What Investors Want: Four basic points that we can learn from this article and the examples
the guiding principles of investment decision making are:
1- more benefits, in the form of profits or cash flow, are preferred to less
2- near-term benefits are preferred to more distant benefits
3- safe investments are preferred to risky ones
Although it’s easy to fall into the trap that somehow the basic principles of investment are different in start-up ventures than in large, mature companies, these principles apply to all investments, in all markets, and for all investors. according to the stage of a firm’s development as well as other factors.
When someone invests capital in a business, any business, that investment invariably takes the form of cash or at least something that is convertible into cash. To illustrate, suppose a company’s share price is $50, and that a particular investor owns 1,000 shares. By phoning his (or her) stockbroker, the investor could convert those shares into $50,000 of cash. Why doesn’t he? The logical answer is that he believes, rightly or wrongly, that by holding on to the shares he will receive cash from the investment in the future that has a present value equivalent greater than $50,000. If he didn’t believe this, the only logical course of action would be to bail out of the company and put the cash somewhere else.
This simple example points out several important lessons about capital markets and how customers in capital markets (i.e., investors) go about the business of deciding where to invest their resources. First, it shows that the value of any investment is based on the future and not the past. If investors have cash tied up in the company today, which must be true because their investments can be converted into cash in the present simply by issuing sell orders to their brokers, they do so because of expectations that they will receive more cash in the future by hanging on to their shares. The past still matters because it helps investors to form expectations of the future, but ultimately it is only expectations of the future and not realizations of the past that determine the value of any company.
The second key lesson is that value is based on capital market expectations of performance. The practical consequence of this lesson is that value is driven by the beliefs of investors and potential investors. A company can be blessed with the world’s best managers and value-creating strategies, but unless the capital markets believe it there is no value creation. When it comes to valuation, if the capital markets don’t believe it, it’s not true. This fundamental reality points out the central role of communications in affecting market perceptions of value and risk.
Third, because investors tie up cash in the present, it is the prospect of getting even more cash in the future that gives companies any value at all in the capital markets. This is why finance professionals place so much emphasis on cash flows. Companies have value precisely because they can deliver cash flows to investors in the future. Those companies that are not perceived as having that ability are unable to raise capital.
More specifically, the cash flow investors care about is called “free cash flow.” It’s normally defined as a company’s operating cash flows (i.e., the cash generated from its day-to-day business activities), net of whatever investment is required to sustain and grow these cash flows. The remainder, or free cash flow, represents the amount of cash that the company will then be able to give to its shareholders, bankers, and bondholders. In other words, it is the cash flow left over, after investment, for distribution to capital providers. Because capital providers invest in companies precisely because of the prospect of future cash rewards, and free cash flow represents the cash the company will be able to give back, the value of any business must be a function of its perceived ability to generate free cash flows in the future. This does not mean that free cash flows have to be positive this year, or even next, for a company to have value now. It only means that investors must believe in the company’s ability to generate positive free cash flows in the future. If investors do not believe this is possible, to them the company has no value now.
The fourth, and final lesson this example teaches us is that because any cash flows that a company might provide its investors will appear in the future, all such cash flows must be discounted. The discounting process, which reflects both the time value of money and the risk that the expected cash flows might not materialize, allows investors to convert a stream of expected benefits (to be received at different points in the future) into a common point of reference called the present value equivalent. In short, future free cash flows are discounted by a cost of capital, or interest rate, which reflects the rate of return that investors would expect if they invested in another company of similar risk.
While the basic aim of investing is the same for any investor, namely the highest risk-adjusted returns on capital, the cast of characters changes dramatically as companies make the transition from private to public ownership. Logically, therefore, publicly traded companies market themselves differently than start-ups or growth companies that have not yet gone public. For example, the market for venture capital or angel investing is of little or no interest to Cola-Cola or Intel. Instead, their sales efforts in the capital markets are targeted mainly at large institutional investors in the mutual fund, pension fund, and insurance industries.
While the dominant motive for investing is the desire to earn competitive returns, there can be other motives, too. For example, some investors in the start-up or early-stage investments are attracted by the opportunity to play a role in the entrepreneurial process. They may have been successful entrepreneurs themselves, and welcome the chance to play that role again. The free time and financial security provided by earlier successes give them the means to do this. Altruism can play a part, too, especially for investors who want to “give something back” to their local communities or hometowns. They may hope to stimulate investment or entrepreneurial activity in the region by offering capital and expertise to budding entrepreneurs. But while these motives can sometimes play a role in the allocation of capital, their importance is overwhelmed by the desire of capital providers to earn the highest risk-adjusted returns possible on their capital.
Although the world’s capital markets are bigger than ever, the competition for capital has never been greater than it is now. With so many businesses competing for this capital, the process of raising capital has become as much of a marketing function as a finance function. Logically, therefore, the key elements of marketing come into play. For example, “know your market.” This means understanding who your best prospective investors (buyers) are, what they want to know, and what sort of investment opportunities they look for. Trying to sell a security to the wrong prospective buyer is expensive and wasteful, particularly when the range of tastes for securities covers virtually every kind of company and every kind of industry.
Another tent of marketing is to “know your product.” This means knowing every aspect of what your business has to offer investors. What can you offer them, in terms of risk-adjusted returns, that other investment opportunities cannot? In order to compete successfully for capital, any company must be prepared to demonstrate—clearly, forcefully, and honestly—those factors about itself that indicate why it would be such a good investment. Another tenet of marketing is to “know how to communicate effectively.” One of the authors attended an investor forum where would-be entrepreneurs had 10 minutes each to explain their business concepts and risk-return prospects. Half of the presentations were so poorly done that they didn’t stand a chance, however good their business concept might have been. Today, managers talk about creating a value proposition for their customers. They must do likewise for their capital providers. In short, they must convince investors that their business offers a superior risk-return profile (i.e., a superior value proposition) to alternative investment opportunities (i.e., competitors).
Source: (ATTRACTING INVESTORS) BY Philip Kotler, Hermawan Karyajaya, S.David Young
