Does the Market Know Your Company’s Real Worth?

Not long ago I asked the officer of a regional investment banking firm why the price-earnings ratio for a small publicly held company was so low. “After all,” I said, “this company has the potential to grow since it’s in the dental equipment industry. It seems to me it warrants a high ratio.” “Don’t you know,” my friend replied, somewhat puzzled, “that that company is mainly a machine shop? That puts it into a low-growth industry classification.” Why is it that even companies in the same industry have markedly different P-E ratios? And how can investors arrive at appropriate P-E ratios when they are confused about which industry a company belongs in? To wonder about such things in an era when respected finance textbooks refer to the “efficient capital market hypothesis” seems to be the height of irreverence. Isn’t the P/E up to the forces of the market—a market whose participants are all knowing? How does one account for the wide differences in companies’ P-E ratios—even in businesses within the same industry classification? In the Moody’s Industry Review of January 15, 1982, under the 1981 rankings for “Textiles—Miscellaneous,” 28 companies are listed. One of the companies, Guilford Mills, the sixth largest, is first in operating profit margin and first in return on capital but only twelfth in P-E ratio (its below-average rank is 6.7/1). In fact, for 23 of the 28 companies that made a profit in their last fiscal year in this category, the range of the P-E ratios was from 47.5/1 to 1.6/1. The latest industry grouping for restaurants (dated February 26, 1982) includes 42 companies. The smallest company listed, Florida Capital Corporation, is third in operating profit margin and fourth in return on capital yet last in the P/E ranking for the 37 companies that reported a profit. The list could go on and on. And what about the hundreds of thousands of closely held businesses? If shareholder wealth is a function of both a company’s earnings and its P/E multiple, can anything be done to raise the P/E? I believe management can do a number of things to influence its P/E multiple—too many, perhaps, to include in one article. Nevertheless, in the following pages, I attempt to identify the most important financial issues for management to consider. For instance, why is a company classified in one industry instead of another? What can a company do about being classified in a poorly valued industry? And what does a company’s pattern of earnings tell a prospective buyer or the stock market? Can normally intelligent, reasonable people discern the profitability of a company, or is it so hidden that it can be observed only after tedious examination? And if the company shows an unfavorable earnings pattern to those making valuations, are there favorable patterns that it might look for? Should a developing company seek listing on an exchange or remain in the over-the-counter market? How should management deal with stock market movement? And what about dividends for the developing company? Can they improve the market value of the business, or do they send out the wrong signals about the company’s stock? Finally, of what importance is a company’s debt-equity ratio in the subjective appraisal of share value for publicly held companies or the company’s overall valuation if the business is closely held? While there are other subjective factors—largely nonfinancial—that might influence the value of a developing company, I believe these are the most important of the subjective financial factors. My main concern is the developing business. The owners of the privately held company should be at least thinking about eventually going public. Most of the strategies I discuss in the next pages are inappropriate for the privately held business that never intends to go public. Determining the Industry Which industry is your company in? That question sounds simple, but it is not easy to answer. I recall working with a person who was quite experienced in corporate acquisition. Together we were examining a small publicly held concern that made electrical products. At least that was the way the company was presented to us. One man held majority ownership, so the acquisition would not be unduly complicated. But a line of not very exciting electrical products? Why bother? Then it occurred to this person that this company really made test equipment, which was much more financially attractive than electrical products. What’s in a name? Quite a lot, I think. Calling the company a manufacturer of testing equipment rather than a maker of mundane electrical components might make a huge difference in its overall financial attractiveness. A company’s industry classification tends to set the range of its P-E ratio, especially if the business is closely held. We rank such businesses by classifying them as “growth industries,” “services,” “job shops,” or “run of the mill businesses.” Aftertax multiples for closely held businesses may be six to eight times the earnings for a low-technology type of company and more for a high-technology concern or one with fast growth prospects. Once publicly held developing businesses become identified with a particular industry, changing their identification to another P/E industry category is difficult. When Milan Panic established International Chemical and Nuclear, Inc., it was quite apparent that he had his eye on at least two industries with strong investor appeal. In the mid 1970s, the company was renamed ICN Pharmaceuticals, presumably to avoid the negative connotation of nuclear on the one hand and to gain the positive connotation of pharmaceuticals on the other. Why a concern comes to be identified with a specific industry in the first place is perplexing. Failing to realize the importance of the P-E ratio can easily lead one to say, “What difference does it make?” But if you look at two businesses with the same sales