Valuation Across the Business Spectrum
The preceding section considered the different issues we face in estimating cash flows, growth rates, risk, and maturity across the business life cycle. In this section, we consider how firms in some businesses are more difficult to value than others. We consider five groups of companies:
- Financial services firms, such as banks, investment banks, and insurance companies
- Cyclical and commodity businesses
- Businesses with intangible assets (human capital, patents, technology)
- Emerging-market companies that face significant political risk
- Multibusiness global companies
With each group, we examine what it is about the firms within that group that generates valuation problems.
Financial Services Firms
While financial services firms have historically been viewed as stable investments that are relatively simple to value, financial crises bring out the dangers of this assumption. In 2008, for instance, the equity values at most banks swung wildly, and the equity at many others, including Lehman Brothers, Bear Stearns, and Fortis, lost all value. It was a wake-up call to analysts who had used fairly simplistic models to value these banks and had missed the brewing problems.
So what are the potential problems with valuing financial services firms? We can frame them in terms of the four basic inputs into the valuation process:
- The existing assets of banks are primarily financial, with a good portion being traded in markets. While accounting rules require that these assets be marked to market, these rules are not always consistently applied across different classes of assets. Since the risk in these assets can vary widely across firms, and information about this risk is not always forthcoming, accounting errors feed into valuation errors.
- The risk is magnified by the high financial leverage at banks and investment banks. It is not uncommon to see banks have debt-to-equity ratios of 30 to 1 or higher, allowing them to leverage up the profitability of their operations.
- Financial services firms are, for the most part, regulated, and regulatory rules can affect growth potential. The regulatory restrictions on book equity capital as a ratio of loans at a bank influence how quickly the bank can expand over time and how profitable that expansion will be. Changes in regulatory rules therefore have big effects on growth and value, with more lenient (or stricter) rules resulting in more (or less) value from growth assets. Finally, since the damage created by a troubled bank or investment bank can be extensive, it is also likely that problems at these entities will evoke much swifter reactions from authorities than at other firms. A troubled bank will be quickly taken over to protect depositors, lenders, and customers, but the equity in the banks will be wiped out in the process.
- As a final point, getting to the value of equity per share for a financial services firm can be complicated by the presence of preferred stock, which shares characteristics with both debt and equity. Figure 1.8 summarizes the valuation issues at financial services firms.
Figure 1.8 Valuation Issues at Financial Services Firms
Analysts who value banks go through cycles. In good times, they tend to underestimate the risk of financial crises and extrapolate from current profitability to arrive at higher values for financial services firms. In crises, they lose perspective and mark down the values of both healthy and unhealthy banks, without much discrimination.
Cyclical and Commodity Companies
If we define a mature company as one that delivers predictable earnings and revenues, period after period, cyclical and commodity companies will never be mature. Even the largest, most established of them have volatile earnings. The earnings volatility has little to do with the company. It is more reflective of variability in the underlying economy (for cyclical firms) or the base commodity (for a commodity company).
The biggest issue with valuing cyclical and commodity companies lies in the base year numbers that are used in valuation. If we do what we do with most other companies and use the current year as the base year, we risk building into our valuations the vagaries of the economy or commodity prices in that year. As an illustration, valuing oil companies using earnings from 2007 as a base year will inevitably result in too high a value. The spike in oil prices that year contributed to the profitability of almost all oil companies, small and large, efficient and inefficient. Similarly, valuing housing companies using earnings and other numbers from 2008, when the economy was drastically slowing down, will result in values that are too low. The uncertainty we feel about base year earnings also percolates into other parts of the valuation. Estimates of growth at cyclical and commodity companies depend more on our views of overall economic growth and the future of commodity prices than they do on the investments made at individual companies. Similarly, risk that lies dormant when the economy is doing well and commodity prices are rising can manifest itself suddenly when the cycle turns. Finally, for highly levered cyclical and commodity companies, especially when the debt was accumulated during earnings upswings, a reversal of fortune can very quickly put the firm at risk. In addition, for companies like oil companies, the fact that natural resources are finite—only so much oil is under the ground—can put a crimp in what we assume about what happens to the firm during stable growth. Figure 1.9 shows the estimation questions.
Figure 1.9 Estimation Questions for Cyclical and Commodity Companies
When valuing cyclical and commodity companies, analysts often make implicit assumptions about the economy and commodity prices by extrapolating past earnings and growth rates. Many of these implicit assumptions turn out to be unrealistic, and the valuations that lead from them are equally flawed.
Businesses with Intangible Assets
In the last two decades, we have seen mature economies, such as the U.S. and Western Europe, shift from manufacturing to services and technology businesses. In the process, we have come to recognize how little of the value at many of our largest companies today comes from physical assets (like land, machinery, and factories) and how much of the value comes from intangible assets. Intangible assets range from brand name at Coca-Cola to technological know-how at Google and human capital at firms like McKinsey. As accountants grapple with how best to deal with these intangible assets, we face similar challenges when valuing them.
