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Capital Markets Logic Jo Whitehead, Director Ashridge Strategic Management Centre

Capital Markets Logic

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Capital Markets Logic. Jo Whitehead, Director Ashridge Strategic Management Centre. Pre-read. Chapter 5 of Strategy for the Corporate Level. United Business Media (UBM). Industry sectors. Jewellery Forest products Footwear Primary care medical staff Pharmacy - PowerPoint PPT Presentation

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Capital Markets Logic

Jo Whitehead, DirectorAshridge Strategic Management Centre

Pre-read

• Chapter 5 of Strategy for the Corporate Level

Industry sectors

Events Magazines

News services Data services

Marketing services

• Jewellery• Forest products• Footwear• Primary care medical staff• Pharmacy• Global trade and

transportation• Electronics• Medical device design• Technology based

manufacturing• Aviation

United Business Media (UBM)

PV of the Standalone business (Business

logic)

Added PV from your parenting (Added value logic)

PV of the business

under your

ownership

Sell if PV of the business when owned by another

owner is higher

£, $, Euros

Buy if PV of the business when owned by other owners is lower

Capital markets logic

Value under your ownership Value under another’s ownership

Capital markets logic

Capital markets may over or under valueExample: Volatile Schiller p/E ratios

1860 1880 1900 1920 1940 1960 1980 2000 20200.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

50.00

“Black Monday

“Black Tuesday

Dotcom bust

Lehman goes bust

In reality, hard to out-guess the market

You need to have special information to outguess the market

• Studies suggest:– Insiders (senior managers) do better than the

average investor when buying their companies shares

– Companies also do better than the market when buying or issuing their own equity

• …although these finding are still debated by finance academics

Three challenges to capital markets logic

1. Are there good reasons why the capital markets might misprice this business? – Default position should be that the market has it about right

2. Do you have the superior insight and capabilities required to take advantage of any mispricing?– You need to have superior information, and be a superior

analyst and deal-maker

3. Does the financial analysis suggest that the level of mispricing is significant?– Small gaps may simply be due to over-optimistic

assumptions

Reasons why the capital markets might get it wrong

1. Volatile capital markets (equity and debt)2. Sector or deal-specific characteristics

– Imbalance in number of buyers and sellers– Characteristics of buyers and sellers– Differences in the information available to

buyers and sellers– Deal process

Applying Capital markets logic

11

Market price

NPV of owning the business

Better to be a seller• If you own; Sell• If you don’t own;

Don’t buy

No compelling Capital Markets logic for buying or selling

Better to be an owner• If you own; Hold• If you don’t own; Buy

HIgh

HIgh

Low

Low

Any examples?

12

Market price

NPV of owning the business

HIgh

HIgh

Low

Low

13

Implications for E.ON?

Market price

NPV of owning the business

•German Nuclear

•German Fossil

•Eastern Europe

•Sweden

•Russian generation

•Spanish generation

•Italian generation

•Ruhrgas

•Renewables

•UK•US

E.ON strategy shaped by capital markets logic

• Capital markets offer potential challenges…– Thin market for unwanted Spanish generation assets...

• Few buyers• Risky to put assets onto the market if buyers are not already secured• Significant write down unattractive to management team

– Pressures to reduce or sell edge of heartland businesses in hot sectors• …but also potential opportunities

– Buying in potentially undervalued markets e.g., Russia– Selling highly prized assets such as Ruhrgas to Nationalised utilities

e.g., EdF, GdF/Suez

Capital market logic used in different ways

• As a check on analysis based on business or capital markets logic– Many examples

• As a primary logic driving corporate strategy e.g.,– Warren Buffett– Barry Diller– Private equity companies and banks

Alternative tacticsPotential tactics Example: When a desirable

acquisition is too expensiveE.ON Example - Renewables

Wait for capital markets to stabilise – then follow other logics

Announce the deal is too expensive - hope to buy later

Yes

Change your corporate strategy to become consistent with capital market logic

Sell all your businesses in that sector for a high price – even if it is a heartland business

Possible but tough for management

Hedge the risk of over/under-payment when markets seem over/under-valued

Buy with, or issue, equity or fund with cheap debt

Yes

Educate, Communicate and Signal to influence market prices

Try and talk down the value of the target

Yes – but only if stock is doing well

Structure the deal to bring PV up or price down

Buy the business based on an earn-out formula for the current owners

Yes

Improve parenting performance Raise your parenting ambitions Yes

Your examples?

Which Alternative depends on the answer to the three questions…

• What is reason for the mis-valuation?– E.g., if selling, and there are too few buyers, seek

out more!• Do you or your advisors have the skills,

experience and capabilities to pull off the strategy?

• How big is the valuation gap?

Key messages

• Capital markets logic is always important to apply, often after having evaluated the other two logics:1. Evaluate whether Capital market logic is strong

enough to force reconsideration of portfolio decisions2. Consider if there are any alternative tactics which

might deal with the specific situation• Some companies use capital markets logic more

proactively to drive their acquisition or divestment strategy

Application to Own business

19

1. Consider if there are any businesses outside the middle diagonal2. For one business, evaluate the reasons for the over or under valuation (see over for

list of options)3. Consider whether you can employ any of the alternative tactics (see over for table)4. Summarise the options worth pursuing

Market price

NPV of owning the business

Better to be a seller• If you own; Sell• If you don’t own;

Don’t buy

No compelling Capital Markets logic for buying or selling

Better to be an owner• If you own; Hold• If you don’t own; Buy

High

High

Low

Low

Reasons why the capital markets might get it wrong

1. Volatile capital markets (equity and debt)2. Sector or deal-specific characteristics

– Imbalance in number of buyers and sellers– Characteristics of buyers and sellers– Differences in the information available to

buyers and sellers– Deal process

Alternative tactics (examples)Potential tactics Example: When a desirable

acquisition is too expensiveExample: When a desirable divestment is too cheap

Wait for capital markets to stabilise – then follow other logics

Announce the deal is too expensive - hope to buy later

Announce the business is undervalued – hope to sell later

Change your corporate strategy to become consistent with capital market logic

Sell all your businesses in that sector for a high price – even if it is a heartland business

Sell the business regardless, accepting that the market price is all you can get

Hedge the risk of over/under-payment when markets seem over/under-valued

Buy with, or issue, equity or fund with cheap debt

Use the proceeds to buy up equity (or debt)

Educate, Communicate and Signal to influence market prices

Try and talk down the value of the target

Take the business on a road show, spin off or float a portion of the business

Structure the deal to bring PV up or price down

Buy the business based on an earn-out formula for the current owners

Split the business up into more saleable chunks

Improve parenting performance Raise your parenting ambitions Restructure the business, add more value or bring in a more value adding partner to take a share