Time is Value

Time is Value A doctoral dissertation by

Dr Peter J. Clark

Submitted to the Henley Business School, University of Reading in partial fulfilment for the Degree of Doctor of Business Administration

ISBN: 978‐1‐909507‐50‐0 Copyright© Peter J. Clark Licence to publish granted to Academic Conferences and Publishing International Limited, 2013 For more information see www.academic‐conferences.org

Time Is Value

_______________________________________

A thesis submitted in partial fulfilment for the Degree of Doctor of Business Administration

by Peter J. Clark

Henley Business School University of Reading

September 2010

Abstract One of the curiosities of legacy approaches for company valuation using discounted cash flow-based (DCF) methods is that one of the more important assumptions in terms of effect on company value is also one of the more controversial. This is the supposition within the Gordon Growth Model (also known as the Gordon Formula) that for valuation purposes, all companies experience infinite life spans.

This Researcher’s phrase for this supposition is the “perpetuity conjecture”. On the basis that (i.) time (t) —as represented by companies’ life span durations—is a variable and determinant of company value and (ii.) firms’ overall actual median life spans are less than a decade, reliance on this perpetuity conjecture can and does result in errors.

This thesis confronts the perpetuity conjecture in the Gordon Formula on multiple bases, encompassing both primary and secondary research. An argument is presented for modifying future versions of the Gordon Formula to allow for t to be projected on the basis of past information adjusted for emerging developments, similar to the projection approach already utilised to calculate the Gordon Formula’s other three variables, FCF, g and WACC. The resulting evolutionary change will result in the Gordon Formula expanding from a three variable ratio to a four variable serial equation. Some of the possible categories of approaches for projecting that future time (t) variable on a company-by-company basis are explored on a preliminary basis.

i

Acknowledgements I have a debt of gratitude to many friends, family and colleagues who have helped make this study possible. In particular, I wish to thank the following: My principal supervisor, Professor Roger W. Mills, whose interest in this topic including its future ramification provided a continuing source of encouragement.

His insight and guidance at key points inspired my efforts and helped to define parameters for this investigation.

Dr. Carole Print, who served as acting supervisor and later as secondary supervisor. Her patience and helpful suggestions throughout this process were appreciated.

Professor Bill Weinstein, who kindly acted as interim supervisor during a literary stage.

To all of the twenty-five valuation practitioners who participated in the nonconfidential survey undertaken in Spring 2010, several of whom demonstrated their enthusiasm for this research topic and the purpose of this study by their helpful and often extended responses. Included in that group are Stephen Penman, Bartley Madden, Timothy Luehrman, Justin Petit, David Young and Stephen O’Byrne.

And most of all to my wife, Dr. Lillian Clark, for her love and support over the years of this study’s development and preparation.

ii

Author’s Declaration At this writing, none of the material presented within this thesis has previously been published.

All the work contained within this thesis represents the original contribution of the author.

iii

Table of Contents 1 Introduction .................................................................................................................1 1.1 Background ..........................................................................................................3 1.2 Perpetuity Conjecture Issue Explained: The Company Valuation Duration Dilemma ........................................................................................................................7 1.2.1 Equation Simplicity ....................................................................................11 1.2.2 Emphasis on Variables Other Than t ..........................................................11 1.2.3 Equivalence and Insignificance ..................................................................11 1.3 Time and Future Value: Terminal Value (TV) Estimation Dilemma in DCF2S Stage 2 .........................................................................................................................12 1.4 Project Valuation Rediscovered: Four Determinants of the Value of Enterprises (VoE I) .........................................................................................................................14 1.4.1 Forward to the Past?....................................................................................15 1.5 VoE II: The Company as a Multiple Investment Project With Continuing Capital Budget and Permanent Financing ...................................................................16 1.6 Three Questions Guiding This Research Approach ...........................................19 1.6.1 Do Companies Experience Perpetual Life Spans in the Real World? (Q1)20 1.6.2 Is it Plausible and Defensible to Assume That Companies Endure Forever for Valuation Estimation Purposes, Only? (Q2) .....................................................20 1.6.3 What Emerges as Most Promising Approach Category to Succeed the Perpetuity Conjecture? (Q3)....................................................................................21 1.7 A Guide to This Document ................................................................................22 1.7.1 Chapter 2, Review of Literature: An Overview..........................................22 1.7.2 Chapter 3 (Methodology), Chapter 4 (Characteristics of This Research): Overview .................................................................................................................22 1.7.3 Chapter 5, Results of This Research and Relevant Comment: Overview ..23 1.7.4 Chapter 6, Conclusions and Future Direction of Research: Overview .......23 2 Review of Literature ..................................................................................................24

iv

2.1 Chapter Summary...............................................................................................24 2.2 Foundation Valuation-Related Corporate Finance Literature ............................25 2.3 Literature Review Relating to Company Valuation Methods ............................27 2.3.1 Overview and Summary of This Part of the Literature Review Chapter....27 2.3.2 On Literature Relating to Development of Alternative Company Valuation Major Approaches ...................................................................................................35 2.3.3 The Academic Contest for Methodological Superiority: DDM v DCF......43 2.3.4 On Valuation Methods For Dealing With the TVP or Continuous Period .52 2.4 Literature Review Relating to Company Longevity ..........................................66 2.4.1 Overview and Summary of This Part of the Literature Review Chapter....66 2.4.2 On Literature Relating to the Concept of Theoretical Company Longevity for Valuation Purposes ............................................................................................69 2.4.3 On Literature Relating to Estimation of Company Actual Longevity from Time of Origin.........................................................................................................72 3 Research Methodology: Selection of Method and Research Questions....................94 3.1 Chapter Synopsis................................................................................................94 3.2 Selection of the Research Questions for This Thesis .........................................94 3.3 Description of the Primary and Secondary Research Questions........................95 3.3.1 Primary Research Question, Context..........................................................96 3.3.2 Secondary Research Question: Conditional and Preliminary .....................96 3.4 A Mixed Methodology Approach ......................................................................97 3.4.1 Primary Research Methodology: Mixed Positivist and Interpretavist Approach .................................................................................................................97 3.4.2 Secondary Issue Methodology: Mixed (Positivist and Interpretavist)......102 3.5 Description of Primary Research Methodology...............................................103 3.6 Description of Secondary Research Methodology...........................................103 3.7 Uses and Users of This Research .....................................................................103 3.7.1 Valuation Practitioners..............................................................................104 3.7.2 Valuation Academicians: “Managerial Group” or DCF-Oriented............104 v

3.7.3 Transaction Intermediaries With Interest in Company Valuation End Results 104 3.7.4 Company Financial and Other Senior Management .................................105 4 The Study, Its Scope, Dataset, The Means of Analysis, The Nature of Results and How It Will Achieve Its Objectives...............................................................................106 4.1 Key Issues Addressed in This Study ................................................................106 4.1.1 Time’s (Companies’ Longevity) Role as Acknowledged Variable in Future Gordon Formula ....................................................................................................107 4.1.2 Characteristics

of

the

Insignificance

Exception

(IE):

Feasibility,

Applicability..........................................................................................................108 4.1.3 Empirical Information on Actual Life Spans I: Sufficient to Discredit the Perpetuity Conjecture? ..........................................................................................109 4.1.4 Empirical Information on Actual Life Spans II: Informing CompanySpecific Projections of Longevity for Valuation Purposes ...................................109 4.2 Scope and Limitations ......................................................................................110 4.2.1 Regarding extent and depth of investigation into the secondary research question (3.3).........................................................................................................110 4.2.2 Context relating to analysis perpetuity conjecture: scope implications....110 4.2.3 Subsidised companies excluded from consideration as examples of firms that support the perpetuity conjecture ...................................................................111 4.2.4 Areas of Geographic Emphasis.................................................................111 4.3 Researcher’s Perspectives, Orientation, Possible Biases .................................111 4.3.1 Experiences ...............................................................................................112 4.3.2 Observations and Reflections ...................................................................113 4.3.3 Testing Implications of Concepts in New Situations................................113 4.4 Characteristics of Analysis and Expected Findings .........................................114 4.4.1 Characteristics of Analysis .......................................................................114 4.4.2 Expected Findings.....................................................................................114 4.5 Addressing the Primary and Secondary Research Questions...........................115 4.5.1 Addressing the Primary Research Question .............................................115 vi

4.5.2 Addressing the Secondary Research Question .........................................116 5 Results of the Analysis and Relevant Comment .....................................................118 5.1 Chapter Overview and Summary .....................................................................118 5.1.1 Descriptions of Some Key Findings in This Chapter ...............................119 5.1.2 Overview of the Parts of This Chapter .....................................................122 5.2 Perpetuity Conjecture's Identity Reconsidered: ...............................................125 An Impossible Axiom Supporting Convenience and Equivalence Whilst Denigrating Time's Permanent Role as Company Valuation and Determinant ............................125 5.2.1 Perpetuity Conjecture Identity 1: To Facilitate An Easy Formula for Company Estimated Value....................................................................................126 5.2.2 Perpetuity Conjecture Identity 2: Impossible Axiom Neglecting Time’s Role in Company Valuation ..................................................................................127 5.3 Primary Research Relating to the Longevity of Firms for Purposes of Terminal Value (TV) Estimation in the Two Stage DCF Company Valuation Methodology (DCF2S).....................................................................................................................128 5.3.1 Background, Summary of Overall Findings .............................................128 5.3.2 Overview of Survey Questions .................................................................135 5.3.3 Analysis of Responses to Survey Quantifiable Questions (A1-B9) .........141 5.3.4 Analysis of Responses to Survey Qualitative Questions ..........................153 5.4 Two Analyses of Statistical Errors Attributable to the Perpetuity Conjecture 157 5.4.1 Chapter Part Summary..............................................................................157 5.4.2 Towards an Alternative, Non-Market Value (MV) Measure of Valuation Accuracy................................................................................................................158 5.4.3 Perpetuity’s Exaggeration of Errors in the Other Three GFAP Variables160 5.4.4 Circuit City: Finite Life Span Company Erroneously Valued as Perpetual Firm

163

5.5 Limitations of the Insignificance Exception ....................................................165 5.5.1 Overview and Summary ...........................................................................165 5.5.2 Neale and McElroy’s Observations About the Nature of Projected Cash Flow Projections in Company Valuation ..............................................................166 vii

5.5.3 IE Circumstance 1: Mature, Minimal CF Business Enduring Forever.....168 5.5.4 IE Circumstance 2: Hovering: CFROI Approaches But Never Breaches WACC 173 5.6 Reality Testing the Notion of the Never Ending Company .............................178 5.6.1 Chapter Part Summary..............................................................................178 5.6.2 Improving the Methods for Future Projections of the Gordon Formula’s Fourth Variable, Time ...........................................................................................179 5.6.3 Substantiating Prima Facie Indications of Companies’ Sub-Infinite Life Spans 181 5.6.4 Academic Investigation of Companies’ Brief, Finite Life Spans .............183 5.6.5 Statutory Indications of Finite Life Spans: Government and Other Official Offices 185 5.6.6 Some Other Company Observation-Based Life Span Terminus Indicators 188 5.6.7 Competitive Advantage Period (CAP)- Related Indications, Including Industry Pairs Analysis..........................................................................................190 5.7 Conflicted Apologist for the Perpetuity Conjecture Re-Examined: Penman’s “Truncation Error” Argument Reconsidered.............................................................198 5.7.1 Background, Synopsis of This Chapter Part .............................................198 5.7.2 “Truncation Error” Assertion Examined ..................................................200 5.7.3 Evolutionary Changes in Penman’s Perspectives .....................................200 5.8 Other Logic and Analysis Elements of the Case Against the Perpetuity Conjecture..................................................................................................................203 5.8.1 Overview...................................................................................................203 5.8.2 Organic Concept .......................................................................................205 5.8.3 Time Mathematics ....................................................................................210 5.8.4 Theoretical ................................................................................................212 5.8.5 Methodological .........................................................................................217 5.8.6 Competitive / Economic ...........................................................................221 5.9 Prospect of Future Possible Alternatives to the Perpetuity Conjecture ...........222 viii

5.9.1 Alternatives to the Perpetuity Conjecture and the Primary and Secondary Research Questions in This Thesis........................................................................223 5.9.2 Bespoke Versus Standardised Approaches to the Perpetuity Conjecture Replacement Issue.................................................................................................224 5.9.3 Legacy Category Approaches ...................................................................224 5.9.4 Emergent Category Approaches ...............................................................228 5.9.5 Determining the Basis for Valuation t: Median, Analysed Maximum, Alternative? ...........................................................................................................235 6 Conclusions and Future Direction of Research .......................................................238 6.1 Conclusions ......................................................................................................238 6.1.1 Addressing the Primary and Secondary Research Questions in This Study 239 6.1.2 Briefer-Than-Infinite

(BTI)

Hypothesis

Prevails

Over

Perpetuity

Conjecture .............................................................................................................241 6.1.3 ‘Three Research Questions’ (From Chapter 1) Re-Examined ..................243 6.1.4 Contributions From This Research I: Possible Influence of The Analysis and Results From This Study on Valuation Practitioners’ Behaviour ..................245 6.1.5 Contributions From This Research II: Possible Influence of The Analysis and Results in This Study on the Literature ..........................................................252 6.2 Possible Future Areas of Research...................................................................266 6.2.1 Related to the Primary Research Question ...............................................267 6.2.2 Related to the Secondary Research Question ...........................................269 6.2.3 Other Related Areas for Possible Investigation ........................................271 Bibliography...................................................................................................................274 Appendix A – Glossary of Selected Terms....................................................................288 Appendix B – Some Acronyms In This Document .......................................................291 Appendix C – Formulas and Equations .........................................................................293 Appendix D – Details Relating to Kolb’s Cycle Figure ................................................295 Appendix E – Relating to the Primary Research Conducted for This Thesis................300 Appendix F – Relating to Explicit Projection Period (EPP)- Based Methods...............353 ix

Appendix G – EAC Basis ..............................................................................................356 Appendix H – OYSS Illustration of Value Calculation Errors Caused by Differences Between Actual Valuation Longevity and Theoretical Perpetual Longevity in GFAP .357 Appendix I – PPE Economic Lives................................................................................360 Appendix J – PPE Economic Lifespan Decline Rates...................................................361 Appendix K – Some Alternative Concepts of Company Life Span Terminus ..............362 Appendix L – Industry Pairs Analysis I: Methodology .................................................368 Appendix M – Industry Pairs Analysis II: Other Related Findings...............................371 Appendix N – The Future Case Against Perpetuity.......................................................380 Appendix O -- Effects of Perpetuity Conjecture on Distortions in GFAP Variables ....383 Appendix P – Additional Detail Regarding the Selection of Two Research Questions 387

x

Figures Figure 1.1.1: Components of the Gordon Formula Assuming Perpetuity (GFAP) ...........4 Figure 1.1.2: Perpetuity’s Exaggeration of the FCF Growth Variable (g) in Continuing or Terminal Value (Mauboussin 2007) .....................................................................6 Figure 1.2.1: Briefer-Than-Infinite (BTI) Hypothesis Versus Perpetuity Conjecture.......9 Figure 1.3.1: Company Value Components by Time Sequence Phase............................13 Figure 1.4.1: Project VoE: Four Determinant-Variables .................................................15 Figure 1.6.1: Three Core Questions Guiding This Research Approach ..........................19 Figure 2.3.1: Three Valuation Methods: Uses and Users ................................................38 Figure 2.3.2: DDM and DCF: Common Ancestry in the Gordon Formula ....................39 Figure 2.3.3: Copeland et al.’s DCF to Market Value (MV) Correlation (2000, 77)......47 Figure 2.3.4: Implications of Assumption That the Terminal Value Period (TVP) Is Infinite .....................................................................................................................53 Figure 2.3.5: Gordon Formula Serial Format .................................................................60 Figure 2.3.6: Madden (2005,7) I: CAP Intersect Point and Continuing Operations.......63 Figure 2.3.7: Madden (2005) II: Drivers in Limited Term TVP.....................................64 Figure 2.4.1: Portugal: Empirical Survival Rates (Mata et al. 1995, 470) ......................80 Figure 2.4.2: Canada: Greenfield Exit Percentages From Baldwin and Gorecki 1991, 310 .................................................................................................................................87 Figure 2.4.3: Germany: Survival Rates (Strothman 2006) ..............................................91 Figure 4.3.1: This Researcher’s Orientations, Based on the Kolb Learning Cycle ......112 Figure 5.4.1: Perpetuity’s Exaggeration of Continuing or Terminal Value (Mauboussin 2007)......................................................................................................................161 Figure 5.5.1: Three Alternative Perspectives on Company Future Cash Flows, CFROI ...............................................................................................................................167 Figure 5.5.2: Madden (2005): Mature Company Reaches the End of Its Economic Life Span .......................................................................................................................175 Figure 5.5.3: Variable Investment and Returns Over Corporate Value Life Span (CVL) ...............................................................................................................................176

xi

Figure 5.5.4: Expected and Customary Increases in WACC With Company Age, And the CAP Viability Threshold.................................................................................177 Figure 5.6.1: Companies Overall: A Preliminary Cumulative Failure Experience Curve ...............................................................................................................................182 Figure 5.6.2: Insolvency Trends in England and Wales, 1998-2008.............................186 Figure 5.6.3: Madden (2005, 7): Alternative Indications of Company Demise ............191 Figure 5.6.4: Corporate Value Life Span (CVL) Overview (Contention Versus Participation Phases) .............................................................................................192 Figure 5.6.5: Contention Versus Participation Companies Overall: CFROI Ratio Differences (Annual).............................................................................................193 Figure 5.8.1: Organic Life Cycles: Biosystems Compared to Enterprises ....................206 Figure 5.8.2: Life Stages and Company Decline, From Madden (2005).......................207 Figure 5.8.3: Expected and Customary Increases in WACC With Company Age, And the CAP Viability Threshold.................................................................................221 Figure 5.9.1 Legacy Versus Emergent Replacement Approaches For the Perpetuity Conjecture: Preliminary ........................................................................................225 Figure 5.9.2:

Shrinking Life Cycle Implications:

Post-WWII Auto New Model

Introduction Cycle Time .......................................................................................233 Figure 5.9.3: Nielsen-Cox Recycle ................................................................................234 Figure 5.9.4: A Composite Perspective on Company Longevity ..................................236 Figure 6.1.1: Perpetuity Versus BTI Revisited - Expanding Upon Figure 1.2.1 ...........242 Figure 6.1.2: Re-Examining the Three Core Questions (Figure 1.6.1)..........................243 Figure 6.2.1: A Composite Perspective on Company Longevity ..................................270 Figure K.1: End of Company Life as a Continuum ......................................................366 Figure M.1:

Analysed CFROI 3YMA Ratio Results, Auto Manufacturing: Honda

(Contention) v General Motors (Participation) .....................................................373 Figure M.2: Analysed CFROI 3YMA Ratio Results, Personal Digital Assistant (PDA) Devices: Apple (Contention) v Palm (Participation) ............................................374 Figure M.3: Analysed CFROI 3YMA Ratio Results, Aircraft Manufacturing: Boeing (Contention) v Northrop-Grumman (Participation) ..............................................375 xii

Figure M.4: Analysed CFROI 3YMA Ratio Results, Computer Server Manufacturing: Cisco (Contention) v Juniper (Participation) ........................................................376 Figure M.5: Analysed CFROI 3YMA Ratio Results, Air Carriers: Southwest (Contention) v Alaska Air (Participation) .............................................................376 Figure M.6: Analysed CFROI 3YMA Ratio Results, Personal Care Products: ColgatePalmolive (Contention) v Kimberly Clark (Participation) ....................................377 Figure M.7: Analysed CFROI 3YMA Ratio Results, Health Care Products: Johnson & Johnson (Contention) v Bristol Myers (Participation) ..........................................377 Figure M.8: Analysed CFROI 3YMA Ratio Results, Packaged Foods: Campbell Soup (Contention) v General Mills (Participation) ........................................................378 Figure M.9: Analysed CFROI 3YMA Ratio Results, Consumer Electronic Retailing: Best Buy (Contention) v Circuit City (Participation)............................................378 Figure M.10: Analysed CFROI 3YMA Ratio Results, General Retailing: Nordstrom (Contention) v Macy’s (Participation) ..................................................................378 Figure M.11: Analysed CFROI 3YMA Ratio Results, Drug Stores (Chemists): Walgreen (Contention) v Rite Aid (Participation).................................................................379 Figure M.12: Analysed CFROI 3YMA Ratio Results, Speciality Retailing: Abercrombie & Fitch (Contention) v Gap (Participation) ..........................................................379 Figure M.13: Analysed CFROI 3YMA Ratio Results, Investment Banking: Goldman Sachs (Contention) v Merrill Lynch (Participation) .............................................379 Figure N.1: England and Wales Company Liquidation Trends, 1998-2008 .................382

xiii

Tables Table 1.1.1: Continuing Value (TV) As Percentage of Company Value (CV), By Industry Type ............................................................................................................7 Table 1.2.1: Beyond Legacy: Three Contentions for Retention of The Perpetuity Conjecture, Opposing Arguments ...........................................................................10 Table 1.4.1: Project Valuation (Illustrative): Differences at Three and Six Elapsed Years .................................................................................................................................16 Table 1.5.1: Adapting Project-Based Four Determinants (VoE) To Company Value Estimation................................................................................................................17 Table 1.5.2 Enterprise Consideration of Time, From Project Valuation to Company Valuation .................................................................................................................18 Table 2.3.1: Summary of Valuation Methodologies Examined in This Chapter Part .....30 Table 2.3.2: Company Valuation Methodologies: Non-Scholarly v Scholarly ..............37 Table 2.3.3: Cornell’s Alternative Methods for Terminal Value (TV) Estimation, Including “Direct Comparison” (P/E Multiples).....................................................43 Table 2.3.4: Scholarly, Projection-Based Methods: DDM v DCF .................................44 Table 2.3.5: Arguments Concerning Superiority of Accrual Accounting Methodologies Over DCF, Including Counter-Arguments..............................................................48 Table 2.3.6: Beyond Copeland, Kaplan & Ruback: DCF’s Other Methodological Superiority Points ....................................................................................................50 Table 2.3.7: Characteristics of the DCF Stage 2 Infinite Continuous Period Notion According to Accounting Group Valuation Academicians.....................................55 Table 2.3.8: Methods for Determining the End Point of the Terminal Value Period (TVP).......................................................................................................................61 Table 2.3.9: Cornell’s (1993) Three Methods for TV Estimation, Revisited ..................65 Table 2.4.1: Overview: Theoretical Interpretation of Longevity as Valuation Variable .67 Table 2.4.2: Seven Studies: Cumulative Exit (Failure) Percentages by Age...................69 Table 2.4.3: Key Research and Researchers by “Principal Four” Country .....................77 Table 2.4.4: US: Exit Percentages of Three Cohorts (387 Industries) From Dunne et al., 1988, 509 .................................................................................................................82 xiv

Table 2.4.5: US: Summary of Age Analysis of Exiting Companies From Audretsch, 1995 .........................................................................................................................84 Table 2.4.6: US: Variability in Exit Percentages By Segment From Audretsch, 1995 ...85 Table 2.4.7: Canada: Analysed Cohort Exit Percentages From Baldwin, 1998 ..............88 Table 2.4.8: Germany: Analysed Cohort Exit Percentages From Wagner, 1994 ............91 Table 3.4.1: Yin’s Three Case Study Methodologies, Relationship to Methodology in This Research ..........................................................................................................99 Table 4.1.1: Four Issues Addressed in This Study.........................................................106 Table 5.1.1: Summary of Some Key Findings...............................................................119 Table 5.3.1: Eight Considerations in Design of This Survey.........................................129 Table 5.3.2: A Comparison of Survey Sample Sizes, Other Relevant Comparisons ....131 Table 5.3.3: Current Positions, Roles of the Twenty-Five Interviewee Participants in This Survey ...........................................................................................................132 Table 5.3.4: Non-Conditional Survey Questions Summarised: Topic, Purpose............135 Table 5.3.5 Responses to Survey Quantifiable Questions A1-B9: Overall (Combined Category A and B).................................................................................................141 Table 5.3.6 Responses to Survey Quantifiable Questions A1-B9:Category A (Part-Time Valuation Practitioners).........................................................................................142 Table 5.3.7 Responses to Survey Quantifiable Questions A1-B9: Category B (Full-Time Valuation Practitioners).........................................................................................143 Table 5.4.1: Summary of Appendix O Results: 5, 7, 15 Year Finite Valuation Versus Perpetuity ..............................................................................................................162 Table 5.4.2: Circuit City 2001 Model Valuation: Perpetual Life Span Assumption v Finite Life ..............................................................................................................164 Table 5.5.1: Three Arguments/Analyses Contradicting IE Circumstance 1 (Minimal CFs to Perpetuity) .........................................................................................................169 Table 5.5.2: Wasson’s (1974) Perspectives on Continuing Deterioration Past Maturity Stage ......................................................................................................................171 Table 5.5.3: Three Arguments/Analyses Contradicting IE Circumstance 2

(Nearly

Equivalent CFROI and WACC Rates, Non-Intersecting).....................................173

xv

Table 5.6.1: The Gordon Formula’s Four Acknowledged Variables Plus One: Evolution in Methods for Setting Projected Future Amounts and Rates ...............................180 Table 5.6.2: Cohort Group Cumulative Failure Percentages by Elapsed Years, Seven Academic Studies From Chapter 2 Part 4 .............................................................183 Table 5.6.3: An Analysis of Company Cumulative Failure Experience Based on Audretsch (1995)...................................................................................................184 Table 5.6.4: Company Liquidations in England and Wales, 2001-2008 .......................185 Table 5.6.5: US Bankruptcy Filings Under Different Statutes, Number of Cases, 19992003 (000s)............................................................................................................187 Table 5.6.6: Fitch US High Yield Default Index: 2010 Defaults Year-to-Date by Classification, Report of 21st June 2010, 7............................................................189 Table 5.6.7: Industry Pairs Analysis Summary I: Analysed CFROI, Three Year MA Basis Participation (Declining) Phase Companies ................................................194 Table 5.6.8: Industry Pairs Analysis Summary II: Analysed CFROI, Three Year MA Basis Contention (Mid-Life Stability) Phase Companies .....................................194 Table 5.6.9: Companies Exhibiting Multiple Negative CFROI Ratios in Industry Pairs Analysis .................................................................................................................195 Table 5.7.1: Penman’s Changing Perspectives About Perpetuity and Company Value 201 Table 5.8.1: Logic Issues Related to the Perpetuity Conjecture Question: Five Categories ...............................................................................................................................204 Table 5.8.3: Reconciling Evidence of Briefer-Than-Perpetual Life Spans With the Perpetuity Conjecture ............................................................................................214 Table 5.9.1: Audretsch (1995): Cumulative Failure Patterns of US Companies in Eighteen Industries ................................................................................................229 Table 5.9.2: General Motors v Toyota: Selected Auto Production Statistics, 1986 ....232 Table 5.9.3:

Towards Product Life Cycle-Influenced Estimates of Terminal Value

Period (TVP) Life Spans, By Industry (Preliminary) ...........................................232 Table 6.1.1: Perpetuity Versus BTI Revisited- Expanding Upon Table 5.6.1...............241 Table 6.1.2: Contributions From This Research I: Possible Influences of This Thesis On Practices and Behaviour of DCF Valuation Practitioners .....................................247

xvi

Table 6.1.3: Contributions From This Research II: Possible Influence of The Analysis and Results of This Study on the Literature ..........................................................254 Table 6.2.1: Eight Possible Future Research Areas .......................................................266 Table E1: Eight Considerations in Design of This Survey ............................................308 Table E2: A Comparison of Survey Sample Sizes, Other Relevant Comparisons ........315 Table E3: Miles-Huberman-Patton- Sixteen Categories of Purposive Studies..............319 Table E4: Two Possible Limitations of This Survey, Implications ...............................323 Table E5: Some Definitions of Company Demise, Acquiree Life Span Implications ..332 Table E6: Acquisition Archtypes, Post-Acquisition Status of Acquired Firm ..............335 Table E7: Experience of Two Round Turn Acquirees: NCR, Skype ............................337 Table K.1: Alternative Criteria for Determining Company Demise..............................363 Table L.1: Industry Pairs Contention-Participation Designation: Manufacturing (4 Segments) ..............................................................................................................370 Table O.1: Five Year Life Span Scenarios Versus Perpetuity.......................................384 Table O.2: Seven Year Life Span Scenarios Versus Perpetuity ....................................385 Table O.3: Fifteen Year Life Span Scenarios Versus Perpetuity..................................386 Table T.1: Two Faces of the Perpetuity Conjecture .....................................................388

xvii

Chapter 1 - Introduction

1 Introduction The main appeal of the Constant-Growth valuation model is its simplicity… the market value of the firm (Vo) is a function of just three variables: the expected free cash flows in the next (or first future) period, the firm’s cost of capital (W) and the growth rate of the firm’s free cash flows.

- Bradley and Jarrell 2008, 66.

I don’t follow any single, one approach. What I do instead is to apply multiple methods and see which converge, and how. I don’t ever assume perpetuity from the onset. Instead I might look at a multiple based on EBITDA or other indicator or use whatever rule of thumb approach tends to apply to companies in that industry.

- Survey interviewee B0604.2, full-time valuation

practitioner,

answering

question B13 regarding how they calculate the longevity of analysed companies

for

valuation

purposes.

(Appendix E, Part 2b)

Parts: 1.1 Background and Chapter Synopsis 1.2 Perpetuity Conjecture Issue Explained: The Company Valuation Duration Dilemma 1.3 Time and Future Value: Terminal Value (TV) Estimation Dilemma in DCF2S Stage 2

1

Chapter 1 - Introduction 1.4 Project Valuation Rediscovered: Four Determinants of the Value of Enterprises (VoE I) 1.5 VoE II: The Company as a Multiple Investment Project With Continuing Capital Budget and Permanent Financing 1.6 Transition From VoE to Valuation of Complex Companies: Compromises, Truncation 1.7 Three Questions Guiding This Research Approach 1.8 A Guide to This Document

This thesis challenges the credibility and defensibility of the assumption within the prevailing version of the Gordon Growth Model (Gordon Formula, Gordon Formula Assuming Perpetuity or GFAP) that for valuation purposes, all companies endure forever. In this study, Gordon and Shapiro’s (1956) supposition is referred to as the “perpetuity conjecture.”

Companies do not endure forever, for valuation or any other purpose. Business analysis methods- including equations to monitor, measure or value the forward performance of companies- are credible and accurate only to the extent that they are considered to reasonably reflect commercial reality. Never Ending Companies have never been documented, because they do not and cannot exist.

Companies as a whole exhibit a median life span of approximately seven years, rather than infinity. In many industries and segments, those lives appear to be shrinking with each passing year.1 Time (t), in the form of company longevity or economic life span, is one of the four enduring determinants of company value. Variations in t matter: the longer-lived firm is worth more than shorter-lived firm, assuming that all other valuation-relevant factors are the same and that post-collapse residuals are minimal.2 This introductory chapter describes the dilemma associated with GFAP’s perpetuity conjecture dilemma and why that problem is important. Time—company longevity—is

1

Median estimate is from examination of literature on company failure in Part 4 of Chapter 2 (2.4), Literature Review Relating to Company Longevity, Table 2.4.2, Seven Studies: Cumulative Exit (Failure) Percentages by Age. Shrinking product life cycles and their implications for shrinking company longevity (t) are addressed in Part 9 of Chapter 5 (5.9).

2

The same applies to individual firms depending upon duration of t. Gerstner enters IBM in 1994 and extends that firm’s remaining life span, increasing value. (Gerstner 2003) Management at Northern Rock adopt a fatally flawed financing approach and thereby shorten that firm’s life span, causing valuation to shrink to almost zero.

2

Chapter 1 - Introduction examined as a determinant and variable of the value of all enterprises, beginning with simple, pre-corporate projects. As those commercial entities grow in size and complexity to become companies, the four determinants of value remain, unaffected by that transition.

Three key queries guiding the process of this research investigation are described in this Chapter, followed by a preview of chapters two through six.

1.1

Background

The perpetuity conjecture arose in the mid 1950s for reasons of apparent calculation convenience.3 By disregarding company longevity’s role as a variable affecting value in all enterprises (project organizations and companies alike), the Gordon Formula Assuming Perpetuity (GFAP) may be calculated using just three variables, as confirmed by the Bradley and Jarrell quotation found at the beginning of this chapter.

Prior to the mid 1970s, the Gordon Formula was primarily used to develop approximate company value estimations based on the dividend declarations of company management, as described in Gordon and Shapiro’s 1956 paper.

About twenty years after the publication of the above paper, a slightly adapted form of the Gordon Formula began to be applied in a different manner, to estimate the value of the second stage in today’s Discounted Cash Flow Two Stage (DCF2S) methodology.

The DCF version of the Gordon Formula is shown as Figure 1.1.14.

The concept and components of GF were first described by Williams in 1938 and were later rediscovered and refined by Gordon and Shapiro (1956) and Gordon alone, in 1962. The DCF version of that equation is comprised of three acknowledged variables as described in Figure 1.1.1: FCF, WACC and g.

3

The conceptual and practical reasons why Williams (1938), Gordon (1962) and Gordon and Shapiro (1956) chose to re-interpret the t variable as a perpetuity constant are explored in sub-part 2 in 2.4 (2.4.2).

4

Figure 2.3.2 in Chapter 2 Part 3 (2.3) shows the common ancestry of dividend and DCF versions of the Gordon Formula. The word “apparent” refers here to the difference between initial calculation simplicity and the subsequent mandatory adjustments made for accuracy and completeness. Accurate assessment of simplicity requires that such adjustments be taken into account, beyond the initial ratio.

3

Chapter 1 - Introduction

Figure 1.1.1: Components of the Gordon Formula Assuming Perpetuity (GFAP)

That second DCF stage is typically referred to in the literature as the Terminal Value Period (TVP) or sometimes as the continuing period, continuous period or horizon period.5 Since the actual median life span of companies is briefer than a decade rather than infinite, the use of the perpetuity conjecture as a surrogate for the unacknowledged (by Gordon and Shapiro) fourth, time variable in company DCF valuation may result in errors, as illustrated in Appendices H and O and in 5.4.6

5

Refers to Chapter 5, Part 4 (5.4). Since words “continuous” or “continuing” might be perceived by some as indicating that the second DCF stage must always be infinite in duration, the phrase “Terminal Value” from the academic literature (e.g., Penman and Sougiannis 1996, Fruhan 1998, Mills 2005 and Jennergren 2008) is cited more frequently in this study in referring to the DCF company valuation methodology’s second stage. The second stage in the Two Stage DCF Methodology (DCF2S) is not necessary indefinite, as explored in sub-part 4 in Chapter 2 Part 3 (2.3.4). The phrase “Pickens high debt model” in Figure 1.1.1 refers to T. Boone Pickens’ 1983 analysis that many US companies were under-geared coming out of the 1980-82 recession, and the resulting increase in leverage ratios beginning in the early-mid 1980s, partially as a consequence (Clark 1991).

6

Excluding the limited range and number and circumstances referred to by this Researcher as the “Insignificance Exception” as examined in Chapter 5 Part 5 (5.5). As explored in Chapter 2 Part 4 subpart 2 (2.4.2), Gordon Formula predecessor and influence Williams (1938) does not appear to share all of Gordon and Shapiro’s perspectives on treatment of company longevity (time, t) as a non-variable.

4

Chapter 1 - Introduction As company valuation longevity or t, is interpreted by Gordon and Shapiro as infinite for all companies and circumstances, variations in life spans are effectively disregarded as influences on company value as measured by GFAP. Stated another way, under GFAP two identical companies that differ only in terms of how long they exist (e.g., 2 years versus 20 years versus infinite life) are assumed to have identical value, as time is presumed to be infinite (t+1) for all companies. It is presumed that there is no difference in t, regardless of company or circumstances.7 The difference between projected company life spans assuming perpetuity versus projections of life spans informed by historical failure patterns (Chapter 2 Part 4 (2.4)) results in material errors in value estimation, as illustrated in Appendices H and O and Chapter 5 Part 4 (5.4).

But the perpetuity conjecture also exaggerates errors in any or all of the three active variables in the Gordon Formula: FCF, g or WACC. The distortions caused by assuming that the FCF growth rate, g, continues forever is noted with particular alarm in the valuation practitioner-academician communities: Mauboussin (2007), Mills (2005), Koller et al. (2004), Penman (2001), Copeland et al. (2000), and O’Byrne and Young (2000). Mauboussin expresses concern about the implausible near-vertical g function that arises when a positive rate is extrapolated to infinity, as depicted in Figure 1.1.2.

GFAP is today’s prevailing method for calculating Terminal Value (TV), the value attributed to the second stage in the Two Stage DCF (DCF2S) company valuation methodology, following the forecast period first stage, also known 3 as the Explicit Projection Period (EPP). EPP in this manner represents that portion of the company’s future performance that management feels comfortable in expressing in detailed forecasts of budget quality. The literature suggests that the EPP may be as brief as two years to as long as 15 years, depending on the quality of forecast information and other considerations.

By comparison, the simple three variable GFAP-based calculation for estimating Stage 2 value in DCF2S is general and approximate, especially as the Terminal Value Period (‘continuing period’) does not even begin until after two to fifteen elapsed years.8

7

Including the assumption of negligible residual upon failure of the company in both instances. The alternative mathematical notation for infinite time in the Gordon Formula is t to the infinity (∞) power.

8

Cassia and Vismara 2009; Penman 2001 (GFAP referred to by Penman as “voodoo accounting”). The fifteen year maximum duration of EPP is based on Ohlson and Zhang (1999). As credible operatingbudget forecasts rarely extend beyond three to four years, that represents the beginning elapsed time point for TVP in many DCF2S company valuation analyses.

5

Chapter 1 - Introduction

Figure 1.1.2: Perpetuity’s Exaggeration of the FCF Growth Variable (g) in Continuing or Terminal Value (Mauboussin 2007)

EPP value plus Terminal Value (TV) equals total company value (CV). If any or all of the three acknowledged GFAP variables (FCF, g, WACC) are overly optimistic, variables are excessive, the perpetuity conjecture in GFAP may result in TV levels and TV-to-CV percentages which are sometimes perceived as excessive. Table 1.1.1 represents one example of this recurring problem in DCF valuation of Terminal Value.

The issue of perceived excessive TV is addressed more extensively in 2.3, Literature Review Relating to Company Valuation Methods. In the case of the perceived ‘high’ TV-to-PC percentage, concern might arise that most of a company’s estimated worth corresponds to the second DCF2S ‘continuing period’ stage and the approximate value estimate developed using the GFAP, rather than the forecast period, for which value calculations are based on presumably reliable, near-term detailed analysis.

6

Chapter 1 - Introduction

TV-to-CV Percentage

Industry Description

125%

High Technology

100%

Skin Care

81%

Sporting Goods

56%

Tobacco

Source: Cornell 1993, 145 referring to McKinsey & Co. analysis from Copeland et al. 1990, 208.

Table 1.1.1: Continuing Value (TV) As Percentage of Company Value (CV), By Industry Type

1.2

Perpetuity Conjecture Issue Explained: The Company Valuation Duration Dilemma

A deep understanding of the Gordon Formula (GF) perpetuity conjecture dilemma begins with an understanding of how time (company longevity) is considered in that equation.

A perspective introduced in this Chapter and expressed elsewhere in this study is that time is an unassailable variable and determinant of company value, comparable to Gordon and Shapiro’s original three variables: FCF, g and WACC. For that reason, t is referred as the fourth or phantom true variable of GF: the variable that the Gordon Formula’s creators missed.

Gordon and Shapiro treat time in a dissimilar manner to the other three variables; that difference has not been directly challenged prior to this study, to this Researcher’s knowledge. In GFAP, t is arbitrarily transformed from a variable which typically varies from company to company (or even within the same company, if operating and/or financial circumstances change), into a perpetuity constant. Gordon and Shapiro presume that all companies endure forever for valuation purposes, regardless of factors 7

Chapter 1 - Introduction which sometimes shorten a company’s life span prematurely, such as Circuit City’s failure to confront its market and cost problems and Palm’s fatal delays in developing a competitive smartphone to compete with Apple’s iPhone.

As an indication of company longevity, the perpetuity conjecture in the Gordon Formula is erroneous in two separate but related ways, involving presumptions of: (i.), an extreme, impossible life span duration which no company ever reaches (infinity); and (ii.), the one-duration-applies-to-all-firms inflexibility of this constant rule.

This case against the perpetuity conjecture is more than a matter of methodological consistency. By imposing a perpetuity constant as a surrogate for t, firm longevity is effectively cancelled as one of the variable determinants of company value: when every company lives forever, no company has a life span which is different from any other firm. The 1956 original design error in the Gordon Formula persists to this time.

After 2006, even Professor Stephen Penman of Columbia University, arguably the most adamant defender of the perpetuity conjecture based upon his academic papers from 1996-2006 (as described in 2.3, 5.3 and 5.7) acknowledges the reality of finite life spans for company valuation purposes: Going concerns are expected to go on forever but the idea that we have to forecast “to infinity” is not a practical one… We prefer a valuation method for which a finite-horizon forecast (for a set number of years, for 1, 5 or 10 years, say) does the job (2007, 93, emphasis by Penman).

The two separate but related valuation errors of perpetuity conjecture in GFAP are actual, rather than theoretical. The Appendix H OYSS illustration is based upon customary actual life spans for firms of that type. Many shops fail within 1-5 years.

When a company’s actual life span is a single year, the error caused by assuming a perpetual life span is 21 times.

Instances of companies failing in their two years of life is not uncommon, according to Mata et al. (1994, 1995), Geroski (1991) and other researchers of company failure as described in Chapter 2 Part 4 (2.4). The calculation error arising from valuing nowdefunct US retailer Circuit City on a perpetual conjecture basis instead of actual projected life span is explored in Chapter 5 Part 4 (5.4).

The limitations of the perpetuity conjecture and potential for valuation distortion give rise to the opposite hypothesis, that all companies experience sub-infinite life spans.

8

Chapter 1 - Introduction As a consequence of (i.) the value estimation, logic and other problems associated with the perpetuity conjecture, (ii.) the absence of any empirical evidence that a Never Ending Company exists, and (iii.) extensive evidence of companies’ brief actual life spans in the real commercial world, the perpetuity conjecture faces a directly opposing hypothesis, referred to in Figure 1.2.1 as the Briefer-Than-Infinite (BTI) hypothesis:

Figure 1.2.1: Briefer-Than-Infinite (BTI) Hypothesis Versus Perpetuity Conjecture

Figure 1.2.1 shows in the legacy perpetuity conjecture, forward projections of company longevity are presumed to be infinite (∞) for all companies (constant, k). But in the Briefer-Than-Infinite (BTI) hypothesis at the other extreme of the spectrum, all companies are assumed to experience variable, finite life spans (v).

Another aspect of the BTI hypothesis of note is that the nature of company life span variability is presumed to have two dimensions.

First, t is presumed to be variable on a company-by-company basis. Non-chain dinner restaurants usually fail within five years or less whereas electric utilities in established markets may last for decades or longer. 9 The several factors influencing company life spans are unique to that firm, or at least to firms of similar age in the same industry or segment.10

9

The absence of a single confirmed instance of a Never Ending Company whereas multiple examples of companies with finite life spans causes BTI to be designated in this thesis as a hypothesis “a theory needing investigation,” whereas the word “conjecture” refers to “guesswork, unproved theorem”.

(Encarta, 1999) Part 4 in Chapter 2 (2.4) provides a description of some of the studies on company failure experience. Several of these studies are organised by industry or segment group. Partially because of low entry barriers, consumer retail segments tend to exhibit significantly higher failure rates in early years than other, less volatile segments.

10

Analysis in Part 4 in Chapter 2 (2.4) shows that survival is affected both by industry group and years in business. Like a weak fledgling, the 1-2 year old firm is highly susceptible to early failure. But as the time pass, management learn the secrets of survival and that firm’s chances of failing decline accordingly.

(Jovanovic 1982)

9

Chapter 1 - Introduction Second, t is assumed to be specific to the financial and operating circumstances or scenarios projected to be encountered by the company. Within industries and segments, performance and thus prospects for survival sometimes vary widely (Apple versus Palm). Moreover, an individual firm’s longevity is shaped by specific scenario variables, including management expertise, as evidenced when Gerstner gave IBM a second life (Gerstner 2003).

Table 1.2.1: Beyond Legacy: Three Contentions for Retention of The Perpetuity Conjecture, Opposing Arguments

Table 1.2.1 presents three different of explanations for the persistence of the GF simple ratio (including the perpetuity conjecture) beyond inertia, legacy effect, absence of accepted alternatives, and limited awareness of the perpetuity conjecture element within the GFAP.11

11

As the phrase is used here, “legacy effect” includes inertia combined with a perceived sense of legitimacy resulting from prolonged use by others: That’s the way everyone has always done this.

10

Chapter 1 - Introduction Those three explanations in Table 1.2.1 are: (i.), equation simplicity; (ii.), increase in relative emphasis by Gordon and Shapiro on determinants of company value other than longevity; and (iii.), equivalence and insignificance contentions.

1.2.1

Equation Simplicity

Eliminate time’s established role as a variable influence on company value, and the Gordon Formula may be shrunken down to a simple three variable numeratordenominator ratio.12 Compare that with the multi-column, sometimes obtuse ‘black box’ calculation spreadsheets that plague some valuation analyses, and the appeal is visibly apparent.

Unnecessarily complex models risk instant rejection by reviewing senior managers, particularly those with limited financial analysis backgrounds.

1.2.2

Emphasis on Variables Other Than t

Gordon and Shapiro (1956) and their acknowledged influences Lutz and Lutz (1951) and Williams (1938) direct their valuation attention at issues other than company longevity, which is interpreted as being infinite because of its unknown or indefinite nature.

With any requirement to develop company-by-company projections of the t eliminated by the device of the perpetuity conjecture, GF’s forefathers concentrated on other concerns, such as investment levels and returns on that capital. Time’s actual influence on company value does not change; it simply is not considered.

1.2.3

Equivalence and Insignificance

In the context here, “equivalence” refers to two words which have different meanings, indefinite and infinite, in GFAP as meaning the same thing for valuation purposes.

“Indefinite” means finite but imprecise or difficult to specify. “Infinity” means without 12

Gordon Formula Serial Format (four variable GF serial formula) is in Figure 2.3.5 and Appendix C.

11

Chapter 1 - Introduction either ending (“never ending”, Encarta 1999) or beginning, as represented by the symbol: ∞.

“Insignificance” here refers to the contention that a company’s exact life span is irrelevant for valuation purposes if and when net receipts (Cash Flows, CFs) in future periods become so miniscule as to be immaterial for company valuation purposes. Stated another way, it doesn’t whether the company’s survives for two years or twenty if the cumulative discounted value of future CFs is virtually identical in the two instances .

But evidence emerges to suggest that in many companies, future FCFs are not insignificant, and thus that variability of t does affect company value. The CornellCopeland Terminal Value percentages in Table 1.1.1 do not represent isolated observations: several other valuation academicians comment upon the persistence of the problem of excessive Terminal Value calculations. Excessive TV estimates in turn suggests significant FCF projection amounts in future periods, rather than the miniscule amounts contemplated in Neale and McElroy’s (2004) Insignificance Exception (IE).13

1.3

Time and Future Value: Terminal Value (TV) Estimation Dilemma in DCF2S Stage 2

A company’s valuation reflects analysis and judgments about worth in three timedefined parts: past, present and future, as depicted in Figure 1.3.1.

Net assets of the company accumulated up to the present time provide the foundation for tomorrow’s growth. These are represented in the Figure by 1, Present Value of the Business and Assets in Place.

Without sufficient initial capital, the most compelling business plan amounts to little more than hopes. Insufficient initial capitalisation is a leading factor in company failure during a firm’s first two years of life, based on some of the studies described in 2.4. The current book value of equity is determined from balance sheet reported amounts for assets and liabilities, although some adjustments may be necessary to reflect market appreciation (e.g., real property) or write-offs (obsolete physical assets).

13

Free Cash Flow (FCF) equals Cash Flow (CF) minus period investment (i), as also shown in Table 1.4.1.

The two circumstances comprising the Insignificance Exception (IE) are explored in 5.5, including the related issue of whether those circumstances occur rarely or ever in real world business conditions.

12

Chapter 1 - Introduction

Figure 1.3.1: Company Value Components by Time Sequence Phase

Most of a company’s value occurs in the future, as demonstrated by robust TV-to-CV percentages exhibited in many DCF company valuation calculations. The majority of this future value is represented in the Figure above by 2. Present Value of Future Growth (PVFG).

13

Chapter 1 - Introduction PVFG estimates reflect informed estimates about the company’s future operating and financial performance, as manifested by the present value of Discounted Cash Flows (DCFs). The Gordon Formula Assuming Perpetuity is today used to calculate a portion of PVFG, based upon the three acknowledged GFAP variables, FCF, g and WACC. Each of those variables is actually a separate equation; to the extent that an arbitrary rather than carefully analysed number is used for any or all of the three GFAP variables, valuation inaccuracies may arise.

The potential for value estimates of limited credibility is generally accepted. As Viebig et al. suggest in Equity Valuation, Models From the Leading Investment Banks, “Most DCF calculations are going to be imprecise, and frequently DCFs cannot even facilitate useful calculations” (2008, 207).

A minor value element in Figure 1.3.1 is the salvage residual, represented as 3. PV RR. Assuming that there is any salvage at all, the amount tends to be negligible because of pre-collapse forced dispositions, claims against assets and other encumbrances.14

1.4

Project Valuation Rediscovered: Four Determinants of the Value of Enterprises (VoE I)15

What are the principal determinants of the value of an enterprise? Once it is understood that most of the company’s value occurs in future periods, the next issue to be addressed is what is the most credible and reliable basis for making those future projections.

One perspective is that the answer to that question resides not in the future, but rather, in the past: in the valuation approaches associated with pre-corporate forms of enterprises such as temporary project organisations, as depicted in Figure 1.4.1:

14

This characterisation of liquidation distributions following company collapse and administration is consistent with Fruhan 1998 and the examination of the notion of continuing assets in 2.3, 5.3 and 5.7 in this study If claims exceed asset liquidation values (as is common in many insolvencies per Altman and Hotchkiss 2006) then the post-collapse residual may theoretically be negative, without adjusting for recapitalisations.

15

“Value of Enterprises” is used here instead of “enterprise value” since in today’s financial terminology, the latter refers to the sum of market capitalisation plus debt, plus minority interest and preferred shares, minus total cash and cash equivalents.

14

Chapter 1 - Introduction

Notes: CF: Cash Flow, FCF: Free Cash Flow, NPV: Net Present Value, WACC: Weighed Average Cost of Capital CFROI: Cash Flow Return on Investment

Figure 1.4.1: Project VoE: Four Determinant-Variables

1.4.1

Forward to the Past?

Before there were complex companies with multiple project portfolios, permanent financing and management by company-wide metrics, there was (and is) a more basic form of commercial enterprise.

These project enterprises tend to be temporary, as they are often organised based upon a specific investment or contract. When that original investment is depleted or the contract is finished, that enterprise may not necessarily continue to operate. This is the local landscaping business, the unincorporated sandwich business-on-a-trolley or the niche social network service seeking to compete against established project enterprises and sometimes, companies in the field.

Complex value management metrics are still years away, assuming that such techniques are considered at all. This simple pre-company, project business is managed by the answers to three questions: •

What is our investment?

•

What is the Cash Flow return on that investment? and,

•

Does that resulting overall rate of return on investment exceeds the cost of financial support capital?16

16

The phrase “value management” refers to systematic approaches to continuing value improvement in the company. (Clark 2009) “CFROI” refers here to financial statement Cash Flow Return on Investment, as contrasted with what is believed to be the commercial variant trademarked by Credit Suisse HOLT, as also referenced in HOLT co-founder Madden’s exhibits.

15

Chapter 1 - Introduction Years £000

1

2

3

4

5

6

100

100

100

100

100

100

Period invest. i

10

10

10

10

10

10

FCF

90

90

90

90

90

90

0.935

0.873

0.816

0.763

0.713

0.666

NPV

84.1

78.6

73.5

68.7

64.2

60.0

Cum NPV

84.1

162.7

236.2

304.8

369.0

429.0

CF

CofC fac. @ 7%

Table 1.4.1: Project Valuation (Illustrative): Differences at Three and Six Elapsed Years

Madden (2010), Mauboussin (2007) and others describe their rediscovery of the investment-to-value interrelationship exhibited in project-type enterprises. The illustrative statistics in Table 1.4.1 (based on Figure 1.4.1, preceding) shows why time is a key determinant-variable of that project enterprise’s value. The briefer the duration of project enterprise, the less it is worth, all other value-relevant things being equal.

So long as future period CFs are material—both in absolute terms and relative to cost of capital (WACC)—a longer time period for generation means a more valuable enterprise.

Assuming that the project in Table 1.4.1 continues for the full six year duration as originally contracted, the value shown in Table 1.4.1 is £429,000. But if that same project is instead cancelled after only three years, then that value is only £236,200, or 45% less.

1.5

VoE II: The Company as a Multiple Investment Project With Continuing Capital Budget and Permanent Financing

Regardless of whether the enterprise is in pre-company (project) form or more advanced company form, time’s identity as a determinant-variable of company value endures.

Time (t, duration), and the other three intrinsic determinants of the value of an enterprise (VoE) are shown in Table 1.5.1:

16

Chapter 1 - Introduction

Table 1.5.1: Adapting Project-Based Four Determinants (VoE) To Company Value Estimation

Value of Enterprise (VoE) represents a spectrum extending from project-type organisations to more permanent companies, as suggested in Table 1.5.2:

17

Chapter 1 - Introduction

Table 1.5.2 Enterprise Consideration of Time, From Project Valuation to Company Valuation

Application P1 in Table 1.5.2 corresponds to the project organisation’s investment decision, which resembles the company’s internal capital expenditure evaluation process (CAPEX, P-C1) in key ways.17 C1 in the Table represents the Gordon Formula Assuming Perpetuity (GFAP) inclusive of the assumption that for valuation purposes, all companies exist forever. Statistical value estimates might be generated easily, although contention in this thesis is that some of these calculations may be suspect in some instances.

C2 reflects this Researcher’s past background in valuation as company principal and consultant and is also reflected in interviewees’ responses to Question B13 in the survey related to this study, as described in 5.3.18

17

One difference is that cost of capital is investment specific in the case of P1, whereas in P-C1, the individual investment decision’s discounting rate is determined on the basis of company’s overall cost of capital (WACC).

18 The

survey instrument may be found in Appendix E Part 1 sub-part a (E.1a).

18

Chapter 1 - Introduction

1.6

Three Questions Guiding This Research Approach

Three queries which guide the progression and approach to the investigation in this thesis are depicted in Figure 1.6.1:

Figure 1.6.1: Three Core Questions Guiding This Research Approach

19

Chapter 1 - Introduction Q1 and Q2 in Figure 1.6.1 relate to the primary research question in this thesis as specified in Part 3 of Chapter 3, Research Methodology (3.3). Q3 in the Figure corresponds to the secondary research question in 3.3.

1.6.1

Do Companies Experience Perpetual Life Spans in the Real World?

(Q1)

The investigation progression depicted in Figure 1.6.1 begins with query A1 and the base presumption relating to company longevity (t) in GFAP, that is, that all companies endure forever.

If this is true, then there is no issue to investigate in this study regarding the perpetuity conjecture. Never Ending Companies are the rule in the actual business as rule rather than exception (or, the exclusion).

Before progressing with empirical investigation of business failure levels and patterns, prima facie indicators suggest that (i.) companies experience life spans which are finite but unknown prior to death, and (ii.) firms’ longevity characteristics are unique. The latter means there is no one-duration-fits-all longevity statistic which applies universally.

Every day, there is another announcement in the media about another failed company, with no future business and worthless or near-worthless assets when netted against claims. When they failed, Circuit City, TWA and Webvan were defunct on multiple bases: operational, financial, and competition-wise.19 Each of these companies reached the end of its bespoke and sub-infinite life span, contradicting the perpetuity conjecture.

1.6.2

Is it Plausible and Defensible to Assume That Companies Endure Forever for Valuation Estimation Purposes, Only? (Q2)

Even if the Never Ending Company lacks confirmation in the actual business environment, the perpetuity conjecture might still be plausible if considered solely on a theoretical basis. That hypothesis, including the implicit assumption perpetual t inferred

by Gordon and Shapiro cannot be accepted at face value but instead must be proven

19 Appendix

K, Some Alternative Concepts of Company Life Span Terminus.

20

Chapter 1 - Introduction through scientific analysis. Lakatos (1978, 206) suggests that if someone puts forward (such) a hypothesis without inductive proof, even if it is true, it is not yet a discovery and has no place in the history of science.

But even without such confirmation, some unproven hypotheses such as the perpetuity conjecture nonetheless persist as axioms, generally accepted truths, for other reasons.

The three variable GFAP ratio is far easier to manipulate than the four variable serial version which would be necessary if t is instead treated as variable affecting company value.20 If the answer to query Q2 is “yes” in this investigation, then once again, it would appear that there is no basis for challenging the perpetuity conjecture. An artificial distinction between reality and theory is established, and continuing reliance on the notion of Never Ending Companies continues.

But if the answer to Q2 is “no”, then the perpetuity conjecture then appears to be discredited despite its usefulness, forcing the issue of what might replace infinite t in the GFAP base formula as shown in Figure 1.1.1.

1.6.3

What Emerges as Most Promising Approach Category to Succeed the Perpetuity Conjecture? (Q3)

If this research results in “no” answers to queries Q1 and Q2, then the first research question for this thesis as described in 3.3 is resolved. The investigation moves forward to the question of what replaces the perpetuity conjecture.

Q3 in Figure 1.6.1 corresponds to the second research question in 3.3, which involves preliminary evaluation of the categories of approaches which might plausibly succeed the perpetuity conjecture: a new basis for projecting the t variable which coincides with the actual characteristics of company survival and failure.

The alternatives shown in the exhibit here are divided between those already existing or in process of development at the time of the seminal Gordon and Shapiro paper in 1956 (referred to in the Figure as legacy approaches), and categories for which detailed information did not appear until years later (emergent). These alternative categories of possible successor approaches are considered in 5.9, including insights from the primary

20

The serial Gordon Formula version including t as a variable is shown in 2.3 as Figure 2.3.5 and also in Appendix C.

21

Chapter 1 - Introduction research (from 5.3) and studies of company failure patterns and levels from the literature failure (from 2.4).

1.7

A Guide to This Document

Five chapters follow this introductory chapter. Chapters 3 and 4 relate to the development, methodology and related issues pertaining to the primary and secondary research questions in this thesis. Chapters 2 (Review of Literature) and 5 (Results of the Analysis and Relevant Comment) discredit the perpetuity conjecture with academic journal insight on company longevity and other evidence, including findings from the primary research relating to this research (5.3).

1.7.1

Chapter 2, Review of Literature: An Overview

The Review of Literature is comprised of three parts and a chapter synopsis. Part 2 in that Chapter (2.2) identifies some of the academic writings in modern finance that together establish a foundation for modern scholarly investigation in corporate finance in general and valuation theory and application, specifically.

Part 3 (2.3) examines salient literature pertaining to company valuation methodology encompassing: (i.), the three primary approaches to company value estimation in use today; (ii.), contest for valuation methodological primacy between accrual accountingbased methods and DCF- based methods; and (iii.), issues of importance regarding the second stage in today’s prevailing Two Stage DCF (DCF2S) methodology, the Terminal Value Period (TVP) or the ‘continuing period’.

1.7.2

Chapter 3 (Methodology), Chapter 4 (Characteristics of This Research): Overview

Chapter 3, Research Methodology, contains six Parts following the chapter synopsis.

Parts 2 and 3 (3.2, 3.3) reveal the primary and secondary questions for this Research and how those questions came to be developed. Part 4 in that Chapter (3.4) describes why and how the research in this study follows a mixed methodological approach.

22

Chapter 1 - Introduction Part 5 in Chapter 3 (3.5) summarises the subject and method of the primary (survey) research related to this study. Part 6 (3.6) provides an overview description of the research methods for the secondary research in this study, most of which (excluding 5.3) appears in Chapter 5. Part 7 in Chapter 3 (3.7) describes expected users of the findings and results from this research, and their expected uses.

Chapter 4 relates to Chapter 3. The latter Chapter provides some additional detail relating to the scope of this study, and this Researcher’s relevant orientations and perspectives. Chapter 4 also describes expected findings, and how to ascertain whether and how those findings address the hypotheses underlying the primary research question in 3.3: that the perpetuity conjecture is neither credible nor defensible as a surrogate assumption for time, company longevity, as presently manifested in the Gordon Formula Assuming Perpetuity (GFAP).

1.7.3

Chapter 5, Results of This Research and Relevant Comment: Overview

This Chapter contains context to the assessment of the perpetuity conjecture in GFAP (5.2) along with summaries of findings from the primary (5.3, 5.7) and secondary (5.6, 5.7) research conducted for this investigation of the issue relating to the primary research question (3.3). Part 9 (5.9) considers possible future successor categories to replace the perpetuity conjecture in tomorrow’s adaptations of the Gordon Formula; this is the subject of the secondary research question in Part 3 of Chapter 3 (3.3).

1.7.4

Chapter 6, Conclusions and Future Direction of Research: Overview

Part 1 in this Chapter (6.1) considers conclusions from Chapter 5 in three contexts, in terms of: (i.) the three core questions guiding the approach to this research (Chapter 1 Part 6, preceding); (ii.) possible effects on the behaviour and perspectives of valuation practitioners; and (iii.) possible influence of this work on the literature. The second part of this Chapter (6.2) describes some possible future areas of research related to this study.

23

Chapter 2 – Review of Literature

2 Review of Literature Parts: 2.1 Chapter Summary 2.2 Foundations of Valuation-Related Corporate Finance Literature 2.3 Literature Review Relating to Company Valuation Methods 2.4 Literature Review Relating to Company Longevity

This Literature Review chapter focuses on three areas of relevance to this Research. Part 2 (2.2), Foundation Valuation Literature, provides an overview of some of the concepts and papers underlying modern corporate finance analysis today, including the valuation of companies.

Part 2.3, Literature Review Relating to Company Valuation Methods, considers prevailing and emergent company valuation thought as reflected in the academic literature, including consideration of the accrual accounting versus Discounted Cash Flow (DCF) battle for methodological primacy (2.3.3), and alternative approaches to estimating continuing or terminal value (2.3.4).

Part 2.4, Literature Review Relating to Company Longevity, examines a series of international studies directed at companies’ life spans: failure, measured on the basis of elapsed years from the time of company origin or birth. The actual duration of companies’ lives—and thus, the period available to generate value—differs significantly from the axiom that all companies exist forever implicit in the perpetuity conjecture.

2.1

Chapter Summary

Part 2 (2.2) describes some of the corporate finance writings that help to establish a foundation for future valuation thought and analysis. Miller and Modigliani introduce the concept of company value being determined in part by the pattern and level of a company’s projected performance over future periods. Firms’ net receipts, or inflows, must be discounted back to the present to accommodate the time value of money, thus highlighting the importance of the Capital Asset Pricing Model (CAPM) in setting 24

Chapter 2 – Review of Literature modern notions of the cost of capital, including the writings of Sharpe, Fama & French and Lintner.

Part 3 (2.3) describes the growing visibility of DCF-based valuation approaches in the academic literature since the mid 1990s, to the detriment of the previously-entrenched accrual accounting-based methods, particularly the Dividend Discount Method.

The Two Stage DCF approach combining a forecast value component with terminal value estimation is described and examined in this Part. The incumbent Gordon Formula Assuming Perpetuity (GFAP) including the perpetuity conjecture is the prevailing approach to calculating TV. In the academic literature, the dominant approach for calculating the duration of companies’ valuation life spans over Terminal Value Period (TVP) is to assume that those lives are continuous, or never-ending. Some alternative perspectives are emerging to suggesting finite TVP life spans.

In part, business equations and theories tend to be perceived as credible to the extent that those models and formulas are thought to reflect actual commercial circumstances, influences and interrelationships.

Part 2.4 in this Review of Literature contains an examination of several academic studies of companies’ actual life spans. That analysis suggests that: (i.), the median life span for companies overall is approximately seven years with very few firms surviving for longer than a decade; and (ii.), information on company failures organised by both industry and age at demise may be useful as for purposes of developing projected life spans for similar companies.21

2.2

Foundation Valuation-Related Corporate Finance Literature

Company valuation research is ultimately based on long-established principals of corporate financial analysis, in particular the works of Modigliani and Miller relating to corporate wealth creation, and the works of Sharpe and Lintner relating to aspects of the Capital Asset Pricing Model (CAPM).

Several papers and empirical investigations establish the foundation for modern company valuation analysis and thus are background resources to this Research. These

21

“Age at demise” refers to recorded elapsed years from year of origin, as recorded in the database associated with that study.

25

Chapter 2 – Review of Literature include: Modigliani and Miller (1958), Miller and Modigliani (1961), Sharpe (1964), Lintner (1965), and Fama and French (2004).

The two Miller-Modigliani (“MM”) papers present the propositions that (i.) market value of the company is based on outputs generated over time by firm and (ii.) leverage is irrelevant to company value creation. MM’s concept introduces trade-offs between changes in company capital costs and changes in risk. MM suggest that investors demand increased returns in order to compensate for perceived increased risks.

The Capital Asset Pricing Model (CAPM) concept originates with Sharpe (1964) and is advanced one year later by Lintner (1965) building upon the mean variance perspective of Markowitz. 22 Fama and French (2004, 26) describe Sharpe and Linter’s expansion upon Markowitz’s 1959 analysis to order to develop two foundations of modern corporate finance: (i.) risk-free rate, that is, the baseline cost of funds under assumed conditions of zero default risk, and (ii.) co-variance of individual share return divided by the variance of market return, typically referred to as beta (β).

Integrated into valuation frameworks, the two core concepts of (i.) company value based on period outputs over time and (ii.) CAPM, touch upon several aspects of financialrelated analysis, including this Research: •

Outputs over time define the gross returns attributable to an investment, regardless of whether that investment is in the form of a portfolio of shares passively managed, assets in a project enterprise or a CFs generated by a company.

•

Financing cost algorithms incorporating Beta (β) and risk free rate define each enterprise’s potentially unique Weighed Average Cost of Capital. That WACC, in turn, functions as the discounting mechanism for transforming a stream of future cash flows into the present worth of that company.

22

Lintner’s 1956 papers on the reliability of dividend declarations for purposes of company valuation was also instrumental in establishing early uses of the 1956 Gordon Formula in dividend-based valuation, commonly referred to as the Dividend Discount Model (DDM).

26

Chapter 2 – Review of Literature

2.3

Literature Review Relating to Company Valuation Methods

Sub-parts: 2.3.1 Overview and Summary of This Part of the Literature Review Chapter 2.3.2 On Literature Relating to Development of Alternative Company Valuation Major Approaches 2.3.3 The Academic Contest for Methodological Superiority: DDM v DCF 2.3.4 On Valuation Methods For Dealing With the TVP or Continuous Period

Valuation is neither the science that some of its proponents make it out to be nor the objective search for true value that idealists would like it to become. The models that we use in valuation may be quantitative, but the inputs leave plenty of room for subjective judgment…. In fact, in many valuations, the price gets set first and the valuations follow.

- Damodaran 2001A, 1

2.3.1

Overview and Summary of This Part of the Literature Review Chapter

This part of the literature review is comprised of three sub-parts, 2.3.2 through 2.3.4:

On Literature Relating to Development of Alternative Company Valuation Major Approaches (2.3.2)

This sub-part presents a framework for understanding the three company valuation methods in general use today, including consideration of some authors’ relevant literature. Coverage includes the two methods that predominate in the academic literature today, DDM (Dividend Discount Method, accrual accounting) and DCF 27

Chapter 2 – Review of Literature (Discounted Cash Flow) and also today’s major non-scholarly method,23 Price-toEarnings multiples (referred to in this Chapter Part as “Multiples”).

The Academic Contest for Company Valuation Superiority: DDM v DCF (2.3.3)

The Gordon Formula (GF) is the prevailing method for estimating Terminal Value (TV) in the second stage in the Discounted Cash Flow methodology (DCF2S). The Dividend Discount Method (DDM) shares common ancestry with the Stage 2 TV calculation part in DCF2S. From a GF ratio component standpoint, the only difference between the two forms is whether dividends appear in that ratio’s numerator (DDM) or Free Cash Flows (FCFs).24 Some other differences between accrual accounting-based valuation and DCF-based methods have become increasingly apparent since the mid 1990s, when Copeland et al.’s (1994) book and Kaplan and Ruback’s (1995) paper marked the arrival of DCF methods to the academic valuation literature mainstream.

On Valuation Methods For Dealing With the Continuous Period (2.3.4)

The Terminal Value Period (TVP, ‘continuing period’) refers to the second stage in the Two Stage DCF valuation methodology (DCF2S). Since the Copeland-Kaplan-Ruback breakthrough in the mid 1990s, DCF2S has gained momentum and today is perceived by many as the prevailing academic method for company valuation.25 As noted in the Introduction (Chapter 1), the Gordon Formula Assuming Perpetuity (GFAP, Figures 1.1.1 and 2.3.2) is the prevailing method for estimating TV. Based upon this research, the most likely future challenger to GFAP appears to be an adaption of the Gordon Formula itself: a version which includes valuation life span

23

“Non-scholarly” refers to level of consideration in the valuation academic literature.

24

These two different variants of the GF ratio are apparent in Figure 2.3.2 in this Chapter Part, DDM and DCF: Common Ancestry in the Gordon Formula. The amount of the growth rate (g) also changes based on forms, since g corresponds to FCF future growth rate in the DCF version, whereas in the DDM version, g represents the expected dividend payout growth assumption.

25

The emphasis on “academic” is because DCF-based methods began to predominate amongst financial officers, managers and some analysts starting in the mid- to late 1970s.

28

Chapter 2 – Review of Literature (time, t) as a fourth variable, with company-specific projections of t. This Gordon Formula Serial Format is shown in Figure 2.3.5 and in Appendix C.

A Summary of this Chapter Part: Overall

Table 2.3.1 summarises coverage in the academic literature of the three different company valuation methods: P/E Multiples, Dividend Discount Method (DDM) and the Two Stage Discounted Cash Flow Method (DCF2S).

DDM is believed to be the longest established accrual accounting-based company valuation method. That method is described in Williams’ 1938 book, which is the precursor of the 1956 Gordon and Shapiro paper. DDM continued to be described by its advocates as the leading company valuation method after 2001, despite (i.) the growing presence of DCF (ii.) emphasis by some accrual accounting valuation academicians on methods other than DDM, and (iii.) Lundholm and O’Keefe’s 2001 paper, which is perceived by this Researcher as marking the end point in time of serious debate between DDM and DCF advocates about methodological primacy in the literature.26 The contest was over and DCF methods prevailed.

The column in Table 2.3.1 designated “academic” summarises this Researcher’s perception of the present standing of each of the three major company valuation methodological categories in the academic journals. The column, labelled “nonacademic" identifies some valuation practitioner-related considerations, beyond those typically cited in academic papers and finance texts:

26

DDM is sometimes referred to as the Dividend Value Method (DVM). The accrual accounting Residual Income Method (RIM) received new attention in the mid 1990s with Feltham and Ohlson’s (1995) initial paper on “clean surplus.”

29

Chapter 2 – Review of Literature

Table 2.3.1: Summary of Valuation Methodologies Examined in This Chapter Part

P/E (Price-to-Earnings) ‘Multiples’ In this method, P/Es are often based on a single year’s forward estimate of reported earnings per share (EPS).27 On that basis, the Multiples technique is based on a fraction of the forecast information usually contained in Explicit Projection Period (EPP) analyses, Stage 1 of DCF2S. Multiples are minimally visible in the academic literature. The technique is dismissed by many valuation academicians as little more than an extrapolation of a P/E ratio. Both numerator and denominator in a P/E ratio may be distorted with ease, and the so-called comparable companies that advocates of this technique seek are sometimes non-existent or at least, non-comparable (Dorsey 2010).

In one of the few published academic papers on Multiples, Liu et al.’s (2002) contend that primitive P/Es contain all of the valuation-relevant information of the two more established methods, DDM and DCF. With little to support their claim, Liu et al.’s assertion is more likely to be perceived as promotional rather than analytical.

27

Alternatives to reported earnings (net income) appear in some Multiples calculations, such as Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA).

30

Chapter 2 – Review of Literature

Dividend Discount Method (DDM)

DDM’s standing as the leading accrual accounting-based method was affirmed in 1956, the year of separate papers by Lintner and by Gordon & Shapiro. In his paper, Lintner portrays management’s dividend payout intent as a reliable indicator of companies’ future financial and operating performance. Thus supported, dividends may be inserted into the Gordon Formula numerator.28

Two Stage Discounted Cash Flow Method (DCF2S)

In addressing the two-part method referred to here as DCF2S, emphasis is frequently directed to the second stage, the Terminal Value Period (TVP), largely because TV often comprises more than half of a firm’s total calculated value.

Conventional academic wisdom has been that the duration of DCF2S’s initial stage, the Explicit Projection Period (EPP), is irrelevant to TV. Copeland et al. suggest that while altering the time frontier between EPP and TVP might change the value distribution between the two DCF2S parts, overall company value amount is unchanged (2000, 273).

That contention is questioned by Cassia et al. (2009, 2007) who contend that both (i.) the duration of the Explicit Projection Period and (ii.) the level of Free Cash Flow (FCF) as of the end of the EPP may affect Terminal Value and thus total company value.

Terminal Value remains something of an enigma today, even though the dilemma of excessive continuous period value estimations have been recognised by valuation practitioners for decades.29 DCF2S Stage 2 Terminal Value is not calculated using operating budget-quality information, as is the case with Stage 1 EPP. Instead, the TV statistical result is generated by the interaction of the assumption of three broadly defined acknowledged

28

Figure 2.3.2, DDM and DCF: Common Ancestry in the Gordon Formula.

29

Excessive TVs were addressed in Joel Stern’s symposiums for Chase Econometrics symposiums in 1980, which this Researcher attended. As planning director of Frito-Lay Inc. in the early 1980s, this Researcher encountered the problem of exaggerated TV estimates on several occasions, primarily involving acquisitions.

31

Chapter 2 – Review of Literature variables in GFAP: continuing period initial year annualised Free Cash Flow, cost of capital, and FCF future growth rate or rates (g).

Despite --or perhaps because of-- the approximate nature of this estimation technique, TV is at times viewed as excessive by some academicians. Levin and Olsson (2000, 2) observe “Copeland, Koller and Murrin (1994, 273) report, typical values for some industries: for a company in the tobacco industry, the horizon value accounts for 56% of total company value, in the sporting goods industry it is 81% for a typical company, for a typical skin care business, the figure is 100% and for a high tech company 125%.”30 Others (including Mauboussin 2007, Mills 2005 and 1998, Finnegan 1999) note the issue of possibly suspect company valuations caused by overly optimistic TV calculations using the Gordon Formula.

Following is a summary of this Chapter Part: by sub-part,

Summary of sub-part 2.3.2: On Literature Relating to Development of Alternative Company Valuation Major Approaches

This sub-part provides a framework for company valuation overall on the basis of two categories (scholarly versus non-scholarly) and three methods (DDM, DCF2S, Multiples). Table 2.3.2 identifies some of the differences between company valuation approaches receiving wide coverage and broad acceptance in the literature (“scholarly”) versus other techniques.

Multiples continue to be viewed by many valuation academicians as a non-scholarly, primarily managerial pricing rule-of-thumb rather than a peer-reviewed methodology competitive with DCF and DDM. Nonetheless, Cornell (1993) and Fruhan (1998) describe Multiples as a possible contingent method for estimating TV.

30

Cornell (1993) cites the same figures, as shown in Table 1.1.1 in Chapter 1: Continuing Value (TV) As Percentage of Continuing Value (CV), By Industry Type.

32

Chapter 2 – Review of Literature Summary of Sub-Part 2.3.3: The Academic Contest for Company Valuation Superiority: DDM v DCF

Dividend-based approaches persisted as the primary valuation method in the literature until the mid 1990s. The managerial literature on company valuation began to embrace DCF methods in the mid 1970s, simultaneous with the growth of corporate planning departments and publication of Stern’s 1974 article “Earnings Don’t Count”.

But DCF did not start to become a mainstream academic company valuation methodology until the watershed writings of Copeland et al. in 1994 and Kaplan and Ruback in 1995. Referring to McKinsey & Co.’s multi-company research, Copeland et al. suggest that valuations using DCF-based methods are closer aligned to market value (MV) than accrual accounting-based methods.

•

To the supporters of accrual accounting-based company valuation methods, also referred to in this study as the “Accounting Group”, a new threat emerged to their past primacy in the academic literature on valuation: DCF.

