Session 33: Valuation Loose Ends

In this session 33 of a 36 session corporate finance class, I'd like to talk about how you get from valuing an entire business to getting the value per share. Sounds like a pretty simple process but as you will see there's many a slip between the cup and the lip. In these last few sessions we've laid the foundations for valuing the operating assets of the business. We estimated cash flows, we came up with discount rates, we've talked about growth rates and we put closure on the valuation by talking about estimating terminal value. In this session I want to talk about the final step. So let's say you value the operating assets but you're still interested in getting the value of equity per share. There's many a slip between the cup and the lip so I want to talk about how you get from the value of operating assets to the value of equity. So in the larger scheme of things we're talking about tying up loose ends, getting from that operating asset value to value of equity per share. And in particular here are some items you might want to deal with in getting from the value of the operating assets to value of equity. The first is cash. So if you think about the larger scheme of things and you look at what you've done, the first thing you've got to deal with especially with valuing operating assets is you've got to tell me what you're going to do about cash and cross holdings. That sounds simple right, you just add them on. We'll talk about when that might be appropriate and when it might get you into trouble. Second I want to talk about cross holdings. Cross holdings can throw off valuations. What are cross holdings? These are holdings you have as a company and other companies which you haven't valued yet which you have to bring into the valuation. Then you've got to subtract out debt to get a value for the equity. And then once you have the value for the equity you might have to divvy up that equity between two claim holds. What am I talking about here again? Managers might have a claim on the equity if they've been given options in the company or maybe even venture capitalists might have options in the company. Those equity options have to be netted out before you come up with the value per share. So if you're estimating the value of the operating assets by discounting the free cash flow to the firm at the cost of capital you have a lot of work to do to get the value of equity per share. Things do get simpler if you use the dividend discount model especially use dividends per share. There what you get as a present value could very much be the value per share there's no adjustment to make. If you're using free cash flow equity depending on whether you included in the net income the interest income from cash or not once you're done with the present value you might have the value per equity. If you separate the interest income from cash you might have to add the cash and cross cross holdings to a free cash flow equity valuation as well. So let's take these four pieces cash, cross holdings, any other assets you might want to deal with and equity options and think about what to do about them in the context of valuation. Let's start with the value of cash. I'm going to try and experiment on you. I'm going to show you three companies which look exactly the same in terms of enterprise value. So think of this as the present value of free cash flow to the firm at the cost of capital and let's say you come up with a billion dollars in value for all three companies. All three companies also have a hundred million dollars in cash so they have the same enterprise value the same cash balance. So here's where the three companies are different. Company A is a developed market company that has historically earned a return on capital equal to its cost of capital. Company B is also a developed market company that has earned a return on capital that is less than its cost of capital historically and Company C is an emerging market company that has earned about 10 percent more than its cost of capital. I'm going to argue that in one of these three companies cash is going to be a neutral asset. What I mean by that is a hundred million in cash will be worth a hundred million. In one of these three companies you might attach a discount to the cash and one of these three companies you might actually pay a premium for the cash. You ready? Which of these three companies do you think will have cash as a neutral asset? A chance to think about it? I think it's going to be Company A and here's why. Company A is what I call a block company. What's a block company? It does no good, it does no bad, it earns its cost of capital. You're essentially running in place but that's not value destruction. It's basically doing nothing. A company like that, cash is a neutral asset. A hundred million in cash is worth a hundred million. So that was easy. Which of these companies would you put a discount on the cash? Again, think about it. I'll give you a minute. I think it's going to be Company B and here's why. Look at their track record. The track record suggests that they take a lot of bad investments, right? So here's what you're afraid of. Cash by itself has never hurt an investor. What you're afraid of is what the managers will do with that cash and given Company B's history, you're afraid that they will find a way to waste your cash, right? And as an investor, you have no choice but to discount the cash. I call it a stupidity discount. These managers in Company B are so stupid, you're convinced they'll find a way to waste your cash and you reduce the value of the cash accordingly. In Company C, you might actually attach a premium to the cash and here's why. In traditional corporate finance, no company needs a cash balance and here's why. When you have a great project, here's what I assume you can do. You go to capital markets, you raise the money you need to fund the project, you move on. If capital markets are open and accessible, companies don't need cash balances. Now do you see why I made Company C an emerging market company, an Argentine company specifically? Argentina has had