PART 1: ACCOUNTING
Chapter 1: Accounting Basics
Double entry accounting
When a transaction occurs on one side of the financial statements, one or more accompanying transactions occur elsewhere in the financial statements.
Here are a few examples:
➤ Example 1. A company purchases a product for later sale to its customers:
Result: The balance sheet will reflect a decrease in cash and an increase in inventory.
➤ Example 2. A company sells products to its customers and receives payment by credit.
Result: The balance sheet will reflect an increase in accounts receivable and a decrease in inventory.
➤ Example 3. A company borrows money:
Result: The balance sheet will reflect an increase in cash and an increase in debt.
➤ Example 4. A company purchases a building with a combination of cash and a mortgage note:
Result: The balance sheet will reveal an increase under fixed assets (the purchase price of the building); a decrease of another asset, cash; and an increase on the liability side of the balance sheet, the mortgage note.
Cash versus accrual accounting
Cash Accounting
With the cash basis, as the term implies, transactions are recorded when cash changes hands. Suppose you walk into the local hardware store and purchase a hammer for $10 cash and take immediate possession of it. Under the cash basis, the store owner would record this transaction as a $10 sale because the cash was paid and the item was delivered—the transaction was completed.
Cash basis reporting is not generally accepted in business, but it is allowed for tax purposes in certain businesses that meet some or all of the following conditions (depending on the legal structure of the business):
■ The business does not sell products, meaning that it is service-based and therefore has no inventory.
■ The business keeps records for cash receipts and payments.
■ The business has less than $5 million a year in sales.
Accrual Accounting
With the accrual basis of accounting, transactions are recorded as they occur. Cash does not necessarily have to change hands, but a transaction must have occurred.
Accrual basis reporting is used to capture the overall economic activity of the firm. This is done because in finance and accounting, there is a fundamental notion that businesses are assessed not so much on what they have on hand but rather on their expectations or potential. In the universe of financial reporting, what you see is not always what you get. With accrual accounting, the expectation is that the company will receive those payments at some point in the future, although the reality may entail entirely different outcomes. More specifically, companies book sales when goods are shipped, services are rendered, or a long-term contract is signed.
Creative accounting
As you can well imagine, accrual accounting creates many opportunities for fraud and manipulation. The vague rules governing revenue recognition, along with numerous intangible items, create exciting yet often misleading opportunities for “creative accounting.” The best example of this on an industrywide basis has to do with telecommunications companies using network swaps in the late 1990s to inflate their revenues artificially. At that time, loose accounting standards in a nascent industry opened the door to deceptive methods of financial disclosure. The end result of this practice, sadly, was not unlike many of the cases we cover in this book: billions of dollars of hard-earned investor funds evaporated overnight.
Accounting Principles and Standards
The American Institute of Certified Public Accountants (AICPA) is a professional organization of practicing certified public accountants (CPAs). The recommendations of this organization have been vital to the development of the overall principles that we use in financial reporting and that are known as generally accepted accounting principles (GAAP). For the most part, GAAP is considered to be based on the standards and interpretations of the Financial Accounting Standards Board, which is discussed later in this chapter.
A good deal of confusion arises over who is in charge of what when it comes to accounting and financial reporting. Essentially, the prime overseers of corporate accounting regulations and guidelines are the Financial Accounting Standard Board (FASB) and the Securities and Exchange Commission (SEC).
For many years, there was interest in creating a worldwide standard of accounting. As long as each country was confident that it was employing the best standards, however, that interest produced few results. Then came International Financial Reporting Standards (IFRS). As country-based accounting standards in Europe made it difficult to compare results for companies registered in different countries, the International Accounting Standards Board (IASB) was created to provide a single set of standards. As of 2005, publicly traded companies in the European Union are required to provide financial statements that are based on IFRS. IFRS involves some reclassifications and in some cases alternative valuation methodologies. Countries around the globe have moved to IFRS, and it remains to be seen whether the United States will ever embrace the method completely.
Tax versus book accounting
Very often, companies will create two sets of financial statements. One is reserved for tax reporting, and the other for investor reporting. This enables a company to present its best performance numbers while minimizing its tax burden. Tax accounting is used to make sure that income and deductions reported on tax returns are in compliance with IRS rules and regulations. Book accounting, in contrast, pertains to reporting on a company’s financial statements and is usually in line with GAAP standards, though it may not always be in line with tax standards.
Introduction to financial statements
Common Public Filings
Financial statements are filed periodically with the SEC by all public companies. Here is a summary guide to the more common filings:
10-K. This covers the company’s annual performance and is due after the end of the fiscal year. It contains the following:Income statement
♦ Balance sheet
♦ Cash flow statement
♦ Footnotes to the financial statements
♦ Management discussion and analysis
♦ Auditor’s report
Annual report. Essentially, this is a condensed version of the 10-K with more emphasis placed on marketing the company to investors through colorful charts and pictures.
Proxy statement. This statement is offered around the time of the annual meeting and covers the following:
♦ Management compensation
♦ Management stock options
♦ Related-party transactions
♦ Auditor changes
10-Q. The 10-Q is an unaudited statement of the company’s quarterly performance that is due after the quarter ends. It includes many performance reports similar to those found in a 10-K.
Form 8-K. This form normally is due after any material event such as a major change in ownership or capital structure.
Form 144. Form 144 is a registration document that discloses when insiders buy or sell stock.
Financial Statement Report
Management’s Discussion and Analysis
MD&A report offers a strategic overview of the company’s performance during the prior year as well as anticipated changes in the coming year, provides hints about the company’s plans, goals, and expectations for the coming year.
Management’s Report
The management’s report details the responsibilities of individual managers in preparing the financial reports. It is important to understand who is specifically responsible for the actual preparation of these financial statements.
The Auditor’s Report
Auditors now explicitly disclosure an red flags in their report.
Explanatory Notes and Supplementary Information
If there’s one thing you take away from this section, it should be simply to read the footnotes. There’s no possible way I can stress enough the importance of these supplementary notes. To grasp the importance of this, read on.
Chapter 2: Balance Sheet
The balance sheet (BS) addresses issues of solvency, liquidity, and capital structure. The best way to remember the components of the BS is with this equation:
Assets = liabilities + shareholders’ equity
You might rearrange the equation in this way: Assets – liabilities = shareholders’ equity
1. Assets
Current Assets
The asset section of the balance sheet begins with the assets that are considered to be most liquid, meaning that they can be converted to cash, consumed, or sold within a relatively short period, usually one year. These assets are current assets.
■ Cash
The first of the current assets is the most liquid of all assets: cash. Most bankers would argue that cash is more liquid than water.
■ Marketable Securities
After cash, the company may list short-term investments, or what is referred to more commonly as marketable securities. These are generally liquid investments that the company realistically could sell within a short period.