•

That threat was never met by the Accounting Group. This Researcher’s perception is that the base analyses underpinning the Copeland et al. and Kaplan & Ruback’s writings have never been discredited by the Accounting Group.

Lundholm and O’Keefe (2001) dismissal of the DDM-DCF equivalency contest for academic primacy as irrelevant signalled to many valuation academicians that the battle was over, and that DCF had won. In 2001, Stephen Penman, the unofficial spokesperson for the Accounting Group and an ardent supporter of accrual accounting-based company valuation methods, acknowledged in his response to Lundholm and O’Keefe that DCF approaches had become “prevalent.”

Several of the arguments advanced by the Accounting Group to attempt to slow the pace of DCF incursion may have had the opposite of the intended effect.

In explaining the requirement for an infinite time span assumption so that accrual accounting-based valuation calculations may be statistically equivalent to DCF2S, Penman discloses, perhaps inadvertently, that “forecasting dividends to calculate equity value is problematic because, for going concerns with no liquidating dividend, forecasted payout is not necessarily related to value” (1997, 2).

Feltham and Ohlson’s (1995, 2005) “clean surplus” technique equates balance sheet numbers with external market value (MV), accompanied by a suggestion that the

33

Chapter 2 – Review of Literature manipulated equivalence is proof of extraordinarily high levels of valuation accuracy, as Pariente (2003) observes.

Summary of sub-part 2.3.4: On Valuation Methods for Dealing With the Continuous Period

Today’s prevailing practice calls for estimating Terminal Value (TV) by using the DCF version of the three variable Gordon Formula, as shown in Figure 2.3.2.

Terminal Value (TV) often comprises more than half of a company’s total estimated value (CV), sometimes more than 120 per cent of CV.31 Concerns about excessive TV levels and TV-to-CV percentages are expressed by Levin and Olsson (2000), Copeland et al. (1994 and 2000) and Finnegan (1999).

One valuation-relevant aspect of the boundary between the two DCF2S stages, Explicit Projection Period (EPP, Stage 1) and Terminal Value Period (TVP, Stage 2) is that the Free Cash Flow (FCF) annualised amount as of the end of the EPP is often assumed to be identical to the FCF annualised rate as of the beginning of TVP, thus becoming the FCF variable in the Gordon Formula.

Cornell and Fruhan’s nomination of Multiples as a possible standby technique for calculating TV is noted above. Some other alternatives that arise for calculating TV from the literature include liquidation value (Fruhan 1998), long term gilts or bonds term (Viebig et al. 2008), or value as determined by subjectively designated ‘value drivers’ imagined by their creators as being value determinants but often just being coincidental indicators with no proven causal effect (Rappaport 2006, Madden 2005).

These secondary TV alternatives suffer from limitations in data availability and/or quality, preventing a serious challenge to today’s prevailing method for valuation of the continuing period in DCF2S.

31

Total company value (CV) equals DCF2S Stage 1 Explicit Projection Period (EPP) value plus DCF2S Stage 2 Terminal or continuing Value (TV).

34

Chapter 2 – Review of Literature 2.3.2

On Literature Relating to Development of Alternative Company Valuation Major Approaches

The time-worn and traditional approach to valuation, still used by Wall Street analysts and investment bankers, is a multiples approach.... One common example of a multiple is the average of the comparable’s market price per share divided by their earnings

before

interest,

taxes,

depreciation, and amortization (EBITDA).

- Copeland in Thomas and Gup 2009, 69.

A review of the salient academic literature on company valuation methods begins with distinguishing non-scholarly approaches from scholarly approaches. Table 2.3.2 displays several characteristics in each category.

One of the two “scholarly” methods in Table 2.3.3 is the Dividend Discount Method.

This is the primary accrual accounting method considered in this study, in part as DDM is the accounting valuation method that is most closely aligned with the historical (since 1938) Williams-Gordon-Shapiro formula.32 The second “scholarly” method is today’s prevailing company valuation methodology, Two Stage Discounted Cash Flow (DCF2S).

Both scholarly methods are today widely represented in peer-reviewed journals. Two factors contribute to this Researcher’s belief that academic literature coverage of DCF valuation methods appears to be increasing, with a corresponding retreat in DDM and the other accrual accounting-based valuation methods.

Those factors are: (i.) growing popularity of DCF methods (as noted by Penman, 2006, 50); and (ii.), the persuasiveness of Lundholm and O’Keefe’s (2001) and others against

32

Within the accrual accounting category, DDM also benefits from Penman’s consistent advocacy. By contrast Residual Income Method (RIM) is (i.) directly critiqued in Lundholm and O’Keefe (2001) and (ii.) is utilised in Ohlson’s clean surplus technique.

35

Chapter 2 – Review of Literature the accrual accounting valuation equivalence contention, which effectively relegated DDM to declining future visibility in the literature.33 Multiples emerge as today’s major non-scholarly category, usually in the form of price– to-earnings per share (P/E) ratios. Some practitioners view Multiples as an emerging alternative method for company valuation, applying the technique of analysing and then comparing P/Es of different comparables to suggest future market pricing.

But reliance on Multiples is broadly discredited by valuation academia. That there have been only a few academic papers about Multiples over two decades suggests that this approach is yet to be seriously considered by the academic valuation community. Liu et al. concede “while multiples are extensively used in practice, there is little published research in the academic literature documenting the absolute and relative performance of different multiples” (2002, 135-136).

33

Penman’s anguish (2001) about valuation research funding being diverted away from accrual accounting academicians (and presumably re-directed to competing DCF valuation academicians) signals the growing resignation of the Accounting Group to the inevitability of DCF methods (5.7) Some journals are traditionally oriented towards accrual accounting-related valuation methodology such as Contemporary Accounting Research, Journal of Accounting Research and Accounting Horizons. The Journal of Applied Corporate Finance is oriented towards DCF methodologies, while The Journal of Finance encompasses both sides of the valuation methodological divide. Penman is one of the few authors with a continuing presence in both categories of valuation-related peer-reviewed journals.

36

Chapter 2 – Review of Literature

Table 2.3.2: Company Valuation Methodologies: Non-Scholarly v Scholarly34

34

“Pharm 04” refers to Clark, P. and Neill, S. (2nd November 2004). “New Value Challenges in the Global Pharmaceuticals Industry.” The Economist’s 6th Annual Global Pharmaceuticals Industry Conference.

“Gartmore 09” refers to Hilton, A. (23rd Nov. 2009) “Why the £ Billion Tag on Gartmore?” Evening Standard, 23.

37

Chapter 2 – Review of Literature

Figure 2.3.1: Three Valuation Methods: Uses and Users

38

Chapter 2 – Review of Literature

Figure 2.3.2: DDM and DCF: Common Ancestry in the Gordon Formula

2.3.2.1 Reasons for including both “non-scholarly” and “scholarly” company valuation categories in Table 2.3.2 Both scholarly and non-scholarly categories are shown in Table 2.3.2, although focus in this literature review is on the academic literature. The inclusion of Multiples in that Table (i.) reflects the extensive present use of the Multiples by a part of the valuation practitioner community; and (ii.) because some valuation academicians and practitioners such as Cornell and Fruhan cite hybrid methods including Multiples in their contingent list of possible methods for estimating Terminal Value. (i.). Extensive use of Multiples by a part of the practitioner market Multiples are used as an ad hoc company pricing technique by some managers, business brokers and analysts. These users appear to be positioned at the lower end of the practitioner spectrum in terms of company size and the manager’s level of financial sophistication and knowledge, as shown in Figure 2.3.1.

Pratt (2009, 2008, 2001) is a highly visible US business broker who is also a selfdescribed valuation expert. He advocates Multiples-type valuation approaches as do his competitors, all of who primarily pursue the US middle market. In the UK, Heslop’s recent book (2008) is nominally supported by the Institute of Directors.

39

Chapter 2 – Review of Literature Particularly in the case of the manager of a small to medium enterprise (SME) who has limited familiarity of corporate finance principles, the appeal of Multiples is understandable. To the non-numerate manager, even the simple three variable GFAP might be perceived as opaque and unnecessarily ornate, and rejected on that basis alone. (ii.) Time lag: evolutionary process suggesting further consideration of some managerial valuation methods in some academic journals Academic journal coverage of emerging valuation methodologies lag behind management practice by decades. DCF valuation methods first became widely visible in the general management publications in the mid 1970s with Stern’s “Earnings Don’t Count” 1974 article in the trade Financial Analysts Journal. It was not until 21 years later in 1995 that Kaplan and Ruback’s seminal paper on DCF-based company valuation methodologies appeared in The Journal of Finance.

Today, even Multiples-based company valuation techniques receive minimal, sporadic coverage in the academic journals. Alford’s paper describing alternative Multiples-based value estimation methods appeared in the Journal of Accounting Research in 1992. Liu et al.’s paper appeared in that journal one decade later.

Two considerations suggest that there may be a gradual increase in coverage of Multiples in the academic journals in the future: (i.), the prevalence of Multiples-based methods amongst SME managers and some analysts and business news reporters in The City and on Wall Street (e.g., Hilton 2009); and (ii.), the growing general use of Multiples-and-DCF hybrids to estimate Terminal Value.35 2.3.2.2 Issue: Whether Multiples may someday become a scholarly company valuation method The issue is whether Multiples is presently positioned to join accrual accounting (DDM) and DCF as the third major scholarly company valuation methodology category.

Multiples-based approaches are apparently simple, but suffer from other limitations.36 Although Liu et al. and other advocates of Multiples insist that P/Es contain the same

35

Several valuation practitioner participants in the survey related to this study (5.3) indicate that they are using or considering hybrid methods including Multiples, or that they use the Multiples as a secondary calculation to ensure that their original DCF calculation (especially the TV part) is reasonable and defensible. Thomas and Gup (2010) describe several Multiples and Multiples-DCF company valuation hybrids. Viebig et al. (2008) are oriented towards different variation of the base DCF2S methodology, some including Multiples.

36

“Apparently” refers to the issue also raised in Chapters 1 and 5 that the overly-simple equation may actually be complex when all of the adjustments necessary to ensure a method that is perceived as credible and accurate are implemented.

40

Chapter 2 – Review of Literature valuation-relevant information as Free Cash Flow-based DCF analysis over multiple periods, such assertion appears to stretch interpretations of the concept of Semi-Strong Market Efficiency (Mills and Dahlhoff 2003, Campbell and Lo 1997) to an implausible extreme.

Assuming that Multiples are considered at all by the academic valuation community, the approach tends to be viewed as a management-level target company pricing shortcut lacking the completeness of DDM or DCF. Most P/E and P/EBITA Multiples are based on one year’s trailing or leading performance. Such a shallow basis for analysis means that Multiples may be particularly vulnerable to bubbles and extremes of business cycles.

A triple digit P/E appeared to be suitable for Lehman Bros.’s pricing of the Lastminute.com Initial Public Offering in mid March 2000, based on recent market pricing of comparable Net-oriented firms. Six weeks later, the Internet bubble burst, causing Dot Com valuations based on Jan.-Feb. 2000 P/E to appear spectacularly overvalued.

Multiples-based valuations tend to rely on a single reference ratio, imagined by that analyst as a comparable for calculating the worth of his, different company. But usable comparables are rarer. In March 2010 Pat Dorsey, head of equity research at Morningstar, tell this Researcher that he is eliminating many of his industry categories because of non-comparability between firms within each group.

Management at some pharmaceuticals companies continue to price possible acquisitions based on rudimentary P/E Multiples as guidelines, but that is only to identify the a broad upper and lower range of possible acquisition cost. After rough estimates are made using Multiples at Boehinger-Ingelheim (B-I, UK) and Johnson & Johnson (J&J, US), the more promising targets are then re-analysed using DCF approaches. Multiples merely perform the role of preliminary screen.37 Liu et al.’s 2002 paper argues that Multiples should be considered seriously as a primary method, competing with DCF and DDM. Liu et al. and other advocates of Multiples argue that: The multiple approach bypasses explicit projections and present value calculations….We find that multiples derived from forward earnings explain

37

This Researcher was involved in B-I UK’s acquisition explorations in 2001-2 and was also contracted by J&J in 1989 in conjunction with divestment of that firm’s Devro Ltd. unit in the UK.

41

Chapter 2 – Review of Literature stock prices remarkably well: pricing errors are within 15 percent of stock prices for about half our sample.” (135) To this Researcher, Liu et al.’s arguments above make a better case for exclusion from peer-reviewed journals than for inclusion. The authors’ statement about “pricing errors within 15 percent of stock prices for about half our sample” raises concerns about the reliability of what appears to this Researcher to be a crude mechanism, as fifteen per cent divergence divided by 0.5 (“half our sample”) suggests a 30% overall error rate.38 A single forward year’s Earnings Per Share should correlate closely with share price, assuming that analysts’ EPS estimates are reasonably accurate. But any method reliant upon just 1-2 years of projection estimates faces Penman’s “truncated error” (1997, 98) argument that some value is uncounted because of an artificially brief analysis time period.

2.3.2.3 Default option: Multiples as a possible secondary continuous period method While Multiples face an uphill battle to advance in terms of visibility in the literature, that does not mean that secondary uses of the technique do not arise. Fruhan (1998) includes Multiples in his varied and extensive list of possible approaches for estimating TV. Multiples are presented as a possible default option in place of GF-type “continuous period” calculation in Cornell (1993, 146-163). Cornell’s terminology for Multiples in Table 2.3.3, following, is “Direct Comparison”.

38

0.15 / 50% = 30%.

42

Chapter 2 – Review of Literature

Table 2.3.3: Cornell’s Alternative Methods for Terminal Value (TV) Estimation, Including “Direct Comparison” (P/E Multiples)

2.3.3

The Academic Contest for Methodological Superiority: DDM v DCF

Perceptions of value have to be backed up by reality, which implies that the price that is paid for any asset should reflect the cashflows it is expected to generate.

- Damodaran 2002, 1.

Accrual accounting-based methods (primarily DDM) and cash flow-based methods (DCF2S) encompass today’s primary scholarly approaches for company valuation.

Some of the differences between those two categories of methodological approaches are shown in Table 2.3.4:

43

Chapter 2 – Review of Literature

Table 2.3.4: Scholarly, Projection-Based Methods: DDM v DCF

2.3.3.1 The DDM-DCF methodological contest: a three period perspective The company valuation methodological battle between accrual accounting (DDM) and DCF in the literature is described in terms of three time periods: 1956-1993, 1994-2001 and 2002 to the present.

1956-1993: Lintner’s paper enables the Gordon Formula 1956 marks the beginning of scholarly valuation’s first phase. That was the year of Gordon and Shapiro’s seminal paper and the Lintner’s related paper advocating use of management’s dividend payout intentions as a primary basis for estimating company value.

As noted in 2.4, Gordon and Shapiro restate some of the analysis from Williams’ 1938 book. The Williams book, Gordon and Shapiro’s 1956 paper and Gordon’s 1962 book which all describe a method for estimating company value using dividend payout information, applying a version of the perpetual annuity formula.

44

Chapter 2 – Review of Literature When Lintner articulated his case for dividend declarations in 1956, dividend payouts became widely accepted as a basis for estimating company value.39 Lintner’s objective was to portray Board dividend policies as a consistent and reliable future basis for valuation, proclaiming the “the adequacy and reliability of the model and the stability of the indicated patterns of behaviour and policy” (97).

Lintner’s perspective clashes with today’s perception that some share (stock) dividends are vulnerable to unforeseen events or the changing mindsets of directors.40 1994-2001: Transition: a compelling case arises for DCF methodological superiority

Kaplan and Ruback’s (1995) study of 51 highly leveraged transactions (HLTs)… explained about 70 percent of the crosssectional variation in market price scaled by book value.

Copeland, Koller and Murrin (1994) regressed

analyst-generated

discounted

cash flow estimates (in 1988) of the values of a set of 35 large industrial companies against their market values and found an rsquared of 94 percent. The regression was repeated for 31 survivors from the original set and the r-squared was 92 percent.

- Thomas and Gup 2009, 68-69.

Accuracy of a valuation methodology is typically measured on the basis of comparing analysed company market value (MV) with that method’s comparable value estimation result.

39

Dividend-based company valuation existed before 1956, but tended to be limited to utilities and similar companies that were priced by the financial markets completely or almost completely on the basis of yield.

40

At this writing, BP’s dividends are suspended at least for the remainder of calendar 2010 in the aftermath of the 2010 Gulf Coast offshore spill. During the 2007-9 economic downturn, numerous companies cut back on their declared dividend payouts to preserve cash when the interbank funds market nearly froze twice.

45

Chapter 2 – Review of Literature In 1994 and again in 2000, Copeland et al. disrupted the academic valuation universe with their empirical study suggesting that a nearly perfect (0.92 to 0.94) correlation existed between the DCF/book value ratios for 31 large companies and those firms’ market value to book value (MV/BV) ratios.

The 1999 version of that analysis is shown in this Chapter Part as Figure 2.3.3. The 0.92 r-squared in that Figure identifies that exhibit as referring to the original Copeland et al. analysis, as described in Thomas and Gup (2010). On a comparative basis, accountingbased measures indicated a far lower level of correlation. MV-to-accrual accounting rsquares developed in a separate study by Copeland et al. indicated a far lower 0.42-0.45 range. (Copeland et al. 2000, 75-77) Copeland et al.’s watershed analysis in 1994 was followed by a supportive paper authored by Kaplan and Ruback in 1995. DCF-based company valuation methods had entered the academic valuation mainstream.

The Copeland-Kaplan-Ruback statistical findings have never to this Researcher’s knowledge been discredited by the accrual accounting valuation academicians, some of whom (e.g., Penman 2007, 2006) persisted in their belief in the superiority of accrual accounting-based company valuation methods while never challenging the research upon which either the Copeland or Kaplan-Ruback studies were based.

The dual shocks of the Copeland and the Kaplan-Ruback analyses spawned a series of defensive papers from the Accounting Group, presumably aimed at slowing the pace of DCF incursion into the valuation literature mainstream. These papers either claimed equivalence with DCF methods, or in some instances, superiority. Papers during this period by Penman and Sougiannis (1998), Case and Shane (1998), Levin and Olsson (2000) and Courteau et al. (2000-1) are examples.

Feltham and Ohlson’s (1995) clean surplus approach, a re-conceptualisation of the accrual accounting Residual Income Method (RIM), also emerged during this period.

Ohlson suggests that his clean surplus technique results in a superior correlation to market value (MV) when compared with DCF. Lundholm & O’Keefe (2001) and Pariente (2003) dismiss Ohlson’s clean surplus analysis as statistical slight of hand. In both papers the authors suggest that equating accounting balances to MV on its own provides no proof of superiority of Ohlson’s adapted accrual accounting method over DCF. Referring to the Residual Income (RI) method at the centre of Ohlson’s clean surplus argument, Lundholm and O’Keefe suggest that “any claim of the RI model’s superiority 46

Chapter 2 – Review of Literature over the CF method is mistaken.” The two authors dismiss clean surplus RIM argument as comparable to inputting identical numbers to both sides and then claiming that the different calculations result in a near-perfect standard deviation or r-squared (2001, 315).

Figure 2.3.3: Copeland et al.’s DCF to Market Value (MV) Correlation (2000, 77)

2002 to present: DCF continuing momentum in the academic community The aftermath of the Lundholm and O’Keefe’s paper was that by 2002 many academicians (excluding accrual accounting valuation champions such as Penman, Sougiannis, Ohlson and Zhang) began to realise that DCF had prevailed in the contest for company valuation methodological primacy.

Even considering the polite discourse of academic papers, it appeared to this Researcher that Penman was agitated about Lundholm and O’Keefe’s perfunctory dismissal of the Accounting Group’s claims of equivalence with DCF (2001, 4).

47

Chapter 2 – Review of Literature 2.3.3.2 Accounting Group’s attacks on DCF misfire Some of the arguments generated by Accounting Group in support of their preferred method appear to this Researcher to backfire, supporting the opposite method, DCF, instead. Some of these arguments are summarised in Table 2.3.5:

Table 2.3.5: Arguments Concerning Superiority of Accrual Accounting Methodologies Over DCF, Including Counter-Arguments

Contention: The Benjamin Graham arguments (avoidance of speculative guesses about future performance) In his 2006 paper, Penman cites a passage from Benjamin Graham’s 1951 book, The Intelligent Investor: “Understand what you know and distinguish it from speculation; put your weight on what you know and avoid building speculation into your valuation” (2006, 46).

By inferring a connection between Graham’s investment acumen and accrual accounting-based methods for estimating value, Penman attempts to portray DDM as valuation analytical bedrock. In contrast, Penman portrays DCF as speculative guesses about the future, referring to Graham’s similar sentiments.

48

Chapter 2 – Review of Literature What Penman does not acknowledge is that the dividend-based accrual accounting also rely on projections about the future. While dividend payouts levels might be maintained by selling off assets when a company’s profits decline, such methods tend to be temporary expedients. Dividend payouts are ultimately dependent on future company cash flow generation performance, the same ultimate source as DCF analysis.

Contention: Attacking Errors in Future Estimations of Variables in DCF Version of Gordon Formula In 2006, Penman declares that errors might arise in DCF company valuation methods when overly optimistic assumptions about two of the variables in the Gordon Formula -initial Free Cash Flow (FCF) and subsequent growth (g)-- are made. This concern about the errors that might be caused by unsupportable assumptions of variables in the Gordon formula were shared by DCF valuation academicians, but without the agenda of attempting to discredit DCF. Mills (1998, 2005) and Mauboussin (2007) make similar observations to those of Penman.

Contention: Superior correlation of accrual accounting methods to market value (MV), particularly under so-called "clean surplus" version The circular nature of Feltham and Ohlson's 1995 clean surplus arguments was addressed above. Lundholm and O’Keefe view the device of equating accounting statement amounts with MV as a theoretical statistical ploy, rather than analysis-based proof.

Contention: Reduced research opportunities for accrual accounting valuation researchers In his response, Penman comments that: “Lundholm and O’Keefe, unintentionally, leave the impression that we may be cynical about that accounting researchers with a reduced agenda.” (2001, 18) Penman’s primary concern appears to be to defend the research budgets of Accounting Group valuation researchers, who might find themselves threatened by a rise of DCFbased valuation methods in academia, possibly resulting in reduced research funding for Penman and some other accrual accounting-oriented company valuation academicians and practitioners.

49

Chapter 2 – Review of Literature Such overt lobbying appears to be both subjective and non-scientific. The merits of the DCF v. DDM methodological battle were set aside by Penman, replaced by concerns about academic budgets. This Researcher was surprised to see Penman reveal his apparent actual motivation in a peer-reviewed journal.41 2.3.3.3 Other points from the academic research suggesting DCF’s growing momentum as a scholarly methodology Table 2.3.6 summarises three other points from the academic literature in support of the notion that cash flow-based company valuation methods are displacing accrual accounting-based methods:

Table 2.3.6: Beyond Copeland, Kaplan & Ruback: DCF’s Other Methodological Superiority Points

Consideration: Accounting Group’s pursuit of statistical equivalence with emergent DCF methods Instead of attempting to discredit the foundation of the Copeland et al. and Kaplan and Ruback studies, the Accounting Group is instead content to re-present their

41

These issues are also addressed in Part 7 in Chapter 5 (5.7), Conflicted Apologist for the Perpetuity Conjecture Re-Examined: Penman’s “Truncation Error” Argument Reconsidered.

50

Chapter 2 – Review of Literature methodological equivalence arguments in slightly different ways from 1995 to 2005, time and again.42 In this Researcher’s judgment, the analyses underlying the Copeland et al. and Kaplan & Ruback papers have never been refuted.

One possible explanation is that the Accounting Group view the statistical analyses contained in the two mid-1990s DCF studies as unassailable. By contrast, accrual accounting-based valuation methods are self-described by the accrual accountants as being of limited worth for the valuing companies: “In the dividend discount model (DDM), forecasted dividends over the immediate future are often not related to value” (Penman and Sougiannis, 1996).

In that same paper, Penman and Sougiannis admit that some manipulations of time (t) must be made for DDM to be equivalent with DCF: “the forecasted period has to be long or a (often questionable) terminal value calculation made over some shorter horizon” (3).

Consideration: Dividends subject to management discretion Lintner (1956) and Myers (1984) both envision dividends as stable indications of company future performance, suitable for purposes of estimating company value.

Dempsey et al. describe the consistency between dividend payout levels and investment requirements and earnings.

Others are less convinced of the suitability of dividend expectations as a means for calculating company value. Rozeff contends that "dividend payout ratios vary widely among corporations.” Referring to Higgins (1972), Rozeff suggests two possible reasons for this variability: "the firm's fund requirements for investment purposes" and levels of debt financing (1982, 249).

Rappaport cautions that dividend payouts patterns may become erratic if management’s basis for setting the payout ratio changes from one year to the next: "Calculating cash dividends as the product of earnings, an accrual accounting flow, and a payout rate can introduce substantial valuation errors if the basis for the payout rate is not carefully assessed" (1986A, 52).

Brigham and Gapenski (1991) caution that a decision about dividend payout levels is "one of the most judgmental decisions that a manager must make” (1991, 549). Nor do profitable operations necessarily ensure that dividends will be paid: Steele (2010)

42

Ohlson, J. (2005). “On Accounting-Based Valuation Formulae.” Review of Accounting Studies. 10: 323347.

51

Chapter 2 – Review of Literature describes a decision by Rentokil management in 2010 to cancel their dividend payout in order to conserve cash, despite that firm’s return to profitable operations.

Consideration: Fundamental adjustments required for dividend information to be useful in company valuations Bethke and Boyd (1983) argue that a yield adjustment is necessary to adapt dividend information for use in company valuations, referring to the Capital Asset Pricing Model: “Most discounted dividend valuation models ignore the tax effect by relying on the standard pre-tax version of the CAPM. As a result, they have a bias in favour of highyield stocks and against low-yield stocks” (1983, 24). Rappaport refers to his set of necessary adjustments to dividend data as “the affordable dividend approach” (1986A, 52).

Suggesting modifications does not per se indicate that the originally methodology is irreversibly flawed. But Rappaport‘s proposed 1986 changes represent fundamental reforms of DDM rather than incremental adjustments. On that basis, contentions of DDM equivalence to DCF appear to this Researcher to be weakened further.

2.3.4

On Valuation Methods For Dealing With the TVP or Continuous Period

2.3.4.1 Terminal value (TV) as a major component in total company value Stage 2 Terminal Value typically represents more than half of the company’s overall estimated worth. Sometimes that percentage exceeds 130%. Overly optimistic assumptions of one or more of GFAP’s three variables is one of the factors contributing to excessive TV. Mauboussin (2007, 11), Levin and Olsson (2000, 2), Mills (1998, 40) and others describe circumstances in which Terminal Value-- as expressed as a percentage of total company value (CV)-- appears to be excessive.

The perpetuity conjecture is an indirect cause of exaggerated TV-to-CV percentages, as also explored in 5.5 in this thesis and Appendix H. Combine infinite analysis period (t) with overly-optimistic assumptions for FCF, WACC and/or g, and the consequence may be a TV amount and percentage (of company overall value) that is not credible.

There are no absolute rules about what represents an acceptable TV-to-CV percentage, although to this Researcher many valuation academicians seem to become 52

Chapter 2 – Review of Literature uncomfortable when TV exceeds seventy per cent of CV.43 Copeland et al. observe that terminal value percentages tend to vary from industry to industry, influenced by factors including the level and pattern of investment, pricing flexibility, novelty of the productservice being introduced to market and the level of competitive intensity (1994).

The valuation academicians’ discomfort with perceived high TV-to-CV percentages arises in part because the Terminal Value component of value (i.), is generated further in the future than Stage 1 EPP value; and (ii.), using the Gordon Formula’s three simple, approximated variables (FCF, g, WACC).

Stated another way, the larger part of the company’s total value is originates from the lesser method (between EPP and TVP) in terms of substance and timing.44 In Figure 2.3.4 Koller et al. (2005) illustrate the implications that arise when the theory of continuous life spans is applied to DCF2S’s second stage, the Terminal Value Period:

Figure 2.3.4: Implications of Assumption That the Terminal Value Period (TVP) Is Infinite

43

As Director of Planning at Frito-Lay (US) in the early 1980s, this Researcher prescribed a maximum 60% TV-to-CV percentage ceiling following a series of TV calculations that were criticised by senior management as non-credible because of perceived very high Terminal Value as a percentage of total company value.

44

This does not mean that EPP Stage 1 component estimates may not be inaccurate due to erroneous data or similar reasons. But with the Stage 1 (EPP) component an extension of the company’s two-year operating budget in many instances, that component of value is likely to be viewed as based on more credible assumptions than TV calculations, which (i.) occur further in the future and (ii.) are based on three generalised component variables, only.

53

Chapter 2 – Review of Literature

Koller et al. suggest that “While the length of the explicit forecast period is important, it does not affect the value of the company; it only affects the distribution of the company’s value between explicit forecast period and the years that follow” (2005, 277).

Consistent with Cassia and Vismara 2009, Koller et al. appear to presume in Figure 2.3.4 that the duration of the EPP may vary. As noted, the time ranges for EPP in the literature are from a minimum of two years to a maximum of fifteen years, but even Explicit Project Period expert Cassia does not venture a guess about the ideal duration limit for EPP. By assuming that all companies endure forever for valuation purposes, Koller et al. suggest that the same $893 total company value results, regardless of Explicit Projection Period duration. Since the Gordon Formula Assuming Perpetuity (GFAP) disregards time as a variable and determinant of company value, such statistical result is to be expected. (i.) EPP duration, or when does the TVP (continuous period) commence?

But the longer the presumed duration of Stage 1 EPP, the more speculative that estimations of stage 2 Terminal Value potentially become. Calculating Terminal Value when Stage 2 is presumed to begin a couple of years from the now is one matter. But if the Terminal Value Period is not presumed to even begin until ten-plus years from today, the reliability of those estimates are likely to be less (Cassia et al. 2009). (ii.) TVP equation: simple or simplistic?

Bradley and Jarrell articulate the simplicity argument for GFAP: The main appeal of the Constant-Growth valuation model is its simplicity.… the market value of the firm (Vo) is a function of just three variables: the expected free cash flows in the next (or first future) period, the firm’s cost of capital (W) and the growth rate of the firm’s free cash flows (2008, 66).

Cornell concurs, but suggests that this simplicity may have a negative aspect by reducing perceptions about the reliability of value estimates for Terminal Value: “the simplified procedures used to estimate continuing value are less accurate than valuations based on explicit cash flow projections” (1993, 144).

Cornell infers that the ease-of-use advantages of the GFAP may also represent that method’s prime shortcoming, as the three variable version is sustainable only if one disregards other important value influences. Cornell does not specify time, but that is the determinant of value that comes to this Researcher’s mind.

54

Chapter 2 – Review of Literature While valuation academicians from both Accounting and DCF academic groups criticise the calculation basis of specific variables in the Gordon Formula (e.g., Penman 2001, 2006; Ohlson and Zhang 1999) and their DCF counterparts alike (e.g., Mauboussin 2007, Mills 2005) the Gordon Formula per se has tended to attract only indirect opposition in the writings of Cassia et al. (2009), Jennergren (2008) and Mauboussin (2007). Penman’s 2001 paper is arguably the most direct attack on both the formula and its component variables.

2.3.4.2 Key characteristics of the prevailing approach to estimating value in the ‘continuous period’ As of this writing, the Gordon Formula Assuming Perpetuity (GFAP) remains without serious challenge as the prevailing method for estimating terminal value. Fruhan lists liquidation value of company assets at market value and Multiples (1998); Cornell’s (1993) alternatives include Multiples, as shown in Table 2.3.3. Table 2.3.7 shows several of the arguments in support of the notion that all companies experience infinite life spans:

Table 2.3.7: Characteristics of the DCF Stage 2 Infinite Continuous Period Notion According to Accounting Group Valuation Academicians

55

Chapter 2 – Review of Literature Following the Copeland-Kaplan-Ruback shocks of the mid 1990s, the only way that methods such as DDM could appear to be equivalent with DCF would be for any discrepancies between the two methods to be statistically smoothed through the disguising mechanism of an infinite time period.

•

At first, the twenty percent statistical discrepancy between two different methods may appear to be significant.

•

But with infinitesimal reductions of that gap each period over an infinite analysis time frame, statistics from accrual accounting valuation might be managed in such a way as to make the difference appear immaterial.45

Even the fiercest defender of the continuous period notion acknowledges that companies do not exist forever. Consider the following two conflicting statements, both from Penman (2007): Firms are usually considered to be going concerns, that is, to go on indefinitely.

There is no terminal date and no liquidating period that can be forecast (91); Going concerns are expected to go on forever but the idea that we have to forecast “to infinity” is not a practical one… We prefer a valuation method for which a finite-horizon forecast (for a set number of years, for 1, 5 or 10 years, say) does the job (93, emphasis by Penman).

Each of the five defences for this key aspect of the prevailing GFAP methodology for ‘continuous period’ value estimation is described as follows: Different treatment of time compared to other company value determinants Central to this aspect of the prevailing methodology is the use of a separate and different calculation approach for time --company longevity-- than for the other determinants of company value. Those other determinants include (i.) future projections of company inflows, (ii.) cost of capital, (iii.) investment requirements and patterns. In GFAP, the g, FCF and WACC variables are means for estimating those determinants.

Gordon (1962, 3) commented upon the calculation elements comprising his equation.

Time --company longevity-- is conspicuous by its absence, particularly as t is a key value determinant in project valuation and valuation of simple companies, as described in Part 4 in Chapter 1 (1.4).

45

It is the artificially long time frame that helps to make the two different results appear equivalent (Strange 2007).

56

Chapter 2 – Review of Literature “Indefinite” interpreted as “infinite” The fact that companies’ prospective life spans are infinitely variable, that is, indefinite, is acknowledged in the academic literature (Jennergren 2008, Penman 2007). No one can specify the exact duration of a company’s life span until an irreversible failure has occurred, and that is sometimes prone to judgment.

But applying the assumption that valuation life spans should reflect actual life spans would jeopardise the ‘Accounting Group’s’ arguments of equivalence with DCF by eliminating the statistical smoothing device that an infinite analysis time frame provides.

Thus wording arises in attempt to blur the distinctions between “indefinite” and “infinite”, even though the two words have different meanings.46 Gordon proclaims that “the horizon is infinite if an indefinite cycle of asset purchases and sales is contemplated.” (1962, 20) Jovanovic (1982, 653) and Damodaran (2000, 2-4) concur.

From the formula developers’ perspective, the advantage of this re-definition is to simplify terminal value estimation in Stage 2 of the DCF2S. The variability of companies’ actual life spans is removed from the formula.

“Truncation error” This phrase appears in several of Penman’s papers in the 1990s and also Ohlson and Zhang’s 1999 paper. Penman’s co-author Sougiannis expresses the argument in 2001 in his paper with Yaekura: “forecasts are over a truncated (finite) forecast horizon, and thus they may not reflect in all cases the expected payoffs over the market’s horizon (theoretical infinity)” (333).

Penman’s reasoning is that if all company life spans are presumed to be infinite, then any t which is Briefer-Than-Infinite (BTI) leaves some inflows to the company uncounted for and thus “truncated” and erroneous.

While this assertion defends the use of a perpetual constant for t in the continuing period, the logic is difficult to defend when viewed in terms of companies’ experiences.

Suggesting that a company’s (expected) actual life span duration is “truncated”, and thus erroneous, contradicts the rules of data reliability. Those rules suggest that observation as the most authoritative basis of confirmation. But since perpetual time has no end point by definition, nether Penman’s truncation error period nor the value imagined to have been missed during that period can be measured.

46

“Indefinite” means “of unknown duration” while “infinite” means “not measurable” and “exceedingly great” (Encarta 1999).

57

Chapter 2 – Review of Literature Statistical equivalence with the emergent DCF method Dividend, approaches respective

cash are payoffs

flow

and

equivalent are

earnings when

the

projected

“to

infinity”….

-Penman and Sougiannis 1996, 3 Faced with this threat of reduced research funding for accrual accounting-oriented valuation academicians, Penman (2006, 18) and other in the Accounting Group pursued ways to seemingly narrow the statistical gap between DDM and DCF. Since a company’s dividend payouts are almost always less than free cash flows (FCFs) for the same company and periods, it is logical to expect a lower total value estimate when dividends are utilised in the numerator of the Gordon Formula, rather than FCF. Penman and Sougiannis described the role that extending the time horizon may perform in obscuring statistical differences: “In the dividend discount model (DDM), forecasted dividends over the immediate future are often not related to value so the forecasted period has to be long or a (often questionable) terminal value calculation made over some shorter horizon. (1996, 3) Others in the Accounting Group express similar views, including Case & Shane (1998) and Levin & Olsson (2000).

Simplicity in the form of reduced number of variables The re-interpretation of t from variable to perpetuity constant facilitates calculation simplicity by reducing the number of value elements which are treated as variables in the Gordon formula from four to three, as Bradley and Jarrell explain (2008, 66).

If t is a variable, the valuator has to conduct a fourth, additional calculation: the number of finite years for the valuation analysis period, presumably influenced by expectations of median or maximum reasonable life span.

The offsetting consideration is the prospect of the easy-to-use but possibly inaccurate calculation methods. Adjustments required to correct for deficiencies in the base formula may cancel any initial convenience.

2.3.4.3 Alternative TVP (‘Continuing Period’) Methodologies I: Time-Basis The possible alternatives to the prevailing methodology for TVP valuation are divided into two sections. The first section involves alternatives that are similar to the Gordon Formula, but assumes alternative, finite analysis time spans, based on academic

58

Chapter 2 – Review of Literature literature to date. The second section (2.3.4.4) considers some other possible alternative methods.

Today’s prevailing method for valuation of companies’ ‘continuous period’ is introduced in Part 1.2 in the initial chapter and depicted in Figure 2. In what this Researcher refers to as the Gordon Formula Assuming Perpetuity (GFAP) version, company valuation life span is presumed to be infinite for every company.

•

That perpetuity conjecture implicit in GFAP is, at this writing, widely accepted amongst some valuation academicians; that does not mean that it is universally embraced by all, or in all aspects and applications.

•

Up to this time, any challenges to infinite life span notion within GFAP are accurately characterised as fragmented and incomplete. While any concept involving “infinity” is potentially vulnerable to dismissal on multiple bases when applied to real world company measurement, direct challenges and possible alternative approaches to date have been sparse.

For example, Vélez–Pareja and Burbano–Pérez (2003), Fruhan (1998) and Cornell (1982) view sub-infinite duration as representing one major assumption for TVP duration, but then they also list infinity.

Jennergren (2008) challenges the infinity notion on the basis that the lives of the property, plant and equipment (PPE) assets which represent the ultimate source of the company’s operating Cash Flows are finite. The implication is that calculations based on life spans of selected plant and equipment assets credible as an amount for t than infinity.

With no present serious challenger to the Gordon Formula and with observations about the three variables primarily being limited to criticism of overly-optimistic assumptions, that leaves the phantom variable --time-- as the primary basis for today’s existing partial and alternative methodologies for valuing company worth in the ‘continuing period’, or Terminal Value Period (TVP).

“Partial” above refers to the fact that as of this writing, these possible alternatives to the prevailing methodology for estimating terminal value --the ‘continuous period’-- the Gordon Formula Assuming Perpetuity (GFAP) are incomplete.

The duration of a project or an enterprise’s life is a principal determinant of project or company worth. As illustrated in the theoretical example in Appendices H and O, an error in estimating the time analysis period may result in significant value estimation errors.

59

Chapter 2 – Review of Literature Such a possibility is not a remote theoretical supposition. The analysis of company longevity in the literature review part that follows (2.4) suggests a median life span for all companies of approximately seven years. Assuming customary positive CFs consistent with a stable business, differences in value arise with variations in life spans.

The three-variable Gordon formula removes the time, or t variable and replaces it with a constant value for all companies: infinite life. The alternative to Gordon Formula Assuming Perpetuity (GFAP) as depicted in Figure 1.1.1 in Chapter 1 and Figure 2.3.2 in this Chapter is a Briefer-Than-Infinite (BTI) serial alternative, as included in Appendix C and also shown below in Figure 2.3.5:

Figure 2.3.5: Gordon Formula Serial Format

Accordingly, the principal alternatives to Gordon Formula Assuming Perpetuity as represented in the academic literature to date are nascent versions of possible future subinfinite versions of the Gordon Formula. Table 2.3.8 considers these alternative approaches or pre-methodologies in the context of the prevailing, established method for estimating value in the continuous period:

60

Chapter 2 – Review of Literature

Table 2.3.8: Methods for Determining the End Point of the Terminal Value Period (TVP)

Infinite: no end point As noted, the prevailing postulate regarding the timing of the end of the Terminal Value Period is that there is no ending. The reasoning is twofold: (i.), durations of companies’ life spans are indefinite, unknown and not readily projected; and (ii.), an infinite life span is a suitable surrogate for an indefinite life span.

Possible alternatives to the continuous period approach to date are fragmented and partial. Presently there is no complete challenge to the continuous period approach on the basis of incorporating both (i.) a consistent framework for developing those forward estimates, and (ii.) a basis for generating specific company longevity estimates.

The list of advantages associated with the incumbent method begins with precedent.

Bethke and Boyd (1983) are amongst the several authors citing apparent simplicity as a factor. Gordon in 1962 responds to Williams’ concerns over whether to provide for both finite and infinite end time points by dictating that only the latter applies in all instances.

61

Chapter 2 – Review of Literature But several disadvantages also arise in the academic literature are Jennergren (2008) and Penman (2007) are amongst the academicians who acknowledge that actual company life spans are finite in nature. de Geus (2002) and Harrigan (1988) consider the eventual death of companies as unavoidable organic reality.

Finite I: Company bespoke estimation Two different alternative pre-methodologies of the finite type begin to emerge, based on the academic literature.47 The first is bespoke on a company-by-company basis. The finance director, managing director or both dictate the appropriate valuation analysis time horizon, possibly influenced by experience or prior acquisition analysis precedent.

Fourteen to twenty years is a typical range.

Finite II: Competitive Advantage Period (CAP) The essence of the Rappaport-Mauboussin-Johnson proposition is that the company’s timing as a viable entity ends when Cash Flow Return on Investment (CFROI) rate no longer exceeds that firm’s cost of capital rate. The logic is that the company’s days are numbered –and the end point of its limited life span imminent-- when returns on investment no longer exceed costs.

The method has some theoretical appeal and yet faces multiple obstacles as an alternative methodology. Controversies over the basis for determining cost of capital based on the Capital Asset Pricing Model persist. (Penman 2006, 49) Marginal CFROI may be the more appropriate basis for setting the numerator in the convergence equation, rather than total CFROI (Clark 2009, 19).

Cassia et al. (2007, 100) and Bradley and Jarrell (2008, 66) separately suggest a more restrictive interpretation, in which it is assumed that the company only earns its cost of capital during the second DCF stage, TVP. But by the Mauboussin-Johnson CAP criteria, that company has no viable business after the forecast period (EPP) is over, as the value spread (CFROI minus WACC) is zero.

Companies sometimes continue to operate after the CFROI /WACC intersect point for different reasons. Company management may be oblivious to the fact of their firms’ effective death, so long as daily trading continues. The literature on new company startups indicate that some firms begin trading for non-economic reasons. It is logical to

47

Although some elements of possible future valuation methodologies exist in academic papers, such analyses have not yet developed into consistent propositions. (5.9) These possible future ‘premethodologies’ involve alternative methods for setting expected life span, on the basis of asset economic lives (Jennergren 1988, Hartman and Murphy 2006), industry patterns (Audretsch 1995) or product life cycles (Womack and Jones, 1990).

62

Chapter 2 – Review of Literature believe that at least firms may decide to remain in business after their CAP-determined life span end point, so long as some liquid funds remained. General Motors languished in a state of effective company demise more than two year preceding that company’s formal filing for bankruptcy.48 Or alternatively, several intersect points must be reached before a definitive indication of the end of that firm’s life span emerges. Madden’s CAP illustrative example in his 2005 paper shows a inconsistent pattern of CFROI/WACC convergence points, as the returns rate first slips below the cost of capital, and then later, rises above WACC. Although described as “stylized” rather than actual, the illustration raises some questions about relying on this method to anticipate the company’s end.

Figure 2.3.6: Madden (2005,7) I: CAP Intersect Point and Continuing Operations

In Figure 2.3.6, should the first point in time when CFROI slips below cost of capital be considered as the end of that company’s life span? The second intersect point? Neither?

48 Many

of the same researchers investigating company failure (exit) in 2.4 also investigate the related issue of company entry, or start-up: Geroski 1995, Mata and Portugal 1994, Baldwin and Gorecki 1991. US automaker General Motors is included in the Industry Pairs analysis in 5.6 and Appendix M.

63

Chapter 2 – Review of Literature Other finite variants on GFAP In Viebig et al.'s alternative, infinite t is replaced with sub-infinite term based on the duration of long-term capital. The form of capital that Viebig cites is long-term (US) bonds or (UK) gilts. Based on the maximum term for US method, that suggests a longevity period (t) for all companies of thirty years.

As with any constant, the stipulated t may be inaccurate for most companies, except by chance. Viebig et al. dismiss such concerns, arguing that those inaccuracies in the prescribed finite term are insignificant when considered in the context of other possible value estimation errors (2008, 207).

2.3.4.4 Alternative TVP (‘Continuing Period’) Methodologies II: Other In some other possible emerging methodological alternatives to GFAP, the focus is not so much on the end point of the second valuation phase in DCF2S, as it is on a different conceptual approach to determining the basis for companies’ success and failure, and thus, their value.

Figure 2.3.7: Madden (2005) II: Drivers in Limited Term TVP

Figure 2.3.7 originally appeared on page 41 in Madden (2005). Value drivers may be useful in value management if the presumed driver(s) can be shown to cause increases in company value rather than merely reflect those changes after the fact. But drivers’ imprecision and their subjective nature make then less compelling as a possible basis for determining Terminal Value in DCF2S’s second stage. Relationships between Madden’s drivers and his “warranted value” are presumed rather than proven.

64

Chapter 2 – Review of Literature Cornell suggested that value driver-type GFAP alternatives might be readily quantified.

His “value-driver” equation is shown in Table 2.3.3. But closer consideration suggests that Cornell’s equation may be no more precise in defining TV than Madden’s. In Cornell’s Value-Driver equation, gnom is similar to construction and meaning to g (FCF growth rate) in the Gordon Formula Assuming Perpetuity (GFAP).

Table 2.3.9 shows this Researcher’s diagnosis of all three columns in Cornell’s earlier exhibit in this Chapter Part, Table 2.3.3. That Table is entitled Cornell’s Alternative Methods for Terminal Value (TV) Estimation, Including “Direct Comparison” (P/E Multiples).

Table 2.3.9: Cornell’s (1993) Three Methods for TV Estimation, Revisited

Easily comprehended by many non-financial managers, Multiples are based on a precarious conceptual foundation as a means for TV valuation. Copeland (2009) cautions that finding suitable comparables for use in the Multiples calculation is sometimes difficult. Short-term spare price bubbles may distort P/Es. Cornell is not the only one to nominate Multiples as a possible secondary method for valuing the DCF2S’s second stage Terminal Value. Viebig et al. (2008) cite other

65

Chapter 2 – Review of Literature supporters, although Cornell is amongst the most visible commenting upon this valuation aspect in the literature and in finance texts.

2.4

Literature Review Relating to Company Longevity

Sub-parts: 2.4.1 Overview and Summary of This Part of the Literature Review Chapter 2.4.2 On Literature Relating to the Concept of Theoretical Company Longevity for Valuation Purposes 2.4.3 On Literature Relating to Estimation of Company Actual Longevity from Time of Origin

2.4.1

Overview and Summary of This Part of the Literature Review Chapter

Sub-part 2.4.2 addresses relevant literature relating to the historical conceptual basis for considering the phantom time (t), or company longevity, variable in company valuation.

Sub-part 2.4.3 is comprised of an examination of several studies of companies’ actual longevity from the literature.

2.4.1.1 Summaries, By Sub-Part Summary of sub-part 2.4.2: On Literature Relating to the Concept of Theoretical Company Longevity for Valuation Purposes Table 2.4.1 reflects the academic conceptualisation of time as a company valuation variable to the present:

66

Chapter 2 – Review of Literature

Table 2.4.1: Overview: Theoretical Interpretation of Longevity as Valuation Variable

While Gordon and Shapiro’s seminal 1956 paper is often viewed as the most of important on this issue, an examination of that paper and its acknowledgements suggest that Williams (1938) should also be included for consideration.

A challenge encountered in examining the origins of conceptual though about t by the Gordon Formula’s developers aspect is that time (t)-- the unknown future life span of a company being valued-- is of secondary importance to the academicians identified in Table 2.4.1. They are primarily concerned with other aspects of company valuation, such as the variability of inflows or timing of investments (i). Time (t) is literally relegated to the footnotes.

Summary of sub-part 2.4.3: On Literature Relating to Estimation of Company Actual Longevity (CAL) from Time of Origin The exact life span of any company may only be determined precisely after that firm’s confirmed demise. Still, there is substantial academic research into company actual longevity available to inform projections of future company longevity for company valuation or other purposes.

More than a dozen relevant research papers have been developed by the thought leaders in the field of company failure and survival monitoring. Those studies, most of which were published during the 1990s, are international in scope and fairly consistent in their 67

Chapter 2 – Review of Literature findings, as suggested by Table 2.4.2, Seven Studies: Cumulative Exit (Failure) Percentages by Age. Considered as a whole, the academic research studies on longevity suggest that life spans of less than a decade from the year of origin is reality for most companies, rather than infinite life.

Ten to twenty per cent of firms fail before they are one year old. The median company life span-- the age at which half of all companies fail-- appears to this Researcher to be approximately seven years based on Table 2.4.2. That is briefer than Geroski’s and de Geus’s / de Rooij’s separately developed estimates of company “average” life span in the 12.5-13 year range.49 Some research studies of company failure predate Gordon and Shapiro’s 1956 paper, but those early studies are of questionable quality. There is no reference by Gordon and to Crum’s 1953 book of company failure, the seminal work on the subject in the 1950s. It appears to this Researcher that Gordon and Shapiro had already decided that the best way to deal with the fourth variable, t, was to transform time into a non-variable for purposes of their equation.

Marshall’s examination of failures in the Lancastershire cotton trade shows failure percentages similar to modern cohort analyses, but his study is ancient (1833) and involved less than 100 firms. Crum’s (1953) examination of US companies from 1909 to 1945 contains numerous data gaps and demonstrates some of the other problems that may arise when methodologies and/or source data are suspect.

The majority of papers examined in this Chapter Part were published from 1988 (Dunne et al.) to 1999 (Audretsch and Thurik book). The studies in this second generation of company failure analysis are national in scope, time series-based and involve multiple groups, or cohorts, of companies organised by birth year.

49

de Geus, 2002, 2 (12.5 years, based on estimates by de Rooij, 2002); Geroski, 1995, 424 (13 years). de Geus refers to “average” longevity. As one can only accurately calculate averages when the results of all the companies in the sample die, it appears that de Geus may have intended to refer median life spans, instead.

68

Chapter 2 – Review of Literature

A G E 1

Study

2

3

20.0

4

5

6

50.0

7

8

9

10

11

Mata 95

US

Dunne 88- 67

63.9

79.0

US

Dunne 88- 72

57.5

78.2

US

Audr 95

19.0

CN

BG 91 Gfield

10.2

20.0

28.2

34.6

40.5

44.9

50.1

55.3

59.7

64.4

CN

Baldwin 98

9.8

19.4

26.7

33.5

38.6

43.6

48.6

53.5

57.8

62.0

66.3

GE

Wagner 94

9.6

18.9

27.2

31.9

38.3

41.6

43.8

46.6

49.3

51.4

53.5

44.0

51.6

56.9

87.6

61.8

66.3

US Dunne 88- 67C: 1967 entrant cohort, from Table 8, 508, 387 manufacturing industries US Dunne 88- 72C: Same as Dunne 88- 67C, except 1972 entrant cohort instead US Audretsch 95: Based on first year in two year indicated exit range, Table 7.2, 158.

CN Derived from Fig. 4, Average Rates of Exit by Greenfield Entrants by Age Class from Baldwin and Gorecki 91, 310.

GE

Derived from Table 1, Survival and Growth of New Small Firms in Lower

Saxony, Table 1, 144, Observation Weighed

Table 2.4.2: Seven Studies: Cumulative Exit (Failure) Percentages by Age

2.4.2

15

70.0

PO

33.2

13

On Literature Relating to the Concept of Theoretical Company Longevity for Valuation Purposes

This sub-part examines the academic literature relating to the theoretical concept of company longevity (time) as a determinant in company value.

2.4.2.1 Time (longevity) Is Deleted as a Value Determinant and Variable in the Gordon Formula Chapter 1 describes the evolution of modern methods for assessing the worth of enterprises. In both temporary project-based organisations and in longer-lived companies, time—company longevity—endures as a determinant in the value of enterprises (VoE).

69

70.3

Chapter 2 – Review of Literature The equation referred to today as the Gordon Formula calls for company Terminal Value to be estimated on the basis of three variables that may vary on a company-bycompany basis: initial period annualised Free Cash Flow (FCF), future growth of FCF (g) and cost of capital.

The missing variable is company longevity, or time. By treating t as an infinity constant rather than a variable, Williams-Gordon-Shapiro consciously disregard t as a determinant of company worth.

2.4.2.2 Analysis Vacuum: Re-Conceptualisation of t Caused by Conscious Avoidance of Consideration of Time as a Factor Affecting Value In adopting the conceptual stance that life spans are both infinite and constant for all companies, the developers of the Gordon Formula commit a universal error: a presumption which is erroneous for all companies.

Compared to the other three variables in the Gordon Formula (FCF, g, WACC), t is an afterthought, literally commented upon only in the papers’ footnotes. Williams-GordonShapiro do not envision time as a material influence on company worth.

2.4.2.3 Description of the Four Papers in Table 2.4.1 Williams (1938) In his book, Williams’ emphasis is on valuation issues and variables other than time. T is set at infinite in order to facilitate use of a variant of the perpetual annuity formula for company valuation. By imagining that company life spans are infinite, Williams is able to state that “the annuity of payments, adjusted for changes in the value of money itself, may then be discounted at the pure interest rate demanded by the investor” (55).

Despite his enthusiasm for the simplicity of company value calculations facilitated by the perpetual conjecture assumption, Williams pauses to consider whether his expedient for t always applies to all companies.

Williams develops two different perspectives of companies’ life spans. One of the assumptions is that firms endure forever. But in footnote 2 on pages 55 and 56, Williams suggests that a finite basis for estimating t may be appropriate for some companies, in some circumstances: In certain special cases the sum of all the terms in an infinite series is a finite number and not infinity, even though the number of terms is infinite.

70

Chapter 2 – Review of Literature Gordon and Shapiro (1956) The authors imply but do not explicitly state that t is irrelevant to calculation of company value. But in referencing the two precedents works summarised above (Williams 1938 and Lutz & Lutz 1951). This Researcher’s interpretation is that Gordon and Shapiro view the dilemma of developing credible projections for companies’ indefinite future life spans as a non-issue: some thing with so little effect on value as to not require serious consideration.

Shapiro and Gordon criticise Williams’ two-sided approach for estimating t as introducing unwelcome complication: “In his Theory of Investment Value, a classic on the subject, J. B. Williams tackled this problem of growth. However, the models he developed were arbitrary and complicated so that the problem of growth remained among the phenomena dealt with qualitatively” (104). Calculation convenience appears to prevail over all other considerations: “It is mathematically convenient to assume that the dividend is paid and discounted continuously at the annual rates Z” (105, emphasis by this Researcher).

Gordon (1962) The purpose of Gordon’s lesser known work appears to be to encourage adoption of the concepts described in the 1956 joint paper as a foundation for management action: “My purpose is to create a model for explaining the valuation of a corporation that may be used to find the investment and financing by the corporation that maximizes its value” (1962, x).

Gordon re-iterates his concept of t as a non-variable in the calculation of company worth, not based upon what is included in his list on page 3, but rather, by what is excluded. Note the absence of any mention of company longevity or elapsed time as a variable affecting value in the following: “A model that predicts the value of a share on the basis of four variables—current income, retention or investment rate, rate of return on investment, and the rate of profit investors require on the share….”

Gordon consciously blurs the meanings of the words “indefinite” and “infinite” in relegation of t to status as a valuation non-variable: “The horizon is infinite if an indefinite cycle of asset purchases and sales is contemplated” (20). When every company’s life span (t) is presumed to be infinite, there are no differences in life spans between companies, or in the same company under different circumstances. In effect, time is historical role as a variable and determinant of the value of enterprises as described in Chapter 1 is nullified.

71

Chapter 2 – Review of Literature

2.4.3

On Literature Relating to Estimation of Company Actual Longevity from Time of Origin

Approximately half of all companies fail in their first seven years of existence, based on the multiple-country, multiple-academician research. Refer to Table 2.4.2, Seven Studies: Cumulative Exit (Failure) Percentages by Age. 2.4.3.1 Two Early Company Failure Analyses: Data Limitations and Other Challenges Marshall (1833), in Lloyd-Jones and Le Roux (1982) In 1833, Alfred Marshall developed what this Researcher believes to be the earliest statistical analysis of company failure experience developed on a birth year, or cohort, analysis basis. Marshall monitors the survival and failure patterns of the ninety companies entering the Manchester cotton industry in 1815. The year that the monitored company ceases to appear in the list of active companies is designated by Marshall as that firm’s exit date, a possible but not decisive indication of failure.

Marshall’s failure percentage observations are similar to findings developed more than 150 years later, some of which are shown in Table 2.4.2. The date of Marshall’s observations (1833) and his small sample size (n = 90) mean that such similarities may be matters of coincidence. Nonetheless, those 19th century observations appears to be generally consistent with the findings of failure findings from the modern era studies examined in this Chapter Part.

Forty-two percent of companies starting their business in Manchester’s cotton industry in 1815 failed within two years. (Lloyd-Jones and Le Roux 1982, 146, Table IV) That percentage is comparable to rates emerging in the modern era company failure studies in the literature by Mata et al. (1994, Portugal) and Audretsch (1995, US), the results from which are summarised in Table 2.4.2, Seven Studies: Cumulative Exit (Failure) Percentages by Age. Within six years of entering the Lancastershire cotton industry about 55 per cent of the companies had exited and presumably, failed.50 Audretsch’s 1995 study exhibits a comparable failure rate pattern.

50

Some alternative criteria for determining the date of a company’s demise are considered in this study in Appendix K. In the 1833 Marshall study, exit was tantamount to failure since there were no alternative

72

Chapter 2 – Review of Literature Marshall’s analysis also provides insight into possible distortions that may arise when there is either (a.) an insufficient sample number of companies in the birth year-defined cohort group or (b.) too few cohorts: a. Too few companies in the cohort group, and the sample size n may not be sufficient to be indicative of companies overall or even firms in that industry or segment. 51 b. Too few cohort groups, failure results may be unduly distorted by the particular economic circumstances of that time. In the US, one expects extremely high failure rates for mortgage-related companies starting business in 2006, for example.

Crum (1953) Crum’s book The Age Structure of the Corporate System, is primarily cited here to illustrate some of the deficiencies with company failure studies prior to 1988. Crum’s goal for his book is ambitious: "to awaken an interest in the vital statistics of corporations by showing how various significant inferences can be drawn from one limited body of such statistics" (1953, ix).

The author’s reference to a "limited body of such statistics” is telling. In cohort studies as in some other statistical analyses, calculation and comparability problems may arise when original source data is (i.) developed for other purposes or (ii.) incomplete and inaccurate.

Crum’s source data appear to be vulnerable on both bases. In his multiple cohort study of companies starting their lives in years ranging from 1909 to 1945, the author relied on information developed and compiled from the US Bureau of Internal Revenue (IRS, comparable to the UK’s Inland Revenue) and thus was dependent on that organisation’s monitoring and compiling capabilities and selection criteria.

The company failure percentages indicated in Crum’s analysis are significantly lower than modern era cohort analyses such as the seven studies summarised in Table 2.4.2.

Two possible explanations are: •

Timing: Crum’s entry year-defined cohorts range from 1909 to 1945. These companies existed in an era when the conduct of business was different from

market opportunities for early 19th century cotton goods manufacturers. The issue of “exit” sometimes not being the same as “failure” is addressed elsewhere in this Chapter Part.

51

Sample size adequacy in non-probabilistic (purposive) studies is addressed in this study in Appendix E Part 1 sub-part e (E.1e).

73

Chapter 2 – Review of Literature post-war times characterised by hyper-competition and globalisation (Wiggins and Ruefli 2005).

•

Data quality: Gaps in base information arise in several of the earlier years in the study. In some cohort years, sample sizes are miniscule. Crum admits to making some arbitrary assumptions and extrapolations to adjust for these gaps. The author admits that some of the recording practices of the Internal Revenue Bureau may have been inconsistent and incomplete, especially during the 1930s Depression.

Of even greater concern is data integrity. Statistics developed primarily for tax purposes tend to be at least partially dependent on self-proclamation, thus introducing an additional possible source of distortion. Self-reporting for tax purposes tends to be under-reported, but Crum makes no adjustments.

Crum’s entry and exit estimates were based on archival legal records of company incorporations (birth) and bankruptcy filings (death). That narrow scope excludes unincorporated companies, thereby missing a large number of smaller enterprises that should have been included in a representative study. Crum’s failure percentages were flawed because of this selection bias towards larger firms, since longer-lived companies tend to be less susceptible to failure than shorter-lived firms, based on later analyses of others in the field.

2.4.3.2 Some Other Methodological Issues Relating to Company Exit/Failure Research of This Type Besides the limitations in the Marshall and Crum studies, other methodological and content-related issues arise in the scholarly research of company failure levels and patterns, including: When company exit does not necessarily indicate company failure From the time of Marshall’s study (1833) to the present, the primary method for developing insight into companies’ failure experiences has involved measurement of firms’ entry and exit experience on a cohort birth year basis.

Entry is often treated as a surrogate for company origination (birth), and exit as a proxy for failure and death. 52 Exit often but not always indicates a firm that is defunct or close

52

For example, Circuit City’s liquidation (Lemos 2008) was preceded by management’s admission that it could no longer compete in the US consumer electronics industry and exit from active competition.

Woolworth’s (UK) exit from high street trading indicated that firm’s imminent liquidation.

74

Chapter 2 – Review of Literature to failure. Mata et al. describe some circumstances when a company’s exit from the cohort database might not indicate a failed or failing firm: A company may not be included in the firm’s file of active firms (and thus, treated as an exit) for a number of reasons other than the end of operations. It may be absent from the file because it suspended operations, because it had no paid employees in that year, or simply because it failed to send (in) the survey form (1994, 229).

The authors also describe the situation of a profitable family business where the children do not want to take over the company or to be involved in any way. Those parents choose to wind down their business rather than see the firm controlled by strangers.

Unless situations such as these are anticipated and correctly diagnosed, some exit statistic might easily be mis-recorded as failure.

Limited insight into remaining life spans of established companies While estimating the life span of start-up companies is useful for numerous purposes including start-up valuation, company financial planning, and in some instances, Initial Public Offering (IPO) pricing, the survival issues facing well-seasoned firms differ from those confronting start-ups. By design, cohort groups are start-ups, except in the circumstance of a factory-company switching from one industrial classification to another.

Statutory filings As noted in the examination of the limitations of Crum’s approach, statistics compiled by government agencies normally have a high level of reliability but may present problems when some groups are under- or over-counted, as in the case of Crum’s source data from the IRS. Commercial business lists The availability of such lists is offset by other issues which may limit usefulness of the information for purposes of academic research. Business lists such as those compiled by Dun and Bradstreet (D&B, US) or Tokyo Shoko Research (TSR) in Japan are primarily used by subscription-basis customers for purposes of lead generation and sales prospecting.

Responding to the requirements of their primary clientele, these business lists tend to emphasise the largest number of possible companies and names. Such a source data orientation at times has at times proven to be inconsistent with scholarly research, such

75

Chapter 2 – Review of Literature as experienced in the Evans (1987) and Phillips and Kirchhoff (1989) studies, both of which depended on the D&B database as their primary statistical source.

Industrial registers Baldwin’s and Gorecki’s research of Canadian companies and Dunne et al.’s US research both relied on Census of Manufacture (CoM) source data, in which companylevel information is developed by combining lower level data on plants and other company facilities with distinct Standard Industrial Codes (SICs). One major limitation with industrial registers is the exclusion of pure service companies. Unless the firm’s service is described as part of a firm with a manufacturing, assembly or distribution function, that services firm is probably under-reported in the CoM records.

The balance of this Chapter Part is organised as follows:

Sub-part 2.4.3.3 summarises research from multiple academic thought leaders who address the company failure or exit part of this research area, as organised by the Primary Four countries as shown in Table 2.4.3.

Sub-parts 2.4.3.4 through 2.4.3.7 cover each of those Principal Four analyses involving companies based in Portugal (2.4.3.4), US (2.4.3.5), Canada (2.4.3.6) and Germany (2.4.3.7).

Sub-part 2.4.3.8 summarises some of the relevant research and researchers from countries not included in this Researcher’s Principal Four grouping Shown in Table 2.4.3.

2.4.3.3

“Principal Four” Country Research Summarised

Source data on companies’ entry and exit patterns is typically organised on a national basis.

The Ministry of Employment information utilised in Mata et al.’s two studies is restricted to Portuguese companies. CoM data by Baldwin (1998, 1991) and Gorecki (1991) apply only to Canadian firms.53 The German studies described in this Chapter Part involve even smaller geographic areas: regions within that country.

53

While eventual emergence of trans-national databases for cohort studies is appealing, some barriers exist.

Compilation of data is sometimes compiled and reported differently from one country to another.

76

Chapter 2 – Review of Literature Each of the four columns in Table 2.4.3 corresponds to one nation’s key researchers on company exit and the year of their research papers.

Table 2.4.3: Key Research and Researchers by “Principal Four” Country

“Principal Four” in Table 2.4.3 refers to this Researcher’s four nations chosen for further cohort analyses of actual company failure experience in this Chapter Part. The researchers identified in that Table are considered by this Researcher to be thought leaders in this field, largely on the basis of references to their writings by others in the field. Audretsch’s several analyses of US company failure levels and patterns are particularly well-known.

Each of these thought leaders applies the birth year cohort group approach to measuring company entry and exit (failure). Their databases are extensive, with the exception of the two German studies. Only major economies are indicated in Table 2.4.3, with the exception of Portugal.

Government agencies tend to be reluctant to give up their control of statistical information, partially because of the budgets associated with those roles. The possible development of transnational studies is identified in this study as a possible area for future research in Part 2 in Chapter 6 (6.2).

77

Chapter 2 – Review of Literature In that Table, Cohort Half Sample Life Span Indication refers to the approximate median failure point of firms sampled: when approximately half of all company in that data base exit, that is, an approximate indicator of company failure. Cohort Infancy Life Span refers to exit experience in the company’s initial year of existence. Some methodological practices and other aspects of importance which are explored in subparts 2.4.3.4 (Portugal) through 2.4.3.7 (Germany) are also summarised in Table 2.4.3: 2.4.3.4 Portugal: A Review of Some Thought Leaders’ Exit and CAL Research Thought leaders: “Mata et al.”: Mata and Portugal (1994); Mata, Portugal and Guimaraes (1995) The two Mata et al. studies were developed using a cohort approach, with groups of companies identified by year of origin. All members of that group were individually monitored to determine when and how many exit from the Ministry of Employment (MoE) database.

The two mid-1990s papers pointed towards three conclusions: (i.), approximately onefifth of all Portuguese enterprises exited in their first year of life; (ii.), roughly half of all firms in Portugal exited and failed on or before four elapsed years; and (iii.), approximately seventy per cent of Portuguese enterprises failed before the seventh anniversary of their origin (1995, 479).

Some Methodological Considerations Portugal’s MoE is described by the authors as a highly reliable source of information on company new formation (entry) and failure (exit). As the nation’s central repository for information about companies with employees, MoE is considered by Mata et al. as wellpositioned to provide accurate indications of company longevity in Portugal.

Firms were recorded as beginning their life spans in the first year that data appear in the MoE database. The first year that information on that company does not appear after consecutive years’ presence in the database is interpreted as a signal of exit, or failure.

Care is taken by Mata and his co-researchers to adjust for factors which might cause distortions, including mergers and other consolidations, divestments and temporary discontinued operations.

1994: Brief economic lives for Portuguese companies Mata et al.’s 1994 study is based on 3,169 companies from Portugal’s MoE database of approximately 17,000 firms. That sample included companies in manufacturing,

78

Chapter 2 – Review of Literature distribution and service-related industries. The survival rate for companies overall after four years is reported by Mata et al. as approximately fifty (50%) per cent (228, 235).

The authors cite insufficient scale as the principal reason for high failure in early years.

Almost all start-ups begin their lives with zero or negligible market share. To survive, firms must grow big, fast, by capturing new market share and by achieving sufficient production scale to compete with the low cost leaders already in their segments. Mata et al. note other contributing reasons for failure, including management incompetence and insufficient initial capital investment (233).

1995: Implications, linkage to conceptual studies of industrial evolution In their 1995 follow-on study based on the same MoE source data, Mata et al. reconsider their results in the context of some of prevailing theories of industrial evolution and company survival.

Caves and Porter (1976) contend that diversification has no positive effect on companies’ survival chances. Figure 2.4.1 based on the Mata et al. 1994-1995 statistics appears to support that contention. Enterprises with a diversified mix of plants exhibit the lowest survival rate at nearly every company age (as measured in elapsed years from origin). In Portugal and elsewhere, one explanation is that diversification endangers the adolescent firm by spreading scarce capital and management expertise too thinly across the organisation.54

54 Mata et al. contemplate the implications of insufficient company size (scale) in the 1995 paper in the following comment about Audretsch’s 1991 paper: “Audretsch (1991) found that, among a cohort of new firms in US manufacturing, the probability of plant exit was decreasing with initial size. (Explaining this development) is that new firms enter typically below the minimum efficient scale in the industry”(460). The second parenthesis immediately preceding is added by this Researcher.

79

Chapter 2 – Review of Literature

Figure 2.4.1: Portugal: Empirical Survival Rates (Mata et al. 1995, 470)

2.4.3.5 US: A Review of Some Thought Leaders’ Exit and CAL Research Thought leaders: Dunne, Roberts and Samuelson (“Dunne et al.”), 1988, 1999 Audretsch, 1991, 1994, 1995, 1999 (with Thurik) Dunne, Audretsch and their co-authors emerge as the leading academic researchers of US companies’ longevity.

Dunne et al.’s two studies in the late 1980s are based on the standardised industrial Census of Manufacture (CoM). Audretsch’s five US studies during the 1990s were based on the Small Business Data Base (SBDB), which includes services. Because of that difference in scope, Audretsch’s studies are considered by this Researcher to be more illuminating than Dunne’s.

Two issues which both Dunne and Audretsch investigate are the relationships between company exit patterns and both (i.) the new firm’s size and (ii.) its industry group.

Dunne’s size analysis is based on revenue measures and thus tends to be more informative than the employment-based measures of size relied upon by some of the others researchers in this field. Audretsch’s analysis suggests that companies in different Standard Industrial Code (SIC) industry categories experience differing life spans.

80

Chapter 2 – Review of Literature Audretsch’s papers emphasise “technological regime”: a company with a high level of technological development relative to its industry is well-positioned to extend its life span beyond the norm for that group. Audretsch’s notion is extensively described but measures are imprecise.

Dunne et al., 1988, 1989 Dunne et al. are not the first to argue for reliance on quality source information of the CoM calibre instead of sometimes inconsistent information from business list generators. His argument is well developed, establishing the cohort study source data standard for subsequent analyses: Data must originate from an independent, non-commercial source. The data must be compiled on a recurring basis at regular intervals with a view towards capturing relevant information on all firms in that geographic area, not merely voluntary self-registrants. Company information must be available in a form permitting easy separation into entry year cohort groupings. The reasoning is that unless firms’ dates of birth or origin are both available and accurate, then life span determination is impossible.

Dunne et al.’s Table 2.4.4 indicates company exit patterns similar to those in Mata et al.’s two studies. The two Portugal studies suggest that about half of all companies fail within their first four years of existence.

Longevity and industry-segment category In Dunne et al.’s exhibit on page 506 (1998), the authors examine differences in exit (failure) patterns by industry segments, based on two-digit SIC codes. The two segments exhibiting the highest exit (failure) percentages at five years are electrical and electronic instruments at 46.5% and apparel at 45.3%. The two segments exhibiting the lowest failure percentages at five years are tobacco (22.3%) and primary metals (27.7%).

Audretsch also addresses the correlation of industry category to company longevity. One of Audretsch’s analyses on differences in failure rates based on industry groupings appears in Table 2.4.6.

Possible effects of size and scale on company longevity Another Dunne et al. interest is the effect of small company size (by revenue) and inadequate initial financing on company failure. In 387 industries, the smallest companies are deleted from the base data until firms representing one percent of that industry’s total revenue is subtracted. The comparable database adjustment for initial

81

Chapter 2 – Review of Literature undercapitalisation is to reduce the failure rate percentages by about ten per cent (1998, page 503, Table 2).

Table 2.4.4: US: Exit Percentages of Three Cohorts (387 Industries) From Dunne et al., 1988, 509

Audretsch Audretsch views life spans of less than a decade as part of the Darwinian survival of the fittest in increasingly competitive industries, referring to “a massive number of new firms entering each year, but only a subset surviving for any length of time, and an even smaller subset that can ultimately challenge or displace the incumbent large enterprises” (1995, 7).

Audretsch’s exit statistics as depicted in Table 2.4.5 are approximately twenty percentage points lower than Dunne et al.’s comparable statistics for US companies.

Although timing is different (Dunne et al.’s papers were published eight years before Audretsch’s 1994-1995 research) that does not appear to explain the difference. With underlying product-service life cycles shrinking over time (5.9), the expectation is for higher exit percentages in the latter studies, rather than lower percentages.

The more plausible explanation for the difference between the Dunne and Audretsch findings is the difference in data sources.

Audretsch’s analyses are based on information originating from the SBDB database, which is both larger than the Census of Manufactures and more diverse. The SBDB database includes service company categories in some versions, while the CoM excludes service-only categories.

Table 2.4.5 reflects the results of SBDB data on 61,034 companies exiting in 1978.

Almost one-fifth (19.0%) of those firms examined were 1-2 years old at the time of their departure and presumed failure. More than 77% of all companies exiting had survived for 20 years or less when they exited from their respective industries.

82

Chapter 2 – Review of Literature Table 2.4.5 indicates that as companies age and become more established, their propensity to fail decreases. Survivors amass the necessary customer base and production scale necessary to survive a while longer.

Like Mata et al. and Dunne et al., Audretsch refers to Jovanovic’s “learning” to help explain the high failure rates of companies in adolescence. Jovanovic (1982) and Jovanovic and Macdonald (1994) contend that survivors gradually gain an understanding of their industries’ production best practices over time, and then begin to narrow their manufacturing cost disadvantages compared to the industry’s low cost producers. The results are manifested in the fifth column in Table 2.4.5, Incremental Percentage. Exit percentages decline 19% in Years 1-2, to 4.8% by Years 3-4.

Naïve entry provides is explanation for the differences in exit rates as companies age and mature. This consideration is mentioned by Audretsch but then not explored by the research in adequate depth to confirm his suspicion. While many academicians describe the initial market entry decision as a rational judgment reflecting knowledge of returns, risks, initial and ongoing financial requirements and competition, Geroski (1995) departs from this notion of conscious, rational entry. The researcher notes that other, noneconomic factors often may distort company entry decisions, contributing to very high failure rates in Years 1-2.

The time required to reach minimum sustainable industrial scale and market share may be misjudged by new market entrants by several years. A desire for independence may result in inadvertent over-estimation of revenues. But the most common factor in naïve entry (and subsequent high failure rates) appears to be inadequate levels of initial and continuing financing.

83

Chapter 2 – Review of Literature

US: Age Cohort (Years) of Exiting Establishments: Numbers and Percentages Adapted From Table 7.2, Audretsch 1995, 158

Age

Number of

Percentage

Cumulative

Incremental

Cohort Yrs.

