ManagementJournalVol.21,No.5,pp.635–646,2003
2003ElsevierLtd.Allrightsreserved.
doi:10.1016/S0263-2373(03)00112-
9 PrintedinGreatBritain0263-2373/$30.00 WhyisFundamentalValuesoFundamentaltoDirectors?
ADRIANBUCKLEY,CranfieldSchoolofManagement Fundamentalvalueforafirmisthatrangeofvaluebaseduponthepresentvalueofestimatedfuturecashflows.Fundamentalvalueandmarketvaluemaydiffer. Wheremarketvalueisabovefundamentalvalue,thefirmmaycreatewealthfromjudiciouslytimedequityissuestopartieswhoarecurrentlynonshareholders,particularlyintakeoversituations.Wheremarketvalueexceedsfundamentalvalue,returnofsurplusfundsshouldlogicallybeviaaspecialdividendratherthanasharerepurchase. Wherefundamentalvaluepershareexceedsmarketvaluepershare,thefirmmaycreateshareholdervalueforcontinuingequityinvestorsbytimelybuybacks.2003ElsevierLtd.Allrightsreserved. Keywords:Fundamentalvalue,Intrinsicvalue,Marketvalue,Financing,Takeovers,Sharerepurchases FundamentalValue(akaIntrinsicValue) WhydidMarconipaycash,ratherthanshares,initsacquisitionofUShighpanies?
WhydidFrancedomuchthesameinitsprogrammeofhightechacquisitions?
WhydidadvertisinggiantWPPfundits2001acquisitionofTempuswithcashasopposedtoofferingitsequityasconsideration?
WhydidRentokilInitialundertakeasharebuybackprogramme?
AndwhydidCableandWirelessdothesame?
Notallofthesefinancingdecisionsareexamplesoflogicalmanagerialtactics.Weconcludethattwoappeartofallintothecreditablecategoryandthreeareexamplespromisingvaluedestructionforshareholderswhocontinueto holdthesharesofthefirmsconcerned.Whydowereachtheseconclusions?
Becauseweapplytheideasoffundamentalvaluetotakeoverfinancingandsharebuybacks. Butwhatdowemeanbyfundamentalvalue?
Andwhyisitsoimportant?
Initially,inthispaper,wefocusupontheformerquestion.Wedefinefundamentalvalue(orintrinsicvalue,asitissometimesknown)forafirmanddemonstratehowitmaybeapproximated.Wethenmoveontohighlightitsimportance.Wearguethataclearideaoffundamentalvalueisofcentralrelevancetotheimplementationofalogicalfinancialstrategydesignedtoenhancevalueforshareholders.Weconcludethatindividualmembersofcorporateboardsarelessthanreasonablyequippedtocarryouttheirdutiesintheinterestsofequityinvestorsiftheyarenotuptospeedonicoffundamentalvalue.Inthisarea,wewouldplacefundamentalvalueasacentralbuildingblockin-leveldecisionsrangingfromacquisitionstodivestments,fromthefinancingoftakeoverstosharerepurchases.Ifourviewofitspivotalroleinthesestrategicareasofpotentialvaluecreation—ordestruction—isconvincinglyarguedandepted,ourclaimforitscriticalimportancetoboardsofdirectorscannotbedenied. Theordericsconsideredinthispaperisasfollows: ❖definitionoffundamentalvalue❖howfundamentalvaluemaybeapproximated❖whyfundamentalvalueissoimportantininvest- mentanddivestmentdecisions❖whyfundamentalvalueissoimportantinfinanc- ingacquisitionsandotherfundingdecisions❖whyfundamentalvalueissoimportantinshare repurchasedecisions EuropeanManagementJournalVol.21,No.5,pp.635–646,October2003 635 WHYISFUNDAMENTALVALUESOFUNDAMENTALTODIRECTORS?
WhatisFundamentalValue?
