Financial Engineering Today -- November, 2002

A One on One Interview with Two Partners from Standard & Poors Corporate Value Consulting Practice:  David Spieler and Alan Cody.

Since the bursting of the stock market bubble in 2000, corporate valuation has become a “hot” and debated topic among financial practitioners. In order to explore this topic, FEN recently sat down with David Spieler and Alan Cody, both managing directors in the Corporate Value Consulting practice at Standard & Poor’s.  Dave’s background includes over 20 years of experience in management consulting and financial valuation including positions in at Arthur D. Little and PricewaterhouseCoopers.  He has a BS and MS in civil engineering and an MBA from the Tuck Business School at Dartmouth.  He is also a Chartered Financial Analyst.  Alan’s background also includes over 25 years of valuation experience including positions at Arthur D. Little and PricewaterhouseCoopers  He holds a AB degree in mathematics and an S.M. in management from MIT.  Also, he is a  Chartered Financial Analyst.  This interview was conducted on September 25, 2002.

FEN: For starters, tell us about Corporate Value Consulting at Standard & Poor’s.  What is it that you do and work on?

Spieler:  We cover a fairly broad market in terms of our client base. We work with large multi-nationals, mid-cap companies, small-cap companies as well as start-ups and private enterprises. We’re a national practice with over 400 professionals in 13 offices.  However, within this broad market scope our mission is very focused:  We provide independent, objective financial advice to the boards and senior managements of companies.  Our expertise is in providing business and asset valuations, as well as corporate finance advisory services.

FEN: So you guys probably work “hand in glove” with the well-known credit rating function and services that S&P is also known for?

Cody: Actually, just the opposite.  We are an autonomous, independent business unit within S&P. In fact, we have no communications with the S&P credit rating function.

FEN: So give us an example of an assignment you would undertake on a regular basis.

Spieler: That’s difficult to do because of the broad range of companies we work with.  In our view, every valuation analysis and assignment is unique.  But, let me give you an example of one type of assignment we frequently undertake.  Let’s say you’re the owner of a private company that’s interested in using stock options to provide incentives to your senior management team in order to avoid a deferred compensation charge against income.  However, being a private firm, you need a valuation of your company’s equity whenever options are granted.  It may seem like a fairly straightforward exercise, one that your internal finance staff or your banker could easily perform for you.  But, at the time such a private company is considering an IPO, the SEC (US Securities & Exchange Commission) will require that independent and objective valuations have been prepared for each stock option grant date.  To avoid deferred compensation charges, reduced income and potential tax consequences you have to set the strike price on any options at the fair value of the underlying.  And, your auditor or the SEC ( if you subsequently offer your stock to the public) may come back to question how you arrived at your valuation.  Having an independent third party like S&P provide this analysis is very important.

FEN: So, what’s new in the field of corporate valuation?  Tell us about any new approaches or techniques that are being used?

Cody:  Although it’s not a “new” approach in the sense that it has been around for over 5 years, the application of real options analysis to business and corporate valuations has been an important step forward in the field.

FEN: What is real options analysis?  Does this replace the traditional discounted cash flow approach to valuing businesses?

Cody:  In fact, it complements DCF valuations and greatly improves on them by reflecting and incorporating the uncertainty of future cash flows, and the future degrees of freedom that management has to alter their strategic and financial plans based on how any particular scenario of future cash flows plays out.

FEN: But this uncertainty of future cash flows- isn’t their riskiness reflected by the appropriate cost of capital or equity employed in the DCF valuation?

Cody: It is.  But what a traditional DCF analysis fails to reflect is that management has future options and decision points to either proceed, terminate or modify future spending plans based on how the future- up to the that point in time- has evolved.  For example, a company that is committing to a long-term strategy of leadership in a particular industry is facing a series of multiple investment decisions over, say, the next 10 years.  Traditional DCF analysis can only evaluate whether this strategy will or won’t create value assuming the strategy is fully played out and all the future investments over ten years are made.  What real options analysis reflects is that management can modify it’s strategy and spending plans in the future depending on how their strategy is or isn’t working.  Incorporating the value of these real options in the DCF analysis frequently produces very different conclusions of the value from a simpler DCF analysis without them.

