8.16 Valuation of a Company

Company valuation enters into ebusiness in three ways:

1. Valuation quantifies matters. Which market sectors should a new company investigate? How serious are the factors identified by SWOT analysis? What Internet revenue models are the safest or most lucrative? Companies need an objective and time-proven way of putting hard figures to the opportunities.

2. Armed with a better understand of ebusiness, readers may wish to invest in fledgling Internet companies, which requires evaluating them as seasoned investors will, and investment banks do for their clients.

3. The Internet has greatly facilitated company valuation, providing ready access to information, tools and valuation models.

Two other considerations are important.

1. Entrepreneurs will increase their chances if they follow proven ways of adding value to companies.

2. Job seekers should evaluate the financial standing of companies offering employment if they want long-term and satisfying work.

Types of Valuation

Broadly speaking, there are three approaches to valuation:

1. Market value. Five million shares trading at US$12.49 per share values the company at US$ 62.45 million. Sometimes shares are bought for their revenue streams, the dividends they will pay to shareholders over the years. Others — by a process called the 'greater fool theory' to explain the wild flights from common sense in boom times — are purchased to turn a profit on their future sale. {1} {2}

2. Intrinsic value. Intrinsic value is the value of future cash flows the stock will provide expressed in today's money. {3} Though cash flows so discounted (DCF, or discounted cash flow approach) are calculated by a simple formula, much effort goes into calculating those cash flows exactly and arriving at an appropriate discount rate. (In contrast to such 'fundamental analysis' is 'technical analysis', {4} {5} where the price movements known as as 'head and shoulders' and 'double bottoms' etc. formations do appear to have some modest predictive power. {6})

3. Assets value. Companies are effectively valued at what someone will pay for their assets. The business price is what a willing buyer will pay, and a willing seller will accept for the business. Both parties are assumed to act in full knowledge of all the relevant facts, with neither being under compulsion to conclude the sale. {7} Such assets may not appear fully on the balance sheet, but represent access to new markets for the acquiring company, new technology, or simply a need to absorb likely competition. Sometimes a sale is worth considerably less than the book value: the few companies with a conceivable interest in the now badly-located supermarket chain, the ailing factory or service company simply have too much on their hands already: they don't have the ready funds or management to turn the acquisition around, nor perhaps any wish to.

Introduction to Stock Market Investment

Types of Shares

The stock market enables individuals, investment houses, pension and other companies to share in the fortunes of particular businesses. Stock (also called 'equities', and simply 'shares' in Britain) comes as common and preferred shares. Common shares represent ownership in a company and a claim (dividends) on a portion of profits. Investors get one vote per share to elect the board members. Through capital growth, common shares yield better returns than most types of investment, but carry higher risks as their owners are the last to be compensated if the company fails (after creditors, bondholders and preferred shareholders). Holders of preferred shares are usually guaranteed a fixed dividend every year, are compensated ahead of common share holders, but do not have the same voting rights.

Primary shares are those of an initial public offering (IPO) where an investment bank has handled the floatation of the company, taken a commission for doing so, and guaranteed to purchase any shares unsold. Most shares are secondary: they are continually resold, with proceeds going to new shareholders and their brokers, and not the issuing company. Companies may of course raise more cash subsequently by issuing further (secondary stock) shares, or share splits (offering shareholders two shares for the original one). Rather than paying larger dividends, companies may increase shareholder value by buying back their own shares. {1} {2}

Exchanges

Stocks are traded on exchanges, places where buyers and sellers meet and decide a price. Some are physical locations where transactions are carried out on a trading floor. Others are virtual, composed of a network of computers where trades are made electronically. The top twelve in 2007-8: {8}

Stock Exchange	2008 Market Capitalization ($ Billion)	Value of Shares Traded in 2007 ($ Billion)
New York	11,387	29,910
Tokyo	3,306	6,476
Nasdaq	3,239	15,320
Euronext	2,869	5,640
London	2,796	10,334
Shanghai	2,704	4,069
Hong Kong	2,345	2,137
Toronto	1,608	1,634
BM&FBovespa (Brazil)	1,337	1,370 {9}
Bombay	1,306	400 {10}
BME Spain	1,297	2,970
Frankfurt	1,292	4,325

