Granted, it is now hard to believe that newspaper publisher Johnston Press (JPR) was ever fashionable, although it really was. However, Patisserie Holdings (CAKE), an operator of up-market cafés, was flavour of the month right up to the instant its bosses revealed a likely fraud at the heart of its operations, with perhaps £39m gone missing. Shares that might be worthless, moments before traded at 429p, valuing the company’s equity at £430m, or 25 times its latest earnings.
The bigger point is that investors might want to acquaint themselves with such sights because if – or is that when? – the developed world’s economies flip into recession then they will need to know how to respond. More specifically, how will they learn to scavenge for value in the growing pile of decaying companies?
A decent starting point, which I have advocated before, is to use a version of the famous Black-Scholes options pricing model, adapted to value a company’s shares as an option on its survival. The principle is the same as any option – that value will come from the difference between the underlying value of whatever is on offer and the aggregate of the cost of the option and the exercise price. To put that into figures, first imagine that securities of some sort are really worth 30p each (and that somehow that value will shortly be realised); second, imagine an option to buy them at 25p (the exercise price). If the cost of the option is 3p then intrinsic value of 2p is on offer. It’s that intrinsic value – that something for nothing – that Black-Scholes helps reveal.
Let’s flesh this out, using Johnston Press. For 18 months now its bosses have sought ways to avoid the annihilation that approaches next June when £220m of fixed-rate debt comes due with no realistic hope of repayment. Last week they acknowledged they could come up with nothing better than putting the group up for sale. Whether suitors will be tempted depends on how much value they spot over and above that £220m debt-redemption cost. Obviously the market thinks there is very little because, at its current 2.6p, the share price values Johnston’s equity at just £2.8m, barely more than 1 per cent of the debt.
Putting these figures into the context of the Black-Scholes model, the £220m of debt becomes the exercise price of the option and the £2.8m value of the equity is the price of buying the option. So £2.8m will be a profitable price to pay for the equity if intrinsic value comes out at more than £222.8m. The model helps suggest how likely that will be, and online readers can click the link below to take them to a spreadsheet showing the workings of the model with the relevant inputs for Johnston.
True, there is a clear shortcoming in this adaptation of Black-Scholes, stemming from the fact that, more than anything, the model runs on price volatility; the more the price of an underlying security bounces around, the more likely it is there will be a profitable opportunity for a holder of the option. That’s because the bouncing may well take the security’s price clear of its fixed exercise price.
So volatility equals value. However, unquoted corporate debt – perhaps even straight bank debt – plays a big part in this variation of the model yet it has no market price, so no volatility. Sure, the shares have a market price, which is likely to be very volatile and, given a decent data base, such volatility can be accurately measured. But because in distressed situations equity value will comprise a small part of the enterprise value (equity and debt combined) then a bouncing share price will have little impact on the weighted volatility of debt and equity combined and this certainly applies in Johnston’s case.
At least Johnston has a simple debt structure, with a clear redemption date. With most listed companies, these factors are likely to be more obscure, which makes inputs for the cost and the duration of the debt fuzzy. And – for what it’s worth – the model does suggest there may be value in the shares as an option, something like 4.5p compared with the 2.6p market price. But don’t go overboard. Chiefly, that return is driven by the time value of money – the return an investor would get anyway from use of his or her free capital while pondering whether or not to exercise the option. Proof, perhaps, that the market rarely offers a free lunch.
As for Patisserie, it does not carry any debt, or at least it didn’t in its most recent – though possibly phoney – balance sheet, so this variation of the Black-Scholes model won’t have much meaning in this situation. And sceptics might rightly ask how much meaning the model has at all. But the point is that for serious investors it is another tool to have in the box. Sure, its applications will be limited to those distressed companies where there is the right mix of debt and just enough equity; but the inputs needed are data that analysts scouring a company’s accounts will collect anyway, so you might as well use it. Like any valuation tool, it does not offer certainty; it offers food for thought. In the coming slowdown, that will be much needed.
