Equities markets efficacy, and private company valuation

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In Business Valuation Posts

Definition of efficacy

Efficacy is a word used principally in pharmacology. It is defined as “the power to produce a desired result or effect”. In a financial equities markets context consider the word efficacy in the context of each of the short term and the long term. The short-term, taken to be day/day may prove to be quite different than the long-term, taken to be months or years.

I suggest this is worth canvassing having regard to equities markets performance since January 1, and particularly in the last seven trading days up to and including June 30. Taking the Dow Jones Industrial Average as a proxy for U.S. equity markets, here are the closing DJIA index numbers for selected days.

Equities markets proxy: DJIA monthly close December 2015 to June 2016


DJIA - 12:31 - 6:30, 2016

December 31, 2015, March 31, 2016 and June 30, 2016 are all quarter ends. These are reporting periods for investment managers. Note the significant increase in the DJIA in March, a gain of 1,068 points over February’s close.

Unless someone thinks otherwise, there was little by way of significant positive or negative macro-economic or country-specific news in the quarter ended March 31 – perhaps other than ongoing discussion of whether the U.S. Federal Reserve was or was not going to add a further interest rate hike to the one it made in December 2015.

Equities markets proxy: DJIA close June 20 to 30, 2016 with commentary


DJIA Close - June 20-30, 2016

Note: blue bars indicate an “up” daily close, red bars indicate a “down” daily close.

June 20 and 21 were three and two days prior to the so-called Brexit referendum vote on whether or not the United Kingdom would remain in the European Union. It was broadly thought on both those days – and concurrently remarked on by many equities markets commentators – that the “remain” vote would prevail on June 23 but that the vote was too close to call. On those two days the DJIA closed up 29 and 25 points respectively.

On June 22, the day prior to the Brexit referendum, it was broadly thought that the pendulum may have shifted and that the “leave” vote might carry the day, but again that the vote was too close to call with many “undecided” voters. That day the DJIA closed down 49 points.

During June 23, Brexit referendum day – where the United Kingdom is 5 hours ahead of New York’s Eastern Time – the consensus was that the “remain” votes would carry the day. That day the DJIA closed up 230 points, or 1.3%.

In the early morning hours of June 24, before the U.S. equities markets opened for trading, a majority “leave” Brexit referendum vote was announced. This caught the world by surprise.

On June 24, in the aftermath of that “leave” vote the DJIA closed at 17,401, down 610 points. On Monday, June 27 it dropped a further 261 points to close at 17,140 – a 4.8% drop in the two trading days following the announcement of the Brexit “leave” vote.

Then in the three trading days June 28, 29 and 30, the DJIA reversed itself, increasing by 270, 285 and 234 points respectively to close on June 30 at 17,930 – only 81 points down from the June 23 close. Again, that was the day of the Brexit referendum, and as previously stated a day when it was broadly thought the “remains” would win.

On Friday, July 1, the DJIA closed up a further 19 points to close at 17,949. U.S. equities markets are closed on July 4, U.S. Independence Day.

What has happened after the Brexit vote?

Here are some of the things that happened after the Brexit referendum vote up to June 30.

  1. UK Prime Minister David Cameron resigned the morning the Brexit “leave” vote was announced.
  2. A Brexit “leave” vote leader, Boris Johnson, announced he was not going to run to become UK Prime Minister.
  3. Scotland’s first minister Nicola Sturgeon and others voiced interest in holding a Scotland referendum vote in the aftermath of the Brexit vote. The European Central Bank suggested more quantitative easing may be in the cards.

But nothing of real economic consequence – either positive or negative – was reported in the June 24 – June 30 period.

Equities markets efficacy questions

This raises three interesting questions.

First, how much influence did the fact that June 30 signaled the end of an investment manager reporting period have on the equity markets in the three days ended June 30?

Second, if that was an important factor that drove the DJIA higher – and indeed to a level 244 points higher than the March 31 close, which itself was 260 points higher than the December 31 close – what does that say about the short-term efficacy of equities markets (or at least the DJIA)?

Third, what do those DJIA day/day market index results say about the long-term efficacy of the equities markets where at some point one might think the macro-economic state and the equities markets have to find a state of equilibrium. This where a state of equilibrium can easily be argued not to exist on June 30, 2016.

Fourth, how if at all does financial market volatility and arguable disconnect with prevailing world economic conditions and prospects impact the work of business valuation experts currently who are rendering notional private company business valuation opinions? This where a notional valuation is one where the value opinion or estimate is a hypothetical view not tested in the open market.

The equities markets and business valuation

Many business valuation practitioners use public equities markets indices, equities markets price relationships for listed companies they deem to be comparables, and other financial and equities markets metrics when developing their opinions or estimates of current private company values.

That is a practice that evolved out acceptance that the public financial and equities markets reflect prices for minority trading lots. This where:

  1. it is generally accepted that those trading prices can be appropriately adopted – subject a variety of adjustments – as an important input when developing the en bloc fair market value of the outstanding shares of private companies.
  2. the en bloc valuation of all of the outstanding shares of a private company at a given point in time is in theory an aggregation of the present value of all expected net after-tax free cash flows plus the value of all redundant assets if they exist, discounted to present value.

Simply put, if the financial or equities markets are out of sync at a given point in time with the macro- and relevant country specific economy in which the business being valued operated – and aside from important issues that cast doubt on the use of comparable company comparisons – private company business valuators will invariably overstate or understate their valuation conclusions.

This is something to be explored in further articles. In the meantime it is something to think about if you are someone who:

  1. renders private company business valuation opinions or estimates.
  2. a business owner or advisor to business owners who relies on such valuation opinions or estimates for any purpose.

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