Finance is really about one thing: Valuation. How do you put a price on an asset? Publicly announced merger and acquisition transactions occur all the time for both private and public companies. These M&A transactions occur over a period of time marrying negotiation with basic financial tools that can justify any reasonable valuation, just as long as buyer and seller agree on terms – largely subjective. The hard part, that current finance finds difficult, is how to value a public company that trades everyday, without a transaction where two parties agree on valuation through price. Current financial tools when applied to public markets usually are lacking in relevancy, scope and hard pressed to price any asset independently, irrespective of its publicly available stock price.
The question is – can finance (Valuation) be more objective? Can we take the mystery out of the valuation process, showing interested people the fair market value of the company in real time so investors can ask the following questions? How much should I pay for this company? Would now be a good time to sell? What risks jeopardize the value of my asset? What can I do to mitigate them? So obviously having a more objective and constant reading on what the asset is worth investors can move on to other questions that are easier to answer.
Model Price is a service like no other in the world of finance. We objectively calculate through our algorithm model price or fair market value of what a public company is worth on a daily basis. Model price is largely a function of mean earnings estimates from publicly available data sources. Our algorithm is so robust we can calculate model price on any company, in any industry in minimal time.
We also include in our work what we call Economic Book Value. Economic Book Value is derived from the company’s balance sheet and its iterations (parallel lines) are used as support and resistance areas for the company’s stock price.
By delivering two pieces of information, Model Price and Economic Book Values, users can quickly discern two independent pieces of information about valuation of the company in question. To deliver these two pieces of information we had to identify and develop new financial concepts not previously in existence in any textbook or periodical.
The financial concepts listed below are new to the field of finance and you will not find them in any textbook nor course material delivered in any undergraduate finance program nor MBA or CFA accredited programs. The good news is you don’t have to know these concepts to use our model price charts. These concepts are included in our algorithms that produce model price and economic book values and we only highlight them for a deeper understanding of the math behind our algorithms. Also we will specifically highlight individual concepts in blogs when we want to make a deeper observation of what a company maybe doing right or wrong resulting in a higher share price or valuation.
Is there a limit to the amount of debt a company can handle?
Believe it or not our current understanding in finance says no, there are no limits! However every businessperson instinctively knows this cannot be true and there must be limits like everything else in nature. Well in our world of finance there are limits on debt a company can handle and to understand these limits we highlight our Solvency Ratio and Solvency Curve under the concept of Solvency.
Here is the formula:
All public companies have balance sheets which are released quarterly. Picking out the variables in the above formula is an easy exercise. Once you compute R and P separately it is important that you note these variables because you may use R and P again for another concept that we call Theoretical Earnings (TE). For the concept of Solvency we divide R over P to formulate a result. This result can be viewed on what we call the Solvency Curve.
The output, numerical value, can be viewed in relation to Chart 1 below.
We have derived the Solvency Curve theoretically, and this curve is constant across all companies no matter which industry or category. First principle theoretical discussion of this curve is beyond the focus of this website, however the Solvency ratio is included in our Model Price calculation and considered when reviewing the financial structure of a company.
Elements of our Solvency Curve
The top of our Solvency Curve is 0.689. If the Solvency Ratio of a company is 0.689, this is the maximum and optimum ratio that matches the debt in the company with its assets. If the Solvency Ratio is less than 0.689, the company is sliding to the left side of our Solvency Curve placing it in a form of insolvency once 0.499 is breached. The lower the Solvency Ratio, from this point, the higher order of insolvency. It is important to note a company can exist in a form of insolvency for quite some time. However if any negative shock should occur, the company would be insolvent quickly resulting in a collapsing share price.
Chart 2: Blow up of the left side of the Solvency Curve
On the right side of our Solvency Curve (see Chart 1), a company can be what we call “Super Solvent”. This occurs when the Solvency Ratio is 1.7 or higher. Companies on the extreme right side of our curve could use more debt to appropriately increase leverage on the company assets, to increase returns on equity and efficiency of the balance sheet itself. As the Solvency Ratio approaches 0.689 from a Super Solvent state – moving up the right side of the curve – model price will increase recognizing a more optimum state of the company.
One of the key components of Model Price™ is the calculation of Theoretical Earnings (TE).
How do we define theoretical earnings?
We first start with the balance sheet. Balance sheets are constantly in flux. They are expanding or contracting depending on numerous variables. (e.g. earnings, depreciation, dividends, etc.) We can calculate the specific earnings number that a company needs in order for its’ balance sheet to maintain state or constant in the future. This earnings number we call Theoretical Earnings.
The calculation of theoretical earnings and its evaluation can give investors useful information of the production performance of the company. TE can give insights not only on past investment returns but also a strong predictor of future performance. We illustrate two instances below:
First, determining the company’s value.
Once we calculate theoretical earnings, we then can compare this to actual earnings. The differential between these two values we can use to determine a company’s market value. This differential can be a multiple times higher than the value of theoretical earnings. As a rule of thumb the higher this multiple, the higher the valuation of the company in question.
Second, comparing the absolute value of theoretical earnings over time.
By observing theoretical earnings over time we can infer how management manages its balance sheet. For instance, if management transacts a large acquisition, theoretical earnings can increases significantly as the size of the balance sheet (R+P) increases depending on the size of the acquisition and the way its financed (R/P). If the multiple of earnings, differential between theoretical earnings and the new consensus earnings post acquisition, hasn’t at least stayed the same (multiple) or has deteriorated, the acquirer’s stock price usually declines on the announcement reflecting the compression differential between theoretical earnings and pro forma earnings post acquisition.
Economic Book Value
We would like to emphasize that the EBV prices are calculated and are a function of a company’s balance sheet. They are not trended, nor are they derived through technical analysis, although it may appear that way.
