Characteristics of Growth Companies and their Value Drivers

Characteristics of growth companies

            Growth companies are diverse in size, growth prospects and can be spread out over very different businesses but they share some common characteristics that make an impact on how we value them. In this section, we will look at some of these shared features:

1. Dynamic financials: Much of the information that we use to value companies comes from their financial statements (income statements, balance sheets and statements of cash flows). One feature shared by growth companies is that the numbers in these statements are in a state of flux. Not only can the numbers for the latest year be very different from numbers in the prior year, but can change dramatically even over shorter time periods. For many smaller, high growth firms, for instance, the revenues and earnings from the most recent four quarters can be dramatically different from the revenues and earnings in the most recent fiscal year (which may have ended only a few months ago).
2. Private and Public Equity: It is accepted as conventional wisdom that the natural path for a young company that succeeds at the earliest stages is to go public and tap capital markets for new funds. There are three reasons why this transition is neither as orderly nor as predictable in practice. The first is that the private to public transition will vary across different economies, depending upon both institutional considerations and the development of capital markets. Historically, growth companies in the United States have entered public markets earlier in the life cycle than growth companies in Europe, partly because this is the preferred exit path for many venture capitalists in the US. The second is that even within any given market, access to capital markets for new companies can vary across time, as markets ebb and flow. In the United States, for instance, initial public offerings increase in buoyant markets and drop in depressed markets; during the market collapse in the last quarter of 2008, initial public offerings came to a standstill. The third is that the pathway to going public varies across sectors, with companies in some sectors like technology and biotechnology getting access to public markets much earlier in the life cycle than firms in other sectors such as manufacturing or retailing. The net effect is that the growth companies that we cover in chapter will draw on a mix of private equity (venture capital) and public equity for their equity capital. Put another way, some growth companies will be private businesses and some will be publicly traded; many of the latter group will still have venture capitalists and founders as large holders of equity.
3. Size disconnect: The contrast we drew in chapter 1 between accounting and financial balance sheets, with the former focused primarily on existing investments and the latter incorporating growth assets into the mix is stark in growth companies. The market values of these companies, if they are publicly traded, are often much higher than the accounting (or book) values, since the former incorporate the value of growth assets and the latter often do not. In addition, the market values can seem discordant with the operating numbers for the firm – revenues and earnings. Many growth firms that have market values in the hundreds of millions or even in the billions can have small revenues and negative earnings. Again, the reason lies in the fact that the operating numbers reflect the existing investments of the firm and these investments may represent a very small portion of the overall value of the firm.
4. Use of debt: While the usage of debt can vary across sectors, the growth firms in any business will tend to carry less debt, relative to their value (intrinsic or market), than more stable firms in the same business, simply because they do not have the cash flows from existing assets to support more debt. In some sectors, such as technology, even more mature growth firms with large positive earnings and cash flows are reluctant to borrow money. In other sectors, such as telecommunications, where debt is a preferred financing mode, growth companies will generally have lower debt ratios than mature companies.
5. Market history is short and shifting: We are dependent upon market price inputs for several key components of valuation and especially so for estimating risk parameters (such as betas). Even if growth companies are publicly traded, they tend to have short and shifting histories. For example, an analyst looking at Google in early 2009 would have been able to draw on about 4 years of market history (a short period) but even those 4 years of data may not be particularly useful or relevant because the company changed dramatically over that period – from revenues in millions to revenues in billions, operating losses to operating profits and from a small market capitalization to a large one. 

While the degree to which these factors affect growth firms can vary across firms, they are prevalent in almost every growth firm.

Growth companies- Value Drivers

Scalable growth

The question of how quickly revenue growth rates will decline at a given company can generally be addressed by looking at the company's specifics – the size of the overall market for its products and services, the strength of the competition and quality of both its products and management.  Companies in larger markets with less aggressive competition (or protection from competition) and better management can maintain high revenue growth rates for longer periods.

            There are a few tools that we can use to assess whether the assumptions we are making about revenue growth rates in the future, for an individual company, are reasonable:

1.     Absolute revenue changes: One simple test is to compute the absolute change in revenues each period, rather than to trust the percentage growth rate. Even experienced analysts often under estimate the compounding effect of growth and how much revenues can balloon out over time with high growth rates. Computing the absolute change in revenues, given a growth rate in revenues, can be a sobering antidote to irrational exuberance when it comes to growth.

2.     Past history: Looking at past revenue growth rates for the firm in question should give us a sense of how growth rates have changed as the company size changed in the past. To those who are mathematically inclined, there are clues in the relationship that can be used for forecasting future growth.

