The Pizza Theory of Business Valuation

23/06/2012 17:44Body

of 3file:///Volumes/Data/sanjaybakshi/Dropbox/Personal%20Site/SB's%20Sit…hi/Articles_&_Talks_files/The_Pizza_Theory_of_Business_Valuation.htm

The Pizza Theory of Business ValuationSometimes it helps to think of a business as a pizza

The Pizza Story

Imagine that you have gone to a pizza restaurant with a very hungry friend. You are sitting at your tablewaiting impatiently for the waiter to take your order. The waiter eventually arrives and takes your order.He, then, turns to your friend, who is, by now, quite starved. Your friend tells the waiter:

"Please get me a cheese pizza as quickly as you can and because I am very hungry today, please makesure that the Chef cuts my pizza into twelve slices instead of eight."

The waiter looks at your friend in a puzzled way, scratches his head and walks towards the kitchen.Equally puzzled, you ask your friend to explain his irrational behaviour. He tells you:

"If I request that my pizza be cut into twelve slices instead of the usual eight, then the total amount ofpizza I will get to eat will be more than before. The size of my pizza depends upon the number of slices itis cut into. If you don't believe me, take a look at what happens in the corporate world and thestockmarket."

What Happens In The Corporate World

Children learn early on that the size of a pizza does not depend upon the number of slices that it is dividedinto. But when they grow up to be chief financial officers (CFOs), they appear to follow a different rule:the more cuts, the better. In a bid to boost their total market value, companies issue bonus shares to theirshareholders. This can best be explained with the help of an example in which we will think of thecompany as a pizza and each outstanding share as a slice in the pizza.

Suppose a company has no debt (this assumption is made only for the sake of simplicity) on its balancesheet. The stated value of it's total assets is, say, Rs 1,000 crore. Since there is no debt, the stated networth of the company, that is our pizza, will also be Rs 1,000 crore. If there are 1 crore sharesoutstanding, that is, if there are 1 crore slices in our pizza, then the per share (slice) net worth, or per share(slice) book value will be Rs 1,000. If the par value of each share (slice) is Rs 100 then the paid up equitycapital of the company must be Rs 100 crores and its reserves must be Rs 900 crores.

Now let's assume that this company earned post-tax profits of Rs 250 crore in 1996-97. That translatesinto to a return on assets of 25 percent. Assume that the post-tax return on long-term, high-grade bonds is12.5 percent. This means that if Rs 1,000 crores were invested in long-term, high-grade bonds, they wouldyield only Rs 125 crores as post-tax income or half of what our company is earning on its assets. We cantherefore conclude that because our company is deploying its assets twice as profitably as high-gradebonds, these assets should command a price in the market which is twice the price of the bonds. Thereforethe intrinsic value of the company should be Rs 2,000 crores which translates into a per-share intrinsicvalue of Rs 2,000. In other words, our pizza is worth Rs 2,000 crores and each slice is worth Rs 2,000.

Now assume that the market price of the company's shares is also Rs 2,000 each. The company's CFOnow gets a "bright" idea. He thinks that by issuing bonus shares in the ratio of 1 share for every existingshare, he can increase the total market value of the company. He feels that when the total number ofoutstanding shares doubles from 1 crore to 2 crore, their market price will not fall from Rs 2,000 to Rs1,000 per share. Instead, he feels, they will fall to Rs 1,200 per share. In other words he feels that he can

23/06/2012 17:44Body


increase the size of the pizza by increasing the number of slices without any improvement in profitabilityor a fall in market rates of interest. Asked, why does he feel that, his answer is likely to run along thefollowing lines:

"The current market price of our stock is Rs 2,000 per share. There are 1 crore shares outstanding. Themarket lot is 50 shares. Therefore, for investors to buy our stock, a minimum investment of Rs 1 lac isrequired. If we allot 1 bonus share for every existing share, we will double the total number of outstandingshares. The market price may initially fall to Rs 1,000. But now the minimum investment required to buy50 shares will also fall to Rs 50,000. Since there are lots more investors who can afford to invest Rs50,000 than Rs 1 lac, the demand for our shares will go up and so will their price. The shares will betraded more heavily and the increase in liquidity will ensure that the market price eventually settles at Rs1,200 per share and consequently the total market value of our company will go up from Rs 2,000 croresto Rs 2,400 crores. In other words the bonus issue will enrich our shareholders by Rs 400 crores."

