The Hindu Business Line : Merton Miller's valuation theory

IT was received wisdom until Merton Miller in his M&M theorem (along with Franco Modigliani)expounded that the valuation of a company depended largely on the right mix of debt and equity.

A financial theory stating "the market value of a firm is determined by its earning power and the risk of its underlying assets, and is not dependent on the way it chooses to finance its investments or distribute dividends" was a bit of a jolt to those who followed their intuitions on market valuations.

The theorem is more complicated, but the basic idea is that,it makes no difference whether a firm finances itself with debt or equity.

"Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as it is. Or he can separate out the cream and sell it at a considerably higher price than the whole milk would bring." (That is the analogy of a firm selling low-yield and hence high-priced debt securities.)

Of course, the farmer would be left with skim milk having low butterfat content that would sell for much less than whole milk. That corresponds to the leveraged equity.

The M &M proposition says that if there were no costs of separation , the cream plus the skim milk would bring the same price as the whole milk.

Miller is best known for establishing the relationship between the structure of a firm's capital assets and its market value. He argued that managers looked after the best interests of their shareholders by maximising the firm's net wealth rather than worrying about its credit rating.

"What counts is what you do with your money, not where it came from," he once said.

Asked how he felt about having taught many economists including famous ones, self-deprecatingly, Miller said thatit was because, "I've been around so long". He was a professor atthe University of Chicago for 40 odd years.

The only son of a lawyer, Miller was born in Boston, Massachusetts, and followed in his father's footsteps to Harvard in 1940.

Even at that age, he was interested in making money work more efficiently, describing how he used to shuffle his account from bank to bank in order to be paid interest.

"You could get an interest-paying savings account in Harvard Square, provided there wasn't too much activity in your account," he recalled. "I would get my monthly allowance and put it in one of the local banks, making small withdrawals every day to pay expenses.

"If I got a notice from the bank for too much activity, I would walk my money across the street to another bank. There were four banks, one on each corner. I just put the money in the next bank. That way, I managed to have a checking account without paying transaction fees."

After Harvard, Miller worked for the US government. He entered academic life in 1949 by joining the graduate school at Johns Hopkins University, Baltimore.

After receiving his doctorate, he did a one-year stint as a visiting assistant lecturer at the London School of Economics (1952-53), followed by eight years at the Carnegie-Mellon University in Pittsburgh.

While at Carnegie, Miller began a long collaboration with fellow Nobel Laureate Franco Modigliani, and the first of their M&M papers on corporate finance was published in 1958. In 1961, he joined the graduate business school at Chicago, where he worked until his retirement in 1993.

His lectures and eight books expressed deep hostility towards government intervention in the markets, Miller got the Nobel in 1990, sharing it with two others. He died on June 5, 2000, at the age of 77.

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