Pressure creates diamonds

Pressure creates diamonds

When the risk-free rate (usually the 10-year government bond yield) goes up, the return required from an equity investment goes up as well. Tough economic conditions can have a flywheel effect, particularly where investors demand a larger risk premium over and above what is already a higher risk-free rate.

In simple terms: selling a business in tricky economic conditions is harder. High interest rates and consumer spending constraints can put serious pressure on companies and their valuations.

But is there a silver lining? Perhaps there is.

The old adage is that pressure creates diamonds. We may as well dig into another idiom by pointing out that cream rises to the top. In a previous time in the world, people might have talked about separating the men from the boys. You get the idea.

If you own a business that has withstood these conditions and even thrived in them, then suddenly you have a genuine track record of success in the harshest of conditions. It’s easy to look at all the 4×4 options in the market and speculate on which ones would make it through Africa. The best way to know for sure is to test them out and prove it.

Investors are always looking for ways to de-risk an investment decision. Sometimes, the “worst” time to bring a company to market also happens to be the best time, provided there is a track record of success against the odds.

Who holds the keys to the castle

Who holds the keys to the castle?

When we value a company, we are focusing on what the shareholder equity is worth. This doesn’t mean that we start there. A valuation focuses on the operations (i.e. the assets and the cash flows they generate) and then looks at how that value is split across the various providers of capital.

You might hear a term like “capital stack” in the market, referring to the layers of debt and equity on the balance sheet. As companies get larger, they tend to have more complicated capital stacks.

On the spectrum of debt to equity, we find mezzanine funding structures like participating preference shares or convertible loans. But for most businesses, there is usually only equity and asset-backed finance. Occasionally, there is a term loan (general debt) from a bank.

Once the value of the assets is established, then subtracting the value of the debt gives us the value of the equity. It’s entirely possible for the assets to be valuable and the equity to be worthless, as the value of the business might only be enough to cover the debt.

It’s all about who holds the keys to the company castle: bankers or shareholders?

Debt holders like banks get the first bite at the cherry. Depending on the cherry and the size of the bite, there sadly might not be much left for shareholders.

Free cash flow all that really matters

Free cash flow: all that really matters

The “FAANG” acronym is now outdated in the tech sector. Firstly, a couple of names have changed (Facebook became Meta and Google became Alphabet). Secondly, companies like Microsoft and certainly NVIDIA have shown that they have tons of growth ahead of them, so FAANG doesn’t capture all of the fast-growing technology giants.

Acronyms aside, this grouping helps us see that over a long enough time period, the market rewards free cash flow generation. This is the cash available for shareholders after working capital (like investment in inventory) and capital expenditure. In other words, this is the true cash profit generated by the business that doesn’t get tied up in expansion or keeping the thing going.

Amazon and Netflix aren’t great at generating free cash flows. Meta walked a wayward road, with Zuckerberg trying to convince himself and everyone else that the Metaverse is a worthwhile endeavour. Alphabet (Google) has been caught napping in some places and has been distracted in others, but the core business still works. Apple, of course, is simply the market darling that turns consumer loyalty into free cash flow with extraordinary consistency.

Here’s your proof that the market rewards businesses that generate cash:

proof that the market rewards businesses that generate cash

Business owners would do well to remember that if there’s no free cash, there’s ultimately no value. This is why we give our discounted cash flow the highest weighting. If you don’t believe us, you could choose to believe the FAANG investors instead.