■ Accounts Receivable
Accounts receivable, payments owed to the company. Perhaps the company sold products to a customer on credit. Even though payment has yet to be collected, for purposes of financial reporting, it is considered an asset. The expectation is that the payment will be received sometime within the next year. In certain instances, a company may list an allowance for uncollected receivables. A company may do this to depict the likelihood of collecting receivables more accurately or to create some flexibility in balance sheet adjustments through periodic estimate revisions.
■ Inventory
In most non-service-based businesses, the next listing probably will be inventory: what the company produced or purchased but has yet to sell.
Noncurrent Assets
The assumption with noncurrent assets is that they could be liquidated or consumed in the course of a year. Noncurrent assets generally are grouped into broad categories, which might include the following:
■ Tangible Fixed Assets
Usually listed as PP&E, tangible fixed assets might include real estate, manufacturing equipment, furniture, computer hardware, delivery trucks, the corporate jet—anything and everything that constitutes the overall infrastructure of the company.
■ Intangible Fixed Assets
Occasionally, an item will be listed as goodwill under noncurrent assets. Goodwill is a by-product from an acquisition and results from the difference between the price paid for an asset and what is considered its fair value.
Depreciation
This affects not only the balance sheet but the income statement and cash flow statement as well. In theory, depreciation reflects the loss of value of a fixed asset over its expected life. On the balance sheet, the depreciation listed is accumulated over the lifetime of the asset.
Suppose you spend $10,000 on buying a car. The expected life of this car is 10 years. If the car depreciates on a straight-line basis, meaning that it loses an equal portion of its value each year, it would lose $1,000 in value after one year.
On your balance sheet, you would record the following under fixed assets after one year:
—YEAR 1 FIXED ASSETS
Property, Plant, and Equipment: $10,000
Accumulated Depreciation: $ 1,000
Property, Plant, and Equipment, net: $ 9,000
Thus, the loss of $1,000 in value is listed next to accumulated depreciation and subtracted from property, plant, and equipment. How would your second year look?
At this point, you would add another year’s worth of depreciation to accumulated depreciation, which would appear on your balance sheet in the following way:
—YEAR 2 FIXED ASSETS
Property, Plant, and Equipment: $10,000
Accumulated Depreciation: $ 2,000
Property, Plant, and Equipment, net: $ 8,000
Accumulated depreciation is the total of each of the prior years’ depreciation. This continues until the asset is fully depreciated.
Depreciation is often a breeding ground for manipulation. For the most part, there are at least five commonly accepted methods of calculating depreciation, although companies often use their own interpretation of those methods or choose the one that best fits their objectives.
2. Liabilities
Current Liabilities
■ Lines of Credit
This lists the amount drawn from any credit facilities. As with credit cards in personal finance, lines of credit enable companies to obtain short-term funding with few transaction costs. For this item, only the amount outstanding would appear on the balance sheet.
■ Accounts Payable
This refers to amounts owed by the company to vendors or suppliers. Perhaps the company purchased raw materials for manufacturing but has yet to pay for them. Again, the assumption is that the company will have to pay within one year.
■ Current Debt
This might include any type of short-term bond or note issued by the company.
■ Current Portion of Long-Term Debt
Often, when a company issues long-term debt, the amount due in the current year will be listed here.
Noncurrent Liabilities
Noncurrent liabilities usually take the form of long-term debt: any debt that comes due after the course of one year. Certain debt instruments will pay down principal each year as seen under the current portion of long-term debt. Therefore, only the portion of debt that comes due after one year is listed under noncurrent liabilities.
3. Owners’ Equity
Owners’ equity represents the book value of the company, or its value on paper. It is the difference between assets and liabilities, in other words, what is left after the company pays everything it owes with everything it owns. Owners’ equity consists of two components: direct owners’ equity and indirect owners’ equity.
Direct Owners’ Equity
Direct owners’ equity represents funds that are invested directly into the company by the firm’s shareholders. This might include a sole proprietor of a small business investing seed capital to start the business, or it might be the funds raised from the investment of thousands of investors in a public offering. Either way, the funds invested directly into the company represent direct owners’ equity.
Indirect Owners’ Equity
The other component of owners’ equity is indirect owners’ equity, commonly referred to as retained earnings. Retained earnings represent the buildup of equity through the generation of income. This tends to be a bit more complex than most balance sheet items, so brace yourself. Retained earnings very often are overlooked or, worse, taken for granted. In fact, many smaller companies simply plug in this number by using mathematical deduction, which ignores any deceptive accounting or fraud.
Sample Balance Sheet
■ Assets:
• Current assets begins with $8,000 cash, which represents the total cash reserves of the company.
• Account receivable is $10,000, representing the total of payments owed to the company. The company has sold $10,000 worth of merchandise but has yet to collect payment for it.
• The company reveals $14,000 worth of inventory, represents the value of what the company produced but has yet to sell.
• The final current asset is prepaid expenses, which represents expenses that were prepaid and designated for this account in the amount of $2,000. In total, Cunningham Hardware has current assets of $34,000.
• Next are the noncurrent assets, with the value of $45,000 in fixed assets, which is based on historical cost. When these assets were acquired, they were worth $45,000. Finally, the accumulated depreciation of $23,000 is subtracted from the fixed assets, and net noncurrent assets of $22,000 remains.
The total value of current and noncurrent assets is $56,000 (= $34,000 + $22,000).
■ Liabilities:
• The company has accounts payable of $3,000. These are accounts that it owes to any company that has allowed it to purchase items or pay for services on credit. It also has accrued expenses payable representing expenses that have been incurred but are not due yet. Accrued expenses are the opposite of prepaid expenses and are expected to be paid in the period in which they have been incurred. Common accrued expenses include wages and interest. In total, Cunningham has accrued expenses in the amount of $5,000.
• Finally, it has income tax payable in the amount of $1,000, which represents the portion due to the government but not yet paid. Companies make tax payments on the basis of estimated income. This account helps reconcile the differences between estimates and what is owed.
In total, the company has current liabilities of $9,000 (=$3,000 + $5,000 + $1,000).
• Next on the liabilities side of the balance sheet are noncurrent liabilities. The first and only item is notes payable. In this case, there is a note payable in the amount of $19,000.
■ Shareholders’ Equity:
• Direct owners’ equity is $8,000. This represents the amount that the owner or shareholders of the company have invested in the company.
• Indirect owners’ equity is listed as retained earnings, which in this case is $20,000. These retained earnings are generated through the accumulation of income minus dividends over time.
Thus, total shareholders’ equity is $28,000 (= $8,000 + $20,000).
