When does the debt mature?

Another step, especially relevant in the current environment, is to check the ‘term structure of debt’ – that is, when does the debt mature? Ideally the company should have debt maturing in a number of years’ time as a reliance on short-term debt may make renegotiating that debt difficult and expensive if it is all due to mature in (say) the next six months.

Pension fund deficits

The importance of pension fund deficits in corporate valuation continues to dominate the headlines. According to the Pension Protection Fund in the UK, the insurance scheme for the underfunded pension plans of insolvent employers, the aggregate gap between the value of scheme assets and the value of liabilities it guarantees rose to £253.1 billion.

The arrival of IFRS brings the issue to the fore as the impact of deficits will be felt directly on the balance sheet. This will affect the net assets of the business through distributable reserves and hence dividend-paying capacity. In effect this makes explicit the fact that shareholders are exposed to risk through pension guarantees to current and previous employees. The company’s financial position is very much weakened as the deficits are treated as debt.

Crucially, the funds required to make good such promises (and they are often substantial) are funds diverted from the potential income of investors (dividends are being cut as a result of this) or funds potentially invested in the business which help maintain and enhance the company’s competitive position. Clearly both of these drastically undermine the attractiveness of the company as an investment. Similarly, there have been situations where companies looking to reduce their debt through disposals have discovered that the pension fund trustees have a say in how the disposal proceeds are used – and clearly it may be their legal duty as trustees of the pension scheme to insist that the funds make good a deficit.

The accounting for pension funds was also put under the spotlight by a Securities and Exchange Commission enquiry into the assumptions made by US firms on the expected returns from shares. The higher the assumed returns the lower the deficit and the less the need to pay into the fund. As a result earnings benefit or are manipulated. Some companies have been assuming equity returns as high as 10 per cent. The wisdom of doing this when such a high rate has never been delivered over a sustainable period is clearly questionable – let alone given the actual return from equities in recent years.

As well as the ‘flexibility’ of assumptions on expected returns, the other variable that can influence the size of the deficit is the discount rate used. The lower the rate the greater the liability (as future liabilities are discounted to present value at a lower rate) – this may lead to companies choosing a higher rate to lower the deficit. So the choice of discount rate is actually very important. With ‘quantitative easing’ seeing long-term gilts rise in price (and yields correspondingly fall) this can have serious repercussions for the size of the deficit.

The other key assumption is how long the liabilities will run for – i.e. how long will the pensioner live? These longevity assumptions can make a dramatic difference to the size of deficit as the company’s liabilities are running for much longer. It was estimated that Boots’ pension fund deficit would increase by about £350 million if longevity assumptions were changed by three years.

Another aspect that needs to be considered is the asset allocation of the pension fund. The extra volatility of shares as an asset class introduces uncertainty as to returns, and with the introduction of the new IFRS accounting standards this will be evident on the face of the P&L. The risk of this equity exposure and the associated extra volatility results in a higher cost of capital. At the company-specific level companies such as BT and Diageo have high equity exposure within their schemes.

Therefore when assessing the value of a target company the pension fund deficit has to be incorporated into the enterprise value (see p. 273) – the deficit is effectively a liability akin to debt. This is reinforced by the fact that the credit rating agencies take the liability into account when attributing ratings. The link has been made explicit by the bond issues made by many companies (including the largest ever, GM’s $13 billion capital raising) deliberately undertaken to plug a hole in their pension funds. In the UK, Marks and Spencer has also issued a bond specifically to help fund its pension fund deficit.

Sectors susceptible to deficit problems have the characteristics of being mature and labour intensive and often have been government-owned enterprises in the past. Periods of heavy redundancies/early retirements may also create liabilities. Accordingly engineering, automotive, national airlines, brewers, utilities, fixed-line telecomms and support services are sectors where care needs to be taken.

With recent returns from equity markets being so disappointing, companies undergoing ‘triennial reviews’ of their pension funds’ capacity to service future liabilities are likely to see a big mismatch between assets and liabilities. Smiths Group warned (on 24 March 2009) that it may see its contributions rise significantly as it undergoes its review. Its deficit has risen from £11 million to £500 million. On the day it announced this 14 per cent was knocked off the share price. Formerly nationalised businesses such as BT and BA have significant deficit issues as well. BT could be forced to double its annual pension contributions to £560 million a year under a legally binding agreement it signed with the trustees of its pension scheme in 2006 and approved by the Pensions Regulator. BA has on paper a £600 million deficit and is paying £320 million into the scheme – this is a considerable increase in risk given the company’s debt profile and high operational gearing. The probability of its dividend being restored looks very slim on that basis.

