6. Believing that debt raises a stock’s value
Leverage is an accounting reality: if a company carries debt and its return on capital employed (RoCE) is greater then its cost of debt, then its return on equity (RoE) is greater than its RoCE. This leverage formula is based on an accounting tautology and therefore must be correct. From a financial point of view, however, RoCE and RoE are of very limited interest. As they are accounting-based concepts, they do not reflect risk and in no way should they be the company’s sole objective. Otherwise, they could lead to unwise decisions.
For it is easy, as we have seen, to improve RoE by leveraging up, but the company then faces greater risk... something that is not reflected in accounting terms. Hence, if RoE increases with leverage, the required rate of return will rise commensurately and no value will have been created.
There are nonetheless, two special cases, where we believe that leverage can create value in and of itself.
• In an inflationary economy. This was what happened in the 1960s, when debt was a subterfuge that was especially well suited to a strong-growth environment. There are two components to this strategy: heavy investment to expand industrial assets and narrow margins to win market share and keep those assets busy. Obviously, RoCE is low (because of low margins and heavy investment), but the debt that is inevitable incurred (because weak margins produce insufficient operating cash flow to cover all investment in the business) results in increased leverage and inflates RoE. This is all the more so when the real cost of debt is low or even negative because of inflation, and creditors are reimbursed with devalued currency. However, RoE is quite unstable and can drop suddenly when growth in the business slows.
This was the strategy used typically by Moulinex and it allowed it to achieve dominance on its market and to “flatten out the learning curve”, as consultants would say, but this was also the source of later difficulties. With the beginning of the 1980s and the return to a positive real interest rates, i.e. far above the inflation rate, most companies successfully improved their RoE while reducing debt and hence leverage. This is only possible via a strong improvement in RoCE, i.e. by improving asset rotation (e.g., by reducing inventory levels) and by improving margins. This has been a typical strategy of Peugeot throughout the last two decades and more recently of Volkswagen.
•When using heavy leverage, in particular for companies having been bought out in an LBO. But don’t misunderstand. We are not suggesting that improving RoE through leverage creates value, or that tax savings are a real source of value creation. Heavy debt, however, tends to make managers especially efficient, so that the company can use its cash flow to meet its heavy debt-servicing obligations, at the price of constantly having its back to the wall. It is therefore the improvement in RoCE that creates value (1).
7. Believing that raising the dividend increases the value of the stock
If this was always true, companies would long ago have raised their payout to 100% (or even higher) and we would all be rich and happy!
Mathematical models do not necessarily provide a clear picture right off the bat. In the Gordon-Shapiro model, for example, the value of stock whose dividend grows at a constant rate is:
Value of stock = Payout X EPS/(required rate of return – dividend growth rate)
Intuitively, it would seem that if the payout rises, the value of the stock should also rise. However, this is forgetting the negative indirect impact on the company, which, having fewer financial resources at its disposal because of its higher dividend, will be forced to curtail its investments and grow more slowly. The two effects end up cancelling each other out, and the value of the stock remains constant.
This said, there appear to be two ways in which raising the dividend can indeed create value:
a) if the company increases its dividend to return to its shareholders cash that it does not or no longer needs and that it would otherwise invest at a rate below its cost of capital. This is especially true for cash-rich companies such as Microsoft and GlaxoSmithKline. Scientific studies show clearly that raising the dividend leads to gains in the share price.
b) if the company uses this to signal that its economic situation is healthier than the investment community believes. Such a signal is all the more credible as it demonstrates management’s confidence in its future, since it has given up a rare and precious resource – its cash! (2)
8. Believing that to structure a corporate finance transaction is possible without financial analysis first
Would a doctor ever write out a prescription without first examining and diagnosing the patient? Would a tailor make a suit without first taking his customer’s measurements? Of course not!
Similarly, a financial analysis of the company is the first and essential step of any solid basis of reasoning. To forget this is to end up with a haphazard strategy that would only hit the mark by coincidence.