Alan Cody: Standard and Poors
Cody: Traditional DCF analysis can only evaluate whether this strategy will or won’t create value assuming the strategy is fully played out and all the future investments over ten years are made.  What real options analysis reflects is that management can modify it’s strategy and spending plans in the future depending on how their strategy is or isn’t working.  Incorporating the value of these real options in the DCF analysis frequently produces very different conclusions of the value from a simpler DCF analysis without them.

FEN: So, the real options approach to valuation can give you a better answer than traditional DCF?

Spieler: For most complex businesses whose managements must make long-term decisions with high uncertainty, the answer is yes.  An example of this is a pharmaceutical company that must decide where to invest its R&D spending today given that commercialization for each particular drug in the development pipeline may be many years away.

FEN: Strategic call options.  The concept certainly sounds impressive, but how would you begin to value these kind of options without a capital market to assist you?

Spieler:  Strategic options can be framed and analyzed based on some of the original option valuation theory developed in the 1970’s by Fisher Black, Myron Scholes and Robert Merton.  Basically, strategic options in a business can be modeled as binomial processes using decision tree analyses.  However, the difficult part of this process is assigning probabilities under high uncertainty.  For example, one must be able to assign a probability that the size of the market two years hence for a particular product will be, say, greater that $1 billion.

FEN: So, it sounds like you your practice at S&P really “crunches” a lot of numbers!

Cody: We do at the appropriate time in an assignment.  On the other hand, probably over two-thirds of our work occurs prior to any serious quantitative financial work.

FEN: Doing what?

Spieler: The art of financial valuation really rests on one’s ability to cast a wide net, collect a lot of information, sort this to a base of correct data and information to be analyzed.  The next step is to develop insights and forecasts of key value drivers that can be applied in quantitative financial models.

FEN: We’re the newspaper of financial engineering.  We have lots of quantitatively oriented readers who are going to be very disappointed by this comment.  So, you’re saying that two-thirds of the work in any corporate valuation is intuitive, judgmental and- forgive the phrase- “seat of the pants”.  In other words, each assignment reflects a unique methodology you make up as you go?

Cody:  Not really.  In fact, we strive to be very systematic and analytical in our collection and synthesis of information that feeds our valuation models, especially the qualitative information. Let me give you one example:  One of the most crucial areas of discussion with management- especially in light of the speculative bubble we’ve just gone through- is the extent to which the business model for the company can be validated.  For example, is an end customer receiving real value for the price he or she is paying for the company’s products?   And, is the need being satisfied for the customer a real need as opposed to a passing whim?

FEN: This sounds like strategic planning 101.  But can you give us a recent example or type of situation that reflects both the importance of this, and how you use it as an input to your corporate valuation methodology?

Cody: Sure. One situation that we find ourselves focusing on a lot- in the current economic environment because of price deflation in many wholesale and industrial sectors and the resulting cost competition- is how the cost of delivering the value-added is going to evolve.  A typical situation we run into in an industry where there is a lot of pressure on prices, is that distribution channels come under pressure as sources of cost reduction.   Companies that don’t move with the evolution of distribution to lower cost approaches and models end up with stranded distribution costs, in terms of either direct investments in the channels or investments in relationships that are not easily broken and that make them uncompetitive in future years.

FEN: What about the all important yet ethereal factor that people refer to as “quality of management”?  How do you systematically capture this in a valuation analysis?

