Going Once, Going Twice
Article, Accountancy Age – December 2007
Corporate / Corporate consulting
The market price of a company is quite different from its value, a distinction you should ensure that your clients fully understand, writes James Stanbury.
The turbulence of the stock market this summer has put into sharp focus the value of the UK’s leading companies. Any analyst or stockpicker is always trying to find a company that is undervalued or underpriced.
Although these terms are typically used interchangeably, they have very different meanings. Indeed the way companies of all sizes are valued can be very different, depending on their subject characteristics.
Price and value
Of course, the market value of a company should not be confused with its market price. There is a fundamental difference between the en bloc value of a company and its price. The en bloc value is the value of the assets or ownership interests of a business viewed as a whole and, critically, is determined through a notional market valuation. This should be compared with a price that represents the consideration paid in a market transaction between two parties or publicly traded stock market prices.
In general, stock market prices are not representative of the en bloc value for various reasons. Shares are frequently traded in small, minority shareholdings and thus attract a minority discount.
Conversely, such shares are traded in a liquid market and do not suffer from the liquidity (also known as marketability) discount typically applied to private company shares. In addition, publicly traded shares are influenced by a myriad of factors that do not affect a notional market evaluation, for example:
- General awareness, knowledge and interest in a share;
- Trend buying;
- Frequency of trading;
- Increased liquidity;
- Stock price volatility;
- Public perception; such as hype or irrational investing (or divesting); and
- Degree of broker or institutional interest.
Certainly, the price swings in the financial sector stocks since August of this year have demonstrated and will, no doubt, continue to demonstrate many of these factors.
In comparison, shares in private companies are generally valued on the basis of their fair market value (FMV). This is defined as ‘the highest price available in an open and unrestricted market between informed and prudent parties acting at arm’s length and under no compulsion to act, expressed in money or money’s worth’.
Given this definition, the differences between price and value are all too easy to see – indeed, they are quite irreconcilable. For example, one should consider that the parties are deemed under FMV to be ‘informed and prudent’. In the market arena, typically, parties are not always appraised of all information and imprudent and irrational investment decisions are not uncommon, based sometimes only on the whims of personal taste.
The bases of value
So how is a company to be valued? It is important firstly to determine whether a business is worth more as going concern or liquidated (the ‘going, going, gone’ basis) and the proceeds distributed to its shareholders – the higher of the two is the appropriate value.
For the going-concern basis, there are three broad methodologies, namely the earning/cashflow basis, the asset-based approach and the market-based approach (see box).
Before applying the mechanics of these approaches, which will be familiar to readers, it is important to evaluate which basis should be selected and this will depend on the nature of the company being valued.
The value of a company is largely driven by the financial components of its value chain, which can be summarised as the quality and sustainability of its earnings stream and/or cashflow. This is the lesson learned from the dot.com boom where sentiment overrode these fundamental considerations. Of course, all value is prospective, but many e-prospectors dug in the wrong places.
In turn, those financial streams are driven by such factors as, for example, the strength of its supplier chain, the breadth of its customer base, the innovation from R&D, the extent of competition or the quality of its management. The value of management or, rather, the effect of management on value should not be underestimated. Where a business attains ‘key person’ status, its value can be diminished from their notional absence.
Conversely, the existence of a ‘special interest purchaser’ can enhance prospective value from post-acquisition synergistic benefits through economies of scale or strategic advances. It is entirely relevant for FMV as the market is meant to include all buyers.
Nietzsche was not far wrong when he said that: ‘No price is too high for the privilege of owning oneself’. The challenge for any buyer, seller or analyst of a business is to unravel the value from the price.
EARNINGS / CASHFLOW
- Mature company with relatively consistent earnings/cashflow.
- A business where earnings can be reasonably estimated through a business cycle
- Business in which forecasts are not available or unreliable
- An asset-heavy company – for example, a property or investment holding company
- A business with insufficient earnings to provide a reasonable return; on its tangible assets, but where its going concern value is greater than its liquidation value.
- Generally used as a test of value – it is rarely used as the sole basis of valuation.
As appeared in Accountancy Age, December 2007.