The IR Book Chapter Four

It’s All About Valuation

Our number one premise is that investor relations rises to the top as an important function when it is closely aligned with the company’s mandate to create value for investors.

Investor relations has an integral role to play in helping management optimize value within the context of working to have the current stock price accurately reflect the intrinsic or warranted value of the company.

Intrinsic value is defined by James McTaggart in his book, The Value Imperative, as “the present value of expected future cash flows to investors over the remaining life of the business

In our minds, this is not the same as maximizing value.  The goal of a company should not be to get the stock price as high as it can possibly go.  We all saw what happened in the dot-com explosion of the late 1990s when numerous Internet stocks were grossly over-valued.

It’s not in the best interests of investors or the company to have the equity be overpriced.  That’s almost always a temporary situation, leading to a rollback of the stock price as the market realizes it has bid the price up beyond its realistic value.  The market corrects and the price tumbles. 

Of course, investors who sold at the peak made a handsome profit and so did executives who exercised their options at the right time.  That certainly happened during the tech boom of the ‘90s; many investors cashed out at the right time.  But many more found their largesse-on-paper disappearing while scads of investors lost capital as well as their profits.

The ideal situation for management is to have the equity price reflect the full value of the business—not over or under priced by the market at the moment.

Corporate executives should realize this and accept the reality of their equity being fairly valued.  Rather than go around feeling their stock is undervalued, executives need to be working at strategies and initiatives that increase cash flows.  That’s the ongoing job of management.

It’s worth the effort for companies to work at having their stock fairly valued.  There are downsides to equity being undervalued and dangers to equity being overvalued. 

Having a stock price less than it should be puts up roadblocks in making acquisitions and raises the cost, since the company stock has less value.  Retaining the best people can suffer; so can recruiting top talent.  A higher stock price is a compensation incentive.  The company itself may become a takeover target. 

Overvaluation is sure to be corrected by the market eventually.  Having the company’s stock price rise above the intrinsic value and then fall below the fair value level creates a most uncomfortable roller coaster ride that has consequences.

Overvaluation is based on unrealistic market expectations (or greed as analysts and investors ride a good thing even though they know the bubble will burst).  It pressures management to achieve unrealistic expectations. 

Dominic Dodd, a former consultant at Marakon, nailed it in a piece for Valuation Issues: “When a company’s market value is significantly higher than its intrinsic value, management will – by definition – come under pressure to deliver more than it is capable of delivering.”

This can lead to such actions as cutting back on new investments, raising margins through short-term price hikes, making bad acquisitions and other actions just “to hit the numbers,” Dodd writes. 

It also makes it harder for managers to take steps to create new value for customers that get turned into more intrinsic value for the company.  Eventually, investors realize they have run the stock price up too high, and everyone pays the cost.

We believe that an important part of the job of investor relations officers to make sure management understands the valuation process and has a rigorous basis to recognize whether the company’s stock is fairly, under or over valued. 

Common complaints by many CEOs that their stock is undervalued are sometimes based on unrealistic analysis, ignorance or wishful thinking.  IROs may need to express some assertiveness in applying proper formulas to show management how financial experts and professional investors are valuing the company’s equity at the time.

Market Methods: Intrinsic Worth and Comparables

This leads us to the other dimension – how the market values companies.  It’s a complex proposition, with literally hundreds of methods and models at work as investors try to find the “magic” that becomes the better predictor of future market performance.

In one context, as applied to valuing individual companies, all these methods can be brought down to two fundamental approaches – economic based and market based.  The former centers on determining a company’s intrinsic worth through cash flow calculations, then basing buy/sell/hold decisions on whether the market presently is under, fairly or overvaluing the equity. 

Investors use a host of metrics in efforts to develop the best understanding of corporate performance as the basis to project how the company will do going forward.  Some portfolio managers incorporate and “weight” various measures as inputs while others have strong beliefs in the efficacy of just one or a handful of metrics. 