Spieler: You’re right: A proper assessment of the quality of management is clearly a crucial factor in any valuation. We almost always sit down with top management of any company we’re performing a valuation analysis on.  That includes not just the CEO and CFO, but the key operating management as well; it is an absolutely critical step in any thorough valuation analysis.  We have what we believe is a fairly comprehensive list of key questions and issues to inquire about in these management interviews. One obvious test of management quality is to ask them for their past business plans and projections.  We test to see if these plans were actually achieved.  This has historically been a key input to investors evaluating financing requests from corporations, because the track record of an established and successful management team often counts for as much as the business plan or strategy.

FEN: What other qualitative factors do you focus on?

Cody: Well, another factor we consider in corporate valuations is whether the current investment being made in the company, be it capital spending or investments in R&D, or other intangible asset or capability is adequate and consistent with the business model the company has based its strategy upon.  We’ve encountered many instances where, at a corporate level, the free cash flow of the company looks robust and healthy, but when you “look under the hood” and consider the future investment needs of the individual businesses that are generating this corporate cash flow, you see that some currently healthy businesses are being starved to the detriment of those businesses being able to sustain a future level of cash flows consistent with past performance.

FEN: Any other factors?

Cody: Sure, we could probably fill your next issue with an article that captures all of these.  But one additional factor, especially in light of the current of the current environment, has to do with our assessment of a company’s culture. In other words, does the company take strategic planning, operational planning and financial control seriously?  Are reports on company performance issued in a timely fashion, and do they contain the necessary information for managers to act on it? Is there a track record of action being taken to meet plans, and is the financial function adequately staffed? And even more important, are operating management involved in the planning process, do they take an active interest in helping to shape plans, and are there effective incentives and  controls for operating management that give some reasonable assurance they can and will deliver on the plans made?  All of these factors I’ve just outlined- call them qualitative, but nonetheless critical items- are all examples of areas we focus on before we get to the actual financial analytical work that is most often associated with the work of a valuation analyst.

FEN: Let’s jump from the general topic of company valuation to a more specific and -we’d assume- challenging topic of advising companies in the process of mergers and acquisitions deals.  Does your practice at S&P work in this area?

Spieler: We do work in the area of M&A and corporate finance consulting.  Our value proposition is that we work strictly for a fee, with no commission dependent on the deal going through. For that reason, we are often brought in by boards of directors and senior managements to provide opinions on the fair value of a potential acquisition.

FEN: So, after the major wave of acquisitions in the late 1990’s, what has changed in terms of M&A valuation techniques and philosophies in these more “sober” times?

Cody: Let me separate my answer between what has changed externally- that is the dialogue between investors and the management of the acquiring companies- and the separate dialogue that goes on within acquiring companies as they decide whether to bid for an acquisition, and how much to pay.  On the former topic, two changes have occurred since the go-go 1990’s.  First- investors have become much more interested in how past acquisitions have been handled and managed as they form expectations on the wisdom and value-creating potential of new M&A activities.  They want much more than a vision of synergy and a pro-forma of projected and combined future cash flows.  They want to know how you’ve delivered on this type of acquisition in the past”.

Second, the new accounting standards regarding the testing of goodwill and analysis of possible of goodwill impairment really are a “sea change” for companies interested in acquisitions.  For example, now when you buy a company, you no longer have access to pooling accounting.  So you have to allocate of the price paid to the fair value of the underlying assets, the portion of the purchase price that ends up being allocated to the residual is captured as goodwill but is no longer amortized immediately against earnings.  However, the company is required to perform a test each year on that goodwill to determine whether any or all of it is impaired and therefore to be expensed immediately.  The core of the test is really a valuation test to see if the goodwill is still worth what it was originally calculated to be.  We are finding that a lot of companies as a result now are thinking more about “value” relative to price when they bid for an acquisition because of the fear that the market price would result in a significant enough level of goodwill to pose a risk of impairment over the next 2-3 years or beyond.   We view this as a healthy thing, because managers are going to think about whether they really can create the additional value needed to justify the purchase price and support a sustainable level of goodwill before making acquisitions.

