2. Issue Shares. Sound crazy? You might be sitting on piles of cash you don’t know what to do with and the suggestion that you issue more shares may seem downright ludicrous. For some companies, like Apple, this would be unwise. But for many, this might be a good time to reduce leverage below the long-term target to build in a cushion to soften the next downturn. As a general rule, it is better to have more leverage during an up-cycle to accelerate the share-price appreciation and to have less leverage during a downturn to dampen the decline.
This can also help build the financing capacity needed to make opportunistic acquisitions when stocks are next undervalued. But be careful, since investors may react negatively in the short term — especially if the company has a history of making investments that don’t earn adequate returns. If management doesn’t have a disciplined process of making only investments that truly create value, investors may fear the extra financing capacity may be deployed on ill-advised investments.
3. Issue Convertible Debt. When stock prices are at cyclical peaks, they are less likely to rise in the coming years and so convertible debt is less likely to convert — making this a potentially attractive form of financing when stock prices are high. This is essentially “stock-issuance lite” and has many of the same potential benefits and risks discussed above. For managements concerned they cannot convince investors of the merits of stock issuance, issuing convertible debt is a back-door way to at least take some advantage of an unusually high share price.
4. Avoid Buybacks. Given the discussion above, refraining from share repurchases should go without saying. But it’s worth repeating that most companies should avoid the temptation to buy back stock when the market is high. Companies that buy back stock when the price is high earn much lower returns on their buybacks than those that buy when the price is low. Further, our capital market research shows that earnings-per-share growth generated from buybacks is valued on average at about half the P/E multiple of EPS growth from operations. Don’t do it!
This may all seem straightforward. But the question remains: How do you know if you are overvalued? You never really know until you look back later, but management needs to be as careful in its analysis as it would be when examining a potential acquisition. Try to compare valuations not just to peers in the market now, but to the company and peers historically. Be sure to give all valuation context over time and avoid being lulled into thinking your stock is cheap just because it appears so in relation to other companies that might also be overvalued.
Another approach involves creating a forecast that reconciles to the current share price through a discounted cash-flow valuation. This is a good way to judge whether the current price is reasonable in the context of what management believes is achievable in the business.
However you assess your valuation, try to maintain objectivity. If the company appears overvalued or undervalued, make sure to take strategic actions that capitalize on the view of the market.
Gregory V. Milano, a regular CFO columnist, is the co-founder and chief executive officer of Fortuna Advisors LLC, a value-based strategic advisory firm. Copyright © Fortuna Advisors LLC. All rights reserved.