Tuesday, July 10, 2012

The minority shareholder discount to Corporate NPV

Net Present Value is a  fundamental mathematical principles of finance that is used to value projects and whole companies.  NPV provides a way to distill a single value today from all assumed future cash inflow and outflow timings.  It is an extremely valuable number because it tells us what a project or even the largest public stocks are worth today.

NPV only tells you the value of a project from the perspective of its controlling interest
If you own 51% of a project with an NPV of $100, then that project is worth the full $51 to you, because you have complete decision control over what to do with future cashflows, and one of those decision options is to terminate the project/company at its end, and pay out the full $100 (NPV) as dividends to all shareholders, and your share will be $51.  With a controlling interest, you might even be able to divert more (than $51) of the projects proceeds to yourself through salaries and bonuses.

If you are one of the shareholders owning 49% or less, 49% ownership of a $100 NPV project is worth far less than $49 because of every possible alternative decision available to the controlling interest other than paying out the full NPV as dividends
If you own 51% of a project, and thus control it, the alternative decisions (to paying back all profits as dividends) available include increasing your management salary/stock options and hiring friends and family, thereby diverting an additional portion of the profits to yourself and entourage.  A high, but reasonable, salary has no basis for legal objection.  More importantly, you can choose to reinvest the full $100 in new projects instead of paying it back.  Doing so, lets you extend the duration of your reasonably high paying management position, and forces the reinvestment of the $49 that "belongs to" the minority shareholders into subsidizing investments of your choosing.  By reinvesting future project earnings in perpetuity, you guarantee yourself permanent employment, and never have to repay minority shareholders.  I've made a new post focusing specifically on proving just this point, if the above paragraph makes you angry or confused.

The market price of public stocks is close to its NPV
Though not quite provable, the market price of a stock (its extrinsic value), tends to be closer to the NPV value of the corporation instead of the lower intrinsic value to minority shareholders.  Even though nearly all trades occur among relatively low-ownership-positioned-investors, the transactions are at a price that is much higher than the NPV of the funds (intrinsic value) that are expected to be distributed to shareholders.

The only 2 sustainable ways to profit from stock market holdings...
are dividends and take overs.  For private companies and startups, an IPO is equivalent to a take over as a cashing out opportunity.  The false academic defense of using the controling interest value of a company (NPV) as the fair market value of all of the company's stock is rooted in the company's take over potential.  The argument is that even if minority shareholders will never be paid directly by management, some other company will come forward and buy out the entire company because the cumulative value of all of its projects is worth the controlling interest value to the buyer.  The reason this defense is false is that it doesn't apply uniformly to every company.  It applies to the perfect takeover candidate:  One without a controlling interest coalition, with a plain common share structure, and without golden parachute and poison pill provisions designed to block takeovers.  A controlling interest can also block a reasonable takeover bid because it insufficiently compensates them for the loss of their personal piggy bank.

The takeover potential for any individual company can be severely compromised by several factors.
  • Concentrated Ownership.  A transaction for a company at its NPV value is impossible when control is concentrated in few people because the value of empire (salary and nepotism discretion) is worth more to the owners than the NPV value of the company (to acquirer).
  • Dual class shares.  A more sinister version of concentrated ownership that is popular among family owned business and tech companies (GOOG, FB).  This separates common shares into voting and non-voting classes.  This not only lets the controlling owners veto any takeover offer, it also obstructs any possibility of a future dividend payment, because the controlling owners can instead pay themselves by selling some of their non-voting shares without losing any control, or lowering their piggy bank's (company's) cash.
  • Poison pills and golden parachutes.  Even without a controlling interest, management can ensure substantial compensation packages (golden parachute) to trigger in the event of a takeover, or if they have temporary control of the company, enact a permanent corporate bylaw (poison pill) that would significantly increase the costs to any potential acquirer of a takeover.
  • Size of the company.  Only small and medium sized fish get eaten by other fish.  Companies can be too big to have any potential suitors.
  • High Unemployment environment.  One attractive point to potential acquirers is that it allows them to obtain the talent of the company, as a shortcut of getting into that business.  In an environment of permanent high structural unemployment, an alternative of building a competing company may seem cheaper and more attractive.

A simple (incomplete) valuation model for stock ownership investments
The value of an investment to YOU is obviously based on how much that investment will pay YOU or pay whoever you transfer the investment title.  The underlying company's profitability is irrelevant if none of those funds or value will ever be passed on to you.  So the simple  valuation (defined as intrinsic value) of a minority stock position is based on future dividend payments and expected takeover probability and takeover price.  This valuation is substantially less than the NPV value of the company (its extrinsic value/ market valuation), because the company will not pay its full cashflow/earnings out as dividends, and the chance of a takeover at NPV value is lower than 100%.  Before I expand on this, let me criticize extrinsic sources of valuation.

