Speak­ing to Mar­kets

Con­vert­ing or­di­nary noise into a valu­able sig­nal

Finweek English Edition - - Companies & markets - BY JOEL STERN

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?”

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