The New Zealand corporate landscape is suffering from a value gap. Analysis indicates a noticeable difference between how corporates value their operations internally compared to how external investors view the same organisation’s market value.
KPMG research shows that 45% of NZX companies are trading below the book value of equity at their most recent balance date – in some cases significantly so.
These companies have a price-to-book-value ratio (P/BV) of less than 1.0 and they are not alone. 42% of companies listed on the ASX are facing the same issue.
While particularly relevant to companies with a P/BV of less than 1.0, all companies should be comparing internal (company) assessments of value and external (investor) value data points to understand if a ‘value gap’ exists and what they can do about it.
So what are the causes of a ‘value gap’ in New Zealand and what does it mean for directors and company executives and how they retain and attract investors?
The observable value gap
A company’s market capitalisation represents the total value that investors ascribe to the company’s equity or net assets.
Historically the market has largely disregarded balance sheets as being relevant to value as they represented an historical ‘point in time’ view of a company’s financial position. With fair value now firmly entrenched in financial reporting standards, more insight is being provided into the true value of certain assets.
Moreover, accounting standards require company management to test book values of assets for impairment on a regular basis. Boards of directors have become increasingly familiar with impairment analysis over the last three years or so and many companies have recorded impairments to asset values.
Despite such action a significant proportion of listed companies would appear to be viewing value differently from their investors.
Charts 1 and 2 illustrate NZX and ASX data. Across both exchanges there are 378 companies with a P/BV of less than 1. This implies that the market considers those companies’ assets to be worth less than their book value. The impact of the Global Financial Crisis is evident here as the equivalent data in 2007 showed only 21% of NZX companies with a P/BV of less than 1.
Note: Resource stocks have been excluded from the ASX data to improve comparability to the NZX
This data does not tell the full story. P/BV data only highlights the ‘observable’ value gap where market prices trail book values that are not being impaired due to internal value assessments. In our view, while most apparent where P/BV is less than 1, all companies need to be developing their own internal view of value and should be alert to differences between internal and external viewpoints. Steps should be taken to understand the drivers for such differences and focus given to closing the gap where possible.
So let’s look at the value gap from different perspectives and consider what opportunities and challenges it presents.
Market illiquidity’s role in the value gap
The lack of liquidity in the NZ market is often identified as one of the key reasons for stock prices trailing internal value assessments. The consensus view is that many NZ stocks simply do not trade frequently enough to provide meaningful insight into value.
Chart 3 below displays the liquidity of the NZX and the ASX, measured as the ratio of annual trading volume to free float shares outstanding.
The data shows the majority of NZX companies are less liquid when compared to the ASX. Indeed, only 4% of NZX listed companies saw greater than 100% of the total free float traded in 2011 (a recognised measure of a liquid stock).
This compares to 14% of listed companies in Australia that achieved the same liquidity hurdle. In other words, circa 96% of the NZX and 86% of the ASX companies could be deemed to suffer from at least some degree of illiquidity.
A differential with Australia is to be expected, as the NZX includes a greater proportion of smaller listed companies that typically attract less investor attention. The proposed listing of State Owned Enterprises may help to improve the overall liquidity of the NZ market while simultaneously creating more competition for capital.
Notwithstanding the difference in liquidity between the NZX and ASX, the P/BV summaries in Charts 1 and 2 demonstrate the picture in Australia mirrors that in NZ. While still a factor, the role of liquidity in explaining the value gap appears overplayed.
Enhanced investor communication provides opportunity to narrow the value gap
The Global Financial Crisis (GFC) has demonstrated the global inter-connectivity of different markets and different industry sectors. What happens in Greece, impacts values in New Zealand. Understanding this dynamic makes investors nervous and craving better data with which to make informed investment decisions.
In response, the analyst community is regularly evaluating companies by reference not only to an understanding of industry fundamentals but also to perceptions of how well company management is addressing and responding to uncertainty.
Some companies are choosing to be proactive and are upping their game in their market communications beyond standard investor relations management. They are achieving this by improving analytical tools (including internal valuation models) to understand how shocks to the economic environment will impact both their financial performance and business strategy while developing a robust framework for assessing future investment.
Taking this approach allows companies to react quickly to market dynamics and get on the ‘front foot’ in engaging with investors about fast changing external and internal developments. Indeed such an approach will dovetail with forthcoming financial reporting requirements (IFRS 13) where additional disclosure will put key fair value assumptions under the spotlight.