In our experience novices often recoil before a financial analysis, not knowing where to begin or end. They are likely to make mainly descriptive remarks, without trying to tie them together and check for their internal consistency and without trying to figure out which is the cause and which is the effect.
Financial analysis is not just some vague comments on the P&L, balance sheets or some ratios. No, financial analysis is an investigation that must be followed to its logical conclusion and whose parts are not isolated but inter-linked. The main question financial analysis must answer is this: does this make sense? Is this consistent with what I’ve already established, and, if not, why not? The analyst asks several questions and will seek the answers in an accounting document that he does not comment on as such, but which serves as a source of raw materials.
The analyst is like a modern-day Sherlock Holmes or Miss Marple, on the lookout for a logical chain of events, as well as disruptive elements that could signal problems.
The principle that will guide him in his learning and understanding of the company is this: “creating value requires investments that must be funded and must be sufficiently profitable”.
Indeed, a company cannot long survive if it is unable to attract a steady stream of customers that want to buy its products or services at a given price allowing it to generate a sufficient operating profit. This is the basis of everything.
So the first thing that the analyst must study is how the company achieves its financial margins. The first thing a company needs is investment in two forms: acquisition of equipment, buildings, patents, subsidiaries, etc., and building up working capital. And these investments will obviously have to be financed, either through equity or through banking or other financial debt.
After studying the three above elements – margins, investments and financing – the analyst can calculate the company’s profitability, in terms of RoCE or RoE.
The analyst will then have completed his work and can answer the simple questions that motivated it, i.e. is the company able to meet the commitments that it has taken on with its creditors? Is it able to create value for its shareholders? (3)
9. Believing that actual return can long be kept above the required rate of return
This issue is more macroeconomic in nature than financial!
However, economists (and our experience) tell us that no such situation is infinitely sustainable. A company’s RoCE will sooner or later converge gradually towards its cost of capital. This is the law of diminishing returns. A return that is above the required rate of return, when factoring in risk, will naturally attract competitors or the attention of competition watchdogs (see the Microsoft case). Sooner or later, deregulation and technological progress will make net RoCE vanish. Or, as an old adage has it, “there are no impregnable fortresses, there are only fortresses that are poorly attacked!”.
True, the real economy is less fluid than financial markets and it takes longer for its efficiency to show up, but in our view, it inevitably does. After all, the returns of Air Liquide and Coca Cola did indeed converge towards their cost of capital! (4)
10. Believing that calculation replaces reflection
What a fabulous tool Excel is! But what a trap it is for serious reflection!
Mathematicians have made major contributions to finance, through portfolio management, the CAPM, valuing of options, etc.), but finance is not just mathematics. Two examples:
a) 3 years ago, the Chinese market traded at an average P/E of 10x, a risk-free rate of 5%, and an estimated 5% risk premium.
Given the growth rate in China (GDP rose 9% in volume in 2003), the above numbers were clearly inconsistent, even though they may be mathematically correct. Such high growth rates, with a market P/E of just 10 are impossible without the discounting rate being far above the European rate (about 9%), where P/Es were about 17 with weaker growth than in China. In short, the risk premium was financially wrong, even if it was mathematically correct. A discounting rate of about 15% was much more justified, and this is the one that Chinese investors apply themselves to their companies; otherwise P/Es would have been 30 and not 10!
b) The beta of a low-cost airline like EasyJet or Ryanair is significantly higher than for a mainstream carrier like Air France or Lufthansa, which draw most of their earnings from business passengers. This calculation may be mathematically correct, but what a mistake from a financial point of view! Of the two types of airlines, which is more exposed to the state of the economy? Naturally, the mainstream carrier, whose cash flows accentuate fluctuations in the economy, while those of low-cost airlines are much less exposed.
In short, in finance, constantly keep in mind Aretha Franklin song: “think”.