Chapter 33
Value

The value of any asset is subjective. It is worth what someone is willing to pay for it. People may use similar methodologies to value an asset and arrive at the same conclusion, but at times of greater uncertainty they may not. With the recent plethora of high tech and innovative early stage companies in the economy, people may value these companies on their longer term potential more so than on their near-term expectations, this is different than they would value more mature companies. People may consider what an asset cost to make or cost previously to buy, this may add to a buyer’s knowledge, but this sunk cost does not determine the value, it just may give the potential buyer some insight as to what price the seller may be willing to transact. The buyer may also consider what else they could do with their money rather than buy the asset and this opportunity cost is a major factor for both the buyer and the seller. Lastly, a buyer will want to consider how other potential buyers might value a specific asset, because that will set the price where they can sell the asset should they decide to do so.

With typical investment assets like stocks, bonds, loans, convertibles and real estate there are common methods that are often, but not always, used by investors to access value. Ultimately the methodologies are not that different from the past. The value of a project or a company is based on the cash flow that it can generate over time. However, there is lots of subjectivity in how these methods are used. Some investors will value current cash flow significantly more than future cash flow; while others may be more willing to defer current cash flow because they believe the future pay off has so much greater potential. When a company has little or no current cash flow compared to future expectations investors will sometimes use other metrics to monitor potential cash flows. These metrics might include revenue, customer website clicks or market share gains. Companies that are being valued on the potential for future cash flows will often have market valuations that have more volatility because the valuation can be so sensitive to even minor changes in expectations. It is not that cash flow does not matter for these companies, investors are still looking for it; they are just willing to wait for it. They are willing to defer their gratification in part because they believe that these companies can dominate or innovate enough that when the cash flow eventually comes, it will be enormous and will be more than enough to rationalize the current valuations. New economy companies like Microsoft, Google, and Apple have shown a path to enormous cash flow generation.

When evaluating how a company is doing, the media and analysts often discuss earnings. Earnings can have different definitions; net income is often referred to as “earnings” and in fact is the bottom line. It is the figure after all the accounting adjustments, special charges, and taxes are deducted. Because of all that accounting noise that occurs before you get to earnings it may not be the best way to measure the cash generation potential of a business or an asset. Often when assessing the value of a project or a company, an analyst will utilize some measure of cash flow to get more of a “normal” sense of the cash generation. Popular cash flow measures are EBIT and EBITDA (earnings before interest and taxes, and adding in depreciation and amortization for the latter calculation). These figures often also exclude items that are considered a one-time event, such as gains on a large asset sale. It is always worthwhile to look at a company’s financial statements of cash flow and compare any calculated measure of cash flow to the financial statement line item typically labeled “cash flow from operations” as a gut check. Any cash flow figures can be adjusted further by subtracting on going expenditures for capital investment. Because of the variety of definitions of “earnings” and “cash flow,” which one is used can add high levels of subjectivity into a valuation.

The traditional methodology for valuation is to take the stream of expected cash flows over a period and apply a discount to the future values of each cash flow (i.e. discounted cash flow analysis). The discounted value simply means that the cash flow you are expected to get ten years from now is worth less than the one you get next week. This is because you must wait for that future cash flow, but also because there is more uncertainty as to what that cash flow will be the further out you go. So your cash flow projections and the discount value you choose will have a major impact on your view of valuation. Too often people view these projections as absolutes, they are not yes or no questions. It is often better to think of them as scenarios, and to build a few of them with different macro and micro expectations and apply some probabilities than to just build one and think it is a perfect predictor of the future. Scenarios should include potential actions that management might be motivated to take that could change the business model and how the company will capitalize itself. These choices can dramatically impact risk and value. The discount rate is another area of subjectivity; theoretically, the discount you apply to these projected cash flows should factor in the time, uncertainty, and what you can get paid in a risk-free government bond.

There are other factors that increase the subjectivity of value. Each investor will have a different time horizon and what that time horizon is will influence their valuation methodologies and determine the type of investments they will favor. Investors’ time horizons also change during an investment period. Time is the ultimate depleting resource and, despite all the various ways to measure time, no one can be certain how much of it they have.

It is important to understand how others value assets because someone else’s subjective value will determine where you can ultimately sell the asset that you own. The decision to buy something and determine a value is always influenced by the relative value of other opportunities. This opportunity cost is based on how much utility you could have received by buying something else, or doing nothing. Factor in that each investor is assessing their own personal valuation to all these other opportunities in order to determine what they are willing to pay for an asset and you see that value is quite subjective.

