Simple corporate finance rules for strategists

Valuation - projects and companies

It’s about cash. Earnings can be a good proxy if depreciation and capex are broadly inline and have been for several years. P/Es give you a sense of how expensive earnings are comparatively (and tell you about growth expectations)

1. It’s about cash over time. In particular expectations of future cash.

2. Perpetuity maths are simple - use them as a default. A good debate about the assumptions going in to a perpetuity trumps burying assumptions in a DCF

3. Growth is good. But it is irrelevant if it doesn’t flow through to cash today, or doesn’t have a path to do so tomorrow.

4. Multiples are a function of growth, cash conversion and cost of capital. Implicitly, peer multiples are therefore only a good proxy if the peer has similar growth, cash conversion and cost of capital. Investment decisions should not rest on multiple expansion assumptions as this is dependent on the perception of others, and therefore cannot be controlled.

5. WACC is overly complex and unhelpful - 8% won’t steer you too far wrong for a large corporate, unless the business is more risky than normal or has recently had ups and downs, in which case use 10%.

6. WACC is also relative not absolute. During negative interest rates and massive quantative-easing the cost of capital has been much lower than the “calculated” outcome. This reflects excess demand for high(er) yielding options. Investors behave accordingly.

7. Projects in the core business should use the base rate WACC. Expansion projects that are more risky (albeit synergistic with the existing business) should be measured against an approximately 25% premium to base rate WACC to reflect the additional risk.

Sources & uses of capital

Sources

8. Private sources of equity are very expensive. They should only be used if there are no other alternatives available or if public markets are unwilling to fund / support the journey the company is on.

9. Debt accelerates returns to equity. Broadly 0.5 debt/(EV-cash) -> 2x RoE. Debt is also cheaper than equity and provides a tax shield. It is also desirable in that it forces management to pay interest and meet obligations so it forces discipline. Therefore the “right” amount of debt is a/ as high as possible while b/ not leading to more expensive debt and c/ not leading to distress in plausible economic and market scenarios. This is a judgment call, as well as a reflection of rating agency and debt market conditions.

Uses

10. Capital should be seen as plentiful but expensive. Shareholders expect operational managers to allocate capital against all value creating opportunities in front of them that fit with the capabilities of the organisation. They are happy to increase the capital available to the organisation if needed to go after attractive opportunities.

11. A progressive dividend policy is seen as a symbol of management’s confidence in the strength of the business’ positioning and ability to generate “excess” returns. So a strong business is either one that is growing rapidly or is able to deliver on a strong year-on-year dividend profile. As an aside, a dividend yield > 8% typically reflects that the company is expected to have to cut its dividend. An uncovered dividend occurs when the dividend is not covered by operating cash flows - either a sign of growing weakness or management confidence in the business’ future prospects.

12. If the business has too much cash compared to the opportunities available, shareholders expect the business to return the cash through dividends or share buybacks. The choice between the two depends on the tax treatment of the two (income tax vs. Capital gains). By in large share buybacks are preferred for one-off distributions.

M&A

13. Shareholders consider themselves to be better resource allocators than operational managers. If there are no synergies between assets, shareholders would prefer to make their own portfolio decisions rather than leave this allocation to operational managers. As a result, assets with no synergies should be divested, and synergies should be seen as a pre-condition of any acquisition. Failure to do so results in a conglomerate discount.

14. Markets are willing to support acquisitions if they can see a strong strategic logic for a deal and there are clear synergies. However, unless the deal is earnings accretive in years 1 or 2, confidence in management would need to be extremely high for there to be support (unless very small) since implicitly it is a “trust me” deal. Ideally the deal should also be accretive solely on the basis of the cost synergies identified as revenue synergies are frequently speculative.

15. Selling assets requires careful preparation and carve out of the legal entities to be divested. Arms-length contracts between an entity and other parts of the group need to be established and can form the basis of any transition services. Carving out is an 18 months journey. At least 6 quarters of audited financials for the new perimeter is also required for a clean high quality sale.

16. There is no such thing as a merger of equals. One company ultimately takes over the other, and it shows.

Managing equity markets

17. Shareholders expect management to be transparent and open with them. Earning the market’s trust by delivering on commitments and calling any issues transparently and openly is key for management. Any deviation from consensus expectations therefore needs careful steering and communications. Failing this test, companies become “show-me” stocks i.e. ones where everything management says is discounted and the company is judged purely on the financial results generated with no reserves of trust and goodwill to draw upon.

18. Yet being transparent is difficult as internal discussions make calling reality hard: presenting a different long-term plan to the board requires (external) disclosure. This means plans are frequently not accepted / signed-off / final. This means where issues exist there is a dance with scenarios; ongoing work on the plan etc to avoid crystallising any issues until as late as possible. This can result in missing the opportunity to call any issues. This requires explicit leadership from the CEO / CFO (and the board)

19. Many shareholders are not conviction holders - passive funds etc. require holdings. Near-term holders are buying the exposures or the mean-reversion hope. Long-term ‘Conviction’ holders are an important quality signal. Large amount of shorting or activist interest is a warning sign regarding market support for management or strategy.