Last week I wrote about capital market participants being overwhelmed by technology innovation and winding up totally stupid about valuation. Understanding the fundamentals of valuation theory helps us see how we got off the rails on value again – houses, stocks, etc – and how to think about value in the environment we are likely to see in 2009.
I was fortunate to do my vocational training in New Haven with some great luminaries in the field of valuation – Steve Ross, Roger Ibbotson, Bob Shiller among the more famous. I came away with a wonderful set of sophisticated tools and two fairly simple rules. Rule #1 – the best measure of “today’s” value is the price that a “willing buyer” pays to a “willing seller” (please note that “willing” is not synonymous smart but is frequently synonymous with amorous). Rule #2 – the only scientific measure of any assets value is the discounted value of the cash flows that asset can produce in the future. It doesn’t matter if the asset is a T-bill, a tech company or a first growth Bordeaux – each asset can be reduced to a black box that generates cash flow in the future. In a world populated by unemotional math majors with a common view of the future, Rule #1 and Rule #2 should produce similar results.
In the world we actually live in people make decisions from their heart, or their gut or often from one of two regions slightly below their gut. In our emotional world there are times when Rule #2 becomes irrelevant – eventually these periods are called bubbles and crashes. I remember a time in early 2000 when public technology consulting companies were trading a value that equated to over $2 million dollars per employee. Anyone with a calculator would know that even if each employee worked productively for 1000 years they could never produce the cash flow to justify the valuation.
Of course many fortunes are made by both the brilliant and the dumb playing on Rule #1. If willing buyers are paying over $2 million per employee for a tech consulting firm, then it can be smart to buy one for $1.5 million per – AS LONG AS YOU GET AN EXIT BEFORE RULE #2 COMES BACK INTO PLAY.
We all know entrepreneurs who sold at the right time and those who didn’t. We also know hedge fund managers who seem smart enough to know when Rule #2 is suspended and then recognize the signs that Rule #2 is coming back into play and exit the market with their bubble gains intact. Some hedgies are even smart enough to short the market at these times. (If you run a hedge fund – it seems pretty key to understand the current valuation fashion – or to have access to CNBC so you can create a bubble or a run on the bank.)
But if you run and/or own a company – then you run a serious risk if you try to play the market and ignore Rule #2 when making tactical or strategic decisions. Maximizing value for shareholders is about maximizing the long term positive cash flows coming out of your business – period. If an acquirer comes along who is driven by fashion (or synergy) and is inclined to pay you a lot more than your expected cash flows, then the only economic answer is to sell (are you listening Mr. Yang?).
So what is your business worth today? Unless your company is a T-bill, then there is a distinct shortage of “willing buyers.” During crashes, like bubbles, Rule #1 tends to separate from Rule #2. During a crash, few people are buying and those that do tend to pay less than the expected value of future cash flows. Just last week we saw the BOD of UK based Macro4 endorse a bid at a little better than 3x annual cash flow. Here in Massachusetts we see Soapstone trading at a 60% discount to cash. Hence the advice from Eric Upin at Sequoia to hoard enough cash to survive until we see the mood swing back towards Rule #2 – if not all the way to another bubble.
Theoretically, Rule #2 says your business is worth more or less what is was worth last year. Of course we have to adjust for recent growth and any decline that the recession might bring. In practice, if you must sell now then all valuation is relative and the comparable companies – be it Merck, Google, or JPMorgan – have been crushed since last year. If you need to sell now, then you need to find a “willing buyer” (2 or more would help) and we are afraid to state the obvious – but your value has declined dramatically since last year.
Yet another lesson for entrepreneurs that you can not control the heart, gut, or other body parts of investors. But you can do your best to control future cash flows and with adequate capital Rule #2 will set the floor on your exit value.