Momentum can also drive asset valuations. The value of an industry sector, a company’s stock, or any asset that begins to attract capital and rise in value will often attract more capital; and that in turn will likely push values even higher. Part of this is driven by the fact that investor’s may feel there is less uncertainty in an asset if other people are buying it. Momentum buying gets support, in part, because of studies that have shown the success of various momentum trading strategies. Index funds, technical traders, and some program trading can all add to this momentum. This valuation may be caused by the change in some risk or uncertainty around the investment or it might be driven by an over-reaction to a price move or a news item that triggers a piling on effect as investors buy based on a fear of missing out (FOMO in millennial parlance) rather than any fundamental change in the ultimate value. Momentum can, however, also change directions and assets can fall out of favor. Sometimes this can happen when data doesn’t back up the rationale for the momentum.

Some of the best insights about the perception of value can be gleaned by watching how market valuations for an asset moves and react in different periods and to different types of news. Markets tell you other people’s perceptions of value. Through watching the markets you can gain knowledge that can help reduce your uncertainty about how the asset will act. Ultimately this can help you determine value and give you an idea how the asset will be valued by others when you decided to sell the asset.

When you can get market valuations they are good to use. Markets may not always be right about the valuation of an asset, but they are definitely giving you a signal on values and what other people believe they are worth. Even if a company does not have a public stock you can often look at comparable companies or acquisition transactions to get a sense of valuation of a company, just as you would compare prices of similar cars in the car market to get some sense of what you should pay.

Mr. Milken and his team at Drexel Burnham Lambert were early champions of using the market value of equity as a measure of asset value rather than the book value of equity that gets recorded on company balance sheets. They also developed a solvency measure using market values. Instead of measuring a debt/equity ratio using the balance sheet, they used a market adjusted debt (MAD) ratio using market values instead of book values. Some of the complaints about this methodology have been that since the market value can fade or boom so quickly it may be less reliable and markets are fallible. These concerns are valid, but, book equity also has flaws as it is adjusted by many accounting issues and may not reflect what anyone is willing to pay for the assets. As asset valuations change much more quickly than in the past, due to factors like barriers to entry and working capital shifting so rapidly, the measurement of market value of equity becomes a more valuable tool as it is much more responsive to change.

When public companies report their earnings, valuations of that company, and sometimes similar companies, will move in response. Similarly, broad market valuations of stocks, bonds and loans might move when economic data is released. However, often this is not due to the actual earnings figure or the economic data. Valuations often move because of other information the company gives or text that is attached to an economic press release. Valuations move on this news because it changes people’s perceptions of the outlook. Management may hold a conference call and make confident statements that could increase or decrease uncertainty. Some typical items that can trigger valuation changes include:

Of course, sometimes management can act erratic and if management throws a fit or starts singing a song during an earnings conference call, it is likely that it would increase uncertainty, too. You may disagree with how the market reacts to something in a corporate or economic report and may believe that over time the market will come around to your point of view or that future news will change their minds. If this is the case, then this is an opportunity to react–whether it is on a macro, medi or micro basis.

Much of what drives value can be uncertainty. However, you must make decisions with a certain level of uncertainty. Otherwise, there would be little to no reward. Differing views in the level of that uncertainty can lead to different views on valuation and as uncertainty increases or decreases, valuations will change. Sometimes a news release changes the perceptions of uncertainty. Markets and how they react can add to your knowledge of how other people are viewing uncertainty, and this is powerful because part of how you value an asset may be based on how you believe you can get the market to value it in the future.

Being able to show the ability to generate actual cash flow helps decrease uncertainty. When a company fails it is usually because they cannot generate enough cash flow or attract capital. When this happens, the question arises as to what the assets of the company are worth. If it owns a building and a production plant that makes boxes, another investor may look at it and figure if they can transform the building or repurpose the machines, they can generate cash flow from these hard assets and use this anticipated cash flow to decide what they will pay for the assets. However, new companies may have fewer tangible core assets. Sometimes their assets are very specialized and it is difficult for someone else to monetize them. For example, a company has built a complex supply chain, but does not own it. The new economy company may have intangible intellectual property that someone else wants, but the audience of purchasers may be small. The more specialized that intangibles are, the harder they will be to monetize in a time of crisis. When intangible intellectual property accounts for the bulk of a company’s value, the recoveries for investors may be more challenging and this all should be factored into valuations as well.

New technology can change the value of existing assets. Music streaming has changed the value of recorded music and music rights. The incredible dispersion of large television audiences into a multitude of smaller diverse venues has oddly increased the value of an event, which can draw a large national audience. More efficient and green technology companies over time could dramatically impact the value of older power generation equipment or fossil fuels. Broad based, rapid, technological innovation impacts value because it unleashes potential growth but it also increases uncertainty.