Yesterday’s Remaining Days in Term post was more important than might have been gleaned from a casual read.   Revenue Under Contract is important to telecom service companies.  However, accurate tracking is elusive.

In the post, I illustrated how straight-forward it is to gain visibility into the numbers.    With a couple of clicks in Salesforce.com, I can find Revenue Under Contract.   Just one more click and I get all the individual orders that compile this number.   And just one additional click takes me to any one of the individual orders–and allows me to see the detailed information such as the original contract date, the term, and the calculation of how many days are remaining in the term.

As my former colleague Jon Yount used to say far too often, “Yada.  Yada.  Yada.”  and with a skeptical voice, I can hear him asking “But how do you know the data is accurate?”

Well, I am sure it isn’t 100% accurate.   Hell, the data only was entered into the system over the past six months.  However, it important to recognize the following:  the data is ZB’s only database of record for this info.  It feeds the billing system.  Account Executives have complete access to it and use it for account planning.   It feeds our monthly financial decks.  And, as I illustrated, anyone–including me–can drill down and sanity check the numbers.

Data Integrity is driven by the combination of:

• Transparent data
• Single database of record
• Integrated database architecture (that is, same data persists through opportunity, activation, account management, and billing)
• Data Accuracy Accountability (for example, the account exec is identified on each record, and they have no excuse for letting inaccurate data persist in their customer account records)
• Consistent monthly reporting (so if data is messy, the trend lines will reveal inconsistency)
• And, most importantly, extreme ease of access to the data

Oh, and one more thing.    Management cares!    If not, would I be writing this blog post?

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Today, we will wrap up the series on Measuring Value Creation all together.   The formula is:

Value Creation = Intrinsic Value less Paid-In Capital-Net less Opportunity Cost

Focus on the time period ~”three quarters from now”.  Two principles underpin this:

First, performance in near term drives financial results “three quarters from now”.  Sales that are made in 2Q09 lead to installs next quarter which leads to financial statement revenue in 4Q09.  Likewise, cost reduction projects that are identified and approved in 2Q09 improve the cost structure in 4Q09.   Examples of these are network expense optimization and SG&A savings initiatives.  If service has been great in the recent past, customers will be more likely to not disconnect their service and to order more.  If service is poor, churn will increase and it will be harder to win new sales.   If the marketing/product group, with support of other groups, has a well tuned in quoting and pricing process, sales success will be higher, and results a few quarters hence will be boosted.

Second, Financial results can be forecasted with a high degree of accuracy for the next few quarters.    Per #1, most of the events that will drive 4Q09 performance have happened already.   A fine-tuned forecasting process produces an accurate bottoms-up projection of Income Statement, Cash Flow Statement, and Balance Sheet for the next handful of quarters.

Use the projected Balance Sheet to tabulate Paid-In Capital-Net at the end of “three quarters from now”.  If your business unit is returning cash, it is reducing its Paid-In Capital-Net and thereby helping the Value Creation equation.  If it is consuming additional cash, it is increasing the Paid-In Capital-Net.  Note that even one-time changes that help or harm cash are accounted for in the Value Creation equation.   Using Paid-In Capital-Net maintains emphasis on the flow of capital between the business unit and its parent.

Calculate Opportunity Cost by Multiplying the Paid-In Capital-Net by Cost of Capital.   Recall this is a cumulative calculation, where the calculation is made every quarter to “three quarters from now”, and these numbers are summed together to reflect the Opportunity Cost.  As part of this calculation, the management team assesses what Cost of Capital would leave investors neither thrilled nor disappointed in the business unit’s performance.

Derive an appropriate EBITDA Multiple for the Business Unit: Understand the relationship between EBITDA and Cash Flow.  Consider what longer-term growth rate is appropriate to assume for the business unit.  Peg what income tax and capital will be at the long term growth rate.  Show what EBITDA Multiple is implied by these assumptions and the business unit’s Cost of Capital.  Use EBITDA multiples of similar public companies to provide color to the analysis, but not as a substitute for showing a bottoms up derivation.

Estimate Intrinsic Value by multiplying EBITDA “three quarters from now” by the EBITDA Multiple.

