On valuation, dilution and market capitalization

[Poster wanted to know what effect market cap and dilution had on CPTC, and claimed he needed to be "unedumicated"]

Inquiring poster - Better to be "unedumicated" than to be "misundereducated". What it means is that the market capitalization, that is the total value of the company based upon the share price, is very high, for example CTC would have a fully diluted market cap of a half billion bucks at $2 per share. What does that mean?

Let's first look at return on investment of a company's stock without regard to market pricing. If I decided I was going to invest in an ongoing privately held corporation or enterprise, I would probably expect to get two or three times conservative investment (mutual funds,time deposits, etc.) market returns on my money for the added but still minimal risk. So, if I expected the company to earn me dividends or profit distributions of 10% on my investment, and the company had a net profit after taxes of 10% of sales, I would expect every dollar I invested to be represented by a dollar or more in sales of product. Assuming the company becomes increasingly successful and doubles sales and/or profits after my investment, the valuation of the investment becomes greater in proportion because it is earning a higher return, so subsequent investments can command a higher price.

But that depends upon whether subsequent investments are in the marketplace or to raise capital. As to market activity, if the company was now paying out twice the dividends and I were to sell my appreciated stake to you, I could get double what I paid, yet your investment would still give you the 10% return I was originally getting, and down the road you could possibly do the same to another as I did to you, and everybody does fine as long as the company does... or as long as the market THINKS it is doing well, or the shareholders think they are doing well regardless the fortunes of the company, for that matter.

On the other hand, if you were to buy newly issued or treasury stock from the company instead of my stock from me, the proceeds from the sale would become working capital and the total outstanding shares upon which dividends are paid would increase, meaning that my percentage of the total profit distributions would be reduced, which reduces the rate of return on my investment and thus it's market value. But it's not that simple because if the company sold you the stock so it could put the capital to work expanding sales or developing new products for future sales, I may simply be getting a smaller percentage of a much bigger pie and I am not going to care, in fact I would likely encourage it.

So, it is important that when a company dilutes it's shareholders to raise capital or pay for "services rendered" that it does so in a manner that keeps the earnings rising faster than the rate of dilution so the shareholders enjoy either a favorable dilution-adjusted return or increased market (resale) valuation of their stake. The relative balance between the two, both combined representing the overall return on investment over time, will appeal to different classes of investor according to their investment goals, the most common two being retirees looking for dividend returns and youngsters in the work force looking for growth.

Now, how does this all relate to your investment in CTC? Well, CTC over the past year has roughly diluted a long stake-holder's interest by about a third, from 160 million shares to 240+ million shares, which means that if the company HAD been earning a profit your share of the distributions would have dropped by a third, meaning the return on your investment in the earlier example would now be 6.6% instead of 10% if all things were stagnant, and a buyer looking for a 10% ROI would only be willing to pay you 66% of your original price for your stock.

Of that dilution, roughly a quarter was for financing to keep the lights on last year and another quarter is keeping them on this year, BUT half of that dilution is represented by the EU merger deal which is capitalization toward increasing sales and hopefully profits as well. Capitalizing to sustain continuing losses in a going concern is a vicious downward spiral... the more you dilute to raise money the lower the valuation and the more you have to dilute to raise even less money. That's a toilet in operation.

But diluting for the EU merger, that's a different matter altogether. Now, if I were heading an investment group or VP business development for a large company and I were looking at EU last year as the wind market was picking up steam, I would probably have valued that package right around the forty million bucks CTC did, perhaps half that in a cash deal; They had an installed base of users, they had existing products and know-how, and they had operating losses of a couple million that could be sustained for a couple years if necessary, and a need for another fifty to hundred million or so to execute a two or three year business plan to get to several hundred million in sales. So, for a hundred to hundred-fifty million total investment, I could have a company that was spitting out ten or twenty million in profit in a couple years in an exponentially increasing market, and perhaps have a half billion to couple billion dollar company in five to ten years with a well executed plan.

But when you value a venture like that, you need to look at a reasonable snapshot of what you expect the company to be doing five or ten years down the road and work backwards to obtain a present-day market value, and then "discount" for risk. So if the company is doing a billion annually in sales in five years (a reasonable goal) and earning a hundred million, your initial investment of a hundred million would be paid off in that year alone and in multiples thereafter. But your hundred million if conservatively invested elsewhere (opportunity cost) would have probably been able to earn thirty-five million at 6%, so the true cost of your investment is greater than you at first think and as many CTC longs have painfully realized. Further, due to the risk of the investment, you have to expect a much higher rate of return than current market rates, like ten, twenty or even thirty times normal. Why? Because venture capitalization is a very risky business, with fewer than one in twenty ever paying off, so you have to make it really big on the seeds that sprout to cover all the duds, and though EU was not the type of start-up that would normally command a thirty to one return, a ten to one overall return (valuation plus earnings) after five years would be a conservative expectation on the part of those risking so much capital. And though it could be a bust, it also gives a chance of a twenty to one as well and, as they say, nothing ventured, nothing gained.