3.     Sector data: The final tool is to look at revenue growth rates of more mature firms in the business, to get a sense of what a reasonable growth rate will be as the firm becomes larger.

In summary, expected revenue growth rates will tend to drop over time for all growth companies but the pace of the drop off will vary across companies.

Sustainable margins

To get from revenues to operating income, we need operating margins over time. The easiest and most convenient scenario is the one where the current margins of the firm being valued are sustainable and can be used as the expected margins over time. In fact, if this is the case, we can dispense with forecasting revenue growth and instead focus on operating income growth, since the two will be the equivalent. In most growth firms, though, it is more likely that the current margin is likely to change over time.

            Let us start with the most likely case first, which is that the current margin is either negative or too low, relative to the sustainable long-term margin. There are three reasons why this can happen. One is that the firm has up-front fixed costs that have to be incurred in the initial phases of growth, with the payoff in terms of revenue and growth in later periods. This is often the case with infrastructure companies such as energy, telecommunications and cable firms. The second is the mingling of expenses incurred to generate growth with operating expenses; we noted earlier that selling expenses at growth firms are often directed towards future growth rather than current sales but are included with other operating expenses. As the firm matures, this problem will get smaller, leading to higher margins and profits. The third is that there might be a lag between expenses being incurred and revenues being generated; if the expenses incurred this year are directed towards much higher revenues in 3 years, earnings and margins will be low today.

            The other possibility, where the current margin is too high and will decrease over time, is less likely but can occur, especially with growth companies that have a niche product in a small market. In fact, the market may be too small to attract the attention of larger, better-capitalized competitors, thus allowing the firms to operate under the radar for the moment, charging high prices to a captive market. As the firm grows, this will change and margins will decrease. In other cases, the high margins may come from owning a patent or other legal protection against competitors, and as this protection lapses, margins will decrease. 

            In both of the latter two scenarios – low margins converging to a higher value or high margins dropping back to more sustainable levels – we have to make judgment calls on what the target margin should be and how the current margin will change over time towards this target. The answer to the first question can be usually be found by looking at both the average operating margin for the industry in which the firm operates and the margins commanded by larger, more stable firms in that industry. The answer to the second will depend upon the reason for the divergence between the current and the target margin. With infrastructure companies, for instance, it will reflect how long it will take for the investment to be operational and capacity to be fully utilized.

Quality Growth

A constant theme in valuation is the insistence that growth is not free and that firms will have to reinvest to grow. To estimate reinvestment for a growth firm, we will follow one of three paths, depending largely upon the characteristics of the firm in question:

1.     For growth firms earlier in the life cycle, we will adopt the same roadmap we used for young growth companies, where we estimated reinvestment based upon the change in revenues and the sales to capital ratio.

Reinvestment_t = Change in revenues_t/ (Sales/Capital)

The sales to capital ratio can be estimated using the company's data (and it will be more stable than the net capital expenditure or working capital numbers) and the sector averages. Thus, assuming a sales to capital ratio of 2.5, in conjunction with a revenue increase of $ 250 million will result in reinvestment of $ 100 million.  We can build in lags between the reinvestment and revenue change into the computation, by using revenues in a future period to estimate reinvestment in the current one.

2.     With a growth firm that has a more established track record of earnings and reinvestment, we can use the relationship between fundamentals and growth rates that we laid out in chapter 2:

Expected growth rate in operating income = Return on Capital * Reinvestment Rate + Efficiency growth (as a result of changing return on capital)

In the unusual case where margins and returns and capital have settled into sustainable levels, the second term will drop out of the equation.

3.     Growth firms that have already invested in capacity for future years are in the unusual position of being able to grow with little or no reinvestment for the near term. For these firms, we can forecast capacity usage to determine how long the investment holiday will last and when the firm will have to reinvest again. During the investment holiday, reinvestment can be minimal or even zero, accompanied by healthy growth in revenues and operating income.

With all three classes of firms, though, the leeway that we have in estimating reinvestment needs during the high growth phase should disappear, once the firm has reached its mature phase. The reinvestment in the mature phase should hew strictly to fundamentals:

Reinvestment rate in mature phase = 

In fact, even in cases where reinvestment is estimated independently of the operating income during the growth period, and without recourse to the return on capital, we should keep track of the imputed return on capital (based on our forecasts of operating income and capital invested) to ensure that it stays within reasonable bounds.

The Little Book of Valuation

Aswath Damodaran

Characteristics of Mature Companies and their Value Drivers

Characteristics of Mature Companies

            There are clear differences across mature companies in different businesses, but there are some common characteristics that they share. In this section, we will look at what they have in common, with an eye on the consequences for valuation.

