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Business Valuation Decisions are made Differently

 

Coming from all types of backgrounds, valuation practitioners bring their experience and biases with them. Even day traders are influenced by insights on valuation. When we talk about valuation practitioners, however, we are talking primarily about investors and corporate leaders, both of whom are more concerned with longer-term intrinsic value than with today’s stock price.
Simplistic solutions, shortcuts, personal bias, politics, poor communication, and misdirected incentives make valuations difficult and subject to wide variations. There is a fog about how corporate insiders, outside investors, and analysts value companies. Corporate leaders generally receive incentives to build value, but the payments may be heavily weighted on
weak value drivers like revenue and GAAP earnings per share (EPS). As one goes further down the organization, the links between incentive compensation and value creation are even weaker. Rarely does the head of a business unit in a public company have a sense of ownership of the performance and reporting of the unit. Many performance measures used by public companies to judge their division heads, such as quarterly sales and earnings growth, are poor replacements for real value-building metrics, such as growth of cash flow and return on invested capital (ROIC) over the long term.
Both insiders and outsiders are mining databases to make better value-building decisions. Analysts who develop a deep understanding of both the company fundamentals and how the company compares to the broader corporate universe are on the leading edge of value thinking.
How a public or private company approaches value building is of great interest to both the outside analyst and management. There is a growing body of knowledge dealing with how people influence markets with their personal biases, wishes, hopes, and not-always rational behavior. For example, agency risk and so-called moral hazard play unfortunate roles, as managers too frequently find themselves in positions where they can benefit from taking inordinate risks, due to asymmetrical payoffs under their compensation arrangements.
Valuing a business or a stock from the outside requires mastering insight in two opposing dimensions. The fact that people participate in markets means that the right-brain creative insights and the left-brain analytic urge to quantify are often at odds. Since analysts and managers are all wired differently, it is not surprising that we all have different views on valuation
and how the world actually works. People make their own decisions, and often defy the logic of the best economic model. All too frequently, the carefully computed numbers effect is completely overwhelmed by the unanticipated people effect, wreaking havoc on plans and projections, and occasionally causing bubbles. Because people make decisions in every activity, the people effect has an impact on everything from a divisional projection to overall market efficiency.
Wise leaders have often repeated, ‘‘What gets measured gets managed!’’ Yet we see a wide variety of communication styles and approaches to business measurement. Regulatory authorities attempt to prescribe how public corporations communicate to their investors, with minimum standards for frequency and disclosure. For years accounting bodies in the United States have been setting standards and rules resulting in the development of GAAP. Despite their best efforts, GAAP still is an imperfect measurement system, and now with globalization it must face international challenges from the International Financial Reporting Standards (IFRS). Accounting improvements and acceptance never seem to keep pace with the creativity of new financial instruments and business models. While most managers and valuation professionals in the United States must rely on GAAP, they find it poorly suited to understanding the real economics of a business and estimating intrinsic value. GAAP provides only a starting point, and a distorted one at that.
In the growing spirit of improving transparency, many corporate
leaders stick to GAAP and EPS-speak, despite its well-known weak-
nesses. Yet some more enlightened corporate leaders have gone beyond GAAP to disclose both non-GAAP measures and forecasts of future performance. While public companies are reluctant to give forecasts due to frequent changes in the environment, private-equity-owned businesses are required to provide forecasts and cash budgets to their owners. This more disciplined forecasting and planning requirement alone can give private equity fund managers a great advantage over their public company and mutual fund peers.

Because people are different, there will always be a wide variety of valuation techniques, from the simple to the most complex. While some analysts swear by simple multiples, sophisticated managers and private equity investors dig deeper into the drivers of future cash flow. The better ones allocate limited capital based on DCF approaches, not accounting ratios. The more sophisticated analysts, money managers, and corporate executives use more advanced versions of the basic DCF techniques. Because DCF is not a perfect valuation tool, they use it as a framework to adjust for risk, while adding a variety of refinements such as scenarios, option models, and simulations. The better corporate value builders find ways to communicate these value-building metrics and techniques. They use every opportunity to inform everyone both inside and outside the company that management has a plan and understands the path to greater value.

 

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