Summary: Directors might overlook valuable opportunities depending on how attuned management is to market changes.
FREMONT, CA: Investors consult detailed, quantitative valuation models before making investment decisions. Companies tend to improve price-earnings ratios (PE) by driving revenue and margins based on historical heuristics or summaries of previous experiences that need to be systematically analyzed and more accurate. Besides handicapping management teams, this approach can hinder a company's ability to identify opportunities and neutralize threats. Threats can arise from how their company functions independently, differences in how it is valued compared to competitors within and across industries, or changes in their valuation over time.
If executives fail to manage their business models to the changing market pitch, they will miss opportunities and suffer threats they might avoid. Lacking such a model leaves executives operating on decades-old rules of thumb.
Valuations: According to an EY-Parthenon analysis of quarterly data from thousands of companies across hundreds of industries over 20 years, unpredictable factors account for most of the variability in market valuations. Management teams can understand these fluctuations to create near-universal models that compare industries, companies within, and companies across industries. As the market values of any of these companies change over time, the model can help leaders understand these changes.
Valuation Drivers Change over Time: It offers general truths about the companies analyzed. Few company managers realize how much these principles change over time. The implications can be startling. In early 2013, you were the new CEO of a packaged meat company without a comprehensive market analysis. The market rewards you for strong margin growth, so you concentrate on that. Returns suffer as margin growth shrinks and revenue growth rises. As the year ends, you pay close attention to analysts and financial journalists; you look at PE ratios; you pay close attention to revenue. Things start improving after a few quarters, but revenue becomes less important as shareholders' cash returns dominate and total returns suffer.
Valuation Clarity Can Identify Opportunities and Threats: A new CEO from another industry may expect to learn a new industry but may also carry some preexisting beliefs, such as what drives stock value and when the company recruits and hires them. Changing direction requires time, and managers cannot always act based solely on an analysis like this. However, it is important to note that market drivers change their importance over time. Hence, a company has time to prepare and execute a plan before the valuation environment completely changes. An updated value-driver diagnostic will inform you if the environment has changed.