1.     Revenue growth is approaching growth rate in economy: In the last section, we noted that there can be a wide divergence between growth rate in revenues and earnings in many companies. While the growth rate for earnings for mature firms can be high, as a result of improved efficiencies, the revenue growth is more difficult to alter. For the most part, mature firms will register growth rates in revenues that, if not equal to, will converge on the nominal growth rate for the economy.

2.     Margins are established: Another feature shared by growth companies is that they tend to have stable margins, with the exceptions being commodity and cyclical firms, where margins will vary as a function of the overall economy. While we will return to take a closer look at this sub-group later in the book, event these firms will have stable margins across the economic or commodity price cycle.

3.     Competitive advantages? The dimension on which mature firms reveal the most variation is in the competitive advantages that they hold on to, manifested by the excess returns that they generate on their investments. While some mature firms see excess returns go to zero or become negative, with the advent of competition, other mature firms retain significant competitive advantages (and excess returns). Since value is determined by excess returns, the latter will retain higher values, relative to the former, even as growth rates become anemic.

4.     Debt capacity: As firms mature, profit margins and earnings improve, reinvestment needs drop off and more cash is available for servicing debt. As a consequence, debt ratios should increase for all mature firms, though there can be big differences in how firms react to this surge in debt capacity. Some will choose not to exploit any or most of the debt capacity and stick with financing policies that they established as growth companies. Others will over react and not just borrow, but borrow more than they can comfortably handle, given current earnings and cash flows. Still others will take a more reasoned middle ground, and borrow money to reflect their improved financial status, while preserving their financial health.

5.     Cash build up and return? As earnings improve and reinvestment needs drop off, mature companies will be generating more cash from their operations than they need. If these companies do not alter their debt or dividend policies, cash balances will start accumulating in these firms. The question of whether a company has too much cash, and, if so, how it should return this cash to stock holders becomes a standard one at almost every mature company.

6.     Inorganic growth: The transition from a growth company to a mature company is not an easy one for most companies (and the managers involved). As companies get larger and investment opportunities internally do not provide the growth boost that they used to, it should not be surprising that many growth companies look for quick fixes that will allow them to continue to maintain high growth. One option, albeit an expensive one, is to buy growth: acquisitions of other companies can provide boosts to revenues and earnings.

One final point that needs to be made is that not all mature companies are large companies. Many small companies reach their growth ceiling quickly and essentially stay as small, mature firms. A few growth companies have extended periods of growth before they reach stable growth and these companies tend to be the large companies that we find used as illustrations of typical mature companies: Coca Cola, IBM and Verizon are all good examples.

Mature companies: Value Drivers

Operating Slack

When valuing a company, our forecasts of earnings and cash flows are built on assumptions about how the company will be run. If these numbers are based upon existing financial statements, we are, in effect, assuming that the firm will continue to be run the way it is now. The value of a firm is a function of five key inputs and changes in three of them can increase operating asset value. The first is the cash flow from assets in place or investments already made, the second is the expected growth rate in the cash flows during what we can term a period of both high growth and excess returns (where the firm earns more than its cost of capital on its investments) and the third is the length of time before the firm becomes a stable growth firm. Figure 11.2 captures these elements:

Determinants of Value

A firm can increase its value by increasing cash flows from current operations, increasing expected growth and the period of high growth, by reducing its composite cost of financing and managing its non-operating assets better.

Financial Slack

There are two aspects of financing that affect the cost of capital, and through it, the value that we derive for a firm. First, we will look at how best to reflect changes the mix of debt and equity used to fund operations in the cost of capital. Second, we will look at how the choices of financing (in terms of seniority, maturity, currency and other add-on features) may affect the cost of funding and value.

            The question of whether changing the mix of debt and equity can alter the value of a business has long been debated in finance. While the answer to some may seem obvious – debt after all is always less expensive than equity – the choice is not that simple.  Debt has two key benefits, relative to equity, as a mode of financing. First, the interest paid on debt financing is tax deductible, whereas cash flows to equity (such as dividends) are generally not.[1] Therefore, the higher the tax rate, the greater the tax benefit of using debt. This is absolutely true in the United States and partially true in most parts of the world. The second benefit of debt financing is more subtle. The use of debt, it can be argued, induces managers to be more disciplined in project selection. That is, the managers of a company funded entirely by equity, and with strong cash flows, have a tendency to become lazy. For example, if a project turns sour, the managers can hide evidence of their failure under large operating cash flows, and few investors notice the effect in the aggregate. But if those same managers had to use debt to fund projects, then bad projects are less likely to go unnoticed. Since debt requires the company to make interest payments, investing in too many bad projects can lead to financial distress or even bankruptcy, and managers may lose their jobs.  Relative to equity, the use of debt has three disadvantages—an expected bankruptcy cost, an agency cost, and the loss of future financing flexibility.