Balance Sheet Games
The balance sheet in many instances creates a great hiding spot for corporate managers. Nowadays, the use of this statement for such purposes is becoming increasingly complex. For this reason, corporate managers will go to great lengths to reveal a clean bill of health, which will often involve a clever scheme. Manipulation of this statement can occur in the following ways:
■ Improperly recording the value of assets or liabilities
■ Mark-to-market accounting
■ Removing liabilities from the balance sheet entirely
Improper Valuation
Most asset values on the balance sheet are recorded at historical cost. However, new standards have evolved by which certain items may be adjusted to current market price. Items such as marketable securities are relatively volatile while being fairly liquid; therefore, accounting standards necessitate that they be reflected at their fair market value. Other, less volatile assets may be adjusted downward but not upward. As a result, financial managers often are given the freedom to interpret these values.
Mark-to-Market Accounting
Mark-to-market accounting is used to assign value to an asset on the basis of its current market price. With mark-to-market accounting in place, the changes in value of these instruments are recorded on a regular basis on the financial statements of the company holding them. In other words, they are marked to market rather than listed at cost (what was paid for them).
The world is divided on mark-to-market accounting. There are those in favor of it because it increases transparency in financial disclosure. As the argument goes, if something loses value, the financial statements should reflect the loss of value. The opposing argument is based on the idea that trying to estimate market values can do more harm than good and ultimately prove misleading, especially in illiquid markets.
Off-Balance-Sheet Items
If a company is seeking to maintain a solid debt-to-equity ratio, it may simply remove certain liabilities from its balance sheet. With a wonderful invention called the off-balance-sheet transaction. By meeting certain ownership stipulations, some balance sheet items can be transferred from the parent company’s balance sheet to that of an affiliate company.
Most off-balance-sheet structures involve the use of special-purpose entities (SPEs). These are some of the many culprits behind several large accounting scandals in corporate America, including Enron and Cendant. An SPE is formed as a separate entity loosely affiliated with a parent company and is based on specific rules of ownership. The SPE is created by designating a specific entity to carry out an activity or series of transactions related to a defined purpose. It is formed through one of the following structures:
• Limited partnership
• Limited liability company
• Corporation
• Trust
Chapter 3: Income Statement
Income Statemnet Components
A good income statement reveals a company with earnings that are stable, predictable, and sustainable. Of course, these are relative measures, and so they must be compared with overall industry measures. It is important to remember that the income statement reflects the financial standing of a company over a period of time. This differs from the balance sheet, which is a snapshot of a company at one particular time.
Revenues
Revenues (or sales, net sales) are a reflection of market demand and represent payments recorded in exchange for goods and services. Because most companies use accrual accounting, revenues are rarely a reflection of cash payments.
Expenses and Costs
There is a distinction between expenses and costs. Costs reflect what is paid to produce or acquire goods and services, associated with each unit sold. Thus, in a company that manufactures widgets, the cost of the raw materials involved in the manufacturing will be listed under cost of goods sold, or cost of sales.
Expenses pertain to what is paid to run the company on a day-to-day basis. Items such as salaries, rent, utilities, legal, marketing, accounting, and telecommunications will be included in expenses.
Income
Income, often referred to as earnings or profit, is what is left over after expenses and costs are subtracted from revenues. If expenses and costs exceed what is listed as revenue, the income statement will show negative net income, or a net loss. Otherwise, income will be listed as net income.
Common Items on the Income Statement
There are various items that frequently appear on income statements.
■ Sales or Revenues
This item represents proceeds, either cash or credit, received in exchange for products or services.
■ Cost of Goods Sold (COGS)
Also listed as cost of sales, these are costs that are tied directly to production. However, this is listed only upon the sale of an item. Therefore, when an item is sold, the cost to produce or acquire it is reported here.
■ Selling, General, and Administrative (SG&A)
This covers most day-to-day operating expenses.
■ Depreciation
Depreciation is a noncash expense that is based on the reduction in the fixed value of assets. On the income statement, you see just the depreciation for that particular year, which is treated as a noncash expense.
■ Interest
This pertains to payments made to service debt.
■ Taxes
This will vary depending on how the company treats taxes and, more specifically, whether the company defers taxes.
■ Net Income
This is the company’s profit, or its bottom line: what is left over after all these expenses and costs are subtracted from revenue.
Sample Income Statement
In the most recent year, the company recorded $100,000 in sales.
COGS = $60,000.
Gross profit = $40,000 (=$100,000 – $60,000).
SG&A = $24,000.
EBITDA = $16,000 (= $40,000 – $24,000).
From $4,800 in depreciation is subtracted to arrive at EBIT $11,200 (= $16,000 – $4,800).
Once the interest expense of $1,600 is subtracted, EBT $9,600 (= $11,200 – $1,600).
Finally, taxes are subtracted to arrive at a net income of $6,400 (= $9,600 – $3,200).
EBITDA, EBIT, and EBT
Banker-speak is riddled with the fabled terms EBITDA and EBIT. These numbers are useful for three reasons:
• First, they measure profitability at different levels.
• Seconds, they enable companies to highlight their strongest level of profitablity.
• Third, they make bankers seem more sophisticated than they really are.
■ EBIT
For example, Cunningham Hardware makes interest payments of $1,600. Its nearest competitor, by contrast, perhaps does not have any interest charges because it does not have any debt to repay. Perhaps this competitor is financed entirely through equity. Aside from this difference, assume that the two businesses are virtually identical. They have a similar customer base, similar products, and comparable revenues and expenses. If you were to compare the two companies on a net income basis, all other things being equal, you would see that the competitor might perform somewhat better because of the missing interest. However, this is misleading, as it does little to explain how the companies perform on the basis of their ability to generate profits. Rather, it underscores a difference in their capital structures, which is another issue entirely. To draw a fair comparison, we look at these two companies and evaluate their profitability before interest is subtracted. To do this, we compare them on the basis of earnings before interest and taxes—EBIT.
■ EBITDA
What happens if Cunningham Hardware has depreciation of $4,800 and its competitor has no depreciation because it has no fixed assets? If there are no fixed assets, there is no depreciation. Perhaps the competitor simply leases its property, plant, and equipment. If you were to compare the profitability of these two companies, all other things being equal, you would see that the competitor might perform somewhat better than Cunningham because of these depreciation expenses. These differences might be skewed further as a result of the leasing charges that the competitor assumes for its assets. Regardless, a fair comparison is difficult to make because of depreciation, and thus, it may be more useful to compare the profitability of the two companies on earnings before interest, taxes, depreciation, and amortization basis—EBITDA. Amortization, like depreciation, involves the expense or payment of an obligation over an extended period. Rather than the item being expensed at one time, it is distributed over a period of time in installments. This might be helpful when a company has assumed significant research-and-development costs for a product that has yet to be launched. When these costs are expensed over time, the profits do not fall drastically in any one year.