Brokers

Shares have to be purchased through a stock broker, usually a brokerage firm, which may also offer investment advice as part of a ' full service'. Such services are expensive, however, not always disinterested, have a mixed track record, {2} and may be more suited to wealthy investors who lack the time or interest to conduct their own research. Now the Internet has facilitated immediate access to the relevant information, many investors employ discount brokers who make the purchases and sales, provide research information and some tools at a modest price. Charles Schwab, E*Trade, Fidelity, Scottrade and TD Ameritrade are some of the best known. Commissions are in the $5-20 range, considerably cheaper than the full service of professional management, where commissions are often $100-200 per trade. {1}

Professional Management

Why not leave investment to the professionals? Many do. The largest 100 money managers hold $6.8 trillion of stocks, or 52% of the US stock market's total market capitalization. Four of those managers hold some $400 billion apiece. {11} The big players are household names: Bank of America, Citigroup, Goldman Sachs, JP Morgan Chase and Wells Fargo. Their approach is generally top-down, i.e. they 1. make some prediction about the future, 2. estimate the effects on certain stock, and 3. buy or sell that stock accordingly. Such approaches are not over-successful, however. Predictions go wrong as often as they come right, and, on balance, managers tend to marginally underperform the market (i.e. do a little worse than an uneducated guess, before commissions are deducted).{12}

Money managers are handicapped in four ways.

1. Short time horizons. To maintain confidence and their jobs, managers must continually outperform their peers, month in month out, which renders impossible a safer, long-term strategy. Herd behavior predominates. {13}

2. Funds are very large, and the adequate diversification required by law of mutual fund managers greatly restricts their choice, often to only 10% of the market. (Holding of more than 5% in a company triggers SEC filings.) {13}

3. Managers are further restricted to particular sectors of the market, and cannot hold cash: i.e. they must stay fully invested in their allocated sector even though common sense suggests riding out unrealistic bull runs. {2}

4. Managers don't have the time to properly understand the companies they invest in (let alone undertake discounted cash flow analysis) but must make their selections based on recommendations in the newspapers and magazines that every other manager reads. {2}

DIY Approaches

Many successful investors employ a bottom-up approach based on intrinsic value. They find well-run and long-established companies with an enduring competitive advantage, buy their stock an attractive price, and hold on to their investments year after year until it's profitable to sell and the money is needed for an even better investment. Day-to-day turbulence in the market is ignored. Prior to purchase, however, they have understood how the companies operate, analyzed their financial statements carefully, and waited (months or years) until the stock was available at an acceptable price. Even legendary investors like Warren Buffet often hold very few companies in their portfolios, though each has been carefully selected. Most of what's needed for analysis is in the annual reports of the companies concerned, though several years' results are examined to take a long-term view and ensure that announced plans are effectively carried through by management. Helpful for background are the many business information sources on the Internet: Smartmoney, Kipliger, Investor's Business Daily, Barron's, Grant's Interest Rate Observer, Morning Star, S&P's Outlook Online, Value Line, Financial Times and the Wall Street Journal to name a few. {1} {2}

A Word of Caution

With America currently in recession, the Fed is rumored to be building confidence in the economy by supporting the stock market — in two ways.