Alternatively, companies may review portfolios and look to dispose of non-core or under-performing operations. By communicating this approach to the market they demonstrate active balance sheet management and the drive to increase shareholder returns.
Communicating key drivers of value to the market will provide critical information and insight to the analyst community, and so create a more open dialogue with investors. If Boards and executives are really committed to enhancing shareholder value in a relative sense this is a ‘quick win’ when compared to other challenges.
Done well appropriate communications can make substantial inroads in bridging the value gap between internal and external value perceptions.
There are other factors that can cause a divergence between internal value and market pricing the following.
- The price of certain stocks correlates strongly with near term dividend paying capacity and is therefore sensitive to short term fluctuations in performance or significant capital expenditure programmes. Such short term factors may not impact longer term values and indeed significant capital programmes are likely to be undertaken only if they are expected to add to shareholder value over time.
- The price of other stocks is influenced by shareholder configuration such as the presence of a cornerstone shareholder with its own strategic agenda. This may cause uncertainty and speculation as to the future direction of the company and the impact on smaller minority shareholders. This translates to how the stock gets priced in the market.
- Smaller companies sometimes trade below fair value as a result of the disproportionate impact of listing and other public company costs.
Incorporating market data into internal assessments
While understanding liquidity and enhancing investor communications may help bridge the value gap, Boards should also consider the other side of the coin. Perhaps company management are being too bullish on internal valuations and are not having sufficient regard to market indicators. The result may mean more robust impairment analysis is required.
A brief consideration of the value gap from an accounting perspective offers some guidance.
Accounting standards impact liquidity justification of value gap for listed companies
IFRS has its own view on how to consider the impact of liquidity in assessing fair value. Accounting standards refer to an ‘active market’.
An active market is defined as “a market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis”. In practice, this is a much lower liquidity threshold than what might be considered from a corporate finance standpoint. This has a bearing on the Value Gap as a lack of liquidity cannot be used to bridge the Gap – rather the company needs to demonstrate that there is not an active market. For a public company this is rarely the case.
Control premia only apply in certain instances
As market capitalisation is based on trades of small parcels of shares, corporate finance theory would suggest that a control premium may be applied to the stock price when assessing the value of all shares.
Consequently, when performing impairment analysis, company management often look to use a control premium to bridge the value gap.
The problem is that IFRS considers control premium purely from the point of view of acquisition synergies and allows no premium for the rights attributable to a controlling shareholding itself. This means it can only be applied in one of the two methodologies permitted by accounting standards.
- Fair Value less costs to sell (‘Fair Value’) assumes a hypothetical sale of the business and allows a control premium to be included in the assessment of value.
- ‘Value in Use’ is the present value of future cash flows expected to be derived from an asset or business and assumes continued operation by the existing owner of the business i.e. no transaction and no control premium.
KPMG research shows that 82% of listed companies in New Zealand elect to use Value in Use as their preferred impairment methodology (See Table 1). As a consequence, a control premium cannot be used to bridge the Value Gap for these companies.
Considering the opportunity to apply a control premium that is afforded by the Fair Value methodology, it is surprising not more than 12% of companies are utilising this approach in impairment testing.
Table 1 also offers some interesting insights into the market and the key assumptions used by listed companies in performing their internal valuations.
- Discount rates look low once converted to post tax equivalents.
- Terminal growth rates appear consistent with current indicators but will need to be continually assessed as long term growth expectations change.
While 2011 saw an increase in the total dollar value of impairments to $896m, it will be interesting to see what 2012 brings.
A greater regard to external indicators could see a rise in impairments as more companies reflect the realities of an extended period of uncertainty and little or no growth. This could play a significant role in diminishing the value gap.
So where do we start?
This analysis leads to a series of questions directors should be asking regarding navigating the value gap:
Do I have a robust analytical framework and tools to review the value of my business?
Am I using them to engage with investors and articulate value drivers and the impact of changes in the broader business environment?
Am I challenging internal views and valuation assumptions with sufficient external evidence? Are post GFC data points being used appropriately?
What more can I do to improve shareholder confidence and attract new investors?
While the current economic conditions represent challenging times for us all, those that can adapt, respond and address issues in a timely matter will be best placed to prosper
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