Establishments

of Total

Percentage

Percentage

1 to 2

11,597

19.0%

19.0%

19.0%

3 to 4

8,664

14.2%

33.2%

4.8%

5 to 6

6,592

10.8%

44.0%

3.4%

7 to 8

4,664

7.6%

51.6%

3.2%

9 to 10

3,207

5.3%

56.9%

2.4%

11 to 12

3,004

4.9%

61.8%

0.3%

13 to 14

2,740

4.5%

66.3%

0.4%

15 to 16

2,455

4.0%

70.3%

0.5%

17 to 18

2,231

3.7%

74.0%

0.4%

19 to 20

1,947

3.2%

77.2%

0.5%

47,101

77.2%

13,933

22.8%

61,034

100.0%

Total through Above 20

Totals

20

Table 2.4.5: US: Summary of Age Analysis of Exiting Companies From Audretsch, 1995

84

Chapter 2 – Review of Literature US: Age Cohort (Percentages) of 1978 Exiting Establishments: Industry Patterns* Adapted From Table 7.3, Audretsch 1995, 159 COMPANY AGE AS OF EXIT IN Industrial

Number of

Group

Establishments

1978 1 to 2

2 to 4

5 to 6

7 to 8

9 to 10

Food

4,234

13.2%

9.8%

7.7%

6.1%

4.9%

Textiles

2,008

19.0%

11.8%

9.1%

5.5%

4.1%

Apparel

5,301

21.4%

12.9%

10.4%

6.9%

5.2%

Lumber

5,682

15.3%

12.5%

8.7%

6.9%

4.8%

Furniture

2,496

20.4%

12.9%

10.3%

6.1%

4.2%

681

18.1%

12.8%

12.5%

7.2%

3.7%

Printing

9,626

15.0%

13.9%

10.8%

7.5%

5.5%

Chemical

2,239

18.6%

13.1%

10.8%

7.8%

4.9%

Petroleum

278

27.3%

16.9%

9.0%

7.6%

5.4%

1,630

23.7%

21.2%

13.1%

8.8%

5.2%

701

21.4%

14.0%

11.4%

7.0%

3.7%

2,877

17.9%

14.0%

10.6%

7.5%

4.2%

812

24.0%

15.6%

12.7%

5.4%

4.7%

4,674

20.4%

14.5%

10.8%

8.0%

5.5%

7,266

18.6%

14.4%

10.6%

8.9%

6.6%

2,687

27.2%

19.0%

14.7%

9.0%

5.8%

Equipment

1,970

26.9%

19.2%

14.3%

9.2%

5.2%

Instruments

1,460

22.0%

18.0%

12.4%

8.4%

5.5%

Totals

56,622

Paper

Rubber and Plastics Leather Stone, Clay & Glass Primary Metals Fabricated

Metal

Products Machinery electrical)

(Non-

Electrical Equipment Transportation

Table 2.4.6: US: Variability in Exit Percentages By Segment From Audretsch, 1995

85

Chapter 2 – Review of Literature 2.4.3.6 Canada: A Review of Some Thought Leaders’ Exit and CAL Research Thought leaders: Baldwin and Gorecki (1991), Baldwin (1998) Baldwin and Gorecki are considered are leaders in failure analysis of companies based in Canada. Both are affiliated with Statistics Canada, which maintains that nation’s Census of Manufacture report and database.

Canada’s CoM resembles its American counterpart as an extensive and consistently updated survey of multiple manufacturing industries. As with the American version of the CoM, pure services companies are excluded, although data on some service business within companies classified as primarily being manufacturing or distribution concerns are included.

The two Baldwin studies indicate that about ten per cent of Canadian firms fail within one year. That is approximately half of the failure percentages indicated in the Mata et al. (Portugal) and Audretsch (US) studies.

Baldwin and Gorecki (1991) A major portion of these authors’ paper is directed at the data integrity of the Canadian Census of Manufacture (CCoM) reports from Statistics Canada. CCoM data is organised in a manner that permits monitoring of individual plants and or entire firms over their life span, a requirement for longitudinal analysis of company exit or failure analysis (302).

Based on their analysis of Canadian manufacturer during the 1970s, Baldwin and Gorecki suggests an average annual failure rate of approximately 6.5 percent (307).

Figure 2.4.2 is from page 310 in the 1991 Baldwin-Gorecki paper. The first year exit rate is approximately half that percentage indicated in the Mata et al. (1994 and 1995) and Audretsch (1995).

86

Chapter 2 – Review of Literature

Figure 2.4.2: Canada: Greenfield Exit Percentages From Baldwin and Gorecki 1991, 310

Baldwin (1998) Baldwin’s 1998 book was published seven years after the second Baldwin and Gorecki paper described above. Statistics reflect then current versions of Statistics Canada / CCoM database.

In seeking an explanation for why some firms fail earlier than others, Baldwin considers Jovanovic’s “learning concepts”, combining that notion with the concept of scale adequacy of Pakes and Ericsson (1988) who state that: “learning and adaptation can be inferred from the relative size and importance of entrants at birth and their subsequent history.”

Gorecki and Baldwin suggested an exit profile of the new start-up, or “greenfield” firms that they examine: “the average length of life of a Greenfield entrant implied by this distribution and the estimated parameters was about 13 years…. Upwards of 50 percent of Greenfield births die by the end of the decade” (1998, 19 and 29).

Baldwin comments upon the similarities between his findings and those of Dunne et al., in the US, citing reliance of both on CofM source data. And yet, Baldwin’s exit rates in page 20 of his 1998 book more closely Audretsch’s US findings after firms reach the six year mark in their life spans.

In Table 2.3.7, the gross statistics from Baldwin’s Table on page 20 are weighed by this Researcher by the number of observations. The exit rates are slightly adjusted in Years 6 and 11 consistent with Baldwin’s and others’ findings of decreasing exit rates as companies age and become more established.

87

Chapter 2 – Review of Literature

YEAR

O F M A R K E T E X I T - E L A P S E D Y E A R Sa

Cohort

Numbers of Firms

Year Entry

1

2

3

4

5

6

7

8

9

10

11

1971

151

138

65

100

63

51

59

43

52

45

87

1972

118

71

66

41

40

42

31

40

33

51

1973

64

100

59

52

54

31

54

49

48

1974

110

101

94

88

34

53

54

69

1975

101

95

72

29

44

32

48

1976

32

35

28

18

28

24

1977

31

17

10

20

21

1978

126

116

106

145

1979

50

73

93

1980

86

103

1981

51

Cohorts

11

10

9

8

7

6

5

4

3

2

1

Sum

920

849

593

493

284

233

246

201

133

96

87

Total

9367

8881

8090

7302

5557

5333

4912

4147

3118

2251

1427

Percentage

9.8%

9.6%

7.3%

6.8%

5.1%

4.4%

5.0%

4.8%

4.3%

4.3%

6.1%

Adj Pct b

9.8%

9.6%

7.3%

6.8%

5.1%

5.1%

5.0%

4.8%

4.3%

4.3%

4.3%

CUM

9.8%

19.4%

26.7%

33.5%

38.6%

43.6%

48.6%

53.5%

57.8%

62.0%

66.3%

a Source: Baldwin, J. (1998), Table 2-3, 20. b Adjustments in elapsed Years 6 and 11 to continue decreasing trend, consistent with pattern of prior periods.

Table 2.4.7: Canada: Analysed Cohort Exit Percentages From Baldwin, 1998

88

Chapter 2 – Review of Literature 2.4.3.7 Germany: A Review of Some Thought Leaders’ Exit Research Thought leaders: Wagner (1994), Strothman (2006) The size of Germany’s economy and the fact that the two German researchers examined here, Wagner and Strothman, seek to imitate the methods of Gorecki and Audretsch, suggests inclusion in the Principal Four group of companies in Table 2.4.3.

An offsetting consideration is geographic scope: each of those two authors’ studies is limited to a region within Germany, rather than the nation overall.

Wagner and Strothman’s exit investigations point to first year failures percentage of about ten per cent. Those results are about half the level of the Mata-Audretsch percentages but about the same as the findings of Dunne et al., Baldwin and Gorecki.

In later years, the two sets of German results differ from the other three national studies.

Canadian and American firms analysed appeared to reach the median point at which half of all companies exit by around Year 7. That median is not reached until elapsed Year 10 in the two German regional studies.

Wagner (1994) Half of Wagner’s 1994 paper is composed of his longitudinal study of 676 companies based in Lower Saxony, organised in four cohort years: 1979, 1980, 1981 and 1982. The other half of that paper and all of his 1999 paper are comprised of Wagner’s exploration of possible equations to explain survival and failure of companies in the region.

According to the author, the geographic limit for Wagner’s paper arose as the Lower Saxony government considered all company information as confidential and thus not to be made available for analysis outside of their statistical office. A similar limitation restricted the geographic scope of Strothman’s study.

Wagner’s sample is small; the total number of companies comprising the four cohorts analysed is less than 700 and his 1982 Lower Saxony cohort involves a sample of 130 companies.

The median age when half of the new market entrants fail is ten years in both Wagner’s and Strothman’s papers. That is about three years later than the medians in the comparable American and Canadian studies examined in this Chapter Part. At 9.6% Wagner’s Year 1 exit indications are consistent with Baldwin and Gorecki (Canada, 1998, 1991) and about half the level in percentage terms as Mata et al. (Portugal, 1995) and Audretsch (US, 1995).

89

Chapter 2 – Review of Literature Strothman (2006) This Researcher’s study is based on a sample of approximately 2100 small (less than fifty employees) companies in the Baden-Wuerttemburg region. Strothman’s exit percentages results are similar to those from Wagner’s 1995 and 1999 studies in terms of failure rates of companies in their early years (ages 1-2).

Strothman’s findings support his exploration of three “liabilities” contributing to company failure: smallness, infancy and adolescent: The well-known thesis of the liability of smallness is proved for the manufacturing sector in Baden- Wuerttemberg….The more economies of scale play a role…. the bigger the cost disadvantages of the small start-up the greater the risk of closure…. As small new firms have a particularly high risk of death there is support for the ‘revolving door hypothesis’ which coincides… with Jovanovic (1982 ,95).

The second “liability” concerns companies in their infancy: one year or less from their origin or birth. Referring to the prior research by Mata et al. in Portugal, Wagner in Germany and Audretsch in US, Strothman explains that companies’ risk of sudden failure and exit tends to be greatest in the first “one or two years and decreases monotonic afterwards” (89).

The third Strothman’s “liability” concerns companies in the adolescent stage in their life span. Strothman focuses on the period from Year 2 to Year 4 as the period that shapes that firm’s destiny. In Mata et al.’s 1994 and 1995 studies, half of all companies exit on their fourth birthday or earlier. Figure 2.4.3 shows the fastest rate of decline in viability occurs in Years 2-5, moderating in later years.

90

Chapter 2 – Review of Literature

Cohort

Cohort

Yr 19

n

1

79

187

80

2

3

12.0

26.0

40.0

48.1

62.1

66.0

72.0

78.9

214

19.0

38.1

61.0

71.9

86.0

93.1

96.1

81

145

16.0

34.9

46.0

55.0

63.9

69.0

82

130

17.9

29.0

37.1

41.0

47.1

64.9

128.0

184.0

215.9

676

676

676

Total n

676

9.6%

b

Cohorts

18.9%

4

5

6

7

8

9

10

11

81.0

87.0

89.0

101.0

105.1

105.9

72.1

77.0

82.9

53.0

56.0

58.0

259.1

281.2

296.2

314.9

269.0

192.9

676

676

676

676

676

546

401

187

27.2

31.9

38.3

41.6

43.8

46.6

49.3

48.1

47.6

%

%

%

%

%

%

%

%

%

27.2

31.9

38.3

41.6

43.8

46.6

49.3

51.4

53.5

--

89.0

Failure

9.6%

18.9%

%

%

%

%

%

%

%

%

%

4

4

4

4

4

4

4

4

4

3

2

1

a Adapted from Wagner, J. (1994), Table 1, 144, Survival and Growth of New Small Firms in Lower Saxony b 89, 90: Trendline adjust.

Table 2.4.8: Germany: Analysed Cohort Exit Percentages From Wagner, 1994

Figure 2.4.3: Germany: Survival Rates (Strothman 2006)

91

Chapter 2 – Review of Literature 2.4.3.8 Others: Sweden, England Research relating to company exit experience in three other countries are summarised here.

Sweden (Box, 2008) Box examines “2,200 firms in seven birth cohorts of Swedish joint-stock companies.”

The researcher’s data source is information from Sweden’s Patent and Registration office, comparable in terms of data provision quality and scope to the Mata et al.’s MoE based in Portugal (384).

But there the similarities to the research in the Principal Four countries in Table 2.4.3 end. Box’s seven birth cohorts range from 1899 and 1950. Comparable in some ways to Crum’s 1953 study of US companies, Box’s study was a pre-WWII investigation and thus does not fully reflect modern competitive circumstances or post-war company survival and failure patterns.

Not surprisingly, by Age 4 the failure rates are significantly lower than the findings from the Principal Four researchers identified in Table 2.4.3. Box observes that “Generally, firms were terminated at a young age- a quarter of the total population of 2,154 firms did not survive beyond the age of four.” (385). That 25% cumulative exit percentage compares is lower that Mata et al.’s 50% (Portugal), Baldwin and Gorecki’s 33.534.6% (Canada) and Wagner’s 31.9% (Germany).

UK: Hudson (1987), Lloyd-Jones and Le Roux (1982) The UK trails other Western countries in terms of development of company cohort exit studies of the Dunne-Audretsch standard. Explanations include: (i.), the absence of an infallible source of source data; and (ii.), fewer researchers in academia interested in performing the roles of Box in Sweden or Mata in Portugal.

Another consideration may be some coverage of UK companies by thought leaders in this field who primarily concentrate on companies in other countries. Baldwin (1989, 389) observes that “High infant mortality rates (cited in the analysis here of Canadian companies) is consistent with results for the… United Kingdom reported in Geroski (1991).”55 Hudson’s 1987 paper on UK companies is directed primarily at the different classifications of insolvency types. The author refers to Lloyd-Jones and Le Roux’s

55 Referring

to Geroski, P.A. (1991). “Innovation and the Sectoral Sources of UK Productivity Growth.” The Economic Journal. Nov. 1438-1435.

92

Chapter 2 – Review of Literature paper, particularly their description of Marshall’s 1833 cohort study of the Lancastershire cotton industry.

93

Chapter 3 - Research Methodology: Selection of Method and Research Questions

3 Research Methodology: Selection of Method and Research Questions Parts: 3.1 Chapter Synopsis 3.2 Selection of the Research Questions for This Thesis 3.3 Description of the Primary and Secondary Research Questions 3.4 A Mixed Methodology Approach 3.5 Description of Primary Research Methodology 3.6 Description of Secondary Research Methodologies 3.7 Uses and Users of This Research

3.1

Chapter Synopsis

The primary and secondary questions of this thesis arose from this Researcher’s background in commercial and academic company valuation analysis, combined with his longstanding interest in all issues relating to Terminal Value (TV), which is often the critical calculation in estimations of a company’s total worth.

The Gordon Formula Assuming Perpetuity (GFAP) is today’s prevailing method for calculating TV. This Researcher’s suggestion is that the perpetuity conjecture within GFAP represents an original design error by Gordon and Shapiro (1956) as they incorrectly treat time (company longevity) as a perpetuity constant—that is, a constant value continuing forever-- rather than as a variable and determinant of company worth.

The primary research issue in this study concerns whether or not the perpetuity conjecture provides a credible and defensible basis for projecting firms’ valuation life spans, as currently applied within GFAP. The related secondary research question involves exploration of characteristics of possible replacements for the perpetuity conjecture.

3.2

Selection of the Research Questions for This Thesis

The decision to embark on this study was made in December 2005 following preliminary consideration of the perpetuity conjecture problem and its possible 94

Chapter 3 - Research Methodology: Selection of Method and Research Questions relationship to chronic dilemma in DCF valuation of companies, excessive Terminal Value amounts.

This selected areas of investigation for this research—and thus, the research questions at the centre of this study—were influenced by this Researcher’s professional and academic background in company valuation-related analyses. As a consultant, author, and lecturer in company valuation the issue of best practice in DCF valuation methodology has long been an interest.

This Researcher first encountered the DCF Terminal Value estimation dilemma in the early 1980s as a planning manager with acquisition research responsibility at US’s FritoLay. Years later, as a consultant in strategy and mergers at a New York-based management consultancy, it became evident to this Researcher that the problems of untenable TV estimations could not be explained by overly optimistic assumptions of the three acknowledged Gordon Formula variables (FCF, g, WACC) alone. The logical and structural original design error that allowed companies that would fail in seven years to be valued on the basis that they continued to exist forever has to contribute to the problem, perhaps by further exaggerating any elements of TV calculation.

The primary research question (3.3) relates to the credibility and defensibility of the perpetuity conjecture as a mechanism for estimating an analysed company’s future projected life span. If time (longevity) is a determinant of value, then why not instead treat t as a variable to be projected on a company-by-company manner, in similar fashion as the Gordon Formula’s other three variables? The hypothesis underlying this question is that time, company longevity, is the unacknowledged fourth variable in GF, although not presently treated in that manner.

That research question, in turn, leads to the related question of what replaces the perpetuity conjecture assuming that the perpetuity conjecture is discredited as a surrogate for the phantom Gordon Formula variable, t.

3.3

Description of the Primary and Secondary Research Questions

This Research primarily focuses on the defensibility of what is referred to in this Document as the perpetuity conjecture within the Gordon Formula. The related

95

Chapter 3 - Research Methodology: Selection of Method and Research Questions secondary research issue concerns preliminary approaches towards developing a replacements for the perpetuity conjecture within GF.

3.3.1

Primary Research Question, Context

Is the perpetuity conjecture within the Gordon Formula tenable and defensible as a basis for estimating specific companies’ reasonably expected future life spans, for valuation purposes?

Note that the primary research question of this study as articulated above does not concern whether the Gordon Formula is easy to use. This is conceded: a three variable ratio tends to be easier to manipulate than more complex equations containing a greater number of key variables.56 What the primary research question does concern is the continuing suitability of the perpetuity conjecture as a surrogate mechanism for estimating the unrecognised t variable in the Gordon Formula. With the projected longevity of any and every company set at infinity, the effective result is to nullify times historical role as a variable and determinant of the value of an enterprise (VoE I, Part 4 in Chapter 1).

3.3.2

Secondary Research Question: Conditional and Preliminary

If the answer to the primary research question above is “no”, then a subsequent question arises: What are the broad characteristics of a replacement approach for estimating companies’ prospective valuation longevity (t) in future versions of the Gordon Formula?57 This secondary research question indirectly relates to the primary question in the sense that a continuing lack of alternatives to perpetuity conjecture would likely mean that the

56

The “apparent simplicity” caveat in Chapter 1 was that ease of use must take into account all of the adjustments necessary for the equation to be fit for purpose as an accurate means for calculating company value. If the adjustments and adaptations are required to reach that standard, those are to be taken into account in assessing the true ease of use of the original simple ratio.

57

The phrase “valuation longevity” refers to prospective estimates of company duration or longevity (t) for purposes of company valuation. In GFAP, valuation longevity is presumed to be infinite for all companies and at all times.

96

Chapter 3 - Research Methodology: Selection of Method and Research Questions incumbent approach continues, regardless of the evidence and analysis developed in addressing the primary research question. This secondary question is both conditional and preliminary: •

Conditional in the sense that this part of the research does not proceed unless the answer to the primary question as articulated above appears to be “no”.

•

Preliminary in the sense that the intent is a preliminary exploration of possible categories of candidate alternatives to the perpetuity conjecture, rather than develop specific recommended replacement method(s).

3.4

3.4.1

A Mixed Methodology Approach

Primary Research Methodology: Mixed Positivist and Interpretavist Approach

The methodological approach applied in this study to address the primary research question is both positivist and interpretavist in nature. A combination approach is necessary because of (i.) the nature of the research issue and (ii.) the characteristics of the data and information being evaluated.

3.4.1.1 Positivist Methodological Approach58 Addressing the primary issue in this study depends on examination of sufficient evidence to discredit the perpetuity conjecture. The notion of Never Ending Companies dissolves in the face of thousands of instances of confirmed company liquidations, insolvencies and administration orders: tangible evidence of sub-infinite company life spans.

Applying a positivist’s perspective to the primary question in this research means that conclusions about company duration derive from empirical (secondary) and survey (primary) evidence. It becomes difficult to argue that companies experience perpetual lives when statistical evidence points towards the opposite hypothesis, Briefer-ThanInfinite (BTI, Chapter 1).

58

As explained in Remenyi et al. (2002, 32), “positivism” refers to the search for rules that are comparable to physical laws in terms of their validation by observation or equivalent empirical data.

97

Chapter 3 - Research Methodology: Selection of Method and Research Questions 3.4.1.2 Interpretavist (Constructionist, Phenomenologicalist59) Methodological Approach Some other aspects of the research involved in this study suggest methodological approaches which are more interpretavist in nature.

By its nature, variability suggests a requirement for further understanding and interpretation. In the context of this investigation, possible variability arises regarding the measurement of exactly when a company dies, important for specifying the exact duration of companies’ sub-infinite life spans. For example: •

In Figure 2.3.6 in Chapter 2 Part 3 (2.3), Madden’s “stylized company” example depicts a firm in which the Cash Flow Return on Investment (CFROI) rate first exceeds and then falls below cost of capital (WACC), providing mixed signals as to whether that company is dead and alive according based on MauboussinJohnson (1997) Competitive Advantage Period (CAP) framework economic viability criterion.

•

Appendix K in this Document, Some Alternative Concepts of Company Life Span Terminus, touches upon a series of different possible life terminus indicators, of which CAP represents one.

Interpretation and judgment are required in order to discern the more reliable actual life span terminus indicator from the others. Without further analysis and interpretation of additional indicators and data, companies’ dates of death—and thus, the duration of their finite life spans-- cannot be measured and recorded with certainty.

3.4.1.3 Related Case Studies Approaches: Yin’s Three Dimensions This requirement for interpretavist insight also directs this Researcher towards Yin’s three dimensions of case study methodologies.

Challenging an assumption within an equation in use for longer than half a century does not suggest customary methods. Add the fact that perpetuity is by definition not finite and therefore, not measurable using conventional mathematical methods, and a broadening of methodological approaches appears to be required.

59

Interpretavism is often described as the opposite to positivism. Cohen et al. describe interpretavism as phenomenology-based approach, that is, in which results may tend to be attributed to bespoke experiences, in a word, phenomenon (2007). Remenyi et al. (2002) refer to the “unique incident in its own right” (35), cautioning that “phenomenological research is not readily conducive to rules”. Stated another way, the interpretavist-phenomenologist does not seek to develop general rules.

98

Chapter 3 - Research Methodology: Selection of Method and Research Questions Yin seems to anticipate the dilemma of the non-customary research investigations in proclaiming that: Case study research... is appropriate when investigators either desire or are forced by circumstances (a) to define research topics broadly and not just isolated variables, and (b) to cover contextual or complex multivariate conditions and not just isolated variables, and (c) to rely on multiple and not singular sources of evidence (2003, ix).

Yin proceeds to describe three different “dimensions” of case study research which are possibly applicable to such situations. Those dimensions are shown in Table 3.4.1, along with related areas in this Research: Dimension

Description per Yin (2003), 5.

As Relates To Analysis In This Research (partial)

Exploratory

Descriptive

Explanatory*

“defin(es) the questions and hypotheses of a subsequent study… or at determining the feasibility of the desired research procedures.”

“presents a complete description of the phenomenon within its context.”

“presents data bearing on causeeffect relationships- explaining how events happen.”

Perpetuity notion described as an unproven axiom and conjecture rather than hypothesis subject to test by observation, falsification.

Exploration of acknowledged (Williams, Lutz & Lutz), unacknowledged (annuity- to- perpetuity) influences.

Exploration of alternative definitions of corporate death (end of life span for valuation analysis purposes).

Exploration of principle supportive arguments, opposing hypothesis and its evidence.

Possible causal roles of (a.) intra-segment competition and (b.) shrinking underlying product life cycles in reducing actual life spans

Addressing central issue: does immaterial explanation apply under real- world circumstances of over- estimations and distortions?

Indefinite = Infinite (deliberately blurred)

* alternatively referred to by Yin as “causal”.

Table 3.4.1: Yin’s Three Case Study Methodologies, Relationship to Methodology in This Research

3.4.1.4 Exploratory As described by Yin, this case study dimension involves the feasibility of proving or disproving a theory. As the perpetuity conjecture is adopted but not proven, this aspect of Yin’s approach appears to be especially applicable to this Research.

99

Chapter 3 - Research Methodology: Selection of Method and Research Questions Perpetuity is treated by Gordon and Shapiro as an axiom; an unproven concept which is nonetheless accepted as if it is true, in part because it enables the overall equation to perform its intended function.60 Gordon and Shapiro’s treatment affects the basic nature of this Research in the sense that the notion of Never Ending Companies may not even qualify as a valid hypothesis, for two reasons: •

Kuhn notes that hypotheses typically arise from observations, as the hypothesis creator eventually devises a general rule to help explain this and similar observations. But as perpetuity is not measurable, it is also not observable nor the basis for an observation-based hypothesis (Fuller 2006).

•

Popper points to falsification as an essential characteristic of a valid hypothesis.

Unless a concept may potentially be discredited (falsified) through observation or other means, questions arise about that theory’s viability (Fuller 2006, Popper 2002).

For purposes of this Research, the importance of qualifying as a hypothesis is that a lower level of evidence is presumed by this Researcher to be required to discredit concepts that are below hypothesis tier. Thus the use of lower-level designation “conjecture” in referring to companies that exist to perpetuity. Encarta’s (1999) definition for “conjecture” is as follows: “an opinion or judgment based on incomplete or inconclusive information.”

The procedural aspect of this Yin dimension also may have bear on a central issue of importance in this Research. As noted, the perpetuity conjecture’s level of distortion is minimal if and when projected future cash flows are miniscule. But since there (i.) is potential for distortion when CFs are not minimal; and (ii.) are numerous instances when such over-estimations occur, a reasonable issue arises:

Should this insignificance

argument be excluded at the onset of this Research as a matter of procedure?61 3.4.1.5 Descriptive Yin’s case study dimension is also directed at the detail relating to the selected research question. Gordon and Shapiro’s 1956 is properly viewed in context of Williams (1938).

The near-equivalence of the Gordon formula to the formula for perpetual annuities

60

61

“Axiom” definition per Encarta (1999): “A basic proposition of a system that, although unproven, is used to prove the other propositions in the system.”

This Insignificance Exception is addressed in Part 5 in Chapter 5 (5.5).

100

Chapter 3 - Research Methodology: Selection of Method and Research Questions dictates that the rationale and calculations relating to that equation are addressed in this research.

This descriptive dimension also points to the importance of examining the deliberate blurring of the meanings of the different terms “indefinite” and “infinite”. Supporters of the perpetuity conjecture may imply that the two words are identical, within the context of company valuation. And yet, this Researcher contends that the two concepts have distinct and different meanings, both in general and in a value estimation context.

Combine this definitional issue with Yin’s preceding exploratory dimension, and the importance of considering the opposite to the perpetuity conjecture becomes apparent.

Weekly instances of companies slipping into insolvency with no continuing value after that collapse doesn’t merely suggest a prima facie case against the perpetuity conjecture—that is, a compelling argument that is “clear from first impression” (Encarta, 1999).

Those observations also point towards an alternative hypothesis: that companies tend to experience Briefer-Than-Infinite (BTI) lives of unknown duration— unknown until that firm’s exact future date of demise. If evidence can be shown to support this BTI hypothesis, this Researcher suggests that the perpetuity conjecture is then discredited, on the basis that two diametrically opposite theories cannot both be valid.

3.4.1.6 Explanatory Yin’s alternative phrase for his third dimension is “causal”. As applied to the central issue in this Research—that is, whether or not the perpetuity conjecture is tenable and defensible— one considers the range of possible influences that may shorten life spans.

Answers to the question When is the company dead? may also help to address the related question, What caused that company’s demise?

Possible alternative approaches to determining actual companies’ dates of death are explored in this Research in 2.4, 5.6 and Appendix K. This explanatory aspect is important as certain candidate measures such as multiple court filings of the US Chapter 11 bankruptcy code-type are voluntary in nature, suggesting that self-proclamation may be used to establish the end of a company’s life span. Other candidate measures such as UK’s insolvency administrative orders are involuntary in nature.

Yin’s explanatory dimension suggests the need for depth to valuations typically missing from simplistic equations. There is no provision in the Gordon formula for the productservice life cycle patterns or sudden intrusion by major competitors. And yet, both of those factors directly influence company longevity and value. Causal considerations 101

Chapter 3 - Research Methodology: Selection of Method and Research Questions also help in the exploration of possible successors to the perpetuity conjecture, as a superior alternative will presumably incorporate several of the more important causal factors.

3.4.2

Secondary Issue Methodology: Mixed (Positivist and Interpretavist)

The second issue in this Research concerns the characteristics of possible replacements for the perpetuity conjecture. This is a conditional issue as it does not arise until and unless the perpetuity conjecture is shown to be untenable (Research Issue 1).

3.4.2.1 Positivist Findings emerging from a positivist approach— that is, based on observations and other empirical evidence pertaining to company life span duration— may also point towards some possible future successors to the perpetuity conjecture.

For example, obsolescence data in Appendix G and multiple-industry asset (property, plant and equipment) life data in Appendix I may suggest possible bases for predictive models of company life spans based on asset and/or industry longevity patterns.

3.4.2.2 Interpretavist The diversity of data such as found in the Appendices points towards an interpretavist approach. Questions arise which require interpretation. For example, does one assume average lives, maximum lives or neither in setting a possible briefer-than-infinite life span?

And how does one integrate insights about longevity-influencing factors such as product life cycle (PLC) patterns with asset and industry statistics? Empirical findings emerging from positivist approaches require a combination of analytical and interpretative approaches, in this Researcher’s judgment.

102

Chapter 3 - Research Methodology: Selection of Method and Research Questions

3.5

Description of Primary Research Methodology

A survey instrument was developed in support of the investigation of the primary and secondary research questions in this thesis, as described in Part 3 in this Chapter (3.3).

The survey was administered by this Researcher to twenty-five (25) full- and part-time valuation

practitioners.

Details

about

the

design,

development,

compilation,

implementation, sample and other aspects of the primary research methodology may be found in Part 1 of Appendix (E.1).

3.6

Description of Secondary Research Methodology

In addressing the central issue of companies’ life span, both overall and specifically for purposes of company valuation, this Researcher primarily looks to academic studies regarding both the issue of actual longevity levels and patterns (2.4) and related issues of how and whether theoretical notions such as the perpetuity conjecture are applied to the company valuation analysis (2.3, 5.8).

In 5.6, statistics from UK and US government agencies on company longevity supplement the findings from academic studies. This Researcher examines the specific writings of the perpetuity conjecture’s most consistent past defender, Penman, both in 2.3 and 5.7.

3.7

Uses and Users of This Research

A range of different groups may find the analysis and findings contained in this study useful. Some of those groups and their possible uses include: valuation academicians, bankers and other deal facilitators with interests in valuation methods and company managers.

103

Chapter 3 - Research Methodology: Selection of Method and Research Questions 3.7.1

Valuation Practitioners

Those who apply valuation theory to actual commercial transactions and other valuation-related analyses have an interest in accurate calculation of the time variable in DCF valuation, as that affects usefulness, credibility and accuracy of the method applied.

Today, practitioners who neglect the persistent problem of excessive Terminal Value calculations in DCF2S valuations—including the role of the Never Ending Company perpetuity conjecture in contributing to those exaggerations—risk seeing their analysis ignored or worse.

3.7.2

Valuation Academicians: “Managerial Group” or DCF-Oriented62

This refers to valuation academicians who use DCF-based methods for estimating company value. In some circumstances and companies, possible replacement of the perpetuity conjecture with Briefer-Than-Infinite (BTI) life spans may significantly affect estimated value. For example, for some companies in industries normally prone to extremely brief life spans, a significant reduction in assumed longevity translates into lower Terminal Values (‘continuing values’).

The possibility of re-classifying time (that is, company longevity) from unproven axoim to variable may affect how the Gordon formula of the future operates, a concern to DCF valuation academicians.

3.7.3

Transaction Intermediaries With Interest in Company Valuation End Results

Possible replacement of the perpetuity conjecture with BTI company life spans threatens to reduce justifiable prices for some Initial Public Offerings (IPO) and secondary offerings for some firms. For investment bankers, deal finders and others dependent on transaction fee income, this possible reduction in some pricings may be unwelcome.

62

The phrase “Managerial Group” is used here to describe DCF valuation academicians, (i.) because of the historical roots of DCF company analysis as a financial manager’s valuation methodology beginning in the 1970s and (ii.) to different this group from the “Accounting Group” as described in 2.3. The latter refers to proponents of accrual accounting-based valuation methods in the literature, particularly DDM.

104

Chapter 3 - Research Methodology: Selection of Method and Research Questions Speculative acquisitions in which the analysis time period is arbitrarily extended to help make a marginal deal appear to be more reasonable also face closer scrutiny. If the perpetuity conjecture comes to be displaced by BTI, it is likely that deliberate management of the analysis time period dimension in order to manipulate the valuation end result also becomes suspicious as a possible indicator of manipulated, unachievable acquisition numbers.

3.7.4

Company Financial and Other Senior Management

Presuming that the company’s chief executive and others in top management: (i.) perceive their roles to be that of agents for shareholders (Jensen, 1986); and (ii.), embrace maximising shareholder value as their priority role, company managers are potentially interested in any developments involving the accuracy of prevailing valuation equations.

Both inorganic and organic growth plans of the company could conceivably be affected by movement away from the perpetuity conjecture and towards BTI company life spans.

Some companies’ external (acquisition) growth strategies may be affected. The days of confusing the merger overbid with the value of the target company are not over, but one erroreous assumption which causes some value estimates to be unrealistic— relating to company time (t) or longevity— now faces more careful and exacting systematic calculation.

Some time miscalculations border on active deception. Embattled management at the mature company might be tempted to boost the calculated value of their near-death firm adventure by assuming high returns from a promising new project, combined with an assumed infinite life span for the company overall. “Value” in the statistical sense soars, reminiscent of the Dot-Com bubble (Clark, 2000). But when that same company collapses a few years later with little or no residual worth, the delusionary value estimates are revealed.

105

Chapter 4 - The Study, Its Scope, Dataset, The Means of Analysis, The Nature of Results and How It Will Achieve Its Objectives

4 The Study, Its Scope, Dataset, The Means of Analysis, The Nature of Results and How It Will Achieve Its Objectives

Parts: 4.1 Key Issues Addressed in This Study 4.2 Scope and Limitations 4.3 Researcher’s Perspectives, Orientations, Possible Biases 4.4 Characteristics of Analysis and Expected Findings 4.5 Addressing the Primary and Secondary Research Questions

4.1

Key Issues Addressed in This Study

Table 4.1.1: Four Issues Addressed in This Study

106

Chapter 4 - The Study, Its Scope, Dataset, The Means of Analysis, The Nature of Results and How It Will Achieve Its Objectives Four issues directly related to the primary research question in this study (3.3) are shown in Table 4.1.1 and described in the pages that follow.

4.1.1

Time’s (Companies’ Longevity) Role as Acknowledged Variable in Future Gordon Formula

The original developers of the Gordon Formula deliberated over how best to deal with the computational problems associated with the unknown (or “indefinite”: Gordon 1962, 20) nature of companies’ future life spans in their company value calculations. The writings of Williams, Gordon and Shapiro suggest that the creators of GF recognised that t affects company value (and thus, is a variable and determinant of company value) since the issue of time in value would be moot if variations in life span were irrelevant to company worth.

Williams (1938) specifically raises the issue of differences in life spans amongst different companies being valued, thus designating t a variable. But Gordon’s subsequent approach to calculating the t effectively nullifies time as a variable: when time is treated as a perpetuity constant for all companies and all company circumstances, time no longer effects company value, since the exact same calculated value statistic is generated by GFAP, regardless of actual company longevity in the real business universe.

Thus, while time is contemplated by GF’s developers as a variable, t is not treated in that manner in today’s commonly applied version the Gordon Formula. Only three variables (FCF, g and WACC) comprise GF today; time—company longevity—is not amongst them.

Inclusion of a variable t in the Gordon Formula would signal (i.) the end reliance on the perpetuity conjecture as a surrogate calculation basis, and (ii.) expansion of the GF to a four variable serial version (Appendix C).

The examination of this issue encompasses several considerations, beyond the aforementioned deliberations of the Formula’s creators in 2.4. The historical role of company longevity as a variable and determinant of enterprise and project value is introduced in parts in Chapter 1 (1.4, 1.5). Chapter 5 addresses the consistency of variable estimation approaches amongst GF’s four true variables, including the phantom variable, t. analysis.

107

Chapter 4 - The Study, Its Scope, Dataset, The Means of Analysis, The Nature of Results and How It Will Achieve Its Objectives 4.1.2

Characteristics of the Insignificance Exception (IE): Feasibility, Applicability

The phrase “Insignificance Exception” (IE) is introduced in Chapter 1. IE refers to a specific combination of assumptions under with value calculations using the perpetuity conjecture results in almost the same exact value result as if company-by-company specific, life span projections were used for estimating the t variable, instead.

When future Cash Flows are negligible and/or if the CFROI rate is almost identical to WACC63, then there is no significant difference in value regardless of elapsed time, on a present value basis (Neale and McElroy 2004).

If IE circumstances reasonably apply to all companies at all times, then use of the perpetuity conjecture for all GF valuation calculations appears to be correct, as the value of a firm that fails after five years from origin is the same as for the same firm in comparable circumstances that endures for fifty years. Stated in another way, if the IE applies all or most times, then the hypothesis that is represents the polar opposite to the perpetuity conjecture, the BTI hypothesis is moot; the value statistic generated by GF is the same regardless of company actual life span.64 Accordingly for purposes of this study, two questions of importance emerge relating to IE: •

Are these circumstances envisioned by Neale and McElroy theoretical to the extent of being highly unlikely to occur in real world business circumstances? If the answer is “yes”, then there are no IEs, t is affirmed as a variable of company value, and finite-but-unknown life spans apply to all DCF company valuations.

•

If the answer to the question above is “no”, other questions arise. Do the number of IE instances represent exceptions to the rule for the BTI hypothesis or instead, are those instances so extensive as to justify continuing use of infinity (the perpetuity conjecture) as a surrogate for time in the Gordon Formula?

63

As noted in Chapter 1 and also 5.5, an IE key presumption is that CFROI rate always remains slightly above WACC, since if WACC=CFROI, that intersection (Viability Threshold) suggests an end to that company’s life span on CAP basis, confirming a sub-infinite life span (t).

64

Assuming identical FCF and zero or negligible residual at point in time that failure occurs.

108

Chapter 4 - The Study, Its Scope, Dataset, The Means of Analysis, The Nature of Results and How It Will Achieve Its Objectives 4.1.3

Empirical Information on Actual Life Spans I: Sufficient to Discredit the Perpetuity Conjecture?

While prima facie indications of companies’ finite life spans (t) arises with every announcement of the collapse of another company with negligible post-failure residual after death, the issue arises as to whether the confirmed instances of sub-infinite lives either (i.) challenges the notion that all companies endure forever for valuation purposes, or, (ii.) represent such a substantial volume in terms of breadth and depth as to support the opposite of the perpetuity conjecture, BTI (as depicted in Figure 1.2.1 in Chapter 1).

The number and range of studies of company failure as described in 2.4 relates to this issue, as does the government agency and other confirmed statistical evidence cited in 5.6.

4.1.4

Empirical Information on Actual Life Spans II: Informing CompanySpecific Projections of Longevity for Valuation Purposes

Extensive document proof exists to affirm companies’ finite life spans. But unless those indications can help to develop an eventual alternative method for estimating t instead of the present default surrogate of infinity, then the perpetuity conjecture might continue to be used, even after it has been discredited.

Consideration of this issue includes examination of the types of detail included in the literature on company failure (2.4) and other sources (5.6), including the insights of valuation practitioners (5.3).

109

Chapter 4 - The Study, Its Scope, Dataset, The Means of Analysis, The Nature of Results and How It Will Achieve Its Objectives

4.2

4.2.1

Scope and Limitations

Regarding extent and depth of investigation into the secondary research question (3.3)

As noted in 3.3, the secondary research question in this study (relating to preliminary investigation of possible successor categories to the perpetuity conjecture) is “preliminary” which for scope interpretation means identifying the broad categories of possible alternatives to the perpetuity conjecture approach and not the development of specific codified candidate alternatives. The latter represents a possible future area of investigation as identified in 6.2, Possible Future Areas of Research, but is outside of the parameters of this study’s investigation.

4.2.2

Context

relating

to

analysis

perpetuity

conjecture:

scope

implications

Although the perpetuity conjecture at the centre of this research resides within GFAP, the primary focus in the study is on that infinity supposition, rather than with the Gordon Formula per se. While insight into the possible strengths and limitations of the GF emerges from an examination of the literature (2.3) and a consideration of the mathematical effects of an infinity assumption on the accuracy of GF calculations (Appendix H, 5.4), the suitability of the Gordon Formula in general as a method for calculating Terminal Value is not at issue, although that is also identified in 6.2, Possible Future Areas of Research.

The perpetuity conjecture’s role in facilitating an easy-to-use means for developing approximate TV estimates using the Gordon Formula Assuming Perpetuity is not an issue; that GFAP is simple is acknowledged. What is at issue is whether use of ∞ as a surrogate for the Gordon Formula’s fourth, true, variable, time, is defensible and credible.

110

Chapter 4 - The Study, Its Scope, Dataset, The Means of Analysis, The Nature of Results and How It Will Achieve Its Objectives 4.2.3

Subsidised companies excluded from consideration as examples of firms that support the perpetuity conjecture

Collapsing companies that receive significant direct subsidies (e.g., US TARP programme in 2008-09) or comparable indirect assistance to forestall their collapse a few periods or a few years longer are excluded from being considered as examples of perpetual companies, thereby supporting the perpetuity conjecture.65 That such companies continue to trade after receiving survival subsidies is irrelevant; such extraordinary funding or refinancing assistance is not available to the typical company, and thus any that belief companies’ lives are infinite represents an illusion.

4.2.4

Areas of Geographic Emphasis

Much of the research, analysis and commentary in this thesis relates to companies that are US- or UK-based. In considering intelligence into companies life spans provided in 2.4, a broader geographic scope applies: some of the more credible studies of companies’ life span patterns and failure rates come from Canada and Portugal for example.

4.3

Researcher’s Perspectives, Orientation, Possible Biases

This Researcher’s perspective and orientations influence the selection of research questions for this thesis (3.3) and how this research is conducted.

Figure 4.3.1, the Kolb Experiential Learning Cycle, provides insight into some experiences shaping this Researcher’s orientations and perspectives relevant to this topic. Appendix D, Details Relating to Kolb Cycle Figure, provides additional detail relating to some of the specific items shown in that Figure:

65

Bankruptcy reorganisations are interpreted here as possibly an indirect forms of subsidy. On that basis MCI Inc. is not the same continuing company as Worldcom, which declared bankruptcy and thus failed in the early 2000s. Worldcom’s failure represents one example confirming the finite nature of companies’ life spans, contradicting the theoretical perpetuity conjecture. Related analysis in Appendix E Part 1 subpart g, (E.1g) Table E5, Some Definitions of Company Demise, Acquiree Life Span Implications.

111

Chapter 4 - The Study, Its Scope, Dataset, The Means of Analysis, The Nature of Results and How It Will Achieve Its Objectives

Figure 4.3.1: This Researcher’s Orientations, Based on the Kolb Learning Cycle

4.3.1

Experiences

In 1980 as a director at the Frito-Lay division of PepsiCo, this Researcher attended Stern’s Chase Econometrics corporate seminar on value-based management (VBM).

Those sessions provide an introduction to DCF valuation principles and also into some of the more controversial aspects of Gordon Formulas, especially when used to calculate TV. During the 1980s leveraged buy-out (LBO) bubble, this Researcher observed that some motivated acquirers and M&A intermediaries appeared to manipulate their Terminal Value calculations however necessary to ensure winning bids and the transactiondependent fees resulting from that activity (Clark, 1991). Accountants issued a so-called fairness opinion letter in 1988 supporting Maxwell Communications Corporation’s (MCC) acquisition of Macmillan Publishers for $2Bn. This Researcher’s original value estimation amount was half the amount, but the assertive MD of MCC utilised overly optimistic variables plus the perpetuity conjecture to create a paper value estimate that was half of the original amount (Item 1b. in the Figure).

In mid-March 2000, Lastminute.com’s Initial Public Offering occurred on the exact date of the exhaustion peak of the 1996-2000 Net Bubble. In order to bring Lastminute.com’s 112

Chapter 4 - The Study, Its Scope, Dataset, The Means of Analysis, The Nature of Results and How It Will Achieve Its Objectives IPO pricing in line with then-prevailing external prices (MV), Lehman Bros.’s corporate finance department extends the horizon period, generating the appearance if not the reality that TV had been substantially increased. After the Internet Bubble imploded in late April 2000 the market realised the ploy: Lastminute.com’s market capitalisation was halved from the IPO levels (1d. and 1e. in Figure 4.3.1).

4.3.2

Observations and Reflections

As a consequence of the roles described above plus writings on value creation and destruction in acquisitions (1991), this Researcher developed a sense of how the limitations of TV models might be exploited by some parties interested in the results of those analyses.

Acquisition evaluation is the underlying reason for many value estimation exercises.

Despite proclamations to business media that unaffordable acquisitions— those in which the deal price exceeds conservative, defensible valuation— will not be pursued, this Researcher’s experience is that those words are quickly forgotten in the heat of the acquisition chase. Fortunately for the deal promoter but unfortunately for shareholders, mechanisms such as the perpetuity conjecture within the Gordon Formula may be used in combination with manipulation of the other three GFAP variables in order to distort realistically achievable estimates of value.

4.3.3

Testing Implications of Concepts in New Situations

If one presumes that all acquisitions require supportive analysis to support that decision, prevailing thought that most mergers fail (Bruner 2002, Clark 1991, Coley and Reinton 1988) suggests: (i.), the failure of at least some of the excessive TV estimations underlying those excessive valuations; and (ii.), a contributing TV distortion role by the perpetuity conjecture to the extent that the supposition exaggerates errors in any of the three acknowledged Gordon Formula variables, FCF, g and/or WACC.

113

Chapter 4 - The Study, Its Scope, Dataset, The Means of Analysis, The Nature of Results and How It Will Achieve Its Objectives

4.4

4.4.1

Characteristics of Analysis and Expected Findings

Characteristics of Analysis

The analysis contained in this thesis study is extensive, multi-faceted and aligned with the research questions (3.3).

“Extensive” means an investigation which is probing in nature. For example, while some valuation practitioners and other who utilise GFAP may be aware of the existence of Gordon’s seminal 1956 paper with Shapiro, few are aware predecessor Williams’ 1938 work of Williams or that author’s different perspective (compared to Gordon) on the role of time as a variable in the company valuation approach which would later be referred to as the Gordon Formula.

Time in valuation is examined on multiple bases in this study, including t’s role as a determinant and variable in pre-corporate project value, and the inner disagreements between the various forefathers of GFAP about how to interpret the role of company longevity in company valuation schemes. By investigating a wide range of relevant cohort-based studies and their methodologies (2.4) and relevant empirical evidence of sub-infinite life spans (5.6) that this Researcher was able to significantly address the primary research question in this study.

4.4.2

Expected Findings

The key expected finding is that the perpetuity conjecture is discredited on multiple bases, in the context of the primary research question as articulated in 3.3; that is, as a basis for forward estimates of company longevity (t) in the Gordon Formula.

A related expected finding is that as a group, companies’ median life spans are briefer than a decade and that 95-98% percent of firms fail within 15-20 years. Both of those expected findings directly contradict any supposition that companies’ lives are infinite.

It was also expected that in the survey, some valuation practitioners would seek alternatives to GFAP for purposes of estimating company TV, in part because of the potential of the perpetuity conjecture within GFAP to distort results. The perpetuity conjecture has long been considered by this Researcher as the Gordon Formula’s most 114

Chapter 4 - The Study, Its Scope, Dataset, The Means of Analysis, The Nature of Results and How It Will Achieve Its Objectives vulnerable presumption; at the onset of this study, it was expected that this Researcher was not the only DCF valuation practitioners-academician who thought that way.

4.5

Addressing the Primary and Secondary Research Questions

The primary question relates to the issue of the credibility and defensibility of the perpetuity conjecture in the present prevailing version of the Gordon Formula (GF).

That question and related issue are addressed in this thesis on multiple bases, with both primary and secondary research utilised in the subsequent analysis and arguments.

As the secondary research question (concerning possible category successors to the perpetuity conjecture) is preliminary and exploratory in nature (3.3), historical alternatives available at the time of the Gordon and Shapiro paper in 1956 are considered, including other candidate categories suggested either by historical empirical company failure data (industry groups) or that firm’s competitive viability (productservice life cycles).

4.5.1

Addressing the Primary Research Question

The primary research question begins with developing an understanding of how the counterintuitive perpetuity conjecture came to be included in the Gordon Formula in 1956 and in its predecessor version in 1938. Even the most ardent supporter of GFAP is hard pressed to argue the existence of Never Ending Companies in the real business world, prompting the question of how the developers of GFAP came to assume that amount for the time variable of company value, t.

•

This aspect of the primary research question is addressed through analysis of the formative writings that resulted in the equation referred to today as the Gordon Formula in a sub-part of Chapter 2 Part 4 (2.4), Literature Review Relating to Company Longevity.

Following examination of the perpetuity conjecture’s origin, the next research subject is whether the supposition all companies exist forever is a suitable projection for t in the Gordon Formula. Component amounts for each of GF’s other three variables (FCF, g and WACC) are typically developed on the basis of future projections informed by 115

Chapter 4 - The Study, Its Scope, Dataset, The Means of Analysis, The Nature of Results and How It Will Achieve Its Objectives analysis of relevant past history and emerging trends, prompting the question of why calculations for t are made on the same basis already established for GF variables by that precedent.

•

This aspect of the primary research question is addressed through analyses in several parts in Chapter 5, particularly 5.8, Other Logic and Analysis Elements of the Case Against the Perpetuity Conjecture. The primary research in this research (5.3) supports this part of the analysis in the form of interviewee responses to several of the questions in the survey instrument.

The issue of whether the perpetuity conjecture’s error in estimating specific company longevity manifests itself into errors in company valuation is important to confirm the relevance and materiality of this issue. Except under an infrequently occurring set of exception circumstances (5.5), the argument emerges that the perpetuity conjecture arises, in part because of the significant difference between infinity and the typical company’s median life span of seven years (2.4).

•

This facet is addressed primarily in 5.4, which includes the examination of the now-defunct Circuit City, plus the related analyses in Appendices H and O.

The definitive information contradicting the perpetuity conjecture is the extensive empirical evidence from the literature (2.4) and other sources (5.6) confirming that tens of thousands of companies experience finite life spans of less than a decade.

•

Responses from valuation practitioners to survey (5.3) questions about (i.) whether or not infinite life spans are plausible for valuation purposes and (ii.) their estimates of a typical company’s longevity (life span) supports this part of the analysis.

4.5.2

Addressing the Secondary Research Question

As the secondary research question is preliminary and exploratory in nature (3.3, 4.2), historical alternatives available at the time of the Gordon and Shapiro 1956 paper in 1956 are first considered in 5.9, including other candidate categories suggested either by historical empirical company failure data (industry groups) or that firm’s competitive viability (product-service life cycles).

The second half of 5.9 provides additional insights into historical alternatives to the perpetuity conjecture, plus some additional approaches. Industry-based life spans 116

Chapter 4 - The Study, Its Scope, Dataset, The Means of Analysis, The Nature of Results and How It Will Achieve Its Objectives emerge from the literature (2.4, Dunne et. al. 1998, Audretsch 1995) while product life cycle-based company lives emerge from the general management literature on Toyoda Production System and lean manufacturing, plus this Researcher’s shrink life cycle analyses (2001).

117

Chapter 5 - Results of the Analysis and Relevant Comment

5

Results of the Analysis and Relevant Comment

Parts: 5.1 Chapter Overview and Summary 5.2 Perpetuity Conjecture’s Identity Reconsidered 5.3 Primary Research Relating to the Longevity of Firms for Purposes of Terminal Value (TV) Estimation in the Two Stage DCF Company Valuation Methodology (DCF2S) 5.4 Two Analyses of Statistical Errors Attributable to the Perpetuity Conjecture 5.5 Limitations of the Insignificance Exception 5.6 Reality Testing the Notion of the Never Ending Company 5.7 Conflicted Apologist for the Perpetuity Conjecture Re-Examined: Penman’s “Truncation Error” Argument Reconsidered 5.8 Other Logic and Analysis Elements of the Case Against the Perpetuity Conjecture 5.9 Prospect of Future Possible Alternatives to the Perpetuity Conjecture

5.1

Chapter Overview and Summary

Sub-parts: 5.1.1 Description of Some Key Findings in This Chapter 5.1.2 Overview of the Parts of This Chapter

Several key findings emerging in this Chapter are identified in Table 5.1.1 and summarised in the pages that follow. The sub-section that follows provides an overview of remaining Parts 2 through 9 in this Chapter.

118

Chapter 5 - Results of the Analysis and Relevant Comment 5.1.1

Descriptions of Some Key Findings in This Chapter

The horizon is infinite if an indefinite cycle of

asset

purchases

and

sales

is

contemplated.

- Gordon 1962, 20.

I don’t ever assume perpetuity from the onset. Instead I might look at a multiple based on EBITDA or other indicator or use whatever rule of thumb approach tends to apply to companies in that industry.

- Interviewee B0604.2, responding to survey question B13 about practice for developing projections of company longevity (t) for valuation purposes

Table 5.1.1: Summary of Some Key Findings

119

Chapter 5 - Results of the Analysis and Relevant Comment

5.1.1.1 (A) Time, or company longevity (t) represents a material variable in the DCF valuation.

The statistical evidence from 2.4 suggests that companies in different industries and segments experience different sub-infinite life spans.66 Also, a comparison of companies in early maturity (“contention phase”) with firms in that same segment which are in chronic decline (“participation phase”) in the Industry Pairs analyses in 5.6 and Appendix M shows that companies’ longevity varies because of a variety of influences, ranging from resource availability to new product development effectiveness to management acumen. (Gerstner 2003) For these inter- and intra-company longevity disparities to be relevant to this study, differences in t must be demonstrated as: (i.) significant, meaning not immaterial, and (ii.) causal, that is, directly related to changes in company overall value.67 •

If a company’s future projected CFs are negligible, then value effect of a company surviving a few years longer may be almost immaterial on a Net Present Value (NPV) basis, based upon Neale and McElroy’s (2004) Insignificance Exception as investigated in 5.5.

•

Unless changes in duration are perceived as affecting company value, then the fact that changes in value happen to coincide with changes in t may be coincidental.

But the analysis in Chapter 5 indicates that companies’ differences in duration (t) are both material and causal, in company value terms: Material: The recurring problem of TV overestimation as introduced in 1.1 and 2.3 and as investigated further in 5.4 suggests significant projected CF amounts. Acquisitions and IPOs are principal uses of valuation analysis; over the years, the continuing stream of IPO and M&A transaction volume indirectly point to significant CF projections, as deals and flotations would not occur otherwise.

66

For example, Table 2.4.5: US: Summary of Age Analysis of Exiting Companies From Audretsch, 1995.

67

Part 3 in Chapter 2 (2.3) includes mention of so-called value drivers which are promoted by their developers as creating company value, but which on closer examination are sometimes incidental trailing metrics. Reference is made to Figure 2.3.7, Madden II: Drivers in Limited Term TVP and also to Rappaport (2006), “10 Ways to Create Shareholder Value.”

120

Chapter 5 - Results of the Analysis and Relevant Comment Causal: In project valuation, antecedent to company valuation, the correlation between changes in t and changes in value is demonstrable (Table 1.4.1 Chapter 1). Question A2 in this study’s primary research presented interviewees with two scenarios which are identical except for duration, t. Their responses indicated an appreciation for the causal influence of time on company value.

5.1.1.2

(B) Differences between (i.) projected life spans reflecting actual experience and (ii.) the perpetuity conjecture are significant, for all companies.

The next issue is whether time spans based upon the perpetuity conjecture differ from actual, documented longevity. The answer to this issue likely appears to be self-evident, as no company has ever been observed as achieving infinite life.68 Based on the seven studies considered in Table 2.4.2, companies’ median life span are approximately seven years. That duration is approximately two years briefer than the “typical” company’s lifespan based on responses from survey interviewees.69 Evidence of shrinking product life cycles in 5.9 suggests that companies’ lives are decreasing over time because of factors such as technological obsolescence and increased competition.

5.1.1.3 (C) The supposition underlying the perpetuity conjecture—that companies’ lives continue forever—is refuted on multiple bases.

The typical firm’s life span is shown to be briefer than a decade (2.4, 5.3). Government agency and other sources (2.4, 5.6) confirm the limited nature of life spans for hundreds of thousands of companies: a sufficient sample to discredit the perpetuity conjecture as a universal assumption whilst supporting the opposite premise, referred to in this thesis as the Briefer-Than-Infinite (BTI) hypothesis.

The perpetuity conjecture is also refuted on the basis of logic, mathematics, the organic concept of the company and consistency with calculation practices for the Gordon Formula’s other three variables (5.9).

Defence of the perpetuity conjecture is undermined by changes in the opinion of one of that concept’s leading advocates, Professor Stephen Penman. In a March 2010 discussion with this Researcher, Penman acknowledged the reasonableness of

68

The T Plus One point in 5.8 suggests that confirming infinite life span is impossible, since by definition, infinity require that one more period must always be taken into account, followed by another, and another.

69

“Typical” longevity of 9.2 years based on responses to Question B.9 (5.3).

121

Chapter 5 - Results of the Analysis and Relevant Comment developing finite forward projections informed by historical indications of longevity for companies of that general type (5.8).

5.1.1.4 (D) Valuation practitioners and academicians both appear to be moving away from the perpetuity conjecture, towards other alternatives for t.

Considered as a group, valuation practitioners participating in the survey related to this study expressed reservations about the perpetuity conjecture’s role (i.) in company valuation in general and (ii.) as a surrogate method for estimating the t variable.70 Several valuation academicians, including Cassia et al. (2009), Jennergren (2008) and Mauboussin (2007) express concerns about the perpetuity conjecture’s contributing role in creating exaggerated TVs. 5.1.1.5 (E) Emergence of possible future categories to displace the perpetuity conjecture Initial research into possible future approaches based on either (i.) industry life span patterns and/or (ii.) underlying product-service life cycles appear promising on a preliminary basis as possible future directions for tomorrow’s successor to the discredited perpetuity conjecture (5.9). Interviewees responded positively to both possible successor approaches (5.3).

5.1.2

Overview of the Parts of This Chapter

Parts 5.2 through 5.8 in this Chapter address evidence and analysis relating to the credibility and defensibility of the perpetuity conjecture, which is the purpose of the primary research question.

Part 5.9 considers possible category successors to the

perpetuity conjecture consistent with the secondary research question of this thesis. (3.3) Following are overviews of parts of Chapter 5: 5.1.2.1 Part 5.2: Perpetuity Conjecture's Identity Reconsidered One viewpoint about the perpetuity conjecture is that it (i.) is a practical approach to dealing with the unknown nature of company’s future life spans, and (ii.) facilitates simple, approximate value calculations using the three variable ratio present version of the Gordon Formula. The sub-title of Chapter 5 Part 2 (5.2) suggests the opposite: An

70

Excluding the two interviewees with past or present affiliation with buy side valuation advisory boutique Credit Suisse HOLT, who tend to defend the perpetuity as one of the components of its proprietary ‘fade’ internal methodology.

122

Chapter 5 - Results of the Analysis and Relevant Comment Impossible Axiom Supporting Convenience and Equivalence Whilst Denigrating Time's Permanent Role as Company Valuation and Determinant.

5.1.2.2 Part 5.3: Primary Research Relating to the Longevity of Firms for Purposes of Terminal Value (TV) Estimation in the Two Stage DCF Company Valuation Methodology (DCF2S) This Part summarises the findings from survey interviews with twenty-five valuation practitioners. Findings include that: (i.), time—that is, company longevity— is considered to be a variable which affects company value; (ii.), the typical company has a life span of about nine years from origin, and does not exist forever either in either a theoretical or actual sense; and (iii.), that either industry categories and product-service life cycles (PLCs) may become future replacements for the perpetuity conjecture in GF. 5.1.2.3 Part 5.4: Two Analyses of Statistical Errors Attributable to the Perpetuity Conjecture The perpetuity conjecture exaggerates miscalculations of any of the three already acknowledged Gordon Formula variables (FCF, g, WACC). In an illustrative example involving US electronics retailer Circuit City (now defunct), the assumption of an infinite life span (t) for valuation analysis purposes instead of a reasoned projection of that struggling firm’s likely remaining life span results in material value calculation error.

A separate three scenario statistical analysis supported by Appendix O demonstrates that the briefer the company’s actual life span and the greater the statistical errors in one or more of the Gordon Formula’s three acknowledged variables (FCF, g, WACC), the greater the error which may be attributable to the perpetuity conjecture.

5.1.2.4 Part 5.5: Limitations of the Insignificance Exception (IE) Reliance on the perpetuity results in an accurate value calculation regardless of a company’s actual longevity (t) if either of two IE circumstances described by Neale and McElroy (2004) occur, rendering moot the subject of this study and any concerns about the perpetuity conjecture as expressed in Part 1 of the Introductory Chapter (1.1). But chances of either IE Circumstance 1 or Circumstance 2 occurring in the real business world appear remote to non-existent, based on the analysis and reasoning in 5.5.

123

Chapter 5 - Results of the Analysis and Relevant Comment 5.1.2.5 Part 5.6: Reality Testing the Notion of The Never Ending Company This Part provides government and other empirical information affirming the reality of companies’ sub-infinite, that is, Briefer-Than-Infinite (BTI), life spans, now and in the future (Appendix N). This Chapter Part includes the summary of the Industry Pairs analysis developed for this study (Appendix M).

5.1.2.6 Part 5.7: Conflicted Apologist for the Perpetuity Conjecture Reexamined: Penman’s “Truncation Error” Argument Reconsidered When the most visible proponent of the perpetuity conjecture in the academic literature changes his opinion, one reasonably wonders whether some or all of the earlier espoused arguments were entirely valid. Penman’s “truncation error” argument is examined in 5.7, along with an analysis of non-valuation related factors underlying his opposition to the use of sub-infinite concepts of company’s life spans (t) for valuation purposes, epitomised by his “truncation error” assertion appearing in several papers from 1996 to 1998.

5.1.2.7 Part 5.8: Other Logic and Analysis Elements of the Case Against the Perpetuity Conjecture Logical, mathematical, methodological and other arguments against the perpetuity conjecture are explored in this Chapter Part, including but not limited to: the organic concept, infinite loop error, bounded rationality error, and inconsistent calculation methods for t compared to the other three true variables comprising the Gordon Formula.

5.1.2.8 Part 5.9: Prospect of Future Possible Alternatives to the Perpetuity Conjecture While some BTI alternative methods for projecting t on a company-by-company basis existed in the mid 1950s (the time of Gordon and Shapiro’s paper), reliable sources of industry-defined longevity intelligence and product life cycle-based analysis did not become available until decades later. Several possible replacement approaches are examined on a preliminary basis in 5.9.

Since that time, several other alternative categories of replacement approaches for the perpetuity conjecture arise, including: operational and PPE measures (Jennergren 2008)71; reliance on Explicit Projection Period alone (Cassia and Vismara 2009 and

71

“PPE” refers to property, plant and equipment. The two Appendices in this study relating to Jennergren’s analysis in his 2008 study are I and J.

124

Chapter 5 - Results of the Analysis and Relevant Comment Appendix F), industry-categories (Audretsch 1995, from 2.4) and multiples of productservice life cycles (Womack and Jones 1990, Clark 2001). The latter two approaches are included in the survey questions (5.3, also Appendix E Part 1 sub-part a (E.1a) Survey Instrument).

5.2

Perpetuity Conjecture's Identity Reconsidered: An

Impossible

Axiom

Supporting

Convenience

and

Equivalence Whilst

Denigrating Time's Permanent Role as Company Valuation and Determinant

Sub-parts: 5.2.1 Perpetuity Conjecture Identity 1: To Facilitate An Easy Formula for Company Estimated Value 5.2.2 Perpetuity Conjecture Identity 2: Impossible Axiom Neglecting Time’s Role in Company Valuation

Addressing the perpetuity conjecture within GFAP begins with a reconsideration of the true nature of that supposition.

Envisioned by GF’s creators as a commonsense assumption to facilitate value estimations using the simple GFAP ratio, others view the perpetuity conjecture as a impossible, implausible notion which Gordon and Shapiro arbitrarily inserted into their equation despite being an unproven axiom with neither parallel nor precedent in the actual business world. Perhaps it is because the perpetuity conjecture rendered the Gordon Formula so easy to use that its originators did not sufficiently consider the valuation errors that could and do arise when companies that live and die within one decade are imagined as existing forever.

In order to determine which of those two perspective is correct, this Chapter Part examines the first perspective above (5.2.1, Perpetuity Conjecture Identity 1: Commonsense Facilitative Assumption) followed by the perspective that emerges in this study from the extensive empirical and other evidence contradicting the perpetuity conjecture (5.2.2).

125

Chapter 5 - Results of the Analysis and Relevant Comment 5.2.1

Perpetuity Conjecture Identity 1: To Facilitate An Easy Formula for Company Estimated Value

The role of company longevity, or time, as a variable and determinant of company value is consciously overlooked by two of the three developers of the Gordon Formula, as described in 2.4.

Based on the several examples of variations in value resulting from changes in analysed company life span in parts of this study (including but not limited to the three scenarios in 5.4), the notion that company value generally varies in accordance with company life span duration is supported. But in 1956 Gordon and Shapiro lacked either the inclination and analysis methods or both to treat time as a variable, and thus arose default surrogate of the perpetuity conjecture and its enabling misinterpretation: that indefinite life spans and infinite life spans mean the same thing.

That companies’ life spans are sub-infinite is apparent from the evidence amassed and analysed in 2.4 and 5.6. The volume of that evidence raises serious doubts about the perpetuity conjecture and instead appears to confirm the opposite hypothesis, referred to in this study as BTI. Even in 1956, some studies existed in the literature to affirm the prima facie notion that companies experience sub-infinite life spans, thus raising the question of how a postulate which is contradicted by direct observation and factual evidence ever became a pivotal assumption in one of today’s most extensively utilised company valuation equations. Although primitive compared to the post-1988 cohort studies examined in 2.4, Crum’s (1953) and Marshall’s analysis (1833) both predate the 1956 GordonShapiro paper. Crum’s analysis involved thousands of companies. Marshall studied ninety firms.72 Was the sub-infinite reality of companies’ life spans known to the developers of the Gordon Formula in 1938 and 1956, or at least suspected? Williams’ (1938) contemplation of variability of t and companies’ true sub-infinite life spans suggest an answer of “yes”.

72

Dunne et al.’s 1988 study established standards for source data and monitoring of sample company continuity, establishing a standard for the cohort studies that followed in the 1990s (2.4).

126

Chapter 5 - Results of the Analysis and Relevant Comment A few failed companies might be explained away as exceptions to a rule of company perpetual existence. But when thousands of failures occur, that paradigm is in crisis, leading towards changes in that theorem or possibly even replacement.73

5.2.2

Perpetuity Conjecture Identity 2: Impossible Axiom Neglecting Time’s Role in Company Valuation

“Impossible” is included in the sub-title above on the basis that infinity can neither be reached nor measured.74 An “axiom” is a “basic proposition assumed to be true” (Encarta 1999). But if that axiom lacks any supporting empirical evidence at all (such as in the case of the perpetuity conjecture), it becomes necessary to affix an additional phrase at the end of that definition: but which is disproven by the breadth and depth of contrary evidence.

Without the inertia provided by past use and present incumbency, it is difficult to envision that the perpetuity conjecture could be created anew today, regardless of its role in helping to make the Gordon Formula somewhat simpler than it otherwise would be (three variables in a ratio instead of four variables in a serial equation).

Responses from several of the interviewees to Question B13 supports that expectation.

Faced with an unknown future life span of a company being evaluated, several practitioners described how they eschewed any notions of never-ending company life spans and instead applied their own different, non-GFAP bespoke methods.

73

Presumes negligible or no residuals at time of company failure. Kuhn’s paradigm in crisis notion is mentioned in this Chapter in 5.8 (Fuller 2003, 19).

74

Refer to T Plus One argument, sub-part 3 in Part 8 of this Chapter (5.8.3).

127

Chapter 5 - Results of the Analysis and Relevant Comment

5.3

Primary Research Relating to the Longevity of Firms for Purposes of Terminal Value (TV) Estimation in the Two Stage DCF Company Valuation Methodology (DCF2S)

Sub-parts: 5.3.1 Background, Summary of Overall Findings 5.3.2 An Overview of Survey Questions 5.3.3 Analysis of Responses to Survey Quantifiable Questions 5.3.4 Analysis of Responses to Survey Qualitative Questions

5.3.1

Background, Summary of Overall Findings

The issue of the perpetuity conjecture in DCF company valuation is moot, but not for the reasons that some might imagine; not because GFAP is unassailable, but rather, because at least some leading valuation practitioners have already begun to abandon the perpetuity conjecture in favour of their own bespoke, alternative finite life span Terminal Value (TV) estimation methods.

To these valuation practitioners, the issue is no longer whether the perpetuity conjecture is non-operable, but rather, whether bespoke tactics or systematic alternative(s) will emerge in the future to project companies’ finite-but-unknown valuation life spans (t) for valuation purposes. Industry categories and product-service life cycles received positive responses from the survey interviewees as possible successor categories to the perpetuity conjecture, with qualifications.

This survey research was developed in support of the primary and secondary research questions in this study; those two questions are specified in 3.3. The findings from this survey are consistent with the hypothesis related to the primary question in this thesis: that the perpetuity conjecture in present versions of the Gordon Formula is untenable as a basis for estimating the future time (company longevity, t) determinant and variable in valuation schemes, including a role in estimating the value DCF2S methodology second stage. That second stage is typically referred to as the Terminal Value (TV) period and sometimes as the continuing or continuous period.

128

Chapter 5 - Results of the Analysis and Relevant Comment Methodological detail pertaining to the survey research is provided in Part 1 of Appendix E, including areas of research emphasis, survey design, interviewee qualifications and number, and implementation. Sub-part a in Appendix E Part 1 (E.1a) contains the survey instrument. Each of the survey questions is also summarised in this Chapter Part in Table 5.3.4.

Two methodology-related aspects of note concern (i.) the design of the survey instrument and approach and (ii.) determination of overall sample size (n) adequacy for this survey. Table 5.3.1 relates to the former:

NOTE: Detailed description of Points A-H are contained in Appendix E Part 1 sub-part c (E.1c), Regarding Survey Design and Development

Table 5.3.1: Eight Considerations in Design of This Survey

129

Chapter 5 - Results of the Analysis and Relevant Comment A in Table 5.3.1, Alignment with the process for authorisation and guidance, refers to the fact that all aspects of this survey were subject to consultation during the pre-survey period from 5th November 2009 to mid-January 2010. No interviews were conducted over this time. Instead, this time period was utilised to develop general agreement on a range of relevant issues, ranging from survey area emphasis to specific wording of questions. Dr. David Ewers was involved at several points in this process.

B, Alignment with the process for authorisation and guidance, means that survey questions are aligned with the purpose of this study. Approximately 62 per cent of the survey questions correspond to the primary research question in this study, as described in Part 3 of Chapter 3 (3.3): whether the perpetuity conjecture in the incumbent version of the Gordon Formula is tenable and defensible for purposes of estimating companies’ future unknown life spans for DCF valuation purposes. Two questions (about 15 per cent of total) relate to the secondary research question, which is also described in 3.3.

C, No reference to Gordon Formula by name means that there was no reference to “Gordon Formula” or similar phrases (continuous growth model) because of (i.) sometimes incomplete understanding of what the phrase refers to and (ii.) a desire to emphasise the concepts and calculations relating to the Gordon Formula Assuming Perpetuity (GFAP), rather than the method’s name.

D, Mix of bounded and unbounded questions means that there was a deliberate attempt to combine questions in which responses were directed to a set scale (e.g., A1-A8, utilising five point Likert scale) with questions in which there were no boundaries. The thought was that such a mix would help to keep interviewees engaged with the survey and would discourage pattern answers: providing the same numerical answer each time.

E, Five point Likert scale, refers to the basis for interpreting survey questions A1-A8.

An odd number Likert scheme was chosen in order to allow interviewees to provide an ambivalent response if they wish.

F, Repetition, deliberate changes in question polarity, refers to the fact that the expected primary response for some 1-5 scale Likert questions was “1” and in other instances it was “5”; these deliberate changes in question polarity were designed to discourage pattern responses. Key issues of interest to this research, such as the reasonableness and accuracy of valuation calculation when the company’s life span for valuation purposes is assumed to continue forever and ever were asked in few slightly different ways in order to provide confirmation.

Table 5.3.2 relates to a second methodological related issue as noted above, concerning the adequacy of the overall sample size (n = 25) for this survey.

130

Chapter 5 - Results of the Analysis and Relevant Comment

NOTE: The appropriateness of each of these comparables for purposes of assessing overall survey sample size adequacy is provided in Appendix E Part 1 sub-part e, Regarding Adequacy of Sample Size for This Survey.

Table 5.3.2: A Comparison of Survey Sample Sizes, Other Relevant Comparisons

Minimum samples (n) of ten each for Categories A and B and twenty overall was suggested for this survey by those clarifying and delineating the nature of this survey (Refer to Point A in preceding Table 5.3.1). All three minimums were exceeded.

For purposes of assessing the adequacy of the overall sample size, this surveys overall sample exceeded that of six other comparables as indicated in Table 5.3.2, Items C through H. Point B in the Table (“One saturation indication, this study�) refers to the fact that there was a two-week time period in between the time of twenty-third and the twenty-fifth interview.

In studies characterised by both (i.) a homogeneous sample group and (ii.) a nonprobabilistic, or purposive survey design such as this, Guest et al. (2006, 59) suggests 131

Chapter 5 - Results of the Analysis and Relevant Comment that the concept of “saturation” applies. By this, the authors mean that overall sample size adequacy is signalled when the responses from latter interviewees is almost the same as earlier results. Interviewee Number 25’s responses were very close to those of Interviewee Number 23, suggesting that saturation had occurred and that the actual overall sample size of 25 (n) exceeded the minimum required.

The present roles of the twenty-five (25) part- or full-time valuation practitioners participated in this survey are identified in Table 5.3.3:75

REFERENCE A (14) A1703 A1803 A1903.1 A1903.2 A1903.3 A2303 A2703 A3103 A0104 A0604 A1204.1 A1204.2 A1604 A0305 B (11) B1603 B1803 B1903 B3003 B3103 B0104 B0604.1 B0604.2 B0804.1 B0804.2 B1204

DESCRIPTION (Present role) University administrator, finance and accounting lecturer Partner 1 of medium-size Managing for Value (MFV) Consultancy Entrepreneur and lecturer Partner 2 of medium-size Managing for Value (MFV) Consultancy Lecturer and part-time valuation advisor Company start-ups and turnarounds, academicians Prior FTSE100 director, acquisitions and divestment experience Valuation author in academic journals (comments on TV) Energy company acquisition background Project valuation modelling specialist, some company valuation Professor, co-author of a leading finance text, acquisition advisory Corporate financial analyst, manager for leading cosmetics co.

European business manager, part-time company valuation practitioner Prof. of finance at UK university, part-time valuation practitioner Head of consultancy involved in valuation, executive compensation Investment officer at firm applying DCF methods to equity strategy Analyst at third-party valuation boutique serving buy-side clientele Academician, consultant, author in DCF valuation methods Consultant concentrating in company valuation using DCF methods Turnaround expert, Big Four firm accountant Chairman of a leading financial expert testimony organisation Company valuation academic thought leader, consultant to companies Entrepreneur and ongoing company valuation advisor Company valuation pioneer, a founder of leading valuation boutique Director of research, leading independent investment advisory firm

NOTE: These are summary descriptions of current roles of the 25 interviewees participating in the survey. More complete descriptions are contained in Appendix E Part 2 sub-part a (E.2a), Interviewee Profiles.

Table 5.3.3: Current Positions, Roles of the Twenty-Five Interviewee Participants in This Survey

75

Definitions for “valuation practitioner”, “full-time valuation practitioner” and “part-time valuation practitioner” for purposes of this survey are contained in Part 1 of Appendix E.

132

Chapter 5 - Results of the Analysis and Relevant Comment Participants in the survey included: •

the academician referred to in 2.4 as the leading defender of the perpetuity conjecture in papers starting with his joint paper in 1996 (A3103);

•

a leading valuation advocate of variable WACC, a consideration in one definition of finite life spans as described in Part 5 and 6 in Chapter 5 (B0604.2);

•

three former senior officers from Stern Stewart, the largest Managing for Value consultancy (B1603, B1803 and B3103);

•

the co-founder and a present manager of Credit Suisse HOLT, one of today’s leading valuation boutiques serving buy side clientele (B1903 and B0804.2); and

•

authors of some of today’s leading management and academic writings on DCF valuation and related issues (A1204.1, A3103, B1603, B3003, B0604.2, B0804.2 and B1204).

