How to create equity value in the face of uncertainty

Equity value is a top priority when buying a new business, investing in a new project or starting a new venture. And right now, our economies and capital markets confront endless uncertainties.

Uncertainties come in different shapes and sizes. Some are so obvious that they can be forgotten or overlooked (e.g. the trend in domestic house prices), others are fleeting and quickly resolve (e.g. the recent AdBlue shortage which was quickly resolved) and yet others are big, out of our direct control and extremely difficult to predict how they will resolve (e.g. climate-induced weather events).

Developing and executing strategic plans requires that we have some views as to how those uncertainties might play out and the consequences for the success of strategic plan execution from unexpected and unpredicted outcomes.

Read on to discover how you can improve the foundations of decision-making in your organisation with the aim of creating value from uncertainty.

At the end of this paper is a toolbox you can adapt for your organisation’s decision-making.

Dealing with the question of business and equity value on a daily – sometimes minute by minute – basis

For many of our clients there is a central question: how do I increase the value of my company?

Answering the question “what is the value of my business” or “should we invest in this opportunity” is a particularly and obviously challenging task. [LS1]

Mimicking the buyers and sellers operating  in deep, real-time capital markets, our work involves three key inputs:

1. Understanding the relative competitive position of a business or company
2. Interrogating capital market data
3. Financial analysis and forecasting

We don’t have a crystal ball to accurately predict how the myriad uncertainties in each of these three areas might unfold – but we are equipped with tools, data sources, analysis frameworks and real-world investing experience to support our clients through their major corporate decisions.

Those decisions are often characterised by questions such as:

1. Should we sell the underperforming division?
2. If organic growth is not going to achieve our objectives, should we buy a complementary business?
3. If pivoting our business to adapt to climate change involves major capex, can we justify the risks and capex involved?
4. If inflationary or competitive pressures undermine our margins, are there aspects of our business which need to be redesigned?
5. On the back of geopolitical and pandemic-induced shifts in markets, should we abandon our offshore expansion strategy?

Today, we are overwhelmed by uncertainties.

As a reminder, these include:

• How might the Federal or state elections impact our business?
• Is there likely to be a new strain of COVID that dramatically impacts us?
• How far will interest rates rise?
•  Will trade tensions impact Australia’s ability to penetrate certain markets?
• Will climate-induced warming impact the down-time hours of my outdoor workers?
• Will international freight costs revert to the long-term average?
• How will AI undermine the competitiveness of our business?
• When will immigration to return to pre-pandemic levels?
• How exposed are we to major cyber-attacks?
• Does our education system expressly and adequately address the need to transform certain sectors of our economy?
• How might the roll-back of trade globalisation impact our business?

Then there are the uncertainties that might more directly impact your business (e.g. “will we win that tender we just submitted?”).

There is an abundance of examples of chronically-bad outcomes from major corporate decisions which – with the benefit of hindsight – can plainly be seen to have occurred due to two principal causes:

1. A failure to base the decision on reliable evidence
2. Decision-makers being blind to the range of possible outcomes which were visibly able to arise from resolution of uncertainties

Our task (and yours) is to remedy both of these shortcomings of corporate decision-making by:

1. Ensuring reliable evidence supports decisions (that doesn’t necessarily mean the most accurate or comprehensive)
2. Bringing a view of the range of possible outcomes to bear on the decision analysis so that you can PLAN and ACT to deal with them

We often hear a defence to gathering evidence for decision-making that the future is so uncertain that “its not worth attempting to model it”.

What those who are of that persuasion overlook is that ignoring uncertainty does not make it go away.

Even if expressly considering uncertain futures results in an apparently and impossibly wide range of potential outcomes, the decision is now informed by what is possible and most importantly, what to DO about it.

Planning to DO something in response to the resolution of an uncertainty is critical to creating value.

What prompted the AGL takeover bid?

A guy (that’s unisex) walks into a room and asks “what do a multi-billionaire IT geek and a global infrastructure manager have in common?”.

The answer?

They both believe that $8bn is a fair price to pay to transform one of Australia’s largest energy companies, AGL.

How did they form that view or belief?

Firstly, they formed a view that the current strategy of AGL was not value-maximising.[LS2]

Secondly, they formed a view that there was a better strategy to maximise shareholder value.

