One of the most famous Warren Buffett quotes goes as follows, ‘Someone is sitting in the shade today because someone planted a tree a long time ago’.
This quote acts as a metaphor for valuation. It highlights how valuation includes the present value of a company as well as the future value of a company.
This is because the quote suggests that when the seed of the tree was originally planted, there were unseen future benefits as a product of making that decision in the present moment.
The seed of the tree has a future value because it has the potential to enable people to benefit from the shade for the long-term.
The tree has a social value and can only explain the concept in simple terms, valuation is often more complex in financial terms.
The quote assumes that the tree has continuous long term value, but does not consider a circumstance in which the value of the tree changes.
It would be foolish to assume that in financial terms, value remains constant over time.
It is therefore important to consider the determinants of value as well as why one business might be valued differently to another.
In 1970, a highly regarded finance academic named Fama outlined the efficient market hypothesis, which proposed that stock prices always fully reflect all relevant, available information.
Therefore, the market capitalisation of a firm always represents its true value in a fully efficient market.
The companies with the highest market capitalisation, should be those that achieve the highest cash flows and invest in the most positive NPV projects, with the largest expected future cash flows.
The companies that invest in the riskiest NPV projects should also be valued higher based on the assumption that higher risk projects reap even higher positive cash flows.
If markets are always fully efficient, then every public or private action that a firm takes to maximise shareholder wealth should be priced into the share price.
Therefore, the companies with the highest current and potential future profits should subsequently have the largest market capitalisation and should be ranked accordingly.
In reality, this is not always the case and the efficient market hypothesis has been heavily criticised, even blamed for the financial crisis in 2007.
The alternative to the efficient market hypothesis is the perspective that the stock market is not always efficient and that there are often market conditions that result in inefficiencies.
In 1949, Ben Graham used the analogy of ‘Mr. Market’, proposing that the stock market is much like buying and selling with a real person.
He suggested that sometimes stock prices make sense but that on other occasions, ‘Mr. Market’ is irrational and consequently, stock prices are under or overvalued in relation to the economic realities of the underlying business.
Research from Vissing-Jorgensen echoed this and found that investors are prone to ‘overreact or underreact’ to new information relating to stocks.
Therefore, if stock prices are influenced by investor sentiment, it is not plausible to suggest that the stock market is always fully efficient, which has a consequence for firms who intend to maximise shareholder wealth.
The neglected stock effect can always effect the value of a company. This happens when a firm is under less scrutiny from news agencies, financial analysts and institutional investors.
In simple terms, a neglected firm has less publicly available information, making them less popular with investors and often undervalued in relation to their book value.
This is why the stock market can sometimes be thought of as a popularity contest, where the most trendy companies get the largest returns.
Tesla is a good example of this when compared with other car companies.
In 2020, Tesla stock returned a massive 565% on the stock market, while companies like General Motors, Volkswagen and Toyota made minimal returns (losses in some cases).
Obviously Tesla is a less mature company and can grow faster as a result. However, with their 500% return, Tesla became the most valuable car company in the world – which is a bit ridiculous when the company has never made a profit.
Tesla stock grew so much because they received so much media attention and were viewed as ‘trendy’ investment.
The capital structure of a firm can affect its value.
A change in the debt to equity mix of a company can affect its financing capacity, risk, cost of capital and investment decisions, which ultimately affects shareholder returns.
There are two main theories that have emerged in relation to capital structure in recent years, the optimal capital structure theory, and the pecking order theory.
The optimal capital structure theory denotes that the debt to equity mix of a firm should be balanced in such a way as to maximize its value while minimizing the cost of capital (Modigliani & Miller, 1958).
Pecking order theory, on the other hand, proposes that companies first choose to utilize retained earnings and then if external capital is necessary, debt capital is preferred over equity capital (Myers, 1984).
According to Flath and Knoeber (1980), there is an optimal industry capital structure which firms tend to implement.
Therefore, firms that operate in similar industries should have similar capital structures and should, therefore, have similar stock returns.
Dividend policy can also affect firm value.
Companies are now less likely to offer a dividend to their shareholders, in order to utilize their retained earnings for reinvestment to grow the size of the firm.
In the United States, firms are less likely to offer dividends and as a result firm sizes have grown considerably, while levels of debt have noticeably decreased.
This suggests that firms that do not offer dividends should be valued higher than firms that do because they are able to reinvest all of their retained earnings into more projects that will add significant value to the company.
It could be the case that investors will value a non-dividend paying company higher because they are able to accumulate large cash flows and grow the value of the firm faster than a dividend paying firm.
Firms operating in different sectors have different expected future returns due to the nature of the available NPV projects (Espinoza, 2014).
For example, a technology company may be valued higher than a pharmaceutical company because the NPV projects that the firm are pursuing, have higher expected cash flows.
The value of a firm can either increase or decrease depending upon whether a merger or acquisition is successful or not (Brealey, Myers & Marcus, 1999).
The most profitable firms are able to effectively hire and retain the services of individual or collective employees, that add significant value to the firm (Ranft & Lord, 2000).
Brand equity is described as a set of assets or liabilities in the form of brand visibility, brand associations and customer/investor loyalty that add or subtract from the value of a firm (Aaker, 2017).
Brand equity can be two-fold in finance, it can affect consumer behaviour and investor sentiment or investor sentiment alone.