Valuation Analysis (Part II)

To understand valuation analysis, we need to understand what value is, and furthermore, how do we get it. CEO's, management, and to a lesser degree company directors are responsible for directing companies to enhance shareholder value. What this means is that they are responsible for ensuring that the share price enjoys a sustained increase over time. Given the plethora of information and metrics out there, however, what should be the measures that company management focus on. Is it earnings, growth, revenue, cash flows, research and development, market cap or earnings multiples, EPS or the bottom line, profit margin, CAPEX, debt ratio....and the list can go on for pages. Fortunately, while all these factors are in some way related to value, a list of the principle drivers or value creation is not so exhaustive.

In fact, all that we need to focus on are the simple elements of growth (that is growth in cash flows not earnings), return on capital (ROC) and the cost of capital (COC). In other words as long as what we are generating exceeds the cost of the activity we are engaging in then we are creating value. These elements on their own, however, do not necessarily generate value. Assume that the ROC is lower than COC but growth is still positive. The higher growth goes the faster we burn through capital and therefore the faster we destroy value.The key lesson here is that 'growth is good' mentality is flawed if it does not consider these other elements.

Where management appear to get into trouble is when they prioritise investments based on delivery time rather than contribution to value. The market, perceives or judges to a certain degree value creation based on the last accounting report (or series of). With this in mind and given the fact that CEOs are expected to deliver immediate outcomes it is often the case that value-added projects are substituted for quick delivery items. There is a point to be made here that justifies this action. Since investors cannot see the choices that management are making (agency cost), how can investors trust management to maximise value if the recent history of results are unacceptable. There in lies the problem. 

The recent drive to improve internal corporate governance, which is partly aimed at alleviating this agency problem, has significant implications for market liquidity, performance and value. If the degree of information asymmetry were not as large between firm management and shareholders then the choice for inferior investment opportunities would not be as high. A key decision factor it would suggest to me is when investing that we should consider how transparent a firm is being about it activities, operations, financing activities etc... If it is being transparent then chances are it has less to hide about the choices it is making and those choices are likely to be ones that ultimately maximise shareholder wealth.