There you have it.   Hopefully many BearOnBusiness readers are helped by this long-winded but very important series of Measuring Value Creation.

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We are nearing the end of the series on Measuring Value Creation. Before I provide the wrap up, I need to return to the topic of prior posts: Choosing an EBITDA Multiplier. Let’s recap what we learned about EBITDA Multiples:

1. The true value of a business–called Intrinsic Value–is determined by summing up those future cash flows -appropriately discounted – that the business is really going to generate. Multiplying EBITDA by a number is nothing more than a back-of-the-envelope approximation of discounted cash flows.

2. In many businesses including telecom, EBITDA is preferred over Cash Flow because capital expenditures are a significant component of Cash Flow. A capital intensive business that is growing rapidly will have low or perhaps negative Cash Flows, despite that the business is presumably in a rapid value-creation mode (else, why is it investing capital?). Conversely, slow or negative growth usually is accompanied by low capital expenditures and, hopefully, higher Cash Flow. Therefore, a multiple of near term Cash Flow is an extremely unreliable back-of-the-envelope approximation of Intrinsic Value.

3. Insight can be gained from similar companies that are publicly traded. However, there is danger in relying solely on market comps. First, market comps can change suddenly and substantially. Some of this might be due to legitimate new insights into Intrinsic Value. However, much of it also is due to the inherent difficulty in calculating Intrinsic Value, as small changes in assumed growth rates and Cost of Capital cause wild changes in EBITDA Multiples.  Making market comps even less reliable is that emotions e.g., fear and exuberance introduce noise into the market’s ability to efficiently estimate Intrinsic Value.   Moreover, no two firms are identical.  All and all, there is danger in blindly pegging your business’ multiple to that of a somewhat-similar public company.

4. EBITDA Multiples are highly sensitive to assumptions about growth rates, cost of capital, and the long term durability of cash flows.

I advocate that a business unit should take it upon themselves to derive and justify an EBITDA Multiple that is appropriate for its business. Understand the relationship between EBITDA and Cash Flow. Assess what Cost of Capital would leave investors neither thrilled nor disappointed. Consider what longer-term growth rate is appropriate to assume for the business unit. Peg what income tax and capital will be at the long term growth rate. Use the methodology described in Estimating your EBITDA Multiple to translate these assumptions into an EBITDA Multiple. Explain the results and underlying thinking to your constituents—and use their feedback to refine the derivation.

For many, this might seem theoretical; perhaps even distracting to the higher priority task of selling or provide good service. In my opinion, the learning that occurs when business unit leaders reflect on their EBITDA Multiple is of monumental importance. It provides a framework to dialogue about (a) how EBITDA translates into Cash Flow over the long term; (b) the durability of revenue and EBITDA and (c) what return would leave investors neither thrilled or disappointed. Each of these is essential to discovering opportunities to increase (or avoid destroying) value. For these very reasons, I have begun to probe my management teams to opine on what EBITDA Multiplier is appropriate for their business.

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11.6X EBITDA

Yesterday’s post returned back to the full form of the Value Creation equation:

Value Creation = Intrinsic Value less Paid-In Capital–Net less Opportunity Cost

We learned that Opportunity Cost captures the return that would leave investors barely satisfied with how their investment did. They are neither disappointed nor excited. As a manager of the business, you were neither a hero nor a goat.

We also learned that Opportunity Cost for a particular quarter is calculated by multiplying Paid-In Capital-Net by Cost of Capital. To determine how much value was created, Opportunity Cost needs to be summed up every quarter since inception. Using 12% as the Cost of Capital, I laid out a simple example:

In quarter 1, your company buys another one, spending $100M on the acquisition. The Opportunity Cost = $3M

In quarter 2, cash flow is negative $2M and cumulative Opportunity Cost is $6.06M

In quarter 3, cash flow is positive $4M and cumulative Opportunity Cost is $9M

In quarter 4, a division of this company is sold and the cash flow for the quarter is positive $10M. Cumulative Opportunity Cost is $11.6M

When managing a company, there are practical aspects of focusing on calculating Opportunity Cost.