Make no mistake that the application of $8bn of equity was motivated by philanthropic or altruistic objectives. It was not: both Cannon-Brookes and Brookfield have governance requirements that ensure appropriate returns are generated by any investment.

Whilst the strategy to decarbonise AGL’s business may not have been developed down to a granular, operational level no global infrastructure investor will deploy capital without a sound thesis which supports the expectation of generating acceptable rates of return.

So, how was the decision made?

To the first point above, both Cannon-Brookes and Brookfield are informed by the meta-trend to move our economy from dependence on fossil-fuel based energy to sustainable/renewable forms of energy.

To the second point above, it is clear from the AGL board’s rejection of the takeover offer that the company believes that the capital market has not appropriately priced (valued) the current AGL strategy. They expect that the real value of AGL is in excess of the view that the takeover offer reflects.

Essentially, AGL is telling investors “you haven’t properly valued our strategy and, if you did, you would see the share price elevated above the offer from Cannon-Brookes and Brookfield”.

Peloton has prepared a separate paper dealing with the AGL bid and what lessons can be learned from the “Brooks” bid. That paper will be available on our website shortly.

What is better: business as usual or more uncertainty?

In capital markets, uncertainty means risk.

Investors will price certainty above uncertainty.

The simplest example of this is government bonds where we can observe that investors are prepared to buy 15-year AAA-rated Australian government bonds on the basis that the yield from the investment will be 2.5%[LS3]  p.a.

By comparison, most private equity firms will price high-growth, tech-based investments on the basis that the expected return will be at least 30%[LS4]  p.a.

Why? Because the high-growth, tech-based opportunity presents significant risk that it will not deliver the 30% expected return. The actual return could be more than 30% or it could be, as the investment bankers say, a doughnut.

Ultimately, you will be rewarded for taking a risk (e.g. innovating production processes) than standing still waiting for your competitors to do what you could have/should have.

Creating value means taking risks.

Those risks need to be managed.

Identifying, recognising and investigating the potential uncertainties and then developing a plan to act in response to uncertainty is a superior plan to the one which simply declares “we’ll deal with it when it happens”.

Does anyone have a crystal ball?

The idea of a crystal ball is that the future can be reliably and accurately predicted.

In corporate finance there is the concept of a riskless return.

That concept is applied to the least-risky asset available. That asset isn’t actually “risk-free” but is typically taken to refer to a AAA-rated bond issued by the government of a well-developed economy (e.g. UK, Germany, US, Australia).

There is no investor in the world who has a crystal ball with which to accurately or reliably predict the future share price of any company.

What every investor is doing every day of the week is attempting to form a view on a possible range of future share prices given the available information about the degree of uncertainty of the company’s likely future returns.

In effect, investors are going through an iterative “if this, then what” process to evaluate how the resolution of uncertainties in one way or another is likely to manifest in the value of the company and therefore the company’s share price.

You can build yourself a crystal ball by examining the uncertainties and developing a plan which responds to the alternative outcomes – from a greater level of success than expected to a train-wreck which requires a least-cost extraction plan.

Capital market view of uncertainty

Established capital markets (think ASX, NASDAQ, ICE, NYSE) are virtual (and sometimes physical) marketplaces where millions of global participants are buying and selling equities, bonds, commodities and derivatives of those instruments 24/7, in real time, with no risk of settlement and with near-contemporaneous exchange between buyers and sellers.

Prices in these markets are informed by evidence as to likely future returns from the particular asset.

For every buyer there is a seller who holds a different view as to the likely future returns (excluding – potentially – sellers who are under financial pressure to sell i.e. distressed sellers).

Every buyer has formed a different view to the corresponding seller as to how the available information might impact likely  future returns in terms of value and, therefore, price.

Every single transaction between a buyer and a seller reflect a shared view of value at that point in time but equally, an opposing view as to whether the future likely returns will achieve the required rate of return for the risk presented by the asset being traded.

This is a really important and frequently overlooked aspect of deep, secondary markets: every transaction occurs between parties that have opposing views as to the ability of the asset to deliver the required rate of return for the risk it presents. To reinforce this notion: if every shareholder had the same view of the company’s value, there would be no transactions.