These include discounted cash flow and dividend discount models; tracking returns on net assets, capital/invested capital, equity; pro-forma free cash flow; earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation and amortization (EBITDA); enterprise value; economic profit, economic value added, and cash flow return on investment

Astute investors also are factoring intangible value drivers into the mix – intellectual capital and intellectual property, innovation and R&D, management quality, customer relationships, market position, strategy and strategy execution skills, brand power, employee productivity, and others.  Efforts to measure them and find measurement standards continue to be developed and refined, even though the “numbers” may not be quantitative. 

The Comparables Approach

The other basic investing method depends entirely on what the market is doing.  This approach seeks to understand investor behavior collectively and how it impacts market returns currently and going forward. 

It is popularly called the Comparables approach.  Investors closely follow market movement, trying to determine how best to benefit from it, anticipate when and how it will change, even quantifying the extent of that change.  This approach applies to the market overall, certain sectors and specific companies.

Ratios are important measures to these investors, as indicators of market confidence or lack of confidence in the future performance of a company.  Key multiples cover stock price to earnings, sales, cash flow, book value, earnings growth and enterprise value.

Growth investors target companies with earnings expected to grow at an above-average rate; they seek companies with P/E ratios below their projected earnings growth rate.  Value investors investigate companies with P/E multiples below the market average or stocks in the same industry.  Contrarians invest in stocks or industry groups that are out of favor or trading at or near their low price ranges.

Investors work to anticipate and quantify revisions in market expectations that will cause the stock price to change – rising or falling.  The book, Expectations Investing, by investment gurus Alfred Rappaport and Michael Mauboussin, shows investors how to identify and quantify expectations changes at market and company levels. 

Incidentally, these authors/investors are believers in economic analysis, using discounted cash flow methods and making sure the company’s returns on new investments exceed the cost of capital.

It’s fair to say that investing styles encompass both the economic-based cash flow and accounting-oriented earnings driven investors. 

Ongoing factor analyses of portfolios by Barra, Valuation Technologies, Thomson Financial and other data specialists demonstrate clearly that the major drivers of portfolio composition are constantly changing, dictated by the market. 

However, Valuation Technologies finds that certain factors always are found in most portfolios; these include size, indicating market capitalization ranges and assets; level of trading activity; growth or value styles; and relative strength, which indicates how well the company has performed versus the S&P 500 over the last 12 months.

Historic earnings to price often makes the half-dozen leading factors in portfolios, but cash flow and earnings models tend to rank closely, with one showing up more than the other at any point in time.  Valtechs ranks factors on the basis of their use in portfolios and on the basis of the amount of assets managed against each model.  Overall, earnings-based factors are not dominant among professional investors, as might be expected. 

Still, earnings and other short-term models, such as time-based reversals of market behavior (one month, six months) are plentiful among investors, and they do impact short-term market movement.  We’ve all seen how earnings acceleration and surprises can jolt a company for a few days.

These two fundamental approaches play out in literally an avalanche of investing techniques, which are seen in various styles, active/passive methods and a myriad of models made distinctive by the inputs comprising them.

Bottom line, the market is highly complex.  Investors have a wide range of differences of opinion on how best to predict outcomes.  This is evidenced in the amount of trading taking place daily, domestically and worldwide.  It says loud and clear there is no one right way to invest.  If everyone got it right, there wouldn’t be a market.

The Two Dimensions Of Valuation

Investor relations has a role in helping managements and investors arrive at a stock price that reflects the fair value of the company based on an analysis that makes sense.  It’s our contention that investor relations should be intricately linked to a company’s value proposition.  Being there relies on understanding valuation processes – how the company creates value and how the investment market values the company.

First a definition: Valuation is a process to identify and determine what a company and its stock are worth to investors.  This also serves to determine if the equity is fairly, under or over valued by the investment market at the time.

The notion of Valuation has two major meanings, depending on how it is being used and who is using it. 

1.  Valuation is the total value of the company.  Various words are used to describe that – intrinsic, warranted, inherent, full value.  Corporate managers and professional investors fundamentally agree on this notion.  Both groups use an economic method that calculates the cash flow generated by the company’s businesses to define intrinsic value. Discounted cash flow methods are used.

