WHY VALUE VALUE? When managers, boards of directors, and investors have forgotten these simple truths, the consequences have been disastrous. The rise and fall of business conglomerates in the 1970s, hostile takeovers in the United States in the 1980s, the collapse of Japan’s bubble economy in the 1990s, the Southeast Asian crisis in 1998, the Internet bubble, and the economic crisis starting in 2007—all of these can be traced to a misunderstanding or misapplication of the cornerstones. During the Internet bubble, for instance, managers and investors lost sight of what drives ROIC, and many even forgot its importance entirely. Between 1995 and 2000, more than 4,700 companies went public in the United States and Europe, many with billion-dollar-plus market capitalizations. Some of the companies born in this era, including Amazon, eBay, and Yahoo!, have created and are likely to continue creating substantial profits and value. But for every solid, innovative new business idea, there were dozens of that couldn’t similarly generate revenue or cash flow in either the short or long term. The initial stock market success of these companies represented a triumph of hype over experience. Ignoring the cornerstones also underlies financial crises, such as the one that began in 2007. When banks and investors forgot the conservation-of-value principle, they took on a level of risk that was unsustainable. First, homeowners and speculators bought homes—essentially illiquid assets. They took out mortgages with interest set at artificially low teaser rates for the first few years, but then those rates rose substantially. Both the lenders and buyers knew that buyers couldn’t afford the mortgage payments after the teaser period. But both assumed that either the buyer’s income would grow by enough to make the new payments, or the house value would increase enough to induce a new lender to refinance the mortgage at similarly low teaser rates. Banks packaged these high-risk debts into long-term securities and sold them to investors. The securities, too, were not very liquid, but the investors who bought them, typically hedge funds and other banks, used short-term debt to finance the purchase, thus creating a longterm risk for those who lent the money. When the interest on the homebuyers’ adjustable rate increased, many could no longer afford the payments. Reflecting their distress, the real estate market crashed, pushing the value of many homes below the value of loans taken out to buy them. At that point, homeowners could neither make the required payments nor sell their houses. Seeing this, the banks that had issued short-term loans to investors in securities backed by mortgages became unwilling to roll those loans over, prompting all the investors to sell their securities at once. The value of the securities plummeted. Finally, many of the large banks themselves had these securities on their books, which they, of course, had also financed with short-term debt that they could no longer roll over. This story reveals two fundamental flaws in the decisions taken by participants in the securitized mortgage market. First, they all assumed that securitizing risky home loans made them more valuable because it reduced the risk of the assets—but this violates the conservation of-value rule. The aggregated cash flows of the home loans were not increased by securitization, so no value was created and the initial risks remained. Securitizing the assets simply enabled risks to be passed on to other owners; some investors, somewhere, had to be holding them. After the housing market turned, financial service companies feared that any of their counterparties could be holding massive risks and almost ceased to do business with one another. This was the start of the credit crunch that triggered a protracted recession in the real economy. The second flaw in thinking made by decision makers during the past economic crisis, was in believing that using leverage to make an investment in itself creates value. It doesn’t because, according to the conservation-of-value principle, leverage doesn’t increase the cash flows from an investment. Many banks, for example, used large amounts of short-term debt to fund their illiquid long-term assets. This debt didn’t create long-term value for shareholders in those banks. On the contrary, it increased the risks of holding their equity. WHAT DOES IT MEAN TO CREATE SHAREHOLDER VALUE? Particularly at this time of reflection on the virtues and vices of capitalism, it’s critical that managers and board directors have a clear understanding of what value creation means. For value-minded executives, creating value cannot be limited to simply maximizing today’s share price. Rather, the evidence points to a better objective: maximizing a company’s collective value to its shareholders, now and in the future. If investors knew as much about a company as its managers do, maximizing its current share price might be equivalent to maximizing its value over time. But in the real world, investors have only a company’s published financial results and their own assessment of the quality and integrity of its management team. For large companies, it’s difficult even for insiders to know how financial results are generated. Investors in most companies don’t know what’s really going on inside a company or what decisions managers are making. They can’t know, for example, whether the company is improving its margins by finding more efficient ways to work or by skimping on product development, resource