1. Opportunity Cost has memory. That is, it looks back as to how the company did on cash flow in prior quarters. If prior quarters were unnecessarily cash flow negative, the Opportunity Cost gets bigger and bigger. Likewise, if a company is cash flow positive, it is rewarded with a lowering Opportunity Cost.

2. One time events that impact cash flow matter. If an asset is sold, it has a permanent positive impact on Opportunity Cost. If an investment is made in the business, such as the purchase of a new piece of equipment, it carries with it an ongoing expectation that positive future cash flows must be generated in the future quarters.

3. With regards to discretionary investments, it puts the emphasis on what really happened instead of on the original business case. How much was really spent? How did cash flows were really generated from this discretionary investment? Etc.

4. The expression of “profitable revenue growth” is often used in business. Opportunity Cost puts in perspective what “profitable revenue growth” really means, including the need to cover the cost of the capital invested

5. The time value of money is at the forefront of the calculation. It forces employees to focus not just on if money will be returned but on how quickly.

All these together create a sense of urgency to return cash flow to corporate or, if further investment is being made into the business, to ensure that the result will be an enterprise value that exceeds the total amount invested, inclusive of the Opportunity Cost of those dollars that were put at risk for a duration of time.

One more thought: The Hurdle Rate itself is also at the forefront. Why 12%, not 10% or 14%? How does management’s decision increase or decrease the “riskiness” of the dollars invested? How does the predictability of cash flows help reduce the Opportunity Cost?

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Measuring Value Creation Series Wrap Up

The topic of the past few weeks has been Measuring Value Creation. The depth and breadth of the posts is a reflection of Value Creation being both a difficult concept to understand and a hard metric to measure. Let’s back-track a little bit and close the loop on a few important concepts. First I will present a slightly modified (in terminology only) definition of Value Creation and second I will bring back the concept of Opportunity Cost into our discussion.

Value Creation = Intrinsic Value less Paid-In Capital–Net less Opportunity Cost

I substituted Intrinsic Value for Today’s Value. I also replaced Amount Invested with Paid-In Capital-Net.

Long ago in Bearonbusiness, I positioned Intrinsic Value as the term that is used to discuss the true underlying value of a business. Intrinsic Value is determined by summing up those future cash flows -appropriately discounted – that the business is really going to generate. Therefore, to estimate Intrinsic Value, we need to look forward in time. When it comes to Intrinsic Value, the businesses’ past performance is relevant only to inform estimates of future cash flows.

We also learned that Paid-In Capital-Net is a Balance Sheet term meaning the actual amount that has been invested in a business (or business unit) by the investors (a.k.a Amount Invested). Paid-In Capital-Net is the total amount that has been invested in the business since inception (Paid-In Capital-Gross) less the amount that has been returned to shareholders (Dividends).

Early on, I introduced the concept of Opportunity Cost, which is:

“…the return that would leave investors barely satisfied with how their investment did. They are neither disappointed nor thrilled. It is about what they would have expected if they invested in something else that had the same level of risk. If they were expecting 10%, that is what they got. If they invested $100,000, expected 10%, and received $250,000 back 10 years later, they’d shrug their shoulders. You might not be their hero, but you weren’t their goat either. You did your job, but not much more. If you were a major league baseball player, you might be invited back to Spring Training, but you wouldn’t be playing in the All Star Game.”

To create value for investors, Intrinsic Value must be higher than Amount Invested by a certain minimum threshold, often called a Hurdle Rate; returns must exceed this hurdle to create, instead of destroy, value. Hurdle Rate is the interest rate that the investors would expect to get if they invested the money in a different company that was no more or less risky than yours. Hurdle Rate is, by the way, one and the same as Discount Rate. Another common term is Cost of Capital. Yes, that is right. Hurdle Rate = Discount Rate = Cost of Capital.

How specifically is Opportunity Cost calculated? So long as Paid-In Capital-Net is carefully tracked, it is straight-forward. Simply multiply Paid-In Capital-Net by Cost of Capital. To determine how much value was created, Opportunity Cost needs to be summed up every quarter since inception. Let’s lay out a simple example, using 12% as the Cost of Capital.