Value-based management (VBM) has grown as a term primarily used by consultants to encourage executives to run their businesses to achieve economic returns, measured essentially by cash flow and not earnings.  Cash flow is seen by proponents among investors and corporate managers as a true measure of a business, while they argue that earnings are subject to accounting distortions. 

Thus, value is created by generating more cash than is needed to run all aspects of the business.  This cash is used to invest further to take advantage of growth opportunities as well as to reduce debt, and otherwise reward investors by paying/increasing dividends or buying back shares.

To create value, investments must earn returns greater than their cost.  The money can come from retained earnings (cash), cash at hand and borrowings.  That cost of capital also incorporates the need for investors to earn a return on their money.

Thus, the cost of capital includes a projected return for investors, which takes into consideration their risk for buying the equity.  Most companies combine their equity and debt into an average weighted cost of capital.  The number also is known as the discount rate.  It applies to investors and the company; consider it to be the rate that expresses tomorrow’s value in today’s purchasing power.

2. Valuation also is a term used by investors to determine whether they believe the current stock price represents fair value or whether the market is under or overvaluing the equity. 

Valuation in this context is important to investors.  Obviously, they want to buy stocks that are going to rise in price (value), not fall or remain the same.  Value investors search for good companies with good prospects that are underpriced at the moment. Growth investors expect revenue/earnings growth to continue, pushing the price even higher.

A Primer on Valuation

Financial managers and CEOs are comfortable with economic formulas to calculate intrinsic worth and conduct valuation analyses and projections to determine whether to make acquisitions or do other deals.  At the same time, valuation approaches are used everyday by investment bankers. 

Typically, they use discounted cash flow, trading multiples and comparable transactions techniques to determine a fair price in a merger or acquisition, in debt and equity financing, and to calculate an expected return when making investments. 

While saying no one method is perfect, they tend to opt for discounted cash flow and in most cases, blend the methods in arriving at conclusions.

Discounted cash flow is pretty much the standard for value-based management as well, and it underpins various economic variations, which seek to refine cash flow formulas to make them more robust in capturing the performance of business operations and helping investors accurately assess company operations and prospects.  It is the foundation of economic profit (EP), economic value added (EVA®) and cash flow return on investment (CFROI®) approaches.

Discounted cash flow is used to calculate a company’s value based on estimated future cash flows discounted by a rate that reflects the risk of its business and capital. 

In a speech at a NIRI conference a few years ago, a speaker from investment banking firm JP Morgan cited several benefits for using the DCF method: it forces an understanding of the business, estimates the amount of value being created by a transaction, and can be used to value various businesses and product lines.

DCF has three main components: 1) forecasted free cash flows, namely cash flows before debt service/distributions to shareholders in the form of dividends; 2) terminal value, which is an estimate of value attributed to cash flows expected after the period of the specific forecast period; and 3) cost of capital, or the current return requirements of debt and equity holders.

These three components are variously described by DCF proponents.  Another way: 1) the cash flows from a given asset; 2) the time period over which those cash flows are expected to be generated; and 3) a discount rate or risk factor adjustment to account for the level of certainty/uncertainty of receiving those future cash flows.

Investors and managements alike can readily see the connection between the discounted cash flow method and a company’s operations.

Forecasting cash flows requires in-depth understanding of the business.  Key pieces include understanding expected industry growth and the major opportunities and risks it provides the company; the company’s competitive position, especially in regard to pricing flexibility, market share changes and comparative cost structures; reinvestment needs, including working capital, necessary capital spending and discretionary investments; and expansion opportunities, from new products/facilities, economies of scale and further development costs.

A word about terminal value:  It typically constitutes over half of a DCF valuation.  The terminal value is the period from the end of the forecast period to infinity.  It should be estimated, according to JP Morgan, when the forecast reaches “steady state,” namely long-term assumptions have stabilized.  There is little value to be added from forecasting a longer period; Morgan suggests 10 years.