Believe it or not, this is precisely how companies think when issuing bonus shares - that value can becreated by dividing the business pizza into more slices than before. Can it? Our pizza example suggestsotherwise. Just like the size of a pizza has little to do with the number of slices it is cut into, the total valueof a company also has little to do with the number of outstanding shares it is divided into.

What Happens In The Market

CFO's are not the only irrational people around. Many investors also think that a bonus issue increases thetotal value of the company. If enough number of people behave irrationally, is it surprising that marketprices will also behave irrationally? In the case of bonus issues this is what usually happens. To explainthis let me give you a real life extreme example.

In 1994, pharmaceutical company, Cipla Limited, made history by being the first Indian company to issuebonus shares in the ratio of 5 shares for each existing share. Before the bonus issue, the company hadapproximately 31 lac shares outstanding which were selling in the market at around Rs 4,000 each.Therefore, the total market capitalisation of the company prior to the announcement of the bonus issuewas Rs 1,240 crores. The profits for the year 1993-94, however, were only Rs 14 crores. The shares were,therefore, selling at a price-earning multiple of 88, a very high PE by any standards, but one which canstill be justified if the company's profits were expected to rise exponentially for a number of years, whichwas not the case. In other words, the shares were already overpriced relative to their true value. Then thecompany announced the 5 for 1 bonus issue. Irrational people create irrational prices. When the news ofthe bonus issue broke, many investors lost their heads and became willing to pay much higher prices forCipla shares. The price of the stock, hold your breath, zoomed to Rs 35,500 each. At that price, thecompany's total market cap was Rs 10,850 crores which was approximately twice the then market cap ofthe steel giant Tisco. The PE ratio shot up from a "mere" 88 to an astonishing 775 which means that ifearnings did not grow, it would take an investor who paid Rs 35,500 per share 775 years to break even!

Fast forward to today. The current market cap of Cipla is Rs 1,239 crores. It's profits for the year 1995-96were Rs 29 crores. The PE ratio is 42. The Cipla example demonstrates how investors who buy shares inthe belief that value can be created simply by printing new pieces of paper, can burn their fingers.

Exceptions To The Rule

In an efficient market, bonus issues should have little impact on the total market value of a company. Butthere are exceptions to this rule. These exceptions can, however, be explained. Companies, it is known, donot like to cut dividends. A cut in total dividends paid is perceived by the market as a signal that thecompany's future profits will be lower than its current profits. Whenever a profitable company, therefore,

23/06/2012 17:44Body


declares a bonus issue, the market takes it as a signal that it will, in the future, be able to pay higherdividends than now (here I am talking about total dividends, not dividend per share). These higherdividends, must, therefore, come from higher profits unless they come from fresh capital issued. Thestock price of a company, therefore, can rationally rise on the announcement of a bonus issue, if and onlyif it is expected that the company's profits will rise at a rate which is higher than the current expectedgrowth rate.

When Hindustan Lever or Thomas Cook announce a bonus issue, their stock prices go up not becausevalue is created by printing more "paper money," but because the market is discounting a previously un-discounted growth in the future profits of the company.

Imagine for a moment, that a company such as MS Shoes declares a bonus issue in the ratio of 1 share forevery share held. Do you really think that it's total market cap will permanently rise soon after theannouncement of the bonus issue? I think not, because the market will correctly assess the possibility offuture increase in profits of the company. If an MS Shoes type of company cannot increase its long-termmarket cap through bonus issues but an HLL type of company can, the only rational conclusion which Ican draw is that the rise in market cap occurs not because more shares will become available for sale andpurchase in the market but because of perceived future growth in the company's profits which was earliernot discounted in the market price of the shares.

Conclusion

Many investors love to receive new pieces of paper. They are similar to those who feel they have becomericher by exchanging their 100 rupee notes for ten notes of 10 rupees each. Such irrational behaviour ispunished by the market over the long run. Investment strategies designed with the intention of investing incompanies which are most likely to declare bonus issues, may work for a while in the short-run butusually are doomed to fail in the long run.

A company may be able to achieve a "spike" in its stock price by declaring a bonus issue, but if the"spike" is unrealistic, that is, if the stock price increase is unrelated to any rise in value, then such anincrease is likely to prove to be temporary. In the long run, the pizza theory of business valuation holds.

Note

This article is submitted by Sanjay Bakshi who is the Chief Executive Officer of a New Delhi basedcompany called Corporate Investment Research Private Limited.

© Sanjay Bakshi. 1997.

The Pizza Theory of Business Valuation

Documents

Transcript of The Pizza Theory of Business Valuation