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February 27, 2007The Use of Forward Looking Multiples In Valuation
Accounting-based market multiples are the most common technique in equity valuation. These multiples are present in analysts' reports and investment bankers' fairness opinions. They also appear in valuations associated with corporate transactions. However, it is difficult to know which multiple to apply to the subject company and most multiples used for valuation are trailing multiples, which are based on historical data. If the value driver of a multiple refers to a forecast instead of a historical number, it is termed "forward-looking". Valuation theory tells us that the value of a firm equals its discounted stream of expected future payoffs. Following this principle, forward-looking multiples are more appropriate for valuation purposes.
February 26, 2007The Value of Key Players
These past two months have been a sad time for Denver Bronco fans and for all of us following the tragic deaths of two young promising Bronco players. Both players were considered to be key components of the growth and future success of the Denver franchise and will be missed. This weekend, as I opened the paper and reflected on this latest tragedy I couldn't help but wonder what was in store long-term for the Bronco franchise. How will they regroup as a team? Will they fight harder, struggle, or never miss a beat? Can they fill the shoes of Darrent Williams at corner or Damien Nash in the backfield?
While I recognize that the tragic death of an elite athlete is not the same as losing a key employee, we often find management teams with huge talent and age gaps in their organization. This is especially true in professional services, in which entire generations of employees are lost for a variety of reasons (e.g. a downturn can cause an organization to stop recruiting or be faced with layoffs). In certain cases it reflects management's inability to motivate and retain employees, while in others it may well be external factors. When analyzing the breadth and depth of management teams and their long-term impact on value, we have to consider the expected tenure and skill sets of the organization and its competitors. In a weird way, we look at the future and value in the same way a professional sports franchise may when they are forced to wonder who is going to fill whose shoes and when. All organizations need to plan for change and development of team members, just like the Broncos have to now.
February 19, 2007Buy and Hold vs. Fix and Flip
The phenomenon of RLBOs (or Reverse Leverage Buyouts) has met with intense
public scrutiny of late. The public's attention became fixated on a few
landmark cases such as Refco, which was bought through private equity for
$500 million and subsequently taken public a year later for more than double the price. Not
long thereafter Refco collapsed, its current market cap is $50MM, and the
inevitable lawsuits ensued. Overall, the recent controversy regarding
RLBOs has focused on the use of leverage to provide large divided payouts
to select shareholders (private-equity firms), who then push the
overleveraged firms too quickly into public markets. Detractors cry unjust
enrichment to the detriment of shareholders. So the logical question to
ask is: do RLBOs create or destroy value? As with most questions, the
answer depends.
A recent study, "The Performance of Reverse Leverage Buyouts", by Cao and
Lerner reviewed the post-IPO performance of 496 corporations that were
initiated by private equity firms between 1980 and 2002. The study
specifically focused attention on RLBOs.
The study demonstrates that RLBO firms generally outperform both the
overall market and shares issued in other IPOs that were not backed by
private equity. Bigger IPOs backed by private equity did better than
smaller ones. In many cases, it appears that private-equity firms generally
have a vested interest in maximizing long-term value, and asset stripping
rarely proves prudent. Even after private-equity firms sell - at least in
subsequent IPOs - they often retain significant holdings for years to come.
However, this study is only a partial refutation of the criticism leveled
at RLBOs. Cao/Lerner also assert that firms that were held for less than a
year by private equity performed poorly, indicating that 'fix and flip'
appears to destroy value while 'buy and hold' creates value.
February 18, 2007Free Yes, But Reliable?
Whenever I get something that carries significant value for free, my first inclination is skepticism. As such, I was not surprised to read a recent Wall Street Journal article investigating free real estate valuation services provided by Zillow.com (among others). The general conclusion of the article was that Zillow did provide reasonably accurate real estate valuations... most of the time. However, there were significant stumbling blocks when it came to correctly interpreting data for certain markets and accounting for statistical outliers.
Of course as a financial analyst, working for a business valuation firm I can't help but think of the parallels between a website providing free real estate valuations and a similar animal for business valuation. However, in determining an accurate valuation of a business enterprise, often the most crucial information is provided in the outlying details. Does the company have a key man with responsibilities across the organization? Does the top management have a succession plan? Do new market innovators threaten to drive the company's product or service into obsolescence? The list is long and the relevant questions will differ for many companies.
So, while I have no doubt that many will try to develop accurate business valuation services based on user input and behind the scenes computer algorithms, I am equally confident that they all will carry significant fine print.
February 12, 2007Results Only Please
If you were to guess were I was last Monday at 8:00am, most likely the answer would be work. However, at Culture Rx, a Minneapolis based consulting firm, the contention is that your work is not where you go and when you get there, but what you do. Recently, Culture Rx's philosophy of Results Only Work Environment (ROWE) has taken hold at Best Buy, with some interesting results. Culture Rx claims (as do their clients) that by measuring employees performance by their results and not the actual time spent physically at the office, workforce productivity has increased and turnover, decreased. Best Buy's initial pilot of ROWE was so successful, that 60 percent of the company's workforce is now measured based on ROWE.