Investors and managements typically put a time frame on the realization of the intrinsic value, whether from an acquisition or from running the entire business.  A practical view might be five years.  The key notion is to calculate a growth rate over the designated time period.  Will cash flows grow at 5% a year, 10%, or more?

Calculating the Discount Rate

Calculating the discount rate involves setting a weighted average cost of capital, combining debt and equity.  Bankers like Morgan recommend basing the debt/equity ratio on the market value of the equity and net debt position.  Equity is the significant component and trickiest to calculate.  Academic discussion of how best to do it is unending.  The equity cost reflects the market’s long-term expected total return (TSR), namely share price appreciation and dividend yield.

Most common method is the capital asset pricing model (CAPM).  It combines the risk-free rate on the long bond with a risk factor for investing in the uncertainty of a company’s stock. Beta is the universal metric; Morgan calls this the “undiversifiable risk of an investment.”  The equity risk premium reflects the market’s expectations.

There are critics of CAPM, as the debate over how best to calculate the discount rate continues.  We include in this chapter a number of papers describing the leading views on how to calculate cost of capital as well as presentations on various, primary methods of value-based management and the comparables method of investing.

As indicated before, bankers also use the trading multiples method in fixing the value of a deal or business.  Morgan defines trading multiples as an estimate of the value at which a company should publicly trade in today’s market based on the multiples of similar companies.  This gets us into comparables investing.

Developing an accurate read on trading multiples depends on having a solid understanding of the company and its industry, selecting a similar peer group and applying several multiples.  Morgan points out that the multiples that matter vary by industry.  It uses such multiples as firm value/operating profit, firm value/EBIT or EBITDA, market value/trailing net income, market value/projected net income for current year, market value/projected net income for next 12 months, firm value/sales, firm value/book value.

Focus On Value Creation

Approaching valuation as a company and investor relations officer is a two-sided proposition.  One focuses on the company’s efforts to create value.  Managements have their take on how that is done. 

Managements take actions to grow the business. The fundamental model is to consistently increase revenues and improve/maintain good margins to achieve ever-growing profits and earnings. The purest form of revenues and earnings come from operations – the products and services provided through the business.  Accounting practices enable earnings to grow from such other sources as returns from investments, excess pension plan assets and a host of others.

Thus, the revenue, margin, earnings (profit) model is basic.  Investment bankers have conditioned executives to think in terms of this model; earnings drive market valuations.  Accounting metrics prevail, following generally accepted accounting practices (GAAP). As a result, companies emphasize earnings in their financial reporting.

The push over recent years to pressure managements to improve earnings each quarter has brought accusations of “managing earnings” and worries about overemphasis on short-term results at the expense of longer-term strategic planning to sustain growth.

Economic profit is seen as the better measure among a growing legion of CEOs, CFOs, institutional investors and value-based management consultants.  As previously stated, it says cash is what matters.  Cash pays the bills, enables further investment to grow, and rewards investors through dividends and buybacks.  Investments in assets must earn returns above their cost of capital to create value.

Companies are implementing value-based management practices throughout their business units.  These systems incentivize managers to view their businesses as economic units, succeeding by growing revenues, earnings and cash flows against capital charges.  Managers are compensated on a similar basis.

Proponents argue there is a huge difference in mindset when managers have the discipline to be accountable for the real costs of achieving revenue, earnings and cash returns.  They believe these methods focus and align managers with shareholder value, namely the notion of creating value for investors.

Book References On Value-Based Management

We’re really testing the level of your interest and desire to become an expert on valuation, from A to Z by suggesting that great benefits will come from reading all the books listed here.

The fact is there are even more books, and more are being published all the time.  But there sure is a lot to be learned from this lineup.

Techniques of Financial Analysis: A Guide to Value Creation (McGraw-Hill), by Erich A. Helfert.  This is the 11th edition of Dr. Helfert’s seminal work on valuation.  The book has been printed in nine languages and has sold over a half-million copies.