FEN: Okay, but what about your other observation regarding what has changed internally in terms of the decision process of a company’s management regarding whether to even bid on, or attempt an acquisition?

Cody: Well, this other benefit can be described as a healthy dialogue within companies between the people doing the acquisition, and the people who will be responsible for managing the acquired business and realizing the synergies and value potential that drove interest in the deal in the first place. Some companies have, in the past, acquired businesses at a price presuming a 20% growth in EBITDA, and the operating managers then say “We really can’t achieve more than a 12-15% growth rate in EBITDA.”  Companies in the past might have still been motivated to make the acquisition because the resulting goodwill would be impounded on their balance sheet for many years and only slowly amortized away.  Now, with the new rules on goodwill treatment, that kind of acquisition strategy is almost guaranteed to set you up for a major goodwill impairment charge in the following one or two years because the annual required valuation of goodwill will reveal that what is there is almost certainly less than what you paid for it. As a result of this, there is a lot of thinking going on in companies all the way up to the board of directors on how to forecast, how to value, and how to test the reasonableness of assumptions supporting the valuation instead of what technique- be it DCF, or market multiples are being employed.

FEN: It sounds like there’s a “back to basics” movement with corporate valuations when you mention a renewed interest and focus on the forecasting techniques underlying a valuation analysis.  Is this true?

Cody: Absolutely.  One approach, although it sounds somewhat mundane, is working with management on a series of checklists designed to help them “build-up” to a set of valuation estimates regarding growth, synergies, and cost savings opportunities, instead of the old approach where these were mandated by a CEO as the basis of the acquisition and managers were held accountable to meet these targets.  The goal of this approach is to validate the most important assumptions of a forecast rather than drive a forecast designed to achieve a particular outcome- in this case the “logic” to do the deal.  The old approach and era is going away, and I think companies are much more leery about bidding a price that will “win” the deal, instead of bidding a price that reflects their best forecast of what they believe they can do with the acquisition.  So, that’s a very helpful developments, and a lot more companies as part of their financial reporting function are going to be thinking about value, valuation techniques and the like.  We also see a renewed interest among company directors, especially those directors responsible for the audit function to understand the basic concept of the valuation under consideration.

FEN: Given this “back to basics” movement, we have to ask you one of  the most debated question in the history of financial valuation:  What are your perspectives and opinions on the value and utility of the Capital Asset Pricing Model (CAPM) and some of the alternative approaches to measuring a company’s cost of capital?

Spieler: Regardless of the approach we employ in calculating a cost of equity capital, we look at industry risk, country risk and company-specific risk.  Computing power gets better all the time and sources (like S&P) and quality of data are also improving- leading to more sophisticated approaches such as APT (Arbitrage Pricing Theory).  However, the single factor CAPM is still the most widely used model in practice for estimating costs of equity for business valuations, because this model incorporates the underlying concepts of diversification and expectations of higher returns for higher risk.

David Spieler: Standard and Poors
Spieler: Regardless of the approach we employ in calculating a cost of equity capital, we look at industry risk, country risk and company-specific risk.  Computing power gets better all the time and sources (like S&P) and quality of data are also improving- leading to more sophisticated approaches such as APT (Arbitrage Pricing Theory).

FEN: How about that other basic determinant of company value- the degree to which and time span over which intellectual property will permit returns in excess of a company’s cost of capital?

Spieler: We sometimes find that management starting up a new company, or management of established companies starting up a new business unit frequently underestimate the significance of clearly identifying, valuing and protecting the intellectual property that provides a competitive advantage.  In other words, if you have something that could be patented, get it patented- even if you are not sure that the patent application will be accepted- before you run out and begin talking to potential partners or customers about it.  Because, once you’ve disclosed or discussed it, you run two risks: First, someone else will take the idea, run with it and potentially patent it before you; and second, your discussions are later viewed legally as a public disclosure that voids any claims you might have to such intellectual property.