The Stock market is scam
The extrinsic value of a stock is whatever price you believe you can sell it (back) for by some specified date. The distortion (difference) between extrinsic and intrinsic value is a shared delusion.  It is a purposeful exaggeration influenced by a silent conspiracy of academics, politicians and financial professionals who benefit from shared conjured phantom valuations.

I was amazed to learn that pyramid schemes are unregulated in Russia, and the same scammer has repeatedly created new schemes (that all failed within months) with the most recent one attracting 35M participants (more than 20% of Russians?).  The schemes are not technically fraudulent if (as above example) they are honestly represented as not having any intrinsic value and simply a process to pay early investors with the funds of later investors.  In Canada (and many places elsewhere), pyramid schemes are outlawed regardless of any fraud specifically because they have no long term buy and hold intrinsic value, and possibly because they raise no tax revenue from the transactions, and there is a waste of money's time in that capital is diverted from any productive function.

Despite being fully aware of the complete absence of any intrinsic value in the Russian pyramid scheme, I might be tempted to invest for a 20% 1 month return.  If I were an insider in the pyramid scheme, I might be tempted to reinvest after 1 month if bonus incentives were high enough, and I saw stable inflows into the scheme.  While there might not be any fraud in official communications, it would be easy for me to recruit potential investors by having them focus more on the 20%+ potential monthly returns, and less on the eventual 100% loss if they stay in too long.  I would do so even if internalizing being a shameful social parasite.  Its an astounding statement on the power of human greed that these Russian schemes gain such widespread participation even with the experience of well publicized recent collapses by the same scammer.

Facebook has an intrinsic valuation below its market price, but more than 0$
If FB will never pay dividends, and never accept a takeover offer due to its corporate share structure and complete decision authority held by Mr. Zuckerberg, then it has a 0 intrinsic value for any other shareholder, but those assumptions aren't quite absolute.  First, FB has an NPV somewhere between $10B and $100B depending on very subjective assumptions on user growth, monetization potential, and user acceptance of monetization schemes.  Lets say that you believe FB's NPV will reach $40B in the foreseeable future as those assumptions materialize, and that the valuation becomes clear enough for Mr. Zuckerberg to also believe it.  As the only "real owner" of FB, he might consider a $50B takeover offer.  He would require a high premium due to his attachment to (benefits of) empire and control.  Because the acceptable selling price is well above NPV, the probability of an offer is fairly low.  A $40B NPV value of FB would imply reasonable prospects of earning $3B to $4B per year sustainably.

Now with a $40B NPV, shareholder disgust with FB's refusal to pay a dividend and refusal to accept a reasonable takeover price,  could lead to a market price of $20B, but that value would likely be a floor assuming the $40B NPV is retained.  The reason is that FB would then be compelled to react to shareholder disgust.  If it offered a $1B annual dividend (5% yield), then the intrinsic value of FB to many (enough) investors would be close to $20B or higher, and if it offered a $2B annual dividend (10% yield for $20B market cap), that would likely lead to a market value equal to the NPV of $40B, if the dividends appeared sustainable.  The reason Mark Zuckerberg would care about raising the market price of the stock, even if FB has no intention of raising more money from the market, is that he can personally dump his non-voting shares at a much higher price.

The key to determining the intrinsic value discount to NPV is the boycott price
A company like FB can be forced to provide intrinsic value to shareholders only by demanding that it does and investors collectively refusing to purchase its stock.  This creates an intrinsic value floor in the stock price where the company should intervene and create intrinsic value by issuing a reasonably sized dividend.  The only way to create that intrinsic value in such companies is for investors who do not own them, to demand high dividend payout ratios from them.  The other benefit of dividend payouts to shareholders is that it makes the company a smaller fish that therefore has more potential takeover suitors.

The biggest extrinsic distortion on intrinsic value comes from assumed growth rates
McDonalds (MCD) is a healthy company with a healthy future.  It currently has a $92B market value and a dividend yield of 3.09% which I believe targets a 50% payout of income.  Yet despite its solid foundations, its stock is nowhere close to the safety of a bond, because its market value is based on continued strong growth trends it has enjoyed in recent years, and there would be a severe hit to its market value if growth expectations decline or disappear.  The dividend provides some intrinsic safety, but in the end, the only compelling reason to invest is if you belief consensus growth expectations are too low.  Its practically impossible for outsiders to make an informed guess as to MCD's precise future growth rate everywhere in the world, but relatively easy to rely on its future solid health.