Graham and Dodd’s Security Analysis (McGraw-Hill).  Fortunately, scholars and writers continue to update this seminal book on the securities analysis process, which functions as an in-depth primer on the investment process and a must read for all who wish to build a base of expertise.

Creating Shareholder Value: A Guide for Managers and Investors (The Free Press), by Alfred Rappaport.  The third in our seminal books, it also has been updated.  Professor Rappaport was the first to use terms such as shareholder value and value drivers while encouraging the market to focus on economic metrics and cash flow in articles and in this book in the 1980s.

The Quest for Value: A Guide for Senior Managers (Harper Business) by G. Bennett Stewart, III.  We continue to set the foundation of learning with this book that lays out Stern-Stewart’s EVA® approach to economic valuation.

Valuation: Measuring and Managing the Value of Companies (Wiley) by Tom Copeland, Tim Koller and Jack Murin.  The authors were at McKinsey & Co. when they wrote this best-selling book on economic value-based management.  New editions continue to be published.

CFROI Valuation: A Total System Approach to Valuing the Firm (Butterworth-Heinemann Finance) by Bartley J. Madden.  Bart Madden lays out the complete framework for managing and valuing a company using the cash flow return on investment framework.  Madden was a guru at HOLT Value Associates at the time; the firm is now a part of Credit Suisse First Boston.

The Value Imperative: Managing for Superior Shareholder Returns (Free Press) by James M. McTaggart, Peter W. Kontes and Michael C. Mankins.  Three of the leaders at Marakon Associates, the authors and firm are pioneers in value-based management.

Shareholder Value: A Business Experience (Butterworth-Heinemann Finance) by Roy E. Johnson.  This is a fascinating tale of how a company employs economic profit methodologies in driving value creation.  It is written as a story with real people debating the issues and opportunities and making the key decisions.  Johnson is an insider who has managed value creation operations at companies.

Focus on Value: A Corporate and Investor Guide to Wealth Creation (Wiley Finance) by James I. Grant and James A. Abate.  The authors also speak from real-world experience, as professional investors and educators.  This book tackles valuation from the investors’ perspective.

Expectations Investing: Reading Stock Prices for Better Returns (Harvard Business School Press) by Alfred Rappaport and Michael J. Mauboussin.  Guru Rappaport and young genius Mauboussin have teamed up to describe how investors and corporate executives can anticipate market changes in expectations and act ahead of them.

Business Analysis & Valuation (South-Western College Publishing) by Krishna G. Palepu, Victor L. Bernard and Paul M. Healy.  This is a virtual textbook on business, accounting, financial and valuation analysis, covering every facet in detail.

The Value Enterprise (McGraw-Hill Ryerson) by John Donovan, Richard Tully and Brent Wortman.  As the jacket suggests, this book is “blueprint for implementing the principles” of value-based management as taught to corporate managers by Deloitte & Touche.

The Revolution in Corporate Finance, (Basil Blackwell), edited by Joel M. Stern and Donald H. Chew, Jr.  Numerous well-known authorities on finance and valuation are authors of essays in a comprehensive book created under the tutelage of Stern and Chew from Stern Stewart & Co.

Investment Philosophies: Successful Strategies and the Investors Who Made Them Work (Wiley) by Aswath Damodaran.  This book is a great primer on the investing process, covering virtually every facet from equity analysis and risk management through the various investing methodologies. All of Damodaran’s books should be read:  Investment Valuation, Corporate Finance, Investment Management, Applied Corporate Finance, and the Dark Side of Valuation.  He teaches at NYU and conducts courses regularly for the CFA Institute (formerly AIMR).

The Search for Value (Harvard Business School Press) by Michael C. Ehrhardt.  The focus here is on measuring a company’s cost of capital.  Virtually all the books we’re recommending deal with the cost of capital.  This one dissects it from every which way.

The Value Sphere: Secrets of Creating & Retaining Shareholder Wealth (Value Integration Associates) by John A. Boquist, Todd T. Milbourn and Anjan V. Thakor. The authors introduce us to Jerry and relate his experiences as he builds a small company into a big one using the techniques of value-based management.  The story-telling quality keeps readers interested and learning as the authors delve into the essence of valuation practices.

