How reliable are share and company valuations?

Company and shares valuations are important for both investors and managers. In acquisition and merger analysis, valuation plays a crucial part (Damadoran 2012), it is therefore important for managers to be able to efficiently value the target company (Arnold 2013).  It is also essential for manages who wish to increase shareholder value (Grundy 2014). For investors, it can be used as a tool to compare similar equities in that sector. It is therefore clear that company and share valuations are significant, so how reliable are the methods used to calculate them? In today’s blog I will be analysing three basic valuation methods and assessing their reliability.

Stock Market Valuation

Stock market valuation is the number of issued ordinary shares multiplied by the company’s market price (Watson & Head 2010). This method of valuation is considered reliable if EMH applies. However, in merger and acquisition analysis it can be used as a starting point for estimating the purchase price of a potential target company (Grundy 2014).

Net Asset Valuation (NAV)

There are two different types of NAV: book value and net realisable value (NRV).

Book Value is a straight forward method which uses accounting measures to financially value the company’s assets (Arnold 2013). The main advantage of this method is that it uses historical costs that are both factual and easily available (Watson and Head 2013).

NRV is the residual value of a company’s assets.  It is calculated by working out how much cash would be received if a company’s assets were sold on the open market (Watson and Head 2013).  These values are particularly useful when looking at firms in financial difficulty (Arnold 2013) or firms where their main value comes from their underlying assets (Grundy 2014) e.g. property investment companies (Arnold 2013).

Income Based Valuation

Income based valuations are orientated towards the future, thus assuming the company will continue to remain a going concern (Grundy 2014). There are three main methods which can be used: dividend valuation models, price to earnings ratio model and discounted cash flows (DCF) (Arnold 2013).

Dividend valuation models (DVM)

The most common method is seen with Gordon’s Dividend Growth Model. This approach assumes the company’s growth rate will remain constant (Arnold 2013). The value is therefore calculated by using the present value of dividends in order to determine a price (Watson and Head 2013).

Price to earnings ratio model

PER is one of the most popular approaches to use as it determines the price investors are willing to pay for each unit of earnings (Arnold 2013). It is simply the market price of a share divided by the latest reported earnings per share (Grundy 2014). This ratio can also be used to understand the market’s expectations of that company.

Discounted Cash Flows (DCF)

DCF are based on future cash flows and discount rates (Damadaran 2012). It is the difference between the present values of its pre-and post-acquisition cash flows. This technique contrasts to all the others mentioned above, as it calculates the maximum amount the purchaser should be prepared to pay (Watson and Head 2013).

Issues

Each of the methods highlighted above, may provide managers with different options and techniques to use, however each methods has several issues due to the assumptions made (Fernandez 2005)
Firstly, stock market valuation can cause problems as listed company’s share price do not reflect the value of all shares as only a small proportion are traded daily ( Watson and Head 2013). Furthermore, stock market valuations are reliable if EMH applies. As discussed in my previous blog, are markets efficient? If not, how reliable is this method? It can be argued that these issues seriously question the credibility of this method.
Secondly, net asset valuation does not reflect current asset value. In fact, it ignores intangible assets such a human capital and brands (Watson and Head 2013). Therefore there is a miss- match between actual value and book value (Grundy 2014). Furthermore, NRV is hard to calculate due to the difficulty surrounding unique asset valuations and is only useful when used in liquidation.

Thirdly, all three methods under income based valuation share similar issues. DCF calculations rely on estimation, a common error can be seen with exaggerated optimism when forecasting cash –flows e.g. Enron (Fernandez 2005).  Looking at DVM’s, the  issues arising are due to the fact that the majority of the calculation is based on assumptions and estimates (Arnold 2013) Is the past really a good indicator of the future? Furthermore, PER does not recognise the time pattern of earnings growth (Grundy 2014) as well as the fact that the model is based on distributable earnings (Watson and Head 2013).

Finally, it can be argued that for all of the methods mentioned above these issues are brought to our attention when trying to value unquoted companies. This is because there is less information disclosed (Grundy 2014) making it difficult to estimate and forecast figures, highlighting their dependence on forecasts and estimations.

How reliable are these methods?

The use of valuations will ultimately impact the reliability of the method chosen. As an investor, using a stock market valuation may prove to be reliable when comparing two companies in the same industry. However, as a manager looking to acquire a company, stock valuation methods will not be sufficient enough to determine the value of the target company.

Another example can be seen with NRV. In theory, the market value of a company should be higher than its NRV. Therefore, using this technique only applies when valuing a company in financial distress. It is therefore unreliable to use for companies which are considered to be a going concern.

 Similarly DCF is an appropriate method to use for those firms with positive cash flows which can be easily estimated (Damadaran 2012). Due to the fact that this technique assumes the company is a going concern; it therefore does not work well on distressed firms with negative earnings (Damadaran 2012).