Example:

In quarter 1, your company buys another one, spending $100M on the acquisition. The Opportunity Cost = $100M * 12%/4 = $3M

In quarter 2, cash flow is negative $2M, bringing your Paid In Capital-Net to $102M. The Opportunity Cost for the quarter = $102M * 12%/4 = $3.06M. Cumulatively, it is $6.06M

In quarter 3, cash flow is positive $4M, bringing your Paid In Capital-Net to $98M. The Opportunity Cost for the quarter = $2.94M. Cumulatively, it is $9M

In quarter 4, a division of this company is sold and the cash flow for the quarter is positive $10M. Paid In Capital-Net drops to $88M, and the Opportunity Cost for the quarter = $2.64M. Cumulatively, it is $11.6M

Tomorrow, I will make a few observations about Opportunity Cost that I believe drive good management behavior.

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Amount Invested and Paid In Capital

Yesterday’s post presented the Efficient Market Theory, which asserts that financial markets are “informationally efficient” and therefore stock prices reflect all known information.  It further asserts that the stock prices reflect the consensus of highly skilled valuation professionals.       Naive investors are the prey of skilled investors, which results in a dynamic that leads to stock prices finding their way to that which skilled investors believe appropriate.   And these skilled investors understand the concept of Intrinsic Value.  That is, the most skilled are opining on future cash flows and discount rates.  Therefore, EMT theory implies that stock price reflects Intrinsic Value.

When it comes to measuring value creation, I believe the EMT is the beginning of the story.  As it turns out, like Kool Aid, the EMT comes in multiple flavors:–and understanding these flavors is a launching point to the rest of the story.  The three flavors are:

1. In weak-form efficiency, future prices cannot be predicted by analyzing price from the past. Excess returns can not be earned by using investment strategies based on historical share prices or other historical data.   This implies that future price movements are determined entirely by information not contained in the price series.
2. In semi-strong-form efficiency, share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on new public  information.
3. In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns.  Strong Form assumes that information known by management–if relevant in the determination of Intrinsic Value–is known by stock trading experts and is therefore reflected in the share prices.

Note the difference in the Semi-Strong versus the Strong Form.  In the semi strong, only public information is reflected in the share price.  In the Strong, all relevant information is reflected.  The primary difference is whether information exists (e.g., inside knowledge held by management) that, though relevant to Intrinsic Value, is not known by expert stock traders.  I subscribe to the belief that the Semi-Strong is closest to reality.   Specifically, here is my belief:

1. Management teams are in the best position to accurately estimate their future cash flows
2. A great management team exploits this advantage to the benefit of its investors
3. A great management team ensures a strong competency around forecasting cash flows accurately and objectively
4. taking this a step further, a great management team uses their unique insights into future cash flows to (a) make better decisions and (b) objectively estimate Intrinsic Value
5. If a private company, management’s responsibility is to share these insights with their investors so as to allow the investors to make better investment decisions
6. If a public company, management’s responsibility is similar–though in practice they must live within the practical realities of being a public company

More to come….

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Two day’s ago, the question was posed:  Which of the following beliefs do you consider to be true?

Belief #1:  Enterprise Value, as calculated using the current stock price, IS a good estimate of Intrinsic Value.  Wild swings in stock prices reflect that Intrinsic Value itself can change dramatically over short periods of time.

Belief #2: Enterprise Value, as calculated using the current stock price, IS NOT a particularly reliable estimate of Intrinsic Value.  Wild swings in stock price reflect the market’s difficulty in calculating Intrinsic Value.

Yesterday’s post provided support for Belief #1.  As discussed in 3.6X to 23.3X. Urk, modest changes in the growth rate and/or discount rate produce wild swings in Intrinsic Value.   The Intrinsic Value of TWT, which was used as the illustration, really did experience a roller coaster  ride in the past 12 months.   The ride was fueled by an extreme change in the macro-economic environment.  A year ago, the economy seemed A-OK.  Six months ago was the Great Depression Redux.  Today, the macro-economic environment is somewhere in between.  Any reasonable expectation of cash flows would have changed materially, as would the discount rate.  Therefore, it is natural to conclude that Intrinsic Value was being affected by the macro-economic environment.