To summarize, EBITDA, EBIT, and EBT are used to account for the differences in interest, taxes, depreciation, and amortization—all variables that can affect net income. In an effort to analyze company profitability exclusive of these variables, several levels of profitability can be considered.
Revenue Recognition
In 1999, the SEC issued Staff Accounting Bulletin 101 (SAB 101) to address the issue of when revenue is realized or realizable. The bulletin describes a basic framework for analyzing revenue recognition by focusing on four bedrock principles established in GAAP. Those principles state that revenue generally is realized or realizable and earned when all the following criteria are met:
• Persuasive evidence of an arrangement exists.
• Delivery has occurred or services have been rendered.
• The seller’s price to the buyer is fixed or determinable.
• Collectability is reasonably assured.
Inventory and COGS
There are two common methods of accounting for inventory: FIFO and LIFO. FIFO stands for “first in, first out,” and LIFO stands for “last in, first out.”
• Under FIFO, product costs are charged out to cost of goods sold, in chronological order. Thus, when items are sold, the value that is disclosed under cost of goods sold is done in order of the items’ original purchase.
• A LIFO system, charges out product cost in reverse chronological order: the last item purchased is the first listed under cost of goods sold.
Suppose you acquire four units of a product, one at a time. The first time you purchase the merchandise, you pay $10. A couple of weeks later, you buy another unit, but the price has gone up, so you now pay $12. A few more weeks later, you acquire a third for $14. Finally, the following week, you pay $16 for the fourth. In total, you spend $52 to acquire these four units. Next month, you decide to sell those units in your store. At the end of the quarter, you have sold only three of the four units. Under FIFO, you sell the first three that you purchased: the $10 unit, the $12 unit, and the $14 unit. That gives you a total of $36 to list under cost of goods sold on your income statement. On your balance sheet, the $16 unit, the last one you purchased, remains in inventory. Essentially, the first units you purchased are the first ones out the door. The advantages of FIFO include the following:
• Inventory costs are closer to replacement costs.
• Expense and sales numbers are better matched chronologically, which is helpful in gross margin analysis.
The other method, LIFO selects the last item purchased and then works backward until the total costs for the units sold during the period are removed. Going back to the original example, you acquire four units of a product, one at a time. You pay $10, $12, $14, and $16, for a total of $52. At the end of the quarter, you have sold three of those four units. You have sold the $16 unit, the $14 unit, and the $12 unit, for a total of $42. The first unit, which you purchased for $10, ends up in inventory. On your income statement, $42 is listed under cost of goods sold. The advantages of LIFO include the following:
• Taxable income will be lower during times of rising costs.
• Assigning the most recent costs of purchased products to COGS more accurately depicts the current replacement cost on the income statement.
There is a trade-off that a financial manager faces in determining which method to use: a trade-off between lowering the tax burden and maximizing income. Imagine for a moment that this is a multimillion-dollar company by adding six zeros to each of those numbers. The impact is staggering. We see tax differences of $80 million and income differences of $120 million. Thus, this simple accounting technique can account for millions of dollars in tax savings or millions of dollars in net income.
Depreciation
Depreciation is treated like any other expense except that it involves no cash outlay. It is imputed, meaning that it is based on a specific portion assigned to a specific time period. As you saw on the balance sheet, it is listed in its accumulated form, whereas on the income statement it is listed as an expense specific to that period. Depreciation is usually based on the useful life of an asset and therefore can be subjective. Often, companies deal with new classifications of assets, especially in areas such as technology, biotech, and pharmaceuticals. In the case of new asset classes, it is not entirely clear what the useful life should be. For that reason, determining depreciation schedules sometimes is left to the discretion of the company.
As with most intangible items, a number of problems are associated with depreciation. When businesses use an accelerated schedule, they will deduct more depreciation in early years, meaning they probably will see much larger tax savings in the near term. However, they also are going to see lower net income, which can be perceived as a negative from an investor’s perspective. Furthermore, different depreciation schedules frequently pertain to different asset classes. Any new asset class will have few parameters. For that reason, financial managers may take great liberties in the way they determine depreciation for it.
Earning Release
Each quarter, Wall Street analysts and investors behave like eager little children on Christmas morning. This behavior results from anticipation of the quarterly earnings statement that is issued by most public companies and can bring forth all kinds of surprises. This is essentially a condensed form of a company’s income statement and offers a report card of sorts for the company. The most important grade on this report card is the earnings per share number. It simply records the company’s net income applicable to each share of common outstanding. This number is compared with what Wall Street analysts predicted and a number that exceeds this prediction usually will trigger an increase in the company’s stock price, whereas a number that falls short can mean a drop.
Earnings per share is a very important number in this process of examining overall company performance. It is important because it enables investors to gauge how much they earned on an investment—how much net income per share they earned. Earnings per share numbers are calculated by taking net income and dividing it by total shares of common stock outstanding.
In 1997, the Financial Accounting Standards Board instituted a rule requiring companies to report earnings per share in two ways, basic and diluted.
• Basic refers to net income minus preferred dividends divided by total shares outstanding.
• Diluted reports options, warrants, preferred stock, and convertible debt, reflecting their impact if they were exercised, or converted to shares of common stock.
The growth of stock options as a form of compensation reached unprecedented levels in the 1990s, and concerns arose that if and when those instruments were exercised, they would dilute the holdings of existing shareholders. For that reason, FASB instituted this rule stating that earnings must be reported on both a basic and a diluted basis because any increase in the number of shares outstanding will indeed affect the earnings attributed to each share.
Chapter 4: Cash Flow Statement
The cash flow statement shows how much cash the company generated during the prior period, which leads to how much cash the company has currently. The cash flow statement determines whether a company builds cash on the basis of its operating activities, investing activities, and financing activities. Essentially, it takes the accrual-based numbers from the balance sheet and income statement and works backward to reconcile the changes in cash.
Cash Flow
Cash Flows from Operating Activities (CFO)
Cash flow from operating activities is based on the transactions that normally affect the generation of operating income.
Cash Inflows
• Sale of products or services
• Other extraordinary revenue
Cash Outflows
• Purchases of inventory
• Operating expenses
• Interest expenses
Cash Flows from Investing Activities (CFI)
Cash flows from investing activities involve transactions related to the purchase and sale of securities, land, buildings, equipment, and other assets not generally held for resale. Investing activities are not classified as operating activities because they have an indirect relationship to the central, ongoing operation of a business.
Cash Inflows
• Sale of plant assets
• Sale of a business unit
• Sale of investment securities
Cash Outflows
• Purchase of plant assest
• Purchase of investment securities
Cash Flows from Financing Activities (CFF)
Cash flows from financing activities deal with the flow of cash to or from the shareholders (equity financing and dividends) and creditors (debt financing).
