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Why Do Smaller Companies Receive Higher Valuations for New Initiatives?


In this episode, Steve Strongin of Goldman Sachs Research discusses a new report from Goldman Sachs' Global Markets Institute, titled "What the Market Pays For." One of the main findings is that equity investors tend to pay for persistence or what is sometimes called "visibility." Strongin also discusses why large corporations often feel that they aren't rewarded for innovation the way small firms are. The reason for this, Strongin explains, is how the market perceives the "deep pocket risk" involved. Investors worry that large firms may overspend on failing projects because they have the resources to do so. Smaller companies, however, don't have as much money to be able to do the same. Strongin also discusses how corporate reporting can be managed to improve firms' valuations.

This podcast was recorded on May 1, 2019..

All price references and market forecasts correspond to the date of this recording. This podcast should not be copied, distributed, published or reproduced, in whole or in part. The information contained in this podcast does not constitute research or a recommendation from any Goldman Sachs entity to the listener. Neither Goldman Sachs nor any of its affiliates makes any representation or warranty, as to the accuracy or completeness of the statements or any information contained in this podcast and any liability therefor (including in respect of direct, indirect or consequential loss or damage) is expressly disclaimed. The views expressed in this podcast are not necessarily those of Goldman Sachs, and Goldman Sachs is not providing any financial, economic, legal, accounting or tax advice or recommendations in this podcast. In addition, the receipt of this podcast by any listener is not to be taken as constituting the giving of investment advice by Goldman Sachs to that listener, nor to constitute such person a client of any Goldman Sachs entity.

Copyright 2019 Goldman Sachs & Co. LLC. All rights reserved.

This is an unofficial transcript meant for reference. Accuracy is not guaranteed.
This year's exchanges of Goldman Sachs really discuss developments, curly shaping markets industries in the global economy objects you global head of corporate communications here, the firm, the firm. global markets Institute or GM, I recall, is out with a new report called what the market pays for for this episode were specifically focusing on one of the report's central questions. Why do. smaller companies receive higher valuations for new initiatives than more mature companies top us answer. That question were joined by destroying head of Goldman Sachs researchers. An author of the report, Steve welcome back to the problem always great to be here so little context to begin with. Perhaps the key finding of your report is maybe not totally surprising, but the mark rewards companies for consistency and partial them for surprises explained that dynamic attitude.
We looked at how companies row by the market using a different methodology than typically c and finance one from consumer theory we is the same Matthews to figure out what a new kitchen is worth a house or what leg room is worth on an airplane to understand what investors or pain for when they buy a cup And when you do that, what you find is they largely pay for persistence and forecast ability or what investors usually call visibility and what comes down to. Is you look at the drivers of earnings and the drivers of growth, and you look and to see whether, if today's growth forecast tomorrow's, if that's true, you'll pay for if today, doesn't really tell you anything about tomorrow, you're not gonna, pay a lot for it and that's the really core of how the market looks at companies odyssey. There's some downsides t that focus on predictability and persistence, one common them
just makes management focused on short term, predictable, and miss long term opportunities. It might require deeper investment. There's a cent with that statement is really true years attended see to want to take the newly stream. If you want over the moon shot because the vessels are not interested in moon or if they are interested in Manhattan, they would like to by them on a narrow basis in ones they specifically like managements, key early with love a chance to run their own portfolio of moon. The most famous example of this is how good became alphabet. We had heard them trot over here and kept the core business there, and I made it a lot easier for investors to understand the core business and also. I think this is the part that under appreciated it meant that the investors now had visibility on both how big and what the moon shots