enough defaults over the last three decades that you can play this game out. In Argentina, capital markets often shut down and when they shut down, you could be the best company in the face of the earth, you have no access to capital. The advantage of having a cash balance is not only will it allow you to survive the next downturn, the next capital market shutdown, it might actually give you a strategic weapon you can use to buy assets from other companies. You might attach a premium to the cash. This might sound outlandish, you might say, well do markets actually do something like this? Here's some evidence that they do. This is from a study that looked at how much markets value a dollar in cash in the hands of a company. This was done across thousands of U.S. companies and across the thousands, here's the good news, a dollar in cash is valued at about a dollar, that's a middle bar in that graph. But then when the study looked at mature companies that earned less than their cost of capital, companies like Company B, they found a dollar in cash is valued at 69 cents, that's an astonishing discount. Think of what I've just said, you're a mature company with a bad track record. You have 10 billion dollars in cash, I act like you have only 6.9 billion. I'm discounting the cash because I assume you will find a way to waste this cash. These are the companies that are the best targets for people like Carl Icahn and Bill Ackman, because these are companies where all you need to do is give the cash back to the stockholders for their discount to disappear. That's effectively what these activist investors often push for. And finally, if you focus in on the third subgroup, these are young growth companies that earn more than their cost of capital, a dollar in cash is actually valued at a dollar 22. So you might think cash is a simple asset to value and for the most part it is, but you can see why markets might not always value a dollar in cash at a dollar. So that's my first stop, look at the cash, for the most part don't play games with it, treat it as worth what it states it's worth, but in some cases you might want to second guess that estimate to see if this is the kind of company where the markets might be attaching either a discount or a premium to the cash. Second stop in this process, look at crossholdings. What makes crossholdings difficult to work with is the accounting for crossholdings is all over the place. In particular, there are three ways in which crossholdings are accounted for. If you own a very small piece of a company, let's say five percent, you take no role in how the company is run, it might be classified as a minority passive investment. What happens if you have a minority passive investment? Here's what you have to show in your income statement. You have to show the dividends you receive on these crossholdings and in your balance sheet all you have to show is what you originally invested to get that five percent. Talk about a disconnect with reality. There was a point in time in the late 90s where SoftBank, a Japanese venture capital firm, got 80 percent of its value from a single holding in Yahoo. SoftBank was one of the original venture capitalists in Yahoo and its 50 million dollar original investment was worth 8 billion by the time you got to the late 90s. The market reflected that, but if you looked at the balance sheet for SoftBank, all you'd have seen is a 50 million dollar initial investment and no change cents and on the income statement you'd have seen no evidence of their biggest holding because Yahoo did not pay a dividend. That's a minority passive investment. What's far more common though is a minority active investment. This is when you own 20 percent of a company and take some role, even a small role, in how that company is run. Here's what you have to do. In your income statement you have to reflect 20 percent of the net income or net loss of that company. So you're basically showing at least the income or loss, not just the dividends, and in your balance sheet you have to show your original investment plus or minus 20 percent of the retained earnings every year since. It's like an updated book value. That's a little better than a minority passive investment, but that's a minority active investment. There's a final strata of cross holdings. Let's say you own 60 percent of another company. If you do, both GAP and IFRS require you to consolidate that holding. What does that mean? In your income statement you have to act like you own 100 percent of the company, 100 percent of its revenues and 100 percent of its operating income. On your balance sheet you have to show 100 percent of the assets of the company even though you own only 60 percent. And then the accountant takes the 40 percent that doesn't belong to you and it's shown as a minority interest or a non-controlling interest on the liability side of the balance sheet. You can already see why the first step in cross holdings is to figure out how they're accounted for. In lots of valuations that I see, cross holdings are mangled. They're either treated as at face value or worse. So let's see the right way to value cross holdings and then let's think about the practical problems you might face in using this right approach for valuing cross holdings. In a perfect world, here's how I'd value a company with cross holdings. I would value the parent company standing alone and then I'd take each cross holding company and value it separately. What this allows me to do is treat each company with its own characteristics, its own cash flows, its own growth, its own risk rather than apply one bludgeon cost to capital growth rate across the board. However, to do this I need the parent company financials and I need full financials for each cross holding. That's often tough to come by and that's why I would suggest two compromise solutions when you cannot get full information. One is to cheat. What I mean by that is if your cross holding is in a publicly traded company, you have a market price for the company, right? You can use that market value. It's cheating because a whole idea behind intrinsic