assets. In technical terms, it is the present value of the future cash flows (the economic profit) of an asset that determines its value. (This subject and its methodology are covered in detail in the next chapter.) But the concept of value is a human invention—one that requires an understanding of human nature and the conflict between rational and irrational behavior in determin- ing value. As stated earlier, the process for determining what is known as the intrinsic value of an asset is fairly straightforward—you take the economic profit of today and forecast its growth rate. You then reflect that future eco- nomic profit in today’s dollars (or euros or yen or currency of your choice) by discounting it using a calculation that incorporates the opportunity cost of in- vesting elsewhere and the riskiness (a/k/a uncertainty) involved. This process is call the discounted cash flow method—the most widely accepted formulaic approach to determining the value of an asset. And, as you will see in the next chapter, the process of calculating the intrinsic value is not an overly compli- cated one. In fact, the most basic version, the Gordon growth model, is so simple to calculate, anyone could do it with a simple three-function calculator (add, multiply, and divide). Actually, the calculating is the easy part. The hard part, the very hard part in fact, is getting the inputs right.
For example, a change in interest rates will have a significant impact on the valuation model inputs because it makes alternative investments like short-term fixed income instruments more attractive vis-à-vis stocks. This then increases the odds of more money being invested in bonds and less money being invested in stocks. A rise in interest rates also raises the cost of capital, which reduces the value of stocks as calculated in valuation models such as the discounted cash flow model. An increase in the cost of capital is an increase in the discount factor of the future economic profit, and that typically results in a lower value for a stock. Lastly, a rise in inter- est rates increases the borrowing costs for businesses, thereby impacting the income statement of a business; this is likely to lead to a reduction of the company’s profitability and growth rate, resulting in a lower valuation.
This example demonstrates the importance of how changes in interest rates can impact a company and its stock in various ways—all of which impact several elements of the valuation model.
Flights of Investment Fancy
A good way to illustrate this issue of simplicity and complexity comes from a book on investment analysis by Robert Higgins, Analysis for Financial Management(McGraw-Hill, 2003), in which the author equates investment analysis and valuation modeling to flying an airplane. Higgins states that flying an airplane, be it a two-seat Cessna Skyhawk or a jumbo jet, is based on exactly the same principles of aerodynamics: lift, drag, and thrust. Every
plane flies on these three principles—including our small Cessna and our large jumbo jet. The principles that enable one plane to go forward, up, down, right, and left are the same principles for the other; the only differ- ence between the two aircraft is complexity. Well, the same is true of valua- tion. The only difference between determining the value of an asset and getting the correct inputs to the formula is complexity. There are many moving parts, and some that are interactive, thereby causing an effect on the other. That leads to a great deal of hard work in getting the data for the inputs right. But the core concept of the inputs is beautiful in its simplicity.
Therefore, the first aspect of valuation that must be appreciated is the fact that the simplicity of the model belies the complexity of being right about the inputs. And because the economy (domestic and global) is a dy- namic place, a highly interactive place, a place where uncertainty is high, getting the inputs correct is the holy grail of valuation. It’s not an easy task, which takes us to another concept that needs to factored into our valuation equation—interactive feedback.
The real economy is highly interactive and interdependent with the fi- nancial economy. And while they may appear to act in isolation, the truth is that what occurs in the real economy has a profound impact on the fi- nancial economy (the markets). And vice versa. A term that describes this dynamic, interactive, interdependent world we live in is reflexivity,21 coined by billionaire George Soros.
We live in a very dynamic world in which various actors impact each other, producing a fairly highly unpredictable environment at times. It is a world in which companies operate, produce products and services, and manage their resources, and they must understand this world well enough so that they can produce economic profits and growth with the least amount of uncertainty. With so many moving parts, companies have their work cut out for them. For investors, there are the added layers of in- vestor expectations; investor emotions like fear and greed; reliable com- pany, industry, and market information capture and analysis; and macro environmental impacts and influences such as governmental action and monetary policies, to name a few. Turning all this data and information into correct inputs into financial models of companies and industries and then into valuation models is a very, very hard thing to do consistently.
RATE OF RETURN > COST OF CAPITAL
The 1980s marked a key turning point and a power shift away from cor- porate America and to Wall Street. And while the decade will be most remembered for the scandals of Ivan Boesky, Michael Milken, and other
masters of the universe, it was also the starting point for the emergence of independent financial managers with clout—money managers who could demand that the senior management of publicly traded companies adhere to value creation principles and move away from perks.
The demands made to the corporate managers were in the form of earning a rate of return in excess of their cost of capital, thereby creating and not destroying value. This revolution, while at times taken to extremes over the past two and half decades, has helped transform how companies are managed. Corporate strategies have been impacted by independent fi- nancial managers.
A central component of the independent financial managers’ approach was a near obsession with creating value.
Earning a rate of return in excess of the cost of the capital possessed by a firm was the mantra. New methodologies such as Stern Stewart’s economic value added (EVA) and Holt’s cash flow return on investment (CFROI) be- came the rage. The value-creation craze even found its way to Wall Street an- alysts as several major Wall Street firms began incorporating value-based approaches (as they were known) into their research methodologies.
The importance of all this and the value to investors is how the dy- namics of managing a business changed. Senior corporate management could no longer ignore the imperative of earning a rate of return on in- vested capital in excess of the cost of that capital.
Whether in regard to a stock investment or a business investment, the issue is the same: Investing involves a risk/reward trade-off. That trade-off must be made by producing a rate of return that is greater than the required return. If not, value is destroyed, because the opportunity cost of not utiliz- ing that money elsewhere at a rate greater than the required return is a value-destroying proposition. This development is profound as it has changed the economic and investment landscape dramatically over the past several decades and has led, no doubt, to the improved managerial skills of corporate leaders today. Senior management knows that the capability of fi- nancial managers, not to mention other more growth-oriented and acquisi- tive corporate leaders, will step into the picture and take the assets of the business away from existing management in the form of a merger or acqui- sition and attempt to earn a rate of return in excess of its cost of capital, its required return. This development has literally changed corporate America.