�      The expected bankruptcy cost has two components. One is simply that as debt increases, so does the probability of bankruptcy. The other component is the cost of bankruptcy, which can be separated into two parts. One is the direct cost of going bankrupt, such as legal fees and court costs, which can eat up to a significant portion of the value of the assets of a bankrupt firm. The other (and more devastating) cost is the effect on operations of being perceived as being in financial trouble.. Thus, when customers learn that a company is in financial trouble, they tend to stop buying the company's products. Suppliers stop extending credit, and employees start looking for more reliable employment elsewhere. Borrowing too much money can create a downward spiral that ends in bankruptcy.

�      Agency costs arise from the different and competing interests of equity investors and lenders in a firm. Equity investors see more upside from risky investments than lenders to. Consequently, left to their own devices, equity investors will tend to take more risk in investments than lenders would want them to and to alter financing and dividend policies to serve their interests as well. As lenders become aware of this potential, they alter the terms of loan agreements to protect themselves in two ways. One is by adding covenants to these agreements, restricting investing, financing and dividend policies in the future; these covenants create legal and monitoring costs. The other is by assuming that there will be some game playing by equity investors and by charging higher interest rates to compensate for expected future losses.  In both instances, the borrower bears the agency costs.

�      As firms borrow more money today, they lose the capacity to tap this borrowing capacity in the future. The loss of future financing flexibility implies that the firm may be unable to make investments that it otherwise would have liked to make, simply because it will be unable to line up financing for these investments.

The fundamental principle in designing the financing of a firm is to ensure that the cash flows on the debt match as closely as possible the cash flows on the asset. Firms that mismatch cash flows on debt and cash flows on assets (by using short term debt to finance long term assets, debt in one currency to finance assets in a different currency or floating rate debt to finance assets whose cash flows tend to be adversely impacted by higher inflation) will end up with higher default risk, higher costs of capital and lower firm values. To the extent that firms can use derivatives and swaps to reduce these mismatches, firm value can be increased.

Probability of management change

There is a strong bias towards preserving incumbent management at firms, even when there is widespread agreement that the management is incompetent or does not have the interests of stockholders at heart. Some of the difficulties arise from the institutional tilt towards incumbency and others are put in place to make management change difficult, if not impossible. In general, there are four determinants of whether management will be changed at a firm:

1.     Institutional concerns: The first group of constraints on challenging incumbent management in companies that are perceived to be badly managed and badly run is institutional. Some of these constraints can be traced to difficulties associated with raising the capital needed to fund the challenge, some to state restrictions on takeovers and some to inertia. 

2.     Firm-specific constraints:  There are some firms where incumbent managers, no matter how incompetent, are protected from stockholder pressure by actions taken by these firms. This protection can take the form of anti-takeover amendments to the corporate charter, elaborate cross holding structures and the creation of shares with different voting rights. In some cases, the incumbent managers may own large enough stakes in the firm to stifle any challenge to their leadership.

3.     Corporate Holding Structures: Control can be maintained over firms with a variety of corporate structures including pyramids and cross holdings. In a pyramid structure, an investor uses control in one company to establish control in other companies. For instance, company X can own 50% of company Y and use the assets of company Y to buy 50% of company Z.  In effect, the investor who controls company X will end up controlling companies Y and Z, as well. Studies indicate that pyramids are a common approach to consolidating control in family run companies in Asia and Europe. In a cross holding structure, companies own shares in each other, thus allowing the group's controlling stockholders to run all of the companies with less than 50% of the outstanding stock. The vast majority of Japanese companies (keiretsus) and Korean companies (chaebols) in the 1990s were structured as cross holdings, immunizing management at these companies from stockholder pressure.

4.     Large Shareholder/Managers: In some firms, the presence of a large stockholder as a manager is a significant impediment to a hostile acquisition or a management change. Consider, a firm like Oracle, where the founder/CEO, Larry Ellison, owns almost 30% of the outstanding stock. Even without a dispersion of voting rights, he can effectively stymie hostile acquirers. Why would such a stockholder/manager mismanage a firm when it costs him or her a significant portion of market value? The first reason can be traced to hubris and ego. Founder CEOs, with little to fear from outside investors, tend to centralize power and can make serious mistakes. The second is that what is good for the inside stockholder, who often has all of his or her wealth invested in the firm may not be good for the other investors in the firm.

