Tuesday, May 17, 2005

Company Value

What is a company worth? There are several possible ways of answering this question.

Book Value / Balance Sheet Value
This is the value that is calculated by accountants and verified by auditors, largely based on a historical view of the company's past and present transactions. This value is published periodically (typically 1, 2 or 4 times a year). However, in principle it could be calculated or estimated in near real-time, given sufficient access to company transaction data.
Market Capitalization
This is the value that is derived from the current share price. It is largely based on investor's views of the company's future prospects, as well as general market sentiment.
TakeOver Value
This is the value that someone is prepared to pay to win control/ownership of the company. (There may be different take-over scenarios, with a different valuation attached to each scenario.)
BreakUp Value Sum-of-the-Parts
This is the value that the company would be worth if broken into separate parts. (There may be different ways of breaking up the company, resulting in different valuations.)

We can make a number of observations.
1
In an idealized rational world with perfect information, we might expect all these values to be the same.
2
In the real world with imperfect information, these generally yield different answers. Some people may like to think that one of them reflects the "true" value of the company. But it is generally better to regard them as simply reflecting different kinds of truth about the company, each valid in its own terms.
3
These also vary on a different timescale. The shareprice of a large company (and therefore the market capitalization) may fluctuate many times in an hour, but it is unlikely that the book value changes with this degree of volatility.
4
A company should normally be worth more than the sum-of-the-parts, because there is some synergy between the parts. But this isn't always the case. When the market capitalization is considerably less than a sum-of-the-parts valuation, it is possible to make money by buying the company and immediately breaking it up. One version of this is known as Asset Stripping, where the new owners profit by selling assets that are worth more than the book value.
5
In a takeover situation shareholders usually expect to be offered a premium to the share price, as an incentive to give up their shares. When a takeover is rumoured or announced, the share price usually rises to a value close to the expected takeover price, and so the market capitalization converges with the takeovervalue.
6
After a takeover, some parts of the acquired company may be immediately sold. This may be to recoup or repay the money that was staked on the acquisition, or to satisfy the demands of the regulator. But where these sales are forced or hurried, they may not realize the most favourable sum-of-the-parts valuation.
7
In the long term, these different valuations cannot continue to diverge. The valuations remain coupled, although extremely loosely, and there are various ways in which the valuations may be brought back into alignment. (These are basically feedback loops with very long delays.) Speculators sometimes make large amounts of money by betting on future market adjustments. But the timing of these adjustments cannot be accurately predicted, and speculators sometimes lose large amounts of money by predicting the right adjustment at the wrong time. As Keynes noted, markets can often remain irrational far longer than an individual investor can remain solvent.

One way of experiencing this complexity is by tracking the shareprice and newflow of a large company over a period of some weeks or months. Sometimes shareprice changes can be explained in terms of the newsflow of the company, including takeover rumours; sometimes they can be explained in terms of the economic environment (competitor newsflow, commodity prices); and sometimes they appear to be little more than random fluctuations.

In Spring 2005, we picked four companies quoted on the London Stock Exchange, and asked our students to track one of these companies and interpret the results. This assignment was intended to give students a practical awareness of the extent to which shareprice could be a meaningful indicator of the present value and future viability of a company, as well as practice in interpreting data. By a happy chance, two of the companies were subject to acquisition speculation during the tracking period, which generated some interesting data for the students to work with.

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