Fundamentalvaluepershareforafirmcanbedefinedasthevaluethatderivesfromananalysisbaseduponthepresentvalueofestimatedfuturecashflowsforthefirm.Thekeyunderpinningofsuchananalysisisdiscountedcashflow,thegoldstandardofvaluation. FundamentalvalueisakintotheconceptofintrinsicvaluewidelyencounteredinthewritingsofBenjaminGraham—see,forexample,Graham(1973).ButthetermwasfirstcoinedbyArmstrong(1848).ordingtoArnold(2002),althoughothersexpressthesamesentiment,‘Grahamisregardedasthemostinfluentialofinvestmentphilosophers’.AndGrahamearnedthedescriptionthe‘smartestmanIeverknew’fromWarrenBuffett—seeLowe(1997). InGrahametal.(1962),theauthorsstatethat‘ageneraldefinitionofintrinsicvaluewouldbethatvaluewhichisjustifiedbythefacts,e.g.,assets,earnings,dividends,definiteprospects,includingthefactorofmanagement’.Theygoontosaythat‘theprimaryobjectiveinusingtheadjectiveintrinsicistoemphasisethedistinctionbetweenvalueandcurrentmarketprice,butnottoinvestthisvaluewithanauraofpermanence.Intruth,putedintrinsicvalueislikelytochange...asthevariousfactorsgoverningthatvaluearemodified.Butinmostcasesintrinsicvaluechangeslessrapidlyanddrasticallythanmarketprice’. Theysubsequentlysaythat‘themostimportantsinglefactordeterminingastock’svalueisnowheldtobetheindicatedaveragefutureearningpower,i.e.theestimatedaverageearningsforafuturespanofyears.Intrinsicvaluewouldthenbefoundbyfirstforecastingthisearningpowerandthenmultiplyingthatpredictionbyanappropriatecapitalisationfactor’. Atthetimeoftheirwriting,theapproachofthesepioneersofinvestmentvaluationwasinnovativeanditwouldjustifyarangeofvalue,giventheinevitableuncertaintiesinforecasting. HowisFundamentalValueApproximated?
Atanunsophisticatedlevel,arangemaybeestimatedforfundamentalvaluebyforecastingfuturecashflowsatoptimistic,mediumandpessimisticlevels.Followingdiscountingandtheuseofsubjectiveprobabilities,aweightedaveragevaluemayresult.Atamuchmoresophisticatedlevel,MonteCarlosimulationorrealoptionsvaluationmayberesortedtoinordertoarriveataspectrumofvalue—seeDamodaran(2002)formoredetails.Ofcourse,plicationsariseinchoosingtheappropri- atediscountrateand,maybe,inestimatingterminalvalues. Whetherequityvaluesarearrivedatviaadividenddiscountmodelwithaterminalvalueorviafreecashflows,thefigurearrivedatshouldparable—fordetailedmethodologyseeDamodaran(2002).Histextalsoshowshowvaryinggrowthratesmaybeincorporatedintothevaluation. Differentdiscountingapproaches,suchaspurediscountedcashflow,adjustedpresentvalueorfreecashflowtoequity,ifimplementedcorrectly,shouldarriveatthesamebottomlinevaluation—seeRossetal.(2002).Usingthebasicdiscountedcashflowmethod,atemplateforequityvaluationappearsinTable1.Thisbeginswithavaluationofeachofthefirm’soperationsaggregatedtogether.Withsurplusassetsaddedinandwiththepresentvalueofdebtandnon-equityshareholders’interestsandminorityinterestseliminated,wearriveatthefundamentalvalueofpany’sequity.Afterallowingforoptionsandthelikeanddividingbythenumbersofequitysharesinvolved,anestimateoffundamentalvaluepershareisobtained.Naturally,thisprocessmayrequiresomerefinementwhereindividualcircumstancesvaryfromthebasicmodel. Itisworthmentioningthataplicationarisesinrespectofliabilitiesversusassetsinthefirm’spensionfund.Thisisparticularlythecasewherepanyrunsafinalsalaryscheme(oranyotherfundofferingdefinedbenefits).Basedonstockmarketlevelsofassetsataparticularpointintime,pensionfundliabilitiesmightexceedassets—orviceversa.Buildinginthisfactorwillusuallycreateawiderrangeoffundamentalvalue.Sowillvarioussensitivityanalysisexercisesinthisarea.Forexample,thepreferredmethodofdealingwiththeproblemmightbetoassessthedeficitorsurplusinthepensionfundbyvaluingassetsinordancewithlong-runaveragemarketlevelsandreturns.Sothebasecasevaluemaybeinlinewithlong-runequitylevelsreflectingaprice/earningsratio1ofbetween13and14andanequityreturnofaround6percentin2realterms—seeDimsonetal.(2002).Aroundtheselong-runinputs,furthersensitivitiesmightbebuilt. Wewouldstressthatusingthetemplateinthetableshouldideallybepaniedbypinpointingandappraisingassumptions,businesslogicandusingratioanalysisandotherrealitychecks.Rememberthatfirmsachievinghighrelativereturnsoncapitalorhighmarginsversustheirreferencegrouprarelycontinuetodosoforlongunlesstheirmarketpositionisunderpinnedbysubstantialbarrierstoentry,monopolypositionsgrantedbygovernments,orbypatentprotectionorthelike.Withthisbackground,questioningandshadingofforecastreturnsand/ormarginsmaybecalledforinthemodellingexercise.Insupportofthereferencetotheunsustainabilityof 636 EuropeanManagementJournalVol.21,No.5,pp.635–646,October2003