management, maintenance, or marketing. Since investors don’t have complete information, companies can easily pump up their share price in the short term or even longer. One global consumer products company consistently generated annual growth in earnings per share (EPS) between 11 percent and 16 percent for seven years. Managers attributed the company’s success to improved efficiency. Impressed, investors pushed the company’s share price above those of its peers—unaware that the company was shortchanging its investment in product development and brand building to inflate short-term profits, even as revenue growth declined. Finally, managers had to admit what they’d done. Not surprisingly, the company went through a painful period of rebuilding. Its stock price took years to recover. It would be a mistake, however, to conclude that the stock market is not “efficient” in the academic sense that it incorporates all public information. Markets do a great job with public information, but markets are not omniscient. Markets cannot price information they don’t have. Think about the analogy of selling an older house. The seller may know that the boiler makes a weird sound every once in a while or that some of the windows are a bit drafty. Unless the seller discloses those facts, a potential buyer may have great difficulty detecting them, even with the help of a professional house inspector. Despite such challenges, the evidence strongly suggests that companies with a long strategic horizon create more value than those run with a short-term mindset. Banks that had the insight and courage to forgo short-term profits during the last decade’s real-estate bubble, for example, earned much better total shareholder returns (TSR) over the longer term. In fact, when we studied the patterns of investment, growth, earnings quality, and earnings management of hundreds of companies across multiple industries between 2001 and 2014, we found that companies whose focus was more on the long term generated superior TSR, with a 50 percent greater likelihood of being in the top decile or top quartile by the end of that 14-year period. In separate research, we’ve found that long-term revenue growth— particularly organic revenue growth—is the most important driver of shareholder returns for companies with high returns on capital. What’s more, investments in research and development (R&D) correlate powerfully with long-term TSR. Managers who create value for the long term do not take actions to increase today’s share price if those actions will damage the company down the road. For example, they don’t shortchange product development, reduce product quality, or skimp on safety. When considering investments, they take into account likely future changes in regulation or consumer behavior, especially with regard to environmental and health issues. Today’s managers face volatile markets, rapid executive turnover, and intense performance pressures, so making long-term value-creating decisions requires courage. But the fundamental task of management and the board is to demonstrate that courage, despite the short-term consequences, in the name of value creation for the collective interests of shareholders, now and in the future. OVERVIEW OF VALUATION CONCEPTS AND METHODS The fundamental point behind successful investments is understanding what is the prevailing value and the key drivers that influence this value. In this lesson, the valuation and the processes in valuation will be discussed. According to the CFA Institute, valuation is the estimation of an asset's value based on variables perceived to be related to future investment returns, on comparison with similar assets, or when relevant, on estimates of immediate liquidation proceeds. It includes the use of forecasts to come up with reasonable estimate of value of an entity's assets or its equity. Valuation places great emphasis on the professional judgment that are associated in the exercise. As valuation mostly deals with projections about future events, analysts should hone their ability to balance and evaluate different assumptions used in each phase of the valuation exercise, assess validity of available empirical evidence and come up with rational choices that align with the ultimate objective of the valuation activity. Key Principles in Valuation The value of a business is defined only at a specific point in time. Value varies based on the ability of business to generate future cash flows. Market dictates the appropriate rate of return for investors. Firm value can be impacted by underlying net tangible assets. Value is influenced by transferability of future cash flows. Value is impacted by liquidity. Risks in Valuation In all valuation exercises, uncertainty will be consistently present. Uncertainty refers to the possible range of values where the real firm value lies. When performing any valuation method, analysts will never be sure if they have accounted and included all potential risks that may affect price of assets. Some valuation methods also use future estimates which bear the risk that what will actually happen may be significantly different from the estimate. OBJECTIVE OF THE VALUATION EXERCISE The definition of value may vary depending on the context and objective of the valuation exercise. 1. Intrinsic Value – refers to the value of any asset based on the assumption assuming there is a hypothetically complete understanding of its investment characteristics. It is the value that an investor considers, on the basis of an evaluation or available facts, to be the “true” or “real” value that will become the market value when other investors reach the same conclusion. 