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The Pizza Theory of Business Valuation

Sometimes it helps to think of a business as a pizza The Pizza Story Imagine that you have gone to a pizza restaurant with a very hungry friend. You are sitting at your table waiting impatiently for the waiter to take your order. The waiter eventually arrives and takes your order. He, then, turns to your friend, who is, by now, quite starved. Your friend tells the waiter: "Please get me a cheese pizza as quickly as you can and because I am very hungry today, please make sure that the Chef cuts my pizza into twelve slices instead of eight." The waiter looks at your friend in a puzzled way, scratches his head and walks towards the kitchen. Equally puzzled, you ask your friend to explain his irrational behaviour. He tells you: "If I request that my pizza be cut into twelve slices instead of the usual eight, then the total amount of pizza I will get to eat will be more than before. The size of my pizza depends upon the number of slices it is cut into. If you don't believe me, take a look at what happens in the corporate world and the stockmarket." What Happens In The Corporate World Children learn early on that the size of a pizza does not depend upon the number of slices that it is divided into. But when they grow up to be chief financial officers (CFOs), they appear to follow a different rule: the more cuts, the better. In a bid to boost their total market value, companies issue bonus shares to their shareholders. This can best be explained with the help of an example in which we will think of the company as a pizza and each outstanding share as a slice in the pizza. Suppose a company has no debt (this assumption is made only for the sake of simplicity) on its balance sheet. The stated value of it's total assets is, say, Rs 1,000 crore. Since there is no debt, the stated net worth of the company, that is our pizza, will also be Rs 1,000 crore. If there are 1 crore shares outstanding, that is, if there are 1 crore slices in our pizza, then the per share (slice) net worth, or per share (slice) book value will be Rs 1,000. If the par value of each share (slice) is Rs 100 then the paid up equity capital of the company must be Rs 100 crores and its reserves must be Rs 900 crores. Now let's assume that this company earned post-tax profits of Rs 250 crore in 1996-97. That translates into to a return on assets of 25 percent. Assume that the post-tax return on long-term, high-grade bonds is 12.5 percent. This means that if Rs 1,000 crores were invested in long-term, high-grade bonds, they would yield only Rs 125 crores as post-tax income or half of what our company is earning on its assets. We can therefore conclude that because our company is deploying its assets twice as profitably as high-grade bonds, these assets should command a price in the market which is twice the price of the bonds. Therefore the intrinsic value of the company should be Rs 2,000 crores which translates into a per-share intrinsic value of Rs 2,000. In other words, our pizza is worth Rs 2,000 crores and each slice is worth Rs 2,000. Now assume that the market price of the company's shares is also Rs 2,000 each. The company's CFO now gets a "bright" idea. He thinks that by issuing bonus shares in the ratio of 1 share for every existing share, he can increase the total market value of the company. He feels that when the total number of outstanding shares doubles from 1 crore to 2 crore, their market price will not fall from Rs 2,000 to Rs 1,000 per share. Instead, he feels, they will fall to Rs 1,200 per share. In other words he feels that he can
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increase the size of the pizza by increasing the number of slices without any improvement in profitability or a fall in market rates of interest. Asked, why does he feel that, his answer is likely to run along the following lines: "The current market price of our stock is Rs 2,000 per share. There are 1 crore shares outstanding. The market lot is 50 shares. Therefore, for investors to buy our stock, a minimum investment of Rs 1 lac is required. If we allot 1 bonus share for every existing share, we will double the total number of outstanding shares. The market price may initially fall to Rs 1,000. But now the minimum investment required to buy 50 shares will also fall to Rs 50,000. Since there are lots more investors who can afford to invest Rs 50,000 than Rs 1 lac, the demand for our shares will go up and so will their price. The shares will be traded more heavily and the increase in liquidity will ensure that the market price eventually settles at Rs 1,200 per share and consequently the total market value of our company will go up from Rs 2,000 crores to Rs 2,400 crores. In other words the bonus issue will enrich our shareholders by Rs 400 crores." Believe it or not, this is precisely how companies think when issuing bonus shares - that value can be created by dividing the business pizza into more slices than before. Can it? Our pizza example suggests otherwise. Just like the size of a pizza has little to do with the number of slices it is cut into, the total value of a company also has little to do with the number of outstanding shares