THE LAWYERS WEEKLY
November 12, 2010 | 23
Valuation is more art than science. To be sure,
in efficient capital markets, we value corporate
shares based on principles of finance. Accounting
irregularities, however, make share valuation
more uncertain as the reliability of financial information deteriorates. It is here that market regulators have an important role.
There are two key theoretical elements to
determining the “intrinsic” value of corporate
shares. First, one must determine the total of all
future free cash flows (net of tax) attributable to
the shares. Second, we consider the reliability or
risk of predicting the cash flows. Thus, the intrinsic fair value of shares depends not only upon the
accuracy of the total future free cash flows (net of
tax) that one expects to receive from the shares,
but also on of the volatility of one’s estimates and
the accuracy of predictions.
Estimating the free cash flow attributable to
shares requires certain assumptions about the life
of the corporation. For example, one must assume
that the corporation will be in existence for some
extended period of time in order to generate the
cash flows. Where an enterprise is a going concern, the theoretical rational basis of stock valuation is to discount its future cash flows in perpetuity to their present value. This is the “intrinsic” fair
value of the stock at the particular point in time.
It is difficult, however, to estimate future
cash flows into the indefinite future. Hence, we
use surrogate estimates to determine intrinsic
value. For instance, we can use the price to
earnings (P/E) ratio to multiply the per-share
earnings of a corporation to determine the
present fair value of shares. For example, we
might estimate that a corporation will have net
earnings of $1 per share to have an intrinsic fair
value of $20 per share. This essentially means
that we capitalize the present accounting annual
earnings per share at five per cent.
Estimating cash flows is a difficult task
because one is attempting to forecast the long-term future. Hence, we use the P/E ratio, a
crude surrogate number, for determining
what, in theory, we would normally do in discounting the long-term free cash flows of a
business. In effect, we use the P/E ratio as a
proxy for future cash flows, a number that is
difficult to estimate over an extended period.
The second element, assessing the volatility of
cash flow forecasts, is even more difficult. How
risky is one’s estimate of future cash flows and
what is the appropriate discount factor to apply in
light of the estimated risk? Naturally, the more
stable the cash flows, the lower the risk of volatility and, therefore, the lower the risk that those
flows will not be met. How, for example, do we
estimate the risk of future tax rates?
We can generally predict the pre-tax cash flows
of stable companies, such as electric utilities, with
a far greater degree of confidence because their
prices and rates are regulated and do not fluctuate
in a volatile manner. Similarly, predicting the
future cash flow for a stable industrial company,
such as General Electric Co. or Coca Cola Co., is
easier than predicting the cash flows of an emerging technology company or new business. Hence,
we will use a lower discount rate (or assign a higher
multiple) for a company with predictable cash
flows and a higher discount rate (or lower multiple) for a company with unpredictable earnings.
For example, we might use a five per cent discount
rate (or a 20 times multiplier) for a company with
highly predictable cash flows and a 10 per cent (or
10 times multiplier) rate for a company with less
certain and more risky figure cash flows.
These uncertainties explain why stock market
prices are always moving as investors and, more
importantly, analysts revise their estimates of
earnings based upon real time disclosures of current earnings, future tax rates, and the impact of
those earnings upon future cash flows. For
example, where a company releases earnings that
are lower than market expectations, analysts may
revise their forecast of future cash flows depending
upon the real reason for the reduced earnings.
Thus, it is important not only to interpret reported
accounting earnings, but also to gauge their
impact on future cash flows. For example, a company that writes off non-productive assets may
reduce current earnings, but indicate future savings and enhanced earnings downstream.
Why then would anyone pay more than the
“intrinsic” fair market value of a corporate share?
There are several reasons. First, the buyer and the
seller may have different estimates of the intrinsic
fair market value of the share. For example, an
acquiring company may believe that the estimated cash flows of the acquired company have
been underestimated and attach a higher value to
the shares. Second, the buyer may be prepared to
pay a higher premium for the shares in order to
own all of the shares of the acquired company
and acquire control of the corporation. Third, the
acquiring company may believe that it can derive
certain cost savings and synergies from the
acquired company. For example, the acquiring
company may be able to integrate its marketing
operations with the acquired company and save
in future expenses.
There are two key theoretical
elements to determining the
“intrinsic” value of corporate
shares. First, one must
determine the total of all future
free cash flows (net of tax)
attributable to the shares.
Second, we consider the
reliability or risk of predicting
the cash flows.
To be sure, valuing the intrinsic fair value of
shares is subject to uncertainties. Nevertheless, in
an efficient capital market that distributes information on a timely basis it is possible to arrive at
a reasonable expectation of future cash flows.
However, in an inefficient market with minimal
or opaque information about corporate earnings,
it is much more difficult to predict future cash
flows. The uncertainty is compounded where
accounting irregularities and earnings are distorted by bogus accounting principles or the
application of improper accounting methods.
This makes market regulation of accounting an
important public policy issue.
Vern Krishna is tax counsel with Borden
Ladner Gervais LLP and executive director of
the CGA Tax Research Centre at the University
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