Letter number 17 of July 2006


News : 10 mistakes to avoid in corporate finance (part two)

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”.
(1) For more, see chapter 38 of the Vernimmen.

(2) For more, see the Vernimmen.com Newsletter, February and March 2006 issues.
(3) For more, see chapter 8 of the Vernimmen.
(4) For more, see chapter 13 of the Vernimmen

Statistics : The M&A balance

The M&A balance is the difference in a given country between purchases of foreign companies by domestic groups and acquisitions of local companies by foreign groups.

Studies reveal that:
• The USA is the top destination for acquisitions as this market is large, dynamic, and relatively open. Consequently many non US groups have acquired large market shares in many sectors such as retail banking, automotive, cement, etc.
• In the UK, every company is potentially for sale provided the suggested price is deemed more than fair by shareholders who, most of the time, are very financially minded
• Activity on the Japanese M&A market is low compared to the size of the country
• France is the country where the difference between outflows and inflows is the largest. Some may think it is due to “economic patriotism”, other will link this fact to the dynamism of its groups.

Research : Value and corporate governance in emerging markets

Financial research has consistently shown over a long period that there is a link between investor protection and the market value of firms.  It is often in the best interest of firms to apply higher standards of good governance than the statutory minimum, as shown by Coase (1960) (1). At the same time, it appears that listed companies in countries where the interests of shareholders are better protected are valued more highly by the market.  This is what La Porta et al. (2002) (2) demonstrated in a major study based on worldwide data.
More recently, two researchers Artyom Durnev and E. Han Kim (3) looked at the extent to which good corporate governance could make up for shortcomings in a given legal environment. Their study covered 27 countries, most of them in South East Asia and South America.  They included countries with legal systems that were favourable to investors (Hong Kong, Japan and Chile) and others with less favourable legal systems (Mexico, Indonesia).
The criteria for good governance used in this study were those that are generally relied on – management discipline and incentives, transparency, independence of Board of Directors, responsibility of Board of Directors, management responsibility, protection of minority shareholders.   Unsurprisingly, corporate governance is better in countries with more favourable legal systems. 
More interesting is the relationship between good governance and market (measured by the relationship between market capitalisation and the book value of equity). Although this relationship is often positive, the same improvement in governance increases value by three times more in Mexico than in Hong Kong.  It would thus appear that a less robust legal framework could be set off by high standards in terms of corporate governance.  This phenomenon could explain why studies carried out on US companies have generally not uncovered any substantial impact of corporate governance standards on valuation, since the tight regulatory framework already guarantees good investor protection.
The researchers confirm that some criteria encourage better governance:
• Existence of investment opportunities for the company
• High proportion of outside financing
• Size of majority shareholders’ stake
Here again, the originality of this work resides in its highlighting of a stronger impact of these criteria on the quality of governance in countries with unfavourable regulatory environments.  The existence of investment opportunities is a greater disincentive to management to “fleece” shareholders in these countries, where such behaviour destroys more value.  If outside financing is relied on, accounts need to be more transparent and standards of governance higher, because information asymmetry will be greater.  Finally, the concentration of the shareholder base could reduce conflicts between majority and minority shareholders when the law fails to offer much protection for the latter.
So, it would appear that many firms tend to compensate for shortcomings in the legal environment, but introducing good practices in terms of corporate governance.  Better still, the authors underline the fact that the corporate governance system in place in the company is more important than the regulatory environment when it comes to its market value. 
(1) Coase R, 1960, The Problem of Social Cost, Journal of Law and Economics, vol.3
(2) La Porta R, Lopez-de-Silanes F, Shleifer A et Vishny RW, 2002, Investor Protection and Corporate Valuation, Journal of Finance, vol.57
(3) Durnev A and Han Kim E, 2005, To Steal or Not to Steal: Firm Attributes, Legal Environment, and Valuation, Journal of Finance, vol.60

Q&A : What is venture lending?

Given the high risk of their fledgling businesses, start-ups are usually financed almost completely by equity, which is the most appropriate source of financing in the absence of positive cash flows and lack of visibility over exactly when any cash will actually start flowing in.
Venture lending is a new form of debt financing for companies, granted by specialised funds, usually for amounts of a few million euros and used to finance working capital or the acquisition of tangible fixed assets.
The loan is for a short period (two to four years) with repayment in monthly instalments or at the end of the loan period.  Obtaining this kind of financing is conditional on the issue of warrants to the lender, often worth 1% to 2% of the borrower’s equity.
The main advantage for the borrower is that it limits the amount of equity raised from third parties and thus reduces the dilution of the start-up’s founders.  They pay a price for this reduced dilution in the form of the extra risk assumed.  Very often, however, founders of start-ups, who are usually very upbeat and optimistic types, are blinded by the prospect of success, and tend to brush aside the rather inconvenient matter of risk.  This may not be as irresponsible as one might first think, since if the venture fails, the company is not likely to be worth much, whether it has taken out a venture loan or not.
The cost of this debt financing may appear to be high, at around 10% to 12%, to companies able to borrow at current the Eonia or Eurobor rates +50 to 100 base points.  Start-ups, of course, are unable to do so and they are the major customers of venture loan providers. They do not have access to other sources of borrowing and accordingly, the notion of cost is more or less theoretical given that they have no real alternative.
In short, a venture loan is a bit like a mezzanine debt(1) ,with out the senior or junior debt!
(1) For more on mezzanine debt, see chapter 44 of the Vernimmen