The Blue Line Imperative 2/x
Kevin Kaiser, S. David Young
Part 1.
3/ The Opportunity Cost of Capital
Capital markets have dramatically brought down the Cost of Funding [MK: I wonder why the authors are using this term instead of the common term “Cost of Capital”].
The authors think the definition of growing monetary value of investment is doesn’t fully reflect the purpose of investing into an enterprise, so they prefer seeing this as “an act of moving energy through time”. Energy can be used immediately or accumulated for future use. Saving (money, grain, nuts, etc.), giving birth to children (a long-term investment in the hope that they will feed their parents when the latter lose the ability to perform work) are all forms of deferred consumption of energy. Such savings can perish as a result of pilfering by neighbours or mice (both stealing the saved goods) or wars (where children die). Food is also perishable, so its improper storage makes it unsuitable for future consumption.
MK: The concept of energy looks quite artificial to me: indeed, humans shouldn’t consume all the energy they capture but rather save some of it for the rainy day or famine. I’m concerned that the authors are using the terms “saving” and “investing” interchangeably: a saved bushel of grain can only be considered an investment if it’s planted in the hopes that the size of the resulting crop will exceed the amount planted. Long story short: hoarding is an investment only if one is comfortable with zero returns at best (i.e., no spoilage).
Generally speaking, one can’t obtain something without putting anything in first. Ideally, there should be a choice of what uses of energy give the maximum output. MK: and in the ideal world one can use the “greedy algorithm” to optimise for the initial investment allocation.
MK: While the concept of energy sounds quite crazy, I tend to agree that the ancient humans who invented money (in its various forms of storing value) were smart to choose the embodiment that was of no use to any competing species: no animal would eat a gold or silver coin. At least, the form of money was not perishable. With the observable Lindy effect (the longer something exists – the longer it will keep existing), the trust towards such form of exchange and the length of the tradition of such trust ensures the continuity of such trust. The opposite is also true in the light of USD and EUR holdings of entire countries being blocked by the issuers of these currencies. Trust can be a tricky thing.
The means and the ability to store value (traditionally – in the form of labour and resource use meaning energy) has changed the humans’ approach to work from short-term focus to the long term, creating the possibility of investing or lending money (instead of re-planting of grains) and extending the investment horizons beyond foreseeable future.
Managers can only have a limited view of the investment opportunities available to them; their managers and the ones above them have a clearer picture of the opportunity costs of capital available to the entire firm. Hence, it may so happen that even the best projects in a division may provide an expected return lower than the opportunity costs from other divisions.
The Group CEO, however, is not prescient and doesn’t always have the perfect information about all available opportunities. Sometimes competitors have better cost structures so that their expected returns are higher. So, the benchmark for the opportunity cost has to be external, otherwise the company will only pick the lowest-hanging fruits.
MK: The authors clearly take a global perspective on value creation, which is problematic now in the light of globalisation being seriously challenged.
The risk-free rate (RFR) can’t be zero because we’re mortal (i.e., won’t be able to collect the return) or the business may fall victim to dramatic external factors (sanctions, rapid changes in consumer tastes, etc.). Bank interest rate is a function of the RFR, but is not a determinant of it. The risk-free rate in the US has historically been 2% p/a, matching the GDP growth rate. A good indicator of it is the 10-years Treasury Note.
Any return above the RFR is risky by definition. Reducing risks increases the certainty of the returns. Risks can even each other out (selling umbrellas next to sunglasses ensures customers will leave satisfied anyway), and it’s important to understand that one manager’s risky project can reduce the portfolio risk for the entire division or the organisation. If RFR is lower than the inflation rate (which governments are all too happy to understate), this is a form of implicit value destruction.
Historical equity premiums of US diversified portfolios have fluctuated 3-5% above the Treasury Bond rate.
4/ The Expected Future Free Cash Flows
In any voluntary transaction the seller values the item at less than they charge for it, and the buyer values it at more than the price they pay. Thus, the value of the item will be different for the buyer and the seller.
MK: it’s important to note that either party can be misguided about the perceived value, potentially leading to unpleasant outcomes.
There’s a distinction between share price and shareholder value. The former relates to the monetary amount a share can be obtained in the market, and the latter is the sum of all cash flows shareholders expect to receive from the business. (Really Finance 101.) What’s important here is that many initiatives to raise share price lead to the destruction of shareholder value.
Thus, value can be defined as the sum of all expected future cash flows from the business discounted at the opportunity cost of capital. MK: Welcome to the Discounted Cash Flow approach to valuing a business. Finance 101 again.
The “expected” qualifier is important here because the total expected payback becomes a sum of potential individual scenarios’ paybacks multiplied by the probability of such scenarios happening. Thus, value is probabilistic, not deterministic.
The “future” part means that past costs are sunk and are irrelevant, and also any news / changes from today must be reflected in the value. The authors are making a cliché argument that share price and shareholder value are two different things and that one shouldn’t sacrifice shareholder value for short-term investors. [MK: are people ever going to be tired of this argument?] It’s clear that the book was written before the 2022 share selloff, but this idealism is too hard to swallow.
MK: the fallacy of the authors’ thinking is that “the only relevant factor is the cash-generating ability of the company in perpetuity”. Eternity is a long time ©, and shareholders have a tool at their disposal that managers don’t have, namely the ability to dissolve / liquidate the company. It’s true that executives are meant to act as if the company will live forever, but it’s naïve to think that all shareholders would share this view. Sometimes shareholder value can be unlocked by selling or dissolving the company.
MK: another straw man argument listed in the book is that “finance people ignore the long-term impact of management decisions in their calculations”. They don’t ignore the impact; it’s just the finance people (rightfully so) have to rely on the judgements and calculations of the management to plan ahead. If the finance people had all the numbers and verified assumptions, at best the management should resort to executing the orders of the finance people. Gives me shivers, to be honest.
The book talks about the Free Cash Flow. I’m sure Wikipedia gives a good explanation of the topic. Then there’s the concept of NPV (Net Present Value). Then the authors mention the Modigliani-Miller theorem, which states that (quoting Wikipedia) “in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the enterprise value of a firm is unaffected by how that firm is financed”. [MK: I remember having to prove this theorem in my Corporate Finance class.] In the modern world (post-QE) this theorem remains only theoretically correct: “The Modigliani and Miller Approach indicates that the value of a leveraged firm (a firm that has a mix of debt and equity) is the same as the value of an unleveraged firm (a firm that is wholly financed by equity) if the operating profits and future prospects are same.” (source)
MK: it should be noted that the book lists the “disciplining effect of debt”, and I agree that it exists and creates a gentle push on the managers to perform as there’s this uncomfortable external stakeholder called “the debtors”. I’d add the debt covenants into the mix, too.
WACC (Weighted Average Cost of Capital) is a very comfortable concept (also taught in Corporate Finance 101). The authors are very firm that WACC is the opportunity cost of capital (i.e., the benchmark), not the cash cost of capital (i.e., the actual cost). The authors also firmly state that the “discount rate for the business is determined not by who provides the financing or the return they hope to receive, but by the riskiness of the cash flows, plain and simple” (MK: emphasis mine).
WACC, first and foremost, is NOT the input into the business. It’s the weighted return its investors and debtors expect to receive. Thus, it’s not the cost of capital that drives the discount rate, it’s the discount rate that drives the capital structure to support it. [MK: while it may be obvious to many people, I don’t think it was presented to us at the Corp Finance course, or I’ve completely forgotten it.]
Part 3.