were so they could make a much better decision in a more informed decision about how much they were by you may have coined the phrase. I'd never see him for hope stocks you talk about a fast growing, for instance company with a very singular focus? So, let's hear biotech firm with a single drug that hasn't yet passing clinical trials. I've seen a company like that. There's a lot of upside of things work out, but the financials are predictable at all, but the market comfortable pudding high valuation on those kinds of stock, so Why is the market so enthusiastic about hope stocks while focus on predictability for the more mature companies? There are two parts of the answer. The first is that those hopes stocks are predictable, but very specific sense they take on a very narrow risk. You know what that risk is and if you're right that stock does really well, So there is visibility, but it's not his ability into the company's consistency, but about of a company,
we'll do. If what you expect to happen happens, and so you'll see. this in quality oil stocks were of the oil price goes up, they'll do great. You see it in a pharmaceutical start up where we know the drug is, we know what is being tested for and if it tests out well all we know the size of the disease, so in a risk, since these are very predictable stocks, but it's not the same kind of prediction. The second aspect to it, which I think is a part that really is misunderstood- is that when you're valuing hope it's the way, market looks a downside. There is no question if anyone has her sad through any investment presentation. Ever the people, like dwelling on the upside, you could do so Google search of downside presentations and, if you guys, anything on a less. There would be a shortlist it's an early enough looking statement, the downside risks
its read by the head of invest relations at the beginning, the call, but from an investment standpoint. The real key is that those stocks have less downside than their bigger brethren we call this deep pockets risk, but it really is that the narrow biotech company has so much money canoes summer, for only so much it can lose presumably spending all its money. On that one thing thing right: that sort of easy to assess. Various romanian afterdeck, but assess, says and very limited Where is that? same effort was put aside a larger company. If you ever didn't, we you might spend the money again and that didn't work you might. Spend it again and worse, if it goes really badly, you might get sued
and have somebody else, decide how much money you're gonna spend so that when you do the actual math of the calculations, typically those jobs are worth a little bit more inside the big company than they are in the little company. If everything works out by, if things go badly The downside in the whole company is small. Where the downside a company is enormous. You talk, but how the hope stocks are price like options. I really like that part of the report. plan in Layman's terms. What that means in why it's important to think about the pricing of hope, sock. Sure I met to discuss two ways giving both help people understand. The first is the pure options way there more leverage to the view you have to put up less money and option. You still have the same exposure to the top and therefore you get more exposure for less money. So from one investment standpoint, that's it.
Radiance similar, you buy an optional sack same way by an option on the second which, from an economic stamp. Is actually more important, is much like the option. Again it controls the downside. Is there when things go wrong, you have a very fixed size of loss. We inside of a big company, the loss can grow and grow and grow, and so one less money to get more exposure the outside. But more importantly, you don't have the same exposure to the down and so like an option. What happens to the prices as these businesses mature and become more predictable, but to converge. And very often, which will see, then, is the hope will get bought by a big company goes in France. If you look at the pharmaceutical industry, the typical
it is you do the development of the dragon technology holding companies that are fairly complex institutions. Then, once you have the drug, you spin it into a specialty pharmaceutical biotech company, that's very by structured, like an option and that, if its success fallen works. A big pharmaceutical companies by it and put it in the portfolio is a predictable truck. He's got approval is an annuity, that's right, and so you see this notion of the restructured determining who should and why, throughout the life span of the drug I've seen this dynamic frustrates alot of big mature companies who feel like these cashed start, ups get a free pass essentially from investor. And they're doing all you need things and innovative things. A house that are completely discounted by the market you mentioned. The phrase talk a bit more about deep pocket risk and what you mean there and then why why you busy should? Why is just a fact of life? This is one of those aspects of human nature, you're doing this project, because you
