Corporate Valuation for Portfolio Investment

Analyzing Assets, Earnings, Cash Flow, Stock Price, Governance, and Special Situations

Robert A. G. Monks, Alexandra Reed Lajoux

• Publisher: Bloomberg Press
• Year: 2010
• ISBN:
  9780470936764
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Inversiones y valores

A detailed guide to the discipline of corporate valuation

Designed for the professional investor who is building an investment portfolio that includes equity, Corporate Valuation for Portfolio Investment takes you through a range of approaches, including those primarily based on assets, earnings, cash flow, and securities prices, as well as hybrid techniques.

Along the way, it discusses the importance of qualitative measures such as governance, which go well beyond generally accepted accounting principles and international financial reporting standards, and addresses a variety of special situations in the life cycle of businesses, including initial public offerings and bankruptcies. Engaging and informative, Corporate Valuation for Portfolio Investment also contains formulas, checklists, and models that the authors, or other experts, have found useful in making equity investments.

• Presents more than a dozen hybrid approaches to valuation, explaining their relevance to different types of investors
• Charts stock market trends, both verbally and visually, enabling investors to think like traders when needed
• Offers valuation guidance based on less quantitative factors, namely management quality and factors relating to the company and the economy

Corporate Valuation for Portfolio Investment puts this dynamic discipline in perspective and presents proven ways to determine the value of corporate equity securities for the purpose of portfolio investment.

CHAPTER 1

Corporate Valuation for Portfolio Investment A Philosophical Framework

EQUITY SHARES must be valued—but how? It may seem that sophisticated financiers have taken over valuation. The phrase “equity valuation” may conjure up visions of financial specialists feeding numbers into algorithmic programs, relentlessly making buy, sell, or hold decisions unrelated to the operating realities of businesses or to understandable economic concepts such as replacement value.¹

A great deal of controversy surrounds the mathematicians and physicists (aka “quant jocks”) on Wall Street. Some blame them for the economic problems of the first decade, noting their complex trading programs that, once automated, accelerated doomsday events for markets.² Others say that the quant jocks boosted the overall intelligence of the market by introducing new and sensible ways of looking at risk and return, pointing out that they were among the first to warn against the crisis.³ In fact, sophisticated trading programs do have a role to play, but the programs must be based on sound principles. Sophisticated trading activities are the symptom, not the substance, of stock valuation.

In fact, valuation begins from the hour a company’s leaders find equity investors who believe so strongly in the company’s economic prospects that they are willing to provide capital for it, no strings attached. This belief in a company’s future—in a word, hope—is what makes the value of the stock something more than the current value of all its assets, if sold in a fire sale. Combined with the investor’s own time horizon for a return, hope is the key to securities valuation. Vision and time are the alpha and omega.

Valuable vision is what propels a company’s stock into the marketplace; it is what preserves the value of the stock in spite of market chaos. Understanding this concept requires an integrated theory of valuation that includes consideration of assets offset by liabilities, of income, of cash (liquidity), of securities market dynamics, and of comparable pricing. Understanding also requires consideration of what we call stories—meaningful information beyond the financial statements and market prices. This book is structured accordingly.

Of course, not all investors base their trades on such an integrated framework for valuation. Some are index investors, some are algorithmic traders, and some are fund managers who buy assets based on classes of risk. In fact, fewer than half of all investors actually choose an investment based on the quality of a particular company.⁴ It is for these happy few volitional, value-minded investors that this book is intended.

Cost/Benefit of Information Gathering

There is also the issue (which I found out in the S&P strat⁵) of the price of gathering data. One of the reasons such simple strats exist is the cost of gathering the information you need to implement them is fairly high compared to the payout. Would I be better off screen scraping all the livelong day to implement some lousy subjective strat with a low Sharpe⁶ anyway? Or would I be better off getting a job at a bank, making a lot of money, and buying bonds?”

—Posted by Scott Locklin at the Algorithmic Traders Discussion Board on LinkedIn.com, April 19, 2009.

Valuation Defined

Valuation means determining a value for something. This book sets forth all the elements of a company that are to be valued and offers guidance on how to determine those values.

