2.2. Failure of corporate governance

Question 1

Book value

Answer 1

• the value of the business according to its “books” or financial statements.
• book value is calculated from the balance sheet
• is the difference between a company’s total assets and total liabilities - another term for shareholder’s equity
  e. g. if Company XYZ has total assets of $100 million and total liabilities of $80 million, the book value of the company is $20 million. In a very broad sense, this means that if the company sold off its assets and paid down its liabilities, the equity value or net worth of the business, would be $20 million.

Question 2

Market value

Answer 2

• the value of a company according to the stock market.
• Market value is calculated by multiplying a company’s shares outstanding by its current market price.
  e. g. If Company XYZ has 1 million shares outstanding and each share trades for $50, then the company’s market value is $50 million. Market value is most often the number analysts, newspapers and investors refer to when they mention the value of the business.

Question 3

Market value vs. book value

Answer 3

1. Book Value Greater Than Market Value: the market has lost confidence in the ability of the company’s assets to generate future profits and cash flows. In other words, the market doesn’t believe that the company is worth the value on its books. Value investors often like to seek out companies in this category in hopes that the market perception turns out to be incorrect. After all, the market is giving you the opportunity to buy a business for less than its stated net worth.
2. Market Value Greater Than Book Value: The market assigns a higher value to the company due to the earnings power of the company’s assets. Nearly all consistently profitable companies will have market values greater than book values.
3. Book Value Equals Market Value: The market sees no compelling reason to believe the company’s assets are better or worse than what is stated on the balance sheet.

Question 4

Why is book value not a correct representation of the business’ value?

Answer 4

depreciation of assets can distort the true value of the business

• quality assets depreciated faster than the drop in their true market value => market > book => assets are consistently generating greater profit, then the market understands that those assets are really worth more than what the accounting rules dictate
• depreciated slower than the drop in market value => market < book => (creating a value trap for investors who only glance at the P/B ratio)
• company might use valuable assets to secure loans when it is struggling financially => deceptive book value

e.g. old machinery can lose value in the market because of technological advancements. In these instances, book value at the historical cost would distort an asset or a company’s true value, given what is actually priced in the market.

Question 5

P/B ratio

Answer 5

Market Price per Share / Book Value per Share

- lower ratio indicates business is being undervalued

Question 6

Special purpose vehicle/entity (SPV/SPE)

Answer 6

• a subsidiary company with an asset/liability structure and legal status that makes its obligations secure even if the parent company goes bankrupt.
• a subsidiary corporation designed to serve as a counterparty for swaps and other credit sensitive derivative instruments.

Question 7

Uses of SPV/E

Answer 7

• securitize assets
• create joint ventures
• isolate corporate assets
• perform other financial transactions

e.g. protection of a project from operational or insolvency issues, creating a synthetic lease that is expensed on the company’s income statement rather than recorded as a liability on the balance sheet.

Question 8

Off balance sheet SPV/E

Answer 8

documents its assets, liabilities and equity on its own balance sheet rather than on the parent company’s balance sheet as equity or debt