you, love the outside. You want to talk about the outside. Your excited about the problem is from the market standpoint, which you ve, really communicated, is working to keep spending on this project until it works, And so you think your explaining the upside, which are actually do It is committed to the downside. and the more you talk up that outside the more the market hears we're gonna keep spending, and so you're very counter productive dialogue develop where the company thinks the market didn't understand after explained this better and then explain more and they actually get hurt. So when you think about it, a startup landscape, the fast growing private beneath the Deca. A corns, unlike they often have multiple funding rounds, rather raising all their money at once is that in parts of their ability to spend is entirely limited, and so investor have less exposure to downside risks exactly or more
precisely they get to volunteer for each bit of additional expenditure, so we're gonna give you the money for the first trial, but no more, When we see the results of the first trial will too side whether we want to participate in the second trial, where, if I give you the round for both trials up front than the management's decided and so that ability for the investor to decide is something the investor is willing to pay. for so what are the implications for large companies that want to an innovative riskier projects. Should they spend those projects off, as you ve said or presidium stand alone basis or go ahead and develop the main house is part of a larger firm and then to try to get the value later. There's a couple of asked that depend on the circumstance. If it is important and has tremendous synergies with their existing operations, they certainly should
this isn't an argument about that. It is an argument that remark: it's not going to stand up and applaud and pay them forward until it works. It's just that you have to understand that the market is that interested in pain you in advance. Now, if it's a project that can easily stand on its own. then I think it raises some real questions about whether you want to keep it in house or sell it, because the capital costs may be cheaper if it's done spanned alone, it's easier to control the costs, if its Dunstan, alone, then it's easier to get immediate valuation. If it's done standalone against. That is the synergies you can potentially get inside you, trade. Those too often make rational economic We we seen different answers, indifferent industries and pharmaceuticals, where the risk of very high that awakened are very high and that ability to control downside is very important. We typically see these things spotted reforms, on the other hand, it software, where the
synergies are typically pretty high and dry. I'd risk. Isn't that great we keep it, we see them stay inside and both those decisions, makes sense, as a general case, each investment. Has its own dynamic and has to be viewed separately, but is We always that question of synergies against cost control and risk where the higher the cost control issues and the risk the more likely or to spin the higher the synergies. The more like you are to want to keep. So what can be a complex companies due to reduce de pocket penalties and improved visibility for investors into their main biz? what's there to fix. The first is in terms of getting full credit for your own. Businesses is structured reporting so that people can see it. and there is clean, a line as possible, one of short term long term issues that you alluded to the beginning, a sort of non recurring items in their various forms. The more you are primary businesses reported without now
nor occurring items, Vizier for the market to forecast the outcomes, The more you throw junk in the harder it will be for the market, so cleaning up there reading and making it easier. We'll get you a higher value in terms of the investment projects. The answer is also visibility, but a slightly different kind. Instead of repeating the good side endlessly spent some time on, creating visibility so that the market can see what you're spending. So they understand the downside, I understand the downside end its more limited, because if they can't see what you're spending that, in theory, you could just keep spending forever where if they can see what your spending they get a chance to complain, you have actually explain why you're spending just and high at all That creates more discipline. That's credible! So again, visibility is a good part of the answer, as you suggested talking too much about the great ideas and innovation will. Actually.