Little Book of Valuation

Aswath Damodaran

Characteristics of firms with Intangible Assets and their Value Drivers

Characteristics of firms with intangible assets

            While firms with intangible assets are diverse, there are some characteristics that they do have in common. In this section, we will highlight those shared factors, with the intent of expanding on the consequences for valuation in the next section.

1. Inconsistent accounting for investments made in intangible assets: Accounting first principles suggests a simple rule to separate capital expenses from operating expenses. Any expense that creates benefits over many years is a capital expense whereas expenses that generate benefits only in the current year are operating expenses. Accountants hew to this distinction with manufacturing firms, putting investments in plant, equipment and buildings in the capital expense column and labor and raw material expenses in the operating expense column. However, they seem to ignore these first principles when it comes to firms with intangible assets. The most significant capital expenditures made by technology and pharmaceutical firms is in R&D, by consumer product companies in brand name advertising and by consulting firms in training and recruiting personnel. Using the argument that the benefits are too uncertain, accountants have treated these expenses as operating expenses. As a consequence, firms with intangible assets report small capital expenditures, relative to both their size and growth potential.
2. Generally borrow less money: While this may be a generalization that does not hold up for some sub-categories of firms with intangible assets, many of them tend to use debt sparingly and have low debt ratios, relative to firms  in other sectors with similar earnings and cash flows. Some of the low financial leverage can be attributed to the bias that bankers have towards lending against tangible assets and some of it may reflect the fact that technology and pharmaceutical firms are either in or have just emerged from the growth phase in the life cycle.
3. Equity Options: While the use of equity options in management compensation is not unique to firms with intangible assets, they seem to be much heavier users of options and other forms of equity compensation. Again, some of this behavior can be attributed to where these firms are in the life cycle (closer to growth than mature), but some of it has to be related to how dependent these firms are on retaining human capital.

Companies with intangible assets: Value Drivers

Nature of intangible asset

While R&D expenses are the most prominent example of capital expenses being treated as operating expenses, there are other operating expenses that arguably should be treated as capital expenses. Consumer product companies such as Gillette and Coca Cola could make a case that a portion of advertising expenses should be treated as capital expenses, since they are designed to augment brand name value. For a consulting firm like KPMG or McKinsey, the cost of recruiting and training its employees could be considered a capital expense, since the consultants who emerge are likely to be the heart of the firm's assets and provide benefits over many years. For many new technology firms, including online retailers such as Amazon.com, the biggest operating expense item is selling, general and administrative expenses (SG&A). These firms could argue that a portion of these expenses should be treated as capital expenses since they are designed to increase brand name awareness and bring in new presumably long term customers.

Efficiency of intangible asset investments

When we capitalize the expenses associated with creating intangible assets, we are in effect redoing the financial statements of the firm and restating numbers that are fundamental inputs into valuation – earnings, reinvestment and measures of returns.

1.     Earnings: As we have noted with all three examples of capitalization (R&D, brand name advertising and training/recruiting expenses), the operating and net income of a firm will change as a consequence. Since the adjustment involves adding back the current year's expense and subtracting out the amortization of past expenses, the effect on earnings will be non-existent if the expenses have been unchanged over time, and positive, if expenses have risen over time. With Amgen, for instance, where R&D expenses increased from $663 million at the start of the amortization period to $3.03 billion in the current year, the earnings increased by more than $1.3 billion as a result of the R&D adjustment.

2.     Reinvestment: The effect on reinvestment is identical to the effect on earnings, with reinvestment increasing or decreasing by exactly the same amount as earnings.

3.     Free Cash flow to the equity(firm): Since free cash flow is computed by netting reinvestment from earnings, and the two items change by the same magnitude, there will be no effect on free cash flows.

4.     Reinvestment Rate: While the free cash flow is unaffected by capitalization of these expenses, the reinvestment rate will change. In general, if earnings and reinvestment both increase as a consequence of the capitalization of R&D or advertising expenses, the reinvestment rate will increase.

5.     Capital Invested: Since the unamortized portion of prior year's expenses is treated as an asset, it adds to the estimated equity or capital invested in the firm. The effect will increase with the amortizable life and should thererfore be higher for pharmaceutical firms (where amortizable lives tend to be longer) than for software firms (where research pays off far more quickly as commercial products).

6.     Return on equity (capital): Since both earnings and capital invested are both affected by capitalization, the net effects on return on equity and capital are unpredictable. If the return on equity (capital) increases after the recapitalization, it can be considered a rough indicator that the returns earned by the firm on its R&D or advertising investments is greater than its returns on traditional investments.

