NY Times Chimes in on Required Returns

From the NYT article:

Amid all the grim economic data and a chorus of warnings of a fresh recession, one group on Wall Street has remained remarkably optimistic despite the dangers that may lie ahead — the research analysts who track individual companies.

Typically bullish in the best of times, this group has barely budged on its expectations for earnings in the second half of 2011, even as the economists and strategists at the big brokerage firms have steadily ratcheted down their forecasts for overall economic growth.

That disconnect could prove painful for investors. On Friday, shares of Hewlett-Packard were punished after the technology giant reported results below analysts’ projections and warned them to bring down future numbers. Earlier in the week, similar shortfalls caused shares of Dell and Urban Outfitters to sink.

Let’s imagine this dynamic. Analysts, shareholders, firms expect earnings to grow at an unrealistic rate (why would they? because they have in the past). When the earnings fail to materialize, share prices plunge and firms lay off employees and sell assets until they believe they can return to the high earnings growth rate.  At some (low) level of capital, the current earnings + growth rate will meet the high expectations — even if this requires idle workers and empty storefronts.

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One response to “NY Times Chimes in on Required Returns

  1. I think you’re absolutely right that the minimum required rate of return is a central piece of the puzzle. But I’d be a little hesitant to theorize it in purely economic terms — it may have something to do with the specific sociology of the firm. In any case, as you say, it’s an important constraint on the effectiveness of monetary policy. If firms are investing only in projects that promise returns 20 points above the funding cost, then a one percent fall in the interest rates is only a small change in the required return, and will increase the number of projects that go forward by a lot less than if firms were following the textbook model and investing in anything with a positive net present value.

    As the man says, “the most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners. If a tolerable level of employment requires a rate of interest much below the average rates which ruled in the nineteenth century, it is most doubtful whether it can be achieved merely by manipulating the quantity of money.” In the present context we should talk about the return on financial assets generally rather than the rate of interest, but the point is the same.

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