So, if the market valuation of the company with a billion dollars in sales five years from now is, say two billion on earnings of a hundred million (a P/E of 20) and the company is acquired or goes IPO, you would in fact get that twenty to one return on your hundred million invested, and if the company did half as well you might get your conservative ten to one return. There are further factors that are used to "discount" the net present day value of an opportunity (competitors, technology trends, politics, projected costs of working capital, inflation and interest rates, etc.) that would probably cut those numbers in half again in favor of the investor, but that's not important to the discussion. What IS important is how that "stand alone" evaluation of the EU opportunity differs from the real world post-acquisition opportunity presented to the investor by CTC.

We now have a situation where, by all accounts on this board and as a reasonable business assessment, the wind side of the company presents at least half, and probably significantly more, of the opportunity for CTC over the next five years, but even assuming half, that would place the expected valuation at two to four billion if I were wearing my green eye-shade and pulling the adding machine lever for GE, KKR or Toshiba, which would place the net present day valuation for the total investment (buying CTC AND dumping in a hundred to two-hundred million) at two to three hundred million, and if you strip out the hundred to hundred-fifty million in capital commitment I would have to make to finance the opportunity, that only leaves fifty to two hundred million left for acquiring CTC. [ed. That is the maximum "spread" possible under various combinations of total project costs and capital requirements] Because I am looking at this in the "stand alone" model without regard to the market price of the stock (because I want to buy the company to build the opportunity to increase earnings and not trade in the stock as a holding company), if I were to recommend a tender offer for all CTC shares it would fall in that range. If that offer were translated to a price per share for the fully diluted 240+ million in shares, it would be a maximum of $.82 per share and a minimum of $.20 per share... and that's for the whole company. In a spin-off of the wind division I might consider the present day valuation of that component to be a hundred million due to recent developments and be willing to offer the CTC shareholders $.40 per share in cash or maybe even $.80 per share in GE stock to get just the wind business. That's where "Mr. Valentine" gets his $.75 number.

I think that the present shareholders would not like any of those deals, and that's why I think a buy-out, or big capital investment at favorable dilution rates (as opposed to big players buying stock in the marketplace) is unlikely unless BW and the other controlling parties with zero-basis holdings decide to take their few millions and run. Further, since the going rate for financing dilution has been roughly double the market price of the stock (meaning that for every dollar in PIPE cash they get in, they issue shares and warrants amounting to around twice that in market value) it is not unreasonable to expect that by the time CTC does achieve that goal five years down the road and draws in another hundred to two hundred million in PIPE financing, the dilution would be two to three times what it already is today, and unless the company is at that time earning two to three times the dividends to offset that dilution, if in fact it is paying any at all, the net present day valuation of your investment will have been cut in half again.

That's why I posed the question several days ago about just what people expect from this company. If it is simply a playing field for the stock, where "intrinsic value" as perceived by somebody who wanted to acquire the company is not important and only the market valuation of the stock, and depending upon market perception, your stock could be worth five or ten times today's value in the marketplace or nothing at all. The company could execute the growth plan flawlessly and be pumping out all those dividends while the "market" has dumped wind holdings and jumped into a re-born nuclear industry or some new high-tech emergence like bionics, the "Outernet" or something, and in that case retirees like Saltator will scoop it all up for the dividend payout. On the other hand the company could still be sustaining losses and diluting away to cover them as true believers who don't need any income keep the the stock propped up by averaging down and refusing to sell at any price, ever hoping for that day that more of the same somehow leads to a different result.

That's the market. There are many stocks, like that spam dropped in here the other day and others that come in your email from "John says" or Sharpeyed, that have never produced or earned anything in their entire existence, and that people make and lose money with on the playing field every day. And then there are others (my favorite hunting expedition targets) that trade below their intrinsic or even their liquidation values with solid earnings that nobody cares about because there isn't any "action".

Right now, CTC is getting a lot of "action", but without big sustained capital commitments instead of just replacing the empty bag on the PIPE IV pole every six months, CTC will not achieve those intrinsic value goals, and that kind of big capital will have a real hard time investing without a huge amount of dilution in their favor. You're seeing some big players in the market for sure and that is always exciting for little players who know how to surf that type of action, but you're not seeing any big capital investment in the company that will lead to the fundamental valuation down the road that many of the longs who bought in on the vision are all about, and you won't see it because those types of investors would insist upon the type of real controls and transparency that BW won't give them, and the higher the current "playing field" price goes the less likely you are going to see it as well.

Being the old stick-in-the-mud guy that I am who remembers this stock at $4 and $6, I don't pay any attention to the playing field and I'm just looking for that $6 million down payment on the wind order, and then the "go ahead" $4 million payment in May.