To conclude our short series on small-cap selling discipline, today's article will deal with how the issue of valuation can be factored into the final decision to sell a stock. In last week's column on using a business' returns as a selling discipline, the fall of 3dfx Interactive (Nasdaq: TDFX) provided a handy real-life example. We'll again turn to the real world to illustrate a valuation-based selling discipline, using the recent purchase of Wisconsin-based local exchange carrier Chorus Communications Group by wireless and local service provider Telephone and Data Systems (AMEX: TDS) as the primary example.
As with many business developments in the small-cap world, TDS' purchase of Chorus went largely unnoticed by the mainstream business press when it was announced in late November. In fact, I would have overlooked the deal myself if it hadn't been for two things. First, TDS is a company I keep a casual eye on after becoming familiar with it after its big share price run-up in 1999. But more importantly, news of the Chorus buyout stuck out like a yuppie at a Willie Nelson concert to me because of the purchase price, or valuation, that was involved.
Under the deal, TDS agreed to acquire Chorus for $195 million, which excludes $31 million in debt that will also be assumed. That $195 million price tag works out to $36.28 per share for a company whose shares were changing hands at only $16 per share the day before the buyout announcement. Similarly large take-out premiums crop up from time to time in the stock market, but they never fail to impress me as an indication of how a private buyer can see value in a company even when the market doesn't.
From Chorus' side of things, the decision to sell the company to TDS probably wasn't that tough of a call based on the offered price alone. At more than twice the price investors in the secondary market were willing to pay, it would have been hard for management to turn down the takeover and still claim that they were acting in the best interests of the company's shareholders. Management almost had to bite at such a large premium, especially coming from an established and well-regarded buyer like TDS.
Investors in fast-growing, small-cap companies often face choices similar to the one that confronted Chorus. The big difference, though, is that the market tends to play the occasional role of the buyer offering a big premium, rather than an outside buyer. There are certain times when as an investor you also have to "bite" at the price being offered by the market. Mirroring the thought process of Chorus' management, passing up a substantial premium for your company can indicate that you are not acting in the best interests of your own personal wealth.
Lots of rules of thumb on selling have been created over the years to ease the burden of selling and help investors correctly "time" their sales. Most of these rules involve setting a price target of some kind to act as a signal to hit the sell button and eject a stock from your portfolio. Once a stock goes up 50%, sell it. Or if it goes up 100% in price, sell it. Or if the current price equals the square root of your birth year plus 10, sell it. (I made that last rule up, but you get the idea.)
The problem with such price-centric guidelines is that they are arbitrary and only take into consideration what the market is telling you and not what the business is telling you. Investors should respect the market and listen to it, but they should also pay attention to what is going on at the business level. Paying proper attention to a business means getting to know a business well and understanding what it may be worth based on the free cash flows it can be expected to generate in the future.
Valuation, then, is little more than comparing your expectations for the business to the price being offered by the market at any given time. It is a fluid exercise rather than something you do just once, since your future expectations and the market's offering price are always changing. Common yardsticks such as price-to-sales and price-to-earnings ratios can be used as valuation shortcuts to a certain extent, but they should be treated as just that -- shortcuts. There are no substitutes for knowing a company and developing expectations about the future based on that knowledge.
With that knowledge in hand, your own valuation of the business becomes an effective selling discipline. In the case of Chorus, it's not unreasonable to assume that the company's management had a pretty good idea what the company was worth and what a fair valuation would be. Determining from the sidelines whether TDS overpaid, underpaid, or was just right with its valuation of Chorus would take time and effort to figure out, as well as a familiarity with the company that I frankly do not have. But that's not the point. Let's imagine that the company's managers believed that the pre-bid market price of $16 per share was a fair valuation. What happens then? If that was the case, then it was a no-brainer to take advantage of a buyer offering 125% of that valuation.
Small-cap investors can take the same approach with their own investments. The first step is to understand the business well enough to make a reasonable estimation of what it is worth, and to adjust that estimate over time. Then, the times when the market is offering a price well in excess of that valuation can be seen for what they are -- opportunities to sell. This is how valuation can be used as the basis for a selling decision.
Again, valuation starts with knowing your company and setting expectations about its future free cash flows. We'll delve into those related issues in future columns.