and earnings and one is valued at ten times aftertax earnings and one at five—well, there is no need to pursue the obvious. The case at the start of this article is an interesting example of a company failing to adequately address the question of industry classification. If the company had spun off the higher P/E dental products division (as a stock dividend), the two publicly held businesses thereby created would probably have had a combined total value greater than the one that was viewed as “just a job shop.” Speaking of job shops, one good way to change that classification is to add a proprietary product line. If successful, the business might then be classified as a “proprietary product company” and command a higher valuation than it would as a job shop. By either starting companies or making acquisitions in more attractive industries, a company can take off in a whole new direction. In looking to the long run, however, management must be careful not to redirect the company into a voguish sort of industry. What’s the Earnings Pattern? In textbook finance, a company is worth the present value of its future earnings. To put meaning into this statement, however, one has to ask, What future earnings? And at what discount rate? Whether managers like it or not, the future is forecast from the past. What pattern of earnings has the business established? Furthermore, the people doing the forecasting—whether they be analysts for investment firms, bankers for closely held concerns, or people trying to evaluate the company for the purpose of buying it—are not clairvoyant. I believe that businesses with patterns of earnings that are easy to forecast and analyze will get the highest valuations. Consider the following examples: The ‘where are you going?’ syndrome. The company described in Exhibit I has created a pattern of earnings that makes predicting future earnings difficult. The trend seems to be downward, but it’s anyone’s guess whether that will prove out. Of course, perceptive observers will ask pointed questions about such things as R&D investments for future growth and on that basis try to forecast earnings beyond “time now.” But suppose the person making the forecast is not very clever and imaginative. Suppose, for example, the person doing the forecasting is a junior analyst only obeying instructions to use the past as a basis for projection. Exhibit I Failing to set a trend The conclusion to draw from such a pattern is that the fortunes of the company are sinking and that the cash flow to provide a return to investors or to service a loan for a leveraged buyout is not there. The company’s owners might have “saved” some of the earnings from the earlier period. If they had concluded that future earnings could not keep up with current results, earnings might have been held back by write-downs of otherwise questionable assets—inventory, receivables, or even fixed assets. Thus, future periods would be relieved of these charges against income. The trend might appear level or even upward, but certainly not downward, as it does in the exhibit. The turnaround that doesn’t turn. Then there is the manager who is too eager to get out of the red and doesn’t “clean house,” a situation that is described in Exhibit II. Instead of writing off “all the sins of the past,” management allows earnings to turn positive, only to see them sink into the red again. If analysts perceived that the turnaround was complete after two years and accordingly recommended the stock of this company, imagine how upset they would be (not to mention the people who had bought the stock on the recommendation of these analysts) if earnings fell back into the red. The analysts would probably feel they had been misled and that the only way they would ever recommend the stock again would be if the chief executive deemed responsible was dismissed or left the company. Exhibit II Failing to ‘clean house’ It is not necessarily investment analysts who are misled. Consider how a banker would feel if his own customer fell into this circumstance, especially after a leveraged buyout in which the turnaround had supposedly been completed. Here, the most appropriate strategy would be to allow losses to continue until all the losing projects were written off and the way was cleared for earnings to rise—that is, if the equity section of the balance sheet would support such a move, for you don’t want a negative net worth. The ‘we never pay taxes’ syndrome. How many managers have said that the best way to run a closely held business is not to pay taxes? Too many, I’m afraid. Don’t get me wrong. I’m not saying that businesses should seek to pay as much tax as they can. On the contrary. But how do you value a company that makes no money? If the concern is closely held, it might be possible to minimize earnings by paying a salary or a bonus to the owner-manager and thereby reduce or eliminate taxable income. The problem is that the Internal Revenue Service will consider the reasonableness of such payments when it examines them for tax deduction. If, for the size of the company in question, the IRS decides the remuneration is excessive, it will disallow or reduce the tax deduction. Since many owners know that the IRS might disallow such a deduction, they often resort to “creative ways” of burying the remuneration to reduce taxes. It is at this point that short-run goals like minimizing taxes can interfere with long-run goals—like selling the business. If the “creativity” is so imaginative that others (potential buyers, for example) can’t find where the remuneration and “goodies” are hidden, the creativity becomes counterproductive. The ideal pattern. A pattern should be easy to understand and should slope upward. Consider the examples in Exhibit III. Exhibit III Charting an ideal course The example on the left shows an unbroken trend of rising earnings, so projecting future earnings is quite easy. (Whether reaching such a