One of the key issues has been the deterrent effect the pension deficit has on deals. The deficit is increasingly appreciated as a debt obligation and can add considerably to the take-out value for the deal. This happened in Permira’s proposed acquisition of WH Smith. Similarly, uncertainty over the extent of pension liabilities was an issue in Philip Green’s bid for M&S. On the other hand, one of the reasons Balfour Beatty could take over Mansell was that it had the resources and financial strength to absorb its pension liabilities. Mansell was concerned it would not have the resources both to meet this liability and fund the growth of the business.

Health care liabilities

Another area of particular importance, especially in the US, is the company’s liability for the health care of its employees (past and present). Again assumptions made on the inflation of health care costs and the discount rate used will have a big impact on reported earnings. For the domestic US automotive companies the cost of health care per car is often greater than the cost of steel per car (this is true for both GM and Ford). As well as being a liability that needs to be taken into account when computing economic value, it clearly has a profound impact on the company’s economic competitiveness. Many overseas players without such heavy ‘legacy’ costs are therefore far more competitive. It may also mean that given the need to service these ‘interest’ or liability expenses there is a temptation for the US producers to go for volume to generate cash – hence the discounting in the new car market although the fixed-cost nature of the business also suggests there may be a tendency to go for volume too.

The inevitable impact on margins from such a volume-led strategy (the US majors make very little (if anything) from manufacturing cars) will also heavily influence valuation. Similarly, a poor competitive position undermines the credit ratings of the companies. Interestingly, both S&P and Fitch cited pension and health care deficit concerns (and the risks to the projected returns being used given the actual performance of equity markets) whenever they downgraded GM’s debt.

A company’s liability to its employees in terms of both pensions and health care is a major financial issue. With shareholders shouldering this responsibility it must be factored into valuation. As we have seen with the US car sector, these liabilities really affect the competitive position of the firm and therefore the attractiveness of the company as an investment. The treatment of these liabilities as debt also raises profound questions when examining the appropriate financial structure for a company. These have been very real concerns for some time but the arrival of IFRS accounting standards will crystallise the issues for investors, lenders and dealmakers alike.

Off-balance sheet debt

It always pays to make sure that the company has declared the full extent of its liabilities and that this is incorporated in the debt number. The company may have debt in a joint venture that is not consolidated in the overall debt numbers. This is referred to as off-balance sheet debt. Similarly, the company may have leasing obligations that are, in effect, debt.

The use of off-balance sheet debt was of course a major feature of the demise of Enron, the energy trader. The company flattered its balance sheet by parking debt off balance sheet in joint venture companies. These companies were set up specifically to conceal the debt. An important lesson from this saga was that the off-balance sheet companies had assets equivalent to their liabilities. These special purpose entities (known as special purpose vehicles or SPVs or in the financial services area as structured investment vehicles or SIVs) therefore had gearing of 100 per cent. It can be difficult to unearth this information, but a close look through the notes to the report and accounts is crucial in order to find related-party transactions and liabilities.

The banks have had many of these SIVs which were not apparent to investors as they were not on the balance sheet. However, they were classified as liabilities when things got difficult. Some consider this one of the major regulatory oversights of the banking crisis.

Convertible and preference shares – also debt?

When looking at the gearing ratio you should also consider whether the company has any convertible shares or preference shares that may be to all intents and purposes debt. This may be because the shares are redeemable or will never become equity. Many companies will exclude these from their gearing figures, which gives a much more flattering view of their financial position. Most analysts will treat these as debt and this will give a more conservative view of the financial position.

It is always worth taking a cautious view of overall indebtedness and being as comprehensive as possible in assessing the debt number.

Short- and long-term debt

An important issue to bear in mind when looking at a company’s financial position is the maturity structure of the debt as well as the overall level. If it is all short-term debt at variable rates of interest, profits will be hit hard if interest rates rise sharply. Also the banks may call in the debt when it is up for renewal rather than extending it, which could cause other lenders to panic. Longer-term debt at fixed rates will offer a more stable financial profile. The impact of changes in short-term interest rates would be minimised and there would be no need for constant refinancing. This would also allow for greater stability, liquidity and flexibility than shorter-term debt.

The other important thing to consider in terms of the time profile of the debt is the assets that the debt is used to finance. If the company has invested in factories and capital equipment that have a long economic life, it would be inappropriate to finance this with potentially volatile short-term debt. Debt of long-term maturity or a bond would be far more appropriate (with bank loans and overdrafts funding short-term working capital requirements). It is not dissimilar to buying a house: a mortgage over 25 years is infinitely more appropriate than an overdraft. You could argue that very long-term assets should be financed with equity.

An aspect of the credit crunch and the lack of finance available from the banks is the extent to which companies will now issue more long-term bonds to fund the business rather than loans or overdrafts from the banks.

The valuation of assets and shareholders’ funds

When you have got to grips with the level of debt, you need to ensure that the value of shareholders’ funds is appropriate. In most instances this should not be a problem. However, there are situations where the assets on the balance sheet might be considerably overvalued, such as where an acquisition has been bought at the top of the cycle at a very high price. If the industry then turns down and remains in the doldrums for some time, the value of the asset is likely to be overstated. If the performance of the business has fallen by 40 per cent and the likelihood for improvement is limited, in theory the value of the asset should be 40 per cent lower. It could of course be worth even less, subject to how overpriced the acquisition was in the first place.