This all supports Belief #1.    Enterprise Value, as calculated using the current stock price, IS a good estimate of Intrinsic Value.  It would therefore follow that Intrinsic Value itself has wild swings.  Nonetheless, I believe there is more to the story.   But before I explain why, it is important to fully appreciate the stock market.

I went to University of Chicago and received an MBA.  U of C is renowned in a lot of ways, but perhaps its most famous axiom is the Efficient Market Theory, it asserts that financial markets are “informationally efficient”, or that stock prices reflect all known information.  It further asserts that the stock price reflects the consensus of highly skilled valuation professionals.  It would naturally follow that the best estimate of Intrinsic Value of a public company is reflected in its stock price.  Using the TWT example, today’s stock price of $11.28/share means that all of us should conclude that the best estimate possible of  TWT’s Intrinsic Value is $2.4B.

I believe the Efficient Market Theory is an extremely important starting point.   Anyone who seeks to trade stocks should understand and fully appreciate the EMT.  Likewise, anyone who seeks to Measure Value Creation should pay homage to the EMT as well.  This starts with the presumption that stock prices are usually set by the most savvy and most informed investors, not naive or poorly informed investors.   The former are constantly looking to take advantage of the latter–and this dynamic results in the stock price finding its way to the price that the most skilled believe is appropriate.   And these skilled investors, for the most part, understand the concept of Intrinsic Value.  That is, the most skilled are opining on future cash flows and discount rates.

Keep in mind that I am focusing on the “most skilled” and I am distinguishing them from the “naive”.  There are plenty of institutional investors with nice educational pedigrees that fall in the naive bucket.  They pay little attention to future cash flows, and instead look at other factors such as historical trend, trading ranges, and multiples of similar companies.   I put these folks in the naive bucket–and am skeptical of anyone who claims success with such investment strategies.

My point is this:  Stock prices gravitate toward a consensus expert estimate of Intrinsic Value.   This certainly supports Belief #1: Enterprise Value, as calculated using the current stock price, IS a good estimate of Intrinsic Value.  Wild swings in stock prices reflect that Intrinsic Value itself can change dramatically over short periods of time.

But as I said before, there is more to this story.  To understand it requires a deeper look into the Efficient Market Theory.

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Yesterday’s post ended with a question:  Which of the following beliefs do you consider to be true?

Belief #1:  Enterprise Value, as calculated using the current stock price, IS a good estimate of Intrinsic Value.  Wild swings in stock prices reflect that Intrinsic Value itself can change dramatically over short periods of time.

Belief #2::  Enterprise Value, as calculated using the current stock price, IS NOT a particularly reliable estimate of Intrinsic Value.  Wild swings in stock price reflect the market’s difficulty in calculating Intrinsic Value.

My answer is a bit of a cop out–I think the truth lies somewhere between the two extremes.  Today’s post will discuss why Belief #1 cannot be easily dismissed.

As discussed in 3.6X to 23.3X. Urk, modest changes in the growth rate and/or discount rate produce wild swings in Intrinsic Value and EBITDA multiples.  So perhaps the wild changes in TWT’s Enterprise Value were driven by very real changes in these two variables.  A year ago, the financial crises had not quite hit stride.  Six months ago, it looked like Great Depression Redux.  Today, the macro-economic environment seems okay.  In the absence of a financial crises, growth prospects for TWT were better and the discount rate would have been lower.  In a depression scenario, growth prospects would be much worse and cost of capital far higher.  Today’s outlook is somewhere in between.

Let’s map this to the definition of Intrinsic Value:  “An enterprise is worth what its cash flows, appropriately discounted, are really going to be”.  Any reasonable expectation of cash flows would have changed materially, as would the discount rate.  Therefore, it is natural to conclude that Intrinsic Value was being affected by the macro-economic environment.

This all supports Belief #1.    Enterprise Value, as calculated using the current stock price, IS a good estimate of Intrinsic Value.  It would therefore follow that Intrinsic Value itself has wild swings.  Nonetheless, I believe there is more to the story.