Several of these thought leaders offered their opinion on an unsolicited basis that the subject of this thesis, the perpetuity conjecture within the Gordon Formula, was long overdue for investigation and challenge. Differences in a company’s life span are perceived as a material variable and influence on company value. Rather than companies existing forever, the typical company’s life span was perceived as lasting 9.2 years by interviewees, based on responses to Question B9.

Based on his academic papers from 1996 through 2006, interviewee A3103 is described in several parts of this thesis as the valuation academician who most directly opposes this Researcher’s suggested notion of replacing the perpetuity conjecture with analysisbased projections of Briefer-Than-Infinite (BTI) company life spans. Professor Stephen Penman’s perspectives regarding the perpetuity conjecture are examined separately in 5.7.

Those perspectives have changed since the “truncation error” attacks in the literature directed at suggesting that company life spans are briefer than infinite. In his 2007 book and the conversation with this Researcher in March 2010, an alternative perspective emerges, as noted both in 2.3 and 5.7 in this study. The perpetuity conjecture is now described by A3103, Penman, as a default assumption to be applied only when there is not already a superior basis for developing projections of finite life spans based on analysis of historical information or similar substantive basis.

133

Chapter 5 - Results of the Analysis and Relevant Comment For purposes of this primary research, “valuation practitioner” refers to someone with actual present and/or past experience in applying discounted cash flow (DCF) based analysis in a business situation. Valuation practitioner interviewees are divided into two categories: •

Category A (14 interviewees) is comprised of respondents who describe themselves as spending a portion of their time in past and/or present roles as valuation practitioners. These interviewees’ primary vocations involve other activities. Category A findings relating to survey questions A1 through B9 are summarised in Table 5.3.6.

•

Category B (11 interviewees) is comprised of interviewees who describe themselves as full-time past or present company valuation practitioners.

Category B findings relating to survey questions A1 through B9 are summarised in Table 5.3.7.

This survey’s results support this Researcher’s contention that the time has arrived to restore longevity (t) to its historical role as an acknowledged variable in company valuation; replacing imaginary Never Ending Companies with company-by-company projections based on analysis informed by historical patterns of longevity.

Some holdover support persists for the prevailing perpetuity conjecture: a minority opinion emerged from some the interviewees that there is no significant difference between the words “indefinite” and “infinite” for valuation purposes. But the majority of participants in this survey perceive the words as involving two completely different concepts, and rejected any notion that the difficult-to-project nature of companies’ future life spans means that infinity (the perpetuity conjecture) is an appropriate default duration assumption.

134

Chapter 5 - Results of the Analysis and Relevant Comment 5.3.2

Overview of Survey Questions

Table 5.3.4: Non-Conditional Survey Questions Summarised: Topic, Purpose

The full survey instrument is contained in Appendix E Part 1 sub-part a (E.1a). Table 5.3.4 provides a summary of the topic and purpose of thirteen questions asked in this survey:76 5.3.2.1 (A1) Indefinite v. Infinite The purpose of this survey’s initial question is to assess interviewees’ opinions about the provocative assumption underlying the Williams-Gordon-Shapiro perpetuity conjecture.

The essence of that thinking is that since companies’ future life spans (t) cannot knowingly be specified in advance -- and thus by nature, are indefinite -- it is then

76

Conditional question B12 was answered by one interviewee. That question and related issues are addressed in Appendix E Part 1 sub-part g (E.1g). Regarding designation of conditional v non-conditional questions in the survey design, refer to H in Appendix E Part 1 sub-part c (E.1c).

135

Chapter 5 - Results of the Analysis and Relevant Comment reasonable to assume for valuation purposes those firms’ life spans continue forever, to infinity (Gordon 1962).

Such justification is at the centre of the primary research question in this study (3.3), relating to whether the perpetuity conjecture within the Gordon Formula is plausible, defensible and credible. The two words, indefinite and infinite, have different literal meanings: indefinite means finite but unknown, while infinite means without end.77 This matter surpasses semantics, since those two different words are misinterpreted as equivalent for purposes of apparent calculation simplicity.

5.3.2.2 (A2) Value Differential: Two Year Versus Twenty Year Duration, All Other Things Being Equal This question is designed to assess participants’ perspectives on the possible effect of variations in company longevity (t) on company valuation, which in turn relates to the central purpose of this research.

In the situation presented in Question A2 to interviewees, two different companies are described as exhibiting the exact same value-relevant characteristics, except for a single exception relating to longevity (t). One company survives for only two years before collapsing. The other company remains viable and in business for 20 years. Post-failure residuals are described negligible in both instances.78 If company longevity (t) is considered by the practitioner-interviewee to be a material determinant and variable affecting company value, then the expected response is to agree with the statement that shorter life span company is “worth only a small fraction of an otherwise comparable firm”. If not, a response at the opposite end of the Likert scale is expected (methodology detail relating to the survey is in Part 1 of Appendix E).

5.3.2.3 (A3) Projections Based on Historical (Actual) Company Life Spans as Basis for Estimating Time (Longevity) for DCF Valuation Purposes This question also relates directly to the primary research question (3.3) in this study.

The perpetuity conjecture is a theoretical concept; even the most adamant defenders of

77

As detailed in Chapter 5 Part 8 (5.8), Other Logic and Analysis Elements of the Case Against the Perpetuity Conjecture.

78

As described in Chapter 1, when a company collapses and fails, residuals are typically a minimum onetime distribution at salvage levels, or not even that, if there are outstanding claims against those assets upon failure (5.9). The point that residuals are assumed to be negligible or zero in this question was reinforced by the interviewer (this Researcher) at the time of survey implementation, as explained in Appendix E Part 1 sub-part f (E.1f), (1.) A2 Residual Wording.

136

Chapter 5 - Results of the Analysis and Relevant Comment this element within GFAP tend to acknowledge that in the real business world, companies experience finite-but-unknown life spans (e.g., Penman 2010, 2007).

The issue explored in this survey question is whether future expectations of actual life spans represent the appropriate basis for projecting the t variable in company valuation, or not.

Projections of other three variables in the Gordon Formula (FCF, g and WACC) are customarily developed on a company-by-company basis79 from analysis of past experience, adapted for emergent trends. Thus the question arises to this Researcher, why not the same approach for the Gordon Formula’s fourth, phantom variable, time?

5.3.2.4 (A4) Valuation Methodology: Trade-Off Between Ease of Use and Accuracy In A4, ease-of-use is set at one end of the Likert evaluative spectrum for assessing valuation methods with accuracy at the other extreme, for consideration by the interviewees. This Researcher’s sense was that with regards to financial methodologies in general and the Gordon Formula specifically, there tends to be a trade-off between the robustness of the methodology and apparent simplicity.80 If the hypothesis corresponding to the primary research question in this study is correct and the perpetuity conjecture in GFAP is discredited, one consequence is that valuation t is treated as a variable in future Gordon Formula versions, calculated on the basis of analysis of past data and emergent trends, consistent with existing practice for the other three GF variables. That would result in a four variable GF version (Gordon Formula Serial version, Appendix C): a more complex design than the incumbent GFAP. The context behind the A3 trade-off question is this Researcher’s perspective on the Gordon Formula itself. While that equation might be praised by some, this Researcher’s sense is that it a simplistic and often inaccurate mechanism for estimating TV as a result of: (i.), too few variables to adequately reflect the range of valuation-relevant factors; and (ii.), excepting for WACC, the variables that are included in GFAP are only directly aligned with the determinants of the value of enterprises, as introduced in Chapter 1.

79

And sometimes, with multiple versions developed for each company based on factors such as variations in performance.

80

The dilemma of “apparent simplicity” is described in Chapter 1 as referring to the simplistic (rather than simple) ratio that may require additional modifications to be credible, increasing complexity as a result.

137

Chapter 5 - Results of the Analysis and Relevant Comment 5.3.2.5 (A5) Situation: Inaccurate Value, Perpetuity Conjecture for Valuation t In the situation presented in this question, a company originally valued using the perpetuity conjecture as a surrogate for t is several years later discovered to have failed after only six years in business. Based the information provided to interviewees in the description, it is apparent that the original infinite assumption is far longer than what the valuation would be, had the company’s actual life span been used in the calculation instead.81 A5 represents a check question for A2 since it addresses the extent to which the interviewees believe that variations in companies’ life spans influence company value. A possible complicating consideration in A5 is the issue of reliance on an established methodology. This Researcher’s expectation was that a few interviewees might focus on that aspect in this situational, interpreting methodological incumbency as the issue of importance in A5, rather than effects of changes in life span duration (t) on company value.

5.3.2.6 (A6) Consideration of Industry-Based Groupings as Possible Future Successor Category to the Perpetuity Conjecture If the perpetuity conjecture is discredited in this thesis (primary research issue, 3.3), the question that next arises is nature of the possible successors. In Part 4 of Chapter 2 (2.4), Audretsch’s 1995 analysis shows variations in company failure patterns based on industry type in Table 2.4.6, as do some of the other studies examined in 2.4. Industry categories are also examined as a possible replacement for the perpetuity conjecture in 5.9.

5.3.2.7 (A7) Consideration of Multiples of Product-Service Life Cycles (PLCs) as Possible Future Successor Category to the Perpetuity Conjecture Multiples of PLCs represent the second possible successor category emerging from the beginning of this research investigation. A separate question is asked about the possibility of succeeding the perpetuity conjecture with analysed projections of companies’ possible future life spans informed by product-service historical information and trend data.

81

A similar analysis is conducted in 5.4: Circuit City. Although actual life spans are unknown in advance, methods for developing projections of expected remaining longevity exist, including those described in 5.9.

138

Chapter 5 - Results of the Analysis and Relevant Comment 5.3.2.8 (A8) Continuing Use Assets As An Alternative Indicator of Perpetuity The purpose of this question is to better understand interviewees’ inclinations, if any, to consider the long functional lives of some assets as perpetual. This notion of continuing t arises from time to time. The thought is that assets with recurring uses are sources of continuing value, even after the original owner of the asset has gone out of business.

Residual tend to be minimal at the time of company demise, and any remaining may be subject to claims of creditors, further reducing the asset’s value on a net basis.

5.3.2.9 (B9) Estimate of the Life Span of a Typical Company In 2.4, Literature Review Relating to Company Longevity, this Researcher’s analysis of several academic studies of company survival and failure suggested a median life span for companies overall of approximately seven years from origin. Without that finding being disclosed, interviewees were asked this open-ended question, in part to see if the analysis from 2.4 was confirmed by the valuation practitioners interviewed.

5.3.2.10 (B10) Indications of Company Demise In effect, the question is, how do you know that a company is dead? This relates to the primary research question (3.3), and has two objectives: (i), to see if any interviewees reject the notion of company demise outright, thereby supporting the perpetuity conjecture; and (ii.), to gain further insight into alternative methods for identifying the end of firms’ lives, as addressed in 5.6 and related Appendix K. 5.3.2.11 (B11) Extending Companies’ Life Spans and Viability: Identification of Factors, Other Developments With no possible answers identified in advance, interviewees were asked for their opinions about any developments or factors which they believe might extend “a typical company’s life span as a value-generating enterprise.”

The practitioners’ responses help to inform value management (VM) approaches in a setting in which the focus is on near-term actions over the company’s analysed probable life span. If time is a variable and determinant of value, then actions which extend company longevity would also appear to increase overall company worth.

Many of the valuation practitioners interviewed were already familiar with the Rappaport-Mauboussin-Johnson CAP (1986, 1997) notion of the end of the company’s economic life being indicated by the intersect point between CFROI rate and WACC. Accordingly, for this question, the expectation was that interviewees would mention

139

Chapter 5 - Results of the Analysis and Relevant Comment actions that might reasonably be expected to expand a firm’s CFROI-to-WACC rate differential, or Value Spread.

5.3.2.12 (B13) For Valuation Purposes, Dealing With the Unknown Nature of Companies’ Future Remaining Life Spans This open-ended question also addresses the primary area of emphasis in this survey, the calculation of company worth when one of the value determinants --time-- is presumed to be infinite, but with different phrasing. As the interviewees are asked, in effect, to describe their approaches for calculating company value for the continuous period (Terminal Value Period), this question also helps achieve the survey’s other objective, to examine interviewed practitioners’ methods for determining the company’s life span for valuation purposes.

Does the practitioner simply the Gordon Formula Assuming Perpetuity, or are alternative methods applied the practitioner believes (i.) provides a more accurate and useable valuation result and (ii.) which reflect real world projections of the t variable, instead of the fantastic perpetuity conjecture?

5.3.2.13 (B14) General Valuation Approach (multiple part) Several questions are posed to conclude the interview, with the expected answer in response to the question about prevailing methodology practice (a.) expected to be the Two Stage Discounted Cash Flow (DCF2S).

140

Chapter 5 - Results of the Analysis and Relevant Comment 5.3.3

Analysis of Responses to Survey Quantifiable Questions (A1-B9)

Table 5.3.5 Responses to Survey Quantifiable Questions A1-B9: Overall (Combined Category A and B)

141

Chapter 5 - Results of the Analysis and Relevant Comment

REF A1703 A1803 A1903.1 A1903.2 A1903.3 A2303 A2703 A3103 A0104 A0604 A1204.1 A1204.2 A1604 A0305 range sums n sums/n sums-hl n adj. s2/n2

A1 1 1 2 1 1 5 4.5 5 1 1 5 5 1 1 1to5 34.5 14 2.5 28.5 12 2.4

A2 5 5 4 5 5 5 5 5 5 5 5 5 5 2 2to5 66 14 4.7 59 12 4.9

A3 5 5 3 5 4 5 4 5 5 5 5 1 1 1 1to5 54 14 3.9 48 12 4.0

A4 1 2 4 4 3 5 1 1 1 1 2 2 4 1 1to5 32 14 2.3 26 12 2.2

A5 1 1 4 1 3 5 1 1 4 1 5 5 2.5 2 1to5 36.5 14 2.6 30.5 12 2.5

A6 1 1 3 1 2.5 1 4.5 1 4 1 1 1 1 2 1to4.5 25 14 1.8 19.5 12 1.6

A7 5 2 3 5 3.5 2 4.5 5 5 5 5 5 5 4 2to5 59 14 4.2 52 12 4.3

A8 4 3 4 1 3 1 1 3 5 3 1 4 1 2 1to5 36 14 2.6 30 12 2.5

Table 5.3.6 Responses to Survey Quantifiable Questions A1-B9:Category A (Part-Time Valuation Practitioners)

142

B9 3 12 25 20 1.25 6 8 2.25 10 3.5 10 15 1.25-25 116 12 9.7 89.75 10 9.0

Chapter 5 - Results of the Analysis and Relevant Comment

REF

A1

A2

A3

A4

A5

A6

A7

A8

B9

B1603

5

5

5

1

4.5

1

5

1

17

B1803

1

5

3

3

4

1

5

1

2

B1903

5

1

5

5

3

3

5

3

B3003 B3103

1 5

5 3

5 3

3 4

4 1

3 1

5 5

1 3

1.5 4

B0104

3

5

5

4

5

1

5

1

15

B0604.1

1

5

5

3

1

1

5

3

10

B0604.2

3

5

5

3

3

5

5

1

2

B0804.1

1

5

5

3

4

1

5

1

15

B0804.2 B1204

1 1

3 5

5 5

3 3

1 5

1 5

3 4

1 2

30 2

range

1to5

1to5

3to5

1to5

1to5

1to5

3to5

1to3

1.5-30

sums

27

47

51

35

35.5

23

52

18

98.5

n

11

11

11

11

11

11

11

11

10

sums/n

2.5

4.3

4.6

3.2

3.2

2.1

4.7

1.6

9.9

sums-hl

21

41

43

29

29.5

17

44

14

67

n adj.

9

9

9

9

9

9

9

9

8

s2/n2

2.3

4.6

4.8

3.2

3.3

1.9

4.9

1.6

8.4

Table 5.3.7 Responses to Survey Quantifiable Questions A1-B9: Category B (Full-Time Valuation Practitioners)

5.3.3.1 Introduction and Summary “Quantifiable questions” refers to those qualitative questions in the survey instrument (Appendix E.1a) which were converted into statistical form through application of a five point Likert scale (A1-A8), plus the question in which interviewees were asked for their estimation of the typical company’s life span duration, B9.

Refer to the Notes to Table 5.3.5. “Range” refers to the breadth of responses in Likert scale terms from one to five for Questions A1-A8, and in years for B9. The primary measure in the three Tables (5.3.5, 5.3.6, and 5.3.7) is “s2/n2”: this is the average score adjusted for the deletion of one highest and one lowest response to each question.

Note that the polarity of questions A1-A9 changes, according to whether the normally anticipated response is towards the “5” (total agreement) or “1” (total disagreement) end of the Likert scale.

•

For example, the s2/n2 score of 4.7 for Question A2, a comparison of the relative value of a 2 year firm versus a 20 year firm all other factors being equal indicates almost total agreement with the statement as presented to survey participants. Perfect and complete agreement would be 5.0.

143

Chapter 5 - Results of the Analysis and Relevant Comment •

By contrast, the statement in A6 is expressed in a negative manner, and thus the s2/n2 score of 1.8 suggests near total disagreement with the expression that calculations of company life spans on the basis of industry categories indications do not represent feasible alternatives to the perpetuity conjecture.

Stated another way, the 1.8 s2/n2 score for A6 indicates that interviewees overall are strongly supportive of the notion that someday analyses informed by failure data organised by industry group might someday serve as a replacement to the perpetuity conjecture for purposes of estimating future t for valuation purposes.

5.3.3.2 Analysis of Interviewees’ Responses Overall (From Category A and B interviewees combined)

Statement A1: “Practically speaking, an “indefinite” period of time means exactly the same thing as an “infinite” period of time.”

Range: 1 to 5 (maximum possible range, based on all 23 responses) s2/n2 score: 2.4

At 2.4, this adjusted average s2/n2 score is slightly below the Likert middle point (neutral or ambivalent) of 3.0. Thus interviewees indicate that they are slightly doubtful about the word “indefinite” meaning the same thing as the word “infinite”.

But consider this 2.4 response from a different perspective, and this indication may prove more informative. Implicit in the legacy Gordon Formula Assuming Perpetuity (GFAP) is the presumption that indefinite time means exactly the same thing as infinite time. Regarding A1, such a belief corresponds to a response of “5”. Viewed in that manner, even a single point departure from 5 may reasonably be viewed as potentially significant departures from the incumbent belief.

All of the interviewees were familiar with the Gordon Formula. Thus an overall score that is half the GFAP ideal 5.0 suggests to this Researcher that amongst these valuation

144

Chapter 5 - Results of the Analysis and Relevant Comment practitioners, doubts exist about one of the conceptual foundations of the perpetuity conjecture within GFAP.82 This interpretation is supported by the divergence of interviewees’ responses to the statement as presented. Fourteen interviewees – over half of the total number of interviewees (25)-- responded with a score of “1”, indicating complete disagreement with the notion that “indefinite” means the same thing as “infinity” for valuation purposes. There were eight responses at the other end of the response spectrum, at 4.5 or greater.

Interview categories do not explain this polarisation. The s2 / n2 score for Question A1 for part-time valuation practitioners in Category A, is 2.4 (Table 5.3.3). For Category B full-time valuation practitioners, the corresponding score is 2.3 (Table 5.3.4), almost identical.

Statement A2: “All other things being the same (e.g., annual cash flow generation, investment requirement, cost of capital), a company which manages to survive for two years tends to be worth only a small fraction of an otherwise comparable firm which instead manages to stay in business for, say, 20 years.”

Range: 1 to 5 s2/n2 score: 4.7

A2 is the first of several statements in the survey directed at (i.) probing the interviewee’s concept of time as a variable in calculating company value, whilst (ii.) checking for consistency with responses to A1. If an individual interviewee responded to A1 with a score of “1”, indicating deeply-felt disagreement with the notion that “indefinite” and “infinite” have equivalent meanings, then a score of “5” was expected in responding to the Statement A2.

In the situation described in A2, all of the valuation-relevant variables are deliberately the same for both companies, except for life span. Thus the only reason for any possible value difference is a difference in t.83

82

The philosophical underpinnings to the incumbent version of the Gordon Formula are addressed in Chapter 2 Part 4 sub-part 2 (2.4.2): On Literature Relating to the Concept of Theoretical Company Longevity.

145

Chapter 5 - Results of the Analysis and Relevant Comment Twelve of the fourteen interviewees who responded to Statement A1 with “1” responded to A2 with “5”. Note that a score of “1” indicates total disagreement. This result was expected, based on the reasoning that those who feel strongly that “infinite’ and “indefinite” have different meanings also would be expected to agree strongly (5) with the statement in A2 that a company that endures for just two years tends to be worth only a small fraction of the same firm that lasts for twenty years, all other value-relevant factors being the same.

All but one of the eight interviewees who responded to A1 with a score of 4.5 or more (strong agreement) appear to have perceived the issue differently when expressed in the form of A2. As an example, consider A3103, the valuation professor-practitioner described by this Researcher in Part 4 of Chapter 2 (2.4) as the academician-practitioner who most directly opposes any concept of sub-infinite company life spans: •

As expected, this interviewee responded to A1 with a score of “5”, indicating total agreement. An academician-practitioner who formally in the past dismissed concepts of sub-infinite company lives as “truncation error” (2001,1997,1996), he understandably conceptualises “indefinite” as meaning the same thing as “infinity” in A1.

•

But faced in A2 with the situation of two companies which are identical except for life span, A3103 responds with “5”, suggesting his appreciation for the effect on value caused by differences in variable and finite life spans.

The indicated maximum range of responses (1-5) appears in this instance to be misleading. Delete the single “1” (total disagreement) response, and the resulting adjusted range shrinks to a narrower 3-5. Stated another way, there was little disagreement that the shorter-lived firm is worth a lot less, that is, that variations in company finite life span affect company value.

Statement A3: “A company’s valuation analysis period -- that is, the valuation term for analysing that firm -- should be as near as possible to that firm’s estimated, remaining life span. Stated another way, if the industry is poised to disappear in a dozen years (including most of its participants), it makes no sense to assume for valuation purposes that companies in that industry continue to operate forever.”

83

For Statement A2, this Researcher found it necessary to affirm that post-collapse residual amounts are presumed to negligible in both instances. Refer to Appendix E Part 1, relating to survey methodology.

146

Chapter 5 - Results of the Analysis and Relevant Comment Range: 1 to 5 s2/n2 score: 4.3

This statement strikes at the essence of the perpetuity conjecture within the Gordon Formula Assuming Perpetuity (GFAP): as a theoretical and unreal surrogate for company longevity (t). The interviewee is asked to choose between analysed, actual value (a score of 5) versus the perpetuity conjecture’s fantastic supposition that all companies endure forever (a response or score of 1).

At 4.3, the s2/n2 overall score for A3 is less than one full Likert scale point below the total agreement end of the spectrum (5), suggesting to this Researcher that there is substantial support for reform of GF calling for treatment of time—company longevity-as the fourth Gordon Formula variable to be calculated using company-by-company projections based on analysis of relevant data.

Statement A4: “For purposes of estimating company value based on assumptions about company future performance, ease of calculation is more important than precise accuracy.”

Range: 1 to 5 s2/n2 score: 2.7

Instead of indicating ambivalence, the close-to-middle score of 2.7 instead suggests offsetting, opposing opinions about the importance of convenience versus accuracy as the paramount consideration in DCF company valuation.

Those attacking the primacy of ease-of-use (convenience) with scores of “4” or “5” tended to criticise GFAP as offering false simplicity in their accompanying comments.

Although simpler is better given a choice between equivalents, a concern expressed was that a three-variable ratio lacking specific inputs for investment or marginal ROI may be too basic to adequately reflect dynamics of company valuation.

Some other interviewees directed their response against the accuracy end of the spectrum in A4, arguing that precise accuracy is an unapproachable ideal. As A1204.2 suggested, “It is better to be approximately right rather than precisely wrong.”

147

Chapter 5 - Results of the Analysis and Relevant Comment There are possibly significant difference in responses between Category A part-time practitioners (s2/n2 of 3.2) and responses from Category B full-time interviewees (s2/n2 of 2.2). Some possible explanations are explored in sub-part 5.3.3.3, following.

Statement A5 (following scenario description):“Despite what happened to the company in Year 6, the valuation described (in the situation described in the survey) was accurate. After all, no one could have anticipated at the time that the company would have collapsed and disappeared after only 6 years.”

Range: 1 to 5 s2/n2 score: 2.9

In this situation as described in the survey instrument, a company that is originally valued using the GFAP formula (including the assumption that the firm continues to exist forever) is at a later date discovered to have failed after only six years. The pattern of the individual and overall scores suggests another situation in which opposing responses tend to cancel each other out: •

Nine of 25 interviewees responded to A5 with “1”, indicating their total disagreement with the statement as presented. Such responses are consistent with a belief that the premature collapse of the company in this example suggests that the underlying valuation methodology is flawed. This is not an inference by this Researcher. The phrase ‘the model is broken’ was expressed by several of these nine interviewees.

•

But there were eleven opposing responses of “4” or greater pointing towards the opposite indication: that the early departure of the hypothetical company in this statement does not necessarily indicate a fatally flawed methodology, but rather, a single adverse experience. Several of these respondents commented that it was important to distinguish between company valuation methodological process and the value calculation estimate, or result.

Statement A6:“Developing company life span projections on an industry-by-industry basis based on historical precedent does NOT represent an acceptable alternative to the practice of assuming that companies exist forever, for valuation purposes.”

148

Chapter 5 - Results of the Analysis and Relevant Comment

Range: 1 to 5 s2/n2 score: 1.8

Since this statement is expressed in the negative form, the very low s2/n2 overall score of 1.8 suggests that many interviewees believe that analysed industry life span estimations might some day emerge as a viable alternative to the perpetuity conjecture for purposes of estimating companies’ future life spans for valuation purposes.

There were however multiple responses of “4” or greater. These respondents expressed the belief that industry historical data had too many limitations and shortcomings to be useful for purposes of estimating t.

One interviewee suggested that factors affecting company longevity may change too quickly for historical failure data organised to be useful for purposes of developing future projections of t, mentioning the newspaper industry as an example. Failure rates in that segment have risen significantly since the Internet emerged as a (generally) free competing news provider, with the result that pre-1998 data has little bearing on today’s radically reduced survival prospects in that segment.

Others cited problems with establishing clear and boundaries between industries, especially as successful companies tend to change their business (and thus, their industry) mix over time. One interviewee noted that Nokia started out as a part of a rubber company before diversifying into mobile phone telephony. Interviewee B1204, the head of equity research at a large US independent investment analysis organisation, explained that he has recently discarded all of his firm’s industry groupings and replaced that approach with more general sector classifications because of excessive overlaps in his previous industry-based classification scheme.

Statement A7:“If it is possible to develop credible estimates of company remaining life spans based on underlying product life cycle (PLC) patterns, then that DOES represent a possibly appealing alternative to assuming that companies continue forever for DCF valuation purposes.”

149

Chapter 5 - Results of the Analysis and Relevant Comment Range: 2 to 5 s2/n2 score: 4.5

This statement is similar to A6, except that (i.) a different possible alternative to the perpetuity conjecture is presented and (ii.) the polarity of this statement is the opposite of A6. The high overall s2/n2 response of interviewees (4.5) suggests that many respondents believed that multiples of product-service life cycles might someday emerge as an alternative to the perpetuity conjecture.

One respondent (B0804.1) cautioned that while it may be a relatively straightforward matter to develop product life cycle- (PLC) base life span projections for industrial companies, calculating life cycles for services might be more difficult.84

Statement A8:“Even after a company is liquidated, value continues forever, based on the reasoning that those assets generate continuing worth into the future.”

Range: 1 to 5 s2/n2 score: 2.1

This statement was included in this survey because of one notion that for valuation purposes that the essence of a company continues even after the failure of that firm as many of those assets will be used in the future by others.85 Aircraft engines, machine tools, farm equipment and highway maintenance equipment are amongst the categories of equipment with high re-sale, or secondary market values.86 But high resale values do not necessarily indicate ongoing wealth, particularly if claims of creditors cancel any net realisable value.

84

Supporting this caution is the fact that all of the PLC illustrative analyses in 5.9 involve products, rather than services.

85

This is also addressed in Chapter 5 Part 8, Other Logic and Analytical Elements of the Case Against the Perpetuity Conjecture.

86

This Researcher’s Master’s dissertation was on residual value patterns of certain asset classes. He was also a co-founder and officer of an early financial guarantee company covering exposures of that type.

150

Chapter 5 - Results of the Analysis and Relevant Comment The low s2/n2 score indicates ‘some disagreement’ with the statement as expressed. A majority of respondents perceive the point of liquidation as also representing the end point of a company’s period of economic life span. Most liquidations involve a single final cash inflow, with little or no cash generated after that disposal date.87 An accountant in the survey sample noted that assets at the point of collapse are almost always encumbered with liabilities and multiple claims, which often offset or even exceed any possible future asset worth.

There are possibly significant difference in responses between Category A part-time practitioners and Category B full-time responses. Some possible explanations are explored in sub-part 5.11.3.3, following.

Question B9: “In terms of a specific number of year or years, how long from its time of its origin do you believe that the typical company remains in business? Please provide a specific number reflecting your best guess.”

The s2/n2 average response for Category A and Category B interviewees overall is 9.2 years (three abstentions). That is about three years shorter than de Geus’ 12.5 year estimate (2002, 2) and about two years longer than companies median life span based on the survey information in 2.4.

5.3.3.3 Analysis of Differences in Quantitative Responses Between Category A and Category B Interviewees For purposes of this analysis, a material difference in responses is deemed to exist between the two interviewee categories when the adjusted average in Table 5.3.2 (s2/n2) indicates a difference of nine-tenths of a Likert scale point (0.9) or greater. On that basis, there are indications that material differences between the two interview groups arise regarding A4 and A8:

A4: “For purposes of estimating company value based on assumptions about company future performance, ease of calculation is more important than precise accuracy.”

87

Clark, P. (1989). “Maximum Value Divestment Strategy.” Ch. 4 in Rock, M. and Rock, R. eds. Corporate Restructuring: A Guide to Creating the Premium Value Company. New York, McGraw-Hill.

151

Chapter 5 - Results of the Analysis and Relevant Comment Category A interviewees’ s2/n2: 2.2 Category B interviewees’ s2/n2: 3.2 Difference: 1.0

Category A part-time valuation practitioners were somewhat more inclined to oppose the notion of simplicity as the paramount consideration in company valuation methodology design and approach (2.2 point Likert score, s2/n2 basis) as contrasted with Category B full-time valuation practitioners, with a score of 3.2.

An examination of specific responses within Interviewee Category A (Table 5.3.3) indicates that six respondents, or almost half of the total of 14, responded to A4 with “1”, indicating total disagreement with the statement as presented. Only one interviewee from Category B responded in that manner.

An examination of the specific additional comments made by the six Category A interviewees responding to A4 with a score of “1”, indicating a strong their belief that valuation accuracy should be the paramount valuation methodology concern. These respondents’ understanding of the word “accuracy” appears to correspond closely with this Researcher’s sense of that word, and as applied elsewhere in Chapter 5 of this study: correlation of that advance estimate with verifiable worth reflected in the reasonably projected operating and financial performance of the company in the periods ahead.

By contrast, only one of the eleven Category B interviewees responded with an answer of “1” to A4. Several full-time practitioners describe the notion of precise accuracy in valuation as a dubious or possibly even dangerous. For Category B interviewees, the near middle-of-range s2/n2 score (3.2) suggests to this Researcher that neither consideration identified in the question is viewed as being of paramount importance.

A8: “Even after a company is liquidated, value continues forever, based on the reasoning that those assets generate continuing worth into the future.”

Category A interviewees’ s2/n2: 2.5 Category B interviewees’ s2/n2: 1.6 Difference: 0.9

152

Chapter 5 - Results of the Analysis and Relevant Comment In this instance, Category B’s response suggests that far more full-time valuation practitioners viewed liquidated assets as generating any significant worth after that single salvage asset sale point-in-time. Seven of the eleven Category B interviewees responded to this statement with “1”, and there was no score higher than the middle-ofrange score of three.

Several Category B interviewees mentioned offsetting liabilities which would reduce net proceeds from any liquidation of assets. By contrast, Category A interviewees were more inclined to view assets per se as a source of ongoing value, even after the company fails. Four out of these fourteen part-time valuation practitioners responded with scores of “4” or greater, indicating their agreement with the statement as expressed.

5.3.4

Analysis of Responses to Survey Qualitative Questions88

5.3.4.1 Category and Overall Summary of Responses to B10, Relating to NonViability Event

B10: “What event or development best indicates the point in time when a company is “no longer in business” for valuation purposes, in your opinion?”

This question indirectly addresses the issue of limited company longevity in the real business world versus a theoretical notion of infinite company longevity that exists only in GFAP. Note the inclusion of the words “for valuation purposes” in the phrasing of this question.

If a valuation practitioner believes that infinite company life spans prevail, then the expected response to B10 is that there is no end point at all, that the company operates forever. No interviewee responded in that manner in this survey.

A Summary of Category A Interviewees’ Responses to Question B10 The most frequent response to from Category A interviewees was bankruptcy or a comparable statutory filing or event, such as a formal declaration of administration. A

88 Related Appendix: E, Part 2, sub-part b (E.2b) Individual Interviewees’ Responses to Qualitative Questions: B10, B11 and B13.

153

Chapter 5 - Results of the Analysis and Relevant Comment few respondents cited indicators that normally precede declarations of bankruptcy, such as loss of access to bank financing and lines of credit.

A Summary of Category B Interviewees’ Responses to Question B10 The most frequent response from Category B interviewees involved economic viability based on the Competitive Advantage Period (CAP) framework, although CAP was not always mentioned by name. Some of the other responses from Category B interviewees were similar to those from Category A, including bankruptcy, abrupt deterioration in credit worthiness or non-renewal of bank lines of credit.

Reconciling Category A and Category B Responses to Question B10 Part-time valuation practitioners (Category A) tended to answer this question in terms of a statutory event that signals imminent demise for most firms, such as the filing of a non-voluntary bankruptcy petition or a liquidation order. Category B full-time practitioners emphasised the end of firm’s period economic viability: when CFROI rate no longer exceeds WACC. A secondary response from both groups was denial of access to bank financing.

5.3.4.2 Overall Responses to B11, Relating to Extension of Period of Economic Viability

B11: “What factors, considerations or developments, if any, do you believe to be most important for extending a typical company’s life span as a value-generating enterprise?”

This question arises for two reasons. First, because questions of economic viability— a possible indicator for the end of a company’s valuation life span (Refer to B10, above and Appendix K) logically leads to the related issue of how best to extend the point in time when the a company’s CFROI rate intersects with WACC. Second, a suggestion was made that the act of being acquired tended may extend the life span of the acquiree (the acquired firm). This Researcher was curious to find out how many interviewees might respond with such an answer on an unsolicited basis.89 A Summary of Category A and B Interviewees’ Responses to Question B11

89

Related Appendix E: Part 1 sub-part g. (E.1g) Relating to Subject of Conditional Question B12.

154

Chapter 5 - Results of the Analysis and Relevant Comment The dominant response was that companies’ economic life spans are extended through internal development of new sources of competitive advantage, e.g., line extensions, new markets for existing products and re-positioning.

5.3.4.3 Regarding Conditional Question B12 Relating to Being Acquired As Means for Extending Company Life Span

B12: “Do you believe that acquisitions per se extend the “active life span” of the companies that are acquired, consolidated or absorbed by another firm?”

As explained in Appendix E Part 1 survey methodology detail and also sub-part g (E.1g) within that part, this question was asked only if the interviewee has previously responded to B11 with a response ‘being acquired’ or comparable.

One interviewee, part-time practitioner A1903.1, suggested that being acquired may extend the acquiree’s economic life span. Interviewee A1903.2 expressed the opposite opinion: that being acquired accelerate the acquiree’s demise. No other interviewees specifically addressed this issue.

5.3.4.4 Overall Responses to B13, Relating to Development of Company Valuation Life Span Projections or Assumptions, Without Prior Precedent (‘Greenfield’)

B13: “No one knows for certain how long into the future a company will survive. How do you deal with that unknown, for company value estimation purposes?”

This is another question designed to investigate the interviewee’s opinion about company valuation longevity. While the objective of this question is similar in some ways to Statements A1, A2 and A3, there is a difference: this question is asked about company valuation longevity in a ‘greenfield’ manner, that is, with no incumbent approach or alternative already identified.

A question of this type can be instructive as it helps identify how the practitionerinterviewees deal with the problem of valuation time span (t) in day-to-day circumstances. Rather than asking survey participants to ponder a theoretical concept or to respond to a hypothetical situation, they were instead asked about how they deal with the perpetuity conjecture dilemma in their every day valuation practice.

155

Chapter 5 - Results of the Analysis and Relevant Comment Responses from interviewees overall tended to be split between three different alternatives, referred to here as (i.) industry or other comparable, (ii.) EPP plus two stages, and (iii.) multiple scenario improvisation.

•

Industry or other comparable: In this approach, the valuator considers the longevity patterns of similar industries, specific companies or, if neither is available, individual products to suggest an appropriate valuation life span for the company being evaluated.

•

Explicit Projection Period (EPP) plus two periods: As described in 2.3, the Explicit Projection Period refers to the fist stage in the Two Stage Discounted Cash Flow methodology (DCF2G). EPP generally refers to forecasts based on budget-caliber detail information extended a few years forward. Several interviewees described starting with an initial EPP followed by one or two subsequent periods of slightly less reliable data.90

•

Improvisation, multiple scenarios:

Some other interviewees deliberately

avoided a single approach. Instead, they described how they created multiple alternative approaches and then developing a combined approach by assigning probability or risk weights.

Perpetuity may be one of those term assumptions in the improvisation approach.

Amongst the twenty-three interviewees, only one interviewee responded with “perpetuity”. Not surprisingly, this interviewee is A3103, the same academician who is described in Part 3 of Chapter 2 as the originator of the phrase “truncation error”.

But in this interview, Penman added the additional comment “if nothing better exists” and acknowledged that perpetuity is best applied as a back-up or default assumption regarding life span, if other bases for estimating finite life span based on past substantive information are not feasible.

5.3.4.5 Responses to B14—Concluding Observations

B14: (14a) Which present method (or methods) do you believe to be the most useful, and why?

(14b) What are limitations or deficiencies with that valuation method(s) which you would like to see resolved?

90

Related Appendix: F, Relating to Explicit Projection Period (EPP)-Based Methods

156

Chapter 5 - Results of the Analysis and Relevant Comment (14c) What are limitations or deficiencies with other, possibly competing valuation methods that you would like to see resolved, in order to be considered for use by you?

Regarding 14a: Prevailing Method All but one of the interviewees referred to some form of DCF valuation method. In his writings, the one interviewee who primarily comes from an accrual accounting company background (A3103) stated that DCF is equivalent in valuation result to Dividend Discount Method (DDM), when both are correctly calculated.

Regarding 14b: Limitations to prevailing (DCF) methods Some interviewees complained about poor quality and/or inconsistent data used in many company valuations, especially in the cash flow projection portion. Other interviewees complained that most valuation analyses did not account for the risk or variability of projections adequately.

Two interviewees (A3103 and B0604.2) with recent academic writings on the topic mentioned discrepancies in how cost of capital is calculated for valuation purposes in customary DCF Two Stage methods (DCF2S). They described their bespoke approaches to cost of capital estimation. Two interviewees complained about misuse of selfdescribed value ‘drivers’ which sometimes have little to do with value creation.

5.4

Two Analyses of Statistical Errors Attributable to the Perpetuity Conjecture

Sub-parts: 5.4.1 Chapter Part Summary 5.4.2 Towards an Alternative Non-Market Value (MV) Measure of Valuation Accuracy 5.4.3 Perpetuity’s Exaggeration of Errors in the Other Three GFAP Variables 5.4.4 Circuit City: Finite Life Span Company Erroneously Valued as Perpetual Firm

5.4.1

Chapter Part Summary

157

Chapter 5 - Results of the Analysis and Relevant Comment The perpetuity conjecture error is comprised of two separate but related elements: (i.), miscalculation of company longevity (t) as infinite rather than finite-but-unknown, which is different; and (ii.), imposition of a one-duration-fits-all-companies constant.

Some of the consequences of this two-part original design error by Williams, Gordon and Shapiro error are examined below.91 Sub-part 5.4.3 examines the perpetuity conjecture’s effect in exaggerating errors in one or more of the three acknowledged Gordon Formula variables: Initial Period Annualised Free Cash Flow (FCF), future assumed FCF growth rate (g) and cost of capital (WACC).

Sub-part 5.4.4 relates the issue of errors attributable to the perpetuity conjecture to a specific company, Circuit City, which failed in the closing months of 2008. If one was to value the company in 2001-2 as enduring forever (perpetuity conjecture) instead of failing after seven more years (actual life span), the resulting calculation error is measurable and significant.

5.4.2

Towards an Alternative, Non-Market Value (MV) Measure of Valuation Accuracy

In the valuation academic literature, the phrase “valuation accuracy” is generally perceived as referring to comparisons of the candidate approach and its result with external market-based measures of worth (MV) reflecting in the Semi-Strong concept of Market Efficiency (SSME).92 On that criterion, the most accurate valuation method is the one which is most closely aligned with analysed MV. The high correlation of DCF-based value calculations to comparable market value in the studies by Copeland et al. (1994, Figure 2.3.3) and Kaplan and Ruback (1995) helped to established DCF in the academic literature mainstream, as described in 2.3.

But some concerns arise, even before the issues about rational market and SSME as expressed by Jensen (2005), Fox (2009) and others.93

91

The conceptual background to the three GF developer’s consideration of time as a variable-determinant in company value is described in 2.4.2, On Literature Relating to the Concept of Theoretical Company Longevity for Company Valuation Purposes, in Part 4 of Chapter 2 (2.4).

92 Malkiel

2003; Mills and Dahlhoff 2003; Campbell, Lo and MacKinlay 1997; Mills 1998.

93 Others

expressing concerns about possible company valuation inaccuracies caused in part by overreliance on principles of market rationality and efficiency include Smithers 2009 and Di Justo 2008.

158

Chapter 5 - Results of the Analysis and Relevant Comment Reliance on share price-based MV as sole basis for assessing valuation accuracy contributed to valuation miscues such as the Lastminute.com IPO pricing in March 2000 and Ocado’s embarrassing retreat from IPO target pricing in July 2010:94 •

Assume that a robust share price (or an optimistic share price projection) prevails over all other considerations, and then factor in external-internal equivalence and SSME, and one might imagine that the financial market already anticipated the future FCF levels consistent with those share price indications.

•

But what if the company (1) has never been profitable prior to its IPO, (2) is attempting to deploy a business model that has failed for others in the past (3) is a minor player in its field with a small and highly vulnerable market share and (4) may never be more than minimally profitable in the future?

The result can be a discrepancy between market-indicted and operations-informed indications of company value.95 While external and internal values ultimately must converge, this Researcher’s sense is that it is the MV that eventually becomes reconciled to operations and financial reality, rather than the other way around. Accordingly, the question arises, Why not start with the operations-based indication, instead?

Lastminute.com’s IPO was the last initial financing of the Net Bubble era and as such exhibited the exaggerated share premium that one comes to expect of an exhaustion market peak (Clark 1991). But as a marginal, unprofitable participant in the overall travel sector with little appeal beyond its Net credentials, its initial indicated MV pricing was distorted. Lastminute.com’s share price almost halved six weeks later when the Net Bubble popped and MV became reconciled to the firm’s sombre operational and financial realities . 96 Ocado’s IPO pricing misadventures paralleled the Lastminute.com in many ways, except for the timing in the cycle.

Why not start with the operations-based indication, instead?

A different approach to assessing the accuracy of a valuation calculation is operationscentric in nature: comparing the analysed formula’s calculated worth to conservative

94

“Ocado Floats—Just—At Hefty Discount.” Management Today, Accessed 21st July 2010 http://www.managementtoday.co.uk/newsalerts/dailynews/ocado.

95

As also exhibited in Time is Value v1 (June 2009), Chapter 8 Value Risk Quotient (VRQ) analyses of Vodafone, Reuters and Tesco.

96

This Researcher examined Lehman Brothers’ IPO pricing of Lastminute.com in March 2000 at the request of the Financial Times’ editor Peter Wright. Lehman’s mis-valuation was significantly influenced

by MVs at the time which were out of step with that firm’s operating prospects. (Clark 2000)

159

Chapter 5 - Results of the Analysis and Relevant Comment calculations of value based on defensible forward projections of the firm’s and operating performance and financial cost.

Had Lehman’s pricing of the Lastminute.com’s IPO been based on forward prospective operations rather than peak-of-the-Bubble share prices, the pricing would been approximately half the mid-March offering level.

5.4.3

Perpetuity’s Exaggeration of Errors in the Other Three GFAP Variables

Figure 1.1.1 in Chapter 1 (Introduction) shows the variables comprising GFAP in detail.

That ratio is also shown below:

pvTV =

FCF (t+1) WACC- g

Mauboussin (2007), Mills (2005), Penman (2001) and Finnegan (1999) all note the potential for an infinite time horizon to exaggerate errors in the other three GF variables.

Figure 5.4.1 (Mauboussin 2007) depicts an implausible near-vertical function for g, the FCF growth rate, under conditions of the perpetuity conjecture:97

97

Figure 5.4.1 also appears in Chapter 1 as Figure 1.1.2, Perpetuity’s Exaggeration of Continuing or Terminal Value (Mauboussin 2007).

160

Chapter 5 - Results of the Analysis and Relevant Comment

Related: Figure 1.1.2

Figure 5.4.1: Perpetuity’s Exaggeration of Continuing or Terminal Value (Mauboussin 2007)

5.4.3.1 An Expanded Statistical Analysis of Finite v Infinite Valuation To examine possible distortions attributable to the perpetuity conjecture beyond the illustrative example provided in the introductory chapter (Appendix H), nine statistical analyses were conducted involving three different finite life spans (5, 7 and 15 years) with three difference future performance scenarios for each time span: minimalist, moderate and optimistic.98 Calculations are contained in Appendix O. Table 5.4.1 summarises those nine results, with operations-informed value expressed as a percentage of the related Gordon Formula estimation including the perpetuity conjecture.

98

The seven year scenario (Serial 7A, 7B and 7C in Appendix O) was selected on the basis of the analysis in 2.4 indicating median life span for companies overall of approximately seven years from origin.

161

Chapter 5 - Results of the Analysis and Relevant Comment

Note: Percentages from Appendix O rounded to nearest integer.

Table 5.4.1: Summary of Appendix O Results: 5, 7, 15 Year Finite Valuation Versus Perpetuity

To illustrate, the analysed cumulative NPV of Cash Flows including end-of-life liquidation for Serial 5A scenario (Five Year Company Life Span, Minimalist Performance Assumption Set) is £397,100. That amount is 44% of the GFAP calculation corresponding to that performance, £900,000.

Stated another way and as applied to Serial 5A, if the company’s indicated performance is extended to infinity rather than only to the end of that firm’s five year realistically estimated life span, then the error attributable to the perpetuity conjecture is one minus the percentage shown for 5A in Table 5.4.1, or 56%.

The higher the percentage in Table 5.4.1, the closer that the finite term life span comes to approaching GFAP estimates. Conversely the lower the percentage, the greater the indicated error attributable to use of the perpetuity conjecture.

5.4.3.2 Findings, Implications A finding emerging from Appendix O is that the greater the future projected level of performance, the higher the potential degree of error attributable to the perpetuity conjecture. At 5, 7 or 15 years from origin, Table 5.4.1 indicates lower percentages corresponding to Assumption Set C, Optimistic, compared with Set A, Minimalist.

162

Chapter 5 - Results of the Analysis and Relevant Comment A second finding is that the longer the actual finite life span of the company, the closer that valuation to the GFAP estimation. But assuming shrinking product life cycles (PLCs, Figure 5.9.2) must ultimately result in shrinking company life spans, this type of error should increase in future years, rather than decline.

5.4.4

Circuit City: Finite Life Span Company Erroneously Valued as Perpetual Firm

The perpetuity conjecture error issue is not a theoretical issue; miscalculations of actual companies may arise because of the perpetuity conjecture within GFAP. Table 5.4.2 shows a similar finite-to-perpetual percentage to that in Appendix O, except, that a specific company is involved. Circuit City Stores, Inc. (CC) was liquidated in November-December 2008.

In this example, the error attributable to the perpetuity conjecture is 59 per cent: one minus the value based on defensible FCF projections ($1.717 Bn) divided by the GFAP value ($4.138 Bn).

Expressed another way as shown in Table 5.4.2, the GFAP worth 2.41 times greater than the FCF-based serial projected value.

Circuit City had long trailed behind US market leader in consumer electronics retailing, Best Buy, in terms of key operating performance measures such as unit sales per square foot, gross margins and profits per square foot. In CC’s final Morningstar Research Report (Lemos, 18th Feb. 2009), Circuit City’s Price-to-Earnings (P/E) multiple was reported as negative, as compared to 16.4 times P/E for Best Buy.99

99

P/E is calculated on trailing basis. Best Buy (Contention phase) and Circuit City (Participation phase) represent one of the sixteen Industry Pairs analysed in 5.6 and related Appendices L and M.

163

Chapter 5 - Results of the Analysis and Relevant Comment

Related: Appendix M

Table 5.4.2: Circuit City 2001 Model Valuation: Perpetual Life Span Assumption v Finite Life

By the beginning of 2002—Year 1 in the valuation analysis shown in Table 5.4.2-- CC’s long-term viability was already being questioned by financial analysts.

US government restrictions on sales of highly profitable warranty contracts, and a slowdown in rate of launches of new consumer product (except by Apple, which markets through its proprietary channels) diminished future prospects for the consumer

164

Chapter 5 - Results of the Analysis and Relevant Comment electronics segment overall. Weaker competitors in the segment such as Circuit City were especially disadvantaged by these developments.

By the beginning of 2002 it was reasonable to expect that CC might not remain a going concern for much longer. The firm continually embarked on initiatives aimed at narrowing its competitive gap with Best Buy, without success. The Internet was making increasing inroads into its higher margin niches, drawing revenues and profits from CC.

5.5

Limitations of the Insignificance Exception

Sub-parts 5.5.1 Overview and Summary 5.5.2 Neale and McElroy’s Observations About the Nature of Projected Cash Flow Projections in Company Valuation 5.5.3 IE Circumstance 1: Mature, Minimal CF Business Enduring Forever 5.5.4 IE Circumstance 2: Hovering: CFROI Approaches But Never Breaches WACC

5.5.1

Overview and Summary

“Insignificance Exception” (IE) is this Researcher’s phrase for two projected Cash Flow-related circumstances, both of which support the perpetuity conjecture. In the two circumstances articulated by the Neale and McElroy (2004), either (i.) the company’s future projected CFs are presumed to be so miniscule as to be immaterial in company value terms and/or (ii.) ongoing cash flow returns on investment (CFROI) are almost the same as WACC: the time value of money effectively neutralises any value effect.

While either circumstance is theoretically possible, numerous reasons suggest that these are conceptual exceptions, rarely if ever occur in actual business. Considerations include: •

These exceptions arise only when two of the three GFAP variables, FCF and g, are both assumed to minimal over future periods. As illustrated in 5.4, even moderate levels of FCF or modest growth (g) may mean significant future CFs.

165

Chapter 5 - Results of the Analysis and Relevant Comment Under those circumstances, differences in a company’s life span mean differences in value, contradicting the Insignificance Exception.

•

The persistence of the problem of overly optimistic Terminal Value (TV) estimates suggest that at least some CF projections are excessive, rather than the minimal levels required for IE to be in effect.

Neale and McElroy’s IE ideal perspective is a firm that theoretically remains in business forever in competitive markets despite feeble internal Cash Flow generation.

The notion defies business common sense and observable reality. Far from being supercompanies capable of existing forever, the IE model firm is approaching its deathbed if not already there. Rivals are motivated to the declining company out of business and steal their customers. Examples of such victimised companies include Braniff Airways, Palm, Circuit City, VerticalNet and Bear Stearns.100

5.5.2

Neale and McElroy’s Observations About the Nature of Projected Cash Flow Projections in Company Valuation

Neale and McElroy recognise that the perpetuity conjecture could be jeopardised if projected Cash Flow amounts in future periods are material and significant, as that mean that differences in duration (t) would result in differences in company value, all other things being equal.

In Figure 5.5.1, scenarios (B) and (C) are two examples of companies exhibiting material projected CF amounts:

100

This competitive dynamic, including the role of dominant competitors in helping to accelerate declining firm’s failure, is described in the Industry Pairs in 5.6 and related Appendix M. Some indicators of viability pertaining to acquired are described in Appendix E.1g.

166

Chapter 5 - Results of the Analysis and Relevant Comment

Figure 5.5.1: Three Alternative Perspectives on Company Future Cash Flows, CFROI

So long as CFs are minimal and/or CFs are almost offset by cost of capital discounting, the use of the Gordon Formula Assuming Perpetuity results in accurate valuations despite the counterintuitive perpetuity conjecture.

By presuming that every company experiences the exact same life span, infinite, time is effectively eliminated as a variable. When period DCFs are miniscule, it makes no difference calculation-wise whether the company’s true life span is twenty years or thirty: the calculated value amounts to about the same in both instances.

As Neale and McElroy explain, referring to the nature of companies’ projections of prospective Cash Flows from operations: Many series are effectively perpetuities if they involve high(-ish) discount rates and long(-ish) periods. For example, the PV of a payment of £1,000 in 20 years at 20% is only (£1,000 x 0.026) = £26, so any subsequent payments would add little to the total. Errors introduced by this sort of simplification are unlikely to impose serious distortions (2004, 114).

167

Chapter 5 - Results of the Analysis and Relevant Comment Neale and McElroy’s basic argument is supported further by the time value of money.

Especially during inflationary periods, the discounting rate may be an additional factor in decreasing the calculated net value of future CFs. Two circumstances are suggested by Neale and McElroy’s articulation of the Insignificance Exception.

Circumstance 1 involves the reasonableness of a presumption that the discounted value of future projected Cash Flows are negligible.

•

CFs are presumed to be minimal, consistent with the fading performance of the maturing company, where performance has reverted towards mean as in Scenario (A) in Figure 5.6.1 above, and the beginning of Madden’s Mature stage in Figure 2.3.5 in Chapter 2 Part 3 (2.3).

•

Reduce the already minimal CFs further by applying the cost of capital (WACC) factor, and the NPV of those period Cash Flows becomes negligible, if they weren’t already.

Circumstance 2 involves the circumstance of the Cash Flow Return on Investment rate being almost but not quite as low as a fixed and unchanging company cost of capital (WACC) rate: •

This circumstance also relates to Scenario (A) in Figure 5.5.1 The company’s future projected CFROI rate appears to hover slightly above the analysed constant WACC rate, but never intersecting.

•

Assuming that the two rates (WACC and CFROI) are almost identical, the consequence is to cancel almost all differential value effect. An important caveat is that CFROI rate must never actually intersect WACC, since that would suggest an end to the firm’s life span under Competitive Advantage Period (CAP) framework criterion.

5.5.3

IE Circumstance 1: Mature, Minimal CF Business Enduring Forever

The two sub-parts that follow consider each of the two IE circumstances above (No. 1 and No. 2) with a view towards developing a sense of whether or not substantial evidence supports the occurrence of that circumstance in the actual business world.

Table 5.5.1 presents three arguments which contradict Circumstance 1:

168

Chapter 5 - Results of the Analysis and Relevant Comment

Table 5.5.1: Three Arguments/Analyses Contradicting IE Circumstance 1 (Minimal CFs to Perpetuity)

5.5.3.1 A. Motivations and Indications: Significant Future Period Projected CFs While ‘long tail’ CFROI fade functions of the type shown in Madden (2005, 7) and Figure 5.5.1 in this study arise in the valuation literature, doubts arise regarding the extent to which such curve functions reflect commercial reality.

Company management do not knowingly permit a sloping decline of the type shown in the Figure to occur; instead, they act to diversify or disinvest or take other actions to slow the decline of deterioration in their core business as indicated by their CFROI rate.

In responding to Question A6 in the survey (5.3) several valuation practitioners companies continually attempt to diversify when faced with product lines plagued by declining sales appeal. If the entire business is slumping, a divestment may loom.101 Contrary to the Neale-McElroy perspective of minimal CFs in future periods, commercial motivations contribute to robust CF projections in order to support high acquisition bid prices or high IPO indications. As Damodaran (2002, 1) observes, “In many valuations, the price gets set first and the valuations follow.”

101 Diversification examples include: (i.), Apple entering the mp3 players and then smartphones as demand for desktops and laptops flattened; and (ii.), FedEx becomes a dominant force in ground express delivery after the most profitable part of its overnight delivery service business became challenged by email.

169

Chapter 5 - Results of the Analysis and Relevant Comment With few if any acquisition financial justification post-audits, conscious overbids (and the high future CF assumptions supporting those bids) persist, despite the consistent pattern of value-destruction in acquisitions overall (Bruner 2002, Clark 1991, Coley and Reinton 1988).

5.5.3.2 B. The Implausible Mature Company That Exists Forever The Neale-McElroy perspective of company CFs declining to an minimal levels in maturity, only to abruptly cease that decline and stabilise at survival performance levels forever is contested by those who envision companies as living- and dyingenterprises.102 Harrigan (1988) describes firms’ relentless progression towards decline and inevitably, death. Sensing a failing business, key talent departs. Lenders pull their lines of credits.

Suppliers withhold trade credit and insist on cash payment before delivery. These changes occur at the absolute worst time for the company decline; these actions alone may be sufficient to start the irreversible momentum towards failure.

Wasson’s (1974) similar perspective about the often irreversible nature of the maturing company’s CF decline to eventual failure (and thus, a Briefer-Than-Infinite life span) is depicted in the three columns in Figure 5.5.2 that are identified with (W):

102 “Continuing forever” here means CFROI > WACC, since if CFROI rate intersects with WACC, that firm’s period of economic viability under Competitive Advantage Period (CAP, Mauboussin and Johnson 1997) interpretations is over, suggesting a sub-infinite life span, contrary to the perpetuity conjecture and its Insignificance Exception as described in this Chapter Part.

170

Chapter 5 - Results of the Analysis and Relevant Comment

Table 5.5.2: Wasson’s (1974) Perspectives on Continuing Deterioration Past Maturity Stage

Wasson’s three Issue Periods (second column in the Table) corresponding to a company in maturity are Competitive Turbulence, Saturation and Decline. If Wasson agreed with Neale and McElroy’s perspective of stability continuing forever, then Wasson’s terminal phase, Decline, would closely resemble Corporate Turbulence.

But that is not the case. Wasson describes the Decline phase as a race to commercial oblivion. Remaining accounts and revenues decline precipitously. Opportunistic rivals redouble their efforts to lure away market share from the crippled company now widely suspected to be staggering towards its death. Radical de-costing and disinvestment might delay the day of reckoning for a short while, but such steps are too likely little too little, too late to prevent failure.

5.5.3.3 C. Multiple Specific Exceptions to Industry Mean Reversion

Some firms such as Kellogg, Nestle, Hewlett-Packard and Boeing have

171

Chapter 5 - Results of the Analysis and Relevant Comment consistently earned higher returns than their immediate competitors.

- Waring 1996, 1253.

The phrase “Reversion to LT Industry Returns” appears in Scenario (A) of Figure 5.5.1, referring to the concept of performance mean reversion perspective as described in Mauboussin (2007), Ho and Sears (2006), Wiggins and Ruefli (2002), Ferson and Harvey (1991) and others.

As the phrase is used here, “mean reversion” is the hypothesis that within large aggregations of companies analysed over extended time periods, individual company performance tends to revert towards long-term historical means. On that basis, exceptional performance such as described above by Waring is viewed as a temporary phenomenon. Today’s top performing company becomes tomorrow’s laggard.

Mean reversion is broadly consistent with IE in the sense that the concept is consistent with reductions in performance over time, which in turn supports Neale and McElroy’s minimal DCFs in future periods.

Some mean reversion analyses are vulnerable in their data collection, interpretation, or both. Moreover, the aggregate performance perspective of such analyses is inconsistent with the valuation practitioner’s relevant scale: valuation of the individual company.

Aggregate analysis sometimes provides a useful reference point, assuming that both analysis time span and sample are relevant to the valuation of the specific company being assessed. But without careful scrutiny to ensure that both n and t are suitable, relevant performance indications may be diluted by extraneous and/or excess data.103 Waring (1996) describes multiple instances of companies that exceed their industries mean performance over extended time, contradicting the mean reversion notion and thus contradicting the Neale-McElroy IE notion of minimalist continuing performance. In 2007, Devan et al. describe that a material minority of 9.2 per cent of the 1,077 firms

103

Some mean reversion analyses are vulnerable to distortion caused by either (i.) inappropriately large and/or unrelated samples, and/or (ii.) overly extended time periods. Stockbrokers dealing with poor performance in recent years have long known the statistical trick of expanding the analysed scope by enough (i.) additional time and/or (ii.) additional companies to dilute the actual poor performance over the relevant past. (Strange 2007). Devan, Klusas and Ruefli (2007) obscure minority but material (9.2%) indications of persistent outperformance on the basis of profitability, their closest indicator to CF, by imposing a second non-relevant adjustment: revenue growth. The persistent 9.2% outperformance conflicts with the analysts’ theme, so the extra, non-relevant adjustment helps to reduce redefined outperformance to less than one per cent of the sample. Ruefli, one of the co-authors of that paper, is also co-author (with Wiggins) of a 2002 depending the mean performance reversion hypothesis.

172

Chapter 5 - Results of the Analysis and Relevant Comment analysed in a McKinsey & Co. investigation over ten years (1994-2004) consistently exceeded that sample group’s mean performance on the basis of their profit basis.

5.5.4

IE Circumstance 2: Hovering: CFROI Approaches But Never Breaches WACC

Table 5.5.3 identifies three categories of contradictions to the second IE circumstance as described above, in which the firm’s CFROI rate is imagined to approach yet never intersect with WACC:

Related paper in bold

Table 5.5.3: Three Arguments/Analyses Contradicting IE Circumstance 2 (Nearly Equivalent CFROI and WACC Rates, Non-Intersecting)

“Hovering” in the sub-title (above) reflects the idealised relationship between CFROI rate and WACC rate as imagined in IE, graphically depicted in Scenario (A) in Figure 5.5.1.

In IE Circumstance No. 2, the company’s CFROI rate is imagined to decline very close to the WACC constant rate level, but never intersecting—as that would indicate a subinfinite life span (t) and contradict IE, which supports the perpetuity conjecture.

173

Chapter 5 - Results of the Analysis and Relevant Comment •

Depicted in the Scenario A in that manner, that graphic suggests a perpetual company in which changes in time (company longevity) result in almost no change in that company’s overall value (CV).

•

The t variable is precluded in its role as a determinant of company value, by disconnecting the relationship between time and worth. If and when changes in elapsed time mean no change in value, Neale and McElroy’s IE prevails.

5.5.4.1 A. Multiple Specific Exceptions to Industry Mean Reversion But the unwieldy and unlikely combination of circumstances necessary to support IE Circumstance No. 2 is also that supposition’s undoing.

Hovering—referring to the idealised IE notion of CFROI-defined returns deteriorating to a point of near collapse but then stabilising and continuing forever appears implausible in real world settings. Management of fast-deteriorating companies caught in commercial death spirals rarely receive the chance to even attempt a long-odds turnaround of the type represented by the Scenario A (in Figure 5.5.1) curve.

But as soon as providers of capital to the firm become aware of their borrower’s precipitous decline in performance, they are likely protect their position by withdrawing funds and denying access to new borrowing. That action, in turn, trigger’s the company’s failure, causing sub-infinite life span.

In his illustration intended as representative of actual company circumstances, Madden (2005) depicts the mature company’s performance in CFROI terms deteriorating after the early part of the Mature stage (below) and then intersecting with WACC at several points after that, indicating a finite business by the CAP criterion.

174

Chapter 5 - Results of the Analysis and Relevant Comment

Source: Madden 2005, 7; Related: Figure 2.3.6

Figure 5.5.2: Madden (2005): Mature Company Reaches the End of Its Economic Life Span

For example, Palm Inc. exhibited negative CFROI rates in calendar years 2003 and 2004 on a three-year moving average basis, but then CFROI exceeded estimated constant WACC in 2006 and 2007. By Spring 2010 Palm had collapsed and was seeking salvage acquirers to take over whatever parts of the company still had some value to others in liquidation. (“Palm.� 12th April 2010, Lex column, Financial Times).

Hewlett-Packard performed that liquidator-as-acquirer role in the case of defunct Palm: all operations of the failed Personal Digital Assistant (PDA) and smartphone manufacturing company have now been discontinued and dismembered. The Palm OS (operating system) survives, but as a passive asset of H-P, not as a continuing company.104

104

Such liquidation-type acquisitions in which the acquired company is terminated and a few assets stripped away are commonplace (UK: Amstrad, Marconi, NatWest; US: Signal Cos., Netscape, Digital Equipment Corp., Crocker Bank), representing a part of the primary finding emerging Appendix E.1g.

175

Chapter 5 - Results of the Analysis and Relevant Comment 5.5.4.2 B. Deteriorating CFROI in Company Terminal Life Stages CFROI reflects two of the three acknowledged variables in the Gordon Formula, in combination: FCF and g. Although for purposes of quick TV estimation the three variables are often simple estimates, each variable is properly considered as an equation containing multiple sub-elements, each of which requires specific analysis.

Figure 5.5.3 considers both the net receipts (total FCF, both beginning and subsequent) and investment (i) aspects of the company’s changing CFROI as the firm proceeds from maturity to demise:

Figure 5.5.3: Variable Investment and Returns Over Corporate Value Life Span (CVL)

By the time the company reaches late maturity, emergency dispositions are required to keep CFROI above WACC. But at that near-death stage, obvious value-destroying investments have already been cut, and thus management faces the dilemma that neither changes to the numerator (CF) nor the denominator (i) in the CFROI ratio can hope to reverse the company’s downward spiral.

At that point in time, almost any unanticipated external shock or management misstep may send CFROI below WACC, suggesting an end to that company’s life span and thereby contradicting both the Insignificance Exception and the perpetuity conjecture.

176

Chapter 5 - Results of the Analysis and Relevant Comment 5.5.4.3 C. Likelihood of Increased WACC in Later Life Stages, Increasing the Probability of WACC – CFROI Intersect CAP-type analyses comparing and contrasting a firm’s CFROI and WACC rate functions tend to concentrate on changes in Cash Flow Return on Investment over time, in part because the prevailing practice calls for assuming that WACC is constant for the full duration of that firm’s economic life span.

Source: Thesis v1, Ch. 5.

Reference: Figure 5.8.3 (Chapter 5 Part 9, thesis v2)

Figure 5.5.4: Expected and Customary Increases in WACC With Company Age, And the CAP Viability Threshold

The prevailing notion of a constant, unchanging WACC for a company’s life entire span is represented in Figure 5.5.4 by the AB function.

But Luehrman (1997B) and Clark (2010) both contend that WACC increases as the company matures. Luehrman describes how retained earnings alter the firm’s gearing ratio and thus its capital structure and overall cost of capital (WACC), even if component financing costs for debt (WACD) and equity (WACE) do not change.

Clark identifies two circumstances that arise as providers of financing become aware of the declining company’s reduced viability in mid- to late- maturity: 177

Chapter 5 - Results of the Analysis and Relevant Comment •

As companies mature and their performance declines, lenders are likely to insists on a more conservative capital structure, primarily as manifested in a lower debt-to-capital ratio; and

•

Increases in operating and financial and/or operating risk may increase the cost of debt and equity components as the firm matures.

When and if WACC increases in as represented by line BC in Figure 5.5.4, then the chances of CFROI and WACC intersecting increase. If that intersect occurs, the reality of the company’s sub-infinite life span is affirmed, the perpetuity conjecture is contradicted once again and the Neale-McElroy Insignificance Exception is not relevant.

5.6

Reality Testing the Notion of the Never Ending Company

Sub-parts: 5.6.1 Chapter Part Summary 5.6.2

Improving the Methods for Future Projections of the Gordon Formula’s Fourth

Variable, Time 5.6.3 Substantiating Prima Facie Indications of the Companies’ Sub-Infinite Life Spans 5.6.4 Academic Investigation of Companies’ Brief, Finite Life Spans 5.6.5 Statutory Indications of Finite Life Spans: Government and Other Official Offices 5.6.6 Other Company Life Span Terminus Indicators 5.6.7 Competitive Advantage Period (CAP) - Related Indications, Including Industry Pairs Analysis

5.6.1

Chapter Part Summary

Contrary to supporting the perpetuity conjecture, extensive empirical evidence from academic studies (2.4), government reports and other sources support the polar opposite hypothesis: that all companies experience sub-infinite life spans. This is referred to elsewhere in this study as the Briefer-Than-Infinite or BTI hypothesis.

178

Chapter 5 - Results of the Analysis and Relevant Comment Future trends (Appendix N) suggest that the historical pattern of finite, sub-infinite company life spans is extremely unlikely to change in the future. While the statistical possibility of a Never Ending Company exists in theory, the likelihood of such a development is considered by this Researcher to be so remote as to be non-existent.

5.6.2

Improving the Methods for Future Projections of the Gordon Formula’s Fourth Variable, Time

In the Gordon Formula, the amounts assigned to each of three acknowledged variables are generally, although not always, developed on the basis of projections of future performance of that variable, informed by past history and judgments about emergent trends and other possible change factors.105 Prevailing methods for determining each of the Gordon Formula’s four true variables (the three presently acknowledged variables plus t) are shown in Figure 5.6.1:106

105

For example, in Capital Asset Pricing Model (CAPM) calculations leading to estimation of a firm’s unique cost of capital, that analysis begins with risk free rate as typically indicated by very long term government debt securities.

106

“The models that we use in valuation may be quantitative, but the inputs leave plenty of room for subjective judgment…” Damodaran 2002,1. The use of the phrase “true variable” is to reflect time’s role as a determinant in the calculation of the value of all enterprises (VoE, Chapter 1), whether project or company type. The issue of methodological consistency in projecting methods applied to the four GF variables (the three acknowledged variables plus t) is addressed in 5.8.

179

Chapter 5 - Results of the Analysis and Relevant Comment

Table 5.6.1: The Gordon Formula’s Four Acknowledged Variables Plus One: Evolution in Methods for Setting Projected Future Amounts and Rates

The process is evolutionary. The best practice calculation method for each of the variables may change over time. For, example, Luehrman and Clark expect that their semi-variable notions of cost of capital (WACC) will increasingly be reflected in company valuation calculations in future periods.107 With that WACC precedent and papers such as Cassia and Vismara (2009), which concern future methods for calculation of the FCF variable in the Gordon Formula, the possibility of improvements in the methods for calculating all four of GF’s true variables emerge, as an opportunity to further improve DCF valuation methodology.

Considered in that context, the question regarding the Gordon Formula’s fourth true variable, time, emerges: What is the most appropriate and most defensible basis for projecting the future amount of this variable, on a company-specific basis?

This Researcher interviewed Professor Timothy Luehrman of Harvard Business School on 6th April 2010. Penman also appears to be receptive to consideration of alternative calculation bases for that variable: “Despite considerable effort to develop so-called “asset pricing models”, we really do not know how to quantify discount rates… If we are honest, the discount rate is a matter of considerable speculation….” (2006, 19)

107

180

Chapter 5 - Results of the Analysis and Relevant Comment Gordon and Shapiro’s choice of the perpetuity constant as a universal surrogate for t does not alter t’s identity as a determinant and variable of company value. The 1956 authors’ use of infinity as a default surrogate amount for t represents a form of projection, albeit an extremely inflexible form which is discredited on the basis that there is not one known bit of observation-based evidence of Never Ending Companies.

Thus a corollary to the question above arises: Is infinity the most appropriate and defensible projection basis for estimating the duration of the variable t, for every companies?

No, not for any company.108 The empirical evidence refuting the perpetuity conjecture is extensive and longstanding. Aris notes that “Statistics going back to Victorian times show that the odds of any new venture succeeding are more than three to one against” (1985, 11).

5.6.3

Substantiating Prima Facie Indications of Companies’ Sub-Infinite Life Spans

Based on valuation practitioner interviewees’ responses in the primary research related to this thesis (5.3), the supposition that all companies exist forever appears to be counterintuitive, or “contrary to expectations” (Encarta) to many, based on common sense and direct observation.

With companies observed to be failing on a recurring basis, the Never Ending Company does not merely appear to be unlikely, but also implausible and perhaps impossible.

Figure 5.6.1 is a life span curve based on several analyses including confirmed empirical evidence:

Except as Penman noted in his 31st March 2010 interview with this Researcher, perpetuity might still continue as a secondary default assumption in those instances where substantive historical and other evidence does not exist to inform the development of finite-term projections. (5.7)

108

181

Chapter 5 - Results of the Analysis and Relevant Comment

Figure 5.6.1: Companies Overall: A Preliminary Cumulative Failure Experience Curve

Figure 5.6.1 shows a preliminary pattern of companies’ actual failure patterns. If companies existed forever per the perpetuity conjecture then the ABCD line in Figure 5.6.1 would be a straight line beginning at the lower left-hand corner in that exhibit (0/0: zero elapsed years, zero per cent cumulative failure) then continuing as a horizontal, forever.

But instead, the ABCD function is curved, reflecting the reality of companies’ subinfinite life spans. The ABCD curve is derived from: (A), a venture capital industry ruleof-thumb that between one in ten and one in twenty investee companies tend to survive and prosper;109 (B), Mata et al.’s first of two cohort-based studies of company failure rates and patterns in the mid-1990s as described in 2.4;110 (C), de Geus’s suggestion in 2002 that companies on average endure for 12.5-13 years from time of birth (2002, 2);

109 This

Researcher was an officer of US venture capital firm Heizer Corp. in 1973-1976.

110 Mata

and Portugal’s 1994 study examines longevity of 3,169 specifically identified and monitored companies, all of which began trading in 1983. Only about half of the companies analysed were still trading four years after their origin (227-230).

182

Chapter 5 - Results of the Analysis and Relevant Comment (D), an adaptation based upon Jennergren’s (2008) analysis of Property Plant and Equipment (PPE) asset lives from Appendix J in this thesis; and (E), de Geus’s indication of life of Fortune 500-type companies, interpreted here as a practical maximum (de Geus, ibid).

5.6.4

Academic Investigation of Companies’ Brief, Finite Life Spans

Academic investigations of company failure levels and patterns confirm that companies experience finite life spans. Table 5.6.2 suggests to this Researcher that firms’ median lives are approximately seven elapsed years from origin: This Researcher estimates of companies’ median lives is based on seven representative studies from that Chapter Part as shown in Table 5.6.2: A G E Study

1

2

3

4

5

6

7

8

9

10

11

13

15

Mata PO

95

20.0

50.0

70.0

Dunne US

88- 67

63.9

79.0

57.5

78.2

87.6

Dunne US

88- 72

US

Audr 95

19.0

33.2

44.0

51.6

56.9

61.8

BG 91 CN

Gfield

10.2

20.0

28.2

34.6

40.5

44.9

50.1

55.3

59.7

64.4

9.8

19.4

26.7

33.5

38.6

43.6

48.6

53.5

57.8

62.0

66.3

9.6

18.9

27.2

31.9

38.3

41.6

43.8

46.6

49.3

51.4

53.5

Baldwin CN

98 Wagner

GE

94

US Dunne 88- 67C: 1967 entrant cohort, from Table 8, 508, 387 manufacturing industries US Dunne 88- 72C: Same as Dunne 88- 67C, except 1972 entrant cohort instead US Audretsch 95: Based on first year in two year indicated exit range, Table 7.2, 158.

CN Derived from Fig. 4, Average Rates of Exit by Greenfield Entrants by Age Class from Baldwin and Gorecki 91,310.

Derived from Table 1, Survival and Growth of New Small Firms in GE

Lower Saxony, Table 1, 144, Observation Weighed

Table 5.6.2: Cohort Group Cumulative Failure Percentages by Elapsed Years, Seven Academic Studies From Chapter 2 Part 4

183

66.3

70.3

Chapter 5 - Results of the Analysis and Relevant Comment Table 5.6.2 source data originates from government and industry statistical sources thought to be reliable such as manufacturers’ registers (e.g., Canadian Census of Manufacturers, Baldwin, Canada) or official government agencies (e.g., Mata et al., Portugal; Wagner, Germany) Audretsch’s 1995 (US) shows failure which are generally consistent with the ABCD failure curve in Figure 5.6.2. Audretsch’s study is organised into eighteen separate industry groupings. His results suggests that overall company failure patterns may be further delineated into industry-specific failure patterns:

7-8 Years (Col. 4)

9-10 Years (Col. 5)

16 of 18

16 of 18

(89%)

(89%)

No. of industries

6 of 18

10 of 18

exceeding 55% cumulative

(33%)

(56%)

No. of industries

5 of 18

7 of 18

exceeding 60% cumulative

(28%)

(39%)

69.9% (Elect.