Transits, on both the upside and the downside are strong market signals that the market believes the fundamentals are changing for a company (a breakthrough on the upside indicating improving fundamentals, a breakthrough on the downside indicating the market believes fundamentals are deteriorating).
EBV lines are color coded for ease of analysis.
How do we calculate Economic Book Value (EBV)?
To determine the valuation zones we begin by determining a company’s Economic Book Value (EBV). While the balance sheet reflects the static value of the assets through the shareholders’ equity account, we recognize that the value of a company is more than its physical assets. Value is derived from the organization and use of those assets, creating a dynamic value. This dynamic value reflects the natural growth of the balance sheet is our calculation of Theoretical Earnings, which we add to a company’s book value in order to determine the EBV.
What is the relevance of the EBV in terms of valuing a company?
The EBV is the adjusted book value of a company and we find that companies will bottom at their EBV when their earnings outlook is uncertain. Companies trade below their EBV when their earnings outlook turns from uncertain, such as a temporary slowdown or loss in earnings, to a longer-term outlook of subpar earnings or losses. These companies with poor returns on equity and capital will trade below their EBV as the markets recognizes their inefficient use of capital and assigns it no dynamic value, only static value of its assets.
How do you explain the significance of the parallel lines and how are they derived?
The parallel lines create zones for the equity prices to move around on a daily basis. These valuation zones occur at specific multiples to the EBV. These multiples are constants determined from our underlying mathematics and are applied equally to all companies. As stated above, important market information can be discerned when, what we call, transits occur. Transits, on both the upside and the downside are strong market signals that the market believes the fundamentals are changing for a company.
We would like to emphasize that the parallel lines are calculated and are a function of a company’s balance sheet. They are NOT trended, nor are they derived through technical analysis, although it may appear that way.
The company that I’m interested in is trading below EBV -3. Why are there no more lines?
When a company drops below EBV-3, it is a signal that the market does not believe the carrying value of the assets on the balance sheet. Investors that hold companies trading in this zone should be on the alert for the risk of potential write-offs to the company’s balance sheet.
One of the factors, in our three-factor model, may be difficult concept to grasp, but one we believe to be important as it represents a unique characteristic in our pricing model. This factor measures how sensitive the company’s Economic Structure Value (ESV) is to changes in its market value. We call this measure “convexity” because the final relationship we derive between a company’s price and its Economic Structure Value (ESV) is convex. The more convex the relationship, the more sensitive the company is to changes in its own market value.
How do we define the Economic Structure Value (ESV) of a company? As the name suggests, it measures the value of the economic structure, defined by the balance sheet and the market value of the company, but excludes the earnings of the company. That is, we are interested in the underlying structure of the company, not the earnings it generates. Changes in the price of a security on the public markets, all else being equal, will lead to a change in the economic structure. This is the feedback mechanism between the market value of the company and how the balance sheet of the company is constructed. We therefore have within our analysis the potential to measure the impact that a change in price has on the economic structure and its value.
In general, how do we calculate convexity?
In order to measure the sensitivity of the Economic Structure Value (ESV) to changes in the market value of the company, we calculate the ESV over a range of market values (stock prices). Plotting the ESV against the stock price results in a convex relationship. The greater the convexity, or bend, the greater the sensitivity the Economic Structure Value (ESV) has to changes in its stock price. To measure this sensitivity we fit a quadratic equation through the sample points and take the second derivative to measure how convex the curve is.
What lead us down the path to find convexity?
The development of this factor began with the inquiry of why certain companies have “price momentum”. These stocks typically have high valuations, as the underlying earnings and/or earnings growth are not sufficient to support or explain their valuations. The result is changes in the securities’ own price seemingly reinforcing itself. Rather than just apply the “momentum” label to these companies and leave it at that, our approach was to determine whether certain types of companies are pre-disposed to higher valuations because of their economic structure. The price momentum observed in the market would therefore be, at least in part, a function of this structure as valuations gravitate to levels dictated by the structure. We also can think of the convexity as analogous to friction. The less friction (the higher the convexity) there is, the higher the potential valuation.
What are the practical applications of this math?
- In general, we have found that the more sensitive a company is per our measure (the higher the convexity), the higher the valuation in terms of a higher price-to-economic book value.
- Stock Splits Matter. This will fly in the face of conventional financial wisdom but here it goes. Conventional financial wisdom holds that companies want to split their stock prices because of “perception” and “liquidity”. Perception in that the per share price gets too high that it will scare off some investors. Liquidity in the sense that more shares will equate to more trading volume maybe helping price discovery. In our world, stock splits represent a lowering of the share price (assuming the same valuation), which does two things to our math. Moves the curve closer to the x and y-axis and compresses the convexity of the curve. This movement, heightens our convexity score which increases model price (one of the 3 factors in our model price calculation.) Readers should note the corollary is also true on a reverse split, resulting in lowering convexity and decreasing model price.
- Payment of a dividend, or special dividend. Companies with excess cash may choose to pay a regular dividend to its shareholders or accumulate excess cash and pay this cash out in a lump sum. This will have an impact on the Economic Structural Value (ESV) on the enterprise. By lowering the asset amount on the company’s balance sheet, increases the efficiency in terms of convexity but also in terms of conventional returns on investment and capital.
- Buy back of shares in the public marketplace. Companies with excess cash can choose to buy back their shares in the public market place. This, again, impacts the Economic Structural Value (ESV) on the enterprise. By lowering the asset amount on the company’s balance sheet, increases the efficiency in terms of convexity but also in terms of conventional returns on investment and capital.
Obviously companies can and do both items 3 and 4 over a set period of time. The effect of one versus the other on convexity must be calculated however, in general, both actions have the effect of increasing convexity thereby increasing model price.