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$6.25 to $40

Last Friday’s post 3.6X to 23.3X. Urk was the most recent in a series on Measuring Value Creation.  Friday’s post showed how modest variations in discount rate and growth rate can have a dramatic affect on the EBITDA multiple of a business.  It ended with a statement of frustration: How could anyone possibly know–even approximately–what their business is worth? Before fully addressing this question, I draw your attention to an extremely important take-away.

Used casually, EBITDA multiples are dangerous proxies for estimating Intrinsic Value.

Let’s use TW Telecom to illustrate.   Today, the stock price is about $11/share and their market cap (which is the value of their equity based on the current stock price) is $1.1B.   They have about $1.3B of debt.  Their Enterprise Value (based on today’s stock price) = ~$1.1B market cap + $1.3B debt = ~2.4B.   $104M was their 1Q09 EBITDA; multiple this by 4 and the annualized is $416M.   Divide $2.4B by 416M reveals that their EBITDA multiple is 5.76X.

Is 5.76X reflective of their Intrinsic Value?   That is, does the current stock price translate into a good estimate of Intrinsic Value?  Before you are quick to answer yes, consider TWT’s EBITDA multiple in their recent past.  Six months ago, TWT’s stock price was ~$6/share.  A year ago, it was $18/share.  At $6/share, the Enterprise Value was $1.9B and the EBITDA multiple was 4.5x.  At $18/share,     EV = $3.1B and 7.3x was the multiple.    These are sizable ranges.

So, is today’s $2.4B a good approximation of Intrinsic Value?   Prior to answering, consider the following two beliefs:

Belief #1:  Enterprise Value, as calculated using the current stock price, IS a good estimate of Intrinsic Value.  It would therefore follow that Intrinsic Value itself has wild swings.  That is, Intrinsic Value 6 months ago was $1.9B and 12 months ago, it was $3.1B.   All three estimates were good approximations of the wildly changing Intrinsic Value.

Belief #2::  Enterprise Value, as calculated using the current stock price, IS NOT a particularly reliable estimate of Intrinsic Value.  That is, Intrinsic Value today is not wildly different than it was 6 months ago or 12 months ago.   The fact that Enterprise Value changed dramatically reflects the market’s difficulty in calculating Intrinsic Value.

So, readers, what do you think–#1 or #2?   (MattyG–given your comment, I would be interested in your opinion.)

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In yesterday’s $6.25 to $40 post, we learned that $1 of annual payments could be worth between $6.25 and $40 depending on (a) the annual of the growth rate of the dollar, as it varies from 0% to 7.5% and (b) the discount rate, as it varies from 10% to 16%.

How does this variability affect the EBITDA mutliple?

In 11.6X EBITDA we derived an EBITDA multiple for a Bandwidth Business and declared 11.6x was Maybe or Maybe Not the answer.   The math that produced the 11.6X was:

• Three quarters from now, a Bandwidth Business’ annualized revenue is forecasted to be $100M and its EBITDA is $40M
• The annual growth rate during this three quarters was 15%.  Annualized capital was $35M
• Had the business only have grown by 5%, the capital would have been $10M.  SG&A in a 5% growth scenario would have been $42M, as SG&A costs would be materially lower in the 5% growth scenario
• The cash flow generated by a $42M EBITDA business with $10M of capital is $25M (after we estimated income taxes to be $7M)
• At a 5% growth rate and a 10% discount rate, the $25M is worth $500M
• 11.6X is calculated by dividing $500M by $42M

Well, this is all fine and dandy except for the table above.  Had we just tweaked with the discount rate a little or slightly mis-estimated the growth rate, the 11.6X would be grossly incorrect.   The table below shows the answer could range from 3.6X to 23.3X–ouch!

This second table is derived from the table above, using the same math that determine the 11.6X multiple.  Namely, $25M is multiplied by the various amounts in the first table and then divided by $42M.

This presents us with a dilemna.  How could anyone possibly know–even approximately–what their business is worth?

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$6.25 to $40
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But my Business is Growing!
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Multiples…