It can therefore be argued that using solely one method for valuation can result in an unreliable value being produced. Therefore, in order to increase the reliability of a company’s valuation, a combination of methods should be used, alongside an efficient management team who have the necessary skills to carry this out.

 References

Arnold, G (2013). 'Valuing Shares'. In: Corporate Financial Management. 5th ed. Great Britain: Pearson. pp.723-770

Damodaran, A, (2012). 'Approaches to Valuation'. In: (ed), Investment Valuation Tools and Techniques for Determining the Value of Any Asset. 3rd ed. New Jersey and Canada: John Wiley & Sons Inc. pp.(11-19).

Fernandez, P, (2005). Most Common Errors in Company Valuation. Investment Management and Financial Innovations. 2. pp.(133-136).

Grundy, D (2014). ‘Valuing Shares & Companies (Part 1).’ In: International Finance and Financial Management. United Kingdom: Newcastle Business School.

Grundy, D (2014). ‘Valuing Shares & Companies (Part 2).’ In: International Finance and Financial Management. United Kingdom: Newcastle Business School.

Watson,D and Head, A, (2013). 'Mergers and Takeovers '. In: Corporate Finance Principles and Practice. 6th ed. United Kingdom: Pearson. pp.(358-365).

 

 

How does a lower WACC proposed by regulators as a pricing benchmark affect shareholders?

The weighted average cost of capital (WACC) allows managers to see how much interest the company has to pay. WACC is therefore a useful tool in decision making. In today’s blog I will be looking at how industry regulators propose lower WACC’s for companies in order for them to reduce their prices. Are these WACC’s achievable, if not, what are the implications for the shareholders?  

Practical Application

For a company to grow, cash generated by the business ventures must exceed the returns paid to investors. The WACC can therefore be used as a benchmark; it helps managers make investment decisions and can be used by regulators. The most common use is seen in capital investment decision making: only those projects with a higher return than the company’s WACC will be accepted by management, thus the lower the WACC, the greater the investment opportunities. The knock on effects can be seen with an increase in shareholder returns. 

If a lower WACC is such a positive thing, how can lower WACC proposed by regulators be a problem? Regulators can use WACC as a benchmark for companies pricing models. They can enforce certain rules to companies based on their proposed WACCs.  Examples of this can be seen in the broadband, electricity and water industry.

Ofcom

Ofcom wanted BT to reduce the price of its wholesale broadband products in order to improve internet access in rural areas.  The basis for their proposed cuts in price comes from their estimation on BT’s WACC. As a result, Ofcom proposed a lower WACC of 8.6%.  Analysts said this would in turn cut the price of the subsidiary’s wholesale products across the country. However if BT were to reduce their prices, group revenue could be cut by £150million and earnings could decline by 8%.

Ofgem

Ofgem has allowed electricity distribution network companies to invest £7.2bn in the distribution network. The companies are keen to invest heavily in their networks as the returns they are allowed to earn are based on the size of their assets. However, Ofgem is only permitting price rises of just 5.6% per year on average. The industry argued that this may not be enough to deliver the investment. The decision for this came from the assumed WACC of 4.7%. This is significantly below anyone had anticipated.  Ofgem argued that those companies who manage themselves efficiently could earn up to returns of 13%, while those mismanaged companies could see a 3% return.  Is it really down to the performance of management? Or is the WACC too low?

Ofwat

Ofwat’s final determination foresees average water bills to decline by 1% over the next five years. This is based on Ofwat’s forecasted WACC of 4.5%, lower than companies’ request of 5%.Water companies have argued that this decision favoured customers; they argued that they did not come close to matching any of the price rises they had asked for. Instead they told them to expect a price decrease.

What are the implications to shareholders?

 The above example show how regulators forecasts of WACC are used to enforce new pricing policies. Although a lower WACC is beneficial for companies, enforcing them may have serious implications if they are not achievable. Looking at BT, assuming a lower WACC can be achieved in order to lower prices can have a damaging effect on the company, thus hindering shareholder wealth maximisation. The regulators forecasts are forcing companies to become more efficient to meet their demands, however is this fair? Looking at Ofwat’s terms, it may be difficult for the water companies to meet these requirements due to the high levels of debt most of these companies have. Debt is now more expensive, thus they face rising costs. Is it therefore fair for Ofwat to foresee a decline in water bills?

However, you could argue that Ofgem’s actions could benefit shareholders. Although their proposed WACC is lower than the industry expected, they have argued that those companies who are well managed and efficient could deliver returns of up to 13% to its shareholders. Therefore, could enforcing lower WACC’s benefit shareholders? Does this force companies to become more efficient?

 

Conclusion

It can be argued that for investment purposes a lower WACC is beneficial for companies and can increase shareholder returns due the range of available investment opportunities.  However, is this case when regulators are using this as a benchmark for pricing policies?  The real answer is how realistic are these proposed WACCs? In the case of BT it could be argued that their WACC was too low to achieve and would cause problems which as a result would destroy shareholder wealth.  Regulators should take this into account when setting benchmarks. However, it is also a way to force companies to become more efficient. It is easy to lower the WACC by restructuring a company’s capital structure, thus proposing lower WACC’s aren’t necessarily a bad thing. In Ofgem’s case, they argued that it was down to the management of the company, and those run efficiently would be able to deliver up to 13% in returns.