FEN: But don’t you think that most high tech firms understand this?

Spieler: In traditional high tech, where there are engineers and scientists working on new manufacturing processes or products that may be proprietary, you’re right.  However, the scope of high tech today- in terms of what can be patented- goes beyond that traditional definition.  In fact, there’s a recent example that goes to the heart of your publication’s title: Financial Engineering.  You may be aware that since a landmark legal decision a few years ago, business processes can now be patented.  In this precendent setting case, a financial institution was able to successfully patent and defend its rights to a mathematical algorithm which is used to allocate funds.

FEN: Okay, let’s change subjects again.  You two have dedicated your careers to real world problems in corporate finance and valuation.  What’s your advice to young people who also want to follow this career path?

Spieler: There are some specific things that are critical:  First, most of the senior professionals here in the Boston office of S&P CVC as well as many others across the country are Chartered Financial Analysts (CFA’s).   Over a period of years, we’ve found that those who are willing to study, understand and commit to the body of knowledge in this program are very well qualified to work in the area of corporate valuations.  Beyond the CFA, we look for people who have industry experience and technical backgrounds as well as fundamental valuation analysis skills. We’ve found that the day is gone when a generalist in corporate finance can excel, especially in high tech industries such as life sciences or software.  So, people who come to us with the added education and experience in specific scientific and engineering fields are able to leverage these technical skills in the valuation process.

FEN: You’ve emphasized the Chartered Financial Analyst accreditation program as very important, but what about some of the other financial and risk accreditation programs that are out there?

Cody: People with an ASA accreditation (Accredited Senior Appraiser) are also very valuable in corporate valuation work.  In addition, we also employ CPA’s in our practice because of the critical linkage that exists between cash flow and important accounting considerations such as how the structuring of a deal affects tax considerations.  The final consideration that I think is important to being successful in corporate valuations is the need to be bound by a strong code of ethics and professional standards.  Our clients really emphasize this when we are approached by them with a need to undertake a valuation analysis for them.  The desire of clients for someone bound by a recognized set of ethical standards- such as you’ll find in the CFA program and ASA accreditation- is self-explanatory.  On the topic of professional standards, our clients tell us they want an underlying degree of standardization in the scope and approach of how the valuation analyst will approach the task.  In other words, will the analyst go through a comprehensive and adequate set of procedures encompassing not just a cash flow model, but also considering aspects such as strategic and competitive factors, risk analysis, accounting policy and requirements, even a consideration of the quality of management, in arriving at their final valuation analysis.  We are asked this continually by prospective clients.

FEN: Fundamental financial valuation, the kind you’ve described during this interview, really fell out of favor in the late 1990’s.  In hindsight, we lived through the inflation and subsequent deflation of an equity asset pricing “bubble”.  What are your views on this?

Cody: A lot of relatively new companies went public whose business models and limited operating history made them opaque to investors. As for the bubble: The number of inexperienced companies who went public quickly increased during the late 1990’s due to the amount of liquidity available in the market at the time.  Our practice technical director, Tim Luehrman, thinks that in a situation like that, there’s almost as much information content in what other investors are doing as in what these companies disclose- which given their short time in existence, didn’t provide a lot of history against which to judge future expectations.  In addition, since many of these companies were based on an entirely new business model leveraging a revolutionary technology called the internet, there were no immediate precedents or direct comparisons to make when evaluating their market growth and profitability claims.  At one point, people felt that stocks were no longer risky:  So, back in the bubble, one thing that really concerned us was the value being assigned to goodwill.  Now there are clearly instances where goodwill is very valuable such as Coca Cola and Nike In this sense, goodwill is the expectation that your customer base will remain loyal to your products and services. The goodwill of companies that had only been in existence for one or two years, having just begun commercial activities, should be judged against the quality, quantity and loyalty of their customer base.