conclusion from an extrapolation of such data is correct is another question.) The example on the right shows that in one year the company had a loss but that earnings rebounded quite well and are apparently continuing the upward trend. I think that most analysts or prospective purchasers would “forgive” the concern for the loss year if the cause of the loss had been eliminated. Per Share Earnings & Stock Price What would an “appropriate” earnings per share for a developing business be? This is another way of asking how many shares to leave outstanding and what stock price range to seek. We might say that stock prices fall into four categories—penny stock (which sells for less than $ 1.00), low price ( $ 1.00 up to $ 10), medium price ( $ 10 up to, say, $ 75) and high price (more than $ 75). Which of these is appropriate for a developing company? Penny stocks are usually thought of as being strictly speculative. Mining stocks and oil exploration stocks are examples. Most developing concerns would want to avoid this image if possible. I use the word image advisedly, for I remember a conversation with a man who was trying to sell his closely held business and retire—he was about 70. He said he had been approached by a large company whose president he knew. The owner-manager had looked up the price of the public company’s stock in the newspaper and observed that “it only costs 75 cents. I don’t think that’s very good, do you?” I was tempted to explain that the public company could have changed its stock price upward simply by having a reverse split of its stock, but the owner-manager’s mind was made up. That was a “cheapo” stock, and he wanted nothing to do with that company. In business, it’s not so much what you are as what people think you are that counts. For most developing companies, an EPS that will put the stock—because of the P-E ratio—into the low-price range would seem to be appropriate. In this range you can buy round lots (100 shares) for less than $ 1,000; most people prefer to buy in round lots, not just because the commission is lower for round lots but also because people feel “wealthier” buying round lots than they may actually be. With more potential buyers rather than fewer, the market expands. Using this same line of reasoning, an entrepreneur who had started a medical equipment business was selling his stock to any physician, surgeon, or dentist who would buy it for $ 2.00 a share. He began doing so when the company was formed and did so as long as it remained unregistered, that is, nonpublic. Only once did anyone ask him what P/E the price represented, although it had ranged widely during the two or three years before the company had gone public. His reasoning was simple: How much can you lose on $ 2.00 a share? The situation was rather like placing a bet at the race track, but the strategy worked. Another reason for a developing company to avoid a high stock price is that some advisory services regularly review and recommend low-price stocks. A growing small company that is out of the low-price category risks being overlooked by such analysts and may fail to attract shareholders. Incidentally, if the company’s stock price goes above the desired price range, a stock split may lead to a slightly higher P/E if, after the split, the price is slightly higher than the split indicates. Of course, some spectacular stock offerings like Genentech start out at a substantial price and go on up from there. But few stocks are like Genentech’s. As simple as it seems, stock repurchase for publicly held concerns is another way for management to affect the earnings per share. True, the earnings report contains a footnote “on fewer number of shares,” but the impact is still there. Acquiring another business for a lower P/E than the acquiring company enjoys also raises earnings per share—the so-called “pop in earnings.” Of course, the reverse will cause an EPS dilution. Another factor that might reduce earnings per share is the “treasury stock” method of reporting earnings. If “stock equivalents” exceed 20 % of the outstanding stock, then the earnings must be reported not as “primary and fully diluted” but only one way according to this method. Stock equivalents are convertibles, warrants, and stock options. I remember one developing company that issued too many warrants when it made its initial public offering of stock and a year later found that it needed an 85 % increase in absolute earnings to obtain the 15 % increase in earnings per share it desired. Listed vs. OTC Stock Which is better for stockholders’ wealth—to be listed on the American Stock Exchange or to be in one of the various groupings of the over-the-counter (OTC) market? On the positive side, being a listed company carries prestige and, as a possible consequence, some additional liquidity, especially when a stockholder uses the stock as collateral for a loan. Also, in a merger proposal, a listed stock may be more attractive than an unlisted one. A strong point in favor of an exchange listing is that the latest price quotations are available in any daily newspaper that carries stock listings. If a company is OTC, the stock price may be carried only in newspapers within the company’s region. On the negative side is the potential problem of an undercapitalized specialist handling the company’s stock on the exchange. Of course, all the specialists admitted to participation in an exchange meet its minimum capital requirement, but that doesn’t amount to much. Listing on an exchange also subjects the valuation of a stock much more to the opinion of a single party than if it were OTC with a number of market makers. I remember the open disagreement one developing company’s president had with his Amex specialist about ten years ago. It became so heated that the president withdrew his company from the Amex and returned to the “security” of the OTC. If a company is OTC—and there are numerous categories