One thing that executives of both public and private companies have in common is that neither has a very good understanding of what determines the value of their stock.
When I headed corporate finance policy at the U.S. Treasury Department, I met with groups of Fortune 500 CEOs on numerous occasions, and they invariably complained about how Wall Street priced their stock.
“How can we announce a 20 percent growth in earnings and have our stock price fall?” Easy. If the market expected 30 percent growth, and had priced that into the stock, the earnings announcement told traders they had overestimated the company’s expected cash flows, and the price declined accordingly.
It is imperative for any executive, whether of a public or private company, to understand what determines the value of their business. The value of any business, simply put, is the sum of all expected future cash flows that will accrue to the owners, discounted to the present by a discount rate that reflects the time value of money and the risk of those cash flows materializing.
Just because a company performs exactly as expected does not mean the stock value remains static.
Every time assumptions change about the economy, interest rates, global peace, etc., that evolving world view has implications for a company’s ability to generate cash for its owners in the future. CEOs who complain that Wall Street only cares about short-term earnings are misguided. Please explain Tesla’s stock valuation as a function of its quarterly earnings! Ditto for any growth company. For companies that are not growing rapidly, quarterly earnings are a reliable proxy for future cash flows, so they do matter more.
One advantage public company executives have is that, on any given day, they can look up their stock price. Private company owners cannot; so they tend to focus on the wrong metric, one which is easily monitored: sales. This is very dangerous, as revenues are often a poor proxy for cash flow, which is what dictates value.
Private company owners frequently make false assumptions about how the pricing of a few deals in their industry translate into the value of their business. Not every company in a given sector sells for the same multiple of cash flow, which is commonly estimated by EBITDA. And when companies sell for a multiple of revenues, it is only because they have no cash flow, and revenues are the best signal for future cash flows.
I had the owner of a logistics company try to convince me the value of his company was equal to one times its annual revenue because one of his competitors sold for that amount. His competitor owned sophisticated proprietary software used to schedule shipments for clients; it generated impressive margins. The owner I was speaking with had no proprietary software and produced much lower margins. Each dollar of revenue equated to much less cash for the owners, so the multiple should be materially different.
In selling over 100 companies, I have witnessed countless business owners exhibit extreme confidence in their assessment of their company’s worth, despite never having been through the process. Business valuation is far more nuanced than most people believe. But in some respects, it is also more straightforward. For example, when I explain how cash flow drives valuation, I invariably hear: “What about my people, my reputation, my market position?” If you have good people, a great reputation and a defensible market position, all those will show up in the consistency and growth of your cash flows. If they do not, then you have misjudged their value.