7.     Expected growth rates: Since the expected growth rate is a function of the reinvestment rate and the return on capital, and both change as a result of capitalization, the expected growth rate will also change. While the higher reinvestment rate will work in favor of higher growth, it may be more than offset by a drop in the return on equity or capital.

In summary, the variables that are most noticeably affected by capitalization are the return on equity/capital and the reinvestment rate. Since the cost of equity/capital is unaffected by capitalization, any change in the return on capital will translate into a change in excess returns at the firm, a key variable determining the value of growth.  In addition to providing us with more realistic estimates of what these firms are investing in their growth assets and the quality of these assets, the capitalization process also restores consistency to valuations by ensuring that growth rates are in line with reinvestment and return on capital assumptions. Thus, technology or pharmaceutical firms that want to continue to grow have to keep investing in R&D, while ensuring that these investments, at least collectively, generate high returns for the firm.

The Little Book of Valuation

Aswath Damodaran

Characteristics of Financial Service firms (banks, insurance companies and investment banks) and their Value Drivers

Characteristics of financial service firms

            There are many dimensions on which financial service firms differ from other firms in the market. In this section, we will focus on four key differences and look at why these differences can create estimation issues in valuation. The first is that many categories (albeit not all) of financial service firms operate under strict regulatory constraints on how they run their businesses and how much capital they need to set aside to keep operating. The second is that accounting rules for recording earnings and asset value at financial service firms are at variance with accounting rules for the rest of the market. The third is that debt for a financial service firm is more akin to raw material than to a source of capital; the notion of cost of capital and enterprise value may be meaningless as a consequence. The final factor is that the defining reinvestment (net capital expenditures and working capital) for a bank or insurance company may be not just difficult, but impossible, and cash flows cannot be computed.

The Regulatory Overlay

Financial service firms are heavily regulated all over the world, though the extent of the regulation varies from country to country. In general, these regulations take three forms. First, banks and insurance companies are required to maintain regulatory capital ratios, computed based upon the book value of equity and their operations, to ensure that they do not expand beyond their means and put their claimholders or depositors at risk. Second, financial service firms are often constrained in terms of where they can invest their funds. For instance, until a decade ago, the Glass-Steagall Act in the United States restricted commercial banks from investment banking activities as well as from taking active equity positions in non-financial service firms. Third, the entry of new firms into the business is often controlled by the regulatory authorities, as are mergers between existing firms.

            Why does this matter? From a valuation perspective, assumptions about growth are linked to assumptions about reinvestment. With financial service firms, these assumptions have to be scrutinized to ensure that they pass regulatory constraints. There might also be implications for how we measure risk at financial service firms. If regulatory restrictions are changing or are expected to change, it adds a layer of uncertainty (risk) to the future, which can have an effect on value. Put more simply, to value banks, insurance companies and investment banks, we have to be aware of the regulatory structure that governs them.

Differences in Accounting Rules

            The accounting rules used to measure earnings and record book value are different for financial service firms than the rest of the market, for two reasons. The first is that the assets of financial service firms tend to be financial instruments (bonds, securitized obligations) that often have an active market place. Not surprisingly, marking assets to market value has been an established practice in financial service firms, well before other firms even started talking about fair value accounting. The second is that the nature of operations for a financial service firm is such that long periods of profitability are interspersed with short periods of large losses; accounting standard have been developed to counter this tendency and create smoother earnings.

a.     Mark to Market: If the new trend in accounting is towards recording assets at fair value (rather than original costs), financial service firms operate as a laboratory for this experiment. After all, accounting rules for banks, insurance companies and investment banks have required that assets be recorded at fair value for more than a decade, based upon the argument that most of a bank/s assets are traded, have market prices and therefore do not require too many subjective judgments. In general, the assets of banks and insurance companies tend to be securities, many of which are publicly traded.  Since the market price is observable for many of these investments, accounting rules have tilted towards using market value (actual of estimated) for these assets.  To the extent that some or a significant portion of the assets of a financial service firms are marked to market, and the assets of most non-financial service firms are not, we fact two problems. The first is in comparing ratios based upon book value (both market to book ratios like price to book and accounting ratios like return on equity) across financial and non-financial service firms. The second is in interpreting these ratios, once computed. While the return on equity for a non-financial service firm can be considered a measure of return earned on equity invested originally in assets, the same cannot be said about return on equity at financial service firms, where the book equity measures not what was originally invested in assets but an updated market value.

b.     Loss Provisions and smoothing out earnings: Consider a bank that makes money the old fashioned way – by taking in funds from depositors and lending these funds out to individuals and corporations at higher rates. While the rate charged to lenders will be higher than that promised to depositors, the risk that the bank faces is that lenders may default, and the rate at which they default will vary widely over time – low during good economic times and high during economic downturns. Rather than write off the bad loans, as they occur, banks usually create provisions for losses that average out losses over time and charge this amount against earnings every year.  Though this practice is logical, there is a catch, insofar as the bank is given the responsibility of making the loan loss assessment. A conservative bank will set aside more for loan losses, given a loan portfolio, than a more aggressive bank, and this will lead to the latter reporting higher profits during good times.

