Robert T. Miller Corporate Finance Outline Spring 2013
a. Intro to valuation
Tri-Continental Corp. v. Battye (p 7): Dissenting shareholders of a closed-end investment company (like a hedge-fund; an open-end investment company would be a mutual fund) sues for fair value.
– With a closed-end investment company, you cannot sell your shares and get the asset value of them. You must wait until liquidation of the company. Therefore, the NAV of the company (all the securities it owns) is greater than the market price of their stock, because the NAV won’t be realized until the firm liquidates.
o In this case, the shareholders were not entitled to the liquidation value of their shares, because the firm was treated as a going-concern (not liquidating).
§ Typically the ongoing value is higher than liquidation; you don’t want liquidation (like BestBuy). However, with this type of company (hedge fund), you want liquidation.
· Miller asks why the going-concern value and liquidation can’t both be NAV. Miller did not agree with this opinion.
o They found the value for dissenting shareholders using the Delaware Block method; kind of a kitchen sink approach.
§ This is not done anymore. àUse latest theory of investment valuation Weinberger p. 86
o This case was made to be confusing.
Dissenter’s Rights: DGCL §262: Upon merger, stockholders who object to the merger and who fulfill the statutory requirements to register their objection shall be paid the fair value of their stock on the date of the merger exclusive of any element of value arising from the expectation or accomplishment of the merger.
– Fair value does not guarantee a higher value than the merger price, so you are taking a risk
o Two values:
§ Market Value (easy to ascertain because the shares were publicly traded)
§ Intrinsic Value (i.e., fundamental or real value)
· Determined by financial theory; roughly the future cash flows discounted to today’s dollars
b. Market Efficiency
Efficient Market Hypothesis: investors know what they are doing, and you can trust that the market prices are accurate valuations of companies’ going concern assets.
– However, price changes are random and prices follow a random walk (p 17). The prices today do not help predict the prices tomorrow.
3 Levels of market efficiency:
1. Weak: knowledge of past returns/trading prices reflected in current prices
2. Semistrong: Knowledge of all published (publicly available) information is reflected in the price of all securities
3. Strong: ALL the information that can be acquired by meticulous analysis of the company and economy
o Under the strong theory, nobody would have any superior investment returns, it would all be luck
– Weak market efficiency: simply look at sequence of prices and use them to predict future prices. This follows a RANDOM WALK (like flipping a coin). These are technical analysts, and not fundamental analysts that do this.
o If it were possible to make money doing this, then everyone would do it, but then it would be reflected in market prices and be traded out.
§ Making money on this is probably impossible àTherefore the WEAK form is probably correct
– Strong form of market efficiency: Problem is that some people know of info before it goes public. If the strong form were true, then insiders wouldn’t make money with inside deals.
o The strong for is INCORRECT. Proven by insiders making money on inside deals, and also pump and dump of penny stocks. àRun up price on penny stocks and make money on the “saps” that buy it. But if everyone knew the stock was being fraudulently pumped, it wouldn’t obtain a higher price.
– Semistrong form of market efficiency: Public information is very rapidly put into the price of securities. This used to be widely accepted, but has since been systematically demolished.
o However, there is a qualified version of the Semistrong form.
§ Efficiency Paradox: if information is always put into the stock to reflect the correct price, you cannot make money. You don’t make money by buying at the correct price, you make money by buying at the lower price. Nobody would be fundamental analysts because doing so incurs great costs (time to obtain MBA or PhD), without any benefit if stocks always reflect the correct price.
· Efficient amount of inefficiency: Equilibrium of disequilibrium. There is no guarantee that people are using information correctly. There is just enough inefficiency to make incurring search costs worth it and to make a profit.
o Therefore, there is still a payoff for performing fundamental analysis; however, when you look at all of their costs (education, hiring employees, search costs) their super-market return then vanishes
o Semistrong version was accepted until the tech-bubble. With the tech-bubble these online companies were getting incredible stock prices without showing revenue. The bubble burst, and many people lost tons of money. àShows EMH failed because the publicly available information was not being used correctly.