75.7% (Elect. Equip.)-

Equip.)-

41.7% (Food

36.8% (Food

Producers)

No. of industries exceeding median (50%) cumulative CFP*

CFP*

CFP* Failure Percentage Range, High-Low

Producers) n= 56,622 companies, divided into 18 industry groups.

Note: CFP refers to Cumulative Failure Percentage

Table 5.6.3: An Analysis of Company Cumulative Failure Experience Based on Audretsch (1995)

184

Chapter 5 - Results of the Analysis and Relevant Comment 5.6.5

Statutory Indications of Finite Life Spans: Government and Other Official Offices

The statistical evidence that companies do not experience infinite life spans is extensive and consistent. Two representative examples from UK’s Insolvency Service are Table 5.6.4 and Figure 5.6.2.

Note: P denotes provisional. Includes partnerships. th Source: Insolvency Service and Companies House (UK). Reference INS/Com/31, 6 Feb. 2009

Table 5.6.4: Company Liquidations in England and Wales, 2001-2008

185

Chapter 5 - Results of the Analysis and Relevant Comment

Figure 5.6.2: Insolvency Trends in England and Wales, 1998-2008

While some US bankruptcy categories (e.g., US Chapter 11 reorganisations) do not necessarily involve near-term liquidation other order categories are more final. Table 5.6.5 indicates that there were more than 1,170 Chapter 7 type filings in the US in 2003.

Historically, Chapter 7 statutes have been amongst the most severe of the US bankruptcy statutes, comparable to immediate administration orders for liquidation in the UK. Chapter 7 filings are described in Altman and Hotchkiss (2006, 7) as “a firm’s formal declaration of bankruptcy in a Federal district court, accompanied by a petition to liquidate its assets.”

The US Federal Deposit Insurance Corporation (FDIC) primarily oversees mid-sized US banks and as such thus provides a perspective on financial institution longevity unaffected by distortions caused by government bail-outs or government-brokered corporate marriages of a company that would have failed otherwise.

When America’s First Bank collapsed in February 2009, it was liquidated by the FDIC soon afterwards. Thirty-one US banks were seized by the FDIC since the beginning of the recession in 2008 (Essen and Ebrahim 2009, Evans 2009).

186

Chapter 5 - Results of the Analysis and Relevant Comment

Table 5.6.5: US Bankruptcy Filings Under Different Statutes, Number of Cases, 1999-2003 (000s)

The smaller banks were big enough to fail, but too small to receive the government subsidies that distort end-of-life statistics of some larger financial institutions. On the basis that both Bear Stearns and Merrill Lynch both would have collapsed in 2007 without emergency financial support from the US government, both of those companies are properly designated as having failed in 2007. And thus, being two more statistics in the list of companies exhibiting Briefer-Than-Infinite (BTI) life spans. •

The assets and client accounts of suddenly insolvent investment bank Bear Stearns were seized in Autumn 2007 by JP Morgan at salvage prices indicative of a toxic business that no one would consider acquiring, even with US government financing for the deal.111 Bear Stearns was quickly absorbed within JPM, which acted quickly to expunge all evidence of their acquiree as a separate independent organisation.

111

Consistent with the reality of a failed company sold-off at liquidation, the entire original price paid by JP Morgan for Bear Stearns was reported by business media as less than the value of Bear Stern’s Manhattan headquarters building alone. The original price was later increased slightly.

187

Chapter 5 - Results of the Analysis and Relevant Comment •

Merrill Lynch’s liabilities exceeded its assets by several times when the company began its search for an emergency acquirer in Autumn 2007, indicating a company that was technically insolvent although it continued to trade. Bank of America gained the visibility it sought on Wall Street by procuring the ML nameplate, while disbanding other parts of the acquiree in that season’s second liquidation-disguised-as-acquisition.

5.6.6

Some Other Company Observation-Based Life Span Terminus Indicators

5.6.6.1 Alternative Company Failure Indications To those who might be inclined to view filings under the US Chapter 11 reorganisation statutes as a financial reorganisation rather than failure, US bankruptcy experts Altman and Hotchkiss argue otherwise.

In their study of 1,400 publicly traded companies filing under the more accommodating (at least compared to Chapter 10) Chapter 11 statute from 1979 to 2002, the authors indicate that 21.5 per cent of companies declaring bankruptcy under the reorganisation statute for the first time were eventually liquidated or dissolved.

Nor were the remaining 78.5 per cent of filing companies safe from failure and subinfinite life spans. In referring to Hotchkiss’ 1995 study of 197 firms emerging from bankruptcy by 1989, the two authors comment that “Over 40% of the companies emerging from bankruptcy continued to experience operating losses in the three years following bankruptcy” (2006, 81-84).

In the UK, credit rating agencies provide an additional confirming source of intelligence on company failures. Citing UK credit rating agency Experian, Tyler (5th February 2009) indicates “There was a 30pc increase in UK business failures during 2008, with 65 firms becoming insolvent each day. This takes the total for last year to 23,879.”

5.6.6.2 Factors Possibly Contributing to Increased Company Failures Altman’s seminal paper on bankruptcy patterns and advance indicators of company collapse appeared in the literature in 1968. Argenti (1973) observes company failure levels and patterns in the UK and US several years later: “Out of Britain’s 600,000 companies approximately 8000 were “dissolved” in 1973…that is 1.3 percent. In America, approximately 15,000 fail per year—that is, 0.4 percent.”

188

Chapter 5 - Results of the Analysis and Relevant Comment By the mid-1970s, Argenti developed his own sub-infinite perspective on the longevity of UK firms based on Companies House data, with possible parallels for US-based companies: The number of companies that are put into liquidation each year in Britain is 8000. The number that fail is between 8000 and 26,000—but there is a strong hint that the figure is nearer the latter than the former because most people who have a successful company on their hands would not allow its registrations to lapse… I suggest that 20,000 of the 26,000 companies that are removed from the register each year are failures.112 My guess, then is that if one examines any list of companies in Britain (and America, too, I assume) one in ten would be seen to be in failure, i.e., their profitability is so poor that they are bound to become insolvent within an average of 2 ½ years (page 6).

In its 21st June 2010 report, US credit agency Fitch explores the relationship between defaults on high yield debt and company bankruptcy filings. Fitch Ratings suggests that more than 40% of the defaults in high yield debt year to date accompany filings for bankruptcy under Chapter 11 provisions:

Par Value $Mn.

%

Issuers

%

Chapter 11 Filing

668.4

38.3%

4

44.4%

Distressed Exchange

725.4

41.6%

3

33.3%

Missed Payment

350.0

20.1%

2

22.2%

1,743.8

100%

9

100%

Totals

Table 5.6.6: Fitch US High Yield Default Index: 2010 Defaults Year-to-Date by Classification, Report of 21st June 2010, 7

112

Argenti defines a failed firm as: “a company whose performance is so poor that sooner or later it is bound to have to call in the receiver or cease to trade or go into voluntary liquidation, or which is about to do any of these, or has already done so” (1976, 6). Appendix K contains a series of alternative interpretations of when failure-- as the end of a company’s finite life span-- occurs

189

Chapter 5 - Results of the Analysis and Relevant Comment Increases in individual bankruptcy filings increase the probability of collapses by marginal companies in consumer-related segments. Citing statistics for the nine months ending 30th September 2009, Bloomberg’s Blum reports that there were “1.4 million bankruptcy filings in the year ended Sept. 30, up 35 percent from the previous year, according to the Administrative Office of the U.S. Courts.”

5.6.7

Competitive Advantage Period (CAP)- Related Indications, Including Industry Pairs Analysis

Except in the instance of liquidation with no continuing residual or similar events, the end date of a specific company’s life span is sometimes difficult to determine with precision, even though government agency data is the source.

Altman and Hotchkiss describe the US companies which file under the more accommodating Chapter 11 reorganisation statute (compared to the liquidation-oriented Chapter 7 and 10 statutes), some of which survive for a few years longer after their initial bankruptcy petition.113 Add other, non-statutory indicators of possible firm’s demise, and the answer to the question When is the Company Dead? is a continuum, as represented by Figure K.1 in Appendix K. That Appendix considers a range of different possible indications of the end of a firm’s finite life span, including attributes and limitations of each major alternative method.

Under the CAP framework, a company reaches the end of its period of competitive viability when its Cash Flow Return on Investment rate declines to such a level that CFROI intersects with Weighed Average Cost of Capital.

But in some companies and circumstances, the initial CFROI=WACC intersect (Indication 1 in Figure 5.6.3) is not final. In that “stylized” view of Madden (2005) the company’s CFROI dips and then below constant Weighed Average Cost of Capital:

113

Worldcom (now MCI) and General Motors both declared bankruptcy but both are trading as of this writing. Are they failed companies or turnarounds? This Researcher’s perspective leans towards the former interpretation. On the basis that continuation of ownership interest is one indicator of the continuing form (Appendix E.1g) the recapitalisations necessary for the two firms to trade again mark failure of the original entity as of the date of its original Chapter 11 filing. The firm that emerge from Chapter 11 are recapitalised and thus new entities. This interpretation is consistent with Altman’s double dipper notion of firms that file for Chapter 11 protection more than once (2002).

190

Chapter 5 - Results of the Analysis and Relevant Comment

Figure 5.6.3: Madden (2005, 7): Alternative Indications of Company Demise

In Figure 5.6.3, the company’s CFROI rate first dips below Cost of Capital at the point in time designated as Indication 1, near the beginning of Madden’s Mature stage. But then internal cash generation from operations improve, or management disinvests some assets, or both. As a consequence, the CFROI rate increases, temporarily exceeding WACC once again at the bump immediately preceding Indication 2.

In Madden’s stylised firm, such rebounds tend to be short-lives, particularly if the company’s core business is in decline and management’s primary tactic for keeping CF/i high is to sell off assets: at some point the easy disposals are depleted.

In Figure 5.6.3, CFROI slips below WACC for good after Indication 2. But it is only after several periods pass and CFROI does not bounce up again that it can be observed that, on the basis of Mauboussin-Johnson CAP criterion, the company appears to now be non-viable in economic terms.

Indication 4 refers to multiple indications of Negative CFROI indications. If a CFROI rate of less than zero suggests a company approaching definitive failure, then it follows that a firm exhibiting negative CFROI over consecutive years may have already failed, thereby confirming that enterprise’s sub-infinite life span.

Such a viability measure is used in the Industry Pairs analysis developed for this study.

Industry Pairs (Appendices L and M) sixteen pairs of companies in sixteen identifiable segments: sixteen firms in stable mid-life phase (Contention) and sixteen lagging (Participation) competitors that in decline, which are struggling to keep up with their more profitable rivals. Both phases are exhibited Corporate Value Life Span / Five Domain framework (CVL/5D, Clark 2006): 191

Chapter 5 - Results of the Analysis and Relevant Comment

Source: Adapted from Clark (2006, 2009)

Figure 5.6.4: Corporate Value Life Span (CVL) Overview (Contention Versus Participation Phases)

CVL/5D is an adaptation of the Mauboussin and Johnson’s (1997) Competitive Advantage Period framework. Adjustments include: (i.), additional threshold economic events supplementing the single CFROI=WACC intersection; (ii.), company life phases described on both a competitive and economic basis; and (iii.), identification of five related value management possible initiatives (“domains’) arising over the course of each company’s sub-infinite life.

The Contention phase in CVL/5D approximately relates to the second, Fading Economic Returns stage, in Madden (2005) in Figure 5.6.3. The Contention phase company amongst the leaders in that industry based on of market share, continuing profitability and assessment by larger accounts. Even at this mid-life stage of relative prosperity, net margins and marginal returns on investment (mCFROI) may be beginning to decline from peak levels of previous periods.

CVL/5D’s Participation phase relates approximately to the Madden’s Mature and Failing Business Model stages in the earlier Figure. This is a company approaching its end at accelerating speed: the issue is not whether the firm will fail, but rather, when.

Survival is the Participation phase company’s foremost concern. Management faces the recurring dilemma of whether to preserve capital as a reserve against market shocks and new competition, or to risk the remaining capital on a breakthrough product or service aimed at moving the once-dominant firm back to Contention phase stature.

192

Chapter 5 - Results of the Analysis and Relevant Comment The Contention phase companies in the Industry Pairs analysis exhibit higher performance than their Participation phase competitors in each segment, and overall:

Figure 5.6.5: Contention Versus Participation Companies Overall: CFROI Ratio Differences (Annual)

Negative CFROI rates are utilised in the Industry Pairs analysis in place of the relationship of CFROI rate to WACC rate at the centre for two reasons.

•

First, because negative CFROI is believed to be a more definitive indicator of company failure than either Indicators 1 or 2 in Figure 5.6.3. Madden’s exhibit demonstrates the problem of defining the company’s terminus when CFROI is first below WACC, then above.

•

Second, in order avoid any requirement for a comparison of CFROI rate with WACC rate. Although other valuation academicians are expected to join Luehrman and Clark’s belief in a semi-variable cost of capital (svWACC) function for both valuation and value management in the future, the pace of transition away from constant WACC is difficult to anticipate at this time.

This Researcher suggests that three year moving (3YMA) averages of negative CFROI helps to avoid the problem of possibly unrepresentative single year results. The statistics shown in bold italics in the two Tables following indicate at least two consecutive periods of negative performance on a 3YMA CFROI basis:

193

Chapter 5 - Results of the Analysis and Relevant Comment

Table 5.6.7: Industry Pairs Analysis Summary I: Analysed CFROI, Three Year MA Basis Participation (Declining) Phase Companies

Table 5.6.8: Industry Pairs Analysis Summary II: Analysed CFROI, Three Year MA Basis Contention (MidLife Stability) Phase Companies

194

Chapter 5 - Results of the Analysis and Relevant Comment Note that there are many more of these two-periods-or-greater Negative 3YMA CFROI instances amongst the weaker Participation phase companies (Table 5.6.7) than in the Contention category (Table 5.6.8).

Table 5.6.9 indicates that eight companies-- half of the sixteen Participation phase firms- are at this writing either (i.) economically non-viable or (ii.) have become so fragile that their viability as going concerns is questionable:

Table 5.6.9: Companies Exhibiting Multiple Negative CFROI Ratios in Industry Pairs Analysis

Table 5.6.9 is organised into three categories, based upon the circumstances of that declining company’s actual or near-collapse.114 Category 1A refers to those firms from the 32 which have formally declared bankruptcy.

Category 1B is also comprised of companies which have failed, but their collapse was

114

Three of the eight companies listed in Table 5.6.9 (General Motors, Merrill Lynch and Citigroup) have continued to operate because of US funds. Such bail-outs do not alter the underlying indications of nonviability.

195

Chapter 5 - Results of the Analysis and Relevant Comment accompanied by a liquidation-type acquisition. Category 2 is comprised of companies which continue to trade as independent firms, but which are shadows of their former selves, and scarcely surviving.

The first column in Table 5.6.9 (Ph.) indicates the company’s life phase in the CVL/5D framework, either Contention (C) or Participation (P). There are no Contention, or stable mid-life, firms in the Table.

The number following the letter in Column 1 identifies the number of consecutive 3YMA Negative CFROI indications over the 2001-2007 time frame, corresponding to the statistics in bold, italics in Tables 5.6.7 and 5.6.8.

5.6.7.1 Category 1A: Filed for Bankruptcy or Liquidated General Motors used up the remainder of their uncancellable multi-billion dollar loan facility in 2008, providing an advance warning of their imminent bankruptcy filing less than a year later. Once the world’s auto leader, GM had struggled for more than a decade as market laggard to Japan’s Toyota and Honda. In the Industry Pairs analysis of auto manufacturers, Honda is the Contention phase competitor to GM, trailing behind the market leader in the Participation phase.

Circuit City suffered for a decade as the Participation phase distant follower to the leader in the consumer electronics retailing segment, Best Buy (Contention). Underperforming in terms of both revenue generation and cost management, Circuit City was liquidated at the end of 2008.

5.6.7.2 Category 1B: Forced Merger to Avoid Collapse, No Longer Independent Firm These are outright failures slightly obscured by the transactions occurring at the end of their life spans. Merrill Lynch is today referred to “Bank of America Merrill Lynch”, with no ambiguity about which is the surviving firm. With the exception of AIG, no financial sector firm was decimated more completely than ML; both companies received massive government funding to prevent (or at least, delay) a collapse which otherwise might have spread to global financial markets. Particularly as it is now known that ML’s true exposure to the mortgage derivatives crisis was substantially understated in Autumn 2007, there is little doubt that the company ceased to be a viable freestanding entity at that time.

Palm’s withdrawal from the market was predestined by their late response to the Apple iPhone series. Having slipped from Personal Digital Assistant (PDA) segment leader to also-ran in less than a decade, the stakes in management’s gamble were high: Palm 196

Chapter 5 - Results of the Analysis and Relevant Comment would have survived if its new PreTM smartphone had drawn sufficient market share away from Apple’s iPhone. But that didn’t happen, so H-P purchased Palm and discarded all of that company except the Palm OS software. Palm’s sub-infinite life span ended in Spring 2010.

5.6.7.3 Category 2: Significantly Curtailed Operations Following Threats to Viability These four companies have been forced close to their Viability Threshold points of demise as depicted in the CVL/5D exhibit, Figure 5.6.4.

Participation phase commercial airline Alaska Air was forced to abandon its expansion plans in the lower 48 US states and is today scarcely surviving as a regional air carrier.

Online broker E*Trade was crippled by its exposure to the sub-prime derivatives crisis and did not begin to show a profit again until 2010.115 TARP funding permitted Citigroup to survive as a quasi-nationalised bank.

The sub-heading of Morningstar’s 10th May 2010 analyst’s note on Rite Aid Corporation is: “Unproductive stores and increasing competition make us question Rite Aid’s longterm viability.”

115

Ren (7th May 2010).“Are Online Broker’s Broken?” Barrons.

197

Chapter 5 - Results of the Analysis and Relevant Comment

5.7

Conflicted

Apologist

Examined:

for

Penman’s

the

Perpetuity

“Truncation

Conjecture

Error”

Re-

Argument

Reconsidered

Sub-parts: 5.7.1 Background, Synopsis of This Chapter Part 5.7.2 “Truncation Error” Assertion Examined 5.7.3 Evolutionary Changes in Penman’s Perspectives, As Evidenced by Secondary and Primary Research

5.7.1

Background, Synopsis of This Chapter Part

Professor Stephen H. Penman of Columbia University is referred to in 2.3, Literature Review Relating to Company Valuation Methods, as the leading advocate of the perpetuity conjecture from the mid 1990s through 2006.

That description is based on Penman’s writings over the period and his standing amongst accrual accounting-oriented company valuation academicians, referred to in 2.3 as the “Accounting Group”.116 Neither Penman nor the others in that group confronted the essence of the two mid 1990s studies by Copeland et al. (1994) and Kaplan and Ruback (1995) that changed academic valuation status quo. With DCF methods shown to be more closely correlated to market value (MV) than accrual accounting methods, it was only a matter of time before DCF’s primacy amongst managers also became reflected in the literature.

Concerned about DCF’s threat to valuation research budgets directed to accrual accountants, Penman attacked anyone who questioned the notion of infinite life spans because never-ending analysis periods were critical to sustaining the argument that DDM was equivalent to DCF, in valuation terms.

116

Several of Penman’s papers on TV and the perpetuity conjecture in the 1990s were jointly authored with T. Sougiannis. Bradley and Jarrell (2008), Sougiannis and Yaekura (2001), Ohlson and Zhang (1999) and Case and Shane (1998) refer to Penman’s papers.

198

Chapter 5 - Results of the Analysis and Relevant Comment Penman acknowledges that without that enabling assumption about time (t) accrual accounting-based company valuation methods (i.) do not accurate reflect company value and (ii.) are inconsistent and non-equivalent with competing DCF methods.

But in this Researcher’s judgment, Penman’s truncation error defence inadvertently achieves the opposite of his intent, by supporting the concept of time in value which is the opposite of the perpetuity conjecture.

•

Penman claims that advocates of sub-infinite life spans fail to take into account a material portion of the analysed company’s total worth: the value of that firm attributed to the time period between the “truncated” finite date and infinity.

•

In presenting his truncation error argument, Penman affirms the principle that time—company longevity-- is variable-determinant of company value as introduced in this study in Chapter 1. By claiming that supporters of sub-infinite concepts of longevity miss some value, he infers a correlation between changes in time and changes in value.

•

Implicit in the perpetuity conjecture within GFAP is the notion that time is irrelevant to value. In GFAP, time (longevity) is not treated as variabledeterminant of company value, but rather, as a perpetuity constant. This means that regardless of whether the company’s actual life span is one, five or one hundred years, t for valuation purposes is set at infinity for all companies and under all circumstances. Variations in actual life span make no difference at all for valuation purposes.

•

By Penman affirming time’s historical role as a variable and influence on company value, the Columbia University professor contradicts the perpetuity conjecture. The Gordon Formula version in which company value varies with changes in longevity (time) is the four variable serial version of GF (Appendix C), rather than the incumbent three variable GFAP ratio.

Since 2006, there have been indications that Penman’s perspective towards the perpetuity conjecture is changing: away from outright rejection of any notions of subinfinite lives spans towards, tolerance of finite, sub-infinite projections for t under certain specific circumstances and conditions.

In his March 2010 interview with this Researcher, Penman acknowledged that the analysis of historical failure data relating to the company being analysed may be a superior estimation basis for t. Penman described how the perpetuity conjecture would

199

Chapter 5 - Results of the Analysis and Relevant Comment then revert to a secondary role as a default option, “to be used only if there is isn’t some better basis for determining life span.” 117

5.7.2

“Truncation Error” Assertion Examined

“Truncation” means “to shorten something by removing part” (Encarta, 1999). In Penman’s truncation error defence of the perpetuity conjecture, that “part” is the company value attributed to the time period between the finite date and infinity.

Penman makes his under-counting assertion with no further explanation or clarification.

But the truncation error argument is vulnerable to points of logic: •

Infinity cannot be measured, by definition.118 Which means that Penman’s contemplated time period between a finite date and infinity cannot be defined.

•

If the duration between ∞ and a finite year of company demise cannot even be measured, one reasonably questions how can Penman’s uncounted value can be calculated, much less utilised as a defence of Never Ending Companies.

5.7.3

Evolutionary Changes in Penman’s Perspectives

As reflected in his papers, finance text book (2007) and interview with this Researcher, Penman’s perspectives about the interrelated DCF methodological primacy and perpetuity conjecture issues have evolved, as suggested by the different periods in Table 5.7.1:

117

31st March 2010. As noted in Part 1 of Appendix E relating to survey methodology, the survey was deliberately not presented as confidential in nature. One interviewee requested anonymity, and that individual’s name has not been attributed to any findings or otherwise disclosed in any manner. Penman’s commercial use of and familiarity with DCF valuation methods qualified his as a DCF valuation practitioner for survey purposes.

118

T Plus One (Time Mathematics in 5.8) refers to the specific perpetuity conjecture notation (t+1) for time in GFAP. Perpetuity means that there is always another period to be taken into account; that infinity is indefinite.

200

Chapter 5 - Results of the Analysis and Relevant Comment

Table 5.7.1: Penman’s Changing Perspectives About Perpetuity and Company Value

5.7.3.1 1995-2000: Defence of Accrual Accounting’s Equivalence With DCF Methods The Copeland et al. and Kaplan-Ruback studies of the mid 1990s undermined the notion of the infallibility of accrual accounting methods for purposes of company valuation as reflected in the academic literature. (emphasis by this Researcher) By 1994-1995, DCF company valuation methods had been the company valuation preferred method amongst financial and managers, CFOs/FDs and analysts for at least fifteen years. The peerreviewed journals were finally catching up.

Suddenly, DDM- and RIM-based valuation methods were on the defensive in valuation academia when DCF valuation was shown to be more closely aligned with market value.

As the analyses in the two mid 1990s DCF studies defied challenge, the only defence strategy remaining for the Accounting Group was to claim that their preferred methods were equivalent to DCF. That defence tactic, in turn, dictated reliance on perpetuity. As Penman and his co-author Sougiannis observed, “ Dividend, cash flow and earnings 201

Chapter 5 - Results of the Analysis and Relevant Comment approaches are equivalent when the respective payoffs are projected “to infinity”…”

(1996, 3) 5.7.3.2 2001-2006: Preserving Accrual Accounting Research Primacy Disturbed by the (perceived) dismissive nature of Lundholm and O’Keefe’s comments about accrual accounting company valuation methods contained in their 2001 paper (2.3), it is this Researcher’s sense is that Penman inadvertently revealed more than he intended in his fast retort in the same journal, later that year.

Penman revealed his concern that accrual accounting valuation academic researchers might face “a reduced agenda” (2001, 18) because of the Lundholm and O’Keefe paper and the growing primacy of DCF company valuation methods in academia.119 Penman’s truncation error argument remained, but now it was augmented by suggestions that DCF methods were akin to “voodoo” (2001), as contrasted with the Benjamin Graham-like stability of the venerable Dividend Discount Method.120 5.7.3.3 2007: Acceptance of Finite Life Spans as Practical Valuation Requirement By the time of the publication of his finance text in 2007, Penman’s comments about the perpetuity conjecture changes from those made a decade earlier. Penman proclaims that infinity is not practical for purposes of valuing companies, and that he “prefer(s) a finite horizon forecast” for such purposes. (2007, 91) 5.7.3.4 2010: Perpetuity conjecture reduced to role as default option for purposes of estimating company valuation t In the 31st March 2010 discussion, the prospect of historical and trend data that might inform finite estimations of t was acknowledged by Professor Penman. Some support continued to be expressed by Penman for the perpetuity conjecture, but now as a contingent or assumption for t, “assuming there’s not a better basis for estimation” (of company life span), through fact-based analysis of historical and trend information on comparable companies and segments.

119

David Lee Berkowitz, another interviewee in the survey related to this study (5.3) was formerly a student of Professor Penman at Columbia. Berkowitz, ex-US head of Stern Stewart, attests to Penman’s enthusiastic defence for valuation research budgets for accrual accountants. Interview with this Researcher, 18th March 2010.

120

Penman’s liberal use of quotes from the developer of respected, conservative share investment principals was noted in 2.3.

202

Chapter 5 - Results of the Analysis and Relevant Comment

5.8

Other Logic and Analysis Elements of the Case Against the Perpetuity Conjecture

Sub-parts:

5.8.1 Overview 5.8.2 Organic Concept 5.8.3 Time Mathematics 5.8.4 Theoretical 5.8.5 Methodological 5.8.6 Competitive / Economic

5.8.1

Overview

Logic-related analysis augments the statistical evidence (2.4 and 5.6) primary research (5.3) and error analysis (5.4) amassed in this study against the perpetuity conjecture.

Table 5.8.1 shows the five categories in this Part: (A), organic company concept; (B), mathematics associated with concepts of time; (C), philosophy relating to research using scientific methods; (D), analytical methods used in business; and (E), competitive and economic advantage analysis related to the Competitive Advantage Period (CAP) framework.

203

Chapter 5 - Results of the Analysis and Relevant Comment

Table 5.8.1: Logic Issues Related to the Perpetuity Conjecture Question: Five Categories

Organic Concept (A) refers to perspectives of companies as akin to living entities. This is the notion that firms progress through their economic-commercial lives in identifiable stages not dissimilar to human birth, adolescence, maturity and, ultimately death as described in de Geus (2002), Adizes (1999), Harrigan (1988) and Porter (1985 and 1980).

Time Mathematics (B) refers to issues of a calculation and definitional nature which arise in dealing with numerical concepts which are either imprecise or endless; or in the case of the perpetuity conjecture, both.

The Theoretical (C) category includes conceptual and philosophical issues related to the subject of this research. Methodological (D) refers to GFAP’s treatment of company longevity (t) in the context of similar business equations. Competitive/Economic (E) 204

Chapter 5 - Results of the Analysis and Relevant Comment considers the notion also noted in 5.5 that weakened companies barely capable of earning their cost of capital (WACC) are hardly well-positioned as candidates for perpetual corporate existence.

5.8.2

Organic Concept Like human beings or animals, everything in the marketplace is presumed to be mortal. A brand is born, grows lustily, attains maturity and then enters declining years, after which it is quietly buried.

-Dhalla and Yuspeh 1976, 102.

If companies are comparable to living organisms, then the finite nature of firms’ life spans is affirmed, on the basis that all living entities must eventually die.

The failing company’s characteristics are not unlike those of the failing human’s: reduced capacity, inability to respond quickly and effectively to the outside environment, over-reliance on past beliefs and practices that may no longer hold true.

Whether a living organism or a company, the organic life cycle invariably results in demise. For companies overall, the median duration of that life cycle is believed to be approximately seven years from the time of origin or birth, based on the analysis in 2.4.

5.8.2.1 Organic cycle If one accepts that companies exhibit organic life characteristics, then it follows that firms’ lives as viable entities in the economic and financial sense end at some specific future point in time. Adizes (1999) and de Geus (2002, IX) compare nature’s organic cycle with the commercial cycles. An interpretation is shown in Figure 5.8.1:

205

Chapter 5 - Results of the Analysis and Relevant Comment

Figure 5.8.1: Organic Life Cycles: Biosystems Compared to Enterprises

de Geus suggests that the organic view of companies’ life spans is not a novel concept, but rather, is centuries old: “The ancient Chinese characters for “business” (are) at least 3,000 years old… The first of these characters translates as “life” or “live”. It can also be translated as “survive” and “birth”. (2) 5.8.2.2 Four life stages, progressing towards company death The four life stages in Madden’s Figure 5.8.2 are similar to the four enterprise life stages of the preceding de Geus-Adizes exhibit (Figure 5.8.1):

206

Chapter 5 - Results of the Analysis and Relevant Comment

Figure 5.8.2: Life Stages and Company Decline, From Madden (2005)

High Innovation (Figure 5.8.2) Compared to Early Domination (in preceding Figure 5.8.1)

In adolescence the company enjoys first mover advantage but that early, rapid growth may be unfocused and require unforeseen additional expenditures and investment in order to create a sustainable customer offer. The firm’s product-service proposition is still unknown to many prospective customers and distribution is inconsistent. Scale is too small at this point in time for efficient production.

Fading CFROI (F 5.8.2) / Excess Returns Followed by Excess Entrants (F 5.8.1)

Company management gain product and market insight over time. The mistakes of youth are reduced but not entirely eliminated. The full commercial potential of the company’s product offer appears to be realised; however, increasing revenues are accompanied by declining marginal returns. The profits being earned by industry leaders does not go unnoticed by a first wave of late entrants into to the segment, who pursue the more attractive (to them) market slivers in terms of total profit.

207

Chapter 5 - Results of the Analysis and Relevant Comment

Mature (F 5.8.2) / Decline (F 5.8.1)

More time passes, bringing a second wave of late entrants. These rivals seek to alter the industry’s business model to their own advantage. The once-dominating company is on the defensive, competitively and financially. This firm is increasingly considered by end-customers as responding too slowly and offering too little that is new. Market share losses accelerate. The firm loses control of its own destiny, staggering into an uncertain period of strategic and operational drift.121

Failing Business Model (F 5.8.2) / Market Elimination (5.8.1)

The decline is now chronic, even some management may still be unaware of the company’s true competitive-economic condition and/or be in denial. Reduced to participating on price alone and defending an ever-shrinking customer base, the neardeath company is highly vulnerable to any market or financial shock, made worse by the departure of key talent. Death approaches: the question is no longer whether that company’s finite life span will end, but rather, when.122

5.8.2.3 The company’s immune system becomes overwhelmed

de Geus explores similarities between the human immune system and companies’ defences against competitive encroachment and finds some parallels (2002, 159-162).

Over time, a human’s immune system may become overwhelmed by a combination of factors. Thus it is with companies; a weakened firm struggling to remain solvent and continue trading is pushed closer towards the finite-but-unknown date of its death by unexpected and untimely market shocks.

121

As exhibited at pre-Gerstner IBM in the early 1990s (because of overreliance on the receding mainframe business model) and Eastman Kodak in the latter part of that decade (because of slow responses to the emergence of digital photography) Gerstner 2003.

122

Examples include retailers such as Montgomery Ward, Circuit City and Palm in the US. UK examples include Woolworths, Zavvi and Cable and Wireless. “Key talent” here corresponds to concept of Corporate Key Contributors (CKCs) in Clark 2001.

208

Chapter 5 - Results of the Analysis and Relevant Comment In the UK, embattled music and DVD retailer Zavvi entered administration in December 2008. Zavvi’s immune system was already weakened by: (i.), a business model fifteen years out of date; and (ii.), high fixed costs because of primary reliance on High Street stores as sales channel. The aggressive entry Apple’s iTunes transformed that segment to Apple’s advantage and Zavvi’s disadvantage. Zavvi’s liquidation followed soon after.

5.8.2.4 Limited resources become over-stretched Death is an integral and necessary part of the organic cycle. As Malthus observed in the very late 18th century (1798), collections of living organisms which experience several consecutive periods of robust birth rates but without offsetting deaths, may be threatened with extinction because of scarcity of resources, primarily food.123 Malthus observes that death is an unavoidable aspect of the organic cycle: unless some die, all die.

For the company, the scarce resource is not nourishment, but rather, capital, management expertise, channel access or a combination. The venture capital and private equity (PE) early successes lead to excess, naïve market entry and a combination of over-bidding and underperformance that leads to failure. Clark sees organic life-death cycle in the 1980s Leverage Buy Out boom-and-bust (1991) and the Net bubble (2000).

5.8.2.5 Entropy The Entropy Law itself emerges as the most economic in nature of all natural laws.

- Georgescu-Roegen 1999, 3.

Entropy refers to the process of deterioration and decline that occurs in many closedloop physical systems, such as machines with automatic feedback control mechanisms.124 As applied to companies, entropy is the friction which forces the organic cycle to slow and eventually stop.

Except possibly under rare conditions (e.g., near-frictionless, weightless operation in outer space) entropy is unavoidable reality. Back on earth, the relentless process of abrasion results in gradually deteriorating performance, until the point in time when that mechanism no longer functions.

123

An Essay on the Principle of Population, originally published in 1798.

Georgescu-Roegen (4) describes entropy as a “railroad engine in which coal is gradually and progressively transformed into dust. Dissipation into the whole system where it becomes bound energy”.

124

209

Chapter 5 - Results of the Analysis and Relevant Comment Forces comparable to mechanical entropy contribute to the slowing of the company’s business mechanism. Hartman and Murphy’s analysis of physical deterioration patterns for plant equipment is shown in Appendix G. Over time, decreases in the worth of the machine (based on performance) combine with increasing maintenance costs. At a critical threshold, that asset’s period of functional ends; its life span ceases. This process of decline leading to unavoidable demise resembles Harrigan’s (1988) view of company life stages.

5.8.3

Time Mathematics

Deliberately misinterpreting “indefinite” as “infinite” may have seemed to Gordon as a convenient method for resolving the problem of developing accurate projections of the neglected t variable, but that simplistic answer caused other problems, in mathematical terms.

5.8.3.1 The infinity symbol: neither end nor beginning A state of perpetuity means that there is neither beginning nor end, as epitomised by the ∞ symbol in mathematical notation. On that basis, the extensive evidence of company new entry in 2.4 combines with evidence of company exits to contradict the perpetuity conjecture.

5.8.3.2 T Plus One The phrase “T Plus One” refers to the (t + 1) notation in the numerator of GFAP representing time (company longevity), such as shown in Figure 1.1.1. This T Plus One characteristic means that confirming the existence of the Never Ending Company by observation is impossible, since perpetuity by definition requires consideration of one more additional period, and another and another, and so on. There is nothing stable to consider, envision, or measure.

5.8.3.3 Infinite Loop Error The T Plus One characteristic also corresponds to the mathematical sequence which never ceases, sometimes referred to as an infinite loop error. The phrase arises from errors of circular notation in computer programming, such as when two separate lines of code refer back to each other, resulting in calculations that continue endlessly without resolution. Such a structural error renders the equation invalid.

210

Chapter 5 - Results of the Analysis and Relevant Comment Most infinite loop errors, such as unintentional miscoding, are readily corrected. But some other errors of this type are integral to the functioning of that equation, and thus resolved only through removal. The perpetuity conjecture is integral to functioning of GFAP as a simple three variable ratio. Accordingly, the infinite loop error intrinsic to the perpetuity conjecture must be removed and removed with a finite projection value for GF’s fourth true variable, t, which does not invalidate that equation in mathematical terms.

5.8.3.4 Zeno’s Paradox Zeno’s Paradox refers to a mathematical calculation in which the difference between two lines is continually reduced but those lines never intersect. The illustration sometimes used to explain this notion is that of an arrow shot at a target, and the distance between arrow and target reduced by half in each millisecond. The arrow moves closer and closer to the target, but never hits it.

This mathematical concept is consistent with the notion of gradually fading company CFROI rates over time that approach but never intersect with WACC, a Competitive Advantage Period (CAP)-based conception of perpetuity. If the target is hit and CFROI=WACC, the Viability Threshold is breached and the company’s economic life span ends.

But applied to business reality, the mathematical state of perpetuity represented by Zeno’s Paradox is both implausible and impossible.

•

Implausible since at some point in the fade process, the deterioration becomes destabilising. A firm that can scarcely generate sufficient CFs to cover its financial costs hardly suggests a firm with performance and reserves required in order to continue operating to the end of time.

•

Impossible in the sense that any process that can never reaches a point of termination suggests an infinite loop error, described above.

5.8.3.5 Non-Euclidean Geometry A state in which the CFROI rate function and the WACC rate never intersect such as contemplated above is consistent with the perpetuity conjecture in GFAP: with no intersect, there is no termination of that firm’s life span on a CAP basis. Such a state is reliant on Newtonian (that is, pre-Einstein) concepts of physics which are reflected in traditional or Euclidean geometry.

211

Chapter 5 - Results of the Analysis and Relevant Comment Newtonian-Euclidean geometry is sometimes referred to as 'the geometry of straight lines' for the reason that two parallel lines—or two parallel mathematical functions such as CFROI rate and WACC rate-- are presumed to never intersect. This form of geometry persists as the foundation in fields such as architecture and mechanical engineering (Ryan, 1986).

However, more recent thinking is that Non-Euclidean (Einsteinean) concepts of geometry may prevail, instead. Non-Euclidean geometry permits intersections and thus contradicts the geometry of parallel lines, along with the related concept of perpetuity: parallel lines never meet.

In commercial business terms, the Non-Euclidean notion that intersects do occur is supported by instances in which CFROI rate and cost of capital (WACC) intersect: •

CFROI- to-WACC intersects appear in Madden’s Figure 5.8.2 from his 2005 and 2007 papers and is supported by similar examples in the Credit Suisse HOLT commercial literature (2006).

•

Performance reversion to mean notions (Mauboussin 2007, Wiggins and Ruefli 2002) also suggest eventual intersection.

5.8.4

Theoretical

As an abstract concept, several issues arise relating to the role of perpetuity a surrogate means for calculating individual company’s life spans (t). These include: •

Parallel reality, or reliance of unreal, theoretical longevity for value calculation purposes rather than analysis based on actual lives (5.8.4.1);

•

Mutual exclusivity in the face of substantial proof that most and perhaps all companies experience sub-infinite life spans (5.8.4.2);

•

Kuhn’s description of the axiom that eventually must give way to superior interpretations when confronted with too much in the manner of conflicting evidence and analysis (5.8.4.3);

•

Popper’s falsification principle for assessing the legitimacy and acceptability of theorems (5.8.4.4); and

•

Bounded Rationality Errors (5.8.4.5), referring to the application of perpetuity within a narrow interpretive context that disregards customary practices of 212

Chapter 5 - Results of the Analysis and Relevant Comment developing projections of future variables based upon analysis of past data and emergent trends.

5.8.4.1 Is there such a thing as a parallel dimension to real (time)?

The firm has an infinite horizon…

- Jovanovic 1982, 652.

FirstBank 7th Failed Bank of Year, 32nd of Recession - MarketWatch.com 6th Feb. 2009.

For the perpetuity conjecture to represent company longevity (t) in GFAP while at the same time thousands of companies are observed to fail (2.4 and 5.6), two incompatible conceptions regarding time must somehow be reconciled.

Those two concepts involve: (i.) future projections of longevity informed by analysis of actual information on survival duration, and (ii.) theoretical concepts of never-ending time unknown in the actual world.

The first concept (i.) corresponds to customary notion of elapsed time: duration, measured by the difference between date of origin (birth) and verifiable date or failure (death). That information is in turn may be to help inform projections of specific companies’ future life spans for purposes of valuation, as t is a variable capable of affecting company value.

The second concept (ii.) is wholly theoretical. This alternative supposition about company duration eliminates the challenges encountered in trying to accurately projecting the t variable, by effectively nullifying t’s identity as a variable of company value. This tactic does not resolve the t calculation issue, but rather, disregards it.

5.8.4.2 Dealing with the Briefer-Than-Infinite (BTI) evidence Another possible issue involving mutual exclusivity arises with the extensive evidence of companies’ sub-infinite life spans in 2.4, 5.6 and as perceived by survey respondents in 5.3.

213

Chapter 5 - Results of the Analysis and Relevant Comment

Source: Time is Value v1 (June 2009), Table 5.8

Table 5.8.3: Reconciling Evidence of Briefer-Than-Perpetual Life Spans With the Perpetuity Conjecture

The extensive statistical evidence on company collapse, failure and insolvency in 2.4 and 5.6 support for the Briefer-Than-Infinite (BTI) statement that companies experience life spans that are finite but unknown in advance, which differs from infinite.

In 2.4 it is shown that more than seventy percent of all companies that started in business the same year tend to fail within a dozen years of their birth. Exhibits in 5.6 attest to hundreds of thousands of confirmed instances of companies with limited life spans. The DCF valuation practitioners participating in the survey relating to this study (5.3) believe that the typical company fail 9.2 years after being created. Appendix N, The Future Case Against Perpetuity, indicates why companies will continue to experience finite life spans in the future.

While that alternative, or BTI, hypothesis is also supported by the evidence cited in this thesis and also supported by survey responses (Question B9, Part 3 in this Chapter (5.3)), one cannot yet state that all companies experience BTP life spans. Some firms are

214

Chapter 5 - Results of the Analysis and Relevant Comment presently not counted, and the possibility of a Never Ending Company existing in the future cannot be entirely dismissed, however remote that possibility.

5.8.4.3 Kuhn on Paradigms in Crisis125

Once the number of such “anomalies” has reached a certain threshold, the paradigm is in “crisis”, and only then do scientists legitimately engage in wide-ranging normative discussions about the future direction in their field.

- Fuller (2003, 19) on Kuhn’s process for developing new hypotheses after the original theory becomes suspect.

The emergence of the BTI counter-hypothesis is consistent with the activation of Kuhn’s Paradigm: the intellectual progression by which a substantially discredited concept is eventually put aside after being contradicted by sufficient evidence, regardless of incumbecy or continuing use by some.

Fuller interprets several of Kuhn’s arguments in the latter’s Chapter VIII (1970, originally published in 1962, 77-91). In his 1970 book, Kuhn describes a process of deconstruction of theorems and models when conflicting evidence reaches such a level that an alternative hypothesis is mandated. The three stages in Kuhn’s progression are: 1. Exceptions to the Rule: When the “anomalities” (Kuhn’s terminology) are limited to just one or two which appear to possibly be compatible with the original hypothesis, then those exceptions may fortify the original hypothesis, assuming that they can reasonably be explained as exceptions to the rule.

2. Apologists to the Defence of the Original Hypothesis:

Those number of

anomalities increase and the range becomes more diverse. At this stage in the

125

Marsh, P. (1990). “Short-Termism on Trial.” London, International Fund Managers Association, 8-13.

Marsh comments on reliance on calculation formulas which may fulfil short-term requirements but fall short of providing fully accurate measurement of the phenomenon.

215

Chapter 5 - Results of the Analysis and Relevant Comment progression, defender-apologists for the original hypothesis discover that they must devise increasingly elaborate (and implausible) explanations for why the original hypothesis is still thought to be valid.

3. Forced Transition to Successor Hypothesis:

Assuming that the wave of

anomalities continue unabated, the original hypothesis eventually reaches a tipping point (or “crisis” in Kuhn’s terminology) such that even adamant champions begin to abandon the original hypothesis, which is by this point in time viewed as untenable. As the former prevailing hypothesis recedes, the search for a replacement paradigm accelerates.

In terms of the examination of the perpetuity conjecture in this study, Stage 3 in Kuhn’s progression has been reached. When the empirical evidence of confirmed sub-infinite company life spans in 2.4 and 5.7 is considered, there can be justification for describing BTI instances as the exception that proves the rule (Stage 1).

Former champion of the perpetuity conjecture, Penman, retreats from his late 1990s unequivocal expressions of support for the perpetuity conjecture, as described in 5.8.

The volume, depth (multi-national) and breadth (multiple cohorts, multiple study years) results in the B, or Most, designation for BTI life spans in Table 5.8.3: the successor paradigm energes.

5.8.4.4 Popper’s falsification Under Popper’s concept of falsification, a theory must be capable of being challenged and possibly discredited in order to perceived as viable. (Fuller 2006, 127; Popper 2002) This criterion of Popper would appear to disqualify the perpetuity conjecture on two bases. First, since that conjecture is a wholly theoretical construct the supposition defies challenge on the basis of real world, actual measures. Second, the T Plus One mathematical identity of the perpetuity conjecture means that perpetuity cannot ever be measured, much less critically examined. As explained above, that concept is unstable in numerical terms, since the “+ 1” aspect means more periods must continually be taken into account.

5.8.4.5 Bounded Rationality Error A counter-argument against the Penman’s 1995-2001 attacks against company subinfinite life spans made in support of the perpetuity conjecture, involves a breakdown in logic referred to as the bounded rationality error (BRE).

216

Chapter 5 - Results of the Analysis and Relevant Comment This error sometimes arises when theories are developed based on artificially restricted circumstances pertaining to that situation only.126 In a sociological example, the Japanese soldier who lives in a cave in Okinawa long after World War II is over, might imagine that the war against the Allies is still being waged, but only because of his bounded rationality error: his perception set, which is artificially constrained because he never leaves his cave.

In the case of Penman and the Accounting Group (5.7), their BRE is manifested in the conviction that anything which threatens the academic valuation primacy of the Dividend Discount Method (DDM) is a mistake, which must be corrected. Since endless analysis time periods are required for accrual accounting methods to appear to be equivalent to DCF in company valuation, any notion of Briefer-Than-Infinite time periods is automatically dismissed because of that group’s circumstance-specific BRE.

5.8.5

Methodological

Reliance on the perpetuity conjecture to set t in the Gordon Formula appears to violates several methodological tenets relating to formula-based analyses, including valuation.

The issues raised in this sub-part are: 1. The unproven perpetuity conjecture persists as an experimental axiom (5.8.5.1) despite time’s (company longevity’s) role as a causal variable in determining the value of an enterprise.

2. The perpetual annuity was designed for commercial purposes other than valuation and therefore is misapplied in a GFAP role to calculate company worth (5.8.5.2).

3. Time’s role as determinant of value is diminished and distorted by the imposition of an unreal condition on t: perpetuity (5.8.5.3).

4. Methodological inconsistency diminishes credibility in GFAP, as three of the Gordon Formula’s true variables (FCF, WACC, g) are developed in customary company-by-company projection manner, while the duration of the fourth true variable, t, is arbitrarily imposed (5.8.5.4).

126 Ohlson

and Zhang (1999) cite the issue of bounded rationality error (BRE), as do Gigerenzer and Seltzer, eds. (2002) and Tisdell (1996).

217

Chapter 5 - Results of the Analysis and Relevant Comment 5. Similar to company longevity or t, the future amounts for WACC, FCF and g in the Gordon Formula are also indefinite in the sense that those future amounts cannot be known with certainty in advance. (5.8.5.5) 5.8.5.1 Perpetuity Conjecture as an Experimental, Unproven Axiom As perpetuity is conceptual (sub-part 5.8.4, Theoretical) and cannot be identified with precision (T Plus One in 5.8.3, Time Mathematics), this Researcher’s deduction is that the perpetuity conjecture cannot be proven. There is not one single known, confirmed indication that Never Ending Companies exist. By contrast, the extensive empirical evidence in 2.4 and 5.6 suggest that most (and probably all) companies experience subinfinite life spans (t) of finite-but-unknown duration.

Lacking any supportive evidence, the perpetuity conjecture is reasonably described now and in 1956 as an experimental axiom: a proposition assumed to be valid and true for purposes of GFAP, even though that proposition may not be valid in any other contexts and circumstances.

Gordon and Shapiro’s treatment of a speculative assumption as valuation fact in their 1956 formula raises several methodological dilemmas. While amounts for the Gordon Formula’s other three acknowledged variables (FCF, g and WACC) are presumably developed based on a company-by-company basis with consideration given to experience and emergent trends, time is cancelled as a variable and replaced by a counterintuitive notion that all companies exist forever and ever,.

•

At the very least, the difference in the quality of the calculation method for developing GF variables 1-3 (FCF, g and WACC) as compared to GF variable 4 (t) causes concern.

•

And since variations in t may result in changes in company valuation (as indicated in Appendix H and O, 5.5 and interviewees’ survey responses in 5.3), this inconsistency suggests a basic question: Can the overall formula reasonably be considered credible, valid and legitimate when an integral calculation within that equation is suspect?

5.8.5.2 Misapplication of the Perpetuity Annuity Function for Company Valuation Purposes In the Gordon Formula, an advantage of using a perpetual annuity function to calculate t is simplicity. But the perpetual annuity formula upon which Williams, Gordon and Shapiro based their ratio was originally applied not to company valuation, but instead, to

218

Chapter 5 - Results of the Analysis and Relevant Comment risk mitigation decisions involving an unknown future commitments, such as the pricing of life pension payouts. 127 Faced with the challenge of setting a pension recipient’s unknown remaining life span in advance, the financial provider may choose a conservative assumption of a minimal amount continuing forever. In that application, the perpetual annuity formula contains a known but acceptable error: the individual’s life span known to be finite. By introducing the tolerable error of perpetual life, any benefit accrues to the insurer in the form additional profit. But such benign considerations do not apply when the perpetual annuity function is adapted and applied to company valuation.

Calculating the life span of the newly created company destined to fail in seven year as existing forever represents a structural calculation in Gordon Formula as originally designed.

5.8.5.3 Exclusion of the t Determinant of Company Value Time (t), in the form of company longevity, is described in Chapter 1 as a determinant of company value, that is, a material causal variable. Multiple analyses and evidence in this study affirm that role: time is an important consideration in value.

But in GFAP, time’s identity is disregarded, through the device of inserting the perpetuity conjecture as a surrogate. GFAP is structurally flawed by its exclusion of the time’s role as a variable and determinant of company value.

5.8.5.4 Inconsistent Treatment of t Compared to Other True GF Variables Sub-part 5.8.5.1 notes the inconsistent in the quality of the methodological process between GF variables 1-3 (FCF, g and WACC) and the Gordon Formula’s phantom variable number 4, time. Beyond the methodological process quality issue, this inconsistency also raises in the amounts assumed for each of the four variables.

In the Gordon Formula Assuming Perpetuity in its present form, the three acknowledged variables are typically calculated on the basis of that analyst’s analysis-based best estimation of future projected performance. By contrast, variable 4 (t) is not projected at all in GFAP, but rather, presumed to be infinite:

127

Shesinski 2008, Zimmerman 2006. While the insurer or pension provider might alternatively choose specific projections based on actuarial information, those projections may later prove to be overly optimistic and/or the population covered is so diverse that the most conservative underwriting or pension payout approach is warranted, instead. In the case of assignable payouts that may be assigned to successive generations (living trusts) the infinite life span may be more accurate.

219

Chapter 5 - Results of the Analysis and Relevant Comment •

Variable 1, FCF: As described in Cassia and Vismara (2009) in 2.3, FCF is typically estimated on the basis of the annualised FCF rate as of the end of the preceding Explicit Projection Period (EPP).

•

Variable 2, g: For the potentially volatile future change factor in FCF (Mills 2005, Penman 2001), the most complete calculation approaches tend to call for variations in calculations over the firm’s forward life span (Damodaran 1998).

Although treated as if it was singular input in GFAP, g is composed of separate sub-equations including investment (i) and other factors.

•

Variable 3, WACC: Capital Asset Pricing Model (CAPM)- based constant rate calculations reflecting prevailing risk free rates and equity premia prevail today, with some possible alternative methods on the horizon (Madden 2010, Clark 2010).

Contrast the three descriptions above with GFAP’s treatment of t: arbitrary assignment of a value of infinity for all companies at all times.

5.8.5.5 Indefinite ≠ Infinite From a literal and mathematical perspective, this is the error on which the perpetuity conjecture’s unsteady existence is established.

“Infinity” means “time without end” (Encarta 1999). By contrast and in the context of the subject of this study, “indefinite” refers to a finite company life span, the exact duration of which cannot be precisely predict in advance.

As concepts of time, “indefinite” is separate and distinct from “infinite” in a somewhat comparable manner to the difference between π and ∞.

•

Pi is a mathematical amount which cannot be specified by a numerical value.

But the fact that π is indefinite has no bearing on the fact that it is sub-infinite.

Pi is between 3.1 and 3.2.

•

High Street discount fashion boutiques generally have life spans of between one season (1 year) and four years. A few exceptional performers survive a few seasons longer. But no one reasonably imagines that the fact that Top Shop’s future failure date is unknown therefore means that the UK High Street boutique is immortal.

220

Chapter 5 - Results of the Analysis and Relevant Comment 5.8.6

Competitive / Economic

In Figure 5.8.3, Madden’s ideal graphic is modified to depict the theoretical perpetual company. Performance (CFROI) eventually declines as the individual company’s performance reverts to the industry mean over time.

The cost of capital (WACC) functional line approaches AB but does not intersect, as reaching that Viability Threshold when CFROI rate = WACC rate represents one indication of company life span termination:

Source: Time is Value v1, Ch. 5.

Figure 5.8.3: Expected and Customary Increases in WACC With Company Age, And the CAP Viability Threshold

Customary valuation practice calls for a constant and unchanging WACC for the entirety of that firm’s life span as depicted by AB in the Figure, based on the reasoning that the constant WACC calculation reflects the best available insight into the cost of that firm’s capital components and likely future capital structure.

However, if WACC increases, as represented by function BC in Figure 5.8.3, then the logic of the Never Ending Company unravels if CFROI is intersected, signalling the end of that company’s life span based upon CAP framework criterion.

221

Chapter 5 - Results of the Analysis and Relevant Comment Far from being unusual or unexpected, Luehrman (1997B) claims that increases to WACC over time are to be expected. As profits are earned and retained, the incremental capital changes slightly, altering that firm’s Marginal WACC. Clark (2010) supports Luehrman’s analysis of increasing WACC as customary and expected, noting that •

As companies mature and their performance begins to decline, lenders are likely to insists on a more capital structure as manifested in a lower debt-to-capital ratio; and

•

Increases in operating and financial and/or operating risk may increase the cost of debt and equity as the firm matures.

5.9

Prospect of Future Possible Alternatives to the Perpetuity Conjecture

Sub-parts: 5.9.1 Alternatives to the Perpetuity Conjecture and the Primary and Secondary Research Questions in This Thesis 5.9.2 Bespoke Versus Standardised Approaches to the Perpetuity Conjecture Replacement Issue 5.9.3 Legacy Category Approaches 5.9.4 Emergent Category Approaches 5.9.5 Determining the Basis for Valuation t: Median, Analysed Maximum, Alternative?

This Chapter Part contains a preliminary, category level consideration of some possible successors to the perpetuity conjecture within the Gordon Formula.128 Assuming that GFAP is eventually replaced with a serial version of the Gordon Formula, with company longevity (t) treated as a variable, a requirement emerges for some basis for projecting company valuation on a company-by-company basis.129

128

“Category level” refer to groups or classes of possible replacement approaches, rather than specific recommended methodologies.

222

Chapter 5 - Results of the Analysis and Relevant Comment The search for the best sub-infinite alternative to the perpetuity conjecture relates to the secondary research question of this thesis as described in 3.3.

5.9.1

Alternatives to the Perpetuity Conjecture and the Primary and Secondary Research Questions in This Thesis

The primary research question (3.3) involves issues of the defensibility and credibility of the perpetuity conjecture as a method for estimating company life span (t) in the Gordon Formula. The related secondary question concerns the possible future successors for the perpetuity conjecture within GF. 5.9.1.1 Successors to the Perpetuity Conjecture and the Primary Research Question The existence of possible replacements for the perpetuity conjecture represents an aspect of the overall case against that supposition. One may contend that if no credible alternative to the perpetuity conjecture ever emerges, then that supposition likely persists because of inertia and familiarity.

Based on responses from interviewees (5.3), the transition from the perpetuity conjecture appears to already have started. The current absence of specific replacements for the perpetuity conjecture indicates that the transition process is at an early stage.

The secondary research issue as described in 3.3 is conditional and fractional in nature; it is conditional in the sense that the search for possible replacement(s) for the perpetuity conjecture is activated when and if that supposition is discredited (the subject of the primary research question).

The secondary issue is also fractional in the sense that the scope and depth to which possible replacement categories are investigated is general or category-based in nature (4.2, Scope and Limitations).

129

Could Gordon and Shapiro reasonably have applied one of the then-available finite, sub-infinite approaches available at that time to the challenge of projecting companies’ longevity (t) in what is today known as the Gordon Formula, in 1956 instead of relying on the perpetuity conjecture? Some legacy approaches are identified in Figure 1.6.1. Two that existed in the mid 1950s were (i.) the 40-50 year accounting lives of very long life company infrastructure-type assets and (ii.) the 30 year term of US Treasury bonds. Cohort studies of company failure experience of the Mata-Audretsch-Baldwin-Dunne quality did not emerge appear until 1988 and later, although Crum’s 1953 book provided some indications of the finite nature of companies’ true life spans. (2.3)

223

Chapter 5 - Results of the Analysis and Relevant Comment 5.9.2

Bespoke Versus Standardised Approaches to the Perpetuity Conjecture Replacement Issue

Bespoke approaches typically emerge as companies or valuation practitioners seek ad hoc alternatives to existing, standard methods. Some ‘rules of thumb’ have emerged as alternatives to the perpetuity conjecture’s endless analysis time span.

In his 2007 text, Penman prescribes a fourteen year finite valuation analysis period, rather than deal with the ambiguities of never-ending periods. Boots plc.’s (UK) fifteen year valuation analysis used from 1999 to 2003 is consistent with internal practices of several of the US companies as described in Davis (1996).130 Several valuation practitioner interviewees (5.3) described their bespoke methods for TV, including methods that called for second Explicit Projection Periods (EPP, Stage 1) and some use of Multiples.131

One interviewee described analysing incremental

Terminal Value after the EPP forecast in over successive five year periods, until nearly all of the company’s share price (market value, MV) was explained.

Advantages of bespoke approaches are that they are easily implemented and immediately responsive to concerns of senior managers.

Standardised methods for calculating finite t have the advantages of comparability between firms and broad acceptance, assuming that a generally accepted scheme can be devised which is widely agreed and used.

5.9.3

Legacy Category Approaches

Some historical (legacy) and emergent possible replacements were identified on a preliminary basis in Chapter 1. A portion of Figure 1.6.1 is shown below:

130

Cash Flow and Performance Management. Morristown NJ USA, FERC.

131

“EBITDA” means Earnings Before Interest, Taxes Depreciation and Amortisation. ”Multiples” from 2.3 refers to Price-to-Earnings or Price-to-EBITDA multiples.

224

Chapter 5 - Results of the Analysis and Relevant Comment

Figure 5.9.1 Legacy Versus Emergent Replacement Approaches For the Perpetuity Conjecture: Preliminary

5.9.3.1 Accounting asset lives-based “Accounting-asset lives-based” in Figure 5.9.1 refers to categories of depreciable assets for which accounting-basis life spans have already been established by professional accounting bodies. Atrill and McLaney (2006, 83) cite the following asset lives for Thornton Ltd. based upon the confections manufacturer’s 2004 accounts (years in parentheses): factory freehold premises (50 years); manufacturing plant and equipment (12-15 years); retail store improvements (10 years); retail fixtures and fittings (5 years); retail equipment (4-5 years); and office equipment and vehicles (3-7 years).

An advantage of this type of source is consistency. Changes to stipulated asset life ranges tend to be gradual and incremental. Significant alternations normally occur only after evidence of life span-changing developments involving economic and/or technological obsolescence affecting that asset class.

A disadvantage of this type of source is that asset lives may have little to do with company lives. While it is true that the pizza parlour’s prosperity depends on the productivity and reliabilities of the ovens purchased for that business, the restaurant’s life span is ultimately determined by factors other than mechanical obsolescence.

Competition in the marketplace, access to supplies and channel (location of outlets) are more directly related to that company’s prospects for survival..

Four other problems with this the use of this type of information as a basis for estimating future company life spans are referred to below as Mix, Static-Historical, Conversion, and Accounting-Specific:

225

Chapter 5 - Results of the Analysis and Relevant Comment (i.) Mix: This refers to the difficulty of developing a reasonably consistent life span indicator despite the fact that a company’s balance sheet is comprised of an ever-changing mix of different asset types, each of which has its own accounting life. As the accounting lives of different asset categories sometimes differ significantly (as illustrated by the Thornton’s 2004 accounts) questions arise about the most appropriate way to combine that different information.

Should the asset categories with the longest lives inform company duration? A weighed average? Other mix basis? (ii.) Static-Historical: Chapter 1 establishes that valuation is future-oriented.

(1.3) But balance sheet-based methods are historical by definition. Asset lives and amounts in Year 1 might have some little bearing on the company or its operations eight years from now, when past failure patterns for that industry suggest the firm will fail. (iii.) Conversion: This refers to difficulties in transforming accounting asset life indications into useable estimates for t in the Gordon Formula. While the two life span concepts are somewhat related (there is no company without assets, after all) devising an asset-to-company life span conversion factor may prove difficult.

Although Jennergen’s 2008 study presented convincing arguments to suggest that lives of property, pant and equipment (PPE) relate to longevity of the companying owning those assets, there is no standard conversion from asset lives to company lives.132 (iv.) Accounting-specific: Asset depreciable lives are accrual accounting convention, and thus do not reflect DCF valuation perspectives. Some of the difficulties encountered in attempting to correlate accrual accounting-based measures to company valuation were described in 2.3.133 With DCF company valuation methods prevailing over accrual accounting methods since 2001 according to Penman, one imagines that accrual accounting based measures may be problematic.

132

The word “owning” presents yet another possible conversion issue. If the assets are not owned but rather controlled (lease hire, or relegated to off balance sheet) does that any bearing on the company longevity?

133

“In the dividend discount model (DDM), forecasted dividends over the immediate future are often not related to value.” (Penman and Sougiannis 1996)

226

Chapter 5 - Results of the Analysis and Relevant Comment 5.9.3.2 Long-term capital financing The first year finance student quickly learns that the word “capital” may refer either to the company’s investment base which generates future value, or to the company’s permanent financing that supports company investment.

In the US, the thirty year US treasury bond endures to this day as the customary risk free rate starting point in calculating WACC using the Capital Asset Pricing Model (Chapter 2 Part 2; also, Perold 2004 and Fama & French 2004).

This relationship between capital financing and value suggests that T-bonds’ duration may also represent a useful guideline for the limits of companies’ life spans. Since T. Boone Pickett’s convincing arguments in early 1980s that many firms were underleveraged, the reality at many companies is that the rate of value growth is limited by the availability of financing. (Clark 1991) The thirty year T-bond duration coincides with the lower end of de Geus’s maximum life span range for companies, less ten years (2002, 2).

An advantage of using the duration of T-bonds (or in the UK, longest term government gilts) as a possible basis for company valuation longevity is that the source information is ready available and highly stable. A disadvantage is inflexibility: an unchanging thirty year life span assumption may be suitable for a utility with a stable customer base, yet far too long for a company in a volatile consumer retail segment, such as the sandwich shop company which survives for one year only in Appendix H. 5.9.3.3 Operations-based In recent years, operations management researchers, including Hartman and Murphy (2006) and Jennergren (2008), have sought to analyse the economic, functional lives of plant and equipment (PPE, shop fittings) in order to develop perspectives on the relationship between asset lives and company lives for valuation purposes.

Jennergren analyses the Statistics Sweden database of PPE longevity patterns in twentyfive industries. Appendix I shows results over three years (1996-98), along with the average over the 1994-1998 period (2008, 1555).

In nine of those industries, PPE lives are shown as decreasing over time, based on comparisons of the earlier and later samples (Appendix J). Projected PPE economic life spans are estimated for those nine industries for 2003, five years after the 1998 data.

The resulting 2003 PPE projected economic life spans for 9 out of the 25 industries (36% of total) range from the longest duration 18.8 years for sea transportation equipment to a low of 4.1 years for electrical machinery and optical equipment.

227

Chapter 5 - Results of the Analysis and Relevant Comment While Jennergren’s analysis yields some useful insights, the aforementioned problems of asset mix and conversion to company lives also applies here. A company in a notoriously unstable industry might have considerable investment in long-lived PPE, but ownership of those assets will not prevent failure if new competitors lure away the company’s primary accounts.

5.9.4

Emergent Category Approaches

Two candidate categories to replace the perpetuity conjecture are industry or segmentbased categories (5.9.4.1) and multiples of company product-service life cycles (5.9.4.2).

Audretsch and Dunne et al. are amongst the researchers who exam differences in company life span by industry in 2.4. Product-service life cycle multiples emerge from the writing on innovation introduction, such as the McKinsey & Co. S Curve concept.134 The exhibit that follows is adapted from Table 2.4.6 in 2.4, and shows cumulative failure percentages over time, in years. Audretsch’s 1995 study involved approximately 57,000 US companies organised in eighteen industry categories (page 159):

134

“Multiples” here refers to the fact that product life cycles are typically a fraction of company overall life span, an issue also addressed in this Chapter Part in Table 5.9.3.

228

Chapter 5 - Results of the Analysis and Relevant Comment US: Age Cohort (Percentages) of 1978 Exiting Establishments: Industry Cumulative Failure Patterns Adapted From Table 7.3, Audretsch 1995, 159

Segment

No.

COL. 1

COL. 2

COL 3

COL. 4

COL. 5

1 to 2

2 to 4

5 to 6

7 to 8

9 to 10

Food Production

4,234

13.2%

23.0%

30.7%

36.8%

41.7%

Textiles Mfg.

2,008

19.0%

30.8%

39.9%

45.4%

49.5%

Apparel Mfg.

5,301

21.4%

34.3%

44.7%

51.6%

56.8%

Lumber Producers

5,682

15.3%

27.8%

36.5%

43.4%

48.2%

Furniture Mfg.

2,496

20.4%

33.3%

43.6%

49.7%

53.9%

681

18.1%

30.9%

43.4%

50.6%

54.3%

Printing Services

9,626

15.0%

28.9%

39.7%

47.2%

52.7%

Chemical Supply

2,239

18.6%

31.7%

42.5%

50.3%

55.2%

278

27.3%

44.2%

53.2%

60.8%

66.2%

1,630

23.7%

44.9%

58.0%

66.8%

72.0%

701

21.4%

35.4%

46.8%

53.8%

57.5%

Stone, Clay & Glass

2,877

17.9%

31.9%

42.5%

50.0%

54.2%

Primary Metals Prod.

812

24.0%

39.6%

52.3%

57.7%

62.4%

Fabricated Metal Prod

4,674

20.4%

34.9%

45.7%

53.7%

59.2%

Machinery, Non-elec.

7,266

18.6%

33.0%

43.6%

52.5%

61.1%

Electrical Equipment

2,687

27.2%

46.2%

60.9%

69.9%

75.7%

Transportation Equip.

1,970

26.9%

46.1%

60.4%

69.6%

74.8%

Instruments Mfg.

1,460

22.0%

40.0%

52.4%

60.8%

66.3%

Paper Mfg.

Petroleum Rubber and Plastics Leather Producers

Total, 18 segments

56,622

Source: Table 2.4.6

Ch. 2 Pt. 4

Table 5.9.1: Audretsch (1995): Cumulative Failure Patterns of US Companies in Eighteen Industries

Table 5.9.1 is consistent with this Researcher’s analysis that the median life span for companies overall is approximately seven years from origin. In sixteen of the eighteen industry groupings or segments, the cumulative failure percentage (as shown in Column

229

Chapter 5 - Results of the Analysis and Relevant Comment 4) is 45 per cent or greater. Stated another way, almost half of the companies beginning operations in 1978 failed on or before their eighth anniversary.

Column 5 in Table 5.9.1 (corresponding to 9-10 elapsed years) is consistent with survey interviewees’ estimate in 5.3 that the typical company has a life span of about nine years. Sixteen out of eighteen segments show failure rates of 50 per cent or greater. Ten out of the eighteen segments indicate a 55% cumulative failure rate, and seven of eighteen segments show failure percentages of 60% or more.

Some patterns of life span differences based on industry classification become apparent.

Food producers tend to survive longer than manufacturers of electrical equipment according to the Audretsch study. Lumber companies show longer life spans than firms involved in the manufacture of transportation equipment.

In their answers to Question A6 (5.3), interviewees overall responded positively to the prospect of industry-based lives as a possible replacement for the perpetuity conjecture, with some caveats.

Several interviewees cautioned that historical life span indications may be irrelevant in the case of fast-changing consumer industries, or other segments undergoing technological change such as the newspaper industry.135 Patrick Dorsey, head of equity research at Morningstar, suggests that diversification renders traditional industrysegment classifications irrelevant as many diversified companies are involved in more than one industry.136 5.9.4.1 Multiples of Product-Service Life Cycles (PLCs) This possible replacement approach concept is that companies’ economic life spans are defined by multiples of future projected PLCs, and that these product life cycles often shrink as a result of competitor initiative, technological advances and other factors.

Amongst academic writers, examinations of shrinking PLCs over time include Norton and Bass’s seminal work on diffusion theory (1987), Lambkin and Day (1989, 16, citing Romanelli, 1987) and Souza, Bayus and Wagner’s “New-Product Strategy and Industry Clockspeed” (2006). Clark examines shrinking life cycles in several industries (2001, 162-164). D’Aveni suggests that:

135

Salzman (2010) describes the new forces threatening the viability of US online brokers including Chas.

Schwab, one of the Industry Pairs companies referred to in 5.6.

136Dorsey,

P. (12th April 2010). Phone interview of the director of equity research at US’s Morningstar Reports service with this Researcher.

230

Chapter 5 - Results of the Analysis and Relevant Comment Product life cycle and design cycles have compressed… New models of computers that once had product life cycles of five years now turn over every six months; car models that once were introduced every decade are now changed in five years or less. Design time for new models has been cut in half, from 5 and one half years to 3 years. (1995, 5) The global automobile industry provides an illustration of the potential effect of the leader’s PLC initiatives on TVP term. “Japan Auto” (Toyota/Honda/Nissan) first establishes key production advantages over the US Big Three automakers (Table 5.9.2).

Those market advantages into briefer and briefer product cycles, as indicated in Figure 5.9.2.

The D’Aveni cycle indications above are fifteen years old. The Machine That Changed the World (1990) co-author David Jones indicated to this Researcher in May 2000 that Toyota’s and Honda’s product life cycle-relevant speed advantage over General Motors was approaching 2:1. In other words, Honda is able to bring major new products to market in half the time it takes GM. Logically, a TVP term analysis framework based on shrinking PLC patterns encompasses both (i.) the number of life cycles and (ii.) the duration of each cycle. For insight into point (i.), this Researcher goes to one of the earliest PLC papers, Polli and Cook’s “Validity of the Product Life Cycle” (1969). On page 387 of that paper, the authors show the Nielsen-Cox recycle curve, recreated for this Chapter as Figure 5.9.3.

Part of that name corresponds to Cox’s 1967 study of 258 ethical drug companies. The other part refers to market research firm A.C. Nielsen, which developed the concept of a second, briefer, “recycle” period following the initial cycle.

The Polli-Cook version of the Neilsen-Cox Recycle curve does not include numerical values; however the authors’ comments and the graphic itself (pages 387-391) confirm that the second cycle is briefer than the first.

231

Chapter 5 - Results of the Analysis and Relevant Comment

Table 5.9.2: General Motors v Toyota: Selected Auto Production Statistics, 1986

Table 5.9.3: Towards Product Life Cycle-Influenced Estimates of Terminal Value Period (TVP) Life Spans,

By Industry (Preliminary)

232

Chapter 5 - Results of the Analysis and Relevant Comment

Figure 5.9.2: Shrinking Life Cycle Implications: Post-WWII Auto New Model Introduction Cycle Time

233

Chapter 5 - Results of the Analysis and Relevant Comment

Figure 5.9.3: Nielsen-Cox Recycle

The two components of a possible PLC-informed Terminal Value Period (TVP) term estimation approach are extended to Table 5.9.5.

“LPL” in that Table stands for Leader Product Lifespan, the industry or segment pacesetter’s PLC performance. If Nintendo manages to develop a new major gaming system every 18 months, Microsoft X-Box faces assured slippage in its segment if instead its cycle is 24 months.

Stated another way, it is the segment leader who typically sets the pace in terms of shrinking PLCs: Honda, Apple, Nintendo. In Table 5.9.3, four different competitive scenarios are considered, with TVP term set as two cycles in each. The more volatile the sector and the greater the level of competitive intensity in that segment, the shorter the average lifespan of participating companies.

To illustrate: In a Category 1 established near monopoly such as UK’s British Telecommunications (BT), that firm is essentially “the market”: minor competition invariably arises in the more profitable niche areas, but these short-term competitors exit as rapidly as they 234

Chapter 5 - Results of the Analysis and Relevant Comment enter. For BT, the two cycle guideline results in a sixteen year TVP term assuming an eight year current cycle period.

By contrast, the discount fashion outlet in the Mall faces no more than one full PLC as defined by that industry’s leader. Using the preliminary statistics shown in the Table, and assuming that the segment leader exhibits annual or single year PLC performance, two-thirds of that duration (cycle 1) plus one-third (cycle 2) establishes the expected TVP duration in that instance: one year.

Survey respondents also viewed PLCs as representing a promising possible future direction for replacing the perpetuity conjecture. One interviewee cautioned however that insight into product cycle patterns tends to be far more extensive than base information upon which to develop t longevity hypotheses concerning service industries.

5.9.5

Determining the Basis for Valuation t: Median, Analysed Maximum, Alternative?

Regardless of the separate method or hybrid approach that eventually prevails as the replacement for the perpetuity, a further necessary judgment is required before an alternative basis for estimating company-by-company t may be introduced into the Gordon Formula.

That determination is whether the basis for t is to reflect: (i.), estimated average life span median; (ii.) analysed estimated median life span; (iii.) analysed maximum life, or something in between. By definition, the perpetuity conjecture represents an extreme approximation for (iii.).

The nature of this challenge is indicated by the statements of de Geus and Figure 5.9.4:

235

Chapter 5 - Results of the Analysis and Relevant Comment

Figure 5.9.4: A Composite Perspective on Company Longevity

de Geus postulates that the average company’s life span tends to be between 12.5 and 13 years. The Dutch author and researcher then states that 40 to 50 years is a maximum life span range for companies overall, based on patterns of publicly-traded firms (2002, 2).

Both of de Geus’s statements are reflected in Figure 5.9.4. Forty elapsed years from origin, the lower end of de Geus’s maximum range, is shown in the exhibit as Point D. Ninety-eight percent cumulative failure is assumed rather than 100% as the ultra longlife exception occasionally arises: the Hudson Bay Company or the Stora Ltd. with a life span measured in centuries rather than years. de Geus does not affix a cumulative failure percentage to his “average” life span of 12.513 years, but by developing a curve fit based on several other longevity sources cited in this thesis, this Researcher’s analysis suggests a percentage of approximately 80%, designed by Point C in the Figure.

Every company life span termination that occurs below and to the right of the ABCD curve in Figure 5.9.4 is already incorporated into that cumulative failure mathematical function; possible experiences above and to the left of the curve are not included.

236

Chapter 5 - Results of the Analysis and Relevant Comment Thus a judgment is necessary to select which point along the cumulative longevity curve valuation t is set. Assuming that median life span is that criterion, Figure 5.9.4 indicates Mata and Portugal’s 1994 indication of 4.5 years as the appropriate longevity statistic. If this Researcher’s analysed median based on Table 2.4.2 in 2.4 was used instead, seven years would represent the median t.

While a maximum life span such as represented by Point D in the Figure has the advantage of excluding almost no company, the opposing consideration is for that the majority of companies with actual life spans of less than a decade, use of a 40 year-plus t as a replacement for the perpetuity conjecture still means significant error in that variable for that company.

237

Chapter 6 – Conclusions and Future Direction of Research

6 Conclusions and Future Direction of Research Conclusions (6.1) address the two research questions of this study (3.3), taking into account the research described in preceding Chapters. Possible influences of this work on valuation practice and practitioners are described, as are implications for the literature. Possible Future Areas of Research (6.2) identifies related issues and areas for possible further investigation in other studies.

