Warning: define(): Argument #3 ($case_insensitive) is ignored since declaration of case-insensitive constants is no longer supported in /home/u742613510/domains/strategy-at-risk.com/public_html/wp-content/plugins/wpmathpub/wpmathpub.php on line 65
Acquisition – Strategy @ Risk

Strategy @ Risk

Tag: Acquisition

What is the correct company value?
Nobel Prize winner in Economics, Milton Friedman, has said; “the only concept/theory which has gained universal acceptance by economists is that the value of an asset is determined by the expected benefits it will generate”.

Value is not the same as price. Price is what the market is willing to pay. Even if the value is high, most want to pay as little as possible. One basic relationship will be the investor’s demand for return on capital – investor’s expected return rate. There will always be alternative investments, and in a free market, investor will compare the investment alternatives attractiveness against his demand for return on invested capital. If the expected return on invested capital exceeds the investments future capital proceeds, the investment is considered less attractive.

One critical issue is therefore to estimate and fix the correct company value that reflects the real values in the company. In its simplest form this can be achieved through:

Budget a simple cash flow for the forecast period with fixed interest cost throughout the period, and ad the value to the booked balance.

This evaluation will be an indicator, but implies a series of simplifications that can distort the reality considerably. For instance, real balance value differs generally from book value. Proceeds/dividends are paid out according to legislation; also the level of debt will normally vary throughout the prognosis period. These are some factors that suggest that the mentioned premises opens for the possibility of substantial deviation compared to an integral and detailed evaluation of the company’s real values.

A more correct value can be provided through:
- Correcting the opening balance, forecast and budget operations, estimate complete result and balance sheets for the whole forecast period. Incorporate market weighted average cost of capital when discounting.
The last method is considerably more demanding, but will give an evaluation result that can be tested and that also can take into consideration qualitative values that implicitly are part of the forecast.
The result is then used as input in a risk analysis such that the probability distribution for the value of the chosen evaluation method will appear. With this method a more correct picture will appear of what the expected value is given the set of assumption and input.

The better the value is explained, the more likely it is that the price will be “right”.

The chart below illustrates the method.
15/02/2009
The Probability of Gain and Loss

Every item written into a firm’s profit and loss account and its balance sheet is a stochastic variable with a probability distribution derived from probability distributions for each factor of production. Using this approach we are able to derive a probability distribution for any measure used in valuing companies and in evaluating strategic investment decisions. Indeed, using this evaluation approach we are able to calculate expected gain, loss and their probability when investing in a company where the capitalized value (price) is known.

For a closer study, please download Corporate-risk-analysis.

The Probability Distribution for the Value of Equity

The simulation creates frequency and cumulative probability distributions as shown in the figure below.

We can use the information contained in the figure to calculate the risk of investing in the company for different levels of the company’s market capitalization. The expected value of the company is 10.35 read from the intersection between probability curve and a line drawn from the 50% probability point on the left Y-axis.

The Probability Distribution for Gain and Loss

The shape of the probability curve provides concise information concerning uncertainty in calculating expected values of equity. Uncertainty is reduced the steeper the probability curve, whereas the flatter the curve so uncertainty is more evident. The figures below depicts the value of this type of information enabling calculation of expected gains or losses from investments in a company for differing levels of market capitalization.

We have calculated expected Gain or Loss as the difference between expected values of equity and the market capitalization; the ‘S’ curve in the graph shows this. The X-axis gives different levels of market capitalization; the right Y-axis gives the expected gain (loss) and the left y-axis the probability. Drawing a line from the 50% probability point to the probability curve and further to the right Y-axis point to the position where the expected gain (loss) is zero. At this point there is a 50/50 chance of realising or loosing money through investing in the company capitalized at 10.35, which is exactly the expected value of the company’s equity.

To the left of this point is the investment area. The green lines indicate a situation where the company is capitalized at 5.00 indicating an expected gain of 5.35 or more with a probability of 59% (100%-41%).

The figure to the right describes a situation where a company is capitalized above the expected value.

To the right is the speculative area where an industrial investor, with perhaps synergistic possibilities, could reasonably argue a valid case when paying a price higher than expected value. The red line in the figure indicates a situation where the company is capitalized at 25.00 – giving a loss of 14.65 or more with 78% probability.

To a financial investor it is obviously the left part – the investment area – that is of interest. It is this area that expected gain is higher than expected loss.

11/02/2009
Risk, price and value
This entry is part 3 of 4 in the series A short presentation of S@R

Having arrived at the probability distribution for the value of equity (see full story) we are able to calculate expected gain, loss and their probability when investing in a company where the capitalized value (price) is known. (see “The Probability of Gain and Loss”)

In the figure below we have illustrated the investment and speculative area. The investment area comprice the part of the cumulative probability distribution below 50%.

The speculative area is the area above 50%. The expected value is given at the 50% probability point (stapled line). The literature advices, and successful investors insists, on having a safety margin (discount) of at least 20% between expected value (intrinsic value) and the market price, as shown by the yellow area in the figure below. Graham and Dodd in Security Analysis introduced the concept of a margin of safety in 1934.

In a stochastic framework as ours it is better to set the safety margin at one of the percentiles or quartiles giving directly the value of the safety margin. A fixed percentage safety margin will always give a different probability for gain (loss), depending on the shape of the cumulative probability distribution.

An investor having a portfolio of stocks should thus use percentiles as a margin – having the same probability for gain (loss) throughout the portfolio. In the case below a 20% safety margin coincide with the first quartile, – giving a 25% probability for loss and 75% probability for gain. The expected value of the company is 1.452 the first quartile is 1.160 giving an exepcted gain of 292 or more with 75% probability (dotted lines).

We know that the total risk of any individual asset is the sum of the systematic and unsystematic risk. When computing the figure above we have used the company’s appropriate beta to account for the systematic risk (in calculating WACC). The unsystematic risk is given by the variance in the figure above.

In a well-diversified portfolio the expected value of the unsystematic return is assumed to be zero. When investing in a single asset we should be looking for assets with a high unsystematic return. In our context companies with a capitalized value below the percentile set as limit of the safety margin.

References
1. Security Analysis: The Classic 1934 Edition by Benjamin Graham, David L. Dodd. October 1, 1996, McGraw-Hill Professional Publishing; ISBN: 0070244960
2. and an interesting webiste The Graham-Buffett Teaching Endowment
16/02/2008