I find the logic in some of the valuations I get to see in practice staggering. The value of an entity or business is what you can get out of it. You cannot take revenue of a business and leave the costs of generating the revenue in the business. You cannot take earnings out of a business without maintaining the productive capacity of the operation – unless you want to run it into the ground. You cannot take EBITDA out of a business: who will pay the tax? Who will pay the interest owing on the borrowings? How can you run a business without replacing assets or investing in working capital? And yet I see valuations based on revenue (e.g. 20 times monthly revenue for a restaurant), earnings (a PE ratio of 4 in Johannesburg or 6 in Cape Town) and 4 x EBITDA (why not 5?) all the time.
If you are asked to value a private company for a client who is interested in buying it, you should identify what your client can get out of the company immediately, as well as over time.
If the company is better off dead than alive, the client could liquidate the assets, pay the liabilities and outstanding taxes and withdraw what is left over. This is what the company is worth in these circumstances after deducting withholding tax on the dividend distributed, if any.
If the company gives good value as a going concern, you should determine what could be taken out of the company without affecting its business (non-core resources), and what could be taken out of the operating activities going forward (free cash flow).
Free cash flow is earnings after tax adjusted for non-cash flow items such as depreciation; less capital expenditure to replace operating capacity and less working capital to facilitate growth. Where cash needs to be retained to rectify an over-borrowing situation, this will go to reduce free cash flow. If capital expenditure and working capital can be financed by borrowings, where it is the company’s policy to do so, free cash flow can be increased by the amount used to fund the assets.
Whenever I criticise valuations based on revenue, earnings or EBITDA, I am told: “This is how it’s done in practice”. My answer always is to do it the right way and compare your calculation to the ‘how it’s done in practice way’. If the ‘how it’s done in practice value is too high and you are the buyer, walk away from the deal. If the ‘how it’s done in practice value is too low take the deal. If you do the job properly, you will always win. The mindless follower of conventional wisdom will win only half the time. The independent thinker will win every time. ❐
Author: Charles Hattingh CA(SA), Chartered Financial Analyst, is the Managing Member of PC Finance Research cc
Are investors rational?
There has been, for some years now, serious disagreement in theoretical finance about the nature of investor decision-making. In an upending of the usual formulation of Sayre’s Law, this particular academic argument is vicious, precisely because the stakes are so high.
There are two main sides in the debate. This is how a finance professor might respond, if a junior postgraduate student asked about it. Firstly, there is traditional finance, in which it is assumed that people make investment decisions in conformity with the von Neumann-Morgenstern axioms of utility theory, and Bayes’ formula.
Secondly, there is behavioural finance. It assumes nothing of the sort. Instead, investors display Friedman-Savage double-inflection utility functions, and make decisions in accordance with Kahnemann-Tversky prospect theory. Oh, and they also satisfice (this is not a spelling mistake) under conditions of Simon (1957) bounded rationality. [Understand? Student suddenly remembers urgent appointment, and makes a run for it.]
Have sympathy for that student: this explanation is useful only as an illustration of why he will probably spend his first postgraduate year wandering around campus in a semi-permanent state of dazed confusion. For our purposes, we’ll stick to plain English. The position in traditional finance: investors are rational. In behavioural finance: investors are their own worst enemy.
In traditional finance, people are cold, calculating analytical machines. In the behavioural version of events, they are chaotic and emotional, and prone to a colourful collection of human failings. Investors are overconfident, excitable and lazy. Lots of things frighten them: regret, loss, change, doing statistics. They frequently make shockingly poor investment decisions.
Award round one to the behaviouralists. It’s pretty clear that their description of human nature sounds about right. But the traditionalists do not give up so easily. They say that individual irrationality may be rife in financial markets, but it does not reign supreme. Instead, there are forces that keep it in check, and even if market equilibrium is sometimes shattered, it is always restored. In other words, markets are efficient. Problem is, the academic evidence for market efficiency is famously ambivalent. So, round two is a draw.
As for round three, there is one fundamental part of finance in which behaviouralists have, so far, failed miserably and unambiguously: they have no asset pricing models with the mathematical elegance of those in traditional finance.