A very important aspect of asset valuation at the moment is the valuation of housing and property assets. Banks having made loans to fund the purchase of these assets (or invested in securitised portfolios of assets) may inherit assets which are worth considerably less than the outstanding loan amount if the consumer or company defaults. So the asset backing of banks with big exposures to housing and commercial property may be considerably less than the current book value. Clearly in this case the shareholders’ funds are considerably overvalued.

Similarly, if we take the situation where an acquisition accounted for 50 per cent of assets and those assets, following an ‘impairment review’, are deemed overvalued by 50 per cent, this 50 per cent falls to 25 per cent, while the overall assets fall to 75 per cent. Gearing on this basis would rise dramatically. If the stated gearing is 60 per cent, then on the basis of the real value of the assets this rises to 80 per cent (60/75). Crucially, because the impairment review is done on the back of lower cash flow projections there is a lot less profit and cash flow to service the debt.

An obvious way of checking whether the assets are appropriately valued is to check the return on assets (the assets are worth only what they are generating in terms of cash and returns on investment). So if the return on assets is 5 per cent and has been for some time, the assets are likely to be overvalued. This may apply to certain divisions or to the whole company.

The asset side of the equation is very important to the companies. Often there will be net asset covenants which stipulate that assets should not fall below a certain level or gearing must not exceed 100 per cent. In this situation the temptation is to maintain an asset base as high as possible. The reality of the worth of the assets is clearly very different. Therefore the asset side of the equation is very much worth taking on board.

Interest cover

Interest cover is a measure of how easily the company can pay interest on its debt. This is measured by taking the operating profit and dividing it by the annual interest payments. Both these items are listed in the P&L statement.

How volatile are the operating profits?

As with the debt to equity ratio, the degree of danger in any given ratio depends on the economic characteristics of the business. As the numerator is operating profit, the key issue to focus on is the sensitivity of operating profits to changes in prices and volumes (operational gearing, see p. 219). If we consider the example of the manufacturing company Tin Can, we know from the characteristics of its markets – overcapacity, a commodity product and competition from imports – that prices are likely to be volatile. With turnover of £250 million, a 5 per cent reduction in price will reduce turnover by £12.5 million. With costs fixed, this then reduces profits by £12.5 million (50 per cent) as well.

Similarly, its cost structure, given a high proportion of fixed costs, makes profits highly sensitive to changes in volume.

If we say that operating profits are £25 million and interest payments are £5 million, interest cover is 5∞. However, on a 5 per cent price reduction, profits halve (from £25 million to £12.5 million) and accordingly interest cover falls to 2.5∞. This is falling to dangerous levels. This deterioration is on an all too plausible assumption of a 5 per cent reduction in prices. If prices fell more than 5 per cent and a key contract was lost, the financial position would deteriorate even more sharply. A 10 per cent price reduction would eradicate profits and leave no interest cover at all.

By contrast, for Milk Pops (or Pink Tablet) a stable volume and pricing scenario suggests that the risks are much lower. Accordingly, interest cover ratios could be a lot lower and one would still be comfortable with the company’s financial position.

The danger level for interest cover

Companies with this sort of cover are in a difficult position, especially if operating profits are volatile as discussed above. At 2∞ or below, the company’s bankers will be keeping a close eye on its developments and indeed it may well be that debt covenants (agreements undertaken by the company with its banks) are being broken. This may lead to a downgrading of the company’s credit status and force the company into disposals or a rights issue, or quite possibly both. In an environment as difficult as the current one, it is likely to be only the best parts of the business that will attract buyers. Following the disposals, what is left of the company may not be what originally attracted you to invest. Therefore, when evaluating a potential investment idea, the risks attaching to a company with such a low level of interest cover are very high – it can cost you a lot of money. A simple and effective ratio, such as interest cover, which can be quickly and easily computed, can help you avoid potential disasters.

Cash flow pays interest costs not asset backing

When we looked at the company’s assets we had to consider the possibility that the shareholders’ funds element of the balance sheet was overstated. The assets might be worth far less than their book value. This will inevitably be because the cash flows they are generating are dramatically lower than has been the case historically. But of course it is the cash flows that service the interest costs. Therefore using measures which deliberately take into account the current (and likely future) cash generation of the business is far more effective. The measures cited below are useful because they allow for this.

Cash flow cover – EBITDA/interest payable

A variant on interest cover calculated by using operating profit over interest payable is to compute a cash flow cover. This adds on depreciation and amortisation to operating profit as they are non-cash costs. This obviously means that the cash coming into the business can also be used to meet the interest payments. However, the danger is that funds are diverted from replacement capital expenditure and investing to maintain competitiveness, to servicing the interest. Nonetheless it may be that you wish to take into account the cash flow cover of interest payments.