it is divided into. What Happens In The Market CFO's are not the only irrational people around. Many investors also think that a bonus issue increases the total value of the company. If enough number of people behave irrationally, is it surprising that market prices will also behave irrationally? In the case of bonus issues this is what usually happens. To explain this let me give you a real life extreme example. In 1994, pharmaceutical company, Cipla Limited, made history by being the first Indian company to issue bonus shares in the ratio of 5 shares for each existing share. Before the bonus issue, the company had approximately 31 lac shares outstanding which were selling in the market at around Rs 4,000 each. Therefore, the total market capitalisation of the company prior to the announcement of the bonus issue was Rs 1,240 crores. The profits for the year 1993-94, however, were only Rs 14 crores. The shares were, therefore, selling at a price-earning multiple of 88, a very high PE by any standards, but one which can still be justified if the company's profits were expected to rise exponentially for a number of years, which was not the case. In other words, the shares were already overpriced relative to their true value. Then the company announced the 5 for 1 bonus issue. Irrational people create irrational prices. When the news of the bonus issue broke, many investors lost their heads and became willing to pay much higher prices for Cipla shares. The price of the stock, hold your breath, zoomed to Rs 35,500 each. At that price, the company's total market cap was Rs 10,850 crores which was approximately twice the then market cap of the steel giant Tisco. The PE ratio shot up from a "mere" 88 to an astonishing 775 which means that if earnings did not grow, it would take an investor who paid Rs 35,500 per share 775 years to break even! Fast forward to today. The current market cap of Cipla is Rs 1,239 crores. It's profits for the year 1995-96 were Rs 29 crores. The PE ratio is 42. The Cipla example demonstrates how investors who buy shares in the belief that value can be created simply by printing new pieces of paper, can burn their fingers. Exceptions To The Rule In an efficient market, bonus issues should have little impact on the total market value of a company. But there are exceptions to this rule. These exceptions can, however, be explained. Companies, it is known, do not like to cut dividends. A cut in total dividends paid is perceived by the market as a signal that the company's future profits will be lower than its current profits. Whenever a profitable company, therefore,
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declares a bonus issue, the market takes it as a signal that it will, in the future, be able to pay higher dividends than now (here I am talking about total dividends, not dividend per share). These higher dividends, must, therefore, come from higher profits unless they come from fresh capital issued. The stock price of a company, therefore, can rationally rise on the announcement of a bonus issue, if and only if it is expected that the company's profits will rise at a rate which is higher than the current expected growth rate. When Hindustan Lever or Thomas Cook announce a bonus issue, their stock prices go up not because value is created by printing more "paper money," but because the market is discounting a previously undiscounted growth in the future profits of the company. Imagine for a moment, that a company such as MS Shoes declares a bonus issue in the ratio of 1 share for every share held. Do you really think that it's total market cap will permanently rise soon after the announcement of the bonus issue? I think not, because the market will correctly assess the possibility of future increase in profits of the company. If an MS Shoes type of company cannot increase its long-term market cap through bonus issues but an HLL type of company can, the only rational conclusion which I can draw is that the rise in market cap occurs not because more shares will become available for sale and purchase in the market but because of perceived future growth in the company's profits which was earlier not discounted in the market price of the shares. Conclusion Many investors love to receive new pieces of paper. They are similar to those who feel they have become richer by exchanging their 100 rupee notes for ten notes of 10 rupees each. Such irrational behaviour is punished by the market over the long run. Investment strategies designed with the intention of investing in companies which are most likely to declare bonus issues, may work for a while in the short-run but usually are doomed to fail in the long run. A company may be able to achieve a "spike" in its stock price by declaring a bonus issue, but if the "spike" is unrealistic, that is, if the stock price increase is unrelated to any rise in value, then such an increase is likely to prove to be temporary. In the long run, the pizza theory of business valuation holds. Note This article is submitted by Sanjay Bakshi who is the Chief Executive Officer of a New Delhi based company called Corporate Investment Research Private Limited. Sanjay Bakshi. 1997.

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