Cash Inflows
• Issuance of company stock
• Borrowing (bonds, notes, mortgages, etc.)
Cash Outflows
• Dividends to stockholders
• Repayment of principal amounts borrowed
• Repurchase of shares of stock
Sample Cash Flow Statement
CFO
■ Account Receivables Increase: $3,200
This increase must be subtracted on the cash flow statement. This is done because an increase in receivables between last year and this year indicates that the increase was booked as part of sales on the income statement, though the payments have not actually been collected. The sales line on the income statement reflects that increase, but the underlying cash is not there. In this case, the change is positive because the receivables went up. Because the receivables went up, that difference is subtracted since the cash is not in the company’s hands. It is important to note that this is the change in receivables between last year and this year, not the actual amount that appears on this year’s balance sheet. The number on the balance sheet at the end of this year is the total accounts receivable.
■ Inventory Increase: $3,900
It is nonetheless a cash outflow because the company had to pay to acquire it, so it must be subtracted. Inventory becomes an income statement item only when it is sold, and at that point it is listed under cost of goods sold. Until then, it remains listed as inventory on the balance sheet. Again, the purpose of the cash flow statement is to reflect changes in cash. Thus, the increase in inventory is subtracted out.
■ Prepaid Expense Increase: $600
These expenses do not show up on the income statement but are still cash outflows that must be subtracted. On the cash flow statement, only the portion due in that particular period is expensed.
■ Depreciation: $4,800
It was subtracted much like any other expense. However, on the cash flow statement, it is added back because it is a noncash expense. Although this was listed as a deduction on the income statement, that amount was not actually paid in cash. Again, the purpose of the cash flow statement is to see how much cash was generated or lost during the period, and so depreciation is added back to the net income.
■ Accounts Payable Increase: $300
Accounts payable increased, and so the amount owed to vendors has gone up as well. Hence, that number must be added back. This is done because although this amount is expensed on the income statement in some form, it has not actually been paid yet. Thus, the cash position is effectively higher.
■ Other
Accrued expenses went up, and those expenses also are added back much like accounts payable. Finally, there is an income tax payable increase, meaning the company has a payable due to the IRS. Again, this may have been expensed but has not actually been paid, and for that reason it must be added back. After summing these items, the total cash flow from operating activities equals $4,400. Note that net income is $6,400, but cash flows from operating activities are substantially less.
Cash Flows from Investing Activities
In this case, purchases of property, plant, and equipment amount to $5,000.
Cash Flows from Financing Activities
■ Debt Increase: $2,000 (= $800 + $1,200)
The company borrowed from a short-term debt vehicle, perhaps a line of credit, and in that process raised $800, representing a cash inflow. Next, it reports an increase in long-term debt of $1,200, meaning that the company issued some form of long-term debt and in the process raised $1,200.
■ Equity: $300
The company also issued equity, meaning that it sold shares of stock to raise $300.
■ Dividends: $700
That amount paid is listed here as a cash outflow because it did not show up on the income statement. Since it is still a cash outflow, it is subtracted. The total of these cash flows from financing activities reveals a cash increase of $700.
Ending Cash
A net increase in cash of $100 is calculated. During the period, cash has gone up only $100 despite the fact that income was listed as $6,400. In this case, the increase in cash of $100 is applied to the cash position that the company started the year with, which is listed on the balance sheet as last year’s cash balance.
The beginning cash balance, listed in the statement as $7,900, is the same cash that the company had at the end of last year. The cash flow statement shows a cash gain of $100, which leads to an ending cash position of $8,000. That $8,000 is now transferred to the balance sheet and in turn reflects the cash position for the end of this year. This is the common link between the cash flow statement and the balance sheet. The cash flow statement shows how much cash was produced or lost during the period and is applied to the cash position from last year to get the current cash position.
A Quick Recap of Financial Statements
Now that each of the financial statements—the balance sheet, the income statement, and the cash flow statement—has been described, take time to note the essential elements of each.
Why Cash Flow?
The cash flow statement has been gaining in popularity in light of the proliferation of accounting fraud disguised through various income statement items. However, most Wall Street analysts and many investors tend to focus on the income statement at the end of the quarter, giving supreme weighting to profits. They often stress the fact that cash flows, by contrast, are generally erratic and fail to capture the true performance of a company.
Managing Cash Flow
Steps to Stronger Cash Flows
Companies face significant pressure to manage their cash flows optimally. Most respected companies tend to emphasize the following procedures in an effort to maximize cash flows:
■ Preparing detailed forecasts. Keeping track of detailed budgetary needs and expected revenues will help a company better manage its cash flows.
■ Setting up sufficient cash reserves. This goes without saying—keeping something in the bank will prevent a liquidity crunch during slower times.
■ Creating effective inventory management. Inventory is costly on many levels, and so keeping just enough to meet demand while avoiding surplus will contribute to stronger cash flows.
■ Leasing instead of purchase. Although this will increase operating expenses on the income statement, it no doubt will lower capital expenditures, which should benefit cash flow.
■ Accelerating receivables. The sooner those outstanding payments are collected, the stronger cash flows will be.
■ Decelerating payables. Hanging on to those payments due a bit longer also can help cash flows. But hanging on to them for an extended period can lead to questions about a company’s creditworthiness.
How Much Cash?
How much cash should a company have?” It depends on the type of business. On the one hand, every business requires sufficient cash reserves to cover the day-to-day changes in the business. However, excess cash can mean lost opportunities. On the other hand, deficient cash can mean delinquent payments and lower credit ratings. Business managers often face this balancing act of maintaining just the right amount of cash.
Free Cash Flow (FCF)
FCF is a term that often is used in the world of investment banking. Investment bankers drop this phrase whenever possible but rarely take the time to explain it.
The FCF can have a number of meanings, a few of which are listed here:
• Net income plus depreciation plus any other intangible expense during the period
• Cash flow from operations
• Cash flow from operations minus some or all of the capital expenditures during the year
Chapter 5: Fraud and Manipulation
As long as the accountants, lawyers, and bankers were paid well, there was little cause for concern. An as long as companies are managed by human beings, fraud and manipulation will occur.
Types of Fraud
Money Laundering
Money laundering is essentially taking money from illegal sources and passing it through another business to make the money appear legitimate. For example, an organized crime syndicate involved in the drug trade might create a chain of dry cleaners to pass through money from drug sales in an effort to “wash” those funds.
Sales Skimming
Sales skimming involves the deliberate omission of revenue to lower taxable income. This could very well be the case with small businesses that only accept cash, as it would be difficult to track their sales receipts. It becomes a much larger issue when we are talking about Fortune 500 companies that use creative methods to defer revenue or simply hide revenue, as was the case in many of the recent corporate fraud scandals.