An important feature to monitor in the calculation is that interest is not being ‘capitalised’ and thus excluded from the interest payable figure. Interest may be capitalised when it is included in the cost of building plant or facilities for long-term use (the interest is treated as an important cost of the development and is therefore included in the total cost of the project, i.e. capitalised). Food retail outlets, property developers and hotels are some of the businesses that may capitalise interest. There is nothing necessarily wrong with this practice, but it is worth monitoring if the company is capitalising interest and it is worth checking how much interest is being capitalised. The cover would then be calculated on the interest the company actually pays to banks as opposed to the amount declared on the P&L.

Net debt/EBITDA

This also looks at the cash flow element but looks at how many times the debt exceeds the cash flow. The higher the multiple (i.e. if debt is say more than four times EBITDA) obviously the more uncomfortable the position. The other issue of course is the predictability or otherwise of the EBITDA – which again takes us back to the type of business.

After the lax lending of the earlier part of the decade banks are now being much stricter on these multiples. Future covenants are likely to limit debt at less than three times EBITDA for many sectors.

Fixed charge cover

Also worthy of note is whether there are preference shareholders that have to be paid or other providers of debt to the company such as convertible bonds. The payments to these people effectively constitute interest or a fixed charge, where the providers of this money have a priority claim on funds before the shareholder. Some of these payments may occur ‘below the line’, i.e. after the profits figure has been struck. As a result, they may not feature in the interest line. Accordingly, they should be added to the interest payments when calculating cover. Sometimes this is referred to as a fixed charge cover ratio. Some people take into account other fixed charges, such as lease payments, as this is in effect a form of interest on an asset used in the business.

Gearing and returns

The notion of efficient balance sheets highlights that gearing can be a good thing – as demonstrated by Figure 5.3. It is much cheaper and more tax efficient to fund businesses with debt (the debt payments are deducted before arriving at pre-tax profits). This improves returns. In many cases it is similar to the advantage of buying a property with a mortgage accounting for 100 per cent of the value of the property. Any increase in the value of the property then belongs entirely to the mortgage holder.

It can also be the case that the debt ensures that the business is run efficiently. There is the discipline of making sure the debt can be serviced and that there is extra left over for shareholders.

High gearing and volatile income to be avoided

A high level of financial gearing, however, combined with a high level of operational gearing can be extremely damaging in a downturn. If volume and/or prices fall in a business with high fixed costs, operating profits and cash flow will fall dramatically. This might make it very difficult to service the company’s debt and may well lead to the dividend being cut. In a prolonged downturn this may lead to a period of poor performance and conceivably bankruptcy.

Adding value is defined as producing rates of return over and above the cost of capital. Companies with low levels of debt were encouraged to engage in share buy-backs to improve their cost of capital by increasing the proportion of (cheaper) debt in their financing mix. Gearing generally in the corporate sector has been on a rising trend, partially due to this drive for balance sheet efficiency.

Figure 5.3 Figure 5.3 Efficient balance sheets

It is also worth bearing in mind that (debt) capital was not only cheap in the 1990s and early 2000s, it was widely available. Therefore there was a strong climate that encouraged share buy-backs and of course the private equity industry was very busy taking companies off the stock market and loading them with debt. Indeed, what would happen was that a company that was bid for by private equity would use share buy-backs as part of its bid defence as this was seen as being shareholder friendly.

The current environment is far less supportive of share buy-backs but that does not mean to say that they should not be considered: it does mean that the case for buy-backs has to be rigorously applied and the reasons behind them confirmed as ones that will create shareholder value.

So companies with very strong balance sheets – stable low-risk businesses which require little new investment – may well have a case for a buy-back. In the oil sector, for example, Exxon has been judiciously using buy-backs.

Therefore having an efficient balance sheet means having the right level of debt to minimise the cost of capital. (It should be borne in mind that this only works if the conditions cited above – stable revenues, strong cash flow, low operational gearing, etc. – are all in place.)

So a company that has cash on its balance sheet or no debt would be deemed to have an ‘inefficient balance sheet’. To make the balance sheet efficient it needs to increase the amount of debt (reduce the amount of cash) and it can do this by:

• investing in the business
• making acquisitions for cash
• a share buy-back
• a special dividend
• increasing ordinary dividends.

However, before engaging in any of these activities it is worth considering the following questions.

What type of business is it and how competitive is it?

A key issue is whether the business is capable of having higher gearing – what type of business are we talking about? The advantages of gearing up in terms of reducing the cost of capital and the disciplines of higher debt are confined to companies with predictable revenues (especially price stability) and cash generation. A high proportion of fixed costs (high operational gearing) is also a significant deterrent to debt. Combining high operational gearing and high debt levels is very dangerous – relatively small movements in revenues significantly impair the company’s ability to service debt.