of the OTC, such as NASDAQ listings (National Association of Securities Dealers’ Automated Quotations) and regional OTC—a market for its stock will be made by one or more brokerage firms. For some lightly traded stocks, only one or two brokerage houses will “make a market” in the stock. For others, there may be two or three dozen market makers spread across the country. This arrangement is rather like having two or three dozen mothers watching out for your well-being, but whether it will benefit the P-E ratio—and thus the wealth of your stockholders—is moot. It is logical to assume that the research department of a brokerage firm making a market in a company’s stock will, from time to time, report the progress of the developing company to its customers. These reports can do a lot to bring the developing concern to the attention of investors. If a number of brokerage firms are making a market in the company’s stock, there should be a number of such research reports. And, just as in any form of merchandising, the more buyers who see your product, the better sales will probably be. At least you should have a better chance of getting a higher price for a given quantity. State of the Stock Market From time to time, some industrial groupings get hot in the market and as a group find that their P-E ratios are well above their prior levels. For example, from mid-1970 to early 1972, stocks in the recreation industry category soared to three times what they had been selling for and what they have been traded for since. Real estate stocks, which lagged badly for much of the 1970s, saw a run-up in their stock prices in the early 1980s. Pollution control stocks have also gone through a big price rise in the last four or five years. And the list goes on. When these upswings occur, what should management do? How do you distinguish a fad in stock price movement from an ordinary shift in P-E ratios? Again, a complete discussion of this question is too detailed for this article, but the important point is that management should take advantage of such swings and not just sit back and say, “Isn’t this nice.” It should use this period of ebullience in the stock market to further the growth plans of the company, perhaps by offering a new issue of stock to raise funds for expansion or even for acquiring another company. Many companies are swimming against the current. “Don’t waste good earnings on a bad market” is an old saying with more than a modicum of common sense. If the market for stocks in general or for just a particular industry grouping is in the doldrums, the wisest course may be to move earnings sideways for a period rather than trying to buck the trend (assuming, of course, that you can do so legally and ethically). What Price Dividends? Every student of finance knows Durand’s formula for the capitalization rate for a company’s equity: D/P + g, where D/P is the dividend yield and g is the expected growth rate in dividends. And who can deny that dividends are important in the valuation of stocks of large corporations? But what about the smaller publicly held company? What if it pays no dividend and is not expected to in the foreseeable future? Of course, we could substitute earnings for dividends in the formula and, to get a share price, let g be expected growth in earnings, but we would still not be addressing the question of how important dividends are in the stock valuation. By definition, the developing concern is growing and presumably has a way to go before its growth rate diminishes. If such a business were to inaugurate a dividend, wouldn’t analysts ask questions about the reasons behind the action? Can’t the company make better use of such funds? Furthermore, since dividends are taxed as ordinary income, wouldn’t most stockholders of developing companies like to see capital gains rather than ordinary income? Why, then, should a developing company pay a dividend? When a growth company declares a cash dividend, it signals that its growth is slowing down. Is this what the developing business wants to convey to the investing public? Even if the payout is small, would it help the price of the stock? I doubt it. If this dividend signaled a slowdown in growth, the company might be transmitting what is called negative information. Well, if cash dividends are ill advised, what about stock dividends, which are theoretically used as a way of sharing profits while conserving cash? This way, stockholders can increase their shares in the company or sell the dividend stock and can often get capital gains treatment. As I see it, the trouble with this approach is that shares outstanding increase at a compound rate. It’s a 5 % stock dividend this year, but next year it’s 5 % of 105 % , and so forth. This pattern holds down growth in earnings per share. You can argue with some assurance that if the company’s stock price drops less than the value of the stock dividend does, the P-E ratio has actually risen. The only apparent reason for such an occurrence is that the market perceives a stock dividend as a harbinger of continued growth. To the extent that there is growth, modest stock dividends are indicated for growth stocks. Falling Chips This article is an answer to those who argue that a company shouldn’t worry about its P-E ratio because it lies outside company control. “Just keep cutting the wood and let the chips fall where they may!” Indeed, current financial theory speaks of “risk classes” and discount rates “appropriate” to a given risk class, as though such a determination is as easy as adding two and two. For most developing companies, I question the efficient market hypothesis. Instead, I see many investor decisions being made on the basis of subjective impressions as well as objective data. It is up to the smaller company to do all it can to put its best foot forward.

Does the Market Know Your Company’s Real Worth?

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