We have recently been working with a client married to a “sophisticated investor.” When we cracked open the documents telling us what Mr. Investor owned, we found a succession of limited partnerships not one of which offered us any information from which we could begin in ascertain value.
Meanwhile, there were eight of these and one formed the impression at the outset that the investments were heavily weighted towards newly formed businesses.
Valuing any closely held business is a challenge. The typical approaches employed to do this involve measuring the stream of income or cash flow and efforts to find a comparable company that has recently sold. The trouble with startup companies is that they rarely have strong financials. It is not uncommon to engage a business appraiser to have that person come back and report that while they can see value from an intuitive viewpoint, the objective criteria needed to opine about value in an objective report is simply not there.
Occasionally, the stock market affords us a demonstration of this conundrum and the recent transaction involving Merck’s acquisition of tiny Cubist Pharmaceuticals is a good example. Cubist was formed in 1992. It has fewer than 1,000 employees but it has been publically traded at a price that did not crack the $25 mark until 2010. Startup pharmaceutical companies can be a roller-coaster as good and bad news circulates about the products they are trying to develop. Moreover, it costs millions if not billions to bring a meaningful drug to market and that investment is typically a multi-year journey. However, Cubist rose in price on a pretty steady basis until early 2014 when it reached $75 a share. In 2014, after peaking early, it tumbled back toward $60 and then clawed up to $75 a share.
In today’s world pharmaceutical companies trade at about 40x earnings. As December approached Cubist was trading at 87x earnings, more than double the industry average. It’s profit margin was 5.6%. Operating margin was 9.5%. Return on assets was 2.3%. Return on equity 4.47%. On these numbers one could argue that the market had it a little overpriced.
Then Merck stepped in offering to buy the company for $8.4 billion; roughly $110 a share. That’s just about one-third more than the market thought it was worth the day before. But then, on the very evening when the sale was announced, a court in Delaware issued a ruling that challenged one of Cubist’s patents. Cubists shares instantly fell 4% and Merck’s shares fell 5%.
Cubist’s largest individual shareholder holds 176,000 shares. He saw this transaction coming as he is the CEO. Let’s assume he was dividing his property with a spouse. Last Friday his spouse would have been negotiating over shares with a market value of $13,200,000. On Monday those same shares were worth $19,360,000. A day later; $2,640,000 less. If you were being divorced from the shareholder and made your deal on December 5, you would have had no idea that the following Monday would see the shares worth an additional six million. But then who could predict both a court ruling on Tuesday and just how the market would react. The experts are saying Merck overpaid by $2 billion.
The point of this is that we all like certainty when valuing assets. But even it situations where the stock is publically traded, the tides of the market can change precipitously. The problem is all the more difficult the smaller the business involved because small companies, like small boats, are less seaworthy in changing economic climates.