The retail, property and hotels sector saw significant buy-out activity during the boom of 2004–07. The asset backing provides a major opportunity to secure lending – banks will often lend up to 90 per cent against property as opposed to around 70 per cent for an operating business. In some deals this has seen the operating company split off from the property assets. The ongoing rental liability services the debt secured on the property assets. However, given the severity of the downturn many retailers, property companies and hotel companies have run into serious financial trouble.

Questions inevitably arise as to whether operating businesses in these sectors have the degree of visibility of revenue and cash flows to service the high rents and/or high interest payments involved in higher debt levels. This reinforces the notion that it is the visibility of the revenue streams and cash flow that is crucial when gearing up, not the asset backing.

If the company has a high debt burden and a significant amount of cash flow is servicing debt, there has to be a major concern that the company’s competitive position, due to underinvestment in the business or its brands, is severely undermined. These concerns have been manifest with buy-outs returning to the equity market. Given the high leverage and the implications this has for investment in the business, investors were, not surprisingly, very wary about buying these assets back from private equity and very circumspect about the price they would pay. There were concerns, for example, at Premier Foods that the brands had been starved of advertising, which in a very competitive marketplace may result in an erosion of long-term market share. Clearly such a fall in market share severely affects the company’s long-term ability to service debt.

Therefore, while the financial structure of a company is a key determinant of its cost of capital, in the long run it is the company’s competitive position that will determine its ability to add value and service its liabilities. This requires a clear strategy and the managerial and financial resources to compete effectively. While there are advantages to debt finance, it can be self-defeating where competitive pressures need to be met with significant investment.

How will the cash be returned?

If the balance sheet is inefficient and the business can support higher debt without incurring extra risk or undermining the competitive position of the business, the main debate centres around the most effective way of returning the money to shareholders: via a buy-back, a dividend increase or a special dividend. Each has merits in different contexts. As well as the impact on the cost of capital, the other main issue is what each action ‘signals’ to investors.

The tax implications for shareholders will differ and also need to be taken into account. Typically capital gains are taxed at a lower rate or have scope to be managed in a way that income cannot. Buy-back programmes often have structures such as ‘A’ and ‘B’ shares which enable investors to defer crystallising a capital gain.

Another important factor in determining how to remedy the inefficient balance sheet are the different objectives of shareholders – a register that contains mainly ‘value’ shareholders may have very different views from a register mainly populated by ‘growth’ investors. In the current market ‘growth’ appears to be returning to favour – these growth investors on the register may prefer the company to engage in M&As or significant capex programmes.

What is the cost of capital?

A share buy-back corrects an inefficient balance sheet – that is where the company has too much cash (or too little debt) on its balance sheet given the business it is in, the cash it generates and its need for capital for investment. Having more debt on the balance sheet will reduce the cost of capital as debt is both cheaper than equity and enjoys the advantage of being tax deductible. (This is sometimes referred to as the ‘tax shield’.)

By substituting cheap debt for expensive equity the cost of capital is reduced thereby creating value for shareholders. One of the main advantages of a buy-back is that by reducing the cost of capital, future cash flows are discounted back at the lower rate. This can produce significant changes in the value of the business which is then spread over fewer shares in issue.

Are the shares ‘cheap’?

The traditional reasoning favouring a buy-back is that management is demonstrating it believes the shares are significantly undervalued given the company’s excellent prospects. The management is buying an asset it knows. Importantly, the share buy-back is not a cash return to shareholders – it is an investment in the company and shareholders can choose whether to take cash by selling their shares or not.

As the buy-back is a capital allocation decision/investment, it needs to be done at an attractive share price. As Warren Buffett argues, it hardly makes sense to pay $1.10 for a $1 bill. Investors retaining their shares will own a greater proportion of the company and have a greater stake in its future. As a capital allocation decision, share buy-backs only make sense if the shares are cheap. This does of course raise a key issue: does management have the ability to identify whether the shares are cheap or ‘fairly valued’?

If the shares are ‘intrinsically’ cheap (see p. 192) then management by engaging in the buy-back is ‘signalling’ to the market that it believes the company to be undervalued on a long-term basis and that there is no better home for the surplus capital than its own shares. Many shareholders (including Warren Buffett) do look at it this way – and for good reason.

Clearly if the shares are ‘up with events’ or expensive then a buy-back may not be appropriate. A company buying your shares at an overinflated level will destroy value. In which case a ‘special dividend’ or an increase in the ordinary dividend is far more appropriate.

It is not about earnings per share – is it?