So neither side has yet emerged as a clear winner. Thus, back in the real world, finance professionals are left applying an awkward hybrid of the two theoretical positions, and investment finance remains as much an art as it is a science. ❐
Author: Mark Bunting CA(SA), CFA, is an associate Professor of Finance at Rhodes University
5 steps to your ‘Portfolio Life’
Charles Handy penned the term Portfolio Life in the 80’s, which is to have: “a portfolio of activities – some you do for money, some for interest, some for pleasure, some for a cause… the different bits fit together to form a balanced whole greater than the parts”. You effectively manage your time and efforts to achieve better balance between work, home and leisure through experiencing variety and independence.
I offer some pointers below to create and define your ‘portfolio life’, just like our own Ernie Els has by being a golfer, wine estate owner, charitable spokesperson, and restaurateur and property developer.
Step 1: Purpose – is to connect to what is most important in your life. Think, what makes you happy on a day-to-day basis. Define your purpose through what you love doing. Inspire yourself. Your purpose is your own vision and mission in life, your legacy.
Step 2: Operation goals – are those dreams that need to materialise to achieve your Portfolio Life. Be specific and refer to the SMARTER-goals-tool on www.spcoaching.co.za. These specific goals will cumulatively add up to having the ultimate life you want.
Step 3: Current reality – is an audit on where you are now, basically your own SWOT analysis. Think about all your resources, your strengths, weaknesses, opportunities, threats, everything. If you know where you are and know where you want to be, it is easier to plan and manage to get there.
Step 4: Explore alternatives – as a brainstorming exercise. Consider all your options to fulfill your purpose. As you brainstorm, don’t eliminate anything. Think outside of the box. You can never have too many options. The more ideas, the better chance you have at achieving your goals, as you would have considered all angles. More options also mean that you potentially have Plan Bs and Cs if and when needed.
Step 5: Energy and action – is to set the targets and take your first steps. Reward yourself, motivate yourself and stay focused. Start with ‘low hanging fruit’. This will build your confidence and momentum towards implementing more of your options.
Some options will fail but if you make peace with that beforehand, each failure is a step closer to the real deal.
Now, don’t just think about the ideal portfolio life, go out and live YOUR Portfolio Life. And let me know how it goes. ❐
Author: Stanford Payne CA(SA) is an ICF Accredited Executive and Business Coach.
Orchestrating great business performance
When people think of business performance, they usually turn to sports metaphors: the sprints, the training, the teams, the superhuman effort that leads to victory.
But there’s another kind of performance we like to keep in mind: the performance delivered by an orchestra, the beautiful teamwork that underpins a seamless, enriching musical experience. There are no winners or losers at a concert – but if you do it right, everyone leaves feeling that their lives just got a little better. A business that’s in it for the long term should have the same goal: that every customer feels the world is better with you in it.
One of the insights of the orchestra analogy is that an orchestra can’t perform without a conductor – and we like to think that accounting and finance departments operate like conductors for business.
In an orchestra, the overall strategy and goals are set by the composer of the music. After that it’s the conductor, during the performance, who has a comprehensive view of what’s going on and who can provide the feedback the orchestra needs to keep working in harmony. It’s the conductor who sets the pace, monitors what’s going on and lets people know when and how to adjust their performance for the best results.
In just the same way, while the strategy and goals of a business are established by the directors, it’s the finance department that has the clearest day-to-day grasp of what’s going on. With that view, it’s the finance people who will almost always be first to spot when someone is out of tune, rushing ahead or lagging behind the pace – and be able to give them the feedback they need to correct it.
The more dispersed an organisation is, the more important this function becomes. A string quartet doesn’t need a conductor because everyone can see and hear exactly what everyone else is doing – but there’s no way an orchestra could succeed that way.
When the violin can’t see the oboe and neither can see the percussionist, you’re headed for trouble.
One of the key lessons of this analogy is just how important it is that your information be timely. There’s no point pushing the sales team to beat their targets if there’s a production bottleneck at your factory that means you can’t deliver on time. How good are your tools at giving you the information you need, when you need it? ❐
Author: Kevin Phillips CA(SA) is the Managing Director of Idu Software.
Stakeholder engagement – the ‘new normal’
Spurred on by King III, stakeholder engagement is an invaluable tool for keeping businesses current and getting into shape for sustainability.
