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2020 | OriginalPaper | Chapter

2. The Value Triangle

Author : George Calhoun

Published in: Price and Value

Publisher: Apress

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Abstract

As of 2018, the Ford Motor Company operated in dozens of countries, with around 75 production facilities on five continents and tens of thousands of dealers. It employed over 166,000 people to design, produce, and sell hundreds of different products and services, to millions of customers, generating a continuous stream of cash flows, profits, and dividends and providing the fuel for innovation and reinvestment to allow for future cash flows to continue and hopefully to grow. The company buys, sells, invests, divests, and distributes various assets continuously, transacting in many currencies and under many systems of commercial and financial regulation around the world. Its fortunes are constantly in flux, depending on its strategic choices (and those of its competitors) and on the changes in its economic environment (trends in regulation, business cycles, credit conditions). Ford’s value is not just a function of the present moment; it incorporates a broad horizon of expectations regarding the future performance of the company and future states of its environment.

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previous chapter The Ford Dollar: The Mysterious Multiple

next chapter Valuation Ratios

For some reason, many academics prefer to use the inverted form: a Book/Price ratio, B/P. Keeping in mind that, in the nature of any ratio, a high P/B will correspond to a low B/P, the metrics are otherwise the same. Whether this confusion serves any other purpose…

Baruch Lev, Intangibles: Management, Measurement, and Reporting (Washington, D.C.: Brookings, 2001).

All figures as of mid-2018.

Adapted from Baruch Lev, Intangibles: Management, Measurement, and Reporting (Washington, D.C.: Brookings, 2001).

The category “intangible assets” does sometimes appear on the balance sheet, typically when a company has purchased them, and the cost of acquisition can be specified. But the vast bulk of the “intangibles” are simply invisible and show up nowhere in the financial statements. For example, in 2018, Coca-Cola listed several categories of intangible assets on its balance sheet: Trademarks ($6.7 Bn), Goodwill ($9.4 Bn), and “Other Intangibles” ($368 Mn) – a total of about $16 Bn of identified intangibles. But Coke’s Market Capitalization was about $180 Bn, compared to just $17 Bn in Book Value. Something over $150 Bn in valuation is unaccounted for.

Intangible Asset Market Value Study, Ocean Tomo, 2017. “IAMV is determined by subtracting a company’s net tangible asset value from its market cap to determine its net intangible asset value.”

Adapted from Intangible Asset Market Value Study, Ocean Tomo, 2017.

The American Institute of Certified Public Accountants has acknowledged this problem in their Draft guidelines for assessing the fair value of an enterprise: “A historical reporting basis, such as cost, does not provide meaningful comparability across investments” (AICPA Task Force, Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies, Draft (May 15, 2018), paragraph 2.07.

There are other problems with respect to the use of Book Value as a measure of enterprise value. Many of the standard balance sheet asset categories are arguably not assets in the true sense, but more like liabilities. Inventory is a good example; excess inventory is widely seen as a danger signal. Even cash can become more of a liability than an asset under some circumstances. See Chapter 3 for a discussion on Cash-Adjusted Price-to-Earnings.

An argument can be made that Book Value is still useful in evaluating firms in the financial sector, since the majority of their assets are financial assets (e.g., cash, tradable securities, loans with good credit standing), which have values that are easy to convert into current dollars. The financial sector has the lowest P/B ratio of all the sectors in the S&P 500, about 1.68 as of this writing [May 2018].

John Burr Williams, The Theory of Investment Value. Harvard University Press, 1938. The opposing view was perhaps best characterized by John Maynard Keynes, a sort of Behavioral Economist avant la lettre, who held that “animal spirits” played a large and perhaps decisive role, instead of formal calculation of returns, as Williams argued (J. M. Keynes, The General Theory of Employment, London, 1938).

The only important nuance was whether dividends alone were sufficient or should net earnings forecasts also come into the valuation picture. Gordon (writing in 1959) put it this way: “The three possible hypotheses with respect to what an investor pays for when he acquires a share of common stock are that he is buying (i) both the dividends and the earnings, (2) the dividends and (3) the earnings. It may be argued that most commonly he is buying the price at some future date, but if the future price will be related to the expected dividends and/or earnings on that date, we need not go beyond the three hypotheses stated” (M. J. Gordon, “Dividends, Earnings, and Stock Prices,” The Review of Economics and Statistics, Vol. 41, No. 2 (May 1959), pp. 99–105). Of course the orthodox view – embodied in the Miller-Modigliani “dividend irrelevance” proposition – would imply that the first of Gordon’s hypotheses is the correct one. See Chapter 1, Footnote 1.

Florian Steiger, “The Validity of Company Valuation Using Discounted Cash Flow Methods,” European Business School, 2008.

Data drawn from Florian Steiger, “The Validity of Company Valuation Using Discounted Cash Flow Methods,” European Business School, 2008.

Stephanie Larocque, “Analysts’ earnings forecast errors and cost of equity capital estimates,” Review of Accounting Studies, Vol. 18 (2013), pp. 135–166.