Debt and Equity

            In the financial balance sheet that we used to describe firms, there are only two ways to raise funds to finance a business – debt and equity. While this is true for both all firms, financial service firms differ from non-financial service firms on three dimensions:

a. Debt is raw material, not capital: When we talk about capital for non-financial service firms, we tend to talk about both debt and equity. A firm raises funds from both equity investor and bondholders (and banks) and uses these funds to make its investments. When we value the firm, we value the value of the assets owned by the firm, rather than just the value of its equity. With a financial service firm, debt has a different connotation. Rather than view debt as a source of capital, most financial service firms seem to view it as a raw material. In other words, debt is to a bank what steel is to a manufacturing company, something to be molded into other products which can then be sold at a higher price and yield a profit. Consequently, capital at financial service firms seems to be narrowly defined as including only equity capital. This definition of capital is reinforced by the regulatory authorities, who evaluate the equity capital ratios of banks and insurance firms.

b. Defining Debt: The definition of what comprises debt also is murkier with a financial service firm than it is with a non-financial service firm. For instance, should deposits made by customers into their checking accounts at a bank be treated as debt by that bank? Especially on interest-bearing checking accounts, there is little distinction between a deposit and debt issued by the bank. If we do categorize this as debt, the operating income for a bank should be measured prior to interest paid to depositors, which would be problematic since interest expenses are usually the biggest single expense item for a bank.

c. Degree of financial leverage: Even if we can define debt as a source of capital and can measure it precisely, there is a final dimension on which financial service firms differ from other firms. They tend to use more debt in funding their businesses and thus have higher financial leverage than most other firms. While there are good reasons that can be offered for why they have been able to do this historically - more predictable earnings and the regulatory framework are two that are commonly cited – there are consequences for valuation. Since equity is a sliver of the overall value of a financial service firm, small changes in the value of the firm.s assets can translate into big swings in equity value.

Estimating cash flows is difficult

            We noted earlier that financial service firms are constrained by regulation in both where they invest their funds and how much they invest. If, as we have so far in this book, define reinvestment as necessary for future growth, there are problems associated with measuring reinvestment with financial service firms. Note that, we consider two items in reinvestment – net capital expenditures and working capital. Unfortunately, measuring either of these items at a financial service firm can be problematic.

Consider net capital expenditures first. Unlike manufacturing firms that invest in plant, equipment and other fixed assets, financial service firms invest primarily in intangible assets such as brand name and human capital. Consequently, their investments for future growth often are categorized as operating expenses in accounting statements. Not surprisingly, the statement of cash flows to a bank show little or no capital expenditures and correspondingly low depreciation. With working capital, we run into a different problem. If we define working capital as the difference between current assets and current liabilities, a large proportion of a bank's balance sheet would fall into one or the other of these categories. Changes in this number can be both large and volatile and may have no relationship to reinvestment for future growth.

            As a result of this difficulty in measuring reinvestment, we run into two practical problems in valuing these firms. The first is that we cannot estimate cash flows without estimating reinvestment. In other words, if we cannot identify how much a company is reinvesting for future growth, we cannot identify cash flows either. The second is that estimating expected future growth becomes more difficult, if the reinvestment rate cannot be measured.

Financial Service Companies: Value Drivers

Equity Risk

In keeping with the way we have estimated the cost of equity for firms so far in this book, the cost of equity for a financial service firm has to reflect the portion of the risk in the equity that cannot be diversified away by the marginal investor in the stock. This risk is estimated using a beta (in the capital asset pricing model) or betas (in a multi-factor or arbitrage pricing model).  There are three estimation notes that we need to keep in mind, when making estimates of the cost of equity for a financial service firm:

1.     Use bottom-up betas: In our earlier discussions of betas, we argued against the use of regression betas because of the noise in the estimates (standard errors) and the possibility that the firm has changed over the period of the regression. We will continue to hold to that proposition, when valuing financial service firms. In fact, the large numbers of publicly traded firm in this domain should make estimating bottom up betas much easier.

