How does a CFO determine whether a new venture is a good investment decision or not? Pre-GFC most analysts and CFOs dipped into their array of tools and ran the numbers across the business or project. But The Lehman Bros collapse changed the rules. It sent shivers through boardrooms (not to mention government central banks) across the globe. “What were they thinking?” may have been the public front of the corporate survivor but, in fact, Lehman’s was doing what many investment banks - and indeed what many CEOs - had been doing for years: doing deals on back-of-envelope calculations.
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Certainly, the analysts, the CFOs were called in to do the sums. Most applied Internal Rate of Return (IRR) or Net Present Value (NPV) calculations to their assessment of this or that deal. But what has changed is risk and the management of it. ROI calculations predicated on IRR or NPV are only as good as the assumptions of risk. A new paradigm is emerging.
Lehman’s failed because it took too many bets on the wrong assets. A sensibly run retail bank would have leverage of, say, 12 times. In other words, for every $1 of cash and other readily available capital, it would lend $12. At its peak leverage, ratios peaked at an incredible 44 in 2007. When the US government failed to bail out Lehman’s, asset backing - already thin on the ground - plummeted with massive haircuts being applied to bonds, to equities, to buildings, to businesses. The analysts who ran their slide rule over the deals by applying a discount rate (a version of cost of capital) on the numbers may well have been correct – after all, they simply had to demonstrate that the deal could be bought at below the implied value.
NPP or IRR?
The discount rate business valuation is used to judge levels for performance and new ventures alike. A CFO might assess a project based on NPV and IRR . NPV is calculated in terms of currency while IRR is expressed in terms of the percentage return a firm expects the capital project to return. Managers tend to better understand the concept of returns stated in percentages and find it easy to compare to the required cost of capital – a more complex concept.
While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the use of the IRR method can lead to the belief that a smaller project with a shorter life and earlier cash inflows, is preferable to a larger project that will generate more cash. Naturally, applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recommendation. Based on Lehman’s and the wide use of similar methodologies, it is unlikely - in a post-GFC world - whether back-of-the-envelope calculations based on NPV will make it through the new risk-free gates.
Stock broking analysts have for a number of years been applying ‘enterprise value’ as a test for investors. Sales are generated by an operating business, not by the company that finances that business. In other words, we need to consider the price of the entire operating business, not just the company behind it. In the case of Lehman’s doing what it did best – doing deals on listed company assets (or at least their securitised assets in the case of sub prime mortgages) – arguably, it was buying inflated and indebted assets despite the IRR calculations meeting their investment criteria. The ‘enterprise value’ may be a more risk-appropriate methodology. In plain English: businesses have enterprise values, companies and their shares don’t.
Thus, assessing the enterprise value of an operating business involves adding up everything you’d have to pay if you wanted to buy it outright. This includes the market capitalisation of the company that owns the business, plus any money the company has borrowed to finance the business or project, less any cash the company has that is surplus to the business’ requirements. In private equity circles, EV/EBITA is popular as an alternative to the more traditional price-to-earnings ratio as it removes some of the financial ‘engineering’ that the ‘masters of the universe’ at Lehman’s were so adept (or negligent) in applying.
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