicating with investors. But the approach is typically ad hoc: executives get their advice from investor relations consultants, whose backgrounds are more likely to be in PR than in finance. Academics have only recently begun to research the composition of the investor community and communications with it. Advice from bankers is largely anecdotal. No surprise, then, that executives often admit to being dissatisfied with the time they spend communicating with investors and with the results they achieve. Nonetheless, some three-quarters of all investors and analysts say that their communications with top executives do influence their investment decisions.

What is the measure of effective investor communications? It shouldn't be getting the highest possible share price. For managers who focus on shareholder value, the strategic goal should be a stock market value that is in line with the company's intrinsic value. Too high a share price may encourage managers to support it by adopting tactics (such as deferring investments or maintenance) that will limit the creation of value in the long term. In any case, if the stock price of a company exceeds its intrinsic value, the price will eventually decline as the market deciphers its underlying performance. Employee morale will then suffer. As for too low a share price, the drawbacks include takeover threats, difficulties using shares for acquisitions, and demoralized managers and employees.

Although investor communications is a relatively new field, some basic principles can guide companies:

• An investor communications strategy should be based on a thorough analysis of a company's market value and its relationship with management's estimate of the company's intrinsic value.
• A company's message, or "investment story," should be consistent with its underlying strategy and performance. Obvious as this principle may sound, companies don't always line up their message with their strategy.
• With some exceptions, a company is better off being transparent about its performance and about what drives the creation of value. Transparency means providing not only financial results but also the operating measures the company uses to run its business.
• A company can improve the effectiveness of its message to investors by ensuring that it understands them—in particular, how its investor base compares with those of its competitors.

Lining up intrinsic and market value

When the executives of a company complain that financial markets don't understand it, that belief may well reflect a high-level analysis of its price-to-earnings ratios or a random comment by some analyst that its shares are undervalued—not a rigorous analysis of what the share price should really be.

Any good strategy for investor communications must begin with an objective estimate of the gap between management's view of the intrinsic value of the company and its stock market value. Some probing typically shows that no significant gap exists or that the gap can be explained by the historical performance of the company relative to expectations about it.

Consider a large specialty chemical company I'll call Chemco. Its returns on capital are attractive, but its product lines compete in slow-growth segments, so revenue growth has been low. Chemco recently adopted a strategy of buying small companies in faster-growing areas of the industry and then applying its manufacturing and distribution skills to improve their performance. Companies in these faster-growth segments also have higher returns on capital. As of the company's most recent quarterly results, the revenues from these fast-growth segments account for only 5 percent of Chemco's total revenues.

Chemco's managers were concerned that the price-to-earnings ratio of its shares trailed those of many companies with which it compared itself. They wondered whether "intangibles," such as its old-fashioned name or the small number of analysts covering the industry, had kept its value low.

The first step in assessing the value gap was helping these managers gain a better understanding of Chemco's value relative to that of its peers. Some of the peers drew all of their revenues, not just Chemco's 5 percent, from fast-growth segments. Moreover, some were restructuring substantially, lowering their current earnings. When the peers were segmented, it turned out that Chemco's earnings multiple was in line with those of its close peers but behind those of companies in fast-growing areas. A third set of companies had high multiples as a result of current earnings that were low because of restructuring. Chemco and its closest peers also had lower returns on invested capital (ROIC) and much lower growth rates than did companies in fast-growing segments (Exhibit 1). So from a historical perspective, the value of Chemco was consistent with its performance relative to that of its closest peers.

The next step was to reverse-engineer the share price of Chemco and its peers by estimating what the company's future performance would be if it were consistent with the current share price. The result: if Chemco's revenues were to grow by 4 percent annually at its most recent level of margins and capital turnover, its discounted-cash-flow value would equal its current share price. This growth rate was in line with the implicit growth of its closest peers and lower than that of companies in the fast-growing segment. When management's announced revenue growth aspirations—6 percent a year—were valued, it turned out that, if realized, they would raise the company's market value by 36 percent. Could better communications reverse the market's wait-and-see attitude? Not substantially, since Chemco was valued in line with its closest peers. Moreover, little evidence suggested that it could grow faster than the industry in its core businesses and successfully acquire and integrate companies in faster-growth product areas.

Strategic storytelling

Companies commonly suffer a serious disconnect between their strategies for creating value and their investor communications. Effective communications should link a compelling message with the value that management expects to create. This investment story should help investors understand what the company stands for, how it differs from other companies, and why its prospects are better than those of its competitors or even of companies in other industries.

A compelling investment story has three key elements: aspirations, strategy, and evidence. Aspirations, which define what the company wants to accomplish, should be described both in financial terms (such as growth in revenues and profits) and in market terms (market share and product innovation). Not surprisingly, investors tend to be skeptical of wildly unrealistic aspirations, such as the often-uttered, rarely attained hope of increasing earnings per share by 10 percent a year for the foreseeable future.

The strategy part of the story explains the company's competitive advantages or unique skills and how they will help create value. One part of Chemco's strategy, for example, was to boost revenue growth by acquiring small companies in faster-growing segments. Chemco's investment story lacked appeal because it didn't explain how the acquisitions would create value. Had the company explained, for example, that it substantially improved the small companies' margins and returns on capital by applying superior manufacturing techniques that no other company in its industry used, the market might have looked more positively on the strategy.

Last, evidence—which doesn't necessarily mean detailed disclosures but should include success stories—helps investors to assess whether the strategy can actually achieve the company's aspirations.

How much transparency?

Despite the trend toward greater transparency and disclosure after a run of corporate scandals and the subsequent reforms in the United States and Europe, companies still have tremendous latitude about what to disclose. They must therefore decide on a strategy—either to drive their industries toward greater transparency or to disclose as little as possible.