From a global perspective, the United States already boasts some of the world's most productive workers, enabled in great part by continued advancement in technology. However, while technological advancement has greatly benefited employee productivity, I doubt it has had much effect on happiness and motivation, two important and sometimes neglected catalysts for a productive workforce.
So what are the implications of a shift in how we think about corporate culture? Imagine increasing productivity 35 percent (which was the average increase in productivity cited by Culture Rx for teams in a ROWE), while also retaining your employees for far longer periods. Under this scenario it's hard to believe that the bottom line would not improve. How does this impact valuation, well from the initial results, increased expected return and less risk mean squeezing more value from a universal asset, people.
February 07, 2007Firms With Higher Quality Financials Are More Attractive Targets
The most recent Business Week cover story focuses on one of the four big horsemen in Private Equity, the Carlyle Group. This morning while huffing and puffing on the treadmill I listened to the Business Week podcast. While I am generally not a big fan of their podcasts, I was intrigued by the feature on Carlyle. Several points are made on the success of Carlyle (26% compound return after fees) since inception and the fact that they manage a mere $85 billion. They also cut through the surface and brought out three points, which I thought were quite interesting. The first, related to the perception of increased risk in club deals. Carlyle has graduated from small deals like Dunkin' Donuts ($2-$3 billion) to mega deals like Kinder Morgan ($25-$30 billion) in the past few years. When asked if bigger deals had greater risk and how they were managing the exposure Lou Gerstner responded that larger deals actually had less risk from their perspective. Why?
February 05, 2007Using Innovation For Growth
Innovation has long been an important driver of growth across all
industries. Historically, investment in innovative products, practices, and
services has been strong during robust economic climates and weakest during
economic downturns. Because innovation requires investment in the present
for returns in the future, many executives shy towards conservatism during
uncertain economic times. Ironically, shying away from investment in
innovation (the company's future) during economic downturns actually
prolongs the poor business climate. As of this post, innovation has topped
many corporate agendas.
February 02, 2007Negative Savings Rates - What it can mean to your future.
Recently the US Commerce Department released data showing that the national personal savings rate for 2006 was a negative 1 percent. This is the second year in a row where personal savings was negative, and only the forth year in the history of the US. The last, and only other time the population was spending more than they earned was during the Great Depression. While this statistic is frightening enough, the fact that the US economy is experiencing growth above inflation as are personal income levels is a cause for serious concern. Without talking much further about the dangers this represents to the future strength of the US economy, and specifically the dollar, it is important to look at this figure and understand how it could effect your personal retirement planning, especially if a big part of that plan is an assumed sale of your business in the future.
There is no question that owning and operating a successful private business can lead to a very lucrative exit when you are ready to retire. But a big assumption to this retirement strategy is that somebody will be able to purchase your business when you are ready to sell. If the current trend of the American public operating at a deficit continues, the credit-worthiness of prospective borrowers will steadily decline, making securing necessary funds for a transaction as large as a business purchase a much higher hurdle to clear. Moreover, if instead you choose to sell your company for a lower upfront payment, thus easing the burden on the buyer on day one, and structure an earn-out into the agreement, you will be putting your future wellbeing in the hands of whomever you sold to. This understood risk will be compounded by the fact that your future income is dependent on the American economy being able to continue to thumb its nose at all established macroeconomic theory and avoid the large and lengthy recession prescribed by our long standing current account and budgetary deficits. No company, or economy for that matter, can operate in the red indefinitely. Eventually all debts must be repaid, and in one fashion or another the American citizens and their government will have to do the same. Since we are all investors in the US economy, whether we like it or not we will each have to pay our part of what is owed. By accounting for this added expense in retirement or other long term personal savings plans, you can avoid underestimating how much you will need to insure all your other future plans come true.
February 01, 2007Commercial Hype
With the big football weekend approaching, there seems to be the regular hype surrounding the amount CBS is charging for a 30 second spot. An "All-Time High of $2.6 million" reads a CNN story. After recanting the past success stories of ads for Coca-cola, Apple, and Anheuser-Busch, the article goes on to say that in 1997 it cost "just" $1.2 million and a measly $600,000 in 1987. To the writer's dismay, the cost of commercials has "more than quadrupled in the past 20 years."
This is sensational! Kinda, Well not really. Pulling out your handy calculator (all quant geeks have a handy calculator) and solving for the compound annual growth rate, you'll find that to quadruple in 20 years, you need to generate a 7.6% price increase. That's not far off from the increase for your generic cable bill, the price of a home, and far less than the returns for the S&P 500. It certainly pales in comparison to the 15% increases for college tuition or the 19% increases for healthcare.
For what it's worth, $2.6 million is still a lot of money today, but so was $600,000 in 1987. I sure hope the commercials themselves are more sensational than 7.6%.
