5 lessons I learned from Américo Amorim

Some lessons I learned by working with Américo Amorim:

1. Never rely on anyone. You should not depend on a single supplier, bank, or person. If you offer someone the chance to influence your actions, you are effectively exposing yourself and this will become a source of weakness sooner or later. We live and work in a market economy, you should only depend on the system. Use the system to your own advantage;
2. Walk the talk. Working in a company (or a bank) is a choice and a lifestyle. Some chose to become an artist, a politician or a civil servant – you made your own choice. You will meet people from all walks of life: understand what they expect from you and walk the talk;
3. It is often physical. No-one ever seriously developed a business just by sitting in an office. If you work in an industrial company, you need to talk with people on the shop floor. If you sell a service, you need to meet your clients. Travel if you need to. Spreadsheets are good, being on the ground is absolutely fundamental;
4. Keep your promises, and ask others to keep their own. While some people are good at delivering on what they promised, most are not. Remember what you were promised and demand it. Conversely, you should make a real effort to honour your promises;
5. Talk with everyone – including politicians. While you may have your own political views, you cannot afford to alienate a group of people based on their political views, as you may need their support further down the road. This is more tricky to carry out than you might think, since you should make yourself scarce at the same time. Find that balance.

Estimating the cost of capital

In the subject of project valuation, most companies adopt a method that suits their financial and overall economic environment. When valuing a project (or an acquisition), companies need to choose the right parameters for their financial models, consistent with the risks involved and do not behave in the same way. Between choosing the risk-free rate and its periodicity, the cost of debt and equity and the data sources, companies use different valuation methods.

The 2011 survey by the Association for Finance Professionals on the cost of capital (“Current Trends in Estimating and Applying the Cost of Capital”) provides evidence on the project valuation process of 309 companies. The average company evaluates projects using the Discounted Cash Flow model, develops an explicit cash flow forecast for the first five years of the project or investment, and applies an estimated terminal value to all cash flows thereafter.

One of the most surprising facts in this survey is that 84 of the 309 companies surveyed forecast using a one-year horizon, which is inappropriate, as a short projection period will not produce a realistic financial analysis.

Another surprising fact is that the choice of the risk-free rate that is all but consensual in project valuation. Assuming that all the companies in the survey are based in the US, the risk-free rate used should be the returns on US long-term Government bonds, adjusted by the respective country risk premiums if the company in question has operations outside the country. However, this is not the case.

The choices of the typical company

The survey concludes that, on average, a typical company uses discounted cash flow (DCF) analysis to evaluate the uses of its capital when considering competing projects and long-term investments. When estimating the cash flows to be discounted, the organisations develop an explicit cash flow forecast for the first five years of the project or investment, and applies an estimated terminal value to all cash flows thereafter, using the perpetuity growth model to estimate that terminal value.

Recognising the unpredictability of forecasted cash flows, the typical company uses multiple cash flow scenarios, including best case, expected case, and worst case forecasts. To find the rate at which to discount cash flows, the typical organisation calculates its weighted average cost of capital (WACC) and reviews that calculation only when needed for a valuation.

Furthermore, the companies surveyed do not usually adjust the WACC to reflect factors unique to the project or investment being considered. Those companies recognise that the estimate of WACC is not perfect, but believe it to be accurate within a range of plus or minus 75 basis points. When valuing a potential acquisition, these companies use the estimated cost of capital from a group of companies comparable to the potential acquisition target.

To determine the weights to apply to the cost of debt and the cost of equity in determining the WACC, the typical organisation uses the current book debt-to-equity ratio. The nominal cost of debt is based on the current interest rate on the company’s outstanding debt, with the after-tax cost of debt being calculated using the company’s effective tax rate.

The typical company uses the capital asset pricing model (CAPM) to calculate their cost of equity. To perform that calculation, it uses the current rate on the 10-year Treasury note as risk-free rate. Regardless of where that rate is, the typical company does not impose any floor or cap on the risk-free rate.