However, if we see a BHP share transact at $45.46, there is a seller who thinks that price is the most that should be paid for the expected future returns and a buyer who has formed a different view.

The respective views have been formed largely on the basis of a common information pool but as a result of buyer and seller forming different views as to the probability of how that information will impact the likely future returns.

What is also often overlooked is that it is rare for the buyer or seller to be prepared to exchange that BHP share at precisely $45.46. Rather, there will be a range across which the buyer and seller would alternatively be prepared to transact – reflecting the absolute certainty that the likely future returns are, in fact, uncertain.

The range of buying and selling prices might be informed by a third-party valuation (e.g. analyst report), a comparable transaction (e.g. Rio share price or the movement in the ASX Basic Materials Index) or a proprietary view formed by the buyer or seller.

The views of buyers and sellers are effectively changing instantaneously as new information becomes available which informs views as to the risk of the likely future returns. This information might be in regard to exchange rates, borrowing costs, availability of labour in a developing country in which the country operates, commodity prices, underlying demand for the company’s products and many more factors.

Given the continuous disclosure regimes in place in every major exchange, the company is obliged to alert market participants to events and information which might materially impact the value (and therefore the price) of the company’s shares. Every market participant is digesting the uncertainty (or resolution of uncertainty) such that all information pertaining to the company is reflected in their view of value and, ultimately, price.

How is risk priced by investors?
Investors price risk on a relative basis. That is, something that is apparently less risky than other investment alternatives will be priced to deliver a lower rate of return because that return is more certain than the alternatives.

Uncertainties in corporate decision-making introduce risk.

Without taking risks your returns are likely to be less than your peers.

However, it is the management of the risks that uncertainty presents which distinguishes success from failure.

Don’t let the resolution of uncertainty come as a complete surprise: build the response to unexpected outcomes into the business plan.

Toolbox

Navigating uncertainty requires structured analysis, data (evidence) and an actionable response plan.

Here is a toolbox you can use to support your organisation’s decision-making processes:

Conclusions

This discussion paper has focussed on how uncertainty infects all decision-making and expressly considering the possible outcomes (resolution) of those uncertainties impacts on successfully making a decision, executing the decision and then managing the consequences of the decision.

Whether you’re favoured frame for decision-making is reflected in:

• Measure, monitor, manage
• Plan, act, react,
• Now, where, how
• Contemplate, anticipate, activate, recalibrate

…there is a process which leads to successful outcomes and following this process is essential.

Creating value from uncertainty is not an impossible dream. It is the way that all investors become wealthy and just requires explicit recognition of uncertainties and a plan to respond to their emergence and resolution.

Every director and executive knows that there are only three ways to improve the rate of return on invested capital:

1. Invest more capital in assets or projects that are expected to exceed the cost of capital[LS5]
2. Reduce the amount of capital deployed but maintain returns
3. Accelerate the returns on the invested capital

Each of these decisions need to be supported by quality evidence and a plan which embeds flexibility to respond to the resolution of uncertainties in ways which are not consistent with the desired outcome.

There are steps that you can take to mitigate against bad investment decision outcomes. Mostly it is about doing three things:

1. Making sure that forecasts of likely future returns are informed by quality evidence (not solely by the echo chamber of existing management/board knowledge)
2. Improving the decision making support process to incorporate consideration of both less-favourable and more-favourable outcomes
3. Ensuring the project/acquisition plan considers how management will respond to the major uncertainties

Peloton Corporate experience

The specialist team at Peloton Corporate has extensive experience in providing assessments of market value of equity for listed and unlisted companies for various purposes, including financial reporting, IPO’s, impairment testing, investment valuation and regulatory support.

Our experience spans a variety of industries, including financial services, aquaculture, agriculture, infrastructure and many others.

Where appropriate, our team employs decision analysis tools to help map out key uncertainties and management decisions. This enables the development of project and equity models which expressly deal with the financial impact of alternative outcomes.

Buying a new business? Investing in a new project? Starting a new venture? Peloton Corporate employs tools and techniques which will ensure you have a plan to manage for value creation irrespective of the amount of uncertainty you confront. If you require any assistance or advice, please feel free to contact either Dominic Churchill (dchurchill@peloton.group), Luis Senra (lsenra@peloton.group) or Michael Churchill (mchurchill@peloton.group).