Overstating Expenses
This type of fraud often takes the form of running personal expenses through a business to lower taxable income. This is something that might occur in small private companies, and generally it goes unnoticed when done on a small scale. It becomes a larger concern in publicly traded companies, in which a CEO might decide to expense his private art collection to the company.
Bribes and Payoffs
Often committed by large businesses seeking to fix prices or land contracts, this is the type of thing that occurs when a large company is seeking to capture a portion of an international market to secure a large account. Usually some type of bribe or payoff is offered to local government officials or business leaders to gain their approval.
Shifting Sales and Expenses
Between Businesses and Operating Subsidiaries
Often large corporations will shift expenses from a less profitable unit to a more profitable unit. This allows for a smoother distribution of profits, and in some cases it can reduce the overall tax burden. For example, the more profitable unit may be facing an excessive tax bill. When expenses are added to its income statement, that burden may ease.
Phony Off-Balance-Sheet Financing Schemes
Overall, off-balance-sheet entities are not considered to be inherently deceptive. However, a combination of creative accounting and lax observance of ownership rules has created an opportunity to hide liabilities in them. As you saw in Chapter 2, a special-purpose entity is created to take on the debt of a parent company, and in the process, the liability essentially is hidden. The perception is that the holding company has a much stronger BS, something that analysts and investors prefer.
Enron
The Enron story began in the early 1990s when the company incurred large amounts of debt to help it evolve from a simple energy pipeline operator to a sophisticated energy trading house. Within a few years, the vast majority of its revenues were derived from the trading business. Soon afterward, the company was trading everything from telecom bandwidth to pollution emission credits. In fact, Enron officials boasted that they could trade anything, including weather!
SPE
Enron funded the SPEs with its own stock, and the SPEs issued dividends on Enron’s stock to create an artificial source of revenue. This system worked as long as stock prices increased.
Shifting Expenses
Enron hid expenses by shifting them from one SPE to another. This allowed the company to inflate profits artificially.
Revenue Manipulation
Enron would purchase oil and gas rights and record the value of reserves as revenues by using mark-to-market accounting. This type of accounting involves adjusting items to their fair market value. However, in the case of Enron, the company used this as justification to value the reserves off the expected returns discounted to present value. Essentially, those revenues were grounded entirely in speculation.
Enron also would sell ownership of power projects to its SPEs, which in turn would sell contracts for that power back to Enron. Additionally, Enron would sell fiber-optic cable contracts to the SPEs and record earnings from the sales.
Price Fixing
Enron was involved in a major energy price-fixing scheme that led to energy shortages in California.
Profit Smoothing
Many publicly traded companies engage in some form of profit smoothing for reasons ranging from beating analysts’ expectations, to displaying steady growth, to reducing tax liabilities. Managers may do this by deferring revenues and expenses to subsequent periods. By waiting to book revenues or prepaying expected expenses, a company can limit its tax burden in the near term. Such tax savings can be of particular use to a cash-strapped company. A company seeking to boost earnings in an effort to appease Wall Street analysts and shareholders might record a pending sale in the current period. This practice is highly suspect and in most cases is considered outright fraud, yet companies have been doing it for years. In reviewing financial statements, it is important to read the footnotes and understand exactly how revenues are treated and, more important, when they are recorded.
Detecting Fraud
“How do we spot these red flags?” Among other things, it is absolutely imperative that we read the financial statements as well as the footnotes. In particular, we should be aware of certain items that can be a cause for concern.
These include the following:
■ Stock option awards. Stock options, when exercised, can have a strong dilutive effect on existing shares. It is important to understand what that impact might be, and so the best recourse is to discuss this with company management or investor relations if it is not specifically outlined in the footnotes.
■ Pending lawsuits and investigations. Any type of adverse news can undermine company valuation. Again, it is important to understand the potential outcome of these lawsuits and investigations.
■ Segment information. It is very important to understand the specific segments in which the company operates and how the company has performed within those segments. Segment laggards tend to bring overall company performance down, and unfortunately, not all companies disclose the way they perform on a segment-by-segment basis.
■ Off-balance-sheet entities. Anytime you see discussion related to more off-balance-sheet entities or other special-purpose entities, it is important to ask how those entities were structured and for what purpose. Off-balance-sheet entities can mean hidden liabilities.
Pro Forma Financials
Pro forma financials are essentially adjusted financial statements. For our purposes, pro forma financials tend to fall into one of two broad categories:
• Adjusted earnings
• Projections
Pro forma financials are derived from selective editing of information, which can easily mislead investors. Through their use, a company can effortlessly present a deceptive view of operating performance. In fact, statements about a company’s financial results that are true may still be misleading if they omit material information. From time to time, companies will use a pro forma disclosure to reflect a loss as if it were a profit.
Adjusted Earnings
This is used to determine variations on earnings by omitting or including certain extraordinary items on the income statement. One-time charges and write-offs can be overlooked easily, thus turning a loss into a profit. Because there are no consistent standards or regulations for this, companies are able to use their own discretion in crafting informal disclosure and press releases to boost investor appeal.
Reasons for this practice include the following:
• Providing a meaningful comparison to results for the same period in prior years
• Emphasizing the results of core operations
• Exceeding Wall Street analysts’ expectations
• Impressing shareholders
The more common exclusions include the following:
• Restructuring charges
• Write-downs of assets
• Stock option expenses
• Write-offs of research and development costs
• Litigation costs
• Merger-related expenses
Projections
Companies often use pro formas to show the impact of a planned transaction or to spell out expected results. Such statements are useful provided that they are detailed and are understood to be based solely on estimates.
Financial models are useful for the following:
• Building forecasts and budgets
• Assessing funding requirements
• Creating marketing or operational strategies
• Doing business planning
• Raising capital
• Conducting financial analysis
• Determining valuation
There are several ways to form projections, but the best ones tend to have a line-by-line justification for each assumption. Among the more common techniques are the following:
• Line-by-line forecasts for all components of the balance sheet, income statement, and • cash flow statement
• Simple growth rate based on historical averages applied to the individual components of financials
• Economic growth rate applied to company performance
To review, the items to build into your projections include the following:
• Accumulated depreciation
• Bad debt provisions
• Capital expenditures
• Changes in debt
• Depreciation rates
• Dividends
• Fixed-asset values
• General overhead
• Intangible assets
• Interest rates
• Inventory
• Material costs
• Research and development
• Sales volumes
• Selling and distribution costs
• Selling prices
• Share issues
• Tax rates
Chapter 6: Financial Analysis
Financial Statement Analysis
1. Trend Analysis
■ Year-to-Year Change Analysis
The most common way to assess a company’s performance from one year to the next is called year-to-year change analysis. For example, look at a company’s sales growth. If the company over time has increased its sales approximately 10 percent per year, that figure can be compared with the industry average. If the industry average reveals a trend in which sales throughout the industry have grown 20 percent, the conclusion can be drawn that the company has underperformed the industry. If, in contrast, the industry trend is sales growth of 5 percent, the company seems to be doing reasonably well by outperforming the industry average. Year-to-year change analysis allows for the examination of virtually any item on the financial statements to determine a company’s growth. From there, comparisons can be made with other items on the company’s financials or with other companies in the industry.