6.1

Conclusions

Sub-parts: 6.1.1 Addressing the Primary and Secondary Research Questions in This Study 6.1.2 Briefer-Than-Infinite (BTI) Hypothesis Prevails Over Perpetuity Conjecture 6.1.3 ‘Three Research Questions’ (From Chapter 1) Revisited 6.1.4 Contributions From This Research I: Possible Influence of The Analysis and Results of This Study on Valuation Practitioners’ Behaviour 6.1.5 Contributions From This Research II: Possible Influence of The Analysis and Results of This Study on Effects on Prevailing Literature

Conclusions described herein are developed through (i.) analysis and interpretation of related primary and secondary research, and (ii.), to a lesser degree, valuation simulation examples such as the Circuit City analysis in 5.6.

Analyses and resultant conclusions are supported by relevant databases, as applicable.

Those supportive databases are categorised below as direct and indirect:

•

Direct (meaning that this Researcher has direct access to original source statistical data)

Company information from independent equity analysis firm Morningstar provides the basis for analysis of companies' Briefer Than Infinite (BTI) life spans on a multiple year CFROI basis in the Industry Pairs analysis in Chapter 5 238

Chapter 6 – Conclusions and Future Direction of Research Part 6 sub-part 7 (5.6.7). That analysis affirms the reality of sub-infinite company life spans for several of those analysed firms. Table 5.3.2 in Part 3 of Chapter 5 (5.3) shows the results of the database developed by this Researcher relating to the primary research conducted for this thesis. In Part 4 of Chapter 5 (5.4), illustrative base data relating to the interaction of acknowledged (FCF, g, WACC) and non-acknowledged (t) variables of the Gordon Formula are shown in Table 5.4.1, supporting a conclusion that unrealistic estimations of company duration (t) sometimes result in untenable Terminal Value (TV, and thus company) value calculations.

•

Indirect (meaning that this Researcher does not have access to original source statistics)

Other supportive data supporting the conclusions herein is categorised as “indirect”, meaning that this Researcher relies upon other researcher’s compilation and depiction of their source data. In Part 4 of Chapter 2, the summary of seven leading academic studies on company longevity supports the notion of median company life spans of approximately seven elapsed years from origin is shown in Table 2.4.2. Audretsch’s analysis of differences in life span according to industry or segment type (Table 2.4.6) support the analysis—and thus the development of conclusions—in two parts of Chapter 5, Results and Analysis of Relevant Comment. Operations-based longevity database analysis (Hartman and Murphy, Appendix G; Jennergren, Appendices I and J) support analysis in 5.8 and 5.9 and conclusions developed relating to BTI company life spans. US and UK government database sources are prominent in 5.6, supporting that conclusion that a material number of companies do not experience infinite life spans, which in turn directly contradicts the perpetuity conjecture, the focus of this thesis.

6.1.1

Addressing the Primary and Secondary Research Questions in This Study

The primary research question (3.3) is addressed in this document. Based on the evidence and analysis herein, this Researcher’s conclusion is that the perpetuity 239

Chapter 6 – Conclusions and Future Direction of Research conjecture as described in Chapter 1 is neither credible nor defensible as a basis for estimating individual companies’ forward life spans (t) for valuation purposes.

A compelling case emerges from 2.4 and the evidence and analysis in the several parts of Chapter 5 for replacing the perpetuity conjecture with a method for projecting subinfinite longevity (t) on a company-by-company basis.

Several categories of plausible replacement approaches for the perpetuity conjecture emerge in 5.9. Methods based on historical industry failure statistics benefit from a deep base of empirical information, but may require further adjustments due to diversification and rapid technological changes not always reflected in historical data.

Product-service life cycle (PLC)-based methods are consistent with the growing sense that a company’s longevity is ultimately dependent on its effectiveness in the marketplace. Even well-established companies are unlikely to survive more than two or three consecutive disappointing product-service life cycles. The challenges involved in converting PLC insights into useable replacements for the perpetuity conjecture include (i.) development of consistent and credible conversion factors for transforming PLC duration into credible projections of company life spans and (ii.) increased statistical analysis of service life spans, an area of PLC investigation that presently receives only limited attention.

Both industry lives and PLC multiples appear to have some appeal as possible successors to the perpetuity conjecture based on responses from the valuation practitioner interviewed for this research (5.3 and Appendix E Part 2, E.2).

With the perpetuity conjecture discredited, the future structure of the Gordon Formula is expected to evolve from the present three variable ratio to a four variable serial alternative, with time as an acknowledged variable and determinant of company value in the four variable GF serial version.

Time is value.

Table 6.1.1 is derived from Table 5.6.1. The only difference from the earlier exhibit is in the shaded box in the lower right. As a result of the analysis and relevant comment in 5.9, several candidate approaches for developing future projections of t are indicated.

240

Chapter 6 – Conclusions and Future Direction of Research

Table 6.1.1: Perpetuity Versus BTI Revisited- Expanding Upon Table 5.6.1

6.1.2

Briefer-Than-Infinite (BTI) Hypothesis Prevails Over Perpetuity Conjecture

Central to the resolution of the primary research question is the evidence and analysis suggesting that the opposite of the perpetuity conjecture—referred to in this study as the Briefer-Than-Infinite (BTI) hypothesis— emerges as far more credible defensible than the Never Ending Company perpetuity conjecture.

Figure 6.1.1 expands upon the exhibit from Chapter 1 showing BTI at the opposite end of a conceptual spectrum from the perpetuity conjecture. The first three rows in Figure 6.1.1 (designated as: t =, identity of assumption, basis: initial) are repeated from Figure 1.2.1.

241

Chapter 6 – Conclusions and Future Direction of Research

t=

Variable by both company and firm’s scenario

∞

Identity of assumption

variable (v)

constant (k)

Basis: initial

observation

theoretical construct

Supportive evidence

2.4, Chapter 5 multiple parts

(neg.) 2.4, 5.3, 5.6, 5.8

Confirming instances

hundreds of thousands, plus

none known

Valuation accuracy

neutral

distortion, except for IE

Implications for GF future

4 variable (add t), serial

3 variable ratio continues

Figure 6.1.1: Perpetuity Versus BTI Revisited - Expanding Upon Figure 1.2.1

The perpetuity conjecture is represented by the infinity (∞) symbol in that column. In the opposing hypothesis, BTI, all companies are presumed to exist for sub-infinite periods. Those sub-infinite life spans are variable in that they change from company to company.

•

BTI is affirmed by direct observation: companies fail on a consistent basis, and those failure can be observed, measured and recorded. By contrast, there is not one known observation of a perpetual firm.

•

The same evidence supporting BTI in several parts of this study also serve as evidence against the perpetuity conjecture. The volume and consistency of failures suggest that BTI is not the exception to the perpetuity conjecture rule.

•

BTI is as accurate as the component assumptions. The perpetuity conjecture, by contrast, introduces an additional source of valuation if future projected Cash Flows are significant and if the company’s actual life span is brief.137

137

“Future project Cash Flows are significant”: this is another way of saying that the Insignificance Exception rare circumstances described and examined in 5.5 do not apply.

242

Chapter 6 – Conclusions and Future Direction of Research 6.1.3

‘Three Research Questions’ (From Chapter 1) Re-Examined

Figure 6.1.2, below, is adapted from Figure 1.6.1 at the end of the first chapter. The Figure shows how the three queries guiding the process of this study are resolved and concluded.

Figure 6.1.2: Re-Examining the Three Core Questions (Figure 1.6.1)

243

Chapter 6 – Conclusions and Future Direction of Research 6.1.3.1 Q1:

Do companies experience perpetual Life Spans in the Real

World?

Only one of the three guiding queries was addressed in exhibit in Chapter 1, Figure 1.6.1. In response to Q1 (Do Companies Experience Perpetual Life Spans in the Real World?), an initial, preliminary response of “no” (Point B1b) arose on a prima facie basis. Even before research commenced in earnest, daily evidence of company similar failures provide a sense from the onset that companies experience finite-but-unknown life spans, and that companies are not immortal.

In Figure 6.1.2, that B1b “no” remains, but it is corroborated with substantive evidence: the 1988-2007 cohort studies of company failure in the academic literature as described in 2.4, and UK and US government ministry (agency) statistics of liquidations, companies in administration and similar forms of cataclysmic failure, as found in 5.6 and Appendix N. 6.1.3.2 Q2: Is it Plausible and Defensible to Assume That Companies Endure Forever for Value Estimation Purposes Only?

The supposition underlying this second core query is that regardless of the evidence that companies experience sub-infinite lives in the actual business world, this doesn’t matter because only the theoretical concept of infinite company lives matters.

One is hard pressed to find a theory that persists for very long when contradicted by a relentless and substantive stream of conflicting fact. Kuhn’s paradigm in crisis situation arises, as the old conjecture first faces substantial doubts and then is wholly discredited.

Overwhelming statistical evidence of sub-infinite life spans is supplemented by the logic arguments in 5.8, and the fact that the primary advocate of the perpetuity conjecture in the literature, Penman, today acknowledges a role for finite life span projection informed by historical analysis (5.7).

6.1.3.3 Q3: What emerges as the most promising approach to replace the perpetuity conjecture?

As a consequence of the research and analysis involved in addressing Q2, the perpetuity conjecture is discredited. Thus the search begins for a possible replacement for that now untenable supposition within the Gordon Formula structure.

That search begins with the legacy candidate categories as identified in Figure 1.6.1 and repeated in Figure 6.1.2. In some form, each of those alternative surrogates for t existed in the mid 1950s, when Gordon and Shapiro’s paper was written. But all three of those categories (accounting-based asset lives, terms of very long term capital instruments and 244

Chapter 6 – Conclusions and Future Direction of Research operations-based metrics) suffer from either being constants and/or being only indirectly related to company longevity.138 Three of the four Emergent categories (industry classes, multiples of product-service life cycles (PLCs) in Figure 6.1.2 also appear in the earlier Figure. The addition is indications of longevity as suggested by CAP. The objective in addressing Q3 here and the study’s secondary research question (3.3) is directional rather than definitive. The scope of the research directed at this issue (4.3) calls for identifying prospective candidate replacement categories for the perpetuity conjecture, rather than specific successors.

Emergent categories reflect some of those life span-influencing factors but presently have not been developed to the extent that one or the other or a combination may be presented as the consensus successor to the perpetuity conjecture. Furthermore, separate investigation of these candidate categories is included in 6.2, Possible Future Areas of Research.

6.1.4

Contributions From This Research I: Possible Influence of The Analysis and Results From This Study on Valuation Practitioners’ Behaviour

This Researcher’s study provides numerous contributions to both Discounted Cash Flow (DCF) valuation practice and to the literature on company valuation and calculation of the Terminal Value Period (TVP) specifically. This Chapter sub-part (6.1.4) considers influences of this work on the future behaviour and actions of DCF method valuation practitioners. The sub-part following (6.1.5) deals with contributions to the valuation literature.

This Researcher’s most important contribution to the valuation practice in this thesis to eradicate the mistaken but—until recently, persistent-- image of the Gordon Formula Assuming Perpetuity (GFAP) as a benign and reasonably accurate means for estimating ‘continuing’ or Terminal Value, and therefore, for calculating the major component in company value.

But combine (i.) the immense difference between actual company life spans and perpetuity (median company life span is calculated to be seven years from origin in 138

Constant durations are problematic because companies’ life spans are variable, even within the same industry or segment, as shown in the Industry Pairs analysis detail in 5.6 and related Appendix M.

245

Chapter 6 – Conclusions and Future Direction of Research Chapter 2 Part 4 in this thesis) with (ii.) the almost non-existence of the Insignificance Exception (5.5) and the consequence is that the perpetuity conjecture can and does result in TV miscalculation (5.4), as demonstrated in several parts of this thesis.

When the previous principal supporter of the perpetuity conjecture, Penman, acknowledges that finite TV calculations informed by past patterns of longevity have an important role in the future of company valuation (5.7), valuation based on fictional Never Ending Companies becomes untenable.

The survey conducted in conjunction with this study reveals that many DCF valuation practitioners are already moving away from the newly-discredited concept of Terminal Value Periods extending to infinity, replaced by their own bespoke sub-infinite alternative methods.

Therein lies this Researcher’s second major contribution to valuation practitioners: beginning the process of finding tomorrow’s sub-infinite replacement for the perpetuity conjecture.

This thesis examines both historical and emergent major alternatives (6.9), with particular emphasis on two possible directions with support in the scholarly or general management literature already: industry categories (Audretsch 1995) and product life cycles (Womack et al. 1990). Without this initial investigation narrowing down the range of successors, TV calculation declines to non-standard (and thus, non-usable) bespoke, company-by-company individualised techniques.

Table 6.1.2, Contributions From This Research I: Possible Influences of This Thesis On Practices and Behaviour of DCF Valuation Practitioners, summarises ten areas in which the results and analysis contained from this study may change actions and attitudes of those practitioners applying DCF company valuation methods. The Table is organised into three columns relating to: (I), the Gordon Formula specifically; (II), DCF value estimation methods in general; and (III), other valuation related issues:

246

Chapter 6 – Conclusions and Future Direction of Research

Table 6.1.2: Contributions From This Research I: Possible Influences of This Thesis On Practices and Behaviour of DCF Valuation Practitioners

6.1.4.1 Category I- Relating Specifically to Practitioners’ Use of Gordon Formulas IA Revised Perspectives On Legacy Gordon Formula Assuming Perpetuity (GFAP) This thesis is expected to add pace to valuation practitioners’ movement away from reliance on the legacy version of the Gordon Formula, referred to herein as the Gordon Formula as the means for estimating a company’s Terminal Value in the DCF2S second stage.

247

Chapter 6 – Conclusions and Future Direction of Research The perpetuity conjecture reduces the usefulness of GFAP for that purpose. Many of the practitioners interviewed (5.3) describe applying their own bespoke methods for estimating TV and avoiding the Gordon Formula altogether.

Foundations of GFAP are undermined by other interviewees’ responses in the survey related to this study. Practitioners’ response to Questions A2 and A3 indicate a belief that time (company longevity) is a variable rather than a constant, and that variations in longevity affect value. As a group, interviewees believe that the life span of a typical company is 9.2 years, rather than infinite. (Question B9). That response is approximately two years longer than analysed median life spans for companies overall, based on the studies of corporate failure published in peer-reviewed journals (2.4).

GFAP is limited by a three-variable structure that disregards the material effect of time (company longevity) as a determinant-variable of value. The circumstances in which variations in longevity have no effect on value are referred to in this study as the Insignificance Exception (IE, 5.5). While theoretically possible, several arguments and analysis suggest that the IE rarely if ever occurs.

There is no argument with the fact that the legacy Gordon Formula is an extremely easy equation to use; any equation comprised of only three variables is expected to be simple.

By deleting time as a variable and replacing it with perpetuity, Gordon Formula’s developers introduced a fatal flaw into their equation, with the result that valuation distortions may and do arise. Examples of the first (“may”) include Appendix H and the 5/7/15 year analysis in 5.4. Examples of the second (“do”) include the Circuit City analysis in 5.4 and the recurring problem of Terminal Value over-estimation.

IB Serial Version of Gordon Formula Positioned As Successor to GFAP This thesis is also expected to generate new momentum for replacing the three variable GFAP with the four variable serial version of the Gordon Formula. That evolutionary change will help to resolve one of the more serious problems with the Gordon Formula in its present form: systematic miscalculation of the time variable (company longevity) for company valuation purposes. The perpetuity conjecture within GFAP is discredited herein on multiple bases, encompassing both theoretical arguments and actual examples, primary and secondary investigation.

It is expected that serial versions of the Gordon Formula could begin to displace or at least supplement the GFAP ratio in finance textbooks and literature in coming periods.

IC Variable t: Beginning the Search for Defensible Projection Approaches

248

Chapter 6 – Conclusions and Future Direction of Research Assuming momentum towards the four variable serial version of the Gordon Formula (IB), this study provides additional momentum and some initial analysis towards the development of possible methods for projecting individual companies’ unknown-butfinite valuation life spans (t) on a consistent and systematic basis.

Re-establishing time’s identity as a variable in the Gordon Formula brings with it a requirement to develop analysis-based projections on a company-by-company basis. Part 9 in Chapter 5 provides a preliminary perspective on several possible categories of successor methods. Interviewees reacted positively to the prospects of either industry categories or multiples of product-service life cycles emerging as future replacements for the perpetuity conjecture, but some issues arise with each and additional development is required in future studies.139 6.1.4.2 Category II- Relating Practitioners’ Use of DCF-Based Valuation Methods in General IIA Variable WACC The parts of the analysis and comment contained in this study which pertain to Competitive Advantage Period (CAP)-based methods for determining the end of companies’ economic life spans (5.5, 5.8) are expected to add to the momentum for calculating WACC as a rate which varies over time as the company matures.

One of several methods for determining the end of companies’ life spans as described in Appendix K (thus contradicting the perpetuity conjecture) is based on the CAP: the end of the period of economic viability is considered to be at an end at the point in time when Cash Flow Return on Investment intersects with Weighed Average Cost of Capital.

Much of the attention to this CFROI/WACC ratio tends to be directed at the numerator.

Clark (2010) suggests that cost of capital varies over time based on the incremental effect of retained earnings as described in Luehrman 1997B. IIB Dealing With DCF2S’s Problematic Second Stage (Terminal Value) The illustrations in 5.4 of how the perpetuity conjecture exaggerates errors in any of the three GFAP variables (FCF, g, WACC) may eventually encourage greater experimentation with methods that do not involve the Gordon Formula at all. Several survey interviewees indicated that they are already applying their own bespoke techniques for calculating value after the forecast period (EPP), avoiding the Gordon

139

That development is identified as possible future research area in Part 6.2.

249

Chapter 6 – Conclusions and Future Direction of Research Formula entirely. These non-GF alternatives cited by the valuation practitioners interviewed include P/E Multiples, multiple performance scenarios, and extensions of Stage 1 Explicit Projection Period forecasts (Appendix F).

IIC Momentum Towards a Fundamental Reformulation of the Gordon Formula Changing from GFAP to a serial version of the Gordon Formula helps to deal with what is arguably the greatest limitation of the equation in its present form, yet leaves other problems with some of the other variables untouched, particularly g and FCF.140 Those problems, plus the Four Determinants of Enterprise Value as introduced in Chapter 1 may encourage some practitioners to accept a fundamental reform to that equation’s base structure, in order to correct for Gordon and Shapiro’s 1956 design error.

An understanding of some of the issues associated with estimates for two of the other Gordon Formula variables, FCF and g, are undertaken in Chapters 2 and 5 as part of the analysis of the examination of the defensibility of the perpetuity conjecture, the purpose of this study.

A possible problem associated with those two GF variables is that they do not directly represent the four determinants of the value of enterprises as identified in Chapter 1, with investment, i, and marginal returns on investment are likely to be overlooked or at least, under-emphasised.

In theory the combination of FCF and g result in the same thing as CFROI and i. In practice, FCF is frequently miscalculated for reasons described in Cassia and Vismara (2009). Even slight exaggerations of g may significantly distort overall estimations of company value, as suggested in Mauboussin (2007), Mills (2005), Koller et al. (2005) and Penman (2001).

6.1.4.3 Category

III:

Other

Valuation-Related

Issues

of

Concern

to

Practitioners IIIA Dealing With Value Management’s Emerging Primacy Combine limitations of the accuracy of even the best valuation methods with the importance of continuous value improvement implied by the phrase ‘maximising shareholder value’, and the consequence is greater emphasis on value management with reduced emphasis on value measurement.

140 The

corresponding possible future actions as identified in Table 6.2.1 are C1 and C3.

250

Chapter 6 – Conclusions and Future Direction of Research To the extent that the evidence and analysis in this study helps to correct a basic flaw which has persisted in an equation widely used by the financial community since 1956, it may be said that this work assists in transitioning away from unthinking emphasis on the generation of value numbers per se, regardless of the credibility of the method used.

The understated assessments of today’s prevailing valuation methods by some of valuation thought leaders (2.3) are noteworthy.141 Particularly if one presumes that valuation is inherently imprecise by its nature, the critical question with company value becomes less, What is the company worth? and more important, What can be done to increase company value from its present levels?

IIIB Practitioner-Academician Valuation Methodology Schism When there are major differences between the company valuation methods as represented in the academic literature and the methods which are actually used by many valuation practitioners, concerns about the relevance of some of the literature arises.

One of the more surprising findings to this Researcher in 2.3 of this study was that P/E or EBITDA-based Multiples valuation approaches may predominate in the commercial marketplace overall, despite almost no presence in the literature.

Copeland’s 1994 study helped to bring DCF methods to the academic valuation mainstream. And yet, in 2009 (page 69) Copeland suggests that Multiples-based valuation approaches predominate in deal-arranging corporate finance departments of banks, in financial media and elsewhere in The City and on Wall Street.

This raises a question as to whether valuation academia has been too dismissive of Multiples-based approaches. After all, DCF valuation methods began to be widely used by managers in the mid 1970s, two decades before the Copeland et al. (1994) and Ruback and Kaplan (1995) papers.

IIIC Auditing Valuation Accuracy The arguments and analysis demonstrating that time—company longevity—performs an intrinsic role in the valuation of companies are advanced in this study in 1.4 and 5.8.

That valuation life spans are finite rather than never-ending is supported in 2.4 and several parts in Chapter 5. However, some DCF valuation academician-practitioners were troubled by the misrepresentation of time in GF as a perpetuity constant rather than

141

“The models that we use in valuation may be quantitative, but the inputs leave plenty of room for subjective judgment.” (Damodaran 2002, 1); “Most DCF calculations are going to be imprecise, and frequently DCFs cannot even facilitate useful calculations.” (Viebig et al. 2008, 207).

251

Chapter 6 – Conclusions and Future Direction of Research a variable long before this research commenced.142 This thesis should increase awareness and concern about this issue in the academic valuation community and amongst valuation practitioners.

How could the perpetuity conjecture persist for as long as it did? Three explanations occur to this Researcher: (i.); limited awareness; (ii.), the apparent answer of the Insignificance Exception and (iii.) the absence of even minimal valuation post-audit mechanisms.

The first point refers to the fact that even seasoned valuation practitioners are sometimes unaware of the components within GF. The second point is addressed in 5.5: Neale and McElroy’s (2004) two exceptions unwind under close scrutiny.

Which leaves the third explanation, that the absence of post-audit approaches and methods designed to compare the value numbers from prevailing formulas with value as reflected in reasonably achievable performance and longevity (5.4, valuation analysis of Circuit City).143 Under conditions of insufficient post-valuation review (as persists to this time), a moral hazard situation arises in that almost any value statistic might be advanced as possible, so long as the transaction related to that analysis does not collapse almost immediately after the analysis.

6.1.5

Contributions From This Research II: Possible Influence of The Analysis and Results in This Study on the Literature

In terms of the literature, this Researcher’s principal contribution as manifested in this study is to reveal the nature of the original design flaw in Gordon and Shapiro’s 1956 paper and Gordon’s related 1962 book, relating to what is referred to in this thesis as the perpetuity conjecture.

As described in this thesis (2.4), the true originator of the technique of utilising annuity projections to estimate the future value of companies, Williams (1939), expressed doubts about the universal assumption of perpetual longevity to all companies and all

142

This Researcher’s supervisor expressed interest in the provocative problem of perpetual life spans in the Gordon Formula when the work on this study began in earnest in January 2006, as also indicated in his suggestion of the “Time is Value” title.

143

Also MCC valuation of Macmillan Inc. in 1988 and AOL’s acquisition bid for TimeWarner (Clark, P. (15th Jan. 2000) “AOL-TimeWarner.” Motley Fool.

252

Chapter 6 – Conclusions and Future Direction of Research circumstances. In his rush to create a widely used financial method, Gordon (1962) brushed aside his predecessor’s concerns, dismissing rather than logically addressing Williams’ concerns.

This leads to this Researcher’s second major contribution relating to the valuation literature: the rediscovery of time (that is, company longevity) as a variable in Terminal Value calculation.

Time never stopped being a determinant and variable of company value, regardless of Gordon and Shapiro’s treatment of t as neither in 1956. Project enterprise precedent, analysis of the effect of variable durations of t on company value (5.4) and logic (5.8) all affirm the reality of time as the fourth key variable of value. By overlooking that reality and insisting on their three variable calculation version, Gordon and Shapiro effectively imposed a sub-optimal version of the true four variable TV calculation method on company valuators for more than half a century.

But as a result of this study, time has been rediscovered as the missing variable in Terminal Value calculation, indicating the era of four variable TV calculation using a serial version of GF and company-specific estimations of analysed, logical finite remaining life spans.

Table 6.1.3, Contributions From This Research II: Possible Influence of The Analysis and Results of This Study on the Literature, identifies sixteen possible influences on future literature, organised into four categories, A-D:

253

Chapter 6 – Conclusions and Future Direction of Research

Table 6.1.3: Contributions From This Research II: Possible Influence of The Analysis and Results of This Study on the Literature

Category A identifies possible contributions to or influences on the academic literature corresponding to the primary or the secondary research question of this thesis, as described in 3.3. The primary question involves whether or not the perpetuity conjecture in GFAP is tenable and defensible as a method for estimating the time variable in

254

Chapter 6 – Conclusions and Future Direction of Research company valuation. The related secondary question is directed at identification of initial possible replacements categories for the perpetuity conjecture.

Category B refers to possible contributions relating to DCF company valuation approaches as a group, including but not limited to the prevailing DCF valuation estimation method and the Two Stage EPP-TVP methodology (DCF2S) as described in this study in 2.3.

Category C (Relating to Company Valuation Methods and Analysis) refers to possible contributions relating to company valuation methodologies overall. Category D considers the possible implications of the findings and analysis in this study on projection-based business analyses as a category, including but not limited to company valuation analysis.

Following are further descriptions of the seventeen contributions with possible implications for the literature, in four categories as organised in Table 6.1.3: 6.1.5.1 A: Directly Related to Research Questions in This Thesis A1 Variability in company longevity (t) affirmed as a material valuation issue o

Time (company longevity) is an unassailable variable in company value. The fact that Gordon and Shapiro’s 1956 formula mistakenly treats t as a perpetuity constant does not change that variable’s true identity and role in company valuation (5.2); the error merely means that the effects of that variable are misor under-calculated.

This thesis addresses the issue of variations in company longevity as a material factor in company value. This issue is important, because if time (t) is thought to be unrelated or immaterial to company value, then differences in companies’ life spans are irrelevant.

All other things being equal and assuming minimum or no residuals at collapse, the company that fails after year 2 is worth the same as the company that fails after 200 years. That is the illusion fostered in Gordon Formula by the fatal flaw that t is infinite.

Reality (2.4, 5.6) is that t is finite and specific to each company and its circumstances.

The literature describes the consequences of this flaw but prior to this study, does not directly address the root cause: Gordon and Shapiro’s perpetuity conjecture error.

Problems with non-credible, excess Terminal Value are noted in several papers.

Academic champions of accrual accounting valuation methods admit infinite time periods assist in manipulating RIM and DDM statistics and close the gap with DCF, thereby supporting the Accounting Group’s arguments of equivalence.

255

Chapter 6 – Conclusions and Future Direction of Research Under two sets of circumstances referred to in this study as the Insignificance Exception (5.4), the issue of company variable longevity is suggested by Neale and McElroy to be moot: time doesn’t matter when inflows are minimal and/or offset by the time value of money. Example IE carefully, and the circumstances are revealed as remote bordering on impossible.

This analysis and reasoning in this study advances and extends some areas of investigation in other, recent papers developed by critics of the perpetuity conjecture, including Mauboussin (2007), Jennergren (2008) and Cassia and Vismara (2009). The study differs from those in that it is the one of the four which specifically addresses the Gordon and Shapiro’s original perpetuity conjecture error.

Possible related influences on future related literature: That time’s— in the form of company-by-company longevity— true role as determinant and variable of company value is rediscovered.144 Statements in academic and general valuation literature along the lines of ‘companies are assumed to have infinite lives for valuation purposes’ are amended to acknowledge that different companies tend to have different life spans and the duration of those lives may effect that company’s value, when that firm’s finite life span earnings period is taken into account.

A2

GFAP version is discredited, serial version of Gordon Formula emerges as

replacement. o

GFAP is discredited on multiple quantitative and qualitative bases in this study as an method for estimating Terminal Value (TV, continuous value) because of the distortions caused by the t = ∞ perpetuity conjecture error contained therein.

With company longevity re-established as a fourth, true company valuation determinantvariable (A1), the legacy three variable version of the Gordon Formula is obsolete and gradually falls out of general use because of inaccuracy and other problems caused by Gordon and Shapiro’s original perpetuity conjecture error.

Presuming that the GF-type equations continue to be used in the future to estimate Terminal Value (TV) in the second stage of the Two Stage DCF (DCF2S) methodology, a successor version emerges: the serial Gordon Formula shown in this thesis in

144

The word “re-discovered” is used here because time has always been a determinant and variable in the value of all enterprises—projects and companies alike, as described in Part 4 in Chapter 1 (1.4).

256

Chapter 6 – Conclusions and Future Direction of Research Appendix C, with the number of periods involved in the valuation analysis dependent on analysis of that firm’s unique projected remaining life span.

Possible influence on future related literature: This Researcher’s expectation is that with the serial version of the Gordon Formula will begin to displace GFAP in some new academic papers and finance-valuation texts in the coming periods. The timing and pace of this transition is unknown; if the legacy effect of DDM methods is any guide, some may still be advocating valuation using the simplistic three variable GF version several years from mow.145 This process appears to already be under way. Many of the other participants in the survey related to this thesis indicated that longer rely on GFAP to estimate TV, replacing that approach with their own methods calling for finite periods.

Former perpetuity conjecture apologist Stephen Penman acknowledged the superiority of finite life span projections as a basis for estimating t compared to infinity, assuming requisite quality and availability of past information and present trends on which to develop realistic estimates of probable finite life spans.

A3 Affirming the reality of briefer-than-a-decade company typical longevity for many companies o

When it is shown that the majority of companies fail in their first decade of life, contemplation of theoretical valuation concepts imagined as arising a century from now risk damaging the reputation of both the valuation method and that method’s developers.

When theories are shown to have little relevance to the real world business circumstances that those equations are supposed to explain, questions arise about that original postulate. In the case of the Gordon Formula, the issue is not merely the indefensible perpetuity conjecture, but also the related practice of valuing companies as long-life concerns with valuation time horizons extend for decades or longer.

145 Although the limitations of dividend-based valuation appeared in the literature in the late 1980s, DDM continued to be championed by academicians such as Penman well into the 2000s, and still appears in many valuation-related textbooks today, more than 20 years later. Refer to Table 2.3.6: Beyond Copeland, Kaplan & Ruback: DCF’s Other Methodological Superiority Points.

257

Chapter 6 – Conclusions and Future Direction of Research Although cohort-based academic studies of company failure have existed in the literature for more than fifty years, it was not until this study examined several of those papers in 2.4 that the depth of the intelligence affirming companies’ actual finite life spans became apparent. This Researcher’s analysed estimate for companies’ median life span (seven years) contrasts with one of the more commonly cited estimates prior to this study, de Geus’s and di Rooij’s 12.5-13 year life span estimate.

Possible influence on future related literature: This Researcher expects company valuation time horizons in general to shrink, with valuation practitioners using ‘long tail fade’ types of statistical analyses (Collett 2006) less.

A4 Limitations of the Insignificance Exception identified and explored. o

There are some situations in which variations in company longevity (t) have no effect on value. But those circumstances tend to be rare to non-existent in light of day-to-day business realities and ongoing TV calculation practices.

In 5.5, some limitations of this Insignificance Exception are explored. The IE scenario of a company where CFs decline to minimal levels but then that company somehow stabilises and manages to remain in business for ever is shown to be so unlikely as to border on the impossible, based on the analysis in 5.5.

Possible influence on future related literature: Neale and McElroy (2004) articulate the IE circumstances. A more complete consideration of the two circumstances that they describe might result in consideration of the critiques of IE Circumstance 1 and IE Circumstance 2 contained in 5.4.

A5 Regarding the four determinants of enterprise value o

The base determinants of value are the same regardless of whether the enterprise is a temporary project or a longer-lived company. When the project group secures permanent capital and attracts multiple assignments and is in a position to become a formal company, time is not then deleted as a determinantvariable of value.

The project genesis of company DCF valuation analysis is described in Chapter 1. The argument is presented in 1.4 that the same four determinants of value apply to all enterprises, regardless of form: both pre-company project enterprises and company enterprises share the four same basic determinants of value.

258

Chapter 6 – Conclusions and Future Direction of Research It is only in the incumbent version Gordon Formula that one of those four determinants, time (or company longevity) is disregarded. Valuation of Circuit City Stores (5.4) changes materially based on the choice of either an infinite or a real world, finite-butunknown assumed period of company longevity.

Possible influence on future related literature: This re-discovery of company valuation’s project valuation ancestry reaffirms the requirement to replace GFAP with a serial version that fully reflect the reality of t as a variable of company value. Re-examination of the four determinants of enterprise value (both projects and companies) also increases the visibility of investment (i) as a value determinant. In the Gordon Formula, the investment determinant is buried within the FCF and g variables.

A6

Preliminary exploration of possible category replacement approaches for the

perpetuity conjecture o

Pursuit of replacements for the perpetuity conjecture emerge as a valuation methodological imperative, as a result of: (i.), the re-discovery of time as a determinant-variable of company value; (ii.), the reality of t as limited-butunknown, rather than infinite; and (ii.) the possibility that without an eventual replacement, Gordon and Shapiro’s 54 year error may persist for years to come.

The analysis of possible replacement approaches and categories to the perpetuity conjecture is contained in 5.9. Interviewees participating in the survey responded positively to two prospective directions, albeit with qualifications: industry groupings and product-service life cycle (PLC) patterns.

Possible influence on future related literature: At this point, the perpetuity conjecture is discredited but there is no widelyaccepted specific replacement. Perhaps if and when the implications and analysis in this study come to be addressed by the valuation academic community, others will pursue the PLC or industry alternatives in depth.

259

Chapter 6 – Conclusions and Future Direction of Research 6.1.5.2 B: Other Contributions Relating to DCF Valuation Methodology B1 Consideration of life span- variable WACC emerging from an Competitive Advantage Period (CAP) –based definition of company demise o

One of the Gordon Formula’s three current variables, cost of capital, appears to be miscalculated in the later stages of companies’ economic life spans, possibly resulting in estimation of projected longevity (t) which are too long and errors in valuation.

This study adds to the gradually increasing base of literature (Luehrman 1997B, Clark 2010) suggesting that companies’ costs of capital changes over time as the firm matures.

Such notions of variable or semi-variable WACC are contrary to today’s prevailing belief that WACC does not change over time (Collett 2006).

Assuming that the Insignificance Exception calls for CFROI levels which are very near to the WACC rate, even miniscule increases in capital costs may cause CFROI and WACC to intersect, rendering that life span finite under CAP principles.

Possible influence on future related literature: Within a few years, this Researcher expects that many multiple period, multiple life stage company valuation perspectives will reflect variable or semi-variable concepts of capital cost (vWACC), rather than constant cost of capital.

B2 Development of CFROI moving averages as one indicator of end of companies’ life spans o

Some new analytical methods and metrics emerge to help identify companies with are headed towards failure, several periods before that event. Such tools have possible implications for valuation, value management, and credit exposure management.

The Three Year Moving Average (3YMA) CFROI basis for anticipating the end of companies’ economic life spans is shown in the Industry Pairs Analysis in 5.6 and Appendices L and M. The Industry Pairs analysis was conducted in 2007 and proved accurate in anticipating the collapse of several companies in decline, including Palm, Circuit City and Merrill Lynch.

Possible influence on future related literature: This Researcher anticipates that there could be additional studies of this advance indicator method for determining the end of companies’ life spans.

260

Chapter 6 – Conclusions and Future Direction of Research B3 Illuminating Cassia et al.’s observations about FCF variable in the Gordon Formula, a key component in prevailing methods for calculating Terminal Value (TV) o

By addressing the stage preceding the Terminal Value Period in DCF2S, Cassia et al. raise questions about company longevity and also calculation of one of the Gordon Formula’s three original variables: FCF.

Cassia et al. (2009, 136-8) exposes one of the inconsistencies in estimations of companies’ continuous (terminal) value: the nature of specific assumptions pertaining to so-called Steady State inflows. The authors describe how differing assumptions about returns over the course of the Terminal Value Period may result in TV estimations that are both non-comparable and potentially inaccurate.

Possible influence on future related literature: The discussion and analysis in 2.3 may assist in illuminating Cassia et al.’s key points; in discussions with the international valuation thought leaders who participated in this study, it appeared that neither Cassia et al.’s 2009 or 2007 papers are well known at this time.

6.1.5.3 C: Relating to company valuation methods and analysis C1 Exploring an alternative basis for measurement of valuation method “accuracy” o

Full measurement of the accuracy of valuation methods involves more than comparisons to market value (MV). An supplemental approach utilised in this study and its June 2009 predecessor involves comparisons of the equation’s value statistic with reasonable estimations of company worth based on prospective operating and financial performance. 146

One of the most compelling arguments for suggesting that the perpetuity conjecture is untenable relates to this Researcher’s concept of valuation accuracy. Based on that criteria, a value method is deemed “accurate’ if that estimation coincides with worth calculated on the basis of defensible operating performance over the firm’s projected remaining life span (t).

This working definition of accuracy differs from the external MV-based (e.g., share price) definitions, which tend to consider a valuation as accurate if the generated amount is close to that firm’s Market Value of Equity (MVE).147 Such external market

146 The

method is based upon and is similar to the Value Risk Quotient (VRQ) metric described in Chapter 8 of the June 2009 version (v1) of this study.

147

MVE is calculated as market capitalisation minus the market value of debt.

261

Chapter 6 – Conclusions and Future Direction of Research perspectives on accuracy reflect the valuation rule-of-thumb that internal and external measures of company worth are generally equivalent. (Mills, 1998, 73) One of the problem associated with external market-based definitions of accuracy is that mis-valuation may result in instances when the true future prospects of the company are not accurately reflected in the presumed valuation of that company, as reflected in the Lastminute.com IPO in 2000. The operations-oriented alternative definition for valuation accuracy is thought by this Researcher to be required to help avoid valuation pricing errors that sometimes arise from reliance on MVE alone.

Possible influence on future related literature: This Researcher expects the operations-based approaches for assessing valuation accuracy to supplement external market-based approaches in some future valuation literature. The persistence of chronic mis-valuation problems such as excessive TV estimates provide an incentive for accuracy measures which take into account realistically achievable future operating and financial performance.

C2 Confirmation of Multiples as an emergent, minority valuation method in prevailing literature Price-to-earnings or EBITDA-to-earnings multiples are frequently dismissed by valuation academicians as flawed and not reflected in the academic literature on valuation. This perspective is supported by the fact that such simplistic methods are often advocated by today’s commercial valuation underclass, including small-medium business brokers self-proclaimed to be ‘valuation experts’ (as described in 2.3).

However Multiples appear in academic writings going back to Cornell (1993) and are believed by Copeland as representative of the major portion of overall commercial valuation analysis volume by number of transactions.

Possible influence on future related literature: This Researcher expects to see an increase in papers on DCF-Multiple hybrid methods in coming years. Responses from survey participants even suggest the possibility that Multiples might someday displace current methods for estimating worth of the DCF2S second stage.

C3 Regarding methods for suggesting minimum sample sizes (n) for certain types of non-probabilistic primary research.

262

Chapter 6 – Conclusions and Future Direction of Research o

The concept of saturation emerges as an important principle in setting minimum acceptable sample sizes in non-probabilistic (purposive) surveys such as the primary research conducted in support of this study.

In Appendix E, Part 1, sub-part d (E.1d), Regarding Adequacy of Sample Size (n) for this Survey, this Researcher examined a range of survey methodological literature relating to sample size adequacy.

Guest et al. (2007) address the issue of sample size (n) adequacy for non-probabilistic or purposive studies, such as the primary research developed for this study. This Researcher explored the academic sources that Guest et al. cite regarding the proposed approach for determining minimum acceptable n in non-probabilistic studies, including the “saturation” concept as described by Guest et al. and several of their references.

Appendix E1.d provides analysis on this topic that may be useful in designing some other non-probabilistic surveys.

Possible influence on future related literature: This Researcher expects that Appendix E.1d could be adapted into a short survey methodological process paper on some of the issues involves in applying the saturation principle in non-probabilistic surveys.

6.1.5.4 Category D: Contributions Relating to Future Projection-Dependent Methodologies in General D1 Basis for future projections: Arbitrary assumptions versus analysis based on past information and current trends o

One of the methodological dilemmas revealed in this study involves Gordon and Shapiro’s arbitrary insertion of a surrogate value for the t variable. Instead of projections of time being calculated based on the analysis of specific company facts and trends (as is the method for FCF, g and WACC), t is assigned an constant value.

Arbitrary assumptions may be convenient for analyst or practitioner, but unless that assumption coincides with actual experience, the potential for errors may be significant, as considered in 5.4 and 5.8.

Possible influence on future related literature: Challenges to other equations similar to GFAP in which the calculation is dependent on the projections of variables’ future amounts and one or more of those variables is set by arbitrary assumption rather than analysis.

263

Chapter 6 – Conclusions and Future Direction of Research D2

Illuminating of the issue of errors caused when a material determinant is

disregarded. o

“Determinant” is described in Chapters 1 as a variable that exerts formative influence on enterprise (project or company) value. That influence is exerted regardless of whether the determinant is properly measured within the equation.

In GFAP, calculation of companies’ finite-but-unknown life spans based on an assuming that companies endure forever means that duration is effectively disregarded: combine the Insignificance Exception (IE) with the Never Ending Company, and it matters nothing whether the firm’s actual life is two or two hundred years, at least on paper. But those differences in actual company life spans do matter, whether based on interviewees responses to survey question A3 or the City Circuit analysis in 5.4.

Possible influence on future related literature: One surmises that other situations and formulas exist in which a material causal factor—a determinant-- is ignored, leading to possible miscalculation. The examination of time in this study may be instructive to other analyses from a methodological basis.

D3 Methodolological consistency issue: When determinant-variables are calculated in different manners o

Calculating one variable in a wholly different manner than the other three risks errors and the discrediting of that equation as internally inconsistent.

Four variables are present in the prevailing version of the Gordon Formula as shown in Figure 1.3 in the initial chapter of this thesis. Three of those variables, FCF, g and WACC, are developed on a company- and situation-specific basis, influenced by past experience and future expectations. Time (the variable) is instead converted into a perpetuity constant.

From a methodological perspective, the related issue is inconsistent treatment of material variables. This issue extends beyond valuation analysis and even beyond business analysis, to the extent that inconsistency in how variables are estimated arises in other forms of analysis.

Possible influence on future related literature: To the extent that similar problems of inconsistency exist elsewhere, the analysis and arguments as contained in this thesis may be helpful. The Gordon Formula’s inconsistent treatment of value determinants represents one of the 264

Chapter 6 – Conclusions and Future Direction of Research secondary reasons that the perpetuity conjecture is deemed to not be tenable by this Researcher, as noted in 5.8 D4. Questioning the use of infinity in analyses involving organic entities o

Organic lives are limited in duration. Apply the organic concept to companies, and notions of never-ending life become irrelevant.

de Geus (2002), Adizes (2000) and Madden (2005) share a perspective of the company as organic entity, that is, as a corporate body exhibiting many of the same characteristics and frailties as human beings. Today it has become acceptable to view the company as ‘living’ and refer to identifiable stages from of life from birth to adolescence to maturity and ultimately to death. (Clark 2009, Mauboussin 2007) Notions of infinite lives are inconsistent with this organic perspective, as noted in 5.8.

The Never Ending Company is no more likely or defensible than a perpetual motion machine.

Possible influence on future related literature: While notions of infinity play a role in some of the physical sciences and in theoretical mathematics, the suitability of infinity for purposes of business analysis is suspect, based on the arguments and analysis in this thesis. This Researcher would not be surprised to see any similar uses of infinity in business analysis to be challenged and eventually removed.

265

Chapter 6 – Conclusions and Future Direction of Research

6.2

Possible Future Areas of Research

Sub-parts: 6.2.1 Related to Primary Research Question 6.2.2 Related to the Secondary Research Question 6.2.3 Other Related Issues for Possible Investigation Eight possible areas for future research are identified in Figure 6.2.1 and are described in the pages that follow:

* Part 3 in Chapter 3 (3.3) ** Discounted Cash Flow Two Stage Methodology

Table 6.2.1: Eight Possible Future Research Areas

266

Chapter 6 – Conclusions and Future Direction of Research 6.2.1

Related to the Primary Research Question

The primary research question concerns defensibility and credibility of the perpetuity conjecture within GFAP as a means for developing future projection of time (company longevity) for DCF valuation purposes (3.3). Three possible areas for future research are shown in Table 6.2.1.

6.2.1.1

(A1) Determination of effective terminus to companies’ life spans, as contrasted with definitive end point of t

In terms of elapsed time from origin, how many years did comparable companies survive? Development of dependable answers to that question is key to creating useful empirical databases capable of supporting projections of future valuation longevity (t) on a company-by-company basis.

But except for UK formal administration order for liquidation or US Chapter 10 or 13type bankruptcy orders, some statutory, economic and other indicators of a company’s demise are not always final.

Figure K.1 in Appendix K shows several other types of distress indicators which often, but not always predate company failure, such as consecutive periods of negative CFROI performance, to withdrawal of bank loan facilities. Altman (2002) lists “doubledippers”: US companies filing more than once under the less severe Chapter 11 statutes in the US Bankruptcy Code.

Indicators of the liquidation type are decisive and definitive in the sense that there are no companies known to survive such events. However, those signals are not necessarily useful in a managerial or stakeholder sense, since the company is already dead when that signal appears.

That limitation, in turn, suggests the possible future development of alternative failure indicators which both (i.) indicate future company collapses with sufficient reliability to be useful as in developing failure databases, and (ii.) which provide company management and other stakeholders with some degree of advance warning. If, for example, one of measures in Appendix K is perceived as indicating probable failure for most companies in a group of firms (as contrasted to assured collapse of all companies), then that point-of-no-return (PONR) advance indicator may be useful to managers, shareholders, providers of financing and others as a signal.

There are several challenge associated with the development of effective PONR indicators of company death of the type described here; including: (i.) variations by 267

Chapter 6 – Conclusions and Future Direction of Research industry group and stage in the business cycle; and (ii.) reliable calculation of the time period between this PONR signal and actual demise.

Altman’s Z-Score approach (2002, 1968) attempts to provide such advance indications, but is limited to credit-related criteria only, whereas credit deterioration represents one of the types of indicators described in Appendix K in this study.

But the Z-Score precedent is noteworthy for another reason: possible changes to the timing of actual failure. Dr. David Price suggests that to the extent that financing sources use Altman’s Z-Score to pull their funds before bankruptcy, that action may shorten the firm’s actual life span when scores of bankers rush simultaneously to beat the crowd to the exit.148 6.2.1.2 (A2) Development of transnational cohort studies of company failure patterns, trends Post-1988 academic studies of company failure and collapse such as those examined by this Researcher in 2.4 provide a depth of information for challenging any notion that all companies live forever, or even that most non-infrastructure companies endue for longer than a few decades.

But the studies in 2.4 were developed on an intra-national basis, only, suggesting that the examination of company failure patterns on a transnational surveys appears to be overdue. Although bureaucratic, compilation and analysis challenges arise, the benefits from a global perspective on company longevity may be worth the effort, particularly if variable t eventually replaces constant-infinite t in the Gordon Formula at some point in the future.

6.2.1.3 (A3)

Development

of

life

spans

perspectives

for

established

companies: Do origin year cohort analyses suffice?

The following is from 2.4, Limited Insight Into Remaining Life Spans of Established Companies: While estimating the life span of start-up companies is useful for numerous purposes including start-up valuation, company financial planning and in some instances, Initial Public Offering (IPO) pricing, the survival issues facing wellseasoned firms differ from those confronting start-ups.

148

13th May 2008, Henley Research Symposium, Henley-on-Thames. The contagion effect described here is generally viewed as a contributing factor in the collapses of Bear Stearns (2007) and Lehman Bros.

(2008).

268

Chapter 6 – Conclusions and Future Direction of Research The fact that most companies fail before they are a dozen year old (as measured by elapsed years from year of original company formation and registration) means that cohort studies that measure company survival from year of birth are often useful for developing failure profiles to support projections of the t variable.

But exceptions arise, suggesting possible future research directed specifically at companies which are already well-established. Circuit City (US), analysed in both 5.4 and 5.6, was sixty years old at the time of its death. On 23rd December 2008, Bloomberg.com reported that “Thatcher Profit, 160-Year Old Law Firm, to Close Down.”149 Jovanovic (1982), Jovanovic and MacDonald (1994), Audretsch (1995), and Audretsch and Thurik (1999) all suggest that the company’s risk of failure declines the longer that the firm manages to survive, as management gains knowledge of successful sales and trading practices and develops scale economies. Assuming (i) a sufficient large sample size for the cohort group and (ii.) consistent monitoring of failure performance over 12 years or longer, useful insights may at times be gained by monitoring the changes in failure performance over time. Andretti’s 1995 analysis is used in 5.9 (Table 5.9.1) to gain an understanding of changes in failure propensity of companies, both overall and on an industry-by-industry basis.

6.2.2

Related to the Secondary Research Question

The secondary research question (3.3) is preliminary in nature and is directed at initial identification of some of the possible categories of successor approaches to the perpetuity conjecture.

6.2.2.1 (B1) Development of industry or segment-specific cumulative failure curves comparable to Figure 5.9.4 Figure 5.9.4, A Composite Perspective on Company Longevity, provides a cumulative perspective on overall company failure experience based on a few different sources of information, including Jennergren (2008) Mata and Portugal (1994). That figure is repeated below as Figure 6.2.1:

149

Fortado, L. Accessed 23rd Dec. 2008 http://www.Bloomberg.com/apps/news?pid=20670001.

269

Chapter 6 – Conclusions and Future Direction of Research

Figure 6.2.1: A Composite Perspective on Company Longevity

Cumulative failure curve perspectives of this type are potentially useful for informing forward projections of t, as the valuator may choose any percentile point along the curve from median onwards to help inform future estimates of the time variable.

For example, on the basis of the data in that Figure, an valuator who feels confident that the median (50th percentile) Mata and Portugal data at Point B is representative of a typical firm’s likely future failure experience sets t at four years. If an 80th percentile indication is required, then the de Geus – di Rooij indication at Point C of 12.5- 13 years appears to be more appropriate. But if 98th percentile is required, the de Geus alternative maximum indication emerges, at 40 years.

But because different industries exhibit sometimes significantly different t profiles, a future area for development would appear to be cumulative failure curves of the Figure 5.9.4 / Figure 6.2.1 type but on an industry-by-industry basis, instead.

•

Non-chain restaurants on the High Street tend to endure for five years at most.

Thus the numbers in Figure 6.2.1 are based on too broad a company sample to be useful, say, to inform projections for the t variable for a new start-up 270

Chapter 6 – Conclusions and Future Direction of Research restaurant: by the time that the Mata and Portugal median mark of four years for all companies is reached, the majority of new, independent start-up restaurants have already failed.

•

Conversely, for infrastructure companies and utilities with stable customer profiles, the Figure’s time spectrum is too brief. Such firms often survive for thirty years or longer on average. Even troubled firms in those sectors tend to survive for decades, far longer than the Mata et al. median life companies they examined.

6.2.2.2 (B2) Further examination of industry and PLC categories, towards development of specific successor recommendations While survey interviewees believe that both industry-based life span intelligence and/or multiples of product-service life cycles may have promise as possible successors to the perpetuity conjecture, the scope of this study (4.3) and the nature of the secondary research question (3.3) mean that the future development of specific recommendations of single replacement method for the perpetuity conjecture represents a issue for other investigations.

Such an analysis would expectedly involve further investigation into the attributes and limitations of each method, including but not limited to the reliability and availability of source data used in formal approaches of each type.

6.2.3

Other Related Areas for Possible Investigation

Column C in Table 6.2.1 identifies three other areas of possible future research. All three arise from the issues and analysis in this study. While none are directly concerned with the primary or secondary questions, all three areas may be worthwhile because of possible future influence on company valuation using DCF methods and approaches.

6.2.3.1

(C1) Re-Examination of GF Variables I: FCF, g

Methods for projecting two of the Gordon Formula's three presently acknowledged variables-- initial period annualised Free Cash Flow (FCF) and that variable’s future growth rate, g, are shown in 5.4 and related Appendix O. Those examinations considered the contributory role of the perpetuity conjecture in further exaggerating errors in FCF, g or both.

271

Chapter 6 – Conclusions and Future Direction of Research But removing the perpetuity conjecture and replacing it with a more credible and defensible means for projecting the t variable may not be enough to salvage the Gordon Formula as a viable future mechanism for TV estimation.

A second problem possibly requiring correction relates to the nature of FCF and g in that equation. While multiplying FCF against the g generates a statistical surrogate for the company’s total projected inflows (net receipts) over time, concerns arise about whether those metrics are too inexact to provide a credible estimation.

A part of the problem is the crude nature of the GF variable itself and how it is routinely calculated. Cassia and Vismara (2009) describe how the FCF number is routinely generated on the basis of the running rate as of the end of the preceding period (EPP).

This Researcher refers to EPP durations from two to fifteen years, inviting wide variability and questionable statistical reliability. The volatility of positive g projections is cited in Jennergren (2008), Mauboussin (2007), Koller et al. (2005), Mills (2005) and Penman (2001).

The second aspect is that by using FCF times g as a surrogate for company inflows over the company’s life span, Gordon and Shapiro avoid using calculations based on the actual determinants of those inflows, as described in 1.4, Project Valuation Rediscovered: Four Determinants of the Value of Enterprises (VoE I). The causal factors in inflows, embedded and incremental investment and marginal returns on each (macro) are the essence of inflows. FCF and g are rough approximations.

Once again, Gordon and Shapiro (1956) appear to settle for a calculation which raises concerns about accuracy when examined with care. Unless GF’s inexact surrogate variables for calculating inflows (FCF times g) are replaced with something better, that ratio may remain in jeopardy, even assuming that the perpetuity conjecture flaw at the centre of this study corrected.

This Researcher’s sense from discussions accompanying the survey interviews (5.3) is that many practitioners perceive the Gordon Formula as a valuation anachronism: a ratio that must always be included in the first few pages of valuation-related finance texts, but which increasingly is ignored by those applying DCF valuation analysis in the commercial world.

6.2.3.2 (C2) Re-Examination of GF Variables II: WACC Methods used for calculating the third of the acknowledged Gordon Formula variables, Weighed Average Cost of Capital, emerges as a result of this study because of the effect of variable WACC on company as measured by the CAP framework. All other things 272

Chapter 6 – Conclusions and Future Direction of Research being equal, increases in a company's WACC in later life stages tends to increase a company's projected life span duration (5.3 and 5.8), even when Cash Flows are stable, as WACC increases and may intersect with CFROI. Some investigation into this topic has been developed to date by this Researcher (2010) and by Luehrman (1997B), and the debt portion of this issue is examined also by Altman (2002, 1968). Further investigation appears warranted, particularly on the issue of dramatically increasing WACC levels as soon as a company’s credit worthiness becomes questionable.

6.2.3.3 (C3) Possible successor to the Gordon Formula, alternatives to DCF2S While the scope of this study is directed at the perpetuity conjecture within GFAP (4.2), the future evolution of both the host equation for the perpetuity conjecture, the Gordon Formula, also the Two Stage DCF methodology (DCF2S) within which GF functions are both indirectly at issue.

If the combination of (i.) reforms to the approach for the t variable that are at the centre of this study plus (ii.) possible adjustments as described in C1 and C2, are insufficient to reverse the trend of declining use of the Gordon Formula, then the alternative is a replacement for the GF equation in total rather than just adjustments to its components.

One of several methods emerging from this study is the possibility of doing away with DCF2S altogether and extending Stage 1 (Explicit Projection Period) to the expected sub-infinite valuation life span. That possibility is informed by Cassia et al. 2009 and is explored on a preliminary basis in Appendix F.

273

Bibliography

Bibliography Adizes, I. (1988). Corporate Lifecycles: How and Why Corporations Die and What To Do About It. Englewood Cliffs NJ, Prentice Hall.

Agarwal, G. and Gort, M. (2002). “Firm and Product Life Cycles and Firm Survival.”

Technological Change 92 (2): 184-190.

Alford, A. (1992). “The Effect of the Set of Comparable Firms on the Accuracy of the PriceEarnings Valuation Method.” Journal of Accounting Research. 30:1, 331-362.

Altman, E. (2002). Bankruptcy, Credit Risk and High Yield Junk Bonds. Oxford, Blackwell.

Altman, E. (Sep. 1968). "Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy." Journal of Finance. 23:4 589-609.

Altman, E. and Hotchkiss, E. (2006). Corporate Financial Distress and Bankruptcy 3rd Ed. Hoboken NJ USA, Wiley.

Argenti, J. (1976). Corporate Collapses: The Causes and Symptoms. London, McGraw-Hill.

Aris, S. (1985). Going Bust: Inside the Bankruptcy Business. Wallington, Surrey, Andre Deutsch.

11.

Atrill, P. and McLaney, E. (2006). Accounting and Finance for Non-Specialists. Harrow, Prentice-Hall. 83.

Audretsch, D. (1995). Innovation and Industry Evolution. Cambridge MA USA, MIT Press, 159.

Audretsch, D. (1994). “Business Survival and the Decision to Exit.” Journal of the Economics of Business. 1:1, 125-137.

Audretsch, D. (1991). "New Firm Survival and the Technological Regime." The Review of Economics and Statistics. 60, 441-450.

Audretsch, D. and Thurik, A.R. (1999). Innovation, Industry, Innovation and Employment.

Cambridge, Cambridge University Press.

Baldwin, J. (1998). The Dynamics of Industrial Competition: A North American Perspective.

Cambridge, Cambridge University Press.

Baldwin, J. and Gorecki, P. (1991). “Firm Entry and Exit in the Canadian Manufacturing Sector, 1972-82.” Canadian Journal of Economics. 24-2, May, 300-323.

Bayus, B. (1994). “Are Product Life Cycles Really Getting Shorter?” Journal of Product Innovation Management.11(4): 300-308.

Bertaux, D. (1981). “From the Life-History Approach to the Transformation of Sociological Practice.” In Biography and Society: The Life History Approach in the Social Sciences. Ed. D. Bertaux, 29-45. London, Sage.

274

Bibliography Bloomsbury Publishing Plc. (1999). Encarta World English Dictionary (US Edition), Microsoft Corporation.

Box, M. (Dec. 2008). "The Death of Firms: Exploring the Effects of Environment and Birth Cohort on Firm Survival in Sweden." Small Business Economics. 31:4, 379-393.

Bradley, M. and Jarrell, G. (2008). “Expected Inflations and the Constant Growth Valuation Model.” Journal of Applied Corporate Finance. 20-2, 66-78.

Brealey, R., Myers, S., and Allen F. (2006). Corporate Finance 8th Edition. Boston, McGrawHill Irwin.

Brealey, R., Myers, S. (1991). Principles of Corporate Finance 4th Edition. New York, McGraw-Hill.

Brigham, E. and Gapenski, L. (1991). Financial Management: Theory and Practice 6th Edition.

Hinesdale IL USA, Dryden Press, 549.

Bruner, R. (2002). “Does M&A Pay? A Survey of Evidence for the Decision Maker.” Journal of Applied Finance, Spring-Summer, 48-68.

Campbell, J. and Lo, A. and MacKinlay, A.C. (1997). The Econometrics of Financial Markets.

Princeton NJ USA, Princeton University Press.

Case, R. and Shane, S. (1998). “Fostering Risk Taking in Research and Development: The Importance of a Project’s Terminal Value.” Decision Sciences. (29:1) 765-783.

Cassia, L. and Vismara, S. (2009, 2008). “Valuation Accuracy and Infinity Horizon Forecast: Empirical Evidence From Europe.” Journal of International Financial Management and Accounting. (20:2) 135-165.

Cassia, L., Plati, A. and Vismara, S. (2007). “Equity Valuation Using DCF: A Theoretical Analysis of the Long Term Hypothesis.” Investment Management and Financial Innovations.

(4:1): 91-109.

Caves, R. and Porter, M. (1977). "From Entry to Mobility Barriers.” Quarterly Journal of Economics. 91, 241-261.

Cohen et al. (2007). Research Methods in Education Sixth Ed. London, Routledge.

Clark, P. (Apl. 2010). “Exploration of Some Issues Relating to Variable Weighed Average Cost of Capital (WACC) Over a Firm’s Competitive Value Life Span.” Value, The Magazine of the Institute of Value Management, UK. 19:1, 22-26.

Clark, P. (Feb. 2009). “Considerations in the Development of Alternative Discounted Cash Flow (ADCF) Valuation: A Value Management Perspective.” Value: The Magazine of the Institute of Value Management, UK. 18:1, 16-24.

Clark, P. (2006). “Time is Value.” Presentation at Henley Centre for Value Improvement (HCVI) Symposium, 10th June, Henley-on-Thames, Henley Management College.

275

Bibliography Clark, P. (2001). The Value Mandate: Maximizing Shareholder Value Across the Corporation.

New York, Amacom.

Clark, P. (15th Jan. 2000). “AOL TWX.” www.MotleyFool.com, 16th March, TheStreet.com.

Clark, P. (2000). Net Value: Valuing Dot-Com Companies – Uncovering the Reality Behind the Hype. New York, Amacom.

Clark, P. (1991). Beyond the Deal: Optimizing Merger and Acquisition Value. New York, Harper Business.

Coffina, M. (10th May 2010). “Rite Aid Corporation Analyst Note.” Morningstar Reports.

Coley, S. and Reinton, S. (1988). “The Hunt for Value.” McKinsey Quarterly. Spring, 2: 29-34.

Collett, G. (2006). Conversations by this Researcher with manager at CSFB HOLT regarding that firm’s valuation approaches, primarily focusing on terminal value duration assumptions, London.

Copeland, T. (2009). “Comparing Valuation Models.” Chapter 4 in Thomas, R. and Gup, B. (2009). The Valuation Handbook: Valuation Techniques From Today’s Top Practitioners, Hoboken NJ US, Wiley, 67-107.

Copeland, T. and Dolgoff, A. (2006). “Expectations-Based Management.” Journal of Applied Corporate Finance. Spring, 18:2, 82-97.

Copeland, T., Koller, T. and Murrin, J. (2000, 1994, 1990). Valuation: Measuring and Managing the Value of Companies. New York, Wiley.

Cornell, B. (1993). Corporate Valuation: Tools for Effective Appraisal and Decision Making.

New York, McGraw-Hill.

Courteau, L., Kao, J. and Richardson, G. (2001). “Equity Valuation Employing the Ideal Versus Ad Hoc Terminal Value Expressions.” Contemporary Accounting Research 18 (4): 625-61.

Cox, W. (1967). “Product Life Cycles as Marketing Models.” The Journal of Business. Oct. 40 (4): 375-384.

Crabtree, B. and Miller, W. (1999). Ch. 1 “Clinical Research: A Multimethod Typology and Qualitative Roadmap.” in Doing Qualitative Research Second Edition. 3-30, 41-45.

Creswell, J. (2007). Qualitative Inquiry & Research Design Second Edition. London, Sage.

Cresswell, J. (2003). Research Design: Qualitative, Quantitative and Mixed Methods Approaches Second Edition. London, Sage.

Creswell, J. and Plano Clark, V. (2007). Designing and Conducting Mixed Methods Research.

London, Sage.

276

Bibliography Crum, W. (1953). The Age Structure of the Corporate System, Ch. VII, Corporate Births and Deaths. Berkeley CA USA, Bureau of Business and Economic Research, University of California, University of California Press. 125-162.

Danin, A. (25th Mar. 2008). “Palm Inc.” Morningstar Reports.

Damodaran, A. (2002). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. New York, Wiley, 2.

Damodaran, A. (2001A). “Value Creation and Enhancement: Back to the Future.” New York, Stern School of Business. 1-43.

Damodaran, A. (2001B). “The Stable Growth DDM: Gordon Growth Model.” New York, Stern School of Business.

Damodaran, A. (2000). “Closure in Valuation: Estimating Terminal Value.” New York, Stern School of Business. de Geus, A. (2002). The Living Company: Habits for Survival in a Turbulent Business Environment. Boston, Harvard Business School Press.

Dempsey, S., Laber, G., Rozeff, M. (Autumn 1993). “Dividend Policies in Practice: Is There an Industry Effect?” Quarterly Journal of Business and Economics. 13:4, 3-14.

Devan, J., Klusas, M. and Ruefli, T. (May 2007). “The Elusive Goal of Corporate Outperformance.” Research in Brief, McKinsey Quarterly. 1-3.

Dillman, D. et al. (2009). Internet, Mail and Mixed-Mode Surveys: The Tailored Design Method Third Edition. Hoboken NY USA, Wiley.

Dorsey, P. (12th April 2010). Phone interview with this Researcher.

Drever, E. (2006). Using Semi-Structured Interviews in Small-Scale Research: A Teacher’s Guide. Glasgow, The SCRE Centre.

Dunne, T., Roberts, M. and Samuelson, L. (Nov. 1989). “The Growth and Failure of US Manufacturing Plants.” The Quarterly Journal of Economics. 671-698.

Dunne, T., Roberts, M. and Samuelson, L. (Winter 1988). “Patterns of Firm Entry and Exit in US Manufacturing Industries.” RAND Journal of Economics. 19:4,495-515.

Economist (26th Jun. 2010). “Betting the Balance Sheet.” 8-9.

Economist (23rd June 2010). “BASF Seeks a Stable Formula.” Accessed 23rd June 2010 http://www.economist.com/blogs/newsbook/2010/06/chemical_industry?source=hptextfeatur e&fsrc=nwl.

Economist

(16th

Jul.

2009).

“Efficiency

and

http://www.economist.com/node/14030296.

277

Beyond.”

Accessed

23rd

July

2009

Bibliography Edgecliffe-Johnson, A. and Arnold, M. (14th May 2010). “EMI Plans £105 Boost to Avoid Loan Default.” Financial Times. Accessed 6th June 2010 http://www.ft.com/cms/s/0/1b7369e8-5f75-11df-978c-00144feab49a.html.

Enis, B., La Garce, R. and Prell, A. (June 1977). “Extending the Product Life Cycle.” Business Horizons 20: 46-56.

Essen, Y. and Ebrahimi, H. (6th Feb. 2009). “38,000 Companies Expected To Go Bust.”

Telegraph, http://www.telegraph.co.uk/finance/financetopics/recession/4539101/38000-companiesexpected-to-go-bust.html, accessed 8th Feb. 2009.

Evans, D. (1987). "The Relationship Between Firm Growth, Size and Age: Estimates for 100 Manufacturing Industries.” Journal of Industrial Economics. 35, 567-581.

Fama, E. F. and French, K. R. (2004). “The Capital Asset Pricing Model: Theory and Evidence.”

Journal of Economic Perspectives. 18(3): 25-46.

Feltham, D. and Ohlson, J. (1995). “Valuation and Clean Surplus Accounting for Operating and Financial Activities.” Contemporary Accounting Research. 11(2): 689-731.

Fernández, P. (16th Oct. 2008). “Three Residual Income Valuation Methods and Discounted Cash Flow Valuation.” SSRN Working Paper Series.1-17.

Fernández, P. (Jan. 2002A). “Valuing Companies by Cash Flow Discounting: Ten Methods and Nine Theories.” Research Paper, IESE. Fernández, P. (2002B). Valuation Methods and Shareholder Value. Amsterdam, Academic Press.

Ferson, W. and Harvey, C. (May-June 1991). “Sources of Predictability in Portfolio Returns.”

Financial Analysts Journal. 49-56.

Finnegan, P. (1999). “The Application of Shareholder Value Analysis as a Valuation Model in the UK Engineering Industry.” Henley-on-Thames, Henley Management College. i, 3-4, 7, 13, 25-31.

Firth, M. (Mar. 1980). “Takeovers, Shareholder Returns and the Theory of the Firm.” The Quarterly Journal of Economics. 90:2, 235-260.

Fitch Ratings (21st Jun. 2010). “The Extreme Credit Cycle- Making Sense of a 1% US High Yield Default Rate.”

Fitch Ratings (22nd October 2008). “The Rising Corporate Default Rate.”

Forsythe, R., Palfrey, T. and Plott, C. (May 1982). “Asset Valuation in an Experimental Market.”

Econometrica. 50 (3): 553-567.

Fox, J. (2009). The Myth of the Rational Market: A History of Risk Reward and Delusion on Wall Street. New York, Harper Business.

Frey, M., McConnico, W. and Frey, P. (1997). An Introduction to Bankruptcy Law.

278

Bibliography Minneapolis/St. Paul MN USA, West. 20, 22.

Fruhan, W. (8th June 1998). “Note on Alternative Methods for Estimating Terminal Value.” Ref. 9-298-166, Boston, Harvard Business School Press.

Fuller, S. (2006) Kuhn v Popper: Struggle for the Soul of Science. London, Icon.

Gentry, J., Whitford, D., Sougiannis, T. and Aoki, S. (2002). “Do Accounting Earnings or Free Cash Flows Provide a Better Estimate of Capital Gain Rates on Return on Stocks?”

University of Illinois Working Papers. Champaign IL USA. University of Illinois.

Georgescu-Roegen, N. (1999). The Entropy Law and The Economic Process. London, Cambridge MA USA, Harvard University Press, 1-6.

Geroski, P. (1995). “What Do We Know About Entry?” International Journal of Industrial Organization. 13: 421-440.

Gerstner, L. (2003). Who Says Elephants Can’t Dance? How I Turned Around IBM. New York, HarperCollins.

Giaccotto, C. (2007). “Discounting Mean Reverting Cash Flows With the Capital Asset Pricing Model.” The Financial Review. 42: 247-265.

Gigerenzer, G. and Selten, R., eds. (2002). Bounded Rationality: The Adaptive Toolbox. London, MIT Press.

Gordon, M. (1962). The Investment, Financing and Valuation of the Corporation. Homewood IL USA, Irwin.

Gordon, M. and Shapiro, E. (1956). “Capital Equipment Analysis: The Required Rate of Profit.”

Management Science. 3 (1): 102-110.

Gort, M. and Klepper, S. (1982). “Time Paths in the Diffusion of Product Innovations.” The Economic Journal 92: 630-653.

Graham, B. (1951). The Intelligent Investor 4th Revised Ed. New York 1973 reprint Harper and Row, 315-316.

Groves, R. et al. (2009). Survey Methodology, 2nd Ed. Hoboken NJ USA, Wiley.

Guest, G., Bruce, A. and Johnson, L. (2006). “How Many Interviews Are Enough? An Experiment With Data Saturation and Variability.” Field Methods. 18:1 Feb. 59-82.

Harrigan, K. (1988). Managing Maturing Businesses. Lexington MA USA, Lexington Books.

Harrigan, K. and Porter M. (1983). “End-Game Strategies for Declining Industries.” Harvard Business Review. Jul. -Aug. 111-119.

Hartman, J. and Murphy, A. (2006). “Finite Horizon Equipment Replacement Analysis.” IIE Transactions. 38: 409-419.

Hartman, J. and Murphy, A. (2001). “After-Tax Economic Replacement Analysis.” The

279

Bibliography Engineering Economist. 46 (3): 181-204.

Heslop, A. (2008). How to Value & Sell Your Business: The Essential Guide to Preparing, Valuing and Selling a Company for Maximum Profit. London, Kogan Page, 32-39.

Higgins, R. (Mar. 1972). "The Corporate Dividend-Saving Decision." Journal of Financial and Quantitative Analysis. 7, 1527-1541.

Hilton, A. (23rd Nov. 2009) “Why the £ Billion Tag on Gartmore?” Evening Standard, 23.

Ho, C.-C. and Sears, R. (2006). “Is There Conditional Mean Reversion in Stock Returns?”

Quarterly Journal of Business and Economics. 45: 3-4, 49-56.

Hudson, J. (1987). “The Age, Regional and Industrial Structure of Company Liquidations.”

Journal of Business Finance & Accounting. 14:2, Summer 199-213.

Insolvency Service (6th Feb. 2009). “Statistics Release: Insolvencies in the Fourth Quarter 2008.”

Ref.

INS/Com/31

http://www.insolvency.gov.uk/otherinformation/statistics/200902/index.htm. , accessed 6th February 2009.

Insolvency Service (January 2008). “Enterprise Act 2002-Corporate Insolvency Provisions: Evaluation

Report.”

Accessed

11th

May

2008,

www.insolvency.gov.uk/otherinformation/statistics/., Insolvency Service (January 2008).

“Statistics Release: Insolvencies in the Third Quarter 2007.” Ref. INS/Com/34, www.insolvency.gov.uk.

Jennergren, L.P. (2008). “Continuing Value in Firm Valuation by the Discounted Cash Flow Model.” European Journal of Operational Research. 185: 1548-1663.

Jensen, M. (Spring 2005). “Agency Costs of Overvalued Equity.” Financial Management. 5-19.

Jones, D. (May 2001). Discussion with this Researcher about product life cycle compression relating to Clark (2001).

Jovanovic, B. (1982). “Selection and Evolution of Industry.” Econometrica. 50 (3): 649-670.

Jovanovic, B. and Macdonald, G. (1994). “The Life Cycle of a Competitive Industry.” Journal of Political Economy. 102 (2): 322-47.

Kahneman, D. (2003). “Maps of Bounded Rationality: Psychology for Behavioral Economics.”

The American Economic Review. Dec.: 1449-1475.

Kaplan, S. and Ruback, R. (1995). “The Valuation of Cash Flow Forecasts: An Empirical Analysis.” Journal of Finance. 50 (4): 1059-93.

Kirchgaessner, S. and Guerrera, F. (14th April 2010). “Ex-Chief Says WaMu was ‘Bargain Price’.” Financial Times. Accessed 14th April 2010, http://www.ft.com/cms/s/0/7a9eeb4a471a-11df-b253-00144feab49a.html.

Kolb, D., Boyatzis, R. and Mainemelis, C. (1999). “Experimental Learning Theory: Previous

280

Bibliography Research and New Directions.” Cleveland OH USA, Case Western Reserve University, 39.

Koller, T., Goedhart, M., and Wessels, D. (2005). “Estimating Continuing Value.” Ch. 9 in Valuation: Measuring and Managing the Value of Companies, 4th Ed. New York, Wiley.

Kuhn, T. (1970). The Structure of Scientific Revolutions, Second Edition. originally published in 1962, London, The University of Chicago Press.

Kurzel, A. (1992). “Sampling in Qualitative Inquiry.” Chapter in Crabtree, B. and Miller, W., Eds. Doing Qualitative Research. Newbury Park CA USA, Sage, 31-44.

Lakados, I. (1978). “The Methodology of Scientific Research Programmes Vol. I.” Cambridge, Cambridge University Press.

Lee, C. (1999). “Accounting-Based Valuation: Impact on Business Practices and Research.”

Accounting Horizons.

Lemos, B. (18th Feb. 2009). “Circuit City Stores: Analyst Note.” Morningstar Reports. 1-8.

Lemos, B. (10th Nov. 2008). “Circuit City Stores: Analyst Note.” Morningstar Reports. 1-10.

Lemos, B. (6th Nov. 2008). “Circuit City Files for Bankruptcy.” Morningstar Reports.

Levin, J. and Olsson, P. (2000). “Terminal Value Techniques in Equity Valuation-Implications of the Steady State Assumption.” SSE/EFI Working Paper Series in Business Administration No. 2000:7.

Lewis, M. (2010). The Big Short: Inside the Doomsday Machine. New York, Allen Lane.

Lintner, J. (1965). “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets.” Review of Economics and Statistics. 13-37.

Lintner, J. (May 1956). “Distribution of Incomes of Corporations Among Dividends, Retained Earnings, and Taxes.” American Economic Review. 97-113.

Liu, J., Nissim, D. and Thomas, J. (Mar. 2002). “Equity Valuation Using Multiples.” Journal of Accounting Research. 40:1, 135-172.

Lloyd-Jones, R. and Le Roux, A. (1982). “Marshall and the Birth and Death of Firms: the Growth and Size Distribution of Firms in the Early Nineteenth-Century Cotton Industry.”

Business History. 14: 141-155.

Luehrman, T. (1994, updated 2005). “Notes on Valuing Equity Cash Flows.” Harvard Business School Cases. Boston, President and Fellows of Harvard College.

Luehrman, T. (1997A). “What’s It Worth? A General Manager’s Guide to Valuation.” Harvard Business Review. May-June: 132-142.

Luehrman, T. (1997B). “The Pitfalls of Using WACC”, in “Using APV: A Better Tool for Valuing Operations.” Harvard Business Review. May-June: 9.

