The Hindu Business Line : Towards the selectively open kimono

DEALING with financial markets absorbs on an average a fourth of the CEO's time, and almost a third of the CFO's attention, informs Mark C. Scott in "Achieving Fair Value," from Wiley (www.wiley.com) . The activity is thus the single largest drain on the most valuable resource the company possesses, yet many companies bungle at the task, rues the author. The book, therefore, proposes "a constructive way to reduce share price volatility and investor churn" based on fair value.

But what is fair value? It means that the primary focus of management should be on fundamental, operational value creation and ensuring that investors value as accurately as possible, explains Scott. "Pursuing a fair value strategy demands the development of a set of analytical tools and management processes which are typically underdeveloped in most companies," he would remark.

Misvaluation is a trap, warns the author, citing research findings - "that premiums of greater than 40 to 50 per cent of underlying fundamental value typically endure no more than 2 to 3 years." At that point they suffer a `correction', points out Scott. "The moment of correction is usually prompted by a profits warning as the company can no longer deliver on hugely raised expectations for earnings growth."

Thus, managements that raced all along to maximise value can see value destruction; for, corrections punish shareholder value. "A typical correction involves a reduction in market capitalisation of in excess of 50 per cent," notes the author, and adds an eerie observation - that once a stock has suffered a correction, "it takes up to 7 years for it to regain the average market multiple it historically enjoyed before the correction."

Moral, therefore, is not to chase share price maximisation as the objective, but "to seek to achieve a fair market value for the company", so that market cap accurately reflects the company's `sustainable underlying performance'. Don't leave the exercise to the markets because they can get it wrong, is a caveat to bear in mind. Instead, understand your customer, the `institutional fund manager'.

Check if your company fits the criticism, "given the increasingly exotic mix of institutional investors in the typical register, the complex range of motives and behaviours they exhibit, and the short average period of their investment."

Part two of the book deals with `the building blocks of fair value'. Valuation has two component parts, viz. future profitability and the cost of capital needed to finance the generation of profit, explains Scott. Management has to take responsibility for producing a robust valuation, and also be clear about the tolerance range or `fair value corridor', he argues.

Do `account management', he urges, "to target management resources where results can be achieved against `value determining' fund managers". Next, select `fair value levers', that Scott puts in three categories, viz. "what we tell investors, how we tell investors, and what actions we take".

Don't bet on a single lever to stay within the fair value corridor, advises the book. "Managing a fair value strategy requires a coordinated approach among fair value levers which appears absent in many corporate centres." Why so? Because, "different levers fall under the control of different departments, from strategy to finance". A chapter is devoted to `profiling value-determining investors' to help in `getting to know the culprits'. Scott organises the info under four categories, viz. level of influencibility ("Do marginal active portfolio decisions get regularly made on the basis of debriefs and new information about the company?"); core style ("How do they typically exit a position, blast or bleed?"); vulnerabilities ("Has the fund's performance been below its peer group?"); and investment triggers ("Is there a history of strong response to half-year performance to forecast?").

Decide how much to tell investors, using inputs from the book, to shake from the typical management psyche - "that the less that is disclosed, the more flexibility is created to avoid unpleasant surprises". Scott reports that various regular surveys of institutional fund managers show that "the degree to which the company opens its kimono is an increasingly dominant driver of their confidence to invest." There is evidence, according to the book, that a company more frank about its value-generating capability than its immediate competitor, who sticks purely to the disclosure rules, enjoys some sort of competitive advantage. Low disclosure has its costs, reminds the author, and leads you towards `the selectively open kimono' to identify potential disclosure gaps.

An important discussion is on `the role of management quality'. Companies with a fair value strategy tend to de-emphasise the role of the CEO and emphasise the quality of the board, management processes and what could broadly be called `governance', is an insight from the book that your CEO may not like. Yet, look at governance not as a hygienic factor to be complied with but as a value lever to deploy.

Great value for money!

BookValue@TheHindu.co.in

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