valuation is you think markets can be wrong and you're trying to estimate value on your own. But if you have 50 or 60 cross holdings and they're all in public companies, why go looking for trouble? If your cross holding is in a private business, here's approximation you can use. If you know what sector your cross holding is in and you know the book value of the cross holding, you can apply a multiple to that cross hold. Based on what? Let's take an example. Let's suppose you have a cross holding in a chemical company and that cross holding is a book value of 100 million. Let's suppose I was able to tell you that a typical chemical company trades at 1.5 times book value. That's a price to book ratio for a chemical company. Multiply the 100 million dollar book value by 1.5. You have an estimated value for your cross holding. I know it's an estimate. It's not exactly the best estimate, but it's the best you can sometimes do with the information you're given about cross holdings. So the basis here is you want to value the cross holdings and bring them in. Incidentally, if you're valuing a cross holding in a company and it's a majority holding, 60 percent, 65 percent, your task is actually a little more messy. Because if you value the consolidated company, you now have to value the minority interest or non-controlling interest and subtract it out because that 35 or 40 percent of the company that doesn't belong to you has to be taken out of your valuation. That's why I call cross holdings the black hole of valuation. It's where mistakes get made. Be very careful when you have cross holdings and try to do your best to incorporate them correctly into value. Let's now talk about anything else you might want to bring into the valuation. You're looking for assets you haven't counted yet. If you already have counted the cash flows on an asset, you can't count the value of the asset as well because that'll be double counting. So for instance, you're valuing an oil company, you can't do a discounted cash flow value of the company and then add the value of the refineries and the ships and the real estate owned by the company because those are the assets that generate the cash flows. This can be a big issue in companies which have real estate holdings on which they have stores or restaurants and those real estate holdings are actually worth more than the company assets. You have to make a choice. You have to value the company as a going concern based on its cash flows or you can value the company as a collection of real estate holdings. You can't add the two up. That is double counting. So when you look at other assets, you're looking for assets you haven't counted yet. So be careful. Don't double count assets. But if you find a truly vacant asset, a valuable asset that your company owns, try to bring it into the valuation using an estimated market value for that asset. Last stop in the process. So here's where you are. You've got the value of the operating assets, you've added cash, you've added cross holdings, you've added any other assets. Let's say you've subtracted out the debt. You have a value for the equity. Look around because when your company has granted equity options to its managers, it's given away a slice of equity in your company, right? I know there are lots of different ways of dealing with this, some more simplistic than others. But think about why this is a problem. The kinds of companies that give away a lot of equity options to their employees tend to be young, high growth companies, risky companies. And these options tend to be long term. You give away a long term option on a risky company, that's a valuable piece of equity you've given away. So if you're going to value this claim, I think you have to value it as an option. The reason I emphasize that is I see a lot of valuations where people value options based on exercise value, what they think the options are worth today. That's going to underestimate how much of the equity gets given away. Because those exercise values can be low, even for options with significant economic value. So if you have options already outstanding, here's the best way to deal with them. Value those options that are already outstanding and US companies report these as part of their footnotes. Value them as options outstanding using an option pricing model. So you need the maturity of the options which are usually given in that table, the exercise price and the current stock price, value them as options. Subtract the value of the options from the value of equity you got from the company, then divide by the actual number of shares outstanding. Don't double count. There are people who used to who tried to adjust for options by adjusting the number of shares using a diluted number of shares. That's a really backwards way of dealing with options. You're better off actually valuing the options and subtracting them out and using the actual number of shares outstanding. You see, what about future option issues? Treat them for what they are. Companies use options to compensate employees. The rest of compensation expenses we treat as operating expenses. So don't fall for that for the trick that these are non-cash expenses. They're just expenses where you skipped a step. If you'd issue these options in the market and use the cash to pay employees, what do you mean cash compensation? So treat equity options as what they are, as compensation. Reduce your operating income and cash flows in the future. That'll take care of future option issues. So if you want to deal with options, you have to deal with them as options. You can't simplify the process by adjusting the number of shares or treat options as being worth their exercise value. So in summary, getting from the value operating assets to the value of equity per share can be problematic because people try to take shortcuts. If you don't take shortcuts and you work at one step at a time, there's really nothing intensely difficult about this process. And we will try to come back with Disney and look at how each step in this process works out with a company like Disney. Thank you very much for listening.