9 PrintedinGreatBritain0263-2373/$30.00 WhyisFundamentalValuesoFundamentaltoDirectors?
ADRIANBUCKLEY,CranfieldSchoolofManagement Fundamentalvalueforafirmisthatrangeofvaluebaseduponthepresentvalueofestimatedfuturecashflows.Fundamentalvalueandmarketvaluemaydiffer. Wheremarketvalueisabovefundamentalvalue,thefirmmaycreatewealthfromjudiciouslytimedequityissuestopartieswhoarecurrentlynonshareholders,particularlyintakeoversituations.Wheremarketvalueexceedsfundamentalvalue,returnofsurplusfundsshouldlogicallybeviaaspecialdividendratherthanasharerepurchase. Wherefundamentalvaluepershareexceedsmarketvaluepershare,thefirmmaycreateshareholdervalueforcontinuingequityinvestorsbytimelybuybacks.2003ElsevierLtd.Allrightsreserved. Keywords:Fundamentalvalue,Intrinsicvalue,Marketvalue,Financing,Takeovers,Sharerepurchases FundamentalValue(akaIntrinsicValue) WhydidMarconipaycash,ratherthanshares,initsacquisitionofUShighpanies?
WhydidFrancedomuchthesameinitsprogrammeofhightechacquisitions?
WhydidadvertisinggiantWPPfundits2001acquisitionofTempuswithcashasopposedtoofferingitsequityasconsideration?
WhydidRentokilInitialundertakeasharebuybackprogramme?
AndwhydidCableandWirelessdothesame?
Notallofthesefinancingdecisionsareexamplesoflogicalmanagerialtactics.Weconcludethattwoappeartofallintothecreditablecategoryandthreeareexamplespromisingvaluedestructionforshareholderswhocontinueto holdthesharesofthefirmsconcerned.Whydowereachtheseconclusions?
Becauseweapplytheideasoffundamentalvaluetotakeoverfinancingandsharebuybacks. Butwhatdowemeanbyfundamentalvalue?
Andwhyisitsoimportant?
Initially,inthispaper,wefocusupontheformerquestion.Wedefinefundamentalvalue(orintrinsicvalue,asitissometimesknown)forafirmanddemonstratehowitmaybeapproximated.Wethenmoveontohighlightitsimportance.Wearguethataclearideaoffundamentalvalueisofcentralrelevancetotheimplementationofalogicalfinancialstrategydesignedtoenhancevalueforshareholders.Weconcludethatindividualmembersofcorporateboardsarelessthanreasonablyequippedtocarryouttheirdutiesintheinterestsofequityinvestorsiftheyarenotuptospeedonicoffundamentalvalue.Inthisarea,wewouldplacefundamentalvalueasacentralbuildingblockin-leveldecisionsrangingfromacquisitionstodivestments,fromthefinancingoftakeoverstosharerepurchases.Ifourviewofitspivotalroleinthesestrategicareasofpotentialvaluecreation—ordestruction—isconvincinglyarguedandepted,ourclaimforitscriticalimportancetoboardsofdirectorscannotbedenied. Theordericsconsideredinthispaperisasfollows: ❖definitionoffundamentalvalue❖howfundamentalvaluemaybeapproximated❖whyfundamentalvalueissoimportantininvest- mentanddivestmentdecisions❖whyfundamentalvalueissoimportantinfinanc- ingacquisitionsandotherfundingdecisions❖whyfundamentalvalueissoimportantinshare repurchasedecisions EuropeanManagementJournalVol.21,No.5,pp.635–646,October2003 635 WHYISFUNDAMENTALVALUESOFUNDAMENTALTODIRECTORS?
WhatisFundamentalValue?
