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Firm Investment Theory – An Outline

“Firm Investment and Its Impact on the Bottom Line,” by Edward Czarnet, William K. Packer, and Kenneth S. Rogoff, is an excellent study. The book presents extensive evidence from a major representative sample of financial intermediaries to demonstrate the direct impact of firm investment on firm performance relative to other forms of investment. Financial leverage is highly and negatively correlated with firm growth. When a firm expands capacity through leveraged purchases or secures credit through derivatives, it raises both the firm’s fixed and variable costs and lowers productivity.

Firm Investment

The book maintains that one cause of misvaluation-induced cost reduction is an imperfect specification of value. To test this hypothesis, firms should measure external value using a standard set. Alternatively, they should use a pricing tool based on imperfect specifications of value that would not typically be employed by publicly traded companies. Finally, the book examines alternative ways of measuring the values that are consistent with widely used techniques for identifying and measuring value such as the discounted value of a firm portfolio. The primary result is that we do not have a reliable method for accurately determining the value of firm investments.

Probably, the most fundamental piece of the analysis in the later chapters concerns expectations of investors about liquidity. According to the hypothesis, investors expect that publicly traded securities will eventually become less liquid due to over-regulation and because of the high degree of financial risk associated with their issuance. In particular, the hypothesis predicts that misvaluation will reduce liquidity. Because we do not know how investors will evaluate new issues once they become public, we cannot assess how this will affect the total market cap or earnings per share (EPS). However, I find that the estimates in Table 2 justify the conclusion that financial markets are likely to become less liquid.

Another important aspect of the book is its treatment of value investing. Value investing is an investment style that has been adopted by several prominent investors including Warren Buffett. Value investing does not typically involve a complete reinvestment of existing profits but instead concentrates on using newly realized gains to generate small additional returns. The book maintains that because newly realized gains are not liquidated immediately, they tend to be considered worthy by market participants.

The major focus of the book is on identifying undervalued companies. Specifically, the focus is on identifying firms whose assets are underpriced relative to their productive capacity. Using financial data to analyze and select companies is used to establish a “good” value and to estimate the present value of the firm’s stock price. This process is then applied to selected other financial market sectors and industries, including energy, fixed income, industrials, technology, real estate, utilities, and financial instruments.

Another useful part of the book is its treatment of value investing. The book uses a framework based on multiple valuation measures to identify potentially worthy investments. This framework can be applied to any market sector or industry and even to individual firms. The approach establishes that there are certain characteristics of firms that lead them to be undervalued and these characteristics lead them to be overvalued. These are discussed in detail and include the nature of the firm (core versus peripheral), industry characteristics, management factors, financial factors, overall financial strength, and the company’s competition.