The first is uncontroversial. Quantitative easing (i.e. printing money) makes more cash available and so generally boosts stock market performance. {14} {15} {16} {25}

The second is unadmitted, controversial, claimed by a few investment blogs but unreported by the mainstream media. {17-21} Through the Treasury and subsidiaries of private banks that make up the Fed (Federal Reserve Bank), serious difficulties in the currency and stock market are prevented or mitigated by clandestine transactions, a process called 'rigging the market' by critics. The entities involved are firstly the Plunge Protection Team (PPT), known formally as the Working Group on Financial Markets (WGFM), which is 'enhancing the integrity, efficiency, orderliness, and competitiveness of our nation's financial markets and maintaining investor confidence.' {22} The second entity is the Counterparty Risk Management Policy Group (CRMPG), a series of well-connected hedge funds that suppresses rises in the gold price that would otherwise alert investors to troubles in the American economy. {23} The third is the Exchange Stabilization Fund (ESF) {24} which buys and sells foreign currency to promote exchange rate stability and counter disorderly conditions in the foreign exchange market. {24}

If true, the actions place individuals at a disadvantage. Small investors make up only 13% of the stock market, and their modest accounts will always take second place to the interests of the large banks and pension funds. Indeed, picking a solid, well-managed companies with strong growth and earnings prospects may no longer be a sound policy, or not sufficiently so against high-frequency trading or insider knowledge used to anticipate another Fed purchase.

Points to Note

1. Three types of company valuation.
2. The stock market and part played by exchanges, investors and stockbrokers.
3. Alleged manipulation of stock market by government and financial groups.

Questions

1. Compare the three approaches to company valuation.
2. How would you choose a stock broker?
3. What evidence is there for stock market manipulation?

Sources and Further Reading

1. The Neatest Little Guide to Stock Market Investing by Jason Helly. Penguin, 2010.
2. Getting Started in Value Investing by Charles S. Mizrahi. John Wiley & Sons, 2008.
3. Internet Valuation: The Way Ahead by John Briginshaw. Palgrave, 2002.
4. Technical Analysis: Introduction by Cory Janssen, Chad Langager and Casey Murphy. Investopedia. Accessed August 2012.
5. Further Evidence on Technical Trading Profitability and Foreign Exchange Intervention by Simón Sosvilla Rivero, Julián Andrada and Fernando Fernández Rodríguez. Social Science Research Network. 2002.
6. The Efficient Market Hypothesis and its Critics by Burton G. Malkiel. Vixek. April 2003.
7. Business Valuation: the Three Approaches. ValueAdder. Simple introduction.
8. List of Stock Exchanges. Investopedia. June 2012.
9. Brazil Country Report. Global Finance. 2011.
10. Bombay Stock Exchange. Wikinvest. June 2012.
11. The Battle for the Soul of Capitalism by John C. Bogle. Yale Univ. Press, 2005.
12. Beating the Street by Peter Lynch. Simon & Schuster, 1993. p 340.
13. The Fearful Rise of Markets: Global Bubbles, Synchronized Meltdowns, and How To Prevent Them in the Future by John Authers. F.T. Press, 2010. Chapter 2.
14. Does The Government Actually Manipulate The Stock Market? by the 'The Pragmatic Capitalist'. Business Insider. February 2010.
15. The Fed Manipulating Stock Prices? So What? Seeking Alpha. March 2012. Extensive thread.
16. The impact of QE on the UK economy — some supportive monetarist arithmetic by Jonathan Bridges and Ryland Thomas. Bank of England. January 2012.
17. George Let Plunge Slip by June Crudele. New York Post. Investors Hub. June 2006.
18. Not Free, Not Fair: The Long-Term Manipulation of the Gold Price by John Embry and Andrew Hepburn. Sprot Asset Management. August 2004.
19. US stocks: The visible hand of Uncle Sam by 'Japan Focus'. Asia Times. October 2005.
20. U.S. Treasury Bond Teetering Tower Of Babel, Fed Stuck At 0% Forever by Jim Willie. Market Oracle. May 2012.
21. The Greatest Hoax Ever Perpetrated on Mankind by Rob Kirby. GoldSeek. June 2012.
22. Working Group on Financial Markets. Wikipedia. June 2012.
23. They are about to hit the wall' by Lars Schall. Lars Schall. August 2009.
24. Behind Closed Doors by James Turk. USA Gold. April 2001.
25. Z1, QE3 and Deleveraging by Doug Noland. Prudent Bear. September 2012.