Is the Stock Market Accurately Valuing Your Company?

By Matt Dallisson, 10/06/2021

Traditionally, price discovery — determining a company’s fair value price — is based on the interactions of buyers and sellers in a marketplace. The publicly quoted share price demonstrates how capital markets value a company, and it’s the basis upon which the company issues debt and equity. It also helps determine how the company allocates capital towards paying dividends, buying back company shares, compensating employees, paying down debt or reinvesting in the enterprise for future growth.

But today, five trends are colliding to distort how markets are pricing companies. The dangers of this distortion, especially at a time of buoyant stock markets, is that company executives and investors use these incorrect valuations as a basis to enter unaffordable M&A transactions and/or overleverage the company. The five trends are:

1. Low Interest Rates

Historically low interest rates, massive stimulus in response to the global pandemic, and the rising threat of inflation are leading to questions on appropriate discount rates to value a company in its entirety — its equity and its debt, including its pension obligations.

Low interest rates are also fueling enormous money flows into private capital, as are lower expected returns from public markets. Private equity investors are sitting on approximately $2.5 trillion in cash, according to Preqin. That is the highest on record and more than double what it was five years ago. Looking ahead, venture capital and private equity combined ware predicted to more than double their assets from $4.4 trillion at the end of 2020, to $9.1 trillion by 2025.

Capital flows to private equity have been accompanied by a decline in publicly traded companies. According to the Wilshire 5000 Total Market Index, the number of publicly listed U.S. stocks peaked at a record of 7,562 in 1998. At the end of 2020, there were fewer than 3,500. This decline means there are fewer public peers for business leaders to value their companies against, and less liquidity for companies as capital drains from the public capital markets.

2. Shift Towards Passive Investing

Another shift occurring across the investor landscape that can affect company value is the trend away from active investing toward passive funds. From 1995 to March 2020, passive funds grew from 3% of equity markets to make up 48% of assets under management in equities as of March 2020, according to a paper by the Boston Fed.

As of 2019, passive funds are estimated to be around $4.3 trillion, and they’re expected to reach parity with active funds with each totaling $13.4 trillion in assets by 2025, according to Price Waterhouse Coopers.

The growth in passive funds can materially improve stock price stability in the markets, reducing volatility in the shareholder register and potentially in the stock price itself, because passive funds strictly track benchmarks, only sell stocks that leave the benchmark, and are therefore considered long-term, permanent capital. These data suggest a shift which should aid in a better price discovery process – more price stability from permanent capital.

However, the shift towards passive investors tips that balance of power toward a small number of dominant investors, which could create additional complexity for companies. For example, the three biggest passive investors by volume — BlackRock, Vanguard, and State Street — own around 20% of the shares of the typical S&P 500. These three funds combined own 18% of Apple shares, 20% of Citigroup, 18% of Bank of America, 19% of JPMorgan Chase, and 19% of Wells Fargo, according to Bloomberg.

In practice, this means these passive investors wield enormous power – and potentially could find themselves on both sides of, say, an M&A transaction, not only unveiling conflicts that have to be cleared but also potentially impacting the price of a deal. Specifically, the same passive investors would be important shareholders and voters on both sides of a merger between two companies. When the vote comes on whether to accept a bid, investors on both sides of the trade might be willing to accept a lower price than those who solely own shares in the company being sold.

3. The Rise of ESG Investing

ESG market trends, purported to be worth $45 trillion in assets under management in 2020, are creating a quandary for how global corporations think about fair value for their companies and price discovery.

On the one hand, ESG trends impose additional costs of compliance, which can reduce revenues by shutting down products and business lines, as well cutting operations in certain jurisdictions. This creates a risk of undervaluation compared with companies from countries where ESG expectations and costs of compliance are lower.

On the other hand, there is increasingly a risk, particularly in Western capital markets, that companies without strong ESG credentials could see their valuations marked down. These conflicting ESG forces add opacity to the price discovery process.

4. Nationalism, Protectionism, and Other Global Cross-Currents

Fourth, the risk of greater deglobalization promises to impact all manner of how companies do/operate business. Rather than benefit from the synergies of a global business – such as centralized logistics, supply chains and procurement – companies face financial loss as they navigate a series of threats, including:

The collision of these trends suggests price discovery itself is at risk of becoming a more balkanized and less transparent exercise. In a more siloed world, a company’s valuation could suffer from the risk that the sum of its parts may not be equal to, and could be lower than, the whole.

5. Cryptocurrency and Other Global Financial Innovations

Finally, fundamental changes in the global financial architecture — whether the rise of cryptocurrency or the threat of China’s efforts to unseat the U.S. dollar as a reserve currency — could also materially affect the price discovery of a company depending on how it is exposed and positioned.

With respect to cryptocurrencies, issues of volatility and speed lead skeptics to wary of its effects. With customers and suppliers adapting to their use, companies should consider the effects of placing cryptocurrencies on their balance sheet — and the potential impact on company valuation. For instance, Bitcoin’s volatility would make it harder to calculate the true value of a company at any given point. Bitcoin’s three-month realized volatility, or actual price moves, is 87% versus 16% for gold according to a February 2021 report by JPMorgan.

Meanwhile China is now the largest trading partner, foreign direct investor and lender to numerous developed and developing countries around the world. It’s also the largest foreign lender to the U.S. government. Through expansive cross border efforts, such as the Regional Comprehensive Economic Partnership (RCEP) trade agreement, the Belt-and-Road Initiative and its use of derivatives in trading contracts, China is stamping its imprimatur on the globe. But perhaps most crucially China is backing its own digital currency, a virtual yuan, which, although not a peer-to-peer cryptocurrency, could challenge both Bitcoin and the U.S. own attempts at a digital dollar.

Corporations will have to weigh up the risks and benefits of crypto and digital currencies and decide whether to hold them as assets and liabilities on the company balance sheet; a decision that will affect the company’s value.

Business leaders are constantly managing risks and opportunities in an uncertain world in the hope that their companies will continue to operate and appreciate in value. Yet, quite clearly, there are a number of trends that could left unchecked, undermine and harm a company’s valuation — many of which remain widely overlooked by consensus views.

This content was originally published here.