One way for MCD to substantially increase its intrinsic and market value is to boost its dividend payout ratio to 75% or 90%, because its core investors are more interested in its solid sustainability than in gambling on its growth level.  Boosting the dividend by 50% or 80% results in a 50%-80% increase in the company's intrinsic value.  The added benefit is that more of any growth or non growth will be captured by shareholders.

Although 50% payout ratios can still be ok
While, as stated above, very high payout ratios are the ultimate value for investors due to risk reduction, moderate payout ratios such as 50% can be adequate compromises.  If a stock can be likely expected to have the same or higher dividend, and continued sustainability, 10 years from now, then the stock can be valued as though it has a full payout of earnings.

Even if it forever pays only 50% of earnings back to investors, an expectation of sustainable earnings growth with a reasonable payout policy does mean there is tangible/intrinsic value (payout) in the stock and an expectation that in the future it will continue to have tangible/intrinsic value.

Still, there must be a good excuse for a payout of only 50%, including near certain growth.

Bonds have intrinsic value equal to their NPV
Because bonds and loans pay their full income stream to every investor, a bond's NPV is the same for all bond holders, and the intrinsic value of bonds to all bondholders is its NPV.

Reasons why corporate bonds are not as popular despite clear advantages for smaller investors

  • Investor greed: Its easy for potential investors to fall for the sales pitch of future valuation/growth and  to take advantage of the pyramid scheme nature of stocks, by counting on a future "greater fool" who will believe the sales pitch, and buy the shares from the initial investor.
  • Government corruption:  For unjustifiable reasons, governments set the tax rates for profits from share ownership at a substantially lower rate than that for interest income.  This is done entirely to facilitate stock scams where companies get financing from investors that receive far less intrinsic value than what they pay.
  • Lower corporate risk:  From the company's perspective, issuing shares carries no obligation to repay investors, while bonds typically have fixed repayment terms that tend to be impossible to meet in startup phase, and add risk to established companies.
  • Complex bylaws and dilution prevention:  While on a basic level, bonds offer a simple investment proposition that will provide promised returns as long as the company stays healthy for say 10 years, each bond has its own rules that may allow the company to issue more debt that dilutes the bondholder, and even a healthy company get be the target of a leveraged buyout that substantially increases the risk to bondholders.  Management has no duty to bondholders, and can abuse them.

Natural finance loans as an honest solution to investor and corporate needs
Natural finance soft loans have no fixed repayment terms.  Loans are repaid either when the company generates the operating cashflow (and a 3rd party comptroller ensures that they must be repaid when cashflow materializes), or when new investors are willing to bid a lower interest rate for the company's outstanding loans.  The queued structure (first loans are first to be repaid) of natural finance loans ensures that no dilution of lenders is possible.

From the company's perspective, Queued Soft Loans have the same low risk as issuing shares because they carry no obligation to repay if it is unable to repay.  By separating management insiders who retain ownership and control, from outside investors who simply deserve due financial compensation for their investment, natural finance causes less confidence games/abuse because management's belief in grandiose prospects for a company can have the financial rewards of success retained by management, while supporting the loans it borrows from natural finance investors.

Needed social and investment reforms
Institutional investors are the key to any possible reforms, because they have the collective and individual power to demand intrinsic value comparable to their share costs.  In addition to demanding and supporting natural finance instruments, there are 2 main solutions the investment community can pursue:

  • Proper Tax policy: Increasing taxes on capital gains and dividends to match interest income is good for future investors.  There is no need for governments to help scam investors into poor investments with no sustainable returns.  Natural tax policy includes a core recommendation of letting dividends be a tax deductible expense to companies, and include a 10% surtax on investment returns.  Making dividends tax deductible is a key to promoting their payment.
  • Stop government corruption of corporate governance: Governments, most eggregiously Delaware, corrupt corporate governance by restricting institutional and small investors from any influence on the board of directors or management.  Boards that are hand picked or too sympathetic to management will prevent investors from ever being repaid.
  • Boycott shares of companies with low intrinsic value for investors:  If a company has no prospects of being taken over, and refuses to pay substantial dividends, stay away from its stock until it becomes respectful of shareholders, or its price drops significantly enough to become a takeover target.

No comments:

Post a Comment