2. Going Concern Value – the going concern assumption believes that the entity will continue to do its business activities into the foreseeable future. II. Business Deals for Analysis 3. Liquidation Value – the net amount that would be realized if the business is terminated and the assets are sold piecemeal. It is particularly relevant for companies who are experiencing severe financial distress. 4. Fair Market Value – the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. Acquisition – an acquisition usually has two parties: the buying firm that needs to determine the fair value of the target company prior to offering a bid price and the selling firm who gauge reasonableness of bid offers. Merger – transaction of two companies’ combined to form a wholly new entity. Divestiture – sale of a major component or segment of a business to another company. Spin-off – separating a segment or component business and transforming this into a separate legal entity whose ownership will be transferred to shareholders. Leverage buyout – acquisition of another business by using significant debt which uses the acquired business as a collateral. ROLES OF VALUATION IN BUSINESS Valuation is an essential tool for business owners to assess both opportunities and opportunity costs associated with the business resources. It helps them manage the business because they are able to track the effectiveness of the decision-making process and provide them the ability to track performance in terms of estimated change in value, not just in revenue. I. Portfolio Management Fundamental Analyst – these are persons who are interested in understanding and measuring the intrinsic value of a firm. Fundamentals refer to the characteristics of an entity related to its financial strength, profitability or risk appetite. Activist Investors – activist investors tend to look for companies with good growth prospects that have poor management. Activist investors usually do “takeovers” – they use their equity holdings to push old management out of the company and change the way the company is being run. Chartists – they rely on the concept that stock prices are significantly influenced by how investors think and act and on available trading KPIs such as price movements, trading volume, short sales – when making their investment decisions. Information Traders – they react based on new information about firms that are revealed to the stock market. The underlying belief is that information traders are more adept in guessing or getting new information about firms and they can make predict how the market will react based on this. Valuation Techniques in Portfolio Management ∙ Stock selection ∙ Deducing market expectations THE VALUATION PROCESS 1. Understanding the business – it includes performing industry and competitive analysis and analysis of publicly available financial information and corporate disclosures. An investor should be able to encapsulate the industry structure. One of the most common tools used in encapsulating industry is Porter’s Five Forces: Generic Corporate Strategies to achieve Competitive Advantage - Cost leadership – incurring the lowest cost among market players with quality that is comparable to competitors allow the firm to be price products around the industry average. - Differentiation – offering differentiated or unique product or service characteristics that customers are willing to pay for an additional premium. - Focus – identifying specific demographic segment or category segment to focus on by using cost leadership strategy or differentiation strategy. Other ways to understand a business include the following: a. understanding the company's business model which pertains to the method on how the company makes money. b. analysis of historical and financial reports which use horizontal, vertical, and ratio analysis and their interpretations. c. analysis of quality earnings which pertain to the detailed review of financial statements and accompanying notes to assess sustainability of company performance and validate accuracy of financial information versus economic reality. 2. Forecasting financial performance – can be looked at two perspectives: on a macro perspective viewing the economic environment and industry where the firm operates in and micro perspective focusing in the firm’s financial and operating characteristics. Two Approaches of Forecast Financial Performance o Top down forecasting approach – international or national macroeconomic projections with utmost consideration to industry specific forecasts. o Bottom-up forecasting approach – forecast starts from the lower levels of the firm and builds the forecast as it captures what will happen to the company. 3. Selecting the right valuation model – it depends on the context of the valuation and the inherent characteristics of the company being valued. 4. Preparing valuation model based on forecasts – there are two aspects to be considered: - Sensitivity analysis – common methodology in valuation exercises wherein multiple other analyses are done to understand how changes in an input or variable will affect the outcome. - Situational adjustments – firm specific issues that affects firm value that should be adjusted by analysts since these are events that are not quantified if analysts only look at core business operations. 5. Applying valuation conclusions and providing recommendation.