The following are some charts that summarise the most relevant valuation assumptions used to produce valuation estimates, according to the survey:

[Updated December 2012 by Hugo Mendes Domingos]

Free valuation e-book: Modelling Innovation – Chapter on Net Present Value of Free Cash Flows

We are now releasing the preview of the next installment of our free valuation e-book. Chapter 5 can be downloaded here.  Continuing with the company valuation theme, Chapter 5 focuses on describing how to calculate the Net Present Value of Free Cash Flows, answering the following questions:

• What is the Mid-Period Convention?
• How to calculate the NPV of FCF.
• Practical example on valuation of company project.

We look forward to hearing from you, so do let us know your comments.

 

Free valuation E-book: Modelling Innovation – Chapter on DCF Valuation

We are releasing the preview of the first Chapter of our free valuation e-book, which can be downloaded here.  We start with Chapter 2 (Chapter 1 will be the introduction, to be drafted at a later stage). This chapter focuses on DCF valuation, including the following topics:

• What is the Discounted Cash Flow method?
• When should it be used?
• What are the advantages and disadvantages of the DCF method?
• How is a DCF valuation structured?

We tried to cover not only the why i.e. what are the advantages of the Discounted Cash Flow methodology but also the how i.e. in practice, what steps are required to build a credible DCF valuation.

We look forward to hearing from you, so do let us know your comments.

Stop obsessing about the next black swan and innovate

This post was written with Sónia Pereira Coutinho and published in the M&A Portal.  

Financial models have been hailed as the ultimate investor and management tools for decades but may have lost some of their shine following the unpredicted crisis and the onset of an “innovate or die trying” paradigm.

 Financial modelling is done by companies, investors and financial intermediaries in the context of investment projects. Financial forecasts are used by management teams to ensure that a project’s returns are adequate and that all the critical aspects have been covered.  Financial intermediaries use financial models to decide whether, for instance, a loan should be extended to finance a project or an acquisition.

 The popularity of financial models has grown in line with the increase and easier access to data. Modelling the complex reality of an investment project (or an acquisition) makes it easy for everyone involved to understand the critical drivers. In doing this, the analysts behind the models use a minimum number of assumptions that are supposed to capture the key elements of the project or the company being analysed. This is an appealing concept which often leads to dangerous simplifications.

 In the case of innovative projects, there are various drawbacks to building financial models and forecasts to support an investment decision. Innovation (and in particular disruptive innovation) is tough to measure. Either the market does not exist or the company’s cost structure is changed in a profound way. Models usually lack the flexibility to reflect the changes that take place when a company innovates. Many innovative projects are abandoned due to the inability to show their benefits in a financial model.

 Financial models can also give a false sense of stability to a company’s management team. Even in the absence of innovation, the current economic and even political conditions make it difficult to use financial models as a tool to predict future developments. What happened in Europe since 2007 was unprecedented and strategies that assume that market conditions will be stable in coming years may be a recipe for disaster. Reality will be more volatile and the conclusions that result from a financial model always depend on the validity of assumptions (often time series). If these are wrong or change over the projection period, conclusions will no longer hold.

 In reality, few companies manage to build perfect forecasts or make steady profits over a number of years. Even established companies experience unexpected changes in their markets. Strategy must take into account these fluctuations, which can result from demography, technology, competition or any other market factor. Addressing innovation – whether on an incremental or disruptive level, looking for it in-house or on the market – is increasingly a matter of survival.

 This has obvious implications for M&A situations. Acquisitions can happen for a number of reasons. Usually the acquirer is looking to increase size, obtain synergies and economies of scale. In other cases, the target company is an innovative firm acquired by a larger rival. The chart below shows that acquisitions of small and mid-sized European companies in the Telecom, Media and Technology sectors (by larger acquirers) have been steady since 2009, which confirms that we are dealing with a long-term trend which has proven resilient to the crisis. Larger businesses are interested in smaller, innovative companies which provide the top line growth which they often lack.

 

Source: Bureau van Dijk Zephyr, March 2012.
(1) Data for all targets located in Western Europe in the technology, media and telecommunications sectors with revenues < EUR100 M acquired by companies with revenues > EUR500 M, between 1 January 2009 and 31 December 2011

 Acquiring smaller innovative companies offers various advantages from the perspective of larger, more established companies: breaking into a new market, gaining access to new technology. In these cases, the financial model that supports the decision to acquire should include not only the returns from the transaction but also the positive impact of the target’s integration. These aspects are difficult to measure and a number of acquisitions do not reach a conclusion as a result of the acquirer’s inability to quantify these positive outcomes.