Often companies who should know better will refer to the benefit of the share buy-back as having a positive impact on EPS. This is not the rationale for the share buy-back. Any impact from a rising EPS is offset by the higher risk of financial gearing which will reduce the P/E. Crucially, given the change between the equity and debt components of the company’s funding, it is far more appropriate to consider enterprise value when assessing the company’s value (see p. 273). This obviously in theory remains the same (the business is just funded differently): the EV/sales ratio (say) would stay the same and this should only improve if the company’s operating margins or sales growth improve. As we stress below, improving the strategic and operational performance of the business is a crucial element in successful buy-backs.

On a corporate governance note, here it might be that the buy-back is helping the company meet earnings target which also happen to be the key trigger for the executives’ remuneration packages. Again having a target like earnings – which does not necessarily reflect the performance of the business or the creation of economic value – does not make a lot of sense.

What about capital allocation and returns?

In many instances the main reason for the share buy-back may be to reduce the cost of capital and thereby increase shareholder value. However, it may also be desirable from a shareholders’ perspective to ensure that a company with a poor track record in doing deals – acquisitions that consistently fail to add value – does a share buy-back rather than engage in further value-destructive deals. In effect, shareholders are saying that ‘we do not trust you to add value when doing deals’.

This does, of course, beg the question as to why shareholders should trust the management to run the existing assets in the first place – which of course may actually trigger a change in the management team, especially if they are not responsive to shareholder demands.

It is crucial to use shareholder value in evaluating M&As so you should also consider them when doing buy-backs: buy-backs are clearly a form of capital allocation in the same way capex or M&A is. The buy-back must ‘signal’ a commitment to shareholder value when deploying shareholders’ money.

What about capital discipline?

Shareholders are effectively putting an important capital discipline on management. This discipline comes about as (arguably) greater gearing concentrates the mind and makes management far more focused in generating cash returns to service the debt. In addition, as there is little capacity for extra debt, management has to be very selective in capital allocation decisions. In theory, therefore, this rationing ensures management will only engage in projects that generate the best returns. (The ultimate gearing discipline is of course being taken over by a private equity firm where the firm is substantially backed by debt. Thinking of share buy-backs and private equity as part of a continuous spectrum is a useful way of thinking about company funding. Clearly the private equity approach pushes the efficient balance sheet/cost of capital argument to its limit.)

Will there be an increase in the ordinary dividend?

Interestingly, anecdotal evidence seems to suggest that for some very large companies, buy-backs do not seem to have much impact on the share price. This may reflect the fact that the company is of a size where it is indeed ex-growth and the buy-back merely confirms that.

However, what may be more important is that the share price effect is probably reflecting a cross-over point between growth and value investors which will take time to correct. (Growth investors are selling the shares as they no longer offer the prospect of above average growth. However, the yield on the shares has not risen to a level – i.e. the share price has not fallen far enough – to entice value investors.) This is not for one moment to say that the company is all of a sudden a ‘bad’ company, only that its investment appeal has changed significantly as it moves beyond a certain point in its life-cycle. The enhanced ordinary dividend ‘signals’ the board’s confidence in its long-term cash generation capabilities. It also suggests that maybe income rather than capital gain will be the key component of total shareholder return (TSR).

In this situation some might argue that a sharp increase in the ordinary dividend is therefore a better ‘signal’. This is because it commits the company to an increased payout ratio in the future. This ‘permanent’ payout will impose greater discipline on management. If the company is offering lower growth (but is highly cash generative) this makes perfect sense. All the statistical evidence suggests that it is in fact growth in dividend – not a high starting point – that makes money for investors over time. One could argue that Vodafone moved from being a growth stock to a utility. Accordingly, its yield needs to reflect this – and increasing the ordinary dividend and payout ratio would help this process.

Value shareholders (who put more emphasis on the certainty of income rather than the uncertainty of capital growth when assessing total shareholder return) would then find the shares more attractive. Inevitably, however, in some situations management teams are invariably reluctant to acknowledge such a dramatic change in the status of the company.

What are special dividends?

Given that share buy-backs work most effectively if the shares are below their intrinsic value, returning cash to shareholders if the shares have had a strong run or are ‘fairly valued’ by the market poses a different problem. If the shares are fairly valued and management does not feel it appropriate to commit itself to a permanent increase in dividend levels, a ‘special dividend’ may be the most effective way of dealing with surplus cash.

Often special dividends accompany a disposal or a ‘one-off’ gain for the company. (As it is a one-off gain an increase in the ordinary dividend is not appropriate.) A good example is Carillion which has declared that it will pay a special dividend whenever it makes a disposal from its portfolio of private finance initiative investments. As these are one-off events and may occur infrequently a special dividend is an effective way of dealing with the cash proceeds of the disposal.

Clearly if the shares have had a very strong run – perhaps anticipating a major disposal – then this tilts the argument in favour of a special dividend instead of a buy-back.

What about company performance and strategy?

