Creating value

The value of a company is whatever the stock market says it is but how does the rational investor decide the price to buy or sell at? Exactly how he prices a gilt-edged bond. The future cashflows to redemption, discounted at the market interest rate. For companies this means the post-tax cashflows before dividends, discounted at the weighted average cost of capital.

To create value, the company must do things that have a positive NPV – either improvements with no capital cost or high IRR projects. And it must avoid value-destroying capital projects. Don’t underestimate this.

An awful amount of shareholders’ money is wasted on poor projects, particularly company acquisitions. The low growth rate of most companies implies average IRR is pulled down by disasters.

WACC is the return capital providers expect on their money. These are either lenders or shareholders. The weighting reflects how much of each you have. Lenders expect the long-term market interest rate plus a premium for the company’s credit rating. Equity is more risky so shareholders expect a higher return.

Calculating that expected equity return is where most of the trouble, lies. You can estimate the b-factor of your shares, you can buy it from the London Business School, or you can pay a consultant to do the sums for you. But the answer is about 11% – avoid spurious accuracy.

The appropriate debt to equity ratio is an issue. If you have specific finance for a project, typically with a lot of debt, that’s the ratio.

Normally, a company’s investments come out of one pot and the company’s average, or policy level, debt to equity ratio is the right figure. If you work on the marginal debt required project by project you will penalise those undertaken when gearing is high and flatter those undertaken when it is low.

If you invest only in projects with a high IRR, and ensure they achieve the projected return the share price will go up. The clever bit is creating enough good projects.

  • Neil Chisman is a director of several companies and former finance director of Stakis and Thorn.

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