 Management teams, banks and investors may have relied too much on soothing financial models and management metrics and taking unintended risk as a result. No-one questions the importance of using good numbers to take business decisions, but it can be argued that complicated quantitative models did not prevent European banks from taking substantial and unwanted risks in the years that preceded the financial crisis.

 What the crisis has shown is that European companies need to innovate to thrive. Investors and banks can benefit from supporting innovative companies (as their US counterparts already do) and while financial models provide a good basis for discussion, overall their credibility is questionable. We can only hope that innovative companies will find a way to finance themselves without being too constrained by spreadsheets.

[Updated May 2012 by Hugo Mendes Domingos]

Morals and the takeover code do not always mix

This post originally appeared on Bureau van Dijk’s M&A Portal.

CMVM, the Portuguese equity market regulator, has recently opened a  public consultation period (which is now over) for proposed changes to the takeover code. At present, the code allows the use of so-called defensive measures during takeovers. In practice, if an acquirer launches a takeover offer for a company quoted on Euronext Lisbon without the prior approval or the company’s core shareholders, chances are that the offer will not be successful. Most quoted companies are controlled either by families or core shareholders, whose rights are protected by shareholder agreements and other locking mechanisms.

The proposal, in short, consists in removing voting rights limitations and defence mechanisms.

It is safe to say that, in larger European exchanges and in the US, shareholders’ rights are respected. Take the UK as an example: if a foreign or UK investor, be it a corporate or an investment fund, decides to launch a credible takeover offer for a company listed on the London Stock Exchange, offers a suitable premium and convinces more than 75% of shareholders to accept the offer, it will achieve control over the target. It is as simple (and powerful) as that.

In Portugal, if an investor launches a public takeover without gaining prior approval from core shareholders, the target’s Board will likely block the offer before it even gets to a stage where other shareholders can vote on it. 

 

Also consider the following facts:

• So far, no one has found a way to convince core shareholders to let go of their control rights over quoted companies.
• It is widely accepted that most Portuguese quoted companies would be taken over by larger, foreign competitors, if such shareholders did not exist.
• Most Portuguese consider that, if foreign competitors acquired the leading Portuguese quoted companies, this would be a disgrace. International investors (investment funds, pension funds) already own the majority of shares of those companies, which makes it hard to understand this belief. Yet most politicians appear to share this view.
• A large number of investors buy equities purely for financial purposes. These investors will usually hold on to a stock for less than a year. Large volumes of equities are also traded as part of derivatives trades.
• The State and the State-owned bank, Caixa Geral de Depósitos, are under increased pressure to sell non-core assets in order to reduce the public deficit.
• A number of companies quoted on Euronext Lisbon are former State-owned companies that were privatised during the 90s.

I went through the regulator’s consultation document and what caught my attention was the emphasis on principles and moral values. At a certain stage, the regulator attempts to justify the reason why changes to the code are necessary. Reference is made to principles including “shareholder sovereign rights” and “the proportional rule” according to which “capital and voting rights should be proportional”, as if those principles were part of some sort of universal declaration.

 

Why is it so hard to recognise the following?

• The State, directly or indirectly, contributed to create a system in which most quoted companies are controlled by Portuguese core shareholders.
• Some (but not all) of these shareholders depend on the State or State-owned banks for financing. In other cases, the acquisition of the shares was partly debt financed and shareholders will need to reduce their leverage in the short term.

The Status Quo is no longer sustainable and the takeover code simply needs to be amended in order to reflect the new reality. Why call on principles, moral values or use emotionally charged words to justify these changes? As with most policy decisions which result from the financial crisis, this one is pragmatic and owes little to principles. 

 

Still, the proposed changes are a step in the right direction. The regulator had to refer to some principles in order to justify this initiative, which is fine by me.

 

I can understand the reasons why a number of people would oppose these changes – as well as why others will back the reform. One side will defend that the budget needs to be balanced and that the country needs to attract foreign investors. Others will defend the need to preserve the independence of quoted companies and fend off attacks from larger international competitors. The positions of the protagonists will depend on their political allegiances and professional interests.