• Corporate valuation determines the worth of a corporation today (its present value); valuation for portfolio investment joins that present value with a future value. As Al Rappaport said so succinctly in Expectations Investing, the key to successful investing is “to estimate the level of expected performance embedded in the current stock price and then to assess the likelihood of a revision in expectations.”⁷

• Expectation is indeed a fitting word for the process of valuation for investment. “Valuation” comes from the Latin word valere—to be worth something in an exchange⁸.“Investment” derives from vestire—to clothe. It means exchanging money now for something that may offer more money in the future.

Valuation alone is relatively simple; corporate valuation for portfolio investment is complex. Valuation alone says A is worth X today. But valuation for investment says A is worth X today and may be worth Y at a future date. Valuation for investment means determining the present value of future worth.

Valuation is not a one-time event. It is a process. There is no one set of steps to value the stock of an existing public company, but it is generally agreed that the valuation journey proceeds with the following steps:

1. Select the item to be valued (the security).

2. Identify its current price (e.g., today’s closing price).

3. Evaluate whether the current price is low, correct, or high.

4. Make a corresponding buy, hold, or sell decision based on the investor’s own circumstances—including liquidity needs and the timing of those needs.

As part of step 3, the investor can adjust the values of price (step 2) based on six valuation matrices:

1. Time—Short term versus long term

2. Place—Market versus nonmarket

3. Slope—Level versus skewed playing field

4. Volition—Degree of willingness or unwillingness of the buyer or seller

5. Utility—Purpose (e.g., wealth versus liability collateral for a fund)

6. Quality—Level of certainty of return (high, medium, or low grade) based on investing standards

To get real value, one needs to pass each valuation through these six lenses. This paradigm appears throughout this book.

The Importance of Equity

Few financial topics matter more than equity valuation. Without the possibility of placing a reasonably accurate value on equity securities, there could be no equity marketplace. And without an equity marketplace, society would not have such a diversity of products and services. Some corporate undertakings are so long term and expensive that only equity capital—as opposed to operating capital or debt capital—can fund them.⁹ Societal commitments such as payments made out of defined pension plans simply cannot be honored unless the obligated payor (the company or union offering the pension) has access to funding that can beat inflation at the level that equities have achieved historically.¹⁰ It is no coincidence that these financial instruments are nicknamed “stock.” For an equity market to function, the economy at large must “put stock” (trust) in equities and continually “take stock of” (measure) their value.

The presence of the federal government as an investor (discussed in Chapter 2) raises new issues in equity valuation: as the holder of the shares, will a government entity’s focus be on financial return, as in the past, or on matters of broad social significance, such as jobs? There is some precedent for this concern at the state level. Public pension plans have at times made political rather than economic decisions.¹¹In general, however, the equity investment decisions of pension plans are based on universally recognized financial principles. One of the purposes of this book is to articulate those principles so that equity valuation maintains its integrity as a discipline.

Equity Defined

First invented by Dutch and English traders some 500 years ago, the term “equity” or “stock” as a form of corporate financing has been part of the business world for half a millennium.¹² Equity is created when companies offer ownership stake to buyers, giving stock certificates in return for cash. The value of a company’s equity (the number of shares times the current price per share) is its market value.

There is another kind of equity. It’s the accounting kind, namely the dollar-value number remaining on the balance sheet after liabilities are subtracted from assets. This version of equity is also known as “net worth” or “book value.” The accounting number is usually much lower than market value, but it can be used as a check on it because it is far less volatile.¹³

Regulators have done a good deal of hand-wringing over what equity is as opposed to debt. (See Appendix A.) In brief, equity represents ownership with potential for returns, while debt represents a claim entitling the holder to guaranteed payments.¹⁴

The issuance of equity securities brings two distinct values to an economy. For the company’s management, the sale of equity securities can bring patient capital—funds that support growth without making fixed demands for return. To the company’s investors, the purchase of securities can bring returns—a share in a company’s total worth that grows in value as the company does.

