Corporate Valuation

From Enron to Lehman Brothers and the subprime financial disaster, we’ve seen the worst decade ever in my lifetime for equities, down 3.3%. Is it time to start stuffing our money into the mattress or is it time to learn something about corporate valuation from two experts?

Corporate Valuation for Portfolio Investment: Analyzing Assets, Earnings, Cash Flow, Stock Price, Governance, and Special Situations by Robert A. G. Monks and Alexandra Reed Lajoux will inevitably be compared with Security Analysis: The Classic 1934 Edition by Benjamin Graham and David Dodd. Corporate Valuation comes out favorably.

Yes, we have learned a lot during the last seventy years; Monks and Lajoux take readers on a tour de force of valuation methodologies. If you only have one hour to read a book on investing, choose this one. You’ll soon find it is worth the time to devote the additional hours or even days needed to plow through the remainder of the 550 pages. Written for financial professionals, most lay investors will also benefit greatly.

The authors cover the gamut. Let’s take a look at the need to read between the lines to account for paradoxes in human behavior. Behavioral economics has become a field unto itself but the authors quickly walk readers through concepts such as:

• Reflexivity. The relative weight given to factors in valuation and investing are influenced by inherently biased investors because they are active participants, not objective observers. Perceptively flawed fundamentals are self-reinforcing, leading to boom-bust cycles.
• Keynesian beauty contest. Picking who you think others will pick leads to mediocre results.
• The winner’s curse. The winner is more likely to overpay in a bidding contest.
• Cognitive bias. We pay more attention to information that confirms, rather than refutes, our bias.
• Loss aversion bias. People will risk too much, rather than walk away from small losses.
• Survivorship bias. Average performance for the group often looks better because failed companies are no longer on the list.
• Prisoner’s dilemma. Is it is human nature to defect from group cooperation to exploit a slight edge in knowledge? You may lose, if you aren’t first.

And that’s just the beginning. The author’s also have an appendix, “Antivaluation! Human Valuation and Investment Foibles,” that covers another host of tricks of the mind.

Consider this; the first chapter is 30 pages, with another 15 pages of footnotes. There’s also 130 pages of appendices. You can essentially skim and/or read in depth. Either way, there is an excellent chance that you’ll find the time well spent.

One measure that becomes increasingly difficult is estimating the value of intellectual capital. At the height of the most recent bull market, intellectual capital made up about 80% of the value of S&P 500 companies. Value minded investors focus on liquidation value but also on factors considered by those in the Enhanced Business Reporting Consortium, such as: key processes, customer satisfaction, people, innovation, supply chain, intellectual property, information and technology.

Readers of Margaret Blair’s work will be familiar with the term “firm specific human capital.” Monks and Lajoux remind us that much of the value of a firm that expands rapidly during good times is not readily convertible to cash in bad times.

In 2002, the Financial Accounting Standards Board FASB began a project “to establish standards that will improve disclosure of information about intangible assets.” By 2004 it was removed from their agenda, “apparently frustrated by the classic challenge of reconciling high relevance and low reliability.”

Here’s a few tidbits from many that I found interesting:

• Balance sheets don’t tell you much, until you compare them with others in the same industry. Precision improves as analysis becomes more specialized. The authors take us though a series of examples: chemicals, energy, banks, and insurance, with tips on what to look for.
• Find models to assess earnings at the following: Empirical Research Partners LLC, Ford Equity Research, Risk Metrics, Standard & Poor’s, and UBS.
• Both FASB and IASB have identified the cash flow statement as preeminent among the sources of financial information. The book goes on with several methodologies for considering cash flow, including: net present value of cash from a project or company, internal rate of return (IRR), payback period (PB), profitability index (PI), modified internal rate of return (MIRR, discounted payback period, (DPB), and average accounting return (ARR).

In chapter titled Hybrid Techniques for Valuation, the authors discuss 14 commonly used approaches to corporate valuation including many of what have now become the usual suspects such as economic value added (EVA) but I also found several that were new to me. One surprise was the contribution made by Eleanor Bloxham. I’ve read several articles by her but don’t recall reading about her economic value management (EVM), which she created for managers.

I won’t go into any depth here but central to her analysis is the contribution of internal and external suppliers: board, management and employees the inside… providers of capital, customers, citizens, regulators and critical observers, such as the press, on the outside. Monks and Lajoux even attempt to put those factors into formulas, although perhaps they came directly from Bloxham herself. I don’t know, not having read her Economic Value Management: Applications and Techniques.

In addition to the 14 common models for valuation, they add a word of caution regarding the need to make additional adjustments and Monks offers a 15th based on the even harder to measure factors of genius, liberty, law, markets, governance and values. The book also includes a good discussion of “social factors,” such as environmental, social and governance factors (ESG).

Several of the appendixes could become valuable resources in any library, such as the section, “Symbols Used in Financial Mathematics,” included in Appendix E. A good refresher, if you once knew; a good place to start, if you never did.

If you read the book and apply its principles, you will be among a distinct minority of investors, since the majority trade based on technical signals or the need to adjust to an index. The recent financial crisis has shown us just how rare knowledge of corporate valuation is.

Monks and Lajoux have compiled an excellent toolbox. I’ll be recommending it to several fiduciaries and will attempt to incorporate some of their tools for assessment into my own investment decisions.