The EVA Challenge (Wiley) by Joel Stern and John S. Shiely.  This is the EVA® book on how to implement value-added change in a company.

The Value Mandate: Maximizing Shareholder Value Across the Corporation (AMACOM) by Peter J. Clark and Stephen Neill.  The authors are veteran consultants in value-based management and bring practical value as they draw upon extensive experience.

Investor Relations Professionals Can Be Vital Contributors

Thus arises a wonderful opportunity for investor relations professionals to help their companies achieve valuations that reflect the full value of the company’s assets.  The role is two dimensional – understanding and advising on the company’s value creation process, and understanding and advising on how the market values the business.  It means being an “A” student on valuation itself.

Increasingly, corporate managements and their consultants are recognizing the opportunity for investor relations professionals to have a vital and inherent role in value creation.  IROs can seize this moment by the value they bring to the process.

In his article for Valuation Issues, Dominic Dodd cites three actions.  The first is the disclosure role – providing information that enables investors to understand the company’s intrinsic value.  Dodd divides this information into a number of essential components:

  • Disaggregated business unit financial data to unveil the operational essentials of each segment;
  • GAAP accounting measures and economic profit, including cost of capital analysis, so investors can see if the company is growing or destroying value;
  • Corporate strategy, goals, vision and key programs, to help investors assess management’s thinking about the future;
  • Competitive position, advantages and detail, to give investors insights on the company’s distinctive core competencies; and
  • Descriptions of how strategies, goals, capabilities, and progress measured in results contributes to increasing intrinsic value. 

That leads to the second of the three actions, according to Dodd: helping management understand the wisdom of adopting company goals that are “explicitly linked to growth in intrinsic value.”  Having a goal of being the market share leader or generating X amount of revenue per customer doesn’t automatically translate into more intrinsic value, he argues.  Managers must understand and explain to investors how their actions will grow future cash flows – how their “strategic goals will translate into financial results.” 

Dodd goes so far to suggest that management state its principal business goal to be “maximizing intrinsic value.”

The third major investor relations role, he offers, is to pick up the cudgel in convincing top executives to shift from plans that reward managers for short-term earnings and share price growth to pay schemes that reward them for longer-term intrinsic value growth. 

There’s too much emphasis today on share price.  It “undermines the task of aligning intrinsic value and market value.”  His suggestions involve incentives to grow cash flows and economic profit on a relative basis, and to shun such absolute measures as sustaining total shareholder returns in the top quartile of peer companies.

Focus on Longer-Term Institutional Investors

Investor relations officers with deep knowledge of valuation processes and investment market behavior can make a difference in convincing executive teams to build a business management framework around valuation and intrinsic worth.

It means demonstrating the overriding propositions at work in these processes:

1) that aligning business operations with proven techniques centering on economic profit to create value does succeed in creating value; and

2) that investors companies should want to attract as shareholders primarily use economic, value-based methods.  These are the money managers using fundamental analysis to identify the best businesses most likely to sustain growth.

Companies, of course, are run by real people, with their strengths, weaknesses, beliefs, biases.  The challenge for managements is to take these methodologies from theory to sophisticated daily practice.  Many managements have tried; far from all have succeeded.

Still, there are hundreds of companies that have succeeded and are succeeding.  Their efforts are described in numerous books, which also contain the blueprint for creating and implementing value-based management programs.  We include a partial list in this chapter.  A sizable and growing corps of consultants is standing by to help teach, create and implement the methodologies.

As investor relations officer, how big a role do you want to play?   You certainly can be an integral part of the management team teaching executives about value-creation and valuation by the investment market.

This chapter is designed to give you a broad framework for building your own understanding of valuation. To fill out the descriptions, we are including a substantial amount of highly valuable material from our network of third-party experts. 

Definitive white papers and articles are included.  We will continue to add to this valuable literature. 

We also encourage you to read the chapters on this website describing the market.  These are chapters 8, 10 and 19.

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