Let us state at the outset that there should be no reason why the tools that we have developed over time for physical assets cannot be applied to intangible assets. The value of a brand name or patent should be the present value of the cash flows from that asset, discounted at an appropriate risk-adjusted rate. The problem that we face is that the accounting standards for firms with intangible assets are not entirely consistent with the standards for firms with physical assets. An automobile company that invests in a new plant or factory is allowed to treat that expenditure as a capital expenditure, record the item as an asset, and depreciate it over its life. A technology firm that invests in research and development, with the hope of generating new patents, is required to expense the entire expenditure and record no assets, and it cannot amortize or depreciate the item. The same can be said of a consumer products company that spends millions on advertising with the intent of building a brand name. The consequences for estimating the basic inputs for valuation are profound. For existing assets, the accounting treatment of intangible assets makes both current earnings and book value unreliable. The former is net of R&D, and the latter does not include investments in the firm's biggest assets. Since reinvestment and accounting return numbers are flawed for the same reasons, assessing expected growth becomes more difficult. Since lenders tend to be wary about lending to firms with intangible assets, they tend to be funded predominantly with equity, and the risk of equity can change quickly over a firm's life cycle. Finally, estimating when a firm with intangible assets gets to steady state can be complex. On the one hand, easy entry into and exit from the business and rapid changes in technology can cause growth rates to drop quickly at some firms. On the other hand, the long life of some competitive advantages like brand name and the ease with which firms can scale up (they do not need heavy infrastructure or physical investments) can allow other firms to maintain high growth, with excess returns, for decades. The problems that we face in valuing companies with intangible assets are shown in Figure 1.10.
Figure 1.10 Questions About Valuing Companies with Intangible Assets
When faced with valuing firms with intangible assets, analysts tend to use the accounting earnings and book values at these firms, without correcting for the miscategorization of capital expenditures. Any analyst who compares the price earnings (PE) ratio for Microsoft to the PE ratio for GE is guilty of this error. In addition, there is also the temptation, when doing valuations, to add arbitrary premiums to estimated value to reflect the value of intangibles. Thus, adding a 30% premium to the value estimate of Coca-Cola is not a sensible way of capturing the value of a brand name.
In the last decade, the economies that have grown the fastest have been in Asia and Latin America. With that growth, we have also seen an explosion of listings in financial markets in these emerging economies and increased interest in valuing companies in these markets.
In valuing emerging-market companies, the overriding concern that analysts have is that the risk of the countries that these companies operate in often overwhelms the risk in the companies themselves. Investing in a stable company in Argentina will still expose you to considerable risk, because country risk swings back and forth. While the inputs to valuing emerging-market companies are familiar—cash flows from existing and growth assets, risk and getting to stable growth—country risk creates estimation issues with each input. Variations in accounting standards and corporate governance rules across emerging markets often result in a lack of transparency when it comes to current earnings and investments, making it difficult to assess the value of existing assets. Expectations of future growth rest almost as much on how the emerging market that the company is located in will evolve as they do on the company's own prospects. Put another way, it is difficult for even the best-run emerging-market company to grow if the market it operates in is in crisis. In a similar vein, the overlay of country risk on company risk indicates that we have to confront and measure both if we want to value emerging-market companies. Finally, in addition to economic crises that visit emerging markets at regular intervals, putting all companies at risk, there is the added risk that companies can be nationalized or appropriated by the government. The challenges associated with valuing emerging-market companies are shown in Figure 1.11.
Figure 1.11 Challenges Associated with Valuing Emerging-Market Companies
Analysts who value emerging-market companies develop their own coping mechanisms for dealing with the overhang of country risk, with some mechanisms being healthier than others. In its most unhealthy form, analysts avoid even dealing with the risk. They switch to more stable currencies for their valuations and adopt very simple measures of country risk, such as adding a fixed premium to the cost of capital to every company in a market. In other cases, their preoccupation with country risk leads them to double-count and triple-count the risk and pay insufficient attention to the company being valued.
Multibusiness and Global Companies
As investors globalize their portfolios, companies are also becoming increasingly globalized, with many of the largest ones operating in multiple businesses. Give that these businesses have very different risk and operating characteristics, valuing the multibusiness global company can be a challenge to even the best-prepared analyst.
The conventional approach to valuing a company has generally been to work with the consolidated earnings and cash flows of the business and to discount those cash flows using an aggregated risk measure for the company that reflects its mix of businesses. Although this approach works well for firms in one or a few lines of business, it becomes increasingly difficult as companies spread their operations across multiple businesses in multiple markets. Consider a firm like General Electric, a conglomerate that operates in dozens of businesses and in almost every country around the globe. The company's financial statements reflect its aggregated operations, across its different businesses and geographic locations. Attaching a value to existing assets becomes difficult, since these assets vary widely in terms of risk and return-generating capacity. While GE may break down earnings for its different business lines, those numbers are contaminated by the accounting allocation of centralized costs and intrabusiness transactions. The expected growth rates can be very different for different parts of the business, in terms of not only magnitude but also quality. Furthermore, as the firm grows at different rates in different businesses, its overall risk changes to reflect the new business weights, adding another problem to valuation. Finally, different pieces of the company may approach stable growth at different points in time, making it difficult to stop and assess the terminal value. Figure 1.12 summarizes the estimation questions that we have to answer for complex companies.
Figure 1.12 Estimation Questions for Complex Companies
Analysts who value multibusiness and global companies often draw on the averaging argument to justify not knowing as much as they should about individual businesses. Higher growth (or risk) in some businesses will be offset by lower growth (or risk) in other businesses, they argue, thus justifying their overall estimates of growth and risk. They underestimate the dangers of the unknown. All too often, with companies like these, what you do not know is more likely to contain bad news than good news.