their evaluation. What can they do to communicate possibilities without bringing on DE pocket penalty. I think various sort of balance in the statements explain the outside But also explain the uncertainties, and where you're gonna cut it off of it doesn't work. Every project has a potential failure. It there are things that will cause. You should cause you to stop. If the market understands that, you understand that their much less likely to invent horror scenarios to put in place of that process, you what happens when the market thinks that the department risk is greater than management, does and invest, you pessimistic that management will know when to do that, cut their losses and get out you get a short term dynamic which is violations fall. They can press that creates a big deal Sometimes that ends the way it did in Google, where we started where the company changes,
reporting and makes it easier for the market. Sometimes it hence up having to wait until you find out the answer. The project succeeds. Everybody makes nice and the company gets the value from the project or the project fails and eventually the when he cuts are losses and then Everybody agrees again. There's no. dynamic or conversation, that's gonna get everybody on the same page, while the uncertainty is there, so the best way of fixing maddest simply resolve the uncertainty. It's a really interesting topic, especially when you think about where the market is today. Private companies and public companies and how they trade, had you decide to research this topic in the first place, at heart. This is a constant debate. The inability of large companies to get there just rewards. is probably one of the most frequent refrains you here for management, so try to make it really clear. Why that's the case? The second thing,
And you also see this in the newspapers alive- is managements complaining that markets are too short term markets are not short term, markets wide visibility and they want persistence. It's not that they want short term the numbers they just want to know that you can do that. Every quarter, that's right, ad infinitum! At some level we analyse just wants to be right when they do their forecasts and if the right you're gonna get paid for it, so What surprised you most from do all this analysis. I like to think surprise this most. The first was the surgeon, underline genius of the market, and what I mean by that is that when we teach corporate fires- and I remember teaching it more years ago- then I want to think about. We talk about forecasting earnings discounting by risk so fairly complicated process with lots of numbers that are sort of hidden, but the ideas,
risk against reward. When you actually look with a market does this is a very simple but incredibly effective way of accomplishing that that somewhat different than we explain it we're going to look at what drives earnings we're going to look at how persistent that is a forecast of all how long it's going to last, and that tells us how much to pay that's exactly the logic that goes behind classic corporate finance, but it's a much simpler and more efficient way of putting it into practice. Realizing the market was that much smarter than we. Then, when we design the methods, I think we were surprised by it simple. It was, I think. The second thing that surprised us was the actual answers to that question. So the most class Can you see on CNBC when you listen to them talk about areas report, beat on earnings son revenue? The stock went out well. This explains
a very simple way: revenues generally very persistent margin, typically isn't, and so the market pays more further revenues. They miss then the margin where they beat and as a result, you get a net loss now right. Next to that is leverage which is basically how much debt equity the company has and that's, always had in the market place a kind of negative image. On the other hand, it's very persistent balance sheets by their very nature, don't change very often so it turns out. The market pays a lot for a leverage and the return on equity from leverage which is sort of counter intuitive. The way we often talk about companies but makes absolute perfect sense when you actually with the numbers this report's out clients are reading. What kind of questions you getting lots of interesting questions. I think the big one is clear,
come explained to our seo the part about how talking too much about a project lowers the value. I think it's is a difficult thing when a c o is excited about a new project to get them to talk a little less on it. Even if it's making the market nervous, I think the second thing is trying to understand what this implies about, how the company should be right, and this paper really doesn't talk about that. core. The right way to run a company is to make the most profits the highest returns over the longest time, that in the end will create the most value for shareholders with papers. About is how to get the market to pay the most today. both for what you're doing now and what you're gonna do tomorrow, which is a very different question and how you should run the company. Let's bring it back to the central core Jim, the episode in a minute or less, why do smaller companies receive higher valuations for new initiatives to fix they automatic
less downside risk, as they have less money to spend and big companies over commit and those projects, and it makes the market affrightened. Thank you stay for joining us today. Great to be here, That concludes this episode of exchanges. The common sacks thanks for lists and we hope you join us again next, on the spot, ass was recorded on May, first, two thousand nineteen, all price references and market forecasts correspond to the date of this recording. This podcast should not be copied, distributed, published or reproduced in whole or in part. The information contained in this package does not constitute research we're a recommendation from any Goldman Sachs Entity to the listener, neither Goldman Sachs nor any of its affiliates makes any representation or warranty as to the accuracy or completeness of the statements or any information contained in this podcast and any law
ability, therefore, including in respect of direct indirect or consequential loss or damage, is expressly disclaimed. The views expressed in this pod, castor, not necessarily those of Goldman Sachs and Goldman Sachs, is not providing any financial, economic, legal, accounting or tax advice or recommendations in this podcast. In addition, the receipt of this podcast by any listener is not to be taken as constituting the giving of investment advice by Goldman Sachs too. That listener, nor to constitute such person a client of any Goldman Sachs Entity
Transcript generated on 2021-09-19.