Finance theory offers business managers a variety of powerful tools to help evaluate whether a potential investment will add value. Most notably, these include market prices, discounted present value methods, and options pricing methods. I will focus on the first two, since their underpinnings are in efficient market theory.
In an efficient market, if relevant market prices are available, they should be a manager’s top pick out of the valuation toolbox. Why focus on market prices? Again, it is because they offer a free, broad-based opinion on an asset’s value. When managers ignore the information in prices, large and costly mistakes can occur. The most striking evidence is found in the literature on mergers and acquisitions. On average, an acquiring firm pays a substantial premium over the market price for the firm they are acquiring. Analysts prepare page after page of discounted cash flow analysis to justify the high valuations, along with appeals to operating efficiencies or other synergies that would seem to make the target very valuable. But the evidence shows that, on average, acquiring firms overpay and value is destroyed – losses to the stockholders of acquiring firms more than offset the gains to the stockholders of takeover targets. Market prices, it seems, are a better indicator of the value of takeover targets than the detailed studies of investment bankers.
Often market prices are not available, or they are clearly inapplicable to the situation at hand, as in most capital budgeting exercises. In this case the method of discounted present-value analysis is an essential valuation tool that also has its origins in market efficiency. It disciplines investment decisions by forcing managers to carefully assess the likely value added of a prospective investment, and provides a framework to examine key sensitivities. It incorporates the preferences of a company’s stockholders via the choice of the discount rate. The technique involves first projecting all future cash flows that are attributable to that project. This includes any indirect costs or benefits, such as the opportunity cost of using a facility that could otherwise be used elsewhere or sold. The idea is to set the cash flows to a realistic level, not optimistic and not pessimistic. The appropriate risk-adjusted discount rate also must be identified. A project is deemed worthwhile if the present discounted value of cash flows is positive, and is said to have a positive net present value (NPV). In an efficient market, the estimated NPV represents the best estimate of the effect of the project on firm value.
Even though discounted present value analysis is a relatively straightforward technique in broad outline, applying it effectively can be a challenge. Some people feel that projecting cash flows into the indefinite future involves so much speculation, and that the right discount rate is so uncertain, that the resulting estimates are too imprecise to be useful. The question though, is whether there is a better choice. Certainly it is better to have an imprecise estimate of value than no estimate at all or one that is based on an overly simplistic rule of thumb. In the end all investment decisions are subjective, but numbers help to inform judgment and point to potential flaws in purely intuitive evaluations. Explicitly identifying expected future cash flows allows analysts to test the sensitivity of value estimates to these assumptions. Maybe your best guess is that cash flows will grow at 8 percent per year after ten years, but will the project still be worthwhile if the growth rate is only 6 percent? The only way to tell is to lay out alternative assumptions about cash flows and discount rates, and see whether, over a reasonable range of assumptions, a candidate project still appears to be worthwhile.
Some analysts use multiples as an alternative to present discounted value analysis. The idea is that comparable companies should trade at comparable multiples. If, for instance, most computer manufacturers trade at multiples of 20 times earnings, then a company trading at 25 times earnings would appear to be relatively expensive, unless some additional source of value can be identified. This type of analysis rests on the questionable assumption that companies in similar lines of business are in similar positions with respect to earnings and value. It also skirts the question of whether the general level of prices is reasonable. This problem was made abundantly clear with the crash of Internet stocks. Internet stocks were often evaluated in terms of multiples, in part because it seemed impossible to predict when positive cash flows would actually appear. A discounted present value analysis would have identified the lack of foreseeable cash flows as a red flag, but multiples analysis de-emphasizes this problem by focusing primarily on relative value.
For firms that rely on discounted present value analysis, correctly identifying the cost of capital is critical. It is a major determinant of which projects a company will take on and which it will reject. If the rate-of-return hurdle is set too high, managers will pass up profitable investments. If it is set too low, value- destroying projects will be accepted. There are several important considerations to keep in mind in determining the cost of capital.
The first rule is that a project must be evaluated based on a discount rate that reflects how much market risk is associated with it. For a public company, its diversifiable risk is generally not a concern. This rule for choosing a discount rate follows from market efficiency. As discussed above, in an efficient market, diversified investors, whose concern is primarily with market risk, determine share prices. Managers acting on behalf of diversified investors must therefore evaluate whether the expected return is commensurate with the type of risk investors care about. In practice, market risk is usually quantified using a financial model such as the Capital Asset Pricing Model (CAPM). The model provides an estimate of an investment’s “beta,” a measure of the amount of market risk. Some managers make these estimates themselves, while others use the services of a financial consultant. The details of the CAPM and related models are beyond the scope of this essay, but a comprehensive discussion can be found in any modern finance text.
A related principle that is too often overlooked is that the relevant market risk is that associated with the project under consideration. This may be very different from the overall risk of the company. The idea is that the project should be evaluated based on the amount of market risk it contributes to the company at the margin. For instance, if a company that is primarily in the aerospace industry has the opportunity to invest in a supermarket chain, the cost of capital for that project is the one associated with supermarkets, not aerospace. The logic is that investors in an efficient market view companies as a portfolio of all their investments. They therefore require a weighted-average return that reflects the relative importance of each component. If the company consists of 70 percent aerospace, 20 percent electronic components, and 10 percent supermarkets, investors will require a return reflecting the cost of capital for aerospace, electronic components, and supermarkets, with weights of 70 percent, 20 percent, and 10 percent, respectively.
Notice that in describing the determinants of the required rate of return, there has been no mention of how the project is to be financed. This is deliberate. The reason that financing can be neglected is also attributable to market efficiency. Investors in a company’s debt and equity require different rates of return because the two types of investments have very different amounts of market risk. Debt, with its first claim on any cash, carries significantly less risk than equity. A firm’s assets, however, tie down its total amount of market risk. This total risk is conserved, no matter how it is split between debt and equity. Even though debt holders require a lower return than equity, a firm cannot necessarily lower their required rate of return by issuing more debt. Taking on additional debt makes both the debt and the equity of the firm riskier, increasing the required return on both debt and equity.
Serious mistakes can result when companies fail to take these valuation principles into account. Several years ago, an executive MBA student in Thailand told me that his company was getting loans from its Japanese parent company at a rate close to zero percent. As a result, the management considered its cost of capital to be almost nil, leading them to adopt some very marginal projects. The problem with management’s logic was to equate the required return on debt with the overall required return, neglecting the considerable risk borne by stockholders. Companies that invest in risky projects can never have a cost of capital close to zero, even if they can borrow at a very low rate. If other Japanese companies were similarly underestimating their cost of capital, this may be one source of the continuing problems plaguing the Japanese economy.