Lundholm, R. and O’Keefe, T. (2001). “Reconciling Value Estimates From the Discounted Cash

281

Bibliography Flow Model and the Residual Income Method.” Contemporary Accounting Research 18 (2): 311-35.

Lutz, F. and Lutz, V. (1977). The Theory of Investment of the Firm. Westport CT USA, Greenwood Press, reprint of 1951 book, 25-27.

Madden, B. (2010). Wealth Creation: A Systems Mindset for Building and Investing in Businesses for the Long Term. Chapter 5, The Life-Cycle Valuation Model as a Total System.

Hoboken NJ USA, Wiley, 79-105.

Madden, B. (2007). “For Better Corporate Governance, The Shareholder Value Review.” Journal of Applied Corporate Finance. 19 (1): 102-114.

Madden, B. (2005). “Maximizing Shareholder Value And The Greater Good.” Naperville IL USA. LearningThatWorks.

Madden, B. (1998A). “The CFROI Valuation Model.” The Journal of Investing (10014): 31-44.

Madden, B. (1998B). CFROI Valuation: A Total System Approach to Valuing the Firm. Oxford, Butterworth-Heinemann.

Madden, B. (1996). “The CFROI Life Cycle.” The Journal of Investing (10009): 10-20.

Malkiel, B. (Winter 2003). “The Efficient Market Hypothesis and its Critics”, Journal of Economic Perspectives. Vol. 17, No. 1.

Malthus, T. (2004, reprinted). An Essay on the Principle of Population, Oxford, Oxford University Press.

Markides, C. and Geroski, P. (2005). Fast Second: How Smart Companies Bypass Radical Innovation to Enter and Dominate New Markets. San Francisco, Jossey-Bass.

Markowitz, H. (2002). Portfolio Selection: Efficient Diversification of Investments (Cowles Foundation Monograph). originally published in 1959, Oxford, Blackwell.

Mata, J., Portugal, P. and Guimaraes, P. (1995). “The Survival of New Plants: Start-up Conditions of New Firms.” International Journal of Industrial Organization, 13, 459-481.

Mata, J. and Portugal, P. (Sep. 1994). “Life Duration of New Firms.” The Journal of Industrial Economics. XLII (3).

Mauboussin, M. (14th Dec. 2007). "Death, Taxes and Reversion to Mean." Mauboussin on Strategy, Baltimore, Legg Mason Capital Management.

Mauboussin, M. (30th March 2005). “Capital Ideas Revisited.” Mauboussin on Strategy. Legg Mason Capital Management.

Mauboussin, M. and Johnson, P. (1997). “Competitive Advantage Period: The Neglected Value Driver.” Financial Management. 26 (2): 67-74.

282

Bibliography McIver, J. and Carmines, E. (1981). Unidimensional Scaling. Series: Quantitative Applications in the Social Sciences No. 24. London, Sage.

Micklethwatt, J. and Wooldridge, A. (2003). The Company: A Short History of a Revolutionary Idea. London, Widenfeld & Nicholson.

Miller, F. and Modigliani, F. (1961). “Dividend Policy, Growth and the Valuation of Shares.”

The Journal of Business. 4: 411-433.Mills, R.W. (Winter 2005). “Assessing Growth Estimates in IPO Valuations— A Case Study.” Journal of Applied Corporate Finance 17 (1): 73-78.

Mills, R.W. (Winter 2005). “Assessing Growth Estimates in IPO Valuations— A Case Study.”

Journal of Applied Corporate Finance. 17 (1): 73-78.

Mills, R.W. (1998). The Dynamics of Shareholder Value: The Principles and Practices of Strategic Value Analysis. Glos. Mars.

Mills, R.W. and Dahlhoff, J. (Jul. 2003). “Competitive Analysis Period (CAP) Analysis: Looking at Share Price and Firm Value From a Different Perspective.” Henley Discussion Paper Series. Henley-on-Thames, Henley Management College.

Modigliani, F. and Miller M.H. (1958). “The Cost of Capital, Corporation Finance and the Theory of Investment.” The American Economic Review.

Morningstar Research. (2007-8). Morningstar Reports. Chicago.

Morse, J. 1995, “The Significance of Saturation.” Qualitatitive Health Research 5: 147-149.

Motterlini, M. (1999). For and Against Method: Imre Lakatos and Paul Feyerbend. London, University of Chicago Press.

Neale, B. and McElroy, T. (2004). Business Finance: A Value-Based Approach. Harlow, FT Prentice Hall.

Norton, J. and Bass, F. (Sept. 1987). “A Diffusion Theory Model of Adoption and Substitution for Successive Generations of High-Technology Products.” Management Science. 32 (9).

Ohlson, J. (2002). “Residual Income and Value-Creation: The Missing Link.” Review of Accounting Studies 7: 247-251.

Ohlson, J. (1995). “Earnings, Book Values and Dividends in Equity Valuation.” Contemporary Accounting Research 11 (2): 661-687.

Ohlson, J. (1991). “A Synthesis of Security Valuation Theory and the Role of Dividends, Cash Flows and Earnings.” Contemporary Accounting Research. 8 (1): 1-19.

Ohlson, J. (1990). “A Synthesis of Security Valuation Theory and the Role of Dividends, Cash Flows and Earnings.” Contemporary Accounting Research. 8 (1): 648-676.

Ohlson, J. and Lopes, A. (May-Aug. 2007). “Accounting Based Valuation Formulae.” Brazilian Business Review. 4 (2): 95-102.

283

Bibliography Ohlson, J. and Zhang, X. (1999). “On the Theory of Forecast Horizon in Equity Valuation.”

Journal of Accounting Research. 37:2, 437-449.

Oosterwal, D. (2010). The Lean Machine: How Harley Davidson Drove Top-Line Growth and Profitability With Revolutionary Lean Product Development. New York, Amacom.

Pariente, F. (May 2003). “Revisiting Ohlson’s Equity Valuation Model.” Universite Paris IX Dauphine, Paris, CEREG, 1-39.

Patton, M. (2002). Qualitative Research and Evaluative Methods Third Edition. Thousand Oaks CA USA, Sage.

Penman, S. (31st Mar. 2010). Telephone interview with this Researcher.

Penman, S. (2007). Financial Statement Analysis and Security Valuation, International Edition.

Boston, McGraw-Hill.

Penman, S. (2006). “Handling Valuation Models.” Journal of Applied Corporate Finance. 18 (2): 48-55.

Penman, S. (Winter 2001). “On Comparing Cash Flow and Accrual Accounting Methods For Use in Equity Valuation: A Response to Lundholm and O’Keefe.” Contemporary Accounting Research. 18 (4): 681-92.

Penman, S. (1998). “A Synthesis of Equity Valuation Techniques and the Terminal Value Calculation for the Dividend Discount Model.” Review of Accounting Studies. 2 (4): 303-23.

Penman, S. and Sougiannis, T. (1997). “The Dividend Displacement Property and the Substitution of Anticipated Earnings for Dividends in Equity Valuation.” The Accounting Review. 72 (1): 1-21.

Penman, S. and Sougiannis, T. (1996). “A Comparison of Dividend, Cash Flow, and Earnings Approaches to Equity Valuation.” Manuscript, University of California Berkeley and University of Illinois.

Perold, A. (2004). “The Capital Asset Pricing Model.” The Journal of Economic Perspectives. 18 (3): 3-24.

Phillips, B. and Kirchhoff, B. (1989). “Formation, Growth and Survival: Small Firm Dynamics in the US Economy.” Small Business Economics. 1 65-75.

Polli, R. and Cook, V. (1969). “Validity of the Product Life Cycle.” The Journal of Business. 42 (4): 385-400.

Popper, K. (2002). Conjectures and Refutations: The Growth of Scientific Knowledge. London, Routledge.

Porter, M. (1985, 1980). Competitive Strategy: Techniques for Analyzing Industries and Competitors. New York, The Free Press.

Porter, M. (Jan. 2008). “The Five Forces That Shape Strategy.” Harvard Business Review. 79-83.

284

Bibliography Pratt, S. (2009). “Cost of Capital in the Valuation of Stock by the Income Approach: Updated for an Economy in Crisis.” The Value Examiner: A Professional Development Journal for the Consulting Disciplines. Jan.- Feb. 7-13.

Pratt, S. (2001). The Market Approach to Valuing Businesses. New York, Wiley.

Pratt, S. with Niculita, A. (2008). Valuing a Business: The Analysis and Appraisal of Closely Held Companies Fifth Edition. New York, Wiley.

Rappaport, A. (2006). “10 Ways to Create Shareholder Value.” Harvard Business Review. Sept., 66-77.

Rappaport, A. (1998). “Competitive Advantage and Shareholder Value.” The Journal of Business Strategy. 58-67.

Rappaport, A. (1986A). “The Affordable Dividend Approach to Equity Valuation.” Financial Analysts Journal. Jul-Aug.,52-58.

Rappaport, A. (1986B). Creating Shareholder Value: A Guide for Managers and Investors. New York. The Free Press.

Rappaport, A. and Mauboussin, M. (2002). “Valuation Matters.” Harvard Business Review. Mar., 2-3.

Ren, J. (2nd Jun. 2010). “E*Trade Financial Corp. Analyst Report.” Morningstar Reports.

Rink, D. and Swan, J. (1979). “Product Life Cycle Research: A Literature Review.” Journal of Business Research. 7:3.

Rozeff, M. (Fall 1982). "Growth, Beta and Agency Cost as Determinants of Dividend Payout Ratios." Journal of Financial Research. 5:3, 249.

Ryan, P. (1986). Euclidean and Non-Euclidean Geometry. Cambridge, Cambridge University Press.

Saris, W. and Gallhofer, I. (2007). Design, Evaluation and Analysis of Questionnaires for Survey Research. Hoboken NJ USA, Wiley.

Salzman, A. (7th May 2010). “Are Online Brokers Broken?” Barrons.com. Accessed 19th May 2010, http://online.barrons.com/article/SB1273187904286879.

Scherer, F. (1988). “Corporate Takeovers: The Efficiency Arguments.” Journal of Economic Perspectives. 2:1 Winter 69-82.

Sharpe, W. (Sept. 1964). “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk.” The Journal of Finance XIX (3): 425-442.

Sheshinski, E. (2008). Economic Theory of Annuities. Princeton NJ USA, Princeton University Press.

Silander, M. (2nd Feb. 2006). “Stora Enso Swings a Quarterly Loss.” Financial Times. 4.

285

Bibliography Smithers, A. (2009). Wall Street Revalued: Imperfect Markets and Inept Central Bankers. New York, Wiley.

Sougiannis, T. and Yaekura, T. (Fall 2001). "The Accuracy and Bias of Equity Values Inferred From Analysts’ Earnings Forecasts." Journal of Accounting, Auditing & Finance. 16:4, 331362.

Souza, G., Bayus, B., and Wagner, H. (2004). “New-Product Strategy and Industry Clockspeed.”

Management Science. 50 (4): 537-549.

Steele, F. (19th Feb. 2010.) “Rentokil Cancels Payout Despite Soaring Profits.” Times Online accessed

19th

Feb.

2010,

http://business.timesonline.co.uk/tol/business/industry_sectors/support_services/article703320 4.ece.

Stern, J. (July-Aug. 1974). “Earnings Per Share Don't Count.” Financial Analysts Journal. 30 (4): 39-52.

Strange, N. (2007). Smoke & Mirrors: How to Bend Facts and Figures to Your Advantage.

London, A. C. Black.

Strothman, H. (2006). “Entrepreneurial Survival.” Small Business Economics. 28, 87-104.

Teichner, W. (1991). “Note on Bankruptcy in the United States.” Harvard Business School Cases. Boston, President and Fellows of Harvard College.

Thomas, R. and Gup, B. eds. (2009). The Valuation Handbook: Valuation Techniques From Today’s Top Practitioners. Hoboken NJ US, Wiley.

Thorelli, H. and Burnett, S. (1981). “The Nature of Product Life Cycles for Industrial Goods Businesses.” Journal of Marketing. 45: 97-108.

Tisdell, C. (1996). Bounded Rationality and Economic Evolution, Cheltenham UK, Elgar.

Traynor, J. (1994). “The Investment Value of Plant.” Financial Analysts Journal. Mar.-Apl. 1217.

Tyler, R. (5th Feb. 2009). “Business Failures Soar 79 pc in January, Says Experian.” Telegraph http://telegraph.co.uk/finance/financetopics/recession/4513448, accessed 5th Feb. 2009.

Tyler, R. (1st Aug. 2008). “UK Company Administrations Soar 60pc.” Telegraph http://telegraph.co.uk/finance/financetopics, accessed 1st Aug. 2008.

US Bankruptcy Courts, Records, t http://www.uscourts.gov/bankruptcycourts.html, accessed 1015th May 2008.

Vélez-Paraja, I., Burbano-Pérez, A. (2005). “A Practical Guide for Consistency in Valuation: Cash Flows, Terminal Value and Cost of Capital.” Bogata, Columbia.

Vélez-Paraja, I. and Tham, J. (2003). “Do the RIM (Residual Income Model), EVA® and Discounted Cash Flow Really Match?” Bogata, Columbia.

286

Bibliography Viebig, J. et al. eds. (2008). Equity Valuation: Models From Leading Investment Banks.

Chichester, Wiley, 45-48, 203-209.

Verde, M. (30th Oct. 2008). “US Corporate Credit & Default Update.” Morning Credit Brief, The State of the Consumer, Fitch Ratings, 42.

Wagner (Jun.1994). "The Post-Entry Performance of New Small Firms in German Manufacturing Industries." The Journal of Industrial Economics. 42: 2, 141-154.

Waring, G. (Dec. 1996). “Industry Differences in Firm-Specific Returns.” American Economic Review. 1253-1265.

Wasson, C. (1974). Dynamic Competitive Strategy & Product Life Cycles. St. Charles IL, Challenge, 212-214.

Weston, J.F. (1989). “What MM Have Wrought.” Financial Management. Summer: 29-38.

Wiggins, R. and Ruefli, T. (2005). “Schumpeter’s Ghost: Is Hypercompetition Making the Best of Times Shorter?” Strategic Management Journal 26: 887-911.

Wiggins, R. and Ruefli, T. (Jan.-Feb. 2002) “Sustained Competitive Advantage: Temporal Dynamics and the Indices and Persistence of Superior Economic Returns.” Organizational Science. 13 (1): 82-105.

Williams, J.B. (1997). The Theory of Investment Value, Reprint Ed, Burlington VT USA Fraser Publishing, 87-96. Cambridge MA, Harvard University Press (Originally edition published in 1938).

Witkowski, W. (6th Feb. 2009). “FirstBank 7th Failed Bank of Year, 32nd of Recession.”

MarketWatch,

http://www.marketwatch.com/news/story/Georgia-bank-fails-marking-

seventh/story.aspx?guid={0ADB4918-43F9-46A3-8EDD-19A2503A81B3},

accessed

6th

February 2009.

Womack, J., Jones, D. and Roos, D. (1990), The Machine That Changed the World: The Story of Lean Production, New York, Macmillan, 81.

Womack, J. and Jones, D. (1998). Lean Thinking: Banish Waste and Create Wealth in Your Corporation, New York, Touchstone, 118-122.

Young, D. and O’Byrne, S. (2000). EVA and Value-Based Management: A Practical Guide to Implementation. New York, McGraw-Hill, 408-415.

Yin, R. (2003). Applications of Case Study Research Second Edition. Applied Social Research Methods Series 34, London, Sage, xi, ix, xv, 4-5.

Zimmerman, R. (2006). The Annuity: From Mystery to Mastery, Indianapolis IN USA, Dog Ear Press.

287

Appendix A – Glossary of Selected Terms

Appendix A – Glossary of Selected Terms Following are some brief capsule descriptions of a few of the key terms and concepts arising in the research associated with this study.

Accounting Group This refers to valuation academicians who argue that accrual-accounting based company valuation methods are superior to (or at least comparable with) competing DCF methods.

Cash Flow Return on Investment (CFROI) Corporate Cash Flow (CF, this equation’s numerator) is primarily comprised of company Net Operating Profits After Tax (NOPAT), plus depreciation and other noncash items. Denominator, “i”, refers to investment— or for practical purposes here, company assets as recorded at balance sheet amounts. This measure is today considered by many as one of the basic indicators of corporate performance and is a principal component in Competitive Advantage Period (CAP) framework and analysis.

Competitive Advantage Period (CAP) Refers to the time period during which the subject company is economically viable, as measured by the ratio of CFROI to Weighed Average Cost of Capital (WACC). If that ratio exceeds one, then the company is considered economically viable. An abrupt decline in the CFROI / WACC ratio is a warning signal, indicating an imminent decline in economic viability, cash reserves, and competitiveness.

Contribution Phase In the Industry Pairs analysis (part of 5.6), this refers to companies at the stable mid-life stage of their existence in terms of multiple criteria: market share, profits, other indications of industry or segment leadership.

Determinant

288

Appendix A – Glossary of Selected Terms In a DCF company valuation context, believed to exert causal influence on value; e.g., a change in company duration is imagined to be both a determinant and variable of company value if it can reasonably be shown that changes in longevity (t) have direct bearing on changes in the company’s calculated worth.

Gordon Formula Assuming Perpetuity (legacy version of Gordon Formula, GFAP) The horizon (terminal) period estimation equation as described on p. 104 in Gordon and Shapiro (1956). The perpetuity assumption (t + 1) in that formula permits estimates of value using a simple three variable equation, rather than potentially more complex serial methods involving period-by-period analysis.

Participation Phase In the Industry Pairs analysis (5.6), this refers to companies in mature declining stage, based on comparable indications described for Contribution Phase. These companies are struggling to remain in business, and tend to be highly vulnerable to price wars and/or new market entry.

Perpetuity Constant Identifies the two salient characteristics of the perpetuity conjecture (below): (i.), that all companies are presumed to endure forever for valuation purposes; and (ii.), that the exact same life span duration applies to every company.

Perpetuity Conjecture This is the time assumption at the centre of today’s DCF valuation approaches, as represented by the (t + 1) superscript in the numerator of the Gordon formula: that the horizon or terminal value period (TVP) continues to perpetuity.

Product Life Cycle (PLC) This competitive market concept is often attributed to Joel Dean’s 1950 article in the Harvard Business Review. PLC refers to the product line or generation’s time in the market, from time of origin to market exit.

289

Appendix A – Glossary of Selected Terms Steady State As used here, refers to an ongoing, sustainable level of company free cash flows (FCFs) extending into the future at zero percent growth rate in the Gordon formula (g = 0)

Terminal Value (TV) Analysed present value of company cash flows over its Terminal Value Period (TVP).

Terminal value can vary widely with just changes in assumptions about the longevity of the company and other variables. Sometimes alternatively referred to as continuing value, continuous value or horizon value.

Terminal Value Period (TVP) This is the second of the three DCF valuation periods, occurring after Explicit Projection Period and before the Residual. The DCF period that starts when company CFROIm = WACC and ends when CFROI = WACC (that is, the terminus of CAP). Sometimes alternatively referred to as the continuing or continuous period.

Viability Threshold (VT) End of the company’s analysed Competitive Advantage Period (CAP) mathematically defined as the point in time when Cash Flow Return on Investment (CFROI) rate becomes equivalent to Weighed Average Cost of Capital (WACC).

290

Appendix B – Some Acronyms In This Document

Appendix B – Some Acronyms In This Document

BTI

Briefer-Than-Infinite

CAL

Company Actual Life Span

CAP

Competitive Advantage Period

CAPM

Capital Asset Pricing Model

CF

Cash Flow (NOPAT plus non cash items plus some deferrals)

CFROI

Cash Flow Return on Investment

DCF

Discounted Cash Flow

DCF2S

Two Stage Discounted Cash Flow Company Valuation Method

DDM

Dividend Discount Method

DVM

Dividend Value Method (same as DDM)

EPP

Explicit Projection Period

FCF

Free Cash Flow (CF less period investment)

GF

Gordon Formula

GFAP

Gordon Formula Assuming Perpetuity

IE

Insignificance Exception

M&A

Mergers and acquisitions

NOPAT

Net Operating Profit After Tax

NPV

Net Present Value

PLC

Product –Service Life Cycle

P/E

Price-to-Earnings Multiple

RIM

Residual Income Method

SME

Small and Medium Enterprises

SSME

Semi-Strong Form of Market Efficiency

VM

Value Management

VT

Viability Threshold (CFROI = WACC)

291

Appendix B – Some Acronyms In This Document WACC

Weighed Average Cost of Capital

292

Appendix C – Formulas and Equations

Appendix C – Formulas and Equations Annuity-to-Perpetuity Formula (Perpetual Annuity Formula)

PV =

A__ WACC

Where PV = present value of the annuity, A = amount of periodic payment, and WACC = Weighed Average Cost of Capital or discounting rate.

Capital Asset Pricing Model (CAPM) CAPM = rf + Beta (Erm)-rf) Where rf = risk free rate, Erm = expected return on the market portfolio, Beta = covariance of the return on the firm’s shares with the return on the market portfolio (rm) Alternative format (from Cornell, 1993, 219): W. Sharpe’s 1964 legacy CAPM measure of systematic, non-diversifiable risk, depicted as a straight line regression: CAPM = R i,t - R f,t

= Bi * (R m,t - R f,t ) + Ut

where R i,t = Return on security i during period t R f,t = Risk-free rate during period t R m,t

=

Return on the market during period t

Bi

=

Beta (to be estimated)

Ut

=

Random error term

Dividend Valuation Model (DVM, alternatively DDM, Dividend Discount Method) PV =

D1__ r - DGR

Where PV = present value of the dividend stream, D1 = dividend payout amount in initial period, and Dividend Growth Rate or DGR = ROE x (1- Dividend Payout Ratio, or DPR) 293

Appendix C – Formulas and Equations Dividend Payout Ration or DPR = Cash and Equivalent Dividends per share divided by earnings per share Alternative calculations for r: Either r = ROE (earnings / book value), or r = CAPM (above)

Gordon Growth Model (Gordon Formula, 1956) FCF (t+1)

PV =

WACC- g Where PV = present value of the company’s value, FCF = initial period amount of periodic free cash flow (FCF) from company minus period investment, g = projected annual growth rate of FCF, and (t+1) denotes an analysis term presumed to continue to perpetuity.

Gordon Formula Serial Alternative PV =

FCF (t)

+

+

FCF (t2)

FCF (tn)

1 + WACCp1 1 + WACCp2…. 1 + WACCn

+

MR 1 + WACCn

Where PV = present value of the company’s value, t denotes FCF in initial analysis period, t2 denotes FCF in the next period, tn denotes FCF in final analysis year, MR (‘market residual’) assumes single point liquidation of company’s net assets at market level.

“Shareholder Value Analysis” Model (Finnegan, 1999, 29-30) PV =

Σ FCFt / (1+ WACC)t

Where PV = present value of the company’s value, t refers to time periods, WACC = Weighed Average Cost of Capital, FCFt = Free Cash Flow in initial period t, and Σ represents the summation for all periods from t= 1 to t= N (final analysis period). Equivalent to Gordon Formula in application.

294

Appendix D – Details Relating to Kolb’s Cycle Figure

Appendix D – Details Relating to Kolb’s Cycle Figure Related: Chapter 4 Part 4 Researcher’s Perspectives, Orientations

The thirteen items noted the Kolb Cycle Figure in the text are examined in this Appendix in greater detail.

-

Concrete Experiences

This refers to formative experiences which shaped this Researcher’s future orientation to valuation-related issues.

1a. Frito Lay (81) Jupiter This was an internal presentation designed to demonstrate to colleagues at FL the distortions to Terminal Value (TV) and thus overall company value (CV) that may arise when even modest assumptions for g, FCF and WACC. Cost of capital was set at management’s dictated rate (8%) with growth (g) at 2% p.a.

Compared to next best alternative (opportunity cost), the generated numbers justified purchase of a NASA missile by the snack foods producer.150

1b. Coopers & Lybrand (1986): Justification of Late Stage LBOs, (1987-88) MCC Acquisition of Macmillan, Inc.

As a management consultant at C&L, this Researcher was involved with both merger principals and intermediaries. After studying pattern of acquisition purchase premiums during the 1980s LBO bubble, this Researcher observed that TV percentages used to justify acquisitions tended to become higher and higher as the business cycle advanced and asking prices from sellers rose (Clark 1991, 25-47). It was apparent that the perpetuity conjecture aspect of the Gordon Formula made such manipulation possible.

150

Excepting for the opportunity cost comparison, a similar illustrative analysis is developed in this thesis in Part 5 of Chapter 5 (5.5).

295

Appendix D – Details Relating to Kolb’s Cycle Figure C&L client Maxwell, MD of MCC faced rival bids for Macmillan Inc. He directed the C&L valuation team (of which this Researcher was a member) to alter the variables in the TV calculation however necessary in order to cause the paper valuation to increase to a level that supported a winning bid. The perpetuity conjecture element made such a result possible by amplifying any exaggerations in the three variables in the TV-determining Gordon Formula.

1c. Clark (1991): base investigation

This Researcher’s background analysis for Beyond the Deal (1991) in 1997-89 included examination of business cycle acquisition bid patterns and consequences of some of those overbids. Those analyses support this Researcher’s suspicion that conservative valuation principles may be disregarded late in the business cycle when acquisition buying panic arises. The perpetuity conjecture element helps to generate higher apparent value statistics on paper, sometimes with even minor changes in the GF component variables, when all three are altered simultaneously.

1d. Internet Bubble (1996-2000): Profitless Dot-Cons, Lastminute.com IPO

During this bubble, manipulations of the TV (‘continuing’) part in bankers’ valuations (DCF2S Stage 2) helped to justify dozens of IPOs of companies that would not never generate a profit, such as Webvan and iVillage in the US (Clark, 2000) In March 2000, the Financial Times arranged for this Researcher to meet with the Lehman Bros. bankers pricing the new IPO issue for a loss generating, marginal competitor in the travel industry, Lastminute.com. That valuation was distorted on several bases, including the use of radically optimistic TV assumptions in order to create a paper justification for a valuation at the Net bubble’s peak on 15t March 2000.

296

Appendix D – Details Relating to Kolb’s Cycle Figure 1e. Valuation conceptual battles: Copeland v Penman, Lee

By the mid 1990s, it became apparent in the academic journals and to a lesser degree in general management and trade publications such as The Financial Analysts Journal that a battle for valuation methodological primacy was being waged between those supporting accrual accounting methods in general and DDM and RIM specifically Penman (2001,1996, several joint papers with Sougiannis in 1990s) and Copeland et al. (2000, 1994, 1990) are amongst the conceptual leaders of the two competing academic valuation theorist groups. Penman, Ohlsen, Feltham, Lee, Zhang and others support DDM-RIM, whereas Copeland, Young, O’Byrne and others advocate DCF (2.3).

It became apparent to this Researcher that in attempting to reconcile the valuation amounts from accrual accounting methods with DCF, proponents increasingly relied on the limitless time span (perpetuity conjecture) in their Steady State analyses pertaining to the years occurring after the forecast period.

2. Observations and Reflections Description: The experiences above led to new questions and issues relevant this the topics addressed in this thesis.

2a. Detachment of acquisition initiatives and some other valuation-based activities from consistently defensible valuation approaches.

Combined with the Wall Street Big Bang, which increased investment banks’ dependence on fees from their merger arrangement (‘corporate finance’) units, the mismatch of valuation risks and rewards appears to encourage exploitation of the perpetuity conjecture (combined with overly optimistic assumptions for the three GF variable, FCF, g and WACC) to create high valuations on paper. Robust valuations encourage both sellers and buyers, stimulating M&A transaction volume. But with no consistent mechanisms neither acquisition-related valuations or other valuations of companies, the deal intermediary may generate a unrealistic value statistic using GFAP and its perpetuity 297

Appendix D – Details Relating to Kolb’s Cycle Figure conjecture element to cause exaggerated TVs. (Clark 1991, 57) Particularly with poor valuation post-audit provisions, the onus is on the 2b. Logic of variable Cost of Capital in extended period company analysis For years, the generally accepted notion that value estimation calls for a constant, unchanging discount rate over the entire analysis period troubles this Researcher.

To this Researcher, a single, inflexible rate cannot possibly reflect even a small portion of the factors that may cause Weighed Average Cost of Capital (WACC) to vary from period to period. Once again, convenience prevails over accuracy and credibility.

Over a firm’s overall economic life span, debt-to-equity ratios change, as do both operating and financial risks associated with that firm and by implication, its capital (Clark 2010).

3. Formation of Abstract Concepts and Generalisation Description: New concepts and frameworks emerge in this Researcher’s mind. Issues of concern emerge, including:

3a. Contamination of valuation scientific process. In credible scientific experiment or field market research, basic principles of independence and reasonableness must be in place for that process to be widely viewed as legitimate.

3b. Further development of Competitive Advantage Period (CAP), specifically for value management purposes.

To this Researcher, CAP (Mauboussin and Johnson 1997) represents the logical foundation for developing future frameworks specifically directed at value management, rather than value estimation. This Researcher’s perception is that only a fraction of CAP’s potential for use in active value management is developed to date.

4. Testing Implications of Concepts in New Situations 298

Appendix D – Details Relating to Kolb’s Cycle Figure Description: Concepts advance to the status of possible guiding frameworks, requiring sampling and testing.

4a. Acquisition post-assessment: AT&T/NCR In part, this is experiential (1.) in nature. To this Researcher, AT&T’s 1990 acquisition of NCR resulting in a loss of more than $450Mn fours years later exemplifies the central problem of value management as that relates to acquisitions, a principal motivation for valuation calculations.

4b. Ceilings for Terminal Value as percentage of overall company value In some of the value-guess situations emerging during the second half of the Dot-Com bubble, TV represents well over 100% of company value, prompting understandable scepticism (Shiller 2000, Clark 2000).

In work some companies, recommendation emerges from this Researcher to impose a 60-65% ceiling for TV as percentage of total company value (CV) in DCF2S-based company valuations.

299

Appendix E – Relating to the Primary Research Conducted for This Thesis

Appendix E – Relating to the Primary Research Conducted for This Thesis Related: Chapter 3 Part 5: Description of Primary Research Methodology Chapter 5 Part 3: Primary Research Relating to the Longevity of Firms for Purposes of Terminal Value (TV) Estimation in the Two Stage DCF Company Valuation Methodology

Sub-parts: Part E.1 Relating to Methodology for This Survey

E.1a Survey Instrument E.1b Methodology Summary E.1c Regarding Survey Design and Development E.1d Regarding Survey Implementation and Data Compilation E.1e Regarding Adequacy of Sample Size (n) for This Survey E.1f Some Limitations of This Survey E.1g Relating to Subject of Conditional Question B12

Part E.2 Relating to Survey Findings E.2a Interviewee Profiles E.2b Individual Interviewees’ Responses to Qualitative Questions: B10, B11 and B13

E.1a Survey Instrument The following is the final (9th March 2010) version of the primary research survey instrument:

300

Appendix E – Relating to the Primary Research Conducted for This Thesis

A SURVEY RELATING TO THE ISSUE OF COMPANY ASSUMED LONGEVITY FOR PURPOSES OF DISCOUNTED CASH FLOW (DCF) VALUATION OF FIRMS (v09.03.10)

This is a brief, confidential survey on a practical issue of importance to the issue of the valuation of companies—whatever the application: secondary public offering, IPO, acquisition or divestment-related analysis, etc.

PRE-QUESTIONS (2, Qualifier): 1. Do you have any prior applied company valuation experience? IF “yes”, could you please provide at least one example?

Note: Possible ‘qualifying’ answers include involvement in acquisition search or pricing in which DCF valuation was involved, similar involvement in prospective or actual of initial public offerings (IPOs) or secondary offers, development of takeover or disposition strategies involving DCF analysis, involvement in acquisition due diligence ‘Fair Value’ opinions or letters, and/or relative or absolute valuation of companies for investment research purposes (e.g., Morningstar MOAT).

Is “valuation”—that is, development of absolute or relative value estimates of companies—your primary vocation, or do you primarily do something else?

LIKERT SCALE STATEMENTS In Part A, you are presented with a series of statements. Do you agree or disagree?

Please refer to the following five-point scale:

5 In TOTAL Agreement With the Statement as Presented, or Substantially So 4 SOMEWHAT Agree With the Statement as Presented, or Substantially So 3 Neither Agree Nor Disagree With the Statement as Presented, or Have No Opinion 2 SOMEWHAT DISAgree With the Statement as Presented, or Substantially So 1 In TOTAL DISAgreement With the Statement as Presented, or Substantially So

301

Appendix E – Relating to the Primary Research Conducted for This Thesis Part A: Questions A1 Through A8 These are Likert Scale questions / statements, utilising an uneven, five point scale from 1 to 5. The respondent is asked, “Do you agree, or instead, do you disagree with the statement(s) that follow?” with each of the five points representing a distinct response point (above).

A1.

Practically speaking, an “indefinite” period of time means exactly the same thing as an “infinite” period of time.

A2.

All other things being the same (e.g., annual cash flow generation, investment requirement, cost of capital), a company which manages to survive for two years tends to be worth only a small fraction of an otherwise comparable firm which instead manages to stay in business for, say, 20 years.

A3.

A company’s valuation analysis period—that is, the valuation term for analysing that firm—should be as near as possible to that firm’s estimated, remaining life span. Stated another way, if the industry is poised to disappear in a dozen years (including most of its participants), it makes no sense to assume for valuation purposes that companies in that industry continue to operate forever.

A4.

For purposes of estimating company value based on assumptions about company future performance, ease of calculation is more important than precise accuracy.

A5.

(For purposes of valuing a company in advance, assume that the typical company in question reaches peak annualised free cash flow (FCF) by its fourth year of existence. After that time, annualised free cash flow is assumed to continue at about half of Year 4’s levels, forever. Some years later, it is discovered that the company actually collapsed in Year 6.)

302

Appendix E – Relating to the Primary Research Conducted for This Thesis A5. Statement: Despite what happened to the company in Year 6, the valuation described here was accurate. After all, no one could have anticipated at the time that the company would have collapsed and disappeared after only 6 years.

A6.

Developing company life span projections on an industry-by-industry basis based on historical precedent does NOT represent an acceptable alternative to the practice of assuming that companies exist forever, for valuation purposes.

A7.

If it is possible to develop credible estimates of company remaining life spans based on underlying product life cycle (PLC) patterns, then that DOES represent a possibly appealing alternative to assuming that companies continue forever for DCF valuation purposes.

A8.

Even after a company is liquidated, value continues forever, based on the reasoning that those assets generate continuing worth into the future.

Part B, Questions B9 Through B14 (Non-Likert Scale type) B9.

In terms of a specific number of year or years, how long from its time of its origin do you believe that the typical company remains in business? Please provide a specific number reflecting your best guess.

B10.

What event or development best indicates the point in time when a company is “no longer in business” for valuation purposes, in your opinion?

B11.

What factors, considerations or developments, if any, do you believe to be most important for extending a typical company’s life span as a value-generating enterprise?

303

Appendix E – Relating to the Primary Research Conducted for This Thesis B12.

Note that B12 question is not asked if respondent does not identify any specific external events (e.g., ‘reorganisation’, ‘recapitalisation’ or ‘acquisition’) when commenting about “factors, considerations or developments” in Question B11.)

Do you believe that acquisitions per se extend the “active life span” of the companies that are acquired, consolidated or absorbed by another firm?

B13.

No one knows for certain in advance exactly how long into the future a company will survive. How do you deal with that unknown, for company value estimation purposes?

B14.

Finally, please describe your preferred company valuation approach in general terms.

(14a.) Which present method (or methods) do you believe to be the most useful, and why?

(14b.) What are limitations or deficiencies with that valuation method(s) which you would like to see resolved?

(14c.) What are limitations or deficiencies with other, possibly competing valuation methods that you would like to see resolved, in order to be considered for use by you?

E.1b Methodology Summary Sub-parts: E1b.1 Relating to Survey Design and Development (E.1c) E1b.2 Relating to Survey Implementation and Results Interpretation (E.1d) E1b.3 Relating to Adequacy of Sample Size in This Survey (E.1e) E1b.4 Relating to Limitations of This Survey (E.1f) E1b.5 Relating to the Subject Corresponding to Survey Conditional Question B12 (E.1g)

This Methodology Summary is comprised of a description of some of the key points from sub-parts c through g in this Appendix E Part 1.

304

Appendix E – Relating to the Primary Research Conducted for This Thesis E1b.1 Relating to Survey Design and Development (Appendix E Pt. 1, sub-part c: E.1c) The primary purpose of this primary research is to supplement and deepen the secondary relating to this thesis’s primary and secondary research questions. Those questions are specified in Part 3 in Chapter 3 (3.3) and are unchanged from the thesis first version (v1). The survey purpose of addressing questions regarding how practitioners deal with valuation of the continuing period is incorporated into the survey queries designed to support the primary and secondary research questions of this thesis (3.3).

A process of consultation occurred from Nov. 2009- Jan. 2010 to help ensure that the design of this survey and specific questions were aligned with guidance provided on 10th September 2009.

The survey instrument (E1a) combines open-ended questions with semi-structured situational questions. To avoid incumbency or suggestion bias or similar influences which might distort the responses from interviewees, the phrases “Gordon Formula”, “continuing period”, “continuous period”, “perpetuity conjecture” and “Terminal Value Period” were all excluded from the wording of questions.

Situational-type questions were thought to be more helpful to both interviewer and interviewee, as overly broad questions at times result in imprecise responses.

For example, in presenting Question B13 concerning the interviewee’s basis for projecting a company’s t (time) variable for valuation purposes—a central focus of the research in this study—interviewees were not asked to describe a methodological approach in conceptual terms but rather, were asked: No one knows for certain in advance exactly how long into the future a company will survive. How do you deal with that unknown, for company value estimation purposes?

All of the questions in the survey are non-conditional, that is, they do not requiring a prior qualifying response before being asked.

The exception is Question B12, which is conditional by deliberate design. Rather than being open-ended, B12 presents a specific hypothesis to the interviewee and asks for his or her reaction.

For purposes of consistency with the other questions in Part B in the survey, and to avoid any possible suggestion bias as described above, it was agreed following consultation that B12 would be asked only if the interviewee’s response to the preceding

305

Appendix E – Relating to the Primary Research Conducted for This Thesis question (B11) resulted in a response of “being acquired”, or comparable. Additional detail relating to B11 may be found in sub-part g in this Appendix E Part 1 (E1.g).

E1b.2 Relating to Survey Implementation and Data Compilation (E.1d) All surveys were implemented and administered by this Researcher. Questions of an open-ended nature calling for qualitative responses (B10-B14) were separately compiled. Summary versions of interviewees’ responses to Questions B10, B11 and B13 may be found in Part 2 of this Appendix E, sub-part b (E.2b).

Answers to the eight Likert scale-type questions (A1-A8) and the request for an estimate of the typical firm’s life span (B9) are all statistical in nature, and were compiled and then analysed both on an unadjusted basis and also on an adjusted basis. In the latter, the one highest and the one lowest scores are deleted and averages recalculated. Three summary tables in Part 3 of Chapter 5 show individual, average and adjusted average responses for queries A1-B9.

E1b.3 Relating to Adequacy of Sample Size in This Survey (Appendix sub-part E.1e) The completed number of total interviews (25) and the number of interviewees completed for categories A and B (14 and 11, respectively) exceed the minimum (20) stipulated for this survey from the aforementioned consultative discussions in Nov. 2009- January 2010 of the 5th November 2009- 11th January 2010 consultative referred to above.

Also as a result of that consultation, ten interviews were required for part-time valuation practitioners (Category A) and ten from Category B, full time practitioners. Both of those requirements were also exceeded.

This Researcher further suggests that this total number of the completed interviews (25) exceeds the sample size minimums as suggested by (i.) comparables and (ii.) the qualitative survey methodological literature pertaining to non-probabilistic (purposive) qualitative surveys of this type. Additional detail is provided in this Appendix E Part 1 sub-part e (E1.e): Regarding Adequacy of Sample Size (n) for This Survey.

306

Appendix E – Relating to the Primary Research Conducted for This Thesis E1b.4 Relating to Limitations of This Survey (E.1f) Two possible limitations of this survey are identified in sub-part f. Those possible limitations are not considered by this Researcher to detract from the overall findings from this primary research. The interviewees included several prominent thought leaders from valuation academia, who also function from time to time as part-time valuation practitioners.

E1b.5 Relating to the Subject Related to Survey Conditional Question B12 (E.1g) Question B12 in the survey relates to effects on companies’ economic life spans and viability as a result of being acquired by another firm. On multiple bases, the majority indication suggests that the opposite may appears to be true, instead. On a minority basis, some situations are identified in which one may contend that a specific acquiree’s viability appears to have been extended.

E.1c Regarding Survey Design and Development Exhibits Table E1 Eight Considerations in Design of This Survey

Table E1 identifies seven of the design considerations in the development of the survey instrument. Excepting for point A in that Table, each design consideration is described in the pages that follow in terms of both (i.), the reasoning behind that choice and (ii.), the related insights from the literature on qualitative surveys of the non-probabilistic type, as applicable.

307

Appendix E – Relating to the Primary Research Conducted for This Thesis

Table E1: Eight Considerations in Design of This Survey

A. Alignment With Process for Authorisation and Guidance This refers to consultation process, as described above. Major portions of the intended survey design including specific proposed wording was subject to review, comments and guidance from Dr. David Ewers starting with an initial session on 5th November 2009 and extending to mid-January 2010. This Researcher sought that guidance in order to: (i.), better ensure compliance with the parameters in the 10th September 2009 memorandum; (ii.), and to expand upon the base of insight developed in addressing the primary and secondary questions of this thesis (Chapter 3 Part 3).

The foremost purpose of this survey activity was to augment “Time is Value” v1’s base of empirical and theoretical investigation relating to the two research questions in 3.3.

An important but secondary purpose was to assemble and consider some information pertaining to some practitioners’ practices pertaining their estimation of value in the 308

Appendix E – Relating to the Primary Research Conducted for This Thesis Terminal Value (TV, ‘continuing’) second period in today’s prevailing Two Stage DCF methodology.

Additional guidance of a general nature pertaining to the survey design, information compilation, sampling approach and number, wording and data interpretation was provided by Professor Malcolm Higgs, Professor of Human Resources Management and Organisational Behaviour at the University of Southampton’s School of Management. In response to Professor Higgs’ observations, a few changes were made to the wording of a few questions.

B. Emphasis on research purpose Approximately 77 per cent of the questions in the survey are directed to the primary (61.5%) or secondary (15.4%) research questions of this thesis as specified in Chapter 3 Part 3. Those percentages are consistent with the areas of emphasis as described above.

Of the thirteen non-conditional questions in this survey, eight (61.5%) relate to the primary research question: whether the perpetuity conjecture in the incumbent version of the Gordon Formula is tenable and defensible as a means for estimating companies’ unknown life spans for DCF valuation purposes.

Two questions of the thirteen (A6 and A7), or about fifteen per cent of the total of nonconditional questions, relate to this thesis’s secondary research area: possible future categories of approaches to replace the perpetuity conjecture for purposes of estimating t in successor versions of the Gordon Formula.

C. No reference to Gordon Formula by name The decision was made not to refer to the “Gordon Formula” by name in the survey, for several reasons, including to direct the focus of this survey to the perpetuity conjecture within GF, rather than the host equation itself.151 A second consideration was that the Gordon Formula is sometimes known by other names. One of those names, the ‘continuous (or continuing) growth model’ is not useful for purposes of this survey as that name already suggests one specific answer to the question at the centre of this thesis: What is the proper interpretation and estimation of company longevity (time) for valuation purposes in the Gordon Formula equation?

151

As noted in 3.3, usefulness of GF is acknowledged; instead, the focus of this thesis is on the perpetuity conjecture within GF, and the defensibility of the use of a constant amount of infinity as a surrogate for specific companies’ projected life spans for valuation purposes.

309

Appendix E – Relating to the Primary Research Conducted for This Thesis Referring to the Gordon Formula directly also risks introducing bias (Dillman et al.

2009, 126-135) if the interviewee reacts not to the issue, but instead to a past perception of or reputation about that theorem. When a familiar concept is identified by name, an incumbency halo effect might occur, resulting in inadequate consideration of the flaws in that established approach.

D. A mix of bounded and non-bounded questions The survey is comprised of a combination of bounded (semi-directed response) and open-ended questions. The intent was to elicit useful response from the interviewees (Miller and Crabtree 1999, 3-30).

In Questions A1 through A8, interviewees were asked to respond using a five point 1-5 Likert scale ranging from total disagreement (1) to total agreement (5). In Questions B10-B14, interviewees were asked to provide their opinion or to describe their approaches. In Question B9, interviewees were asked to provide their estimate of a typical company’s life span.152 As the word is used here, “bounded” means that interviewee is asked to respond according to a defined scale. The approach for this survey is further described as “semidirected” on the basis that although five Likert points are identified in the survey instrument, the interviewee may choose any response in the continuum from 1 to 5. For example, a few interviewees indicated mid-point scores of “2.5” or “1.5” that better coincide with their beliefs.

E. Five Point Likert Scale The Likert scale is a useful and (to this Researcher) familiar mechanism for conveying qualitative responses in a manner that facilitates quantification and analysis. McIver and Carmides declare, “no scaling model has more intuitive appeal than the Likert scale.”

(1981, 22) Although some authorities on scaling methods favour the Guttman scale method over Likert, this Researcher’s lack of familiarity with the Guttman scale means that it was excluded from use in this survey.

Two question which accompany the selection of the Likert unidimensional scale approach are first, Will there be an odd or an even number of points in the scale? and How many responses are indicated by the selected scale range?

152

When a clarification of what “typical company” was necessary, it was explained that the phrase referred to all companies, regardless of size or whether the firm was publicly traded. This perspective company is consistent with the cohort failure studies examined in Chapter 2 Part 4.

310

Appendix E – Relating to the Primary Research Conducted for This Thesis The answers to those two questions for purposes of this survey are: (i.) odd and (ii.) five, respectively. Some interviewers favour an even number of Likert points on the basis that a positive or negative selection is forced. This Researcher believes if the interviewees are ambivalent and lack a middle-of-scale option, that might cause frustration, possibly resulting in careless answers later in the survey or in extreme instances, no responses at all.

A five points scale was adopted because of this Researcher’s judgments about the shortcomings of a three point (smaller) or a seven point (larger) alternative.

A three point scale means that there is only one positive (approval) and one negative (disapproval) response; it may be argued that such a limited range cannot reflect the customary range of interviewee’s opinions.

Conversely, a seven points scale may be too complex. With three positive and three negative response options, the distinctions between each point may be unclear to interviewees.

F. Repetition, deliberate changes in question polarity The central issue of perceptions about time as a variable and determinant in the Terminal Value (‘continuing’) Period part of DCF valuation was addressed in the survey instrument several times, in slightly different ways. The purpose of this deliberate repetition was two-fold: (i.) to help ensure useful responses to what is today an unfamiliar topic to some, and (ii.) to monitor the consistency of individual interviewee’s responses.

“Polarity” refers to whether the expected response (based on pre-survey test questioning) was at the “1” or the “5” end of the Likert scale. The polarity of questions was deliberately altered in this survey. This Researcher’s thought was that variations would be useful to minimise the possibility of pattern responses: responding to all questions with the same numerical scale answer each time, without necessarily considering the question.

In retrospect, this concern appears to have been exaggerated in this Researcher’s mind.

Changes to question polarity are now considered to be unnecessary in this survey.

311

Appendix E – Relating to the Primary Research Conducted for This Thesis E.1d Regarding Survey Implementation and Data Compilation Sub-parts: E1d.1 Relating to Practitioner Self-Qualification, Other E1d.2 Relating to Data Compilation and Adjustment of Survey Results E1d.3 Regarding Interviewee Prior Familiarity to or Relationship With Interviewer E1d.4 Regarding Informal Limits to the Number of Interviewees From the Same Organisation

Interviews were administered by this Researcher in Spring 2010, either face-to-face or by telephone, except Interviewee A0305, who could not be reached by phone and responded via email. All interviewees had advance access to a copy of the survey instrument (E.1a), except for B0604.1.

E1d.1 Relating to Practitioner Self-Qualification, Other Although prior commercial valuation backgrounds of some of the interviewees were already known to this Researcher (E1d.) each interviewees was asked to describe his or her applied commercial valuation experience, at the beginning of the interview session.

The interview was directed at part-time (Category A) and full-time (Category B) “valuation practitioners”: individuals with past and/or present experience in applying DCF valuation analysis methods in a commercial setting.

Examples of qualifying practitioner experience include but are not limited to involvement in the following: (i.) secondary or initial public offer (IPO) pricing/planning; (ii.) evaluation of start-up firms; (iii.) valuation-informed acquisition, divestment or joint venture analysis; (iv.) strategic valuation investigations involving decisions about the company’s future positioning or direction; or (v.) commercial judgments about whether or not a company’s external market value is consistent with value based on internal operations, sometimes referred to as internal versus external value assessment.

By deliberate intent, the issue of survey confidentially was specified, either in the survey instrument or at the time of the interview discussion. Only one interviewee, A1204.1, insisted on confidentiality of identity and that request has been honoured.

312

Appendix E – Relating to the Primary Research Conducted for This Thesis E1d.2 Relating to Compilation of Data and Adjustments to Survey Results Interviewees’ responses to the survey’s open-ended questions (B10-B14) were compiled separately. Summaries of some of the responses are contained in this Appendix E in Part 2, sub-part b (E2b). In seeking to interpret the findings from Part B questions, this Researcher sought out similar answers or indications.

Answers to the eight Likert scale-type questions (A1-A8) and B9, the interviewee’s estimate of the typical company’s life span were already statistical in nature, and were compiled in order to identify the typical responses, ranges and patterns.

Consistent with Groves et. al (2009), Drever (2006) and Creswell (2006), some attention was paid by this Researcher to the possibility of extreme answers which might distort results.

The s2/n2 analysed version of results from A1-B9 excluded the one highest and one lowest response. Consistent with the expectations for responses from a highly homogeneous sample group in a non-probabilistic survey such as this (saturation issue, E1e, following), that slight adjustment for extreme responses resulted in almost no change to the results.

E1d.3 Regarding Interviewee Prior Familiarity to or Relationship With Interviewer Several of the interviewees have prior business relationships with this Researcher. None of these prior affiliations are believed to influence the independence of survey responses. Care was taken in the interviews not to disclose any opinion about issues relating to any of the questions.

Interviewees A1803 and A1903.2 are partners in the same consultancy organisation, of which this Researcher was associated from 2000 to 2007. Interviewees A2703 and A1204.2 are previous management consulting clients of this Researcher. Interviewee B0604.2’s papers were included in one of this Researcher’s books.

E1d.5 Regarding Informal Limits to the Number of Interviewees From the Same Organisation In administering this survey, a voluntary and non-stipulated aim of this Researcher was that there would be no more than five interviewees from the same company or institution. That informal objective was achieved.

313

Appendix E – Relating to the Primary Research Conducted for This Thesis Three interviewees, A1703, A1903.1 and A1903.3, are faculty at the same university.

Interviewees B1903 and B0804.2 are present or past employees at the same buy-side company valuation boutique. Interviewees B1603, B1803 and B3103 once worked for the same Managing for Value consultancy; today, all three of these individuals work in different organisations.

E.1e Regarding Adequacy of Sample Size (n) for This Survey Related: E.1c Regarding Survey Design and Development

Sub-parts: E1e.1 Summary E1e.2 Regarding Sample Size Parameters for Non-Probabilistic (Purposive) Surveys Applying the Saturation Method

Exhibits: Table E2 A Comparison of Survey Sample Sizes, Other Relevant Comparisons Table E3 Miles-Huberman-Patton- Sixteen Categories of Purposive Studies

E1e.1 Summary Twenty-five (25) interviews were completed for the primary survey research relating to this thesis: fourteen (14) with Category A part-time valuation practitioners and eleven (11) with Category B full-time practitioners. The number of completed interviews exceeded the stipulated minimums for each category (10 each) and overall (20).153 Further, this Researcher contends that this survey size of 25 exceeds the minimum sample size for studies of this general type and sample group composition, based on (i.) precedents and (ii.) emerging parameters in the academic methodological process literature on non-probabilistic qualitative surveys such as this.

153

“Stipulated minimums� refers to required minimum sample sets arising from the aforementioned discussions and correspondence from 5th November 2009 to mid-January 2010.

314

Appendix E – Relating to the Primary Research Conducted for This Thesis Table E2, following, contrasts the final sample size for this survey (25) against several other points of reference:

Table E2: A Comparison of Survey Sample Sizes, Other Relevant Comparisons

(A) n = 25: McConnell (1996)

McConnell’s 1996 study of information technology practices in the risk management field exhibits some similar characteristics to this survey in that both studies involve (i.) a specialist topic not well-understood by the general business community, and (ii.) a limited potential universe of qualified respondents. In referring to McConnell (1996) study overall, Blacker (C, 2010) cites McConnell’s admission that ‘he did too much’ in terms of the total amount of primary research about his topic.154 (B) n = 23 (or less): Saturation, This Survey (2010)

154

Email correspondence from Dr. Keith Blacker to this Researcher, 25th May 2010.

315

Appendix E – Relating to the Primary Research Conducted for This Thesis One saturation indicator relating to this survey suggests that the required minimum sample size (n) for this survey was achieved on or before completion of the 23rd interview.

As examined in greater detail elsewhere in this Appendix E sub-part, the concept of “saturation” as attributed by Guest et al. (2006) to Glaser and Strauss (1967) applies to purposive (that is, non-probabilistic) qualitative investigations such as this survey. The saturation point in time occurs when incremental information fails to materially alter overall results to date. That is “the point at which no new information or themes are observed in the data” (Guest et al. 2006, 59). Crabtree and Miller (1999, 42), Guest and others explain how a highly homogeneous sample group tends to result in a lower the minimum required n compared to divers sample groups and survey objectives. The survey developed for this thesis involved a highly homogeneous universe of interviewees because of the DCF practitioner eligibility requirement.

In implementing this survey, there was a two week pause in Spring 2010 between the date that the 23rd interview was completed and the date that 25th and last interview was completed. A comparison of the responses from the last two interviewees with those preceding indicated that interviews 24 and 25 had almost no effect on the base of findings. Accordingly, based on the saturation criterion, the minimum required n for this survey is considered to have occurred on or before the time of the 23rd interview.

(C) n = 19: Blacker (2001) Blacker’s study on a topic similar to McConnell’s provides a further reference point to the minimum n for this study, as the survey conducted for that 2001 thesis also involved a speciality topic and a homogeneous but specialist sample group.

(D) n = 10: Riemen (1986), cited by Creswell In his observations about sample size adequacy in the case of purposive studies subject to Glaser and Strauss’s saturation point in time concept, Creswell (2007, 126) cites Riemen, explaining that his pattern of responses suggested (to Creswell) that the minimum n was achieved on or before the time of the tenth interview.

(E) n = 6: Guest et al. (2006) As indicated by the title of their paper, “How Many Interviews are Enough? An Experiment With Data Saturation and Variability.” Guest et al. (2006) are interested both in the content from their study of behaviour of African women and in the methodological issue of sample size adequacy for non-probabilistic surveys such as

316

Appendix E – Relating to the Primary Research Conducted for This Thesis theirs (and this survey). The authors conclude that a sample (n) of six sufficed for their study, applying their understanding of the concept of saturation.

(F) n = 5: Miller et al. (1994), cited in Crabtree and Miller (1999) In referring to qualitative studies in which sample size is determined by the point of theoretical saturation and in which a highly homogeneous group of potential interviewees in a purposive study is involved, Crabtree and Miller (1999, 42) cite the 1994 survey of Miller et al. (1994): “Although there are no hard and fast rules, experience has shown that five to eight data sources or sampling units will often suffice for a homogeneous sample (as in the Miller example)…” 155 (G) n = 5: Creswell (2008), cited in Guest et al. (2006) In their paper about minimum sample size in non-probabilistic or purposive surveys, Guest et al. (2006, 61) cite Creswell (2008), which suggests a sample size target of “between five and twenty-five interviews for a phenomenological study”.

(H) n = 3: Dukes (1984), cited in Creswell (2007) Creswell (2007, 126) refers to a minimum sample size of three for purposive, homogeneous qualitative of this general type, citing Dukes 1984, 3-10 interviews, as a useable example.156 Taking into account all of the precedents and comparables in Table E2, it appears to this Researcher that the argument may be presented that the overall survey size (25) for this survey exceeds the requirement for non-probabilistic surveys of this type.

E1e.2

Regarding Sample Size Parameters for Non-Probabilistic (Purposive)

Surveys Applying Saturation Principle Saturation can be of several types, with the most commonly written about form being “theoretical saturation” Glaser and Strauss (1967:65) first defined this milestone as the point at which “no additional data

155

Miller, W. et al. (1994). “Patients, Family Physicians and Pain: Visions From Interview Narratives.” Family Medicine. 26:3, 176-184. As cited in Crabtree and Miller (1999, 380). That 1994 paper was not examined by this Researcher.

156

Creswell (2007) cites Dukes (1984). “Phenomenological Methodology in the Human Sciences.” Journal of Religion and Health. 23:3 197-203 and Riemen, D. (1986). “The Essential Structure of Caring Interaction: Doing Phenomenology.” in Munhall, P. and Oiler, C. Eds. (1986). Nursing Research: A Qualitative Perspective.

Norwalk CT USA, Appleton-Century-Crofts, 85-101. Neither the Dukes paper nor the Riemen book section was examined by this Researcher.

317

Appendix E – Relating to the Primary Research Conducted for This Thesis are being found whereby the (researcher) can develop properties of the category.”

Guest et al. (2006, 64) referring to Glaser and Strauss’s

process-related

criteria

for

determining minimum adequate sample size in non-probabilistic surveys.

Not only does this approach provide more convincing evidence of developed theory, but it also allows one to answer the question, “When can I stop sampling?”

- Crabtree and Miller (1999, 41) referring to use of saturation point to identify minimum n in purposive-

(non-probabilistic)

qualitative

research.

The nature of this primary research, including the types of questions asked and the homogeneity of the sample group, identify this survey as purposive for purposes of assessing sample size adequacy.

Guest et al. (2006) are concerned with this n issue for qualitative surveys of this type.

The authors describe basic differences between determining sample size (n) adequacy for probabilistic studies as contrasted with non-probabilistic studies: For probabilistic studies, the authors describe the mathematical method for determining minimum acceptable n: “based on preselected parameters and objectives (i.e., x statistical power with y confidence intervals).” (60) Most of the balance of the authors’ paper concentrates on the technique of saturation, the method for determining appropriate sample size (n) for nonprobabilistic studies:

“The most commonly used samples, particularly in

applied research, are purposive (Miles and Huberman 1994:94).157 Purposive samples can be of different varieties—Patton (2002) for example, outlined sixteen types of purposive samples- but the common element is that participants

157 Qualitative

Data Analysis.

318

Appendix E – Relating to the Primary Research Conducted for This Thesis are selected according to predetermined criteria relevant to a particular research objective.” (Guest et al. 2006, 62) Patton characterises this purportive study approach as the pursuit of “a wealth of detailed information about a much smaller number of people.” (2002, 227) Table E3 shows the Miles and Huberman and Patton’s sixteen categories. That Table is adapted from Exhibit 5.6, Sampling Strategies, in Patton (2002, 243).

Table E3: Miles-Huberman-Patton- Sixteen Categories of Purposive Studies

319

Appendix E – Relating to the Primary Research Conducted for This Thesis

Table E3 identifies the range of different possible purposive research types, delineated by survey objective. The two types in the table above which appear to correspond to the survey undertaken in support of this thesis are 5, Typical, and 8, Criterion.

In a “Typical” survey, the researcher seeks to identify the most frequently stated response from the majority of interviewees: the average or typical. In the survey associated with this thesis, this Researcher seeks to understand what are the most typical opinions and methods for dealing with the company longevity variable (t) dilemma in DCF company valuation. Patton’s “criterion”, (8) corresponds to the requirement that interviewees must be part- or full-time valuation practitioners.

With purposive studies defined and differentiated from probabilistic investigation, Guest et al. (2006) and others proceed to address the issue of minimum defensible sample size for such studies.

Based on their literature review of the n approaches of other methodological academicians who are also looking at sampling size, the authors suggest the following definition for “saturation”: “The majority of the articles and books that we reviewed recommended that that the size of the purposive study be established inductively until “theoretical saturation” (often vaguely achieved) occurs.” (62) Saturation occurs at “the point (in time) at which no new information or themes are observed in the data.” (parentheses added by this Researcher) The “no new information” qualifier in Guest et al. (2006) suggests the notion of redundancy, meaning duplication of components: when the next incremental interview of survey from the overall sample base results in almost exactly as prior results, there is no new learning.

Guest et al. (2006) and others concerned with sample size adequacy in purposive research (including Morse, Bertaux, Creswell, Kurzel, and Crabtree & Miller) acknowledge that there are some obstacles to reliance on theoretical saturation to determine n.

Frequent recompiling and recalculation of results adds to time and expense to the survey effort while increasing the possibility of calculation and/or transcription errors.

Comparing the latest survey results with the existing database depends on which responses are designated as earliest and which occur later. Surveys are often implemented in bulk manner. If all surveys are administered simultaneously such as by

320

Appendix E – Relating to the Primary Research Conducted for This Thesis electronic means, how does one distinguish between interview number one and interview one hundred?158 These and other challenges associated with the saturation process technique are apparent to Guest et al. (2006), when they suggest the need for advance guidelines to supplement the incremental process analysis of the point of saturation: “Although the concept of saturation is helpful on a conceptual level, it provides little practical guidance for estimating sample sizes, prior to data collection, necessary for conducting quality research.” (59) Faced with this challenge to develop sample size guidelines that might be applied to other purposive studies, Guest et al. embark on two different approaches, both of which are described in their 2006 paper.

Their first approach involves analysing interviewee responses from their own behavioural study of sixty African women with a view towards identifying that point in time (and n number) when no further learning occurs: saturation. For their study, Guest et al. conclude that saturation occurs in a range of 6 to 12: “based on the data set, (we) found that saturation occurred within the first twelve interviews, although basic elements for metathemes were present as early as six interviews.” (59) The second Guest et al. approach is in effect a literature review: their investigation of academic methodologists’ judgments about workable advance parameters about minimum sample sizes for purposive studies. Several of those indications and their sources are shown in Table E2 found at the beginning of this Appendix sub-part under E1e.1 Summary.

Morse, one of the early articulators of the concept of theoretical saturation, acknowledges the potential for subjectivity in interpreting exactly when and where the point of saturation occurs: “In qualitative research, there are no published guidelines for estimating the sample size required to reach saturation equivalent to those formulas used in quantitative research. Rather, in qualitative research, the signals of saturation appear to be determined by investigator proclamation and by evaluating the adequacy and comprehensiveness of the results.” (1995, 147) Consistent with Morse’s observation about subjectivity in diagnosing the point of saturation, the range of academic perspectives on minimum n in purposive studies

158

This issue of sequencing does not arise in the primary research conducted in support of this thesis as interviews were done one at a time, mostly by telephone, over a period of several weeks.

321

Appendix E – Relating to the Primary Research Conducted for This Thesis appears to this Researcher to be wide-ranging in terms of both the degree of precision and the depth of supportive analysis.

Guest et al. (61) for example appear to this Researcher to overstate Bertaux’s (1981) findings when they claim that the French methodologist believes that that “fifteen is the smallest acceptable size in qualitative research”. This Researcher’s examination of that Bertaux literature suggests an academician who is far more concerned with describing the saturation process than in specifying n. (Bertaux 1981, 29-45) Crabtree and Miller (1991, 41-42) observe that “Miller, Yanoshik and colleagues (1994) describe how they saw the same perspectives in the last two interviews as in the first four. The strategies of sampling to the point of redundancy or theoretical saturation… have implications for sample size. Although there are no hard and fast rules, experience has shown that five to eight data sources or sampling units will often suffice for a homogeneous sample (as in the Miller example).”

Kurzel (1992, 31-41) describes how differences in sample homogeneity affect minimum sample size. The author prescribes a minimum range of 6-8 interviews in the case of fully homogeneous sets but more-- 12 to 20—if the sample base is highly divers and/or if the interviewer is “trying to achieve maximum variation.” Kurzel’s maximum variation point corresponds to another of Patton’s sixteen purposive study types as shown here in Table E3.

Creswell (2007,126), one of the most well-written academicians in the survey methodology field, also emerges as one of the most prolific observers of others’ practices on this purposive study n issue: “In phenomenology, I have seen the number of participants range from 1 (Dukes, 1984) up to 325 (Polkinghorne, 1989). Dukes (1984) recommends studying 3 to 10 subjects, and in one phenomenology, Riemen (1986) studied 10 individuals.”

E.1f Some Limitations of This Survey159 Exhibit: Table E4 Two Possible Limitations of This Survey, Implications

159

Only two possible future replacements approaches for the perpetuity conjecture—industry-segment life span patterns and product-service life cycles (PLCs)-- were specified in the survey instrument, in two separate questions. This is not listed as a limitation on the basis that those two categories had already emerged as leading successor candidates in the June 2009 v1 thesis version.

322

Appendix E – Relating to the Primary Research Conducted for This Thesis Table E4 summarises some possible limitations associated with this survey and approach, along with this Researcher’s perception of implications, as applicable.

Table E4: Two Possible Limitations of This Survey, Implications

(1.) A2 Residual Wording Question A2 presents two companies that are described as exhibiting the same valuerelevant performance characteristics excepting for one variable: longevity (t). The first company fails after being in business for two years. The second firm survives for twenty years.

But as presented in the survey instrument (E1a.) Question A2 does not specify that postfailure residual is negligible or zero following the collapse of both companies, although that was always this Researcher’s intent, in order to isolate the company life span time dimension.160 This Researcher supplemented the incomplete A6 wording with oral guidance at the time of survey administration, thus significantly reducing any possibility of misunderstanding.

(2.) A4 Convenience and precision as opposites Statement A4 presents (i.) ease-of-use and (ii.) precise accuracy as opposite ends of the Likert continuum. The related notion was that although the truncated, three variable (FCF, g, WACC) incumbent version of the Gordon Formula is easy to use, the resulting 160

Residual amounts net of encumbrances are typically negligible or sometimes even negative at the time of company collapse (Chapter 5 Part 9 (5.9)). Faced with chronic operating losses and barriers to exit, management’s customary practice is to liquidate any assets to continue trading, in hopes of a business turnaround and/or new capital.

323

Appendix E – Relating to the Primary Research Conducted for This Thesis statistic may have limited credibility if inaccuracies are suspected because of (i.) too few variables, (ii.) the wrong variables, and/or (iii.) miscalculations of any of the three variables which are used.

While many interviewees understood this trade-off dilemma in A4, a few did not.

Several of the interviewees pondered one or the other of the two dimensions in their answers, ignoring the other. In retrospect, this Researcher believes that the two dimensions in Question A4 would have been better addressed in two separate questions.

E.1g Relating to Subject of Conditional Question B12 Related: Appendix E.1a Survey Instrument Appendix E.1c Regarding Survey Design and Development

Sub-parts: E.1g.1 Summary, Context, Implications E.1g.2 ‘Minority Case’: Seeking the Exception: Life Span Enhanced by Acquisition E.1g.3 ‘Majority Case’: Decline in Company’s Life Span Accelerated After Being Acquired

Exhibits: Table E5 Some Definitions of Company Demise, Acquiree Life Span Implications Table E6 Acquisition Archtypes, Post-Acquisition Status of Acquired Firm Table E7 Experience of Two Round Turn Acquirees: NCR, Skype

E.1g.1 Summary, Context, Implications B11.

What

factors,

considerations

or

developments, if any, do you believe to be most important for extending a typical

324

Appendix E – Relating to the Primary Research Conducted for This Thesis company’s life span as a value-generating enterprise?

B12.

Do you believe that acquisitions per se extend the “active life span” of the companies that are acquired, consolidated or absorbed by another firm?

In September 2009, a hypothesis arose that companies’ economic life spans are extended as a result of being acquired by other firms.

That hypothesis is reflected in this survey in conditional question B12 (above), which was asked only if the interviewee answers the preceding related, non-specific and openended question (B11) with an response of “acquisition” or equivalent.

Question B12 was treated in this conditional manner in order to avoid any questions in Part B of the survey presenting any boundaries to the possible range of responses and thus possible presenter bias. (Groves et al. 2009) This approach for B12 was included in the aforementioned consultations, starting in early December 2009.

As noted in Chapter 5 Part 3, the most frequent interviewee response to Question B11 was internal new product development and line extensions. ‘Being acquired’ was an unsolicited response to Question B11 from one of the 25 interviewees, or four per cent.

Two other interviewees (A1903.2 and A0305) specifically suggested suggesting that being acquired accelerates the acquired firm’s demise.

Some analysis and arguments for and against the hypothesis are provided here as a matter of information only. The majority case supports the opposite of the hypothesis in this Researcher’s analysis and judgment. But on an exception basis (‘minority case’) there appear to be several instances when an acquiree’s life span may reasonably be described as being extended after the firm is acquired. Both ‘minority’ and ‘majority’ cases are examined in this sub-part. 161 In the months following completion of either of today’s most common forms of acquisitions, bolt-ons and consolidation, prevailing postmerger integration (PMI) practice calls for eliminating all redundant operations and activities as soon as possible

161

Quotation marks, as ‘majority’ and ‘minority’ reflect this Researcher’s assessment based on the analysis and commentary herein, only.

325

Appendix E – Relating to the Primary Research Conducted for This Thesis after the deal is finalised to help pay down the acquisition overbid premium. While postmerger rhetoric typically includes assurances that the burden of PMI will not primarily be borne by the acquired firm, multiple completed transactions suggest otherwise. The signing of the deal provides an advance indicator of the acquiree’s imminent disappearance.162 Nonetheless, two categories of exceptions to this stark reality appear to exist. These are the two ‘minority case’ categories.

One of the two exception categories includes companies in the first third of their economic life spans which are growing at rates in excess of management’s ability to finance growth. Past the venture capital or angel stage but still with sufficient questions about survival to exclude those firms from Initial Public Offerings (IPOs) financing, some of these companies are assisted by benefactor-acquirer companies with the resources and inclination to help those acquired firms to achieve their growth plans.

One example of an acquiree situation of this type is 3M’s acquisition of the Dallas, Texas company that created the Post-ItTM slips. Another example familiar to this Researcher is Amdahl’s acquisition by Japan’s Fujitsu Computer.163 The second exception category involves mature companies which face seemingly imminent when they are unexpectedly rescued by a saviour acquirer. Such instances occur far less frequently than the first exception-minority category. Whether Enron, Peloton Partners or Worldcom, the fast-imploding company presents a massive risk to the potential acquirer. Such beneficial (to the acquiree) acquisitions tend to be avoided unless some unique attraction is perceived as offsetting that risk.

In the case of acquisitions of both Barings (by ING) and Merrill Lynch (by Bank of America) the appeal was entry to a part of the financial establishment from which the acquiring firm had previously been excluded. PwC’s systems consulting unit was acquired in the mid-1990s by IBM to help facilitate Gerstner’s transformation of that firm into a services company.

But even in these minority (exception) category instances, a vexing question arises as to whether the acquiree even survives as an identifiable separate unit after the acquisition.

162

A few examples include Netscape (acquired by AOL), Fleet Banks (acquired by Bank of America), Digital Equipment Corp. (acquired by Hewlett-Packard) and Croker Bank (acquired by Wells Fargo Bank). Clark (1991) Sections II, “Merger Integration: Creating Postacquisition Corporate Value” 101-264 and III, “Merger Integration and the 1990s” 265-314.

163

This Researcher was officer of US venture capital firm Heizer Corp. in the middle 1970s, when time that the decision was made to sell Heizer’s interest in Amdahl to Fujitsu.

326

Appendix E – Relating to the Primary Research Conducted for This Thesis On both a statutory and financial basis, an argument may be made that the acquired firm effectively ceases to be independent at the moment of acquisition, rendering moot questions about the acquired company’s post-merger improvement.

Original shareholders’ interests in the acquired firm ceases at the point of acquisition except in pooling-of-interest type combinations, which have been rare since the early 1970s. Some (including this Researcher) contend that this discontinuation of ownership interest presents another indication of the demise of the acquired firm.

Any remaining vestiges of independence tend to disappear soon after the time of acquisition. Postmerger propaganda aside, it is management of the acquiring company— rather than the acquiree—who are positioned to make decisive decisions about the future of the company which has just been purchased.

Nor is the standard postmerger marketing tactic of affixing the acquiree’s name to a product or store to be confused with continuity of the acquired company. In the US, the Wyatt chain of grocery stores was acquired by that sector’s leader, Kroger. The purchased stores were temporarily branded with both firm’s names. Behind the scenes, full operational integration was accelerating, with Wyatt’s customer stream the only surviving aspect of the acquiree. A few months later, and Wyatt’s name was dropped, suggesting which of the two entities had survived and which had succumbed.

Chapter 2 Part 4 of this thesis summarises findings from numerous cohort-based academic studies of the actual company longevity, including this Researcher’s analysis based on those studies suggesting that the median life span of all companies appears to be approximately seven years. This Researcher analysed the methodologies of several of those key authors including Mata et al. (1994-5), Audretsch (1995) and Dunne et al.

(1989). That analysis reveals that those three leading authors on corporate failure and demise specifically include mergers and divestments in their statistics on company failure.

E.1g.2 ‘Minority Case’: Seeking the Exception: Life Span Enhanced by Acquisition

This sub-part considers some of the ‘minority case’ instances when it appears that the acquiree is prospering after being acquired. Sub-part 1g.3, following, addresses some of the evidence and analysis in support of ‘majority case’.

In seeking to systematically understand those circumstances when the acquired company is strengthened in a manner such that one might reasonably surmise that the acquiree’s life span has been extended, this Researcher revisited the four determinants of the value 327

Appendix E – Relating to the Primary Research Conducted for This Thesis of enterprises as introduced in Chapter 1 in this thesis. The company in which one or more of those determinants is fortified is well-positioned to experience an extended period of economic viability: a longer life span.

Those four determinants are: support funding (Weighed Average Cost of Capital, WACC), investment (i), adequate positioning, market penetration and pricing to secure a superior return on that investment (Cash Flow Return on Investment, CFROI) and duration, t. As the issue addressed in this Appendix sub-part involves duration (life span) that is the dependent variable of the four.

The principal response from the 25 interviewees’ to Question B11 (‘internal new product development’) implicitly incorporates the three non-dependent determinants.

Madden (2010), Mauboussin and Johnson (1997) and others describe the firm’s investment base (i) as the company’s ultimate font of value. But without financing support (WACC) or increased market presence or pricing (CFROI), that font runs dry.

Which leads the search for those situations, if any, in which one or more of those determinants improves such that the acquiree’s life span is extended.

Not surprisingly, it is instead much easier to identify those instances in which the acquiring firm does little or nothing to fortify the acquiree. In some instances, a financial acquirer plunders its new acquiree, sometimes causing the acquiree to die earlier, or to come dangerously close to that precipice.164 Once a leading Wall Street investment bank, Solomon Bros. was starved of growth capital by its Travelers-Citigroup parent. Undercapitalisation and erratic, frequent changes in strategic direction eventually caused an exodus of talent and irreversible loss of market share. By the late 2000s, Solomon’s stature had declined to such a degree that the once esteemed nameplate was discontinued.

Firms such as Hertz (US) have seen their capital base raided by successive waves of LBO-Private Equity acquirers. Once a leading newspaper-based conglomerate, Chicago’s Tribune Corp. struggles today to meet operating payrolls as a direct consequence of the debt burden affixed to the acquiree by its financial acquirer.

And yet, some other instances arise when it appears to apparent that the acquiree has prospered and survived longer than might reasonably be expected had that firm remained independent. Those two categories of examples referred to here are Post

164

“EMI Plans £105 Boost to Avoid Loan Default.” Financial Times. 14th May 2010.

328

Appendix E – Relating to the Primary Research Conducted for This Thesis Venture Capital Emergent Firms (example: Amdahl) and the Emergency-Exception Salvage (example: Merrill Lynch).

Post Venture Capital Emergent (Amdahl, acquired by Fujitsu)

Fujitsu provided Amdahl with a means to accelerate its pace of growth and market share capture (CFROI) along with new sources of permanent investment capital and working capital (WACC), improving that firm’s research and development capability (i). Without stewardship from Fujitsu, Amdahl faced a future no better than its predecessor’s role (Honeywell) as a distant industry laggard to mainframe industry leader IBM. With the support provided by Fujitsu, Amdahl was partially insulated from that Honeywell’s fate.

Even considering the eventual changes in several aspects of its business and a change in name to Fujitsu Computer Systems, Amdahl remained a semi-autonomous division, at least as long as founder Gene Amdahl remained associated with the firm.

