A Cold Secondary Stock Offering

You can own a sports team. The Green Bay Packers are offering 300,000 shares of stock at a price of $300 per share.There are currently a little over 5 million shares of the Packers outstanding. Of course, you will never receive a dividend and have no say in the operations of the Packers. Since you are now a part of of an NFL franchise, there are rules: You cannot own another NFL franchise, you can't act as an agent for any NFL player, you can't publicly criticize the NFL, its management, coaches, or officials, and you can't bet on any NFL games. It doesn't sound like there is much green investing in Green Bay stock!

Lower Taxes, NPV, and Company Value

A major benefit of the Tax Cuts and Jobs Act of 2017 is that it reduces taxes paid, which increases operating cash flow. Increased cash flow can increase the NPV of a project, even turning a negative NPV to a positive NPV, and increase the overall value of a company. Since the value of a project or the value of a company are both based on the present value of future cash flows, this result is fairly obvious. As a recent article points out, what is less obvious is that the reduced tax rate will also increase the required return on a project or a company. Since the cost of debt that is important for either valuation is the aftertax cost of debt, a reduced tax rate actually makes the cost of capital higher, all else the same. So, in discounting higher future cash flows with a higher cost of capital, the present value will not increase as much as you might think at first glance.

Corporate Underinvestment

A recent article indicates that financial managers may not be following good capital budgeting techniques. The median hurdle rate used to value new projects is 12.0 percent, with an average rate of 13.6 percent. Meanwhile, the same survey notes that the median WACC is 9.8 percent, with a mean of 10.6 percent. While that article infers that these numbers should be the same, we differ on this assumption. If new projects are riskier than the company, which would likely be the case, then the cost of capital for new projects would necessarily be greater than the WACC since the required return on a project depends on the use of funds, not the source of funds.

Underinvestment still does occur, as 67 percent of respondents answers “No” when asked if their company undertook all projects that create value. Common reasons given for not pursuing value creating projects were:

Shortage of management time and expertise (51%)

The project is not consistent with the company’s core strategy (41%)

The risk of the project is too high (39%)

Shortage of funds (38%)

Shortage of employees (32%)

The (Partial) Effects Of Tax Reform

With the U.S. corporate tax rate being among the highest among developed economies, there is discussion of corporate tax reform that would reduce the corporate tax rate from 35 percent to 20 percent, as well as the possibility of eliminating the deduction of interest expense entirely. So how would this affect corporate finance? A cut in the corporate tax rate on interest would reduce the attractiveness of debt as a form of financing, thereby reducing the amount of debt in the optimal corporate capital structure. One estimate is that the U.S. average debt-to-EBITDA ratio would drop from 4.1 to about 3 times, which would also affect the other financial leverage ratios. And the non-deductibility of interest expense would affect the calculation of the weighted average cost of capital. And, finally, at least for now, the decline in corporate debt will likely increase the credit rating for the remaining debt, driving the yield down on debt that does remain. All in all, major changes to U.S. based corporations.

What Is Dell Really Worth?

While students often expect that stock price valuation should result in an exact price that everyone agrees with, this almost never happens in practice. Take the court case involving Dell's management buyout (MBO). When the MBO went through in 2103, the price calculated by management experts, through a year-long process, was $13.78 per share. However, a group of dissident shareholders had independent experts value Dell at $28.61 per share, a difference of $28 billion. In the valuation, both parties used the same components: the forecast cash flows for a specific period, the value of the cash flows beyond that period, and the discount rate (WACC). However, the experts differed on the company's capital structure, as well as the cost on equity. In the end, the court used its own assumptions and arrived at a share price of $17.62 per share. As you can see from Dell, experts can use the same technique and arrive at widely differing answers when valuing a company.

Private Company Valuation

With a public company, the price per share is easy to obtain by looking at the stock market. For private companies, stock prices are more difficult. Although you can price a private company using multiples or free cash flow techniques, the valuation of private companies by mutual funds shows how much disagreement exists. For example, cloud-based storage company Dropbox is valued at $9.40 per share by T. Rowe Price, while Hartford Financial Services Group has a value of $15.20 per share. The valuations on database software company are even wider, ranging from $8.06 to $18.55. As Jeff Grabow, head of the valuation practice at EY states, “Valuation is as much an art as it is a science.”

WACC And Acquisitions

An article on CFO discusses the WACC for S&P 500 companies and the use of the WACC in mergers and acquisition. An interesting number in the article is that, according to research by Bain & Company, the average WACC for a company in the S&P 500 has dropped from 10 percent in 2010 to 8 percent in 2014. Much of this is likely due to lower interest rates. The article also discusses how companies add a risk premium of 200 to 300 basis points to the WACC (the subjective approach) when analyzing a potential acquisition, plus another 50 to 100 basis points due to conservatism about the WACC calculation. Although the article is not specific, we should reiterate the correct WACC to use when analyzing a potential acquisition is the WACC of the target company, not the WACC of the acquiring company. To clarify terminology, the hurdle rate used in the article is the required return, or cost of capital.  

An Uber Valuation

So is Uber ($40 billion) really worth more than insurers Aetna ($38 billion), Prudential ($38 billion), or grocer Kroger ($37 billion)? Probably not, but venture capital valuations can be quite tricky. A recent articlediscusses  some of the fuzziness associated with valuing a private company. In fact, some venture capitalists argue that the valuation of private companies is just a placeholder. Snapchat, the photo-messaging app, has a $15 billion valuation, yet the company has almost no revenues to speak of. One reason for the extraordinarily high valuation of private companies is that VCs often have deals that protect them going forward.

Ratio Valuation Of The Clippers

Steve Ballmer's $2 billion bid for the Los Angeles Clippers shocked many people. Leaked court documents show why. Ballmer's bid was 12.1 times revenues (Price/sales ratio). For the last 25 NBA teams that were sold, only four have sold at a ratio above 4.0, and none had a ratio above 5.0. Similarly, the $2 billion bid price implies an EBITDA multiple of 12.1 times, while the league average has been 6.0 to 6.4 times EBITDA. All in all, it appears that Ballmer is willing to pay a high price for the Clippers, at least relative to revenue and EBITDA.