2.     Do not adjust for financial leverage: When estimating betas for non-financial service firms, we emphasized the importance of unlevering betas (whether they be historical or sector averages) and then relevering them, using a firm's current debt to equity ratio. With financial service firms, we would skip this step for two reasons. First, financial service firms tend to be much more homogeneous in terms of capital structure – they tend to have similar financial leverage primarily due to regulations. Second, and this is a point made earlier, debt is difficult to measure for financial service firms. In practical terms, this will mean that we will use the average levered beta for comparable firms as the bottom-up beta for the firm being analyzed.

3.     Adjust for regulatory and business risk: If we use sector betas and do not adjust for financial leverage, we are in effect using the same beta for every company in the sector. As we noted earlier, there can be significant regulatory differences across markets, and even within a market, across different classes of financial service firms. To reflect this, we would define the sector narrowly; thus, we would look the average beta across large money center banks, when valuing a large money center bank, and across small regional banks, when valuing one of these. We would also argue that financial service firms that expand into riskier businesses – securitization, trading and investment banking – should have different (and higher betas) for these segments, and that the beta for the company should be a weighted average.

4.     Consider the relationship between risk and growth: Through the book, we have emphasized the importance of modifying a company's risk profile to reflect changes that we are assuming to its growth rate. As growth companies mature, betas should move towards one. We see no need to abandon that principle, when valuing banks. We would expect high growth banks to have higher betas (and costs of equity) than mature banks.  In valuing such banks, we would therefore start with higher costs of equity but as we reduce growth, we would also reduce betas and costs of equity.

Quality of growth

To ensure that assumptions about dividends, earnings and growth are internally consistent, we have to bring in a measure of how well the retained equity is reinvested; the return on equity is the variable that ties together payout ratios and expected growth. Using a fundamental growth measure for earnings:

Expected growth in earnings = Return on equity * (1 – Dividend Payout ratio)

For instance, a bank that payout out 60% of its earnings as dividends and earns a return on equity of 12% will have an expected growth rate in earnings of 4.8%.  When we introduced the fundamental equation in chapter 2, we also noted that firms can deliver growth rates that deviate from this expectation, if the return on equity is changing.

Expected Growth_EPS 

Thus, if the bank is able to improve the return on equity on existing assets from 10% to 12%, the efficiency growth rate in that year will be 20%. However, efficiency growth is temporary and all firms ultimately will revert back to the fundamental growth relationship.

            The linkage between return on equity, growth and dividends is therefore critical in determining value in a financial service firm. At the risk of hyperbole, the key number in valuing a bank is not dividends, earnings or growth rate, but what we believe it will earn as return on equity in the long term. That number, in conjunction with payout ratios, will help in determining growth. Alternatively, the return on equity, together with expected growth rates, can be used to estimate dividends. This linkage is particularly useful, when we get to stable growth, where growth rates can be very different from the initial growth rates. To preserve consistency in the valuation, the payout ratio that we use in stable growth, to estimate the terminal value, should be:

Payout ratio in stable growth 

The risk of the firm should also adjust to reflect the stable growth assumption. In particular, if betas are used to estimate the cost of equity, they should converge towards one in stable growth.

Regulatory Buffers

The cashflow to equity is the cashflow left over for equity investors after debt payments have been made and reinvestment needs met. With financial service firms, the reinvestment generally does not take the form of plant, equipment or other fixed assets. Instead, the investment is in regulatory capital; this is the capital as defined by the regulatory authorities, which, in turn, determines the limits on future growth.

FCFE_{Financial Service Firm} = Net Income – Reinvestment in Regulatory Capital

To estimating the reinvestment in regulatory capital, we have to define two parameters. The first is the book equity capital ratio that will determine the investment; this will be heavily influenced by regulatory requirements but will also reflect the choices made by a bank.  Conservative banks may choose to maintain a higher capital ratio than required by regulatory authorities whereas aggressive banks may push towards the regulatory constraints. For instance, a bank that has a 5% equity capital ratio can make $100 in loans for every $5 in equity capital. When this bank reports net income of $15 million and pays out only $5 million, it is increasing its equity capital by $10 million. This, in turn, will allow it to make $200 million in additional loans and presumably increase its growth rate in future periods. The second is theprofitability of the activity, defined in terms of net income. Staying with the bank example, we have to specify how much net income the bank will generate with the additional loans; a 0.5% profitability ratio will translate into additional net income of $1 million on the additional loans.

Little Book on Valuation

Aswath Damodaran