Candy corporations

14: A packet of M&M's: The value of the company

Here’s something very familiar. You will find it almost everywhere – at your newsagent, in the supermarket, in the vending machine on the station forecourt. We are talking about a packet of M&M’s – one of the world’s favourite sweets (‘candies’, to American readers). That Mars Corporation makes 400m of them every day in the US alone is proof of that.

You can buy M&M’s in various flavours – milk chocolate, peanut, almond, for example – and in six colours. And nowadays you can even buy your M&M’s personalised – with a birthday message, or maybe with your company’s logo.

Still, when all is said and done, a packet of M&M’s is a packet of M&M’s. They are all the same. And if you personalise a tube to contain just green buttons and yellow ones then would that be any better than a tube comprising just blue and orange sweets? To your three-year-old, maybe; but not to a rational thinker. A packet of M&M’s remains the same whatever the colour make-up of the contents. The weight is the same; the taste is the same; the calorie count is the same.

That sounds banal, but actually it’s an important lesson in finance because M&M theory says exactly the same. The difference is that now we are talking about the value of a company and the M&Ms in question are not Mars and Murrie – the two after whom the sweets are named – but Franco Modigliani and Merton Miller, two US economists both of whom won a Nobel Prize for their efforts.

In the 1960s these two proposed and proved the notion that the value of a company was the same regardless of how it was financed. The funds could come solely from plain-vanilla equity, or from a colourful mix of debt and equity. It really did not matter. All other things being equal, the overall value of the debt plus the equity would be the same however the two components were mixed.

At the time they made this proposition, M&M theory was radical indeed. Until then it was assumed that the way a company financed itself would affect its value; in particular that too much debt would depress value because it made the equity component riskier.

But M&M started with the ‘law of one price’, which says that if two assets – in this case, two companies – have identical future cash flows then their value today must also be identical. The proof depends on the logic that if their values were not identical then smart investors would arbitrage away the price differential by selling securities in one company and buying securities in the other.

The two explained this in, what was for economists, a colourful way: “Under perfect markets, a dairy farmer cannot earn more for the milk he produces by skimming some of the butter fat and selling it separately, even though the butter fat per unit of weight sells for more than whole milk. The advantage of skimming the milk rather than selling the whole milk would be purely illusory. What would be gained from selling the high-priced butter fat would be lost in selling the low-priced residue of thinned milk.”

So far, so simple. However, what’s really clever about M&M theory is that, having proved that capital structure does not matter for the value of a company, the two then proceeded to show that it did matter. The devil is in the detail; or, with reference to that colourful prose of theirs, in that modifier, “under perfect markets”.

The point is that markets are far from perfect and, in the real world, governments tax debt and equity differently. Taxation encourages borrowing because the interest paid is tax deductible. Less tax paid means more profit left over for the owners of the capital (the debt and the equity), which will raise the value of the company. As the capital structure changes to accommodate more debt in the mix, then the distribution of profits changes, too. In relation to their diminished investment, owners of the equity get more profit. Capital structure suddenly starts to matter very much.

Indeed, it matters so much that this extension of M&M theory provided the intellectual basis for, first, the leveraged buyout craze of the 1980s and, more recently, the expansion of the private equity industry. More than anything, private equity relies on the power of debt to finance a company. Not just because it maximises the tax benefit of using debt rather than equity, but because funding a company mostly with debt helps keep the managers honest – they can’t be shielded against both market forces and their own shortcomings by a cushion of cash and they need to go cap in hand to the company’s owners when they need extra capital.

M&M theory also has much to say about the dividends that companies pay – chiefly, that they shouldn’t bother. At least, in a theoretical world without taxes dividends are irrelevant. It makes no difference to its value whether a company returns all its profits to shareholders, some or none; or whether shareholders get their cash returns via dividends or via selling bits of stock. By the same logic, equity investors should be indifferent to whether they extract cash from their company by receiving dividends or by selling some shares.

Once more, in the real world taxes intervene. The fact that, almost universally, dividends are taxed more heavily than share sales provides a further reason why companies should not pay dividends. The difficulty is that’s the investment equivalent of telling your three-year-old not to eat his sweets. For him, the whole point of having them is to scoff them. Which goes a long way to explain investors’ attitudes towards dividends – they want to gobble them up. M&M’s – the sweets more than the theory – tell us that, too.