Of course, for some purposes, the DCF method may be the “least worst” answer. Valuing a private asset, which has no public market, may invite DCF modeling, if there are no good market-based comparables or similar transactions to consult. Some types of assets – e.g., a rental property with fixed rental agreements for long-term tenants in a stable neighborhood – may be somewhat more suitable for DCF. But for a dynamic public company, in a competitive market, in a typically changeable economic and regulatory environment, the DCF approach will not do. The market price is a superior starting point for valuation analysis.

It is noteworthy that the Financial Accounting Standards Board – the guardian of accounting orthodoxy –has recognized this principle: “A quoted price in an active market provides the most reliable evidence of fair value and shall be used without adjustment to measure fair value whenever available” (FASB 820, Fair Value Measurement (May 2011), paragraph 820-10-35-41).

Charles Henry Dow, Scientific Stock Speculation, The Magazine of Wall Street (1920), p. 37.

Robert Shiller, “Stock Prices and Social Dynamics,” Brooking Papers on Economic Activity, Vol. 1984, No. 2 (1984), pp. 457–510.

The Efficient Market Hypothesis accepts, in its revised versions, that there is some degree of “noise” in the market, which causes the constant small fluctuations in the price viewed over small timescales. Some revisionists also accept that the EMH can allow for small lags in adjusting to new information, so that small and temporary mispricings can occur while preserving the overall context of an equilibrium-seeking efficiency.

Aaron Black, “Walt Disney Has Good Reasons to Remain in Fox Chase,” The Wall Street Journal, June 21, 2018.

Jack Hough, “This Picture Could Still Have a Happy Ending,” Barron’s, April 30, 2018.

Matthew DeBord, “It’s Become Almost Impossible to Figure Out What Tesla is Actually Worth,” Business Insider, August 19, 2017.

For example, on Sunday, May 20, 2018, Tesla CEO Elon Musk announced (on Twitter) that the forthcoming flagship Model 3 – the company’s key mass market offering – would be delayed and perhaps even canceled. He said that actually trying to produce the low-priced Model 3 Tesla could cause the company to “lose money and die” – an unusually dire assessment from a CEO, prompting The Wall Street Journal to ask “Is Tesla Abandoning the Mass Market?” [May 21, 2018.] Still, the price of Tesla’s shares jumped 5% on the following Monday morning. Did Musk’s pessimism suddenly create several billion dollars of shareholder value?

Lately this price point has even acquired a name – the NBBO (National Best Bid and Offer) – and a formidable legal significance. Actually, the complexity of the exchange network today allows for the existence of multiple price points (within a small range) simultaneously on different platforms – which complicates market regulation considerably. As well, the exchange network produces other signals, such as trading volume, bid and ask spreads, order types (e.g., limit vs. market orders), and order book depth, which have some applications but generally do not bear on enterprise value per se.

Algy Hall, “Taking Price-to-Book Ratio to Book,” Investors Chronicle (Financial Times), May 25, 2018: “The price-to-book ratio (P/BV) has a very special place in the hearts of many ‘value’ investors. Indeed, the ratio was made a value classic by no less than ‘the father of value investing’ Benjamin Graham. In his 1949 value-investing bible, The Intelligent Investor, he suggested the ratio be used to identify not only potentially superior returns, but also to measure the ‘margin of safety’ of an investment. Adding to P/BV’s status as a key ratio for identifying value was the evidence of the relationship between low P/BV and improved long-term investment return presented in the hugely influential three-factor model developed by academics Eugene Fama and Kenneth French.”

Alexander Nezlobin, Madhav V. Rajan, and Stefan Reichelstein, “Structural properties of the price-to-earnings and price-to-book ratios,” Review of Accounting Studies, Vol. 21 (2016), pp. 438–472: “Textbooks frequently view a P/B ratio equal to one as ‘normal,’ though it is commonly understood that both anticipated future profitability and conservative valuation of incumbent assets tend to push this ratio above one.”

The difference – and I believe the advantage – is that ROA is unconcerned with how the productive assets were financed, whether through external investment or retained earnings, debt, or equity. It measures the operational value of the business, rather than the value returned to the shareholder as a function of her invested capital.

See examples in Chapter 4.

Efthimios G. Demirakos, Norman C. Strong, and Martin Walker, “What Valuation Models Do Analysts Use?” Accounting Horizons, Vol. 18, No. 4 (2004) pp. 221–240.

This is for Trailing P/E. The Forward P/E uses a forecast of next year’s earnings. See Chapter 3.

Although, even if we rule out “fraud” in the E denominator – a very rare issue in the American markets – we are still left with a set of definitional uncertainties, some of which can be significant. We will consider these in Chapter 6.

Title: The Value Triangle
Author: George Calhoun
Publisher: Apress
Book: Price and Value
Print ISBN: 978-1-4842-5551-3

Electronic ISBN: 978-1-4842-5552-0

Copyright Year: 2020
DOI: https://doi.org/10.1007/978-1-4842-5552-0_2