■ Index-Number Trend-Series Analysis
This method is used for longer-term trend comparisons. It involves choosing a base year for all financial statement items and expressing each item, such as sales, as 100 percent. Every year after the base year, the sales number is adjusted above or below the base number to reflect the change. This process is helpful in assessing how those items have changed over an extended period.
2. Ratio Analysis
There are six broad categories of ratio analysis. Below is a brief description of each one, along with the group that tends to use it:
(A) Activity analysis
Activity analysis describes the relationship between a firm’s level of operations and the assets needed to sustain those operating activities. It is helpful in assessing the overall efficiency of a business. Activity analysis is useful for operations managers as well as management consultants.
■ Inventory Turnover Days
Inventory turnover days shows how frequently a company is converting its inventory to sales. This is important because inventory is costly for a number of reasons. For one thing, there is the cost of storage. Whether the company owns its property or leases it, there will be a cost associated with storage. The longer it takes to sell the inventory, the longer the company must store it and the more costly it becomes. Every time a piece of inventory is produced but not sold, the company faces the risk that eventually that inventory will become obsolete. The longer the inventory is held, the more likely it is to end up liquidated at a discount or not sold at all. The longer the inventory is held, the more the company assumes in financing costs. Thus, there are numerous reasons why inventory is costly, and because of this, company managers look at inventory turnover days:
Inventory turnover days = 365/(COGS/average inventory)
Example: A company has a cost of goods sold of $1 million and average inventory of $100,000. We take the $1 million and divide it by $100,000, which gives an inventory turnover of 10 times. In other words, inventory turns over (sells) 10 times per year. Then we divide that turnover of 10 into 365 days in the year to calculate inventory turnover days of 36.5. By using this, we can conclude that every 36 to 37 days, inventory converts to sales. Is this a good number? That depends. The sonner inventory turns, the better.
■ Accounts Receivable Turnovers Days
The longer receivables remain outstanding, the more costly they become. The longer a company holds on to its receivables, the less likely it is to collect them. Furthermore, if there are receivables outstanding, the company is losing interest on those payments. To measure average collection rate, use accounts receivable turnover days:
Accounts receivable turnover days = 365/(credit sales/average accounts receivable)
Example: A company has $1 million in purchases and $100,000 in average accounts payable, its accounts payable turnover days equals 36.5. The idea here is to obtain as large a number as possible, because the longer the company has to turn over its payables, the better off it is—the longer it keeps that cash on hand.
■ Cash Conversion Cycle
A formula that combines the different turnover numbers is called the cash conversion cycle (CCC):
CCC = AR days + Inv days – AP days
It is calculated by taking accounts receivable (AR) days, plus inventory days, minus accounts payable (AP) days, and it is a good measure of a company’s immediate liquidity.
■ Averages
The term average is prevalent throughout much of ratio analysis: average inventory, average receivables, and average payables are some of the more common applications. Each represents a balance sheet item, which, if you recall, reflects a snapshot at a particular point in time. For example, inventory would reflect the inventory at the end of the last reporting cycle. That may not reflect what occurred during the reporting cycle accurately, and therefore an average inventory number is needed. More often than not, that average number is calculated by taking the inventory number from the end of the most recent year plus the inventory number from the prior year and dividing the sum by 2. It is not perfect, but it works. A similar method of averaging can be used for any of the other balance sheet items when needed.
(B) Liquidity analysis.
This measures the adequacy of a firm’s cash resources and its ability to meet near-term cash obligations. Liquidity analysis is particularly useful for commercial bankers and, to a lesser degree, investment bankers, because it enables the lenders or issuers to understand whether a firm has sufficient cash resources to meet the obligations of a particular offering.
■ Current Ratio
The first and most common measure of a company’s liquidity is the current ratio.
Current ratio = current assets/current liabilities
With the current ratio, the hope is that current assets will exceed current liabilities, resulting in a ratio greater than 1. This proves that the company has sufficient liquidity to cover its near-term obligations, which is a good position to be in. If current assets fall below current liabilities, the company would have a current ratio less than 1—and, more important, a big problem on its hands.
■ Quick Ratio
A variation on the current ratio is the quick ratio.
Quick ratio = (cash + marketable securities + accounts receivable)/current liabilities
The primary difference between the quick ratio and the current ratio is the exclusion of inventory in the quick ratio. Many analysts believe the quick ratio is a better measure of a firm’s immediate liquidity, because it uses a purer form of liquid assets.
■ Cash Ratio
The cash ratio adds cash to marketable securities and divides the sum by current liabilities.
Cash ratio = (cash + marketable securities)/current liabilities
With the cash ratio, both inventory and accounts receivable are excluded because the view is that both are inherently problematic as a result of the difficulty of converting them to cash.
(C) Long-term debt and solvency analysis. This examines a company’s capital structure, its mix of financing sources, and, more important, the ability of the firm to satisfy its longer-term debt and investment obligations. Investment bankers and fund managers often use this type of analysis.
■ Debt-to-Capital Ratio
Investment bankers commonly use this to measure relative levels of debt:
D/C ratio = total debt/(total debt + total equity)
In other words, the debt-to-capital ratio measures debt outstanding relative to the company’s entire capital structure. For example, a company’s 50 percent debt-to-capital ratio could be compared with an industry average. If the industry average is 20 percent, this company is clearly overleveraged. This proves useful in financing decisions, such as deciding on the appropriate mix of debt and equity financing. Investment bankers love the debt-to-capital ratio because they can tell their clients either “You’re overleveraged; we should issue some equity to pay down that debt” or “You’re underleveraged; we should issue more debt.” Either option results in hefty underwriting fees!
■ Debt-to-Equity Ratio
The debt-to-equity ratio is a simple variation on the debt-to-capital ratio.
D/E = total debt/total equity
■ Times Interest Earned Ratio
Finally, analysts use the times interest earned ratio, or what is commonly referred to as the interest coverage ratio. If you have ever sought a loan of any type (e.g., home equity loan, school loan, auto loan), someone at a commercial bank took a look at your times interest earned ratio. This was done by taking your earnings before interest and taxes and dividing it by your interest expense:
Times interest earned = EBIT/interest
The interest coverage ratio helps determine whether a company has sufficient EBIT to cover the necessary interest payments on debt outstanding.
