shell's contradiction

According to the story, Shell is going to buy BG for $70 b. Shell is worth $199 b, and BG is worth $60 b. In July 2014, Shell had a market cap of $280 b, and in April 2011, BG had $88 b. Just a few days back, though, market cap of BG was $42 b. Well, the market has reacted to the news report.

I don't want to get into whether the acquisition makes sense in terms of synergy, control, and other benefits. I will also not comment on whether the acquisition is costly or a bargain for Shell. What I want to note is how Shell is funding its acquisition: It is a combination of cash (383 pence) and stock (984 pence) totaling 1367 pence per share of BG. 

In effect, Shell is paying $50 b in stock. My question is whether it makes sense to pay in stock at the current price. It usually makes sense to use shares as a currency when its price not cheap. In other words, if Shell considers that its stock price is higher than its intrinsic value, it can use it for acquisition. The expectation then is that it will get more value than what is paid out. 

Now let's come to what else Shell is going to do. It has committed to a shares buyback of $25 b in the coming years. There are at least two things to be checked before a firm can go for buyback of its shares: It should have excess cash; and its stock price should be cheap, or at least not higher than its intrinsic value. 

For acquisition to hold good, we have to assume that Shell, in fact, considers that its stock price is on the higher side, otherwise, it would not have used its shares for acquisition. 

Whereas for stock buybacks, we have to assume that Shell, in fact, considers that its stock price is and going to remain on the lower side, otherwise, it would not have committed to the buyback program.

Heck, too much confusion...for the Shell managers, I guess. 

ntpc bonus debentures, and some reporting

NTPC has given away bonus debentures to its shareholders on 23 March 2015. While the corporate action has resulted in a free debt instrument in the hands of its shareholders carrying a floating rate coupon payable annually, there has been some interesting reports about its mechanism. 

It is interesting to note from this report that the company will be able to hold on to them for expansion projects; and this report which says that NTPC has issued bonus debentures for funding its expansion projects. I am not sure whether we should blame them for misguiding the readers, or blame the company for misguiding them who were unable to understand the concept in the first place. Just have a look at what the company has to say about this:

What the heck is happening here, who has paid out cash, and who has received cash? No one; and if there is no cash, where is the question of funding the projects?

Because no one has purchased these debentures, no cash has been received by NTPC. What has happened is simply the transfer from its equity to debt, thus increasing its debt ratio. Needless to say, equity has reduced and debt has increased. The debt portion will start paying interest which will be tax deductible for the company and taxable for the shareholders (now the debt holders). The book entry has managed to let the transferred amount behave like debt from now on. That's about it. 

If the profitability is not going to be affected (because of the additional interest charge), NTPC's return on equity should improve. 

I have written about NTPC before; the performance has been poor, and the stock is actually languishing. 

For someone who invested in the stock in January 2008, we can understand the frustration. The investor should be saying this: It really does not matter whether it will become a 90,000 MW company or not, what matters is its operating performance. How will it fare with its invested capital? Will it generate excess returns on its projects? Should it continue to reinvest its earnings so that it will increase its firm value (and consequently, the stock price), or should it stop reinvesting and start returning its excess cash?  

Capital allocation skills are tough, and under Indian conditions, boy, it's a double whammy.

can you value any asset

I recently wrote about value investors, albeit, for different reasons. Let's spare them for now. How about those who are on the other side, those who claim that they can value any asset? 

There are many who talk about valuation skills, and proclaim that they are adept at it. I wonder whether those skills are restricted to talking and writing only. I wonder whether they are able to profit from those skills in the real world investing. There is a reason why I wonder.

Value of a cash-flow generating asset is the present value of all cash flows that can be realized over its life. Anybody can do valuation. It is that simple: you only need to estimate cash flows and a discount rate to bring them to the present value. 

But wait, there is more to it. Practically, no one can estimate accurately how much cash flows an asset is going to generate in future. That is simply a prediction, and humans are not good at it. Furthermore, no one knows which discount rate is the correct one to use. 

It is clear that any valuation that we do is going to be wrong. It is also going to be colored by so many other factors such as bias and emotions. In this context, how can anyone be able to value, and profit from it? To make profits, we need to identify gaps between value and price. If the price does not factor input estimates of the analyst it is virtually impossible to make money out of his valuation. Prices are set by marginal investors who are usually large institutions. Their input estimates are going to be very different from an investor's. If those estimates are not likely to converge, value and price won't either. 

There is a good news though, if we are prepared to adhere to a different mechanism. Why get into assets whose cash flows are difficult to predict? For instance, technology companies, young growing companies, distressed businesses. It is not possible to come out with a realistic estimate of cash flows for these businesses; not even the insiders can do it. So we cannot value them reasonably, except on paper. 

The correct thing to do is to rather ignore these stocks, and move on to those where we can estimate cash flows, albeit with less precision. There are certain businesses where we can do it. For instance, those with stable and consistent cash flows, which have demonstrated high return on capital and operating margins. It is better to pick those businesses for valuation. Estimate cash flows based on past record, and future prospects (which is a lot easier than for unstable businesses), and come out with a value. This value is more likely to be in sync with the fundamentals of that business. 

The irony, however, is that such stocks usually sell at high prices. But then, who says we have to buy them regularly? There would be times when the markets are going to be in a depressed state (due to crises, or other reasons), or the company's stock itself is going to be depressed (due to issues that are likely to be temporary). These will be the moments when we should be picking. Markets will eventually come back, and that stable company's problems will eventually be solved so that the prices will reflect its fundamentals. Look at history, and you will find that such opportunities were there on several occasions. 

Of course, there are other sound approaches to investing, some of which I do use. Nevertheless, I find that waiting for the right occasion to buy is the best one. Rest of the time, we can do a few things: keep buying the index; do whatever we want to do in life to have fun, and watch (from far) markets fluctuating by the minute.