An Improved Method for Valuing Mature Companies and Estimating Terminal Value
The theory underlying discounted cash flow (DCF) models is uncontroversial in academia. Nevertheless, in practice, DCF models are applied inconsistently with very different valuation results.
In David Holland’s article on discounted cash flow models from our JACF Winter issue the author writes that the theory underlying discounted cash flow (DCF) models is uncontroversial in academia, the economic intuition behind them is straightforward, and the mathematics reassuringly simple. Nevertheless, in practice, they are applied inconsistently with very different valuation results. Because of the assumed infinite life (“going concern”) of a business enterprise, DCF models implicitly assume the ability to forecast future cash flows forever. This forces analysts to make assumptions about the terminal period using simplistic metrics such as P/E or EV/EBITDA to estimate terminal values or to embed a perpetual stream of excess profitability and value creation in the terminal period.
The author offers an uncomplicated alternative to these unrealistic assumptions. The first step is to introduce an adjustable fade rate called f. A fade rate of 100% brings about immediate convergence, and a fade rate of 0% specifies no fade and perpetual excess profitability. The notion that excess profits get competed away over time can be modeled by assuming that the spread of (ROIC – r) fades to zero and that economic profit dissipates.
Intrinsic value is very sensitive to the fade rate assumption and this helps explain the risk premium for quality stocks. The risk of owning quality stocks is that they lose their economic moat and competitive advantage. An adjustable fade rate provides an excellent means to value the effect of profitability attenuation in a DCF model.
Authored by David Holland, University of Cape Town Graduate School of Business
Fundamental Investors Reduce the Distraction on Management from Random Market “Noise”: Evidence from France
Some temporary market enthusiasm may cause management to make value-destroying decisions as the result of random and uninformed stock market volatility
In another of our articles from the JACF Winter issue. the authors find that financial markets have real effects on corporate decisions but that, unfortunately, some temporary market enthusiasm, unrelated to firm intrinsic value, may cause management to make value-destroying decisions as the result of random and uninformed stock market volatility. In particular, they are prone to making bad decisions after stock market overreactions to “surprise” earnings announcements.
This study shows a positive effect of greater long-term ownership on French listed firms. Fundamental investor ownership reduces the degree of market mispricing which serves long-run shareholder value maximization. A fundamental investor is one that, on average, hold his shares for at least two years, is in the top quartile of a firm ownership, and has an active allocation strategy. They are about 8% of all investors. Compared to non-fundamental investors, fundamental investors hold their positions on average three times longer and have positions 1.5 times larger. Fundamental investors are more present in firms which have more liquid stocks, which pay dividends, and which are relatively poorer performers and have relatively lower market-to-book than their industry peers.
Authored by Alexandre Garel, Auckland University of Technology, and Jean-Florent Rérolle, Morrow Somali
Clawbacks” are much discussed in the context of senior executive compensation
“Clawbacks” are much discussed in the context of senior executive compensation, yet the discussion has largely ignored the presence of holdbacks that are already in place in many firms. Holdbacks are deferred compensation that is potentially foregone in the event that the CEO leaves the firm without good reason or they are dismissed for wrong-doing. They are explicit or written features of a CEOs employment contract, as Stuart Gillan writes in the sixth article of the Winter 30.1 issue.
Holdbacks are already in use at 70% of S&P 500 firms and average $18.4 million each. Firms with higher CEO replacement costs, greater information asymmetry, a recent bad experience (fraud, lawsuit, or restatement), or in more certain environments are more likely to have a holdback. In contrast, clawback adoptions are mainly driven by firms’ bad experiences and external pressure from shareholders. Holdbacks and incentive-based compensation are substitutes, as termination incentives can reduce the need for incentive compensation. As managers reasonably demand a premium for accepting risky compensation, a measure of abnormal compensation is positively associated with holdbacks, but there is no significant association between clawbacks and holdbacks.
These findings suggest that the holdbacks many firms already have in place could help an “ex-post settling up” in the event of financial misconduct, or even simply misstated financials. As companies have more control over the amounts held back ex-ante, holdbacks are potentially more efficient.
Authored by Stuart Gillan, University of Georgia, and Nga Nguyen, Marquette University