FEN: But what about the huge number of companies that adopted aggressive stock or stock option incentive plans?  Do you think this was also a part of the speculative bubble companies that resulted, especially in terms of some of the financial and accounting abuses that have subsequently come to light in the last 18 months?

Cody: Investors should be able to see the a company’s financial results with and without expensing of options.  And, we need to think through the robustness of the solutions to these accounting related governance issues such as, expensing options.  There are many ways to value stock option and these solutions need to work both when times are good and bad.

FEN: So, being managing directors of a corporate valuation consulting practice owned by Standard & Poor’s, what would you say if you had the opportunity to get up in front of a meeting of the CEO’s and CFO’s of the S&P 500 regarding shareholder value creation, corporate valuation and how they can do a better job?

Cody: We’d say ‘Look at your business portfolio continually and, make sure that positioning of your company’s strengths against market opportunities is aligned with organizational operating and investment decisions. And particularly, make sure consistent with competitive considerations, that investors understand your business portfolio strategy and how it is aligned with your decision making to realize value.  And finally, establish the incentives, controls, culture and direction to achieve long-term returns on capital with each of your businesses that will exceed what investors expect for these businesses.  We certainly would not advocate buying and selling businesses one year to the next on the basis of short term fluctuations in value.  However, if you’re in a business where investors expected a 13% return on capital in and you’ve been unable to realize much beyond a 9-10% return, you should be willing to exit this business.   If they do this, and the rationale is fully understood by investors, you should be fairly valued by the market.

Spieler: I agree with Alan completely. But one additional point on the subject of sustainable shareholder value: Those companies that have been able to deliver consistent stock price increases year after year, not withstanding the last 24 months, are those that have put in place- among other things- a simplified organizational structure with clearly defined roles and reporting relationships. Also key is that senior management has clearly communicated the company’s business model for creating value including, how management and employees will be rewarded and measured on their performance.  Now that may sound like a set of “motherhood” statements that most people would react to and say “Of course”.  But, the additional requirement for success in our eyes is that these factors need to be combined with an engaging, exciting work environment to motivate the entire management team. We consistently find that people work best when focused on, say, 2 or 3 key goals that aren’t in conflict, and for which they are given the resources and support to achieve, rather than giving 15 goals that contain some inherent conflicts and told to achieve all of them or else.

FEN: This sounds a lot like the Balanced Scorecard Approach to running a company.

Cody: It is, but we’ve observed situations where companies, with an eye towards enhancing shareholder value, have embraced the Balanced Scorecard approach without also applying the KIS principle I just mentioned.  In these cases, all this does is codify a very complex and often conflicting measurement and reward system.  From our perspective as corporation valuation experts, this situation would be a significant negative in our valuation work.  On the other hand, a company with a logical Balanced Scorecard approach with simple and specific goals for every level of management, and also reflecting our earlier advice in your last question, would be viewed positively as we moved from our qualitative analysis to translating these results into a quantitative financial analysis.

FEN: Unfortunately, we’ve got to end this interview. Your closing thoughts to the readers of Financial Engineering News?

Cody: All of what we’ve discussed today adds up to this: The analytical techniques we work with in valuing companies- whether they be based on traditional DCF analysis, Market and Economic Value-Added, Real Options analysis and so on- are simply the language of value creation.  But fundamentally, value is created by good management.

Spieler: Working with a diversity of company managements is what makes this job exciting: We have to go in- sometimes like detectives- and use numerous tests, models, tools, approaches and perspectives that help us quantify the economic value that management claims it is able to create.  And, a big part of this process is qualitative and judgmental- based on our experience- so that we can properly incorporate the opportunities as well as risk factors into an overall conclusion of business value.

For further information about S&P's Corporate Valuation Consulting practice, visit or e-mail Davd Spieler ( ) or Alan Cody ( )

From the November/December 2002 issue of Financial Engineering News. For the rest of that issue see

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