Law Times

PAGE 8 JUNE 30 - JULY 7, 2008 / LAW TIMES A s banks fail and share valu- ations collapse, market investors ask, "What hap- Vanishing stock valuations Financial pened to the predicted earnings estimates of six months ago by financial gurus?" On March 14, the United States Federal Reserve — in conjunction with JPMor- gan Chase — stepped in to bail out Bear Stearns from market col- lapse. Typical of regulators, the fed was behind the curve. The stock was already under water. The reliability of financial in- formation is essential to the proper functioning of the capital markets. As the quality of financial information dete- riorates, so do share valuations. Accounting is the language of the financial community. As with all languages, one can be clear and articulate or obscure and ambiguous. What do the English really mean when they tell you that your statement is "interesting?" What did Dell Inc. — the personal computer maker Matters By Vern Krishna — mean when it said that it dis- covered accounting information that "raises potential issues?" There are essentially two key theoretical elements to deter- mining the "intrinsic" value of corporate shares. First, one must determine the total of all future free cash flows (net of tax) attrib- utable to the shares. Second, one has to consider the reliability or risk of predicting the cash flows. Thus, the intrinsic fair value of shares depends not only upon the accuracy of the total future free cash flows (net of tax) that one expects to receive from the shares, but also some consider- ation of the volatility of one's estimates and the accuracy of predictions. We must make certain as- FREE UNTIL JUNE 30TH sumptions about the life of the corporation for estimating the free cash flow attributable to corporate shares. For example, we assume that the corporation will be in existence for some extended pe- riod in order to generate the cash flows. Thus, where an enterprise is a going concern, the theoreti- cal rational basis of stock valua- tion is to discount its future cash flows in perpetuity to their pres- ent value. This is the "intrinsic" fair value of the stock as at the particular point in time. It is difficult, however, to es- timate future cash flows into the indefinite future. Hence, we use surrogate estimates to determine intrinsic value. For example, we can use the price to earnings (PE) ratio to multiply the per-share earnings of a corporation to de- termine the present fair value of shares. For example, we might estimate that a corporation share to have an intrinsic fair - sentially means that we capital- ize the present accounting annual earnings per share at five per cent. Estimating cash flows is a dif- ficult task because one is attempt- ing to forecast into the long-term future. Hence, we use the PE ra- tio, a crude surrogate number, for determining what, in theory, we would normally do in discount- ing the long-term free cash flows of a business. In effect, we use the PE ratio as a proxy for future cash flows, a number that is difficult to estimate over an extended period. The second element, assessing the volatility of cash flow forecasts, is even more difficult. How risky is one's estimate of future cash flows and what is the appropriate discount factor to apply in light of the estimated risk? Naturally, the more stable the cash flows, the lower the risk of volatility and, therefore, the lower the risk that the entity will not meet the pre- dicted flows. How, for example, do we estimate the risk of future tax rates? We can generally predict the pre-tax cash flows of stable compa- nies, such as electric utilities, with a far greater degree of confidence because their prices and rates are regulated and do not fluctuate in a volatile manner. Similarly, predict- ing the future cash flow for a stable industrial company, such as Gen- eral Electric or Coca-Cola, is easier than predicting the cash flows of an emerging technology company or new business. Hence, we will use a lower discount rate (or as- sign a higher multiple) to a com- pany with predictable cash flows and a higher discount rate (or lower multiple) for a company with unpredictable earnings. For example, we might use a five per cent discount rate (or a 20 times multiplier) for a company with highly predictable cash flows and a 10 per cent (or 10 times multiplier) rate for a company with less certain and more risky figure cash flows. These uncertainties explain why stock market prices are al- ways moving as investors and, more importantly, analysts revise their estimates of earnings based upon real-time disclosures of cur- rent earnings, future tax rates, and the impact of those earnings upon future cash flows. For example, where a company releases earn- ings that are lower than market expectations, analysts may re- vise their forecast of future cash flows depending upon the real reason for the reduced earnings. Thus, it is important not only to interpret reported accounting earnings, but also to gauge their impact on future cash flows. For example, a company that writes off non-productive assets may reduce current earnings but indicate future savings and en- hanced earnings downstream. Why then would anyone pay discounts available Ontario Municipal Legislation Consulting editor: Quinto M. Annibale Provides the complete text of the Municipal Act, 2001, S.O. 2001, c. 25 and the City of Toronto Act, 2006, S.O. 2006, c. 11, Sch. A plus regulations under both Acts. It also includes the addition of several new regulations under the City of Toronto Act, 2006. Ontario Planning Legislation Consulting editor: Bruce Engell This consolidation reflects the changes made during the past year, and includes the completely updated Planning Act; a table of contents that lists the subject matter of each section of the Act; a comprehensive subject index that simplifies your research and a page layout that allows you to quickly identify the section you're looking for. Now includes 32 regulations! Multiple copy more than the "intrinsic" fair market value of a corporate share? There are several reasons. First, the buyer and the seller may have different estimates of the intrinsic fair market value of the share. For example, an acquiring company may believe that the target com- pany is underestimating its future cash flows and attach a higher value to the shares. Second, the buyer may be prepared to pay a higher premium for the shares in order to own all of the shares of the acquired company and acquire control of the corporation. Third, the acquiring company may be- lieve that it can derive certain cost savings and synergies from the ac- quired company. For example, the acquiring company may be able to integrate its marketing operations with the acquired company and save in future expenses. To be sure, valuing the intrin- Ontario Assessment Legislation Consulting editors: Jack Allen Walker, Q.C. and Andy Anstett Included in this new edition are Legislation Act, 2006, Provincial Land Tax Act, 2006 and O. Reg. 290/07 Fees made under the Assessment Review Board Act. Ontario Environmental Legislation Consulting Editor: Dianne Saxe This two-volume consolidation, prepared by a seasoned legal expert in environmental matters, offers the most thorough collection of laws available for this highly involved area. sic fair value of shares is subject to uncertainties. Nevertheless, in an efficient capital market that distributes information on a timely basis, it is possible to ar- rive at a reasonable expectation of future cash flows. However, in an inefficient market with minimal or opaque information about corporate earnings, it is much more difficult to predict future cash flows. We compound the uncertainty and distort earn- ings with accounting irregulari- ties and bogus valuations. Market regulation of ac- counting is an important pub- lic policy issue for regulators. Obscuring accounting irregu- larities makes share valuations more uncertain. It is time to go back to the bare essentials. LT For a 30-day, no-risk evaluation call: 1 800 263 2037 or 1 800 263 3269 www.canadalawbook.ca CA027 Shipping & handling charges are extra (unless payment accompanies your order). Prices are subject to change without notice, and to applicable taxes. www.lawtimesnews.com CA027(LT1-3x4).indd 1 6/25/08 2:57:50 PM LT0625 Vern Krishna is tax counsel with Borden Ladner Gervais LLP and executive director of the CGA Tax Research Centre at the University of Ottawa. His e-mail is vkrishna@ blgcanada.com.

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