GE’s cost of capital in late 2009 was about 5%. Suppose that GE could use $1 billion to ma...

GE’s cost of capital in late 2009 was about 5%. Suppose that GE could use $1 billion to make an investment that would generate positive cash flow of $60 million every year in perpetuity. At a 5 percent discount rate, what would be the value of this cash flow to investors? How much would such an investment add to GE’s market value? Now suppose that the investment actually produces just $10 million per year in perpetuity (or about 1 percent per year relative to the cost of the investment). What is the value of this investment to shareholders, and by how much would GE’s market value fall because of this investment?

General Electric

Falling Short of Expectations

For years, General Electric was perhaps the most admired company in the world. From 1990 through 2000, its stock rose more than 800 percent, making it one of the world’s most valuable companies and earning its long-time CEO, Jack Welch, the title of “Manager of the Century” from Fortune magazine. GE’s stock price peaked in August 2000 at $60.50. Since then, however, GE stock has lost its luster, falling by roughly 50 percent and trailing far behind benchmarks such as the Standard & Poor’s 500 Stock Index. In 2009, GE cut its dividend for the first time since the Great Depression and lost its coveted AAA credit rating.

Why did GE perform so poorly? A simple answer is that GE’s business investments failed to earn a return sufficient to meet the expectations of investors. When a firm’s operating results disappoint investors, its stock price will fall as investors sell their shares and move to a more attractive investment. As one expert explained, “GE has been destroying shareholder capital for years. Their cost of capital is about 5 percent, and their return on assets is about 1 percent. That mathematic equation can’t remain too much longer.”1

For companies to succeed, their investments have to earn a rate of return that exceeds investors’ expectations. But how do companies know what investors expect? The answer is that companies have to measure their cost of capital. Read on to learn how firms do that.