Much of the regulated transparency is too generic and not particularly useful. The more valuable kinds of transparency typically arise spontaneously within an industry, often in response to explicit demands from investors or to the leadership of an industry pioneer. The petroleum industry, for instance, has long published detailed fact books that describe oil production and reserves by geography—key parameters that investors want to know. Pharmaceutical companies provide detailed information about their product pipelines at every stage of research and development. Most industries, however, have less standardized levels of disclosure and transparency, so management must decide.

Companies can show value clearly...

Companies that really want to increase their transparency and to make their valuations more accurate can improve their historical financial reporting and, most important, report on the underlying nonfinancial drivers of performance.

Historical financial reporting. As companies become larger and more complex, it becomes more difficult to interpret their historical financial performance and to forecast their future performance. Large companies tend to have a variety of business units, each with its own growth, margins, and return on capital. Investors like to see the value of the company as the sum of the value of its individual components, but such overall results are often mere averages that don't help investors to understand its underlying performance. To help investors, regulators therefore require companies to disclose their performance business unit by business unit, but they still have a great deal of flexibility in how they do so.

Some companies are responding to the desire of investors for better reporting on segments. Microsoft, for instance, reorganized its reporting on business units in time for its 2003 results in order to show more clearly the economics of its main business activities. Previously, the company had reported on three business units: desktop and enterprise software, consumer software and services, and consumer commerce (Exhibit 2), but many investors found this breakdown less than helpful. The company's new approach clearly shows the high profit margins of leading products (such as the Windows operating system and Microsoft Office software) and the heated competition in markets for products such as the Xbox line of computer games and MSN's online services. With this kind of information, investors can assess the value of the company as a whole and of each of its parts.

Underlying drivers of value. Investors want to understand what drives the revenues, costs, and capital of the companies they invest in, so specifying these basic drivers of value is the most powerful way to help them assess the value of a company's shares. How big is the market? How are the company and its competitors cutting their costs? How much capital will be needed to achieve future growth? Retailers provide some of the answers by disclosing the number of stores they have and their same-store sales growth. When they also report their sales per square foot, investors can monitor the impact of changes in the size and configuration of stores.

...or make value opaque

Many companies, believing that the market is concerned only with smooth earnings-per-share (EPS) growth, regardless of how they achieve it, dislike this kind of transparency. Many managers also believe that it reduces their flexibility: they like to be able to use good results from one business unit to offset bad results from another and to time asset sales to offset good or bad quarters. But investors, who are a lot smarter than such managers think, respond to the causes of results as much as to the results themselves (see "Do fundamentals—or emotions—drive the stock market?"). As Microsoft, for example, began to report the results of new business units, it had to disclose, through their operating losses, how much it had invested in MSN, Xbox, and other new offerings. Microsoft executives even credit the new reporting structure with improving the way the company allocates resources.¹

Too much disclosure can hand an advantage to a company's competitors, customers, and suppliers. Customers that know a product line's profitability, for example, could use that information to negotiate lower prices. In all likelihood, however, your competitors, customers, and suppliers already know more about your business than you realize. Besides, in some situations companies might even benefit from greater transparency. Disclosing a new and hard-to-copy technology, product, or manufacturing process that could give a company a lead over its competitors, for instance, might discourage them from joining the fray. That in turn could persuade the market to increase the company's share price relative to the price of its competitors' shares, thus making the company more attractive to potential partners and key employees.

Know your investors

Does it matter who your investors are? No systematic evidence suggests that one investor base is better than another. Most companies want the market to think that their shares offer growth rather than value. Growth stocks, by definition, have higher P/Es than value stocks do. Most value stocks have low P/Es because the companies are mature, grow slowly, or earn low returns on capital (or some combination of those reasons). These are realities, and though managers may want their companies to be perceived in a certain way, they probably can't do anything to promote such perceptions. Companies are constrained by what they really are. Those with upcoming volatile news, for example, attract investors who like to bet on it.

In general, managers ought to communicate primarily with the investors who matter: those who can affect share prices

Nonetheless, understanding a company's investor base can provide valuable insights: it can help managers not only to foresee how the market will react to important events and strategic moves but also to improve the effectiveness and efficiency of investor relations. In general, managers should communicate primarily with the investors who matter: those who affect share prices. Under certain circumstances, retail investors and sell-side analysts working for brokerage firms—often with a short-term focus—can affect trading imbalances. But in general, the investors who matter most to a company are the large institutional ones.

Efforts to analyze a company's investor base and to identify potential attractive investors are far more art than science. One way to classify investors involves using two dimensions: the horizon of analysis and the dominant content being analyzed.² The combinations that emerge help a company to craft different messages along different dimensions. A company could, for example, craft a long-term strategic message for investors that are highly focused on corporate fundamentals over a five-year period and another message for investors whose interests center on whether strategic or news events will affect the company's short-run value.

Of course, it is the marginal investors that count. At any time, investors will have a wide range of opinions about the value of a company's shares—opinions varying not just by 10 or 20 percent from the current share price but sometimes by 200 percent or more. The investors with the highest estimates aren't likely to sell at all soon, just as the investors with the lowest estimates aren't likely to buy soon. The marginal investors are those who would buy if a bit of good news or some sudden insight led them to conclude that the company's shares were worth more than their current price, as well as those who would sell at a hint of bad news. Theoretically, such investors are the ones that matter and should be the focus of management's attention.

The issues that surround investor communications and the problem of whether executives can "talk up" the share price of a company will remain in flux for some time. Regardless of what you think about these matters, executives who understand investors and how they define value can systematically improve the match between the stock market standing of a company and its intrinsic value.