Intrinsic Value vs. Market Value  669 Intrinsic Value vs. Market Value Senior executives often claim that the stock market undervalues or “doesn’t appreciate” their company. They say this not just in public, where you would expect them to, but also in private. They truly believe that if only they had different investors, or if only the investors or analysts understood their com- pany better, the company’s share price would be higher. Yet often these senior executives have not performed an objective outside-in valuation of their com- pany, viewing it through the lens of a sophisticated investor. Their optimistic belief is based on a superficial comparison of price-to-earnings ratios (P/Es) or a stray comment by an analyst that the shares are undervalued. Any good strategy must begin with an honest assessment of the situation, and a plan for investor communications is no different. It should start with an estimate of the size of the gap, if any, between management’s view of the company’s intrinsic value and the stock market value. In practice, we typi- cally find that no significant gap exists or that any gap can be explained by the company’s historical performance relative to peers or by the way the market is valuing the entire industry. Let’s illustrate with a disguised example. A large apparel manufacturer we’ll call Fashion Co. earns a return on in- vested capital (ROIC) of about 20 percent, but its product lines are in slow- growth segments, so its revenue growth has been low. Fashion Co. recently adopted a strategy to buy small companies in faster-growing areas of the industry with higher ROIC, intending to apply its manufacturing and dis- tribution skills to improve the performance of the acquired companies. Cur- rently, 18 months since the company made its first acquisitions under this strategy, Fashion Co. derives 5 percent of its revenues from the fast-growth segments. Fashion Co.’s managers were concerned that the company’s P/E trailed the P/Es of many companies with which it compared itself. They wondered whether the low value resulted from such factors as the company’s old-fash- ioned name or the small number of analysts covering the industry. We began analyzing the apparent discrepancy by assessing Fashion Co.’s value relative to companies it considered peers. Some of the supposed peers were 100 percent involved in the fast-growth segments, far exceeding Fashion Co.’s 5 percent revenue stream from them. When we segmented Fashion Co.’s peers by growth rates, we found that its earnings multiple—enterprise value divided by earnings before interest, taxes, and amortization (EBITA)—was in line with those of its close peers but behind those of the companies in the fast- growing segment (see Exhibit 34.1). Fashion Co. and its closest peers also had lower ROIC than the fast-growth companies. A third set of companies, also shown in Exhibit 34.1, had high multiples because of current low earnings due to restructuring. So based on recent performance, Fashion Co.’s value was aligned with its performance relative to its closest peers. 670  Investor Communications Next, we reverse engineered the share price of Fashion Co. and its peers by building a discounted-cash-flow (DCF) model for each company and estimat- ing what levels of future performance would be consistent with the current share price. We found that if Fashion Co. increased its revenues at 2 percent per year and maintained its most recent level of margins and capital turnover, its DCF value would equal its current share price. This growth rate was in line with the implicit growth of its closest peers and lower than the companies in the fast-growing segment. Which Investors Matter? Does it matter who your investors are? It is not clear whether one investor base is better than another in the sense of helping to align the share price with a company’s intrinsic value. But understanding a company’s investor base can give managers insights that might help them anticipate how the market will react to important events and strategic actions, as well as help managers improve the effectiveness and efficiency of their investor relations activities. One way to begin seeking an answer to this question is by acknowledging that retail investors do not qualify for consideration in our examination. The reason is that they rarely matter when it comes to influencing a company’s share price. Despite collectively holding around 30 to 40 percent of U.S. equity, they do not move prices, because they do not trade very much. The real driv- ers of share prices are institutional investors, who manage hedge funds, mu- tual funds, or pension funds and can hold significant positions in individual companies. EXHIBIT 34.1  Fashion Co.: Valuation in Line with Close Peers 8.6 20.5 2.0 3.1 2.5 1.9 10.0 11.8 3.4 1.2 19.5 12.2 16.1 33.0 33.9 10.0 5.1 8.5 8.0 6.8 9.7 11.2 9.3 12.2 Enterprise value/EBITA ROIC, 2018, % Organic growth, 2016–2018, % Fashion Co. Close-peer companies California Co. Texas, Inc. Florida Associates Peers in fast-growth segments Vermont, Inc. Montana Co. Restructuring companies Bretagne Co. Normandy, Inc.