Emergency-Exception Salvage (Merrill Lynch-Bank of America)

Merrill Lynch’s cascading losses in subprime mortgage debt and derivatives meant that

by November 2007 the firm was effectively a zombie (walking dead) with at most sixty days until implosion by nearly all accounts. Bank of America’s emergency acquisition helped to prevent that collapse, along with US government funds. At this writing, ‘Bank of America Merrill Lynch’ operates as semi-autonomous unit within BofA with some independence.

Saviour acquisitions of the emergency ML-BofA type tend to be rare compared to the Post-VC variety. One reason is that the acquisition numbers rarely make sense from the acquirer, and the deal must somehow be explained away in strategic (read: moneylosing) transaction terms; indeed, CEO Lewis of BofA lost his job within a year. A second reason is the pace of deterioration. As losses at the once esteemed firm accelerate, attributes quickly become negatives.

Some of the other minority case situations appear to provide temporary extension of life spans, only. A full or partial acquisition ‘buys some time’ for the acquiree to try to sort out its problems, but survival remains far from assured. Recent examples include:

329

Appendix E – Relating to the Primary Research Conducted for This Thesis Waterstones (owned by HMV Group), Chrysler (partially owned by both Cerebus Partners and Fiat) and Palm (acquired by Hewlett-Packard).

In each of these situations, (i.) there is reason to believe that the acquiree might have collapsed without infusion of funds from the full or partial acquirer and (ii.) there is evidence that the parent has provided some internal subsidies, at least on an interim basis: •

Waterstones has been reported in the UK business press as losing money for several years. Unless HMV Group was and is providing financial relief, the bookselling would have already run out of cash.

•

Chrysler required US government subsidies in 2008-9 in order to survive up to this point in time. Co-parent and private equity firm Cerebus was providing additional funds to the US automaker before and during the negotiation of a sale of a minority stake in Chrysler to Italian automaker Fiat.

•

When profits from Palm’s new Pre brand smartphone failed stem the firm’s losses to segment leaders Apple and RIM (Blackberry) widened, management in April 2010 asked its bankers to search for an acquirer. Hewlett-Packard emerged as buyer, and is keeping some parts of Palm’s research and development division alive.165

In each of the three instances above, the acquiree at this writing remains a fully- or semiautonomous division or subsidiary of the parent(s) as contrasted with full integration under active postmerger integration approaches. That qualifier is important, for as explained in the sub-part following on bolt-on and consolidation acquisition PMI, customary postmerger approach calls for pursuing maximum integration, which often results in eliminating all or nearly all vestiges of the acquired firm as a separate business.

In three situations above, the businesses of the acquirer and the acquiree are sufficiently different to render full integration problematic, except perhaps for financing and some back office operations. Conglomerates of the 1970s style (LTV, Litton) or their 1980s comparables (Hanson, Dana Corp., Signal Cos.) or their 2000s counterparts (General

165Financial Times (12th April 2010). “Palm.” It is uncertain whether Palm will survive as a separately identifiable entity in any manner. Based on trade observations as confirmed in The Economist (5th June 2010, “The Future of the Tablet Computer: Not Written in Stone.” 78) H-P’s sole objective may be to strip away Palm’s operating software for its own future smartphone and iPad product offers.

330

Appendix E – Relating to the Primary Research Conducted for This Thesis Electric, Berkshire-Hathaway) tended to keep the operations of acquired units separate from the parent, relying primarily on indirect control.

E.1g.3 ‘Majority Case’: Decline in Company’s Life Span Accelerated After Being Acquired Other evidence points to the opposite conclusion to the hypothesis presented at the beginning of this sub-part. Five arguments/analysis suggesting that being acquired is more likely to accelerate the acquiree’s demise are examined in the pages that follow: •

Acquiree ceases to exist as a distinct identifiable entity, practically speaking

•

Scherer’s (1988) investigation of post-acquisition performance

•

The indirect effects of acquisition overbids on acquiree viability

•

Bolt-ons and consolidations: post-merger integration (PMI) consequences on the typical acquiree

•

Possible lessons learned from acquisition round turns that may pertain to issue of acquiree postmerger longevity

The Acquiree Ceases to Exist as a Distinct Identifiable Entity, Practically Speaking Table E5 lists five alternative definitions of corporate demise that seem to this Researcher to be particularly applicable to the issue of acquiree postmerger viability as addressed in this Appendix sub-part.166 The first column in that Table identifies one of five different types of possible indicators of company demise. The second column explains that indicator. For example, “competitive” refers a situation in which the company’s level of market share is so small and/or the pace of share loss is so rapid that the company is effectively a zombie still in operation but imploding at such a pace that eventual failure is unavoidable.

166 Part 7 in Chapter 5 contains a more extensive perspective on multiple alternative indicators of the end of a company’s life span, as part of the findings that refute the perpetuity conjecture in the present version of GF.

331

Appendix E – Relating to the Primary Research Conducted for This Thesis

Table E5: Some Definitions of Company Demise, Acquiree Life Span Implications

Column 3 indicates the effect on an acquired firm by that event only. As noted above and by ‘X’ in the exhibit, this Researcher suggests that a loss of statutory and (to a lesser extent) financial independence occurs immediately upon the finalisation of the acquisition.

Column 4 corresponds to possible actions corresponding to each of the five alternative definitions of company demise to extend the acquiree’s life span. The first two rows are blank (NA) as the acquiree is already ‘dead’ by those two criteria. The acquiree’s life span can be extended in an economic sense by increasing returns (CFROI) relative to capital costs (WACC) according to Mauboussin and Johnson. If equity is negative, an infusion may revive the struggling acquiree. Market re-positioning may help revive revenues.

While methods for the acquirer to help extend the life span of the acquiree exist in theory (as illustrated by the bottom three rows in Table E1g.), the question is whether

332

Appendix E – Relating to the Primary Research Conducted for This Thesis actions aimed at strengthening the business of the acquiree—and in doing so, extending the acquiree’s life span—occur.

Several documented examples suggest that the answer is “no”. In the 1990s, California’s Croker Bank became little more than a footnote in the financial records of its acquirer, Wells Fargo Bank. Post-acquisition, Croker no longer exhibited any of the customary characteristics of a continuing business entity: there is no separate balance sheet or capitalisation for Croker, no separate business identity with either customers or suppliers.

In the US, SBC Corporation acquired AT&T. The acquiree’s business name is almost the only thing that continues: assets and operations were immediately commingled and almost every form of AT&T’s past identity as an independent firm was eradicated.

Similarly in the UK, recent acquisitions of Amstrad and Marconi marked the end of those firm’s separate identities, marketplace visibility and existence.

Kirchgaessner, S. and Guerrera, F. (14th April 2010) describe the acquisition of US insurer Washington Mutual (WaMu) by JP Morgan Chase as motivated by the acquirer’s interest in the obtaining that acquiree’s customer relationships and policy premium balances and nothing else. WaMu faced the same outcome as many acquirees: quick extraction of any salvageable worth (in that institution’s case, deposits) by the acquirer with the rest of the firm liquidated quickly, typically at salvage prices. By almost every plausible definition of business continuity, WaMu no longer exists.

Scherer’s Analysis of Post-Acquisition Performance of Acquirees Another consequence of the fact that the acquired firms often cease being identified as continuing entities after the acquisition is that monitoring post-acquisition performance of the acquiree becomes problematic and sometimes impossible.

One academician who has sought to overcome these difficulties is Scherer, who refers to average profitability indices of acquired product lines as a surrogate for postmerger performance of the acquiree (1988, 69-82).

Scherer’s methodology is considered by this Researcher as generating as many new questions as it solves. Except in those few instances where the acquired firm or its factories are all retained and operated intact indefinitely, product lines of acquirer and acquiree tend to become combined as normal business practice; even Jeep, with a distinct chassis and market segment eventually saw its production transferred to one of Chrysler’s existing factories.

333

Appendix E – Relating to the Primary Research Conducted for This Thesis Another aspect of Scherer’s surrogate comparison also strikes this Researcher as being problematic. By utilising external market performance of product lines as a surrogate for acquirees’ performance, Scherer is effectively using the performance indications of stillindependent firms in order to diagnose the performance of captive acquirees.

Scherer’s results contradict the hypothesis that acquirees’ performance improved following acquisition: Since the acquired companies had slightly inferior profit performance before takeover and, after abstracting from accounting revaluation effects, the acquired lines continued to have slightly inferior cash flow / sales performance after takeover, one must conclude that operating performance neither improved nor deteriorated significantly following takeover. The hypothesis that takeovers improve performance is not supported. (76)

Indirect Effects of Acquisition Overbids on Acquiree viability Depending on negotiating skill and the point in time the business cycle, acquisition premia (as measured by successful bid price over prevailing market price of the target acquiree) typically range from 15 per cent to over 50 per cent (Clark, 1991).

Despite financial public relations from the acquiring firm attesting to the affordability of the deal, the acquirer is immediately in a hole financially: unless new value is extracted to cover that acquisition premium, company management face the possibility of seeing their deal fall into the two-thirds that are deemed to have failed, based on prevailing criteria. (Bruner 2002, Coley and Reinton 1985) The language accompanying the acquisition chase almost always features indications about ‘synergies’: cost or revenue-side efficiencies that acquiring management promise will cover all or most of the acquisition premium. One indication of credibility of such assurances (or the lack of same) is the acquiring firm’s share price, which almost always declines upon announcement of the acquisition.

Particularly as the acquisition overbid is often financed with short-term debt, management at the acquiring firm may find themselves unable to respond to the acquiree’s requests to support growth (and by implication, extension of its life span) with new and additional support capital. To the contrary, debt overload in the aftermath of the deal may force capital to flow in the other direction (that is, from acquiree to acquirer), particularly when the acquiree has been burdened with a large portion of the acquisition financing itself.

334

Appendix E – Relating to the Primary Research Conducted for This Thesis

Bolt-ons and consolidations: post-merger integration (PMI) consequences on the typical acquiree Although the majority of all acquisitions fail to achieve expectations, Coley and Reinton (1985) claim that those acquisitions which are closely related to the acquirer’s core business tend to be more successful than other types of deals.

Coley and Reinton’s analysis is widely known today. Bolt-ons and consolidations are the two types of acquisitions that correspond to the author’s related acquisition subcategories.

Table E6: Acquisition Archtypes, Post-Acquisition Status of Acquired Firm

The first type, bolt-on, refers to acquisition of a product or channel that fills a void in its existing product-market offer. As the name implies, this is often the acquisition of a single product line or patent. When the acquirer proceeds to buy the entire firm, it is 335

Appendix E – Relating to the Primary Research Conducted for This Thesis usually because that is the only way to obtain the desired product: Hewlett-Packard acquires Palm, but the object of the acquirer’s desire may not be the underperforming PDA company itself but rather, the operating system patents.

A second example of a bolt-on acquisition, Procter & Gamble’s acquisition of Shulton Inc. was effectively to add a single new product line, rather than to nurture and sustain an acquired firm. The balance of Shulton was liquidated in less than a year following acquisition, as the Old Spice brand was quickly integrated into P&G’s personal care line items list.167 Excess capacity is often the undisclosed consideration in consolidation-type acquisitions. Faced with excess production capacity in the industry overall, the acquirer acts to reduce overall capacity and position itself for the future. NatWest was acquired

by RBS, Chrysler by Daimler-Benz, Mobil by Exxon. Rather than prospering in the acquisition, the acquiree may be immediately liquidated in whole or part if its operating efficiency is not superior to that of its acquiree.

Possible lessons learned from acquisition round turns that may pertain to the issue of extended acquiree postmerger longevity Companies which are acquired and then disposed of several years later provide a further possible source of insight into whether acquirees’ life spans are extended as a result of being acquired.

The phrase “round turn” refers to an acquired company which was once independent and later becomes a publicly-traded independent firm later in the future, typically either as a result of a share dividend or an IPO (Clark 1991).

In theory, a round turn-type of acquire should appear to be particularly well positioned to be improved (and its life span extended) as a result of its temporary period of acquisition by a second firm. Unlike the bolt-on or consolidation-type acquisition described above, the round turn candidate is acquired specifically for the purpose of being re-sold at a future date. If too much of the acquiree is obliterated, management at the acquiring firm may discover to their dismay that there is nothing to re-sell back to the financial market.

167

This Researcher was a management consultant to Shulton at the time of the acquisition by P&G acquisition, while at Coopers & Lybrand MCS.

336

Appendix E – Relating to the Primary Research Conducted for This Thesis

Table E7: Experience of Two Round Turn Acquirees: NCR, Skype

Automaker Chrysler, US tax advisory service H&R Block, US retailer Macy’s, car rental firm Hertz and US online broker Chas. Schwab and UK’s Halfords and UK bookseller Waterstone’s have all been parts of other companies, then independent, then in some instances, acquired again by others, in whole or part. The experience of Schwab and Block suggest that their interim period of ownership by others appears to have negligible effect.

The experience at Skype and NCR is summarized in Table E7. In both instances, an argument can be made that the acquiree suffered as a consequence of its brief period of ownership by another firm. Even though the losses from these unwise acquisitions were borne by the shareholders of the acquiring firm (eBay and AT&T, respectively), the almost immediate indication of problems meant that there was little in the way of either of the aforementioned determinants of value (i, CFROI, WACC) made available to the acquired firm.

Even if it might be assumed that Skype and NCR exited those round turns in comparable condition to before being acquired, there’s the matter of opportunity cost to be considered. In each instance, the acquiree was effectively adrift for four years, unable to 337

Appendix E – Relating to the Primary Research Conducted for This Thesis develop and deploy its own growth plan because of the acquirer’s issue with a disappointing acquisition.

Part E.2 Relating to Survey Findings

E.2a: Interviewee Profiles Related:

Appendix E.1c Regarding Survey Design and Development Appendix E.1d Regarding Survey Implementation and Data Compilation Appendix E.1e Regarding Adequacy of Sample Size (n) for This Survey Profiles of the twenty-five valuation practitioners who participated in this survey through 3rd May 2010 are described in the pages that follow. Fourteen part-time valuation practitioners (Category A) were interviewed. Eleven full-time valuation practitioners (Category B) were interviewed. “Valuation practitioner” is defined for purposes of this primary research in this Appendix E Part 1 sub-part d (E.1d) Regarding Survey Implementation and Data Compilation.

The profiles that follow are intended to provide general background information while avoiding specific identification. Gender is excluded from the descriptions below, as are titles, location and the interviewee’s company or institution. In the alphanumeric reference, the initial letter identifies that individual’s category designation (A or B) followed by the date of the interview.

Profiles of Category A Interviewees (14) A1703: University administrator, finance and accounting lecturer This interviewee is a university department director who lectures in accounting and corporate finance, including company valuation using the Two Stage DCF method. In the past this individual has been involved in DCF valuation of companies, primarily privatisations and public-private finance initiatives (PPIs).

A1803: Partner 1 of Medium-Size Managing for Value (MFV) Management Consulting Firm

338

Appendix E – Relating to the Primary Research Conducted for This Thesis This interviewee is a partner in an international value-based management consultancy and has been involved in numerous valuation and acquisition analysis activities, including but not limited to acquisition searcher for a global pharmaceuticals firms and several company unit dispositions. As company valuation represents only a part of this individual's practice, classification for purposes here is as a part-time valuation practitioner, rather than full-time.

A1903.1 Entrepreneur and lecturer This interviewee is a part-time university academician whose past and present valuation practitioner roles include (i.) DCF valuation of candidate start-up venture capital investee companies and (ii.) analysis of the possible future value of start-up firms as publicly-traded companies (IPOs).

A1903.2 Partner 2 of Medium-Size Managing for Value (MFV) Management Consulting Firm Refer to A1803. This interviewee is a part-time valuation practitioner in the same organisation, with similar past and present applied valuation experience involving client firms of that consultancy.

A1903.3 Lecturer and part-time valuation advisor This interviewee is a full-time academician in business studies, who also has some prior practitioner experience in the valuation of several companies, including several firms related to the commercialisation of the English Channel tunnel.

A2303 Company start-up and turnaround academician This university lecturer has a prior background as a company valuation practitioner including work for a large international energy firm. This interviewee regularly values start-up ventures and bolt-on (that is, closely related and incremental) acquisition target companies using Two Stage DCF (DCF2S) methods.

A2703

Prior FTSE100 company director with role in acquisitions and divestment

valuation analysis This interviewee is a former management consultant with two large international firms and who has also functioned as director of planning for a FTSE100 firm. In the latter role, this interviewee had primary responsibility for estimating the value of possible acquisitions and divestments.

A3103 Valuation author in academic journals

339

Appendix E – Relating to the Primary Research Conducted for This Thesis This academician advises buy-side bankers and company principals about the suitability of acquisition bids and is one of the better known academicians writing on the topic of terminal value. He has been identified by this Researcher in this thesis as a most visible opponent to the notion of briefer than perpetual company life spans, based upon those academic papers since 1996.

A0104 Energy company acquisition background This interviewee's DCF valuation background includes both project and company valuation, primarily in the energy sector.

A0604

Project valuation modelling specialist with some involvement in company

valuation This former full-time chemical engineer now manages an online project valuation website for the energy sector, and is also involved in some related DCF company valuations.

A1204.1 Professor, co-author of one of the leading textbooks in corporate finance168 This interviewee is emeritus professor of finance at a large UK university and co-author of a corporate finance book that is amongst the most extensively used texts in its field.

This interviewee has been involved in company and project-related expert testimony using DCF methods and has advised on acquisition and valuation company matters with both principals and buy-side parties.

A1204.2 Corporate financial analyst / general manager for leading cosmetics company This interviewee is a general manager at a leading international consumer products company. In a similar role for the UK’s leading chemist, this individual was actively involved in the valuation of target companies for possible acquisition or divestment.

A1604 European business manager, part-time company valuation practitioner This interviewee is a manager of a Netherlands firm involved in the publication of books on a range of corporate finance topics, including company valuation. This manager has been involved in the analysis and pricing of several prospective acquisitions on the European Continent.

A0305 Professor of finance at UK university and part-time valuation practitioner

168

Confidentiality requested, respected, and maintained by this Researcher.

340

Appendix E – Relating to the Primary Research Conducted for This Thesis This academician-practitioner responded by email following difficulties in reaching this person reached by phone. Past experience includes a range of financial analyses with commercial market implications, including some acquisition and divestment analyses.

Profiles of Category B Interviewees (11) B1603

President of consultancy involved in company DCF valuation relating to

executive compensation This interviewee is the former head of the remuneration division of the largest Managing for Value (MFV) advisory firm. Today this interviewee evaluates companies on a DCF basis and has developed books and articles in academic journals on DCF company valuation, co-authored with B3003.

B1803 Investment officer at firm applying DCF methods to stock-picking This interviewee was a senior operating officer at the largest Managing for Value (MFV) firm, overseeing hundreds of company valuations applying that firm’s proprietary version of the Two Stage DCF valuation methodology. Today this interviewee evaluates companies on a DCF basis for a private equity company.

B1903 Analyst at third-party valuation boutique serving buy-side clientele This interviewee is an analyst and manager at one of the better known third-party valuation boutiques offering its proprietary DCF-based valuation assessments to buyside clients, primarily the corporate finance departments of investment banks.

B3003 Academician and author in DCF valuation methods With B1603, this interviewee is author of one of the more respected recent general management books on DCF company valuation methodologies. This individual has a relationship with B1603’s organisation and is involved in applied company DCF valuation analysis of companies on an ongoing basis.

B3103 Management consultant concentrating in company valuation using DCF methods This interviewee consults to buy-side acquisition clientele as an employee of one of the world’s largest management consulting organisations, and is a DCF valuation author in general management books and articles directed at the financial trade.

B0104 Turnaround expert, Big Four firm accountant This interviewee has a background in developing valuation methodologies for one of the Big Four accountancy firms, and also has DCF valuation experience as venture capitalist 341

Appendix E – Relating to the Primary Research Conducted for This Thesis and as a company turnaround expert. Primarily a lecturer today, this interviewee’s past experience is the basis for B category designation here.

B0604.1 Chairman of a leading expert testimony economic consultancy organisation This interviewee has more that two decades’ valuation practitioner experience, serving clients in the investment banking and private equity fields, as well as company principals involved in acquisitions and divestments.

B0604.2 Company valuation academic thought leader, consultant to companies This interviewee is one of the developers of the concept of Variable Weighed Average Cost of Capital (WACC), a topic related to the determination of company’s analysed life spans for valuation purposes. A professor and senior lecturer at one of the US’s leading business schools, this individual serves as a frequent consultant to management at acquisition-oriented companies. This interviewee has also been a principal in the M&A/Valuation units of (i.) one of the Big Two credit rating agencies and (ii.) one of the Big Four accounting firms.

B0804.1 Entrepreneur and ongoing company valuation advisor A former company finance director with company valuation responsibility for a large international utility company, this interviewee has had multiple DCF valuation roles in the past, including positions in an insurance company and a division of a Big Four accountancy. Most recently, this interviewee has been involved in a new technology start-up which “requires me to conduct valuations of this firm and numerous other companies, on an ongoing basis.”

B0804.2 Company valuation pioneer, a founder of one of the world’s leading valuation boutiques This interviewee is the developer of a company valuation approach that relies on analysis of industry cash generation ‘fade’ patterns over time in developing proprietary future value estimations. The valuation boutique that this interviewee developed is now wholly-owned by an international investment bank.

B1204 Director of Research, leading independent international investment advisory service This interviewee heads the equity research department at one of the world’s largest independent equity investment advisory organisations. The interviewee developed that firm’s DCF-based valuation method and is a chapter contributor to The Valuation Handbook (2009).

342

Appendix E – Relating to the Primary Research Conducted for This Thesis

E.2b Individual Interviewees’ Responses to Qualitative Questions: B10, B11 and B13 Related: 5.3 Primary Research Relating to the Longevity of Firms for Purposes of Terminal Value (TV) Estimation in the Two Stage DCF Company Valuation Methodology (DCF2S)

Questions B10 through B14 in this Researcher’s survey (Appendix C.1) call for qualitative responses from the interviewees. The Appendix provides individual and summary responses follow provide individual interviewees’ responses to questions B10, B11 and B13.

Interviewee numbers correspond to the profiles found in Appendix C.2, above, and the quantitative responses to statements as shown in Tables 2 and 3 in this Chapter Part.

The statements below are based on this Researcher’s manual written notes taken at the time of the interview and transcribed into typed form immediately after each interview.

No recording device was used. The statements below reflect the interviewee’s actual expressions as closely as possible, and thus the use of quotation marks. In a few instances, there may be some minor changes (such as inserting a pronoun) for comprehension purposes only and without changing either content or context of the response. Where insertions have been made by this Researcher for clarification, those are shown in parentheses and italics.

Question B10: What event or development best indicates the point in time when a company is “no longer in business” for valuation purposes, in your opinion?

Category A Interviewees’ Responses to Question B10: By Individual A1703: “Bankruptcy.”

A1803: “If a technology-based firm, (this occurs) when their technology is obsolete. For nontechnology firms, that point occurs when indicated by some financial measure, but not 343

Appendix E – Relating to the Primary Research Conducted for This Thesis bankruptcy. There are plenty of companies that are resurrected after declaring bankruptcy.”

A1903.1 “Liquidation.”

A1903.2 “A company going into administration or declaring bankruptcy.”

A1903.3 “When they take the flowers out of reception and cancel the free coffee (sic). Another indication is when the company misuses its core business to enter into an unfamiliar area, such as Plessy’s foray into television. Ultimately it (the indication of collapse) is when there’s a precipitous decline in (overall) returns or returns on capital employed.”

A2303 “The point in time when bankers lose confidence in the firm and/or its management and then refuse to renew their permanent financing arrangements.”

A2703 “Somewhere in between the point in time when the company can no longer meet its financial obligations and declaration of bankruptcy.”

A3103 “Chronic losses-- consistent deterioration in profitability.”

A0401 “A major investment to the firm becomes unprofitable, such as a black hole (dry well) in the case of an investment by an oil exploration firm.”

A0604 “Miss the payroll, even once.”

A1204.1 “Rapid deterioration of a company’s credit standing, such as indicated in Altman’s Z Model or similar.”

A1204.2 “Bankruptcy. Ceases to trade.”

A1604 344

Appendix E – Relating to the Primary Research Conducted for This Thesis “Statutory events, such as liquidation order or bankruptcy filing.”

A0305 “Closure or takeover.”

Category B Interviewees’ Responses to Question B10: By Individual B1603 “Bankruptcy.”

B1803 “When the value spread is zero, that is, when CFROI (Cash Flow Return on Investment) equals WACC (Weighed Average Cost of Capital). A CAP (Competitive Advantage Period)- based measure.”

B1903 “When debt becomes distressed (that is, when danger arises of a default on the company’s debt), The company reaches a point of survival through radical restructuring of the debt load operations (or both) and if that is not possible, death.”

B3003 “When there is absence of competitive advantage, determined not by CFROI-- I don’t believe in the ratio-- but rather, by the ability of the company to do something better, faster and/or more effectively than its competitors.”

B3103 “Inability to make payroll two years in a row, citing Abercrombie & Fitch as a recent example. Violation of loan covenants is not a good indicator: hotel companies, for example, routinely allow their debt to lapse as a negotiating ploy with their banks.”

B0401 “On a ‘hard’ basis, it is when returns from the business no longer exceed Weighed Average Cost of Capital. On a ‘softer’ basis, it is when the company is no longer investing in growth and is losing its quality people. The overriding measure is current performance plus future potential.”

B0604.1 “No assets, negative equity or missing a payroll all sound like good indicators for this.”

B0604.2 345

Appendix E – Relating to the Primary Research Conducted for This Thesis “Bankruptcy filing, perhaps a second time.”

B0804.1 “As an accountant, it is when economic viability ends, that is, when CFROI (Cash Flow Return on Investment) equals WACC (Weighed Average Cost of Capital). Strategically, it is when the company no longer has advantage over its key competitors.”

B0804.2 “Company is losing money (is) over-leveraged. The knowledge-building process has stopped. There’s a dysfunctional knowledge-building process in the firm.”

B1204 “Multiple bankruptcies.”

Question B11: What factors, considerations or developments, if any, do you believe to be most important for extending a typical company’s life span as a value-generating enterprise?

Category A Interviewees’ Responses to Question B11: By Individual A1703: “Differentiation, in two forms, both product differentiation and customer-market differentiation.”

A1803: “Whether a company can discover and develop a viable new business model (a new strategic product-market-customer positioning suggesting enduring competitive advantage).

A1903.1 “Acquisition.”

A1903.2 “New product development: organic or external growth, possibly including bolt on product acquisitions (purchase of individual products, rather than company acquisitions). Not corporate acquisitions— those mostly fail.”

A1903.3 346

Appendix E – Relating to the Primary Research Conducted for This Thesis “Capabilities of strategic management, level of investment in future markets: new product development.”

A2303 “A change in the business model. Usually cannot change the model without a change in management, as well.”

A2703 “Establishing an advantaged strategic position, which indirectly relates to the skills and imagination of top management in charge.”

A3103 “New product development, product diversity. Generation of entrepreneurial ideas by management.”

A0401 “New product development, product and market extensions—examples include development of new uses for Mars bars.”

A0604 “Reposition: split the company into different parts, and dispose of the non-profitable parts.”

A1204.1 “A significant reduction in gearing percentage—Don’t over-leverage.”

A1204.2 “Pursuit of new, closely-related growth opportunities. New Product Development, but only in areas where the firm is likely to succeed.”

A1604 “Statutory events, such as liquidation order or bankruptcy filing.”

A0305 “Strategy formulation.”

Category B Interviewees’ Responses to Question B11: By Individual B1603 “New product development.”

347

Appendix E – Relating to the Primary Research Conducted for This Thesis B1803 “Adaptability and alignment. By ‘alignment’, I refer to an overriding objective to achieve value over time—not merely an orientation towards increasingly the stock price.”

B1903 “The ability of the company to produce products or services which it can sell at a suitable profit to satisfy the requirements of capital providers.”

B3003 “The ability of companies to reinvent themselves with New Product Development. Even after a long dormant period, established companies can use brand or new developments to re-invent themselves. The critical factor is culture: Does the company have a relentless value-driven culture?”

B3103 “New product development—renewal of products and positioning. It all come down to which firms are able to overcome complacency, and which are able to see into the future and determine who will be winners and who will be losers.”

B0401 “Internal renewal and growth, as caused by the style of management in place… I have to see that leadership is conscious of the situation. Have the brought along key staff?”

B0604.1 “New product development.”

B0604.2 “Changes in the business, such as line extensions and the like. But sometimes I question whether such changes are worth it—sometimes it might be better for a company to remain a shorter life span, single-industry firm than adapt and diversify but move away from its area of special expertise, away from its area of competitive advantage.”

B0804.1 “Reshaping the internal business. Renewal and re-invention.”

B0804.2 “Resurrecting the knowledge-building process, adding new profitable projects.”

B1204 348

Appendix E – Relating to the Primary Research Conducted for This Thesis “Growth, new product development.”

Question B13: No one knows for certain in advance exactly how long into the future a company will survive. How do you deal with that unknown, for company value estimation purposes?

Category A Interviewees’ Responses to Question B13: By Individual A1703: “I start with a preliminary analysis based on the average estimated life span of companies in that industry, adjusted for size. Larger companies within an industry survive longer.”

A1803: “Assume an arbitrary life span of around fifteen years. Reduce profits progressively from year five to year fifteen, when profits become zero.”

A1903.1 “Take the industry (sector) life span average and adjust for possible changes to that average based on existing products and services and new products under development.”

A1903.2 “Look at comparable companies. If there aren’t comparable companies, then look to comparable products and develop company life span projections based on that.”

A1903.3 “Look at critical data on the company: trading figures, whether gearing is going up or down. Ultimately it (the indication of collapse) is when there’s a precipitous decline in (overall) returns or returns on capital employed.

A2303 “Look to the market average for companies of that type or in that industry. Develop a forecast for a few years, and then estimate the remaining life based on a multiple of earnings, consistent with the survival rate for that industry or group.”

A2703 “Company duration is addressed in combination with other considerations. I develop multiple scenarios, of which the duration of the company is one of the variables

349

Appendix E – Relating to the Primary Research Conducted for This Thesis considered. Then I apply an Expected Economic Return (EER) approach to those scenarios in order to devise a defensible single forecast.”

A3103 “Assuming that there’s no better basis for estimation, assume perpetuity.”

A0401 “My approach is to look at cash throw off over a realistic forward period of time, say 3-5 years, and then extend the horizon another 3-5 years if cash generation supports and so on, until predictable cash generation becomes negligible.”

A0604 “I search for competitive market intelligence that provides insights into the probable future life span of the company. Considerations include technological advantage, competitive intensity and ease of industry entry and exit.”

A1204.1 “My approach is to develop an initial forecast, and then one or two forecast periods with slightly less confidence (in the numbers) assumed. Beyond ten years, I assume that performance is the same as the average expected performance for that industry.”

A1204.2 “One doesn’t know the duration in advance, so you have no alternative except to (improvise) a time span approach appropriate for that specific situation. For example, in China for a new business start-up, we established a ten year analysis period, with no residual after that.”

A1604 “It’s an art, not a science. Look at the historical context of valuation analysis terms for companies of that type or in those situations, do a preliminary analysis of 5-10 years and then extend for a further 5-10 years if one can reasonably assume that there might be some viable operation then.”

A0305 (no response)

Question B13:

350

Appendix E – Relating to the Primary Research Conducted for This Thesis No one knows for certain how long into the future a company will survive. How do you deal with that unknown, for company value estimation purposes?

Category B Interviewees’ Responses to Question B13: By Individual B1603 “Use a sales decay (revenue decline) pattern for the company or similar approach in order to develop a view of that firm’s finite, limited term viability horizon.”

B1803 “By estimating that company’s based on current scenario, competitive environment, and estimation of how long it takes before Cash Flow Return on Investment (CFROI) regresses down to the mean of all companies.”

B1903 “Fade returns down to the long run competitive mean, utilising a general country WACC rate adjusted for company size, rather than an industry-specific cost of capital discount rate. The reason for this is that some companies change industry as they evolve—Nokia started as a rubber company, after all.”

B3003 “I start with a five year forecast period followed by two separate continuous periods. In the first of the two post-forecast periods, I assume that the company earns returns in excess of the cost of capital. In the second post-forecast period, I assume that returns are identical to the cost of capital.”

B3103 “Based on comparable companies in that industry.”

B0401 “Start with a arbitrary life span assumption of 15 or 20 years or so and then make adjustments to that based upon industry pattern or just gut feel, all with that company’s stage in its life cycle in mind.”

B0604.1 “Look at the track record of life spans of companies comprising that industry group, and determine a defensible upper and lower (in years) range for that group. Then choose a projected life span near to the upper end, or longest, part of that range. Even if the firm 351

Appendix E – Relating to the Primary Research Conducted for This Thesis is assumed to be defunct at that point in time, there still may be a small liquidation amount at the end of that firm’s projected life span.”

B0604.2 “My present approach is probably not the best. I don’t follow any single, one approach.

What I do instead is to apply multiple methods and see which converge, and how. I don’t ever assume perpetuity from the onset. Instead I might look at a multiple based on EBITDA or other indicator or use whatever rule of thumb approach tends to apply to companies in that industry.”

B0804.1 “Develop a three phase approach. The first phase represents near-term forecast information that we have high confidence in—Explicit Projection Period. Then skip forward to the third phase, where we’re looking at a range of techniques to determine the distant future part. And then we reconcile the middle part.”

B0804.2 “I develop a forecast of net cash receipts for five years or so and then refer to the fade function for that industry. The point in time when WACC no longer exceeds CFROI determines that point in time.”

B1204 “Case by case basis, but influenced by a number of factors, such as industry patterns, management and the characteristics of that firm.”

352

Appendix F – Relating to Explicit Projection Period (EPP)-Based Methods

Appendix F – Relating to Explicit Projection Period (EPP)Based Methods Related: Chapter 2 Part 3: Literature Review Relating to Company Valuation Methods Chapter 5 Part 3: Primary Research Relating to the Longevity of Firms for Purposes of Terminal Value (TV) Estimation in the Two Stage DCF Company Valuation Methodology (DCF2S) Chapter 5 Part 11: Prospect of Future Possible Alternatives to the Perpetuity Conjecture Chapter 6: Conclusions and Future Direction of Research Part 11: Prospect of Future Possible Alternatives to the Perpetuity Conjecture Appendix E Part 2 sub-part b (E.2b): Individual Interviewees’ Responses to Qualitative Questions B10, B11 and B13

Parts: F.1 Overview: Considering the EPP Alternative F.2 An EPP-Only Alternative?

F.1 Overview: Considering the EPP Alternative Cassia and Vismara (2009) illuminate the pivotal role of the first stage in the DCF2S methodology in company valuation overall, the Explicit Projection Period (EPP). More important for the purposes of the study, the authors examine the links between EPP and two of the three GFAP variables, FCF and g. As the GFAP equation is primary method for calculating Terminal Value (Stage 2 in DCF2S), Cassia’s and Vismara’s study bears directly on company valuation and indirectly on the duration of valuation analysis period (t), the subject of this study as identified in 3.3.

Although the scope of this study (4.2) is on the perpetuity conjecture within GFAP rather than on the Gordon Formula itself, the investigation of the former leads this Researcher to also consider a possible EPP-only (Stage 1) alternative to DCF2S. Several interviewees indicated that they no longer use GF-based approaches in developing company valuations. As EPP Stage 1 value is based on forecast data during the company’s initial years, Cassia and Vismara confirm that this component in DCF2S if 353

Appendix F – Relating to Explicit Projection Period (EPP)-Based Methods often viewed as the more reliable of the two value components, EPP value and Terminal Value.

F.2 An EPP-Only Alternative?

GFAP, the prevailing calculation method for DCF2S Stage 2, is confronted with problems that extend beyond the perpetuity conjecture at the centre of this research.

Stage 2 may not even begin until after 15 according to Ohlson and Zhang (1999) although Stage 2 start dates tent to be the norm. FCF and g, the two variables which together comprise net cash receipts (inflows) in GFAP are approximations and thus prone to quick but inaccurate calculations.

The FCF assumption in GFAP is dependent on the Free Cash Flow running rates as of the end of EPP according to Cassia and Vismara, introducing a possible source of error if the EPP calculation is incorrect if the FCF rate as of the end of EPP is not indicative of future company performance. Mauboussin (2007), Mills (2005) and Penman (2001) have commented on the potential volatility of the FCF growth rate.

Faced with multiple potential issues associated with reliance on GFAP to estimate DCF2S Stage 2 TV, a logical question arises: Why not simply do away with the second stage altogether?

If the duration of a company’s EPP is four years and the median company life span appears to be seven years, that means only a three year trend extension in order to coven the entire expected duration (t) of thousands of companies. 169 A further consideration is prevailing practice. Several of the interviewees participating in the survey related to this study is that they were calculating terminal value not by applying GFAP, but rather, by adapting the EPP technique.

For example, one valuation practitioner in 5.3 described (i.) first calculating Stage 1 using the DCF2S method in customary manner but then (ii.) rather than generating numbers perceived as non-credible using GFAP to calculate Stage 2 Terminal Value, analysing future period on a multiple scenario basis in five year segments, until reaching a point in time when the projection seemed too distant in the future to be plausible.

Assuming a five year EPP duration, this practitioner would proceed with a second five year limited post-EPP analysis covering Years 6-10 on a multiple scenario basis, and

169

The issue of residuals upon company collapse is addressed at several points in this study. Despite some concepts that the value of the business continues after failure, the opposite tends to be true, instead, based on actual company liquidation statistics (5.6): little if no residual upon company death.

354

Appendix F – Relating to Explicit Projection Period (EPP)-Based Methods then perhaps repeat that process for Years 11-15 if data assumptions were perceived as credible and if part of the company’s worth still appeared to be unexplained.

355

Appendix G – EAC Basis

Appendix G – EAC Basis Hartman & MurphyA Equivalent Annual Cost (EAC) Basis for Examining Economic Lifespan of Major Investment Assets ($100,000 Asset Basis): Elapsed Age (Yrs.) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Salvage B

Value

NA 11,500 13,225 15,209 17,490 20,114 23,131 26,600 30,590 35,179 40,456 46,524 53,503 61,528 70,757 81,371 93,576 107,613 123,755 142,318 163,665

100,000 80,000 64,000 51,200 40,960 32,768 26,214 20,972 16,777 13,422 10,737 8,590 6,872 5,498 4,398 3,518 2,815 2,252 1,810 1,441 1,153

O&M

EAC

C

100,000 31,500 49,225 64,009 76,530 87,346 96,917 105,628 113,813 121,757 129,719 137,934 146,631 156,030 166,359 177,853 190,761 205,361 221,945 240,877 262,512

All figures in US Dollars Notes: A 2006, 410-411; Adapted from Table 1.

B Operating and maintenance C Original purchase price ($100,000) less salvage value plus O&M Salvage value decreases 20% p.a, O&M increases 15% p.a.

356

Appendix H – OYSS Illustration

Appendix H – OYSS Illustration of Value Calculation Errors Caused

by

Differences

Between

Actual

Valuation

Longevity and Theoretical Perpetual Longevity in GFAP Related: Chapter 1 Part 2: Perpetuity Conjecture Issue Explained: The Company Valuation Duration Quandry Chapter 2 Part 4: Literature Review Relating to Company Longevity Chapter 5 Part 3: Primary Research Relating to the Longevity of Firms for Purposes of Terminal Value (TV) Estimation in the Two Stage DCF Company Valuation Methodology (DCF2S) Chapter 5 Part 5: Two Analyses of Statistical Errors Attributable to the Perpetuity Conjecture

Part H.1 Background and Summary Part H.2 OYSS Base Case: Single Year Duration v Perpetuity Part H.3 OYSS Alternative Cases: Median Company Life Span (7 Yrs.), Practitioners’ Analysed Average From Primary Research (9.2 Years)

H.1 Background and Summary Gordon Formula valuation errors caused by reliance on the perpetuity conjecture rather than realistic projections of firm’s actual life spans are not merely a matter of theoretical observation.

Those errors are actual. As noted in Chapter 2 Part 4, a significant number of companies worldwide fail in their initial year. In the base One Year Sandwich Shop (OYSS, H.2) hypothetical, the value of a services company that fails at the end of its first year in business is compared to value of the same firm under identical value-relevant conditions, except that in the second scenario it is assumed that company’s valuation life span continues to infinity.

In H.3, two alternative OYSS life span scenarios are compared to the perpetuity conjecture, except that the comparative finite life are 7 and 9.2 years respectively. The seven year life span assumption is the same duration as median company as described in 357

Appendix H – OYSS Illustration Chapter 2 Part 4 (2.4). The 9.2 year life span corresponds to the analysed average from valuation practitioner interviewees participating in the primary research relating to this thesis, as described in Chapter 5 Part 3.

In the base case (one year duration, H.2) illustration, the calculation error caused by the perpetuity conjecture exceeds twenty-one times. Stated another way, the value calculation resulting from an infinite duration assumption exceeds the one year life span value by more than 21 times.170 In the first alternative illustration (H.3) involving a company that fails at the end of seven elapsed years, the valuation error caused reliance on the perpetuity conjecture is 4.62 times.

In the second alternative illustration (H.3) involving a company that fails at the end of 9.2 elapsed years, the valuation error caused reliance on the perpetuity conjecture is 2.81 times.

Part H.2 OYSS Base Case: Single Year Duration v Perpetuity One Year Sandwich Shop Company (OYSS) will collapse into insolvency at the exact end of its first year in operation. Competition is fierce; management has underestimated the difficulty of drawing customers away from well-established competitors. Poor cash planning means shortages for those few customers that OYSS manages to attract.

Assuming that OYSS’s annual Free Cash Flow (FCF) is £100 and that the firm’s analysed cost of capital is five per cent, the analysed value of the firm applying a single year variant of the Gordon Formula is £95.20.171 But if OYSS is assumed to continue operating forever, the erroneous value statistic is £2,000, or more than 21 times the actual worth of that firm.172

Part H.3 OYSS Alternative Cases: Median Company Life Span (7 Yrs.), Practitioners’ Analysed Average From Primary Research (9.2 Years) OYSS’s value assuming that the perpetuity conjecture applies is also £2,000 in the two comparisons in this Appendix H Part. As expected, the degree of error attributable to the

170

There is no post-failure residual amounts in any of the three comparisons, consistent with the nature of post-collapse residuals as described in Chapter 1 Part 4 (1.4) and Chapter 5 Part 7 (5.7).

171 £100 single year FCF times discount factor of 0.952 (.01/.0105). Serial version of Gordon Formula, Appendix C. 172 £100 divided by 0.05 (Figure 1.1.1, Chapter 1). Steady state FCF assumption to perpetuity: £100 per year to infinity.

358

Appendix H – OYSS Illustration perpetuity error lessens as the company’s actual life span is extended, all other things being the same.

OYSS Company Assumed Duration at Company Median Life Span: 7 Elapsed Years Assuming a seven year life span and Steady State continuation of FCF at annualised level of £100/year and 5% constant cost of capital (WACC), the value of OYSS assuming that it remains in business for seven years is £432.90, indicating a 4.62 times valuation error (2000 / 432.9 = 4.62x).

OYSS Company Assumed Duration at Interviewee’s Analysed Average Life Span: 9.2 Elapsed Years Assuming a 9.2 year life span and Steady State continuation of FCF at annualised level of £100/year and 5% constant cost of capital (WACC), the value of OYSS assuming that it remains in business for seven years is £712, indicating a 2.81 times valuation error (2000 / 712 = 2.81x).

359

Appendix I – PPE Economic Lives

Appendix I – PPE Economic Lives Jennergren's (2008) PPE Economic Lives (n), based on Statistics Sweden Data Base* SNI No. 01 to 05 10 to 14 15 to 16 17 to 19 20 21 22 23 to 24 25 26 27 28 29 30 to 33 34 to 35 36 to 37 40 to 41 45 51 52 55 60 61 62 74

Industry Agricultural Forrestry, Fishing Mining Foods, Beverages Textiles Wood Products Pulp and Paper Prod.

Publishing, Printing Chemicals, petroleum Rubber and Plastic Non-metallic Mineral Basic Metal Indus.

Fabricated Metal Machinery, Equipment Electrical and Optical Transport Equipment Other Manufacturing Electricity, Gas, Water Construction Wholesale Trade Retail Trade Hotels and Restaurants Land Transportation Sea Transportation Air Transportation Other (Consulting)

1996 16 13 12 12 14 24 10 15 11 11 15 11 9 7 9 12 28 13 10 11 14 10 23 18 10

YEARS 1997 12 13 12 12 15 21 8 14 10 11 16 11 9 6 10 10 26 20 9 9 14 12 24 19 8

Note: * Adapted from Jennergren (2008, 1555): "Table 1, Estimated n and K Using the Statistics Sweden Data Base" PPE: Property, plant and equipment

360

1998

1994-98

11 14 13 12 15 18 8 14 10 12 15 12 8 6 10 10 28 20 9 10 13 13 20 19 9

14 12 13 12 15 22 9 14 11 11 15 11 9 7 10 11 27 16 9 10 14 11 23 18 8

Appendix J – PPE Economic Lifespan Decline Rates

Appendix J – PPE Economic Lifespan Decline Rates PPE Economic Lifespan Decline Rates in Nine Categories, Statistics Sweden Data Base*

Industry Agricultural Forrestry, Fishing Pulp and Paper Prod.

Rubber and Plastic Machinery, Equipment Electrical and Optical Transport Equipment Other Manufacturing Retail Trade Sea Transportation

YRS.

YRS.

1994

1998

16 23 11 9 8 12 11 11 21

11 18 10 8 6 10 10 10 20

PCT. An. Decl.**

7.8 5.4 2.3 2.8 6.3 4.2 2.3 2.3 1.2

YRS. 2003P***

6.7 13.1 8.9 6.9 4.1 7.9 8.9 8.9 18.8

Related: Appendix I Notes: * Only includes those categories in which 1998 estimated life is briefer than in 1994 (9 of 25 industry groups) ** Post 1998 est. annualised decline % based on 1994-1998 statistics *** Projected from 1994-98 annualised decline rate, five years

361

Appendix K – Some Alternative Concepts of Company Life Span Terminus

Appendix K – Some Alternative Concepts of Company Life Span Terminus

Related: Chapter 2 Part 4: Literature Review Relating to Company Longevity Chapter 5 Part 7: Reality Testing the Notion of the Never Ending Company

Parts: K.1

Alternative Criteria for Determining End of Companies’ Life Spans

K.2

A Spectrum of Life Span Terminus Events

Exhibit: Table K.1: Alternative Criteria for Determining Company Demise Figure K.1: End of Company Life as a Continuum

The perpetuity conjecture within GFAP prescribes an infinite life span for all companies. The large number of company liquidation orders (as described Part 7 in Chapter 5 (5.7)), the consistency of company failure patterns in academic studies over fifteen year (2.4) and the absence of any Never Ending Company (5.9) confirm that companies experience Briefer-Than-Infinite (BTI) lives, instead.

But when is the company deceased? The literature contains a range of different answers to that question, ranging from Altman’s Z-Score (1968) to exit from business registries (Mata et al. 1995, 1994), bankruptcy filings (US Bankruptcy Courts) and administrative orders (UK Insolvency Service).

Part K.1 in this Appendix identifies some of the alternative criteria for determining the timing of a specific company’s demise. Part K.2 looks at different possible indicators or events on a time line basis, as some of the earlier indicators (such as loss of credit lines) may effectively mark the end of that company’s existence as a viable commercial entity, even though trading may continue for a few periods longer.

362

Appendix K – Some Alternative Concepts of Company Life Span Terminus K.1

Alternative Criteria for Determining End of Companies’ Life Spans

A series of possible indicator’s of a company’s economic demise exist, in addition to the Competitive Advantage Period Viability Threshold. Several of these are shown in Table K.1 and described in the pages that follow.

Table K.1: Alternative Criteria for Determining Company Demise

K.1.1 Accounting basis: Not a viable basis for determining company demise On an accounting basis, a company may be viewed as non-viable when a condition of negative book equity persists: liabilities exceed assets. But that criteria is of limited use in determining the end of a firm’s life span. The firm in a position of accounting negative equity may have its situation changed by refinancing, such as through a rights offer. Also, calculating negative equity on the basis of the realisable value of assets and liabilities is arguably a more accurate indicator for purposes of determining the extent and timing of insolvency.

363

Appendix K – Some Alternative Concepts of Company Life Span Terminus

K.1.2 Voluntary filings: Directed at reorganisation, rather than business termination The intent of voluntary filings of the Chapter 11 type under the US Bankruptcy Code is to facilitate reorganisation of that firm’s capital structure in order to continue trading.

Accordingly, such filings are not necessarily the most accurate indicator of the end of a company’s life. Altman (2002) describes several companies that proceeded through multiple Chapter 11 filings, over several years.

K.1.3 Statutory-Involuntary: Too insensitive to be useful as a consistent indicator of the end of individual companies’ life spans This refers to involuntary seizure orders of the US Chapter 10 type and comparable UK statutes, such as the administrative order leading to the UK government seizure of insolvent Northern Rock during the recent recession. This tends to be a trailing indicator, as by the time the signal appears, that company has probably already been non-viable for several periods.

K.1.4 Key Accounts Loss: Decisive, but occurring too infrequently to be used as a recurring indicator The situation involves a company which is overly dependent on a few key accounts and then loses most of them. As there is usually not enough time to develop replacements, the company’s chances of continuing in business are low. Examples include Bear Stearns (US, 2007) and Marconi (UK, 2003-4).

K.1.5 Credit Standing: Premature indicator, not always indicative of imminent company failure While a reduction in the credit rating of company’s senior debt to junk level represents an alarming prospect to the company’s management alarming prospect, it may still be several years before company operations are forced to close. Advance indicator ratios such as those developed by Altman (2002) may indicate a deterioration in the analysed firm’s viability, but as Altman acknowledges, the time gap between the indicator and eventual collapse is sometimes inconsistent.

364

Appendix K – Some Alternative Concepts of Company Life Span Terminus K.1.6 Product-Service Market Share: Competitiveness level as indicator173 Demand for products and services as reflected in market share statistics represents one measure of a company’s competitiveness in the marketplace. On the basis that it is only a matter of time before the firm with low market share products collapses, this emerges as an indirect but possibly indicative indicator of likely failure in the periods ahead. As management of failing firms is sometimes able to make adjustments in time to save the firm (Chrysler 1980, IBM 1994) this indicator does not apply to all companies or circumstances.

K.2

A Spectrum of Life Span Terminus Events

With the possible exception of liquidation, no indication of company collapse represents a definitive indication of company failure. And yet, many firms are clearly no longer viable for several years before management receives an administration order (UK) or files for a Chapter 7 or 10 type bankruptcy (US).

Accordingly, Figure K.1 addresses company decline leading to failure as a continuum, with various different events or indications representing landmarks on the slope from viability and competitiveness to the other extreme, insolvency and non-competiveness:

173

Augmenting the Competitive Advantage Period’s (CAP, Mauboussin and Johnson 1997) economic indicators with market competitiveness indicators results in the Corporate Value Life Span (CVL) framework in Clark (2009) and as referenced in the Industry Pairs analysis part in 5.7.

365

Appendix K – Some Alternative Concepts of Company Life Span Terminus

Figure K.1: End of Company Life as a Continuum

In the Figure, the events shown in the dashed boxes along this company failure spectrum appear to be especially important.

At the point in time identified in Figure K.1 as F, the company’s ongoing profitability has declined to such an extent that Cash Flow Return on Investment (CFROI) now approaches cost of capital, indicating the end of the company’s viability based on Mauboussin and Johnson’s Competitive Advantage Period (CAP) criteria (1997).

At Point G, the CFROI-to-WACC Viability Threshold has occurred several times, as suggested in 2.3 in the latter part of Madden’s Mature stage in Figure 2.3.5. There is now at this point in time little doubt that the company is either on the brink of economic non-viability, or already there.

Deterioration progresses and accelerates, as trade support for the company begin taking protective actions, such as by insisting on cash payment in advance for delivery of supplies. When the company’s lead bank withdraws its standby line of credit or suggests that existing credit arrangements might not all be renewed, the signal to the commercial and financial marketplaces is clear: in the future, this company will be denied the requisite financing to sustain its growth.

366

Appendix K – Some Alternative Concepts of Company Life Span Terminus At Point I, there is a single, initial negative CFROI; the issue is no longer whether or not the company’s returns exceed Weighed Average Cost of Capital (WACC); those returns are no longer even positive. By the time that there is a second financial reorganisation arrangement of the US Chapter 11 type or comparable (J), the point of no return has been reached. Although liquidation may still be several quarters or even years ahead, any of the points from H to J could be argued as representing effective failure, since with each step downwards on the continuum, the prospects for reversing the deterioration diminishes.

367

Appendix L -- Industry Pairs Analysis I: Methodology

Appendix L – Industry Pairs Analysis I: Methodology Related: Chapter 3 Part 6: Description of Secondary Research Methodologies in This Research Chapter 5 Part 6: Reality Testing the Notion of the Never Ending Company Appendix M: Industry Pairs Analysis II: Other Related Findings

Parts: L.1 Methodological Overview L.2 Basis of Designation of Companies as Contention, Participation

Exhibit: Table L.1: Industry Pairs Contention-Participation Designation: Manufacturing (4 Segments)

The competitive structure of industries and segments is a microcosm of organic societies, as younger more effective competitors eventually push older less resilient companies closer to death.

Developed in 2007 for this thesis research, the Industry Pairs analysis compares industry leaders (Contention phase companies) with laggard companies in that same segment (Participation phase companies), consistent with the Corporate Value Life Span / Five Domain (CVL/5D, 5.6) adaptation of the Mauboussin-Johnson (1997) CAP framework.

While management of successful companies in the Contention phase are able to guide their segments in directions that benefit their companies, a firm that slips to Participation phase tends to become part of a permanent financial performance underclass. Several of the companies in the Participation category in 2007 have since failed, as shown in Part 6 in Chapter 5 (5.6), Table 5.6.9, Companies Exhibiting Multiple Negative CFROI Ratios In Industry Pairs Analysis.

368

Appendix L -- Industry Pairs Analysis I: Methodology L.1 Methodological Overview In this analysis, indicated CFROI ratio performance for 16 companies believed to be Contention phase companies are compared with performance of 16 Participation phase companies.

Expectation was that the Contention phase companies consistently out

perform their Participation phase companies over the 2000-7 period. In 14 of 16 segments, that expected outcome is what occurs.

The analysis period is 2000-7, with some individual year data going back to 1998 for some firms. Two companies are selected and examined within each segment. Source data is from Value Line Investment Services and Morningstar Research, although this Researcher relies primarily on the Morningstar source.

Information used in the Industry Pairs analysis was from Morningstar Reports. Results were all equated to calendar basis for comparability, with simple proportional allocations made for companies with fiscal years that differed from calendar years (fiscal years ending 31st December).

Use of Cash Flow Return on Investment (CFROI) ratios alone, rather than in combination with WACC as in the Mauboussin-Johnson CAP analysis, avoided some of the problems that may arise with WACC including comparability and the basis of calculation of that capital cost (Madden 2010, Ch. 5; Clark 2010).

In its present form and sample size, the Industry Pairs analysis is illustrative in nature, rather than statistically significant. Care was taken to identify one representative Contention phase company and one indicative Participation company, which means exclusion of some companies due to post-merger expense adjustments (Daimler Benz) or other reasons.

L.2 Basis of Designation of Companies as Contention, Participation Sixteen pairs of Contention and Participation phase companies were identified in sixteen segments in five industrial categories.

Companies were designated as either Contention (stable market leader) or Participation (mature and declining) on the basis of approximate share, profitability and standing with end-customers in that segment.

Following is the Contention-Participation designation analysis for one of the five industry categories (comprised of four segments) manufacturing:

369

Appendix L -- Industry Pairs Analysis I: Methodology Industry: Manufacturing (4 segments) Segment

Contention

Participation

Basis for Designation

Auto Mfg.

Honda

General Motors (Note a)

Honda has been one of the industry's share and profit leaders for the past two decades, and is often the firm that forces change on others. GM is now profitable only during peak years of the business cycle. At this writing, firm is besieged by concerns about cash burn rate and outdated products, uncompetitive cost structure.

Personal Digital Assistant Manufacture (PD)

Apple (Note b)

Palm

With two generations of iPhone PDAs, Apple has successfully altered competitive basics of the segment to its advantage. Palm's convergence product (Treo) appears to have slipped to third place behind RIM (Blackberry).

Aircraft Manufacture (AI)

Boeing

Northrup

Boeing persists as US's primary answer to as the US's primary competitive answer to Airbus, with bidding advantages over competing domestic manufacturers. Northrop Grumman forced years ago to less profitable subassembly role.

Computer Servers (CS)

Cisco

Juniper

Traditional 'first choice' as server provider, Cisco enjoys market share and reputation advantage over rivals. Distant challenger Juniper faces direct competition from later entrants, including IBM.

(AM)

(a) Analysis originally conducted in May-June 2008. In 4th quarter 2008, speculation rose that GM would be forced to declare bankruptcy without US government bail-out. (b) Apple's business also includes other product lines.

Table L.1: Industry Pairs Contention-Participation Designation: Manufacturing (4 Segments)

370

Appendix M

Appendix M – Industry Pairs Analysis II: Other Related Findings Related: Chapter 5 Part 6: Reality Testing the Notion of the Never Ending Company Appendix L: Industry Pairs Analysis I: Methodology Detail

Parts: M.1 Two Industries in Value Migration174: Auto Manufacturing, PDAs M.2 Other Industry Pairs: Participation Phase Firm Failing or Already Effectively Dead?

Exhibits: Figure M.1: Analysed CFROI 3YMA Ratio Results, Auto Manufacturing: Honda (Contention) v General Motors (Participation) Figure M.2: Analysed CFROI 3YMA Ratio Results, Personal Digital Assistant (PDA) Devices: Apple (Contention) v Palm (Participation) Figure M.3: Analysed CFROI 3YMA Ratio Results, Aircraft Manufacturing: Boeing (Contention) v Northrop-Grumman (Participation) Figure M.4: Analysed CFROI 3YMA Ratio Results, Computer Server Manufacturing: Cisco (Contention) v Juniper (Participation) Figure M.5: Analysed CFROI 3YMA Ratio Results, Air Carriers: Southwest (Contention) v Alaska Air (Participation) Figure M.6: Analysed CFROI 3YMA Ratio Results, Personal Care Products: ColgatePalmolive (Contention) v Kimberly Clark (Participation) Figure M.7: Analysed CFROI 3YMA Ratio Results, Health Care Products: Johnson & Johnson (Contention) v Bristol Myers (Participation)

174

The phrase “value migration” relates to Slywotsky on the basis of his book by the same name (1995, Boston, Harvard Business School Press). That work touches upon some of the aspects of industry domination later explored in the Industry Pairs analysis in this study, but without an orientation towards the end of failing (Participation phase) companies’ life spans.

371

Appendix M Figure M.8: Analysed CFROI 3YMA Ratio Results, Packaged Foods: Campbell Soup (Contention) v General Mills (Participation) Figure M.9: Analysed CFROI 3YMA Ratio Results, Consumer Electronic Retailing: Best Buy (Contention) v Circuit City (Participation) Figure M.10: Analysed CFROI 3YMA Ratio Results, General Retailing: Nordstrom (Contention) v Macy’s (Participation) Figure M.11: Analysed CFROI 3YMA Ratio Results, Drug Stores (Chemists): Walgreen (Contention) v Rite Aid (Participation) Figure M.12: Analysed CFROI 3YMA Ratio Results, Speciality Retailing: Abercrombie & Fitch (Contention) v Gap (Participation) Figure M.13: Analysed CFROI 3YMA Ratio Results, Investment Banking: Goldman Sachs (Contention) v Merrill Lynch (Participation)

The Industry Pairs analysis as described in 5.6 provides insight into a segment competitive and economic structure and in doing so, helps to indicate those firms that are approaching the end of their life spans, which are finite in duration.

The intra-segment competitive dynamic emerges as an important consideration both for anticipating the timing of Participation phase (declining) firms’ demise, and to the nature of possible future successors to the perpetuity conjecture (5.9). As the inventor of the first mass market Personal Digital Assistant (PDA) device, Palm’s PreTM smartphone may have dominated that product segment without the entry of Apple’s iPhone line.175 In the air carrier Industry Pair, Southwest (Contention) established expectations for returns and performance that laggard Alaska Air (Participation) cannot achieve.

M.1 Two Industries in Value Migration: Auto Manufacturing, PDAs M.1.1 Auto Manufacturing: Industry Pairs’ advance indication of GM’s demise Compare the 3YMA (three year moving average) CFROI pattern of Honda (black) and General Motors (GM), and it becomes apparent that GM’s bankruptcy filing in 2009

Apple created the PDA segment with its introduction of the under-featured NewtonTM device. That product failed and thus is not designated as a mass market product here. Advanced smartphones of the RIM BlackberryTM, Palm PreTM and Apple iPhoneTM variety are classified as PDAs, thus that designation for the Apple-Palm pair in the Industry Pairs analysis.

175

372

Appendix M resulted from long-term chronic underperformance, with the pace of deterioration accelerating after 2005.

Figure M.1: Analysed CFROI 3YMA Ratio Results, Auto Manufacturing: Honda (Contention) v General Motors (Participation)

As early as 2003, GM exhibited two consecutive periods of negative CFROIs on a 3YMA basis, which has emerged as a fairly reliable advance indicator of future failure.

Note that GM 3YMA CFROI ratio does turn positive during the easy money years of 2004-5, when the US property bubble helped to finance soaring sales of consumer durables. GM lethargic transition away from Suburban Utility Vehicles (SUVs) meant that GM still produces cars for Nineties consumers a full decade later.

The numbers shown in Figure M.1 were all publicly available (Morningstar) and the fact that GM had slipped below minimal profitable market share in the early 2000s was well known in the financial community.

373

Appendix M M.1.1 Auto Manufacturing: Industry Pairs’ advance indication of GM’s demise

Figure M.2: Analysed CFROI 3YMA Ratio Results, Personal Digital Assistant (PDA) Devices: Apple (Contention) v Palm (Participation)

Apple effectively stole this consumer electronics product-services segment away from its originator, Palm, which launched its iPhone competitor product seven years late to be competitive.

Long plagued by manufacturing inefficiencies and distribution problems, Palm management made the fatal decision in the early 2000s to discontinue its maturing line of handheld devices in preparation for a move into smartphone PDAs. Transition planning was poor with the result that instead of investing in its new technology and keeping up with Apple, Palm faced threat of bankruptcy in 2002, eight years before its final demise.176 Palm represents an example of a company that squanders its early Contention (leader) role and later is overtaken by others who understand market dynamics better and respond faster. Palm management fails to obsolete its own product model, so competitors do that job for them in the late 00s. Over a decade, Palm management transformed that company from the PDA value leader into that segment’s cripple, in value and competitive terms

176

As described in 5.7, the company was absorbed into Hewlett-Packard in Spring 2010 when it became apparent that the Pre smartphone launch could not save the firm. That acquiree was dissolved by HP, which retained only the Palm 0S for its own future product designed to compete with Apple’s iPad. Consistent with the majority findings in Appendix E Part 1 subpart g, (E.1g) being acquired did not extend that company’s life span but rather, the opposite, as its demise and liquidation was accelerated, instead.

374

Appendix M

M.2 Other Industry Pairs: Participation Phase Firm Failing or Already Effectively Dead?

The pages that follow contain exhibits relating to eleven of the remaining Industry Pairs.

With the exception of some of the financial services category segments, the frailty of the Participation phase company appears (white columns), suggesting a company which is closer to its finite date of failure than the competing Contention phase company (dark columns).177

Figure M.3: Analysed CFROI 3YMA Ratio Results, Aircraft Manufacturing: Boeing (Contention) v Northrop-Grumman (Participation)

177

Graphics for segments SB (stock brokerage), SR (super regionals) and BB (bracket banks) are not included in this Appendix although the 3YMA statistics are included in 5.7 In some instances, financial services’ segments results appear to be inconsistent with those from manufacturing or retailing. Relatively low level of capital investment provide a partial explanation, along with loss 2005-2007 results hidden in off balance sheet entities and/or understated (Citigroup).

375

Appendix M

Figure M.4: Analysed CFROI 3YMA Ratio Results, Computer Server Manufacturing: Cisco (Contention) v Juniper (Participation)

Figure M.5: Analysed CFROI 3YMA Ratio Results, Air Carriers: Southwest (Contention) v Alaska Air (Participation)

376

Appendix M

Figure M.6: Analysed CFROI 3YMA Ratio Results, Personal Care Products: Colgate-Palmolive (Contention) v Kimberly Clark (Participation)

Figure M.7: Analysed CFROI 3YMA Ratio Results, Health Care Products: Johnson & Johnson (Contention) v Bristol Myers (Participation)

377

Appendix M

Figure M.8: Analysed CFROI 3YMA Ratio Results, Packaged Foods: Campbell Soup (Contention) v General Mills (Participation)

Figure M.9: Analysed CFROI 3YMA Ratio Results, Consumer Electronic Retailing: Best Buy (Contention) v Circuit City (Participation)

Figure M.10: Analysed CFROI 3YMA Ratio Results, General Retailing: Nordstrom (Contention) v Macy’s (Participation)

378

Appendix M

Figure M.11: Analysed CFROI 3YMA Ratio Results, Drug Stores (Chemists): Walgreen (Contention) v Rite Aid (Participation)

Figure M.12: Analysed CFROI 3YMA Ratio Results, Speciality Retailing: Abercrombie & Fitch (Contention) v Gap (Participation)

Figure M.13: Analysed CFROI 3YMA Ratio Results, Investment Banking: Goldman Sachs (Contention) v Merrill Lynch (Participation)

379

Appendix N – The Future Case Against Perpetuity

Appendix N – The Future Case Against Perpetuity Related: Chapter 2 Part 4: Literature Review Relating to Company Longevity Chapter 5 Part 7: Reality Testing the Notion of the ‘Never Ending Company’

Parts: N.1 Accommodating the Remote Possibility Never Ending Company Existing in the Future N.2 Trends and Indications of Future Company Failures (And Thus, Of Company Finite Life Spans)

Exhibits: Figure N.1 – England and Wales Company Liquidation Trends, 1998-2008

However remote, the possibility that a Never Ending Company might emerge in the future must be anticipated and dealt with. In light of trends and new threats, the possibility that companies might stop failing—and thus, might stop indicating BrieferThan-Infinite (BTI) life spans—appears to be miniscule.

N.1 Accommodating the Remote Possibility Never Ending Company Existing in the Future Taleb (2007) and Kim and Mauborgne described the possibility of unanticipated aberrations.178 US Defense Secretary Rumsfeld spoke of “unknown unknows” in 2003, referring to military threats not presently known to exist but which might arise in the future. 179

178

Kim, W.C. and Mauborgne, R. (2005). Blue Ocean Strategy: How to Create Uncontested Market Space and Make the Competition Irrelevant. Boston, Harvard Business School Press; Taleb. N. (2007). The Black Swan: The Impact of the Highly Improbable. London, Penguin.

179

“That is really only the known knowns and the known unknowns. And each year we discover a few more of those unknown unknowns.” 6th June. Rumsfeld, D. (6th June 2003). “Press Conference at NATO Headquarters, Brussels, Belgium”, Office of the Assistant Secretary of Defense (Public Affairs) News Transcript, http://www.defenselink.mil/transcripts/transcript.aspx?transcriptid=3490, accessed 26th May

380

Appendix N – The Future Case Against Perpetuity While the statistical possibility of a Never Ending Company arising in the future cannot be entirely dismissed on a statistical basis, the (i.) long term consistency of failure experience combined with (ii.) the absence of any indications that a perpetual company can exist much less may exist argues against even a remote possibility of such a departure from the evidence to date.

N.2 Trends and Indications of Future Company Failures (And Thus, Of Company Finite Life Spans) While the number of company failures in the years ahead may not be as great as during the recession of 2008-2009, indications of continuing high levels of collapses arise.

Davey (2009) describes the possible surge in bankruptcies of over-leveraged mid-sized companies in the UK when and if banks decide not to renew the credit facilities that are due to mature in 2011-13. Dash describes why the FDIC’s (US mid-sized bank regulatory body) is expecting continuing high levels of financial institution collapses in 2010-2012.180 Altman’s Z-Score model (2002, 1968) suggests that continuing tight credit conditions are likely to result in continuing collapses.

2008.

180

Davey, J. (4th January 2009). “UK Refinancing Timebomb.” Accessed 4th Jan. 2009, accessed 4th Jan. 2009 http://www.TimesOnline.co.uk./business; Dash, E. (24th Feb. 2010). “At FDIC, Bracing for a Wave of Failures.”

Accessed 24th Feb. 2010, http://www.nytimes.com/2010/02/24/business/24fdic.html?ref=business.

381

Appendix N – The Future Case Against Perpetuity

Figure N.1: England and Wales Company Liquidation Trends, 1998-2008

As shown in Figure N.1, the trend of companies in liquidation in England and Wales suggests continuing failure levels.

382

Appendix O -- Effects of Perpetuity Conjecture on Distortions in GFAP Variables

Appendix O -- Effects of Perpetuity Conjecture on Distortions in GFAP Variables Related: Chapter 5 Part 5: Two Analyses of Statistical Errors Attributable to the Perpetuity Conjecture Appendix H: OYSS Illustration of Value Calculation Errors Caused by Differences Between Actual Valuation Longevity and Theoretical Perpetual Longevity in GFAP

Exhibits Table O.1: Five Year Life Span Scenarios Versus Perpetuity Table O.2: Seven Year Life Span Scenarios Versus Perpetuity Table O.3: Fifteen Year Life Span Scenarios Versus Perpetuity

383

Appendix O -- Effects of Perpetuity Conjecture on Distortions in GFAP Variables

Table O.1: Five Year Life Span Scenarios Versus Perpetuity

384

Appendix O -- Effects of Perpetuity Conjecture on Distortions in GFAP Variables

Table O.2: Seven Year Life Span Scenarios Versus Perpetuity

385

Appendix O -- Effects of Perpetuity Conjecture on Distortions in GFAP Variables

Table O.3: Fifteen Year Life Span Scenarios Versus Perpetuity

386

Appendix P -- Additional Detail Regarding the Selection of Two Research Questions

Appendix P – Additional Detail Regarding the Selection of Two Research Questions Related: Chapter 2 Part 3: Literature Review Relating to Company Chapter 3 Part 2: Selection of The Research Questions for This Thesis Chapter 3 Part 3 Description of the Primary and Secondary Research Questions

Parts: P. 1 Column A: Perpetuity Conjecture as Benign/Facilitative P. 2 Column B: Perpetuity Conjecture as Inaccurate / Simplistic

Exhibit: Table P.1: Two Faces of The Perpetuity Conjecture

This Researcher’s decision to proceed with investigation of the two questions in this thesis (3.3) followed following initial consideration of the merits of the perpetuity conjecture versus its possible detractions. Those two opposing perspectives or “faces” of the perpetuity conjecture are listed in Table P.1. The deliberation of those issues is described in the pages that follow.

387

Appendix P -- Additional Detail Regarding the Selection of Two Research Questions

Table T.1: Two Faces of the Perpetuity Conjecture

The four points listed under Column A (Benign, Facilitative) are consistent with a view of the perpetuity conjecture as a helpful enabling assumption which helps to facilitates the Gordon Formula’s (GF) role in DCF valuation as a mechanism for approximating the second part in the Two Stage Discounted Cash Flow (DCF2S) method, Terminal Value (TV).

By contrast, the four points shown under Column B (Inaccurate, Simplistic) view the perpetuity conjecture in negative term: an implausible, counterintuitive and extreme assumption which might contribute to errors.181

P. 1 Column A: Perpetuity Conjecture as Benign/Facilitative A1: The perpetuity conjecture as the only practical method for resolving the dilemma associated with companies’ unknown (and thus indefinite) future life spans

181

Encarta’s (1999) definitions for “simplistic”: “tending to oversimplify something, especially by avoiding or ignoring its complexities.”

388

Appendix P -- Additional Detail Regarding the Selection of Two Research Questions In any valuation analysis dependent on future projections of component variables, a degree of subjective judgment must be applied.182 The future is not always a reflection of the past and some assumptions about the future are invariably necessary, sometimes even with the availability of substantial historical evidence and trend information.

For the company duration variable, t, one method for developing company-by-company projections is to ignore the uniqueness of the factors influencing individual companies’ longevity (2.4) and apply a constant to all companies. And one form of constant is infinity.

Retort: The phrase in A1 which appears to be highly debatable is “only practical”. Even in the mid 1950s, several finite (sub-infinite) alternative approaches to estimating a company’s future life spans exited, instead of the extreme and implausible notion of perpetual life (5.10).

A2: That were no known significant challenges to the perpetuity conjecture in more than fifty-two years.183 One might presume that such a lengthy period without substantive challenge means that the perpetuity conjecture is actively supported, or at least passively tolerated. Even today, many finance text books begin their chapter on valuation with description of the Gordon Formula, typically referred to as the continuing value equation or comparable.

Retort: The same valuation practitioner or academician who believes that it is tolerable to misinterpret “indefinite” as meaning the same thing as “infinite” is unlikely to be concerned about the inner workings of GF, only to be glad that the equation generates some form of TV statistic. A result is (i.) limited knowledge of the perpetuity conjecture within GFAP to date thus (ii.) a reduced inclination to challenge the counterintuitive supposition.

182 The argument is presented in several parts of the thesis (particularly 5.9) is that calculation of t is no different from calculation the other three true GF variables (FCF, WACC, g) in the sense that future projections must be developed. That most of a company’s value occurs in future periods is (i.) affirmed by the TV problem described in Chapter 1 and also 2.3 and 5.5 and (ii.) suggested in 1.3 in Figure 1.3.1, Company Value Components by Time Sequence Phase.

183

Add 28 years longer if Williams (1938) is viewed as the originator of the Gordon Formula (2.4).

389

Appendix P -- Additional Detail Regarding the Selection of Two Research Questions A3: As minimal distant a projected cash flow amounts are minimal, resulting in almost no statistical distortion to be blamed on the perpetuity conjecture On the basis of the assumptions implicit in A3, time— the difference between whether a firm fails at the end of Year 3 or Year 10—might appear to be irrelevant if the net present value of the cash flows between those two points in company elapsed time are no miniscule as to reasonably be considered as insignificant.

Retort: Neale and McElroy’s Insignificance Exception is examined in 5.6. The combination of circumstances such that there is no statistical value difference between two points in times appears unlikely bordering on impossible, on several bases.

A4: Avoids overly-complex spreadsheets comprised of hundreds of columns (each column representing a discrete time period) The perpetuity conjecture permits the Gordon formula to function as a simple numerator/denominator ratio. Assuming that the simpler equation is perceived as generating as reliable a TV estimate as more complex methods, the appeal of simplicity is understandable.

Retort: The aforementioned absence of valuation post-audits increases the likelihood that the simple GF ratio is perceived as equally accurate as more complete methods.184

P. 2 Column B: Perpetuity Conjecture as Inaccurate / Simplistic B1: This refers to the potential for value calculation distortions, if assumptions underlying some or all of the other Gordon Formula variables are overly optimistic.

Refer to preceding Point A3. So long as there is a possibility that the Gordon Formula variables might be exaggerated, then the perpetuity conjecture may multiply those errors further (as demonstrated in Appendices H and O and Part 5 in Chapter 5.

B2: Classifying time as an assumption rather than a variable adds to the problem of GF’s basic design flaw: too few variables, which are too broadly defined.

184 The Circuit City analysis in 5.5 and the (v1, Chapter 8) analyses of Vodafone, Tesco and Reuters are all attempts to develop postaudit valuation insight

390

Appendix P -- Additional Detail Regarding the Selection of Two Research Questions Although treating time as an constant simplifies the Gordon Formula by permitting a three variable ratio design instead of the four variable serial design that would otherwise be required, a counter-argument arises. To this Researcher, two of the surviving three Gordon variables in their present form, g and FCF are both (i.) defined too expansively and (ii.) are reliant on multiple sub-assumptions, any one of which may require specific analysis to accurately assess. If marginal investment and marginal returns on that new investment are key to enterprise value creation (1.5, Table 1.5.1), why not reflect those causal elements in the valuation formula instead?

B3: One (universal) life span duration that fits no company The perpetuity conjecture prescribes the same life span for all companies: forever. But companies do not all experience the same life spans (2.4, 5.7) and no firm as yet has experienced an infinite life span.

B4: Excessive, theoretical life spans extending centuries into the future divert management attention away from nearer-term value development challenges.

It is irrelevant whether company CFROI is slightly above or equal to WACC after eighty years: the company has probably been out of business for sixty years by that elapsed point in time.

In order to pursue optimal shareholder value in earnest, management attention is ideally directed to the time period when decisions affect the value of the company the most: nearer term. Problem is, the perpetuity conjecture and the long fade curves that tend to accompany that notion tend to direct management attention away from this critical focus.

391