Finance and Growth Strategies Term Paper

Pages: 10 (3180 words)  ·  Style: Harvard  ·  Bibliography Sources: 15  ·  File: .docx  ·  Topic: Economics

Finance and Growth Strategies

In an increasingly globalized and competitive marketplace, many companies are seeking more effective finance and growth strategies that will help them grow their businesses and better achieve their organizational goals. In some cases, acquisition of other companies may represent a viable strategic approach to such growth, but in order to ensure that the acquiring enterprise is getting its money's worth, some method of evaluating the value of potential acquisitions becomes critical. To this end, this paper provides relevant definitions, comparisons and an analysis of the effectiveness of three different investment evaluation methods that are commonly used to value companies, to-wit: (a) net asset value, (b) price: earnings (P:E) ratio, and - discounted cash flow. A summary of the research and salient findings are presented in the conclusion.

Review and Discussion

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Background and Overview. Company valuation techniques have become the focus of an increasing amount of attention in recent years, with typical textbook solutions call for projections of a company's future earnings and payouts, accounting for all associated taxes, discounting the yield back to the present based on a market interest rate that reflects the riskiness of the investment (Roberts, 1991). Some company valuation techniques have become increasingly regarded as inadequate because they are unable to capture the broad spectrum of factors that contribute to a company's true value in terms of its ability to provide a return on investment today as well as in the future. Furthermore, these issues can assume even more profound challenges to the financial analyst when the company under consideration for purchase is located overseas where differences in accounting procedures or ineffective or nonexistent corporate governance requirements may restrict access to relevant information required or where insider control prevents or diminishes such access (Harwood, Litan and Pomerleano, 1999). Three company valuation techniques that are commonly used for this purpose, (a) net asset value, (b) price: earnings (P:E) ratio, and - discounted cash flow, are discussed further below.

Term Paper on Finance and Growth Strategies Assignment

Net asset value (NAV). Black's Law Dictionary (1990) advises that a company's net asset value is, "The market value of a share of stock in a mutual fund. The net asset value is arrived at by deducting total liabilities (accounts payable, notes payable, etc.) from total assets (cash, securities, etc.) and dividing such amount by the number of shares outstanding" (p. 1040). For stock appraisal purposes, a company's net asset value is the share which stock represents in the value of the net assets of the company, including all property and value, whether realty or personalty, tangible or intangible, goodwill, and the company's value as a going concern (Black's, 1990). According to Murphy (2000), the formula for a company's net asset value can be expressed as follows:

Closed-end investment companies are the modern equivalent of the British investment trust and are structured like a standard corporation; these enterprises issue a fixed number of shares and invest the proceeds in an actively managed portfolio of financial assets (Fortune, 1997). In this regard, Fortune reports that, "These shares are traded on registered exchanges or over the counter at prices determined by supply and demand, like any other corporation's shares. Closed-end fund shares are often priced at a discount or, less frequently, at a premium to the fund's net asset value per share (NAV). In contrast, open-end mutual funds, which also hold actively managed portfolios of financial assets, are obligated to buy or sell their shares at the fund's NAV. Any transactions in the open-end fund's shares are between the fund and its shareholders at prices linked firmly to the prices of the fund's underlying assets" (Fortune, 1997 p. 45).

In his description of the NAV model, Droms (1997) reports that, "Book value represents the value at which an asset is carried on the company's balance sheet ('the books'). Stated alternatively, assuming that all assets could be sold at book value and all current liabilities paid off, the net asset value, or book value, represents the dollar value of the remaining assets that would be available to pay off each class of security in order of its preference in liquidation-first bonds, then preferred stock, then common stock" (p. 35). In this regard, in his book, Inefficient Markets: An Introduction to Behavioral Finance, Shleifer (2000) reports that, "A closed end fund, like the more popular open end fund, is a mutual fund which typically holds other publicly traded securities. Unlike an open end fund, however, a closed end fund issues a fixed number of shares that are traded on the stock market. To liquidate a holding in a fund, investors must sell their shares to other investors rather than redeem them with the fund itself for the net asset value (NAV) per share as they would with an open end fund" (p. 53). The so-called "closed end fund puzzle" describes the empirical finding that closed end fund shares usually sell at prices that are not equal to the per share market value of assets the fund holds; while in some cases funds sell at premia to their net asset values, in recent years discounts of 10 to 20% have been typical (Shleifer, 2000).

A number of companies is search of buyers emphasize the fact that they represent a good value because their share price is so heavily discounted against their net asset value; however, many analysts agree that a critical issue is to look at where share price is relative to net asset value:

You can't look at that in isolation because you could have a company that has a 20% discount to its NAV, but its return on that NAV is only generating 5% each year," one points out. "That would be below its cost of capital, the cost of equity, so as a shareholder you'd want them to provide returns on that shareholders' capital in excess of what you could get on a long bond, which is effectively risk-free. Firstly, you would want to be compensated on what you could get on a bond, and secondly for the risk you'd take on in excess of what you'd be doing in you'd invested in a bond" (Nevin, 2002 p. 33) critical factor to consider as well is the return on equity of the NAV. Indeed, as Nevin emphasizes:

There are many examples of companies where their ROE is well below 10%, and those companies will not really justify a price that is in excess of their NAV per share. This is a critical issue for analysts. In the past, especially in a bull market, the market has often forgotten about the NAV and concentrated on the price earnings ratio, especially in financial services companies, where much of their earnings are generated by their shareholders' capital unlike factories, say, which are hard assets and that produce goods for sale. Financial companies have financial assets which are their net asset.value and their shareholders' capital, which they use to generate returns. We pay particular attention to this aspect: the price of NAV and return on equity, or return on that NAV. (2002 p. 34)

If the decision is made that this investment analysis approach is the most appropriate for use for valuation purposes, information concerning closed-end mutual funds is obtainable from Moody's Finance Manuals as well as Wiesenberger Investment Companies Service; in addition, the Value Line Investment Survey provides information for some closed-end mutual funds by providing a one-page report that indicates turnover, management fees, and past performance, of the fund (Murphy, 2000). Likewise, differences between market price and net asset value for closed-end mutual funds are listed in the Monday Wall Street Journal for a number of closed-end stock and bond mutual funds, as well as international funds; in most cases, all such financial information can also be obtained directly from the closed-end fund itself or through toll-free 800 telephone numbers (Murphy, 2000).

Price: earnings (P:E) ratio. Profitability ratios such as the price-earnings ratio portray the ability of a company to efficiently use the capital committed by stockholders and lenders to generate revenues in excess of expenses; as a result, such ratios are of interest to both stockholders and potential investors alike (Riahi-Belkaoui, 1998). In his essay, "Profits and Stock Prices: The Importance of Being Earnest," Kopcke (1992) reports that, "Stocks frequently are appraised as a multiple of their recent earnings, the price-earnings ratio. At the very least, this multiple depends on the shareholders' required rate of return, the prospective rate of growth of earnings, and the proportion of earnings that is distributed to shareholders as dividends. Other things equal, the lower the required rate of return, the greater the growth of earnings, or the greater the ratio of dividends to earnings, the greater is the price shareholders are willing to pay per dollar of earnings for a corporation's stock" (p. 26). If the rate of return on a corporation's surplus (e.g., the difference between the value of its assets and the value of its liabilities) remains constant (r) and the rate of growth of profitable investment opportunities is constant… [END OF PREVIEW] . . . READ MORE

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