Rather than just focusing on the ‘financial engineering’ of share buy-backs, real value is driven by making the core business more efficient and competitive. A clear and credible strategy that will deliver improved competitive performance, cash flow and earnings is absolutely critical – the benefits of this are then magnified for long-term shareholders with the improved performance being spread over fewer shares. Similarly this suggests that there may be a case for higher investment in a business or small bolt-on acquisitions rather than returning funds to shareholders. This obviously assumes you trust management to deliver value from such initiatives!

A disposal of a non-core business accompanied by a share buy-back may be greeted positively as it means management can focus on the core business and generate better returns from it, and these improved results will be spread over fewer shares. The cost of capital is reduced but management time is freed up to improve the performance of the core business which will now be valued more appropriately rather than being dragged back by the underperforming non-core operations. Future improvements in performance will then see share price growth.

In this situation, take a shareholder with a 10 per cent stake. A non-core division is disposed of, realising 25 per cent of the market cap. If the shares are bought back then there are now (say) 25 per cent fewer shares in issue. If the shareholder believes that the management is now focused on generating value for them and is making the right decisions about the core that will create a more competitive position for the business, they will hold on to their 10 per cent. (This presupposes that management has done an excellent job convincing investors it can effect a turnaround.)

If the performance of the business improves significantly the shareholder now has 10/75 or 13.3 per cent of the equity. This can be viewed as the opposite of the dilution you get with a rights issue. Therefore this shareholder is entitled to 13.3 per cent of the enhanced EPS and cash generation of the improving business. As mentioned above, the DCF calculation will also make the business more valuable as the discount rate will be lower reflecting the lower cost of capital – not only is the debt higher but the increased focus on the core business should also reduce risks.

Too many management teams just focus on the buy-back. For many large companies engaging in a share buy-back the share price response will be very disappointing if it is not accompanied by actions to improve the underlying performance and/or growth of the business. Clearly, for very large companies this may be a ‘Catch 22’ as they are handing the money back because they do not have major value-creating growth opportunities open to them. (Maybe in this case they should consider the ordinary dividend route discussed above?) Nonetheless, a clear strategy needs to be explained to the market regarding what returns are likely to be delivered in the future.

When do share buy-backs work?

Share buy-backs therefore make sense for a company when:

• the business profile – visibility of cash flows – means it can cope easily with the higher levels of debt
• it has an ‘inefficient’ capital structure – that is, the company does not minimise the cost of capital because it has lots of cash or very little debt on the balance sheet
• the company does not require lots of investment to ensure it remains competitive or is missing out on growth opportunities – investments that, if made, will generate shareholder value
• the company’s share price is undervalued
• it creates value.

Critically, all of these conditions need to apply if the buy-back is to make sense – overpaying is hardly in shareholders’ interests, while incurring extra risk of higher debt finance when it is not appropriate is hardly sensible.

Buy-backs must not be seen as an isolated, short-term response to a flagging share price but as part of a committed, long-term approach to shareholder value. Management must have a clear and credible strategy for delivering improved returns, earnings and cash flow, which spread over fewer shares will benefit those long-term shareholders that have supported the management and its strategy.

There is still a negative association regarding share buy-backs. The situation is often interpreted as indicating a company that is ex-growth with few value-added opportunities for investment or lacking strategic direction. This is particularly important in high-growth sectors where investors are expecting the company to exploit growth opportunities. (Interestingly, buy-backs in the high-tech area are often to avoid the dilution that accompanies employee share option schemes.)

However, buy-backs should be appraised in terms of value creation not growth. Many capital allocation decisions grow earnings but destroy value. Similarly, buy-backs do not excuse a company from having a credible strategy.

Therefore, while the financial structure of a company is a key determinant of its cost of capital, in the long run it is the company’s competitive position that will determine its ability to add value. This means that it can generate the profits and cash flows to service its liabilities. Higher levels of debt – especially if competitors are more conservatively financed – may well undermine the ability to compete. Being competitive requires a clear strategy and the managerial and financial resources to position the company effectively. While there are considerable advantages to debt finance, it can be self-defeating where competitive pressures need to be met with significant investment.

During the boom years of 2003–07 debt was fashionable and available – the ‘cult of equity’ was very much replaced by the ‘cult of debt’. This helped facilitate the move to higher gearing and encouraged companies to use debt finance.

However, the impact of the recession, the ‘credit crunch’ and the widespread use of debt by companies without the quality of earnings/visibility of revenues to service that debt has inevitably led to companies needing to refinance through the equity market.

The fashion has swung back towards low gearing and ensuring a sensible debt profile – i.e. a long-term structure of debt. This has seen many companies – some with more choice than others – engaging in rights issues.

Do you hand your money over?

As ever, when a company and its management team are asking for money the key issue is whether we trust that management team to use the funds to make a real difference to the business and make money. So you need to ask yourself:

• Why are they raising the money?
• What will they do with it?
• Will this generate an appropriate return?

Of course it is complicated with some rights issues because there may be very dire consequences if we do not support the company. However, if we do not have faith in the management team then a change of management may be a condition of the money being raised. Here larger investors will have to play a role to effect the changes needed.