Fundamentalvaluepershareforafirmcanbedefinedasthevaluethatderivesfromananalysisbaseduponthepresentvalueofestimatedfuturecashflowsforthefirm.Thekeyunderpinningofsuchananalysisisdiscountedcashflow,thegoldstandardofvaluation. FundamentalvalueisakintotheconceptofintrinsicvaluewidelyencounteredinthewritingsofBenjaminGraham—see,forexample,Graham(1973).ButthetermwasfirstcoinedbyArmstrong(1848).ordingtoArnold(2002),althoughothersexpressthesamesentiment,‘Grahamisregardedasthemostinfluentialofinvestmentphilosophers’.AndGrahamearnedthedescriptionthe‘smartestmanIeverknew’fromWarrenBuffett—seeLowe(1997). InGrahametal.(1962),theauthorsstatethat‘ageneraldefinitionofintrinsicvaluewouldbethatvaluewhichisjustifiedbythefacts,e.g.,assets,earnings,dividends,definiteprospects,includingthefactorofmanagement’.Theygoontosaythat‘theprimaryobjectiveinusingtheadjectiveintrinsicistoemphasisethedistinctionbetweenvalueandcurrentmarketprice,butnottoinvestthisvaluewithanauraofpermanence.Intruth,putedintrinsicvalueislikelytochange...asthevariousfactorsgoverningthatvaluearemodified.Butinmostcasesintrinsicvaluechangeslessrapidlyanddrasticallythanmarketprice’. Theysubsequentlysaythat‘themostimportantsinglefactordeterminingastock’svalueisnowheldtobetheindicatedaveragefutureearningpower,i.e.theestimatedaverageearningsforafuturespanofyears.Intrinsicvaluewouldthenbefoundbyfirstforecastingthisearningpowerandthenmultiplyingthatpredictionbyanappropriatecapitalisationfactor’. Atthetimeoftheirwriting,theapproachofthesepioneersofinvestmentvaluationwasinnovativeanditwouldjustifyarangeofvalue,giventheinevitableuncertaintiesinforecasting. HowisFundamentalValueApproximated?
Atanunsophisticatedlevel,arangemaybeestimatedforfundamentalvaluebyforecastingfuturecashflowsatoptimistic,mediumandpessimisticlevels.Followingdiscountingandtheuseofsubjectiveprobabilities,aweightedaveragevaluemayresult.Atamuchmoresophisticatedlevel,MonteCarlosimulationorrealoptionsvaluationmayberesortedtoinordertoarriveataspectrumofvalue—seeDamodaran(2002)formoredetails.Ofcourse,plicationsariseinchoosingtheappropri- atediscountrateand,maybe,inestimatingterminalvalues. Whetherequityvaluesarearrivedatviaadividenddiscountmodelwithaterminalvalueorviafreecashflows,thefigurearrivedatshouldparable—fordetailedmethodologyseeDamodaran(2002).Histextalsoshowshowvaryinggrowthratesmaybeincorporatedintothevaluation. Differentdiscountingapproaches,suchaspurediscountedcashflow,adjustedpresentvalueorfreecashflowtoequity,ifimplementedcorrectly,shouldarriveatthesamebottomlinevaluation—seeRossetal.(2002).Usingthebasicdiscountedcashflowmethod,atemplateforequityvaluationappearsinTable1.Thisbeginswithavaluationofeachofthefirm’soperationsaggregatedtogether.Withsurplusassetsaddedinandwiththepresentvalueofdebtandnon-equityshareholders’interestsandminorityinterestseliminated,wearriveatthefundamentalvalueofpany’sequity.Afterallowingforoptionsandthelikeanddividingbythenumbersofequitysharesinvolved,anestimateoffundamentalvaluepershareisobtained.Naturally,thisprocessmayrequiresomerefinementwhereindividualcircumstancesvaryfromthebasicmodel. Itisworthmentioningthataplicationarisesinrespectofliabilitiesversusassetsinthefirm’spensionfund.Thisisparticularlythecasewherepanyrunsafinalsalaryscheme(oranyotherfundofferingdefinedbenefits).Basedonstockmarketlevelsofassetsataparticularpointintime,pensionfundliabilitiesmightexceedassets—orviceversa.Buildinginthisfactorwillusuallycreateawiderrangeoffundamentalvalue.Sowillvarioussensitivityanalysisexercisesinthisarea.Forexample,thepreferredmethodofdealingwiththeproblemmightbetoassessthedeficitorsurplusinthepensionfundbyvaluingassetsinordancewithlong-runaveragemarketlevelsandreturns.Sothebasecasevaluemaybeinlinewithlong-runequitylevelsreflectingaprice/earningsratio1ofbetween13and14andanequityreturnofaround6percentin2realterms—seeDimsonetal.(2002).Aroundtheselong-runinputs,furthersensitivitiesmightbebuilt. Wewouldstressthatusingthetemplateinthetableshouldideallybepaniedbypinpointingandappraisingassumptions,businesslogicandusingratioanalysisandotherrealitychecks.Rememberthatfirmsachievinghighrelativereturnsoncapitalorhighmarginsversustheirreferencegrouprarelycontinuetodosoforlongunlesstheirmarketpositionisunderpinnedbysubstantialbarrierstoentry,monopolypositionsgrantedbygovernments,orbypatentprotectionorthelike.Withthisbackground,questioningandshadingofforecastreturnsand/ormarginsmaybecalledforinthemodellingexercise.Insupportofthereferencetotheunsustainabilityof 636 EuropeanManagementJournalVol.21,No.5,pp.635–646,October2003
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