§ However, EMH people had a response: at the time these companies showed great potential. They were high risk and high return. The facts changed and many were made worthless, but that doesn’t mean they weren’t rational investments at the time.
· Response to this response: that may be true, but the amount of money piled into these stocks was still irrational. Look at AOL: to justify the AOL stock price in the late 90’s, AOL would have had to have grown to be the biggest company in the world with the biggest profit margin in the world in 20 years. àNot rational
o Noise traders: EMH people recognize noise traders, and the theory is that noise traders cancel each other out. One dumb person buys a stock too high, and another person will sell the stock too low. Another theory with noise traders is that arbitragers can recognize them and profit on their mistakes and cancel them out at the same time.
Behavioral Finance: there are certain biases that are predictably irrational
– Example: Pennsylvania neighborhood where no children play on playground equipment. Worried about child abductors, but really a kid is much more likely drown than be kidnapped.
o Another example: teaching someone to throw a curveball; positive or negative reinforcement? Probably doesn’t make much of a difference, there will be regression to the mean.
– Small Firm Effect: Small firm stocks have abnormally high returns, even when controlling for the risk factor. Why?
o Behavioral finance people say that when people look at things that are risky, they over estimate the risk and require higher premiums for the stock
– January Effect: Stocks used to have an abnormally high return rate in January. When this information got out, the abnormal returns vanished
– Sunny Effect: When it is s
on of Returns
Financial statements encompass three items:
(1) Balance Sheet
(2) Income Statement
(3) Cash Flow
Balance Sheet: assets = liabilities + owner equity
– Cash and marketable securities are the most liquid
– Accounts receivable are the next most liquid: credits that are due soon (normally within 90 days)
– Things that don’t appear as assets: goodwill/brand name, employees (you don’t own them), positive relationships with customers/Wall Street, IP patents, etc.
o They are not on here because GAAP doesn’t include them. The theory is that we only care about things when we know their ACTUAL value. There is important stuff that we omit, but we don’t know how to value them.
– Hypo: Super Colossus buys $1 million piece of machinery: cash goes down $1 million, PP&E goes up $1 million. àYou must then factor in depreciation, and bring down PP&E accordingly each year.
o We do not account fair market value, because we don’t easily know what that is for assets
o For intangible products, we give them amortization. Depreciation is only for tangible assets.
– Things that don’t appear as liabilities: contingent liabilities àmight be facing litigation, but there is no way to determine how big of a liability that is.
– Revenue isn’t always a total cash number, you can count notes receivable too
– Hypo: you sell an asset for $3 million, you paid $1 million for it. Cash goes up $3 million, PP&E goes down $1 million, in total assets increase by $2 million.
o Correspondingly, owner equity increases by $2 million. This transaction shows up on both income statement and balance sheet.
Companies presumably go on indefinitely, and to value this, you use perpetuities.
– Perpetuity = P/r
o $7.2 million / .10 = $72 million valuation
§ Intuitively, as you get farther and farther in the future you get closer and closer to a PV of 0
– Growing Perpetuity = P / (r – g)
o “g” = the growth rate, and has to be lower than “r” the discount rate, otherwise the company is worth an infinite amount of money
– For the “P” in these equations, Berkshire Hathaway includes:
o (a) reported earnings, PLUS
o (b) depreciation, depletion, amortization, and certain other non-cash charges, MINUS
o (c) the average annual amount of capitalized expenditures for P&E.
§ (a) + (b) – (c) à “c” is a guess, and many times it is not included for valuations, and only reported earnings is used. However, (c) often is larger than (b) and therefore if they are both excluded, on average that valuation will be too high. This is contrary to what many think, because they think if depreciation and amortization is not included, the valuation will be too low.