Company Value in a Turbulent Economy

If you have owned your company for 10 years or more, “congratulations”, you are surviving a decade of the worst economic ingredients that could ever be thrown at you. You should feel good about that; however, trust that the value of your business has been on the decline. In about a month, we will dubiously celebrate the ten year anniversary of the 9/11 bombings of the World Trade Center. At that time, the United States was beginning the investigation of the WorldCom scandal, and Martha Stewart would be indicted for insider trading two years later. The myriad of other transgressions would remind you of the “Fast and Furious” last decade we have experienced. While I in no way suggest that 9/11 was the beginning of the downturn of poor economic decisions by business and government, I believe that it was the tipping point for all the weakness inherent in our then and now economy.

It was the beginning of a time when decision makers in government and business would begin to be exposed for their ill-conceived ideas. Investors lapped up mortgage backed securities, while the government promoted the concept of the collateralized debt obligation (CDO) through organizations like Fannie Mae and Freddie Mac, conceptualized in the ideology that everyone should own a home. A false sense of security floated in the air creating a mental foundation for each of us to devise our wealth strategy with extensive leveraging as the primary vehicle of that pursuit.

It is now August 7, 2011, and Standard & Poors, one of the three largest credit rating agencies, has just downgraded the credit-worthiness of the United States Government from AAA to AA+. Fitch and Moody's, the other two main credit ratings agencies, maintained the AAA rating for the United States after this week's debt deal, though Moody's lowered its outlook on U.S. debt to "negative." Since the beginning of credit rating agencies in 1917, this has never happened; not even through the 60 plus debt ceiling increases since the 1960’s. The markets and the credit agencies are sending a message to the Administration and Congress. Let us pray this message is resonating.

Gross debt has increased over $500 billion each year since fiscal year 2003, with increases of $1 trillion in FY2008, $1.9 trillion in FY2009, and $1.7 trillion in FY2010. As of August 3, 2011, the Total Public Debt Outstanding was $14.34 trillion dollars, of which $9.78 trillion was debt held by the public and $4.56 trillion was intra-governmental debt holdings. As of the end of the second quarter of 2011, the US GDP was 15.003 trillion. Total Public Debt Outstanding as a percentage of GDP was 100% and debt held by the public was 65.2% of GDP. Together with the budget deficit, this debt was one of the reasons given by Standard & Poor's to downgrade the United States' credit outlook to AA+ from AAA, with negative outlook for the next 12–18 months, on August 5, 2011. The Debt to GDP ratio is now approaching levels not seen since the Great Depression and the build-up prior to World War II. The ratio during the great depression was at 120%. This ratio means the amount of total debt outstanding, both public and private, is 120% of the production levels in dollars in United States economic trade. Stated differently, debt is 1.2 times that of the GDP on an annual basis. Imagine if we were  able to create an annual surplus of $1.0 trillion dollars; it would take over 14 years to repay our debt without interest payments included.

One might argue that the cause of the decrease in credit rating was due to Congress’s wrangling over the issue instead of merely passing a resolution without debate, as if Standard & Poors would not have known the difference and not lowered the credit rating. That camp would be the few that could not believe that AIG’s credit rating was an A rating just prior to its collapse. Now, the remarks from the Obama administration show disbelief that a credit rating agency would downgrade the United States Government. Well, here is a quote from an article in 2007 to expose the hypocrisy, “The big three rating agencies have come under fire since the 2007 collapse in the subprime home mortgage market for issuing rosy ratings on a plethora of securities that are now considered to be junk. The Obama administration and Congress are exploring various reform proposals.” The government is very adept at exploring and investigating, it is just the conclusions and decisions that reflect their ineptness.

So what does this mean to the value of your company. When a business or organizations credit rating is downgraded, the organization is basically seen as more risky. This additional risk is captured when the supply of funds to the organization decreases, likely causing the cost of the borrowings and equity investment to increase. The cost of borrowing and equity investment to your business is a component to the overall valuation. While the increased cost of borrowing may not be directly related to your company, the increased risk is captured in the determination of your cost of equity, as well. Since one of the components of your company’s cost of equity is determined by the risk-free rate, which is estimated by the United States Governments 20 Year Treasury Notes, your cost of equity is likely going up and the value of your company will go down as investors expect more return for greater risk.

Alternatively stated, how much more will China loan to the United States without the expectation of more reward for the increased risk. Just yesterday, commentary suggest that the “Chinese government, the largest creditor to the world’s sole superpower, has every right now to demand the United States address its structural debt problems and ensure the safety of the Chinese investment. International supervision over the issue of the U.S. dollars should be introduced and  a new, stable and secured global reserve currency may also be an option to avert a catastrophe caused by any single country.”

Now, the increased cost of funds only partially explains your companies decrease in value. Another component, depending on the level of foreign trade your company, directly or indirectly, experiences on the purchasing or selling side of the business, is the falling U.S. dollar. As the U.S. dollar loses value, your company’s cost of goods and material is increasing due to additional dollars you are having to use to purchase the same basket of goods. On the sale side of your business, even if your product is not bound for export, the dollars your received do not have the same value. Simply explained, if you travel to Europe today, it will cost you a $1.50 to purchase one Eurodollar. The Eurodollar is not the only currency appreciated against the U.S. dollar. It is happening across the World. Furthermore, do not be misled when the government tells you that our exports are increasing. The only reason exports are up is because the U.S. goods are becoming cheaper every day for foreign purchasers. It is a false sense of security.

What can you do to hold value in your company. There is not much you can do to effect the external cost of borrowing caused by government decisions and the devaluation of the U.S. dollar. However, you can do some things internally to help support the value. Take a few lessons from the large financial institutions that received TARP money from the government and did not loan any of the money to your business. Don’t let go of the money. These financial institutions laid off mass groups of employees, sold off under-performing assets and became lean operational businesses models designed to endure the economic volatility forecasted for the future. Some of these cuts caused huge losses on the income statement, but these institutions were able to dump the problems and clean the balance sheets for the future.

The institutions avoided huge capital expenditures that did not provide immediate cash returns meriting the risk during the projected economic volatility. At this time, the old adage holds true, “Cash is King”. I am not telling you to avoid all investments in the market. I am suggesting the proper due diligence, along with numerous revisions and what-if analysis to cash-flow budgets before an investment is made. There are opportunities out there, but it is now more important than ever that the risk and reward are commensurate, because the cost of capital is high and the failure option is more emanate. Beware of the loss of revenue beyond your control. Monitor your customers and suppliers. They are experiencing similar economic strains in this volatile economy. They may be here one day and gone the next day. When evaluating your options, include the risk of loss of customers and suppliers in your valuation model.