Growth in share prices does not happen in each and every company, but it is common for all companies’ stocks as a net total over any given 10-year period. Based on this general trend, Nobel Prize winners Franco Modigliani and Merton Miller asserted that the payment of dividends does not change the firm’s market value: it changes only the mix of elements in the firm’s financing. The Modigliani-Miller theorem has been true historically, but is it true today? If investors, over time, cannot count on share price appreciation, then the theorem would not hold; dividends would become indispensable for equity investors.

Articles of Faith Undermined: Securitization at Risk

When markets sustain shocks or experience long declines, it is hard for investors to maintain a reasonable expectation of share price appreciation. Such events not only undermine such expectations, but they also diminish faith in securities markets—and understandably so.

Take, for example, the turn-of-the-millennium scandals of Enron and WorldCom. Their share price decline was so rapid and unexpected that it fooled even fairly sophisticated investors.¹⁵In the space of half a year, two giants—large in market capitalization, book value, and revenues—lost almost all their value virtually overnight upon declaring surprise bankruptcies in late 2001 and mid-2002, respectively.¹⁶

A decade later, a new series of giants has fallen, including several Wall Street titans felled by the devaluation of securities backed by weak mortgages that went into default—the so-called subprime mortgage crisis. Following severe financial stress, Bear Stearns became part of JP Morgan Chase, and Merrill Lynch part of BankAmerica. Lehman Brothers Holdings sold off multiple divisions and declared bankruptcy. Even Goldman Sachs got heat from the meltdown when SEC made allegations of fraud in an April 2010 lawsuit, triggering shareholder lawsuits and sparking a subpoena from the Financial Crisis Inquiry Commission (FCIC).¹⁷ By June 2010, Goldman’s stock was trading at two-thirds its previous 52-week high, showing the heavy toll that companies pay for scandal.¹⁸

The events from Enron to Goldman bookend what has been called the “worst decade ever for equities,” with an overall negative return of -3.3 percent, according to one study.¹⁹In this crisis, market prices experienced both artificial inflation and deflation, depending on circumstances. The securities of many companies that appeared to have high levels of capitalization, assets, and revenues should have been trading at lower prices, given economic realities. Conversely, in at least one case (Bear Stea...

Table of contents

• Title Page
• Copyright Page
• Dedication
• Foreword
• Preface
• Acknowledgments
• CHAPTER 1 - Corporate Valuation for Portfolio Investment A Philosophical Framework
• CHAPTER 2 - Valuation Based on Assets
• CHAPTER 3 - Valuation Based on Earnings (Income)
• CHAPTER 4 - Valuation Based on Cash Flow
• CHAPTER 5 - Valuation Based on Securities Prices
• CHAPTER 6 - Hybrid Techniques for Valuation
• CHAPTER 7 - Market Value Drivers of Public Corporations Genius, Liberty, Law, ...
• CHAPTER 8 - Situational Valuation Equity Values throughout the Corporate Life Cycle
• CHAPTER 9 - Conclusion
• APPENDIX A - Equity vs. Debt Securities A Global Definition
• APPENDIX B - Basic Accounting Concepts for Corporate Valuation
• APPENDIX C - Convergence of Global Standards FASB, IASB, and Their Joint ...
• APPENDIX D - Report to the Congressional Oversight Panel Regarding Fair Value ...
• APPENDIX E - The Use of Mathematics in Finance
• APPENDIX F - The Modigliani-Miller Theorems
• APPENDIX G - Uniform Standards of Professional Appraisal Practice (USPAP)
• APPENDIX H - Global Industry Classification Standard (GICS) Sectors and ...
• APPENDIX I - Damodaran Spreadsheets for Valuation
• APPENDIX J - Monte Carlo Simulation for Security Investments
• APPENDIX K - Antivaluation! Human Valuation and Investment Foibles
• APPENDIX L - Fair Value Measurement of Derivatives Contracts
• APPENDIX M - Final Report of the Advisory Committee on Improvements to ...
• APPENDIX N - Valuing Values
• APPENDIX O - XBRL Guidance
• APPENDIX P - Pension Fund Valuation Guidance
• APPENDIX Q - Stock Indexes
• APPENDIX R - U.S. Business Cycle Expansions and Contractions
• APPENDIX S - Wisdom from Norway Two Speeches from a Norwegian State Pension ...
• Recommended Reading on Corporate Securities Valuation
• Index