My view is that the benefits of change are far greater than the disadvantages. Advantages would include improved efficiency: while quoted companies will be more vulnerable to being taken over by larger competitors, this could result in improved management practices as management teams develop competitive advantages in order to retain their independence. Another benefit could be improved access to equity markets, which is crucial at this stage when companies need to deleverage.

Why are acquisition multiples a taboo subject in Portugal? [barrier]

Whenever a UK or US newspaper reports on an acquisition, one of the most usual subjects is a short analysis of the acquisition multiples. Why is this important? One of the main questions that arises when a company is acquired is whether the acquirer paid the right price.

One of the most bewildering facts about the way journalists report acquisitions in Portugal is that price and value multiples are almost never mentioned. I really cannot say for sure why this is the case – there could be several explanations.

One explanation could be that transactions in Portugal are comparatively small and there would be limited interest in the price. But then, why bother reporting at all? Perhaps journalists simply know that, if they were to ask questions about the value of the acquisition, they would not get a straight answer.

Another possibility is that journalists cannot be bothered to calculate an EV/EBITDA multiple. The maths are not challenging… The media sector is going through a difficult phase now with cost cutting and editorial staff limitations, which may explain why there are rarely in-depth articles about acquisitions.

While multiple analysis has a number of limitations, it allows analysts to draw certain conclusions. The lack of transparency in M&A in Portugal is yet another barrier to entrepreneurship. No-one really understands what a company is or could be worth, so why bother starting a business?

Yet there are positive developments. TTR is a financial information company which focuses on providing proprietary information about global M&A transactions which involve Portuguese and Spanish companies.

Should TTR data make its way into mainstream media in Portugal, this could indirectly act as an incentive to entrepreneurship. However, newspapers and TV stations have given up on actually hiring editors and are happy to use and reuse existing news so this could prove unrealistic.

Do you think that mainstream media and particularly newspapers should focus on acquisition multiples? Or would you find it too technical?

More about Apple’s acquisition of Nortel’s patents

It emerged today that Google bid Brun’s constant and Meissel-Mertens constant in the auction for Nortel‘s patents. These numbers are well-known to mathematicians. When the auction got to 3 billion USD, Google bid Pi. The press speculates that the company was either supremely confident or bored.

Here is a thought: Google was not bored and probably knew that there were other corporates in the run. Google’s only goals were to avoid that patent trolls such as Intellectual Ventures ended up owning the portfolio, as well as securing a role in the next stage of the process. Google can talk with Apple if needed but would find it more difficult to talk with a belligerent patent acquisition fund.

Google never liked formal auction processes organised by banks, either in the context of acquisitions or securities offerings. Google’s IPO avoided the usual bookbuilding process.

This is my theory – only the bidders and bankers involved in the process know what really happened.

Patent trolls and Apple’s acquisition of Nortel’s patent portfolio [hack]

There is much to be said about Apple’s acquisition of Nortel‘s patent portfolio. The deal size is impressive, keeping in mind that these are intangible assets.

This deal is proof that a company that fails to bring the results of its R&D activity to market  will face difficulties. Nortel filed for bankruptcy while sitting on a huge and valuable portfolio of patents. Innovation is about bringing new products and services to market and not (only) about filing patents.

Seen from the outside, this looks like a defensive move from Apple. Defensive action knowing that patent trolls were participating in the auction. The term “patent troll” designates acquisition funds and companies that focus on acquiring patents and then suing other companies that use those patents without paying royalties.

Are patent trolls a barrier to innovation or an incentive? There’s plenty of debate on this issue. It appears that Apple could not afford to see these patents fall into the “wrong hands”. There were two patent trolls in the auction according to the press, among them Intellectual Ventures.

This deal also shows the importance of access to competitors’ assets (in this case, intangible assets) developed by other companies. This is especially the case for technology companies. Innovation is not about a lone genius coming up with an idea but more like a collective effort, that involves various companies and experts working together to deliver a novel product or service.

The acquisition illustrates the central role that patents play in a technology company’s development as well as their enduring value.