For years it was a given that successful companies know what they’re doing. With the results to prove it, these businesses feature astute leadership, tested business models and a sound understanding of their markets – but as often as not see little profit in engaging wider than their shareholders and customers. But we’ve entered an era in which changes of all kinds – economic, political, technological, social and regulatory – are speeding through and disrupting established realities. At the same time the penny has dropped that companies can no longer operate in self-absorbed isolation from the communities and environments in which they do business. The global economic shocks of recent years and intensifying social and media scrutiny have shown many corporate titans to be out of touch with broader society – and even their own convoluted products.
One outcome is the introduction of integrated reporting – intended to cut through the fog of corporate ‘spin’ and lack of social and environmental accountability – with a key component being the concept of ‘stakeholder engagement’. For decades the only stakeholders taken seriously were shareholders, regulatory authorities, analysts and customers, but growing statutory and social pressure for ‘sustainable business’ is widening the scope to include employees, local communities and interest groups affected by the company’s activities.
Again, as with most aspects of integrated reporting, stakeholder engagement that goes beyond box-ticking delivers a spread of competitive advantages. In effect, it’s a risk management and intelligence exercise that can also provide early information for reacting quickly to emerging trends in today’s volatile markets. Stakeholder input should be analysed and channelled into company opportunities and risks when evaluating strategy. It is vital to prioritising the ‘materiality’ of what business and social aspects companies should report, and downscaling issues that are peripheral to their stakeholders and markets. Stakeholder engagement reveals what value stakeholders perceive the company to offer, encourages their ‘buy in’ for projects and helps build the brand.
Although ‘old school’ executives may yet regard stakeholder engagement as a waste of management focus and money, time and again stakeholders point out where costs can be cut and services, processes and products improved or removed. Stakeholder engagement is fast becoming a mainstream business practice that aligns companies with societal needs and keeps them informed and sustainable in turbulent markets.
The bottom line: managements must start spreading the love beyond their traditional circles and capitalising on the material benefits to be gained. Or they’ll be left behind with the dinosaurs. ❐
Author: Clive Lotter is an Integrated Reporting Consultant and writer of Annual reports for listed companies.
For the novice investor – start simply with ETFs
ETFs are the most intuitive and transparent investment products for inexperienced investors – and paying commissions is optional.
Unit trusts or exchange traded funds (ETFs) are most commonly quoted as the place to begin for novice investors wanting to start a modest savings plan – the former for their familiarity and the latter for their lower costs.
However, financial advisers seldom promote the ETF ahead of the unit trust – simply because ETFs are designed to be low-cost introductions to the investment market with commission structures unlikely to match other investment products.
However, you should insist on them when consulting with your broker. This advice is offered by Brett Landman, joint CEO of Satrix, the originator of the first ETFs in South Africa and one of seven issuers today. Better still, you can purchase one directly or online through your stockbroker, bank or directly from an issuer such as Satrix.
They’re low cost, you can commence saving with modest amounts and they’re simple to understand and manage.
Leanne Parsons, Head of Equities Trading at the Johannesburg Stock Exchange says: “One of the major features of ETFs is that as listed investment products, ETFs allow investors to spread their investment risk by tracking the performance of a basket of shares, bonds or commodities that form part of an index.”
South Africa currently has a range of 36 ETFs on offer, all listed on the JSE and regularly updated through quarterly rebalancing. These ETFs cover a variety of asset classes, thereby allowing an investor the benefit of diversifying their investments across shares, bonds and commodities, and in so doing, reducing their risk or exposure to a single asset class.
In the case of both unit trusts and ETFs, investment plans are available that enable the investor to invest a minimum lump sum of R1000, or via a monthly debit order starting at about R300. With ETFs, unlike unit trusts, commission is only paid if you use an adviser instead of investing directly yourself.
The ease with which ETF owners can track the performance of their investment on the JSE website and trade that investment at any time during trading hours makes ETFs accessible to all potential investors and ensures total transparency of price. ❐
Local investors have the following options when it comes to ETFs:
• Equity ETFs (such as the Satrix 40 which tracks the top 40 companies on the FTSE/JSE Top 40 Index)
• International Equity ETFs (such as dbx-trackers MSCI World Index)
• Dividend ETFs (such as Satrix Divi that tracks companies with the best dividend policies)
• Bond ETFs
• Property ETFs
• Commodity ETFs (such as NewGold, which tracks the rand price of gold)
• Currency ETFs.
Author: Eamonn Ryan LLB (Hons) is a business Journalist and Experienced Business writer