Work done by Morgan Stanley suggests that rights issues are most successful – that is, the shares go on to perform well – when

• the shares have been very poor performers
• the company raises a significant sum relative to its market capitalisation
• the funds raised are used to reduce debt.

Why does this happen? One way of explaning this is to say that the poor share price performance means that the share price already reflects the considerable risks of the poor financial position. By removing the financial risk completely – because the size of the issue means the company will not be coming back with the begging bowl again in the near future, we can ‘re-price’ the shares on the basis of the company’s now much clearer prospects and lower financial risk. This of course means we still have to see if the company’s competitive position will now make us money. The improved financial position does now, however, mean it can invest more effectively in its franchise and take longer-term decisions.

Interestingly, the corollary of this is that raising smaller amounts of money for purposes other than to reduce debt – let’s say to make acquisitions – have been less successful. We do know of course that the vast majority of acquisitions fail to create shareholder value, so maybe this explains why the paying down of debt is a better reason for supporting the issue.

Implicit in this is that you believe in management to use the breathing space both to invest in the business to improve competitiveness and to implement the business strategy effectively. Therefore using the components of the Valuation Villa provides us with a basis to appraise the rationale for supporting a rights issue.

Why cash flow is important

A healthy cash flow is crucial. At the very basic level a company will go bust without it. Cash enables a company to maintain and grow the business by providing funds to:

• maintain quality of assets
• invest for growth
• service debt
• pay a growing dividend.

If cash flow deteriorates sharply, this can have serious repercussions. This is particularly true if the company is highly geared. The ability to service the debt can diminish rapidly and can lead to a lot of uncertainty (and high risk) for equity holders. The cost of debt is likely to rise, possibly sharply leading to lower profits and earnings for equity holders. Assets may have to be sold to reduce the debt. This may result in a weakening of the business and its prospects. In addition, the price received for any assets may be low as the company is a forced seller. Remember, shareholders come bottom of the pecking order if a company runs into financial difficulties.

It is, therefore, very important to monitor this deterioration in cash flow and the financial position of the company. Sometimes the continued growth of earnings per share can conceal this deterioration. Earnings can be manipulated by accounting policies or adjustments; the cash flowing in or out of the business provides a more effective and straightforward guide to the real performance of the business.

It can also be true that a company is seeing heavy outflows of cash without it being a major concern. It may be investing aggressively for growth or be replacing a particularly large piece of plant and equipment. The important thing in this situation is that the capital expenditure can generate a return that is appropriate for the risks of the project.

You might want to consider the ‘lumpiness’ of the capital expenditure programme – is it one large item or a collection of small discrete items? – and the timescale – i.e. how long will it be before the investment generates a return? The longer the timescale, the greater the risk of a change in economic circumstances. A lumpy investment must be finished to have any value, while small incremental additions have the advantage that they can be curtailed in response to changing circumstances.

A worst case scenario might be a process plant which takes two to three years to build. It is started at the top of the cycle (when there is a shortage of capacity) but comes on stream when volumes and prices are dramatically lower at the bottom of the cycle. Clearly the returns on the investment are likely to disappoint, at least in the short term.

In terms of risk profile, the size of project in relation to the size of the company is worth bearing in mind. Large projects can be plagued by delays and overruns and this can have a material impact on the cash flow and earnings of a smaller company which a larger entity might accommodate more easily.

The higher expenditure will lead to a sharp increase in the depreciation charge which may limit earnings per share growth in the short term. This is not a problem in terms of cash generation. (This is one reason why many start-ups with high capital requirements are valued on an EBITDA basis.)

What to look for

When looking at the cash flow profile of a business it is important to see that the company is generating cash, where it is being generated and where it is being spent. Tracking the movement in net debt is one way of seeing whether the company is generating cash (making sure debt is not coming down due to one-off financing items such as disposals or share issues). It is also always worth making sure that the cash is being generated from the ongoing business and not from, say, a one-off disposal of assets. Discarding peripheral or non-performing assets can be an important and sensible way of running the business, but it may also conceal a poor underlying performance and a response to deteriorating cash flows. Finally, you need to take into account the quality of earnings and the efficiency with which earnings convert into cash. This is particularly important if a high proportion of earnings comes from associates.

A fall in operating cash flow may come about because of money going into working capital (traditionally defined as stocks, plus trade debtors, minus trade creditors). This may not be a problem if it is to meet an anticipated expansion of the business. However, it may herald serious problems if stock is being accumulated involuntarily because of a sharp slowdown in demand.

A key driver of value

Cash flow is one of the (if not the) most important drivers of value – any asset is effectively worth the cash return it can generate. The ability to generate cash is critical for any business to be successful. It is no good growing rapidly and investing aggressively in a business if you are not generating cash – bankruptcy will inevitably follow.