To conclude, using WACC as a benchmark for pricing policies can have both positive and negative implications to shareholders. It should therefore be emphasised that the proposed WACC’s should be realistic, which would allow companies to meet these levels and improve efficiency which as a result would benefit shareholders.

References 

 Arnold, G (2013) Corporate Financial Management. 5th ed. Great Britain: Pearson. 

Portfolio Theory Model: Why are the leading academics not following their own guidelines?

The portfolio theory model (PTM) was developed in 1952 by Markowitz. The idea behind this theory is simple: Investors can reduce risk by diversification and holding a portfolio of investments. If it is so simple, why are leading academics including Markowitz not following this approach? Today in my blog, I will be exploring as to why this is the case.

Portfolio Theory Model

Markowtiz argued that for investors to reduce their unsystematic risk, they would need to hold The diagram uses two parameters: standard deviations and the expected value of the portfolios return. 

 

The envelope curve is represented by the shaded area; investors can construct their portfolio anywhere in this shaded area by holding different combinations of available risky assets.

In order to select the right portfolio, investors risk level need to be taken into consideration as well as identifying the risk free rate of return and capital market line. Taking this into account, maybe adopting the portfolio theory isn’t so simple?

Practical Application

It is can be argued that most people understand the need to diversify; however, the million dollar question is how much?

The proper answer to this question is seen with applying PTM in practice. However, in reality this is not the case.  The vast majority of UK based academics maintain a sensible 60/40 splits between bonds and equities. Leading Academics adopt a similar approach; Markowitz admitted that instead of computing co-variances and drawing up the efficient frontier he split his contributions 50/50. Other examples can be seen with Bill Sharpe and Eugene Fama.  Even those that go that little bit further are only investing into a maximum of 6 funds.

Arnott takes this even further by arguing that most of the advantages of diversifying happen with three or four significant positions in seriously cheap assets.  If you go beyond ten you’re deluding the opportunity set as you are reducing your ability to add value. Tim Bond at BarCap supports this view by saying that in specific circumstances “diversification is the worst solution for your investment needs. Instead you need a narrowly focused portfolio where you are investing in the specific theme.” So why aren’t leading academics following their own advice?

Problems

There are several problems with trying to apply this theory in practice.  One main problem is that the theory is founded on a number of assumptions. Firstly, investors can borrow or lend at the risk free rate; realistically it is highly unlikely that investors can borrow at the risk free rate. Individuals and companies are not risk free thus they will be charged a premium.  Secondly, there are no transaction costs or taxes.  Practically, this is not the case and it can be argued that it is too expensive to construct due these costs. Thirdly, it assumes that utility maximisation is the object of all investors.

Aside from the problems associated with the assumptions made, the biggest question to ask is how easy is it to implement?

PTM is usually implemented using historic returns, standard deviations and correlations to aid decision making about future investments. The model relies on the predictability and stability of the possible profile of returns.  Predicting returns, standard deviations and covariance is a difficult and imprecise art, thus causing potential problems when implementing PTM.  Furthermore, the volume of computations for large portfolios can be inhibiting. 

Could the problems in the theory itself combined with the difficulty in practical implementation be the reasons as to why leading academics are not following their own advice?

Passive Vs. Active

It is clear that the problems mentioned above have significant implications when adopting PTM in practice. However, it should be highlighted that Passive vs. Active management also has an influence on what approach to take.  In fact, it can be argued that those academics, including Markowitz have taken a passive approach. 

Following a passive approach makes asset allocation and diversification easier. It can be argued to be a much simpler and cheaper method of investing as portfolio turnover is much lower thus making it cheaper.  Asset size is not a concern with index funds, and with portfolio turnover being low it explains why those who adopt this method are seen with investing into a total of 6 funds.

Active management involves much more work, and as a result it is argued that portfolio turnover is much higher than the latter thus making this approach more expensive.  However, actively managed funds provide excellent investing opportunities and there are a number of top rated funds which consistently deliver exceptional results. Despite their impressive long-term records, it should be emphasised that these funds can have bad years too. However, overall they best serve the long term interests of fund investors.  PTM can be used as a method of active management.

Conclusion

It is clear that the problems associated with the theory, the difficulty in practical implementation, the different type of investors and the different styles of management need to be taken into account. This can be used to explain why the majority of academics do not follow their own guidelines.  Practical application is a lot more complicated than it appears as other factors come into play.  portfolios consisting of a number of different shares.  As long as the returns of essential assets are not perfectly positively correlated, diversification can reduce risk. Different investors will be willing to take different levels of risk, so how would we choose our portfolio? The theory suggests constructing an efficient frontier of optimal portfolios offering the maximum possible return for a given level of risk.