Speaking to Markets
Converting ordinary noise into a valuable signal
LISTENING TO MARKETS (Dec 7) focused on how markets provide valuable information about companies’ strategic plans and how management and boards of directors can read these signals, with the market providing an independent assessment of a company’s future.
The process is simple. Since a company’s market value is equal to the current value of its future performance, we divide the firm into two parts – the net asset value (NAV) today and the present value of tomorrow’s future EVA (economic value added).
EVA is by how much a company outperforms its required benchmark based on the risk of its business.
If we know the company’s value today, we can obtain the market’s assessment of its future performance by subtracting the net asset value. The result is the expected future performance.
Compare this estimate with management’s own assessment and then let valuable discussion begin inside the firm. For example, is the market right; is it wrong; what can the firm do about it?
It’s this last question that interests me the most: “What can the firm do about it?” This suggests unambiguous signals can be sent from the firm to the market. But will the market believe the message? What converts a signal from being ordinary noise into a valuable signal? How to send credible messages to the market is today’s task. If successful, it can make share buybacks an extremely valuable instrument in propelling the share price upwards, perhaps even permanently.
Turning again to value, the share price depends on NAV and future EVA. Fundamentally, this means the share price is determined by six distinct factors: (1) the base level of trading profits today; (2) the required rate of return for risk; (3) the amount of new investment; (4) the expected rate of return on new investment; (5) the time in years in which the market believes the firm will earn more than is required; and, lastly, (6) the tax shield for debt financing because interest expense is tax deductible.
Numbers 2 and 5, at least in the short term, are largely beyond the influence of management. The required return is based on the market’s assessment of the firm’s business risk and is also related to the level of interest rates. The length of time for which management could earn returns above what is required depends on changes in technology, and the Government’s monetary and fiscal policy and regulation. The remaining four factors – trading profits, tax benefits from debt, new investments and the expected rate of return of new investments – can be communicated by the CEO or chairman to the market.
My opinion in the Seventies and Eighties was that statements from the CEO and chairman could alter the market’s expectations and thus change the share price. I felt that if the company did not deliver the goods, management’s reputation would be damaged and that’s why the market would believe it.
Unfortunately, this view is wrong. Such statements are cheap and too easily subject to manipulation. The market has learned to be distrustful because such manipulation does not violate corporate or securities law.
In short, signals are credible only if management or shareholders bear larger costs than the loss of reputation. There are three concrete examples of how to do it. The first is a share buyback; the second a share split; the third an unnecessary payout of dividends followed by a huge borrowing programme, especially in the case of highly capital-intensive industries such as paper, steel or automobile manufacturing, where capital employed is often much larger than the firm’s turnover.
The share buyback programme is so important by itself that I’m going to devote the remainder of this column to it.
In 1995, a diversified manufacturer in the automobile industry implemented the fully integrated EVA Management System. This included performance measurement; allocating and prioritising capital expenditure on the basis of value add; a training programme for all employees; and an incentive system that provided variable pay for all employees from top to bottom based on improvements in EVA.
Improved efficiencies flowing from this programme reduced fixed costs and improved working capital, generating almost $400m in surplus. The CEO, an alumnus of America’s General Electric, suggested the firm buy back shares even though he planned to make acquisitions the following year in 1998.
The buyback would convince the market of his commitment to operate the firm without a rainy-day surplus. He felt such a surplus would lead his management team to
relax. After all, his shares had soared from $14 to $42 in only 15 months. He was prepared to buy back shares at $42.
However, his head of planning had generated a realistic plan, which in our valuation model scored a remarkable $71/share.
With such a large undervaluation, I suggested the buyback should be a Europeanstyle Dutch Auction, which permitted a share buyback range of $43 up to $55, tendering shares from the top of the range downwards.
The CEO was surprised: Why buy back shares at $55 when they could be bought back at $42? After all, at $42 he could buy back many more shares.
I responded that this was an excellent opportunity to send an unambiguous and costly signal to the market about what the management team felt was the “fair” value of the company. The technique was for the CEO to announce that no insiders in the firm would participate in the share tender. This statement convinced the market that management believed the shares were more valuable than $55/share.
The result was that almost no shares were tendered during the 30-day buyback period. And for good reason. Management had convinced the market that the fair value of the shares was above $55. Next, the CEO announced a straight tender in the market up to $71. Almost instantly the shares leapt to $71, all of the surplus funds were used to buy back shares at $71, and the shares remained at or above $71 thereafter. How about that! But what was the costly signal? The answer is that since management owned shares and was also granted share options, a company that repurchases shares above the market price, but fails to convince the market that the fair value is likewise above the existing price, will send all shares that remain down on a pro rata basis by the premium paid. Such an outcome would reduce the value of the shares and share options held by management.
To reinforce the signal, management agreed to yet another costly one. The profits already earned on its share options when the shares rose from $14 to $42 were to be used to purchase new options to replace all the old ones, with one major change in the design: the new options would have a rising exercise price equal to the required return for risk minus the dividend yield on the shares.
Over a 10-year period, the exercise price would increase from $71 a share to $200. Therefore, if the shares failed to reach $200 within 10 years, management would have lost all of the value of its options. The new option programme was much riskier to management, which had received four times the amount of options it already had. The CEO, for example, had 250 000 shares in options that were converted to 1m, so if the shares did not reach $200, the CEO had no gain at all, but for every $1 above $200 the profit to him would be $1m!
I refer to these options as “win, win first” options, because the shareholder always wins first before management wins at all and nothing is a more unequivocal and costly signal than this. The major benefit to the company was the enormous change in management’s attitude from “bigger is better” to “where is the value?”