An Ode to Modern Financial Theory
As a former professor of finance, I read Donald Chew’s book with great interest. His book is a history of the development of modern financial theory from its early roots in John Burr Williams’ 1938 “Theory of Investment Value” to its beginning in the late 1950’s with the works of Miller and Modigliani on capital structure and dividend irrelevance. He made a mistake in attributing Myron Gordon’s model to Williams.
Chew writes in a very breezy style by referring to Michael Jensen as Mike and Stewart Myers as Stu. From his post as an editor of Stern Stewart’s “The Journal of Applied Corporate Finance,” he got to know most of the major players in academic finance. I too met many of the academics he discusses, and indeed I was an early adopter of Brealey and Myers textbook he highly praises in my corporate finance class during the 1982-83 academic year. I also met, on several occasions, his mentor, Joel Stern.
Chew makes the case that earnings per share don’t count, but rather it is the ability of a corporation to earn a return above the cost of capital with return measured as net operating profit after taxes. It is with this insight that Stern Stewart pioneered the concept of economic value added. (EVA) Indeed, instead of using earnings to value a corporation, value can be defined as the present value of the cash flow associated with existing assets plus the present value of future growth opportunities. Hence, Amazon for example, can trade at values divorced from current earnings.
However, he oversells his point that earning per share doesn’t count. Corporate management and analysts continue to stress earnings per share and woe to the company that misses its quarterly earning estimates. In the short run earnings seem to count a great deal.
He also oversells private equity. To be sure private equity posted extraordinary returns in its first twenty years starting in the 1980’s. Since then, returns have eroded, and their risks have been underrated. Put simply, the industry is guilty of what Cliff Asness of AQR, calls “volatility washing.”
This book is of interest to readers who are interested in how modern financial theory evolved and it is helpful in understanding what forces drive stock prices in long run.