(D) Profitability analysis. Profitability analysis is particularly useful for investment analysts, private equity investors, and company managers.
■ Gross Margin
Gross margin is the greatest ratio ever. It is hard to manipulate and offers an exceptional measure of a company’s profitability at the highest level.
Gross margin = gross profit/sales
Corporate managers are concerned with gross margin because the number is a measure of a company’s distribution efficiency. Specifically, a company with higher gross margins derives more from a sale than does one with lower margins even though their profits may be comparable. Investors prefer a company with a higher gross margin because this indicates greater efficiency.
Additionally, a number of trends have emerged over the past decade that improve gross margins:
• As supermarket chains consolidate, they are able to increase their buying power and achieve better pricing from wholesalers. Additionally, because competition has been eliminated, prices may increase, further improving gross margins.
• By diversifying into new products and services such as organic produce and banking services, supermarkets are able to capitalize on higher-margin offerings.
■ Operating Margin
The software industry typically is characterized by very high gross margins. Software traditionally exhibits these high gross margins because its cost of goods sold tends to be very low. The COGS for software is really the cost of disseminating the software, either on disc or through Web-based applications. That tends to be a very small percentage of overall sales. In software, however, there are much higher operating expenses, which usually involve a significant amount of research and development. These expenses are distributed incrementally, or amortized, over some period. Research and development tends to be a large part of a software company’s expense structure, and so the company’s operating margin is much lower. Operating margin pertains to operating income divided by sales:
Operating margin = operating income/sales
■ Profit Margin
Finally, the most common measure of profitability is the profit margin, net income divided by sales:
Profit margin = net income/sales
(E) Return analysis. This examines the returns on assets, total capital, and equity in an effort to measure investment performance.
■ Return on Assets
Return on assets is calculated by taking net income and dividing it by total assets:
ROA = net income/total assets
■ Return on Total Capital
Another way to calculate return on investment is by calculating return on total capital. Here net income is divided by the sum of total debt plus total equity:
Return on total capital = net income/(total debt + total equity)
■ Return on Equity
ROI can be calculated as return on equity. This is done by taking net income and dividing it by total equity (shareholders’ equity):
ROE = net income/total equity
(F) Market analysis. This measures value, income, and dividends relative to one another. This is useful for investors and market traders.
■ Price-to-Earnings Ratio
The P/E ratio is useful because it enables an analyst to gauge the relative value of a company:
Price-to-earnings ratio = stock price/earnings per share
The share price of a company’s stock reflects that company’s ability to generate profits. The P/E ratio reveals the price an investor must pay to capture a dollar of earnings. A company’s P/E ratio is measured relative to an industry average or peer group. If the P/E ratio of a company exceeds the P/E ratio of the industry, it is usually thought that the company is overvalued. If the P/E ratio of the company is less than the industry average, it is observed that the company might be undervalued. If the P/E ratio of the company is equal to the industry average, the company is probably fairly valued.
■ Earnings Yield
Earnings yield takes earnings per share and divides it by the market price per share. It’s the inverse of the P/E ratio or, in other words, the earnings you buy with a dollar’s worth of stock.
Earnings yield = EPS/market price per share
If the company has earnings per share of $2 and a market price per share of $20, its earnings yield is 10 percent.
■ Dividend Yield
Dividend yield takes dividends per share and divides it by market price per share. This helps assess how much the company is paying in dividends relative to its market price per share, or what percentage of the market price that dividend is. Also, that can be compared with an industry average to see if the company is paying more or less than the industry average.
Dividend yield = dividends per share/market price per share
If the company pays out $1 in dividends with a market price per share of $20, the dividend yield is 5 percent. If the industry average is 10 percent, the company is paying less than the industry.
■ Dividend Payout Ratio
Dividend payout ratio = dividends per share/earnings per share
If a company pays out $1 in dividends and has $2 in earnings, its dividend payout ratio is 50 percent. Again, whether this is a good or a bad number depends on industry averages. The remaining $1 is transferred back to the balance sheet in the form of retained earnings.
■ Price-to-Book Ratio
P/B ratio = market price per share/book price per share
Market price per share is the price observed in the open market. For a publicly traded company, this is the stock price. The book price per share is the price or the value observed on the balance sheet that is listed as owners’ equity, and it usually is not considered a good indicator of company value. Market value is based on the demand for the company or its shares, and it is commonly accepted as a starting point in the sale process. Rarely are these two numbers the same. Usually market price will exceed book price, though there are instances when the two numbers converge, which is often seen as a buying opportunity.
3. Economic Value added
Economic value added, or EVA, is a relatively recent performance measure developed to help companies calculate their true economic profit. One of the major advantages of EVA is that it can be used to measure performance on a divisional level, unlike other methods of analysis and valuation. EVA essentially does this by taking net operating profits after taxes minus a charge for the opportunity cost of invested capital. In other words, it measures a company’s performance after deducting its cost of capital from its tax-adjusted operating profit. Some uses for EVA include:
• Strategic goal setting
• Bonus determination
• Capital budgeting
• Valuation
• Equity analysis
The derivation of the formula for EVA is as follows:
Net sales – operating expenses = operating profit
Operating profit – taxes = net operating profit after taxes
Net operating profit after taxes – capital charges (capital × cost of capital) = EVA
Or simply put:
EVA = net operating profit after taxes – (capital × cost of capital)
EVA is used to measure profitability after a company accounts for its cost of invested capital. This capital charge is what really drives the EVA analysis. Although the company is seemingly profitable, it must exceed the cost of capital to benefit the shareholders. Suppose you manage a large multidivisional, multinational corporation. EVA provides a useful and user-friendly performance measure. You can measure EVA on the basis of operating divisions or even on a regional basis. It is a simple standard that most shareholders can understand, and aside from the cost of capital, it is rarely subject to manipulation. Although EVA is gaining ground in application, it still has a way to go before being universally accepted.
Chapter 7: Managerial Accounting
Managerial accounting is designed almost exclusively for internal decision making. Managers use managerial accounting tools, some standard and others customized, to form better decisions that will hopefully lead to enhanced company performance. In other words, managerial accounting tends to have an internal bias, while financial accounting has an external one. Additionally, managerial accounting tends to be forward looking, while financial accounting tends to be backward looking.
Costing Analysis
Costing analysis can help a manager arrive at the most cost-efficient decisions surrounding the sourcing of a product. An essential part of this is what is called contribution margin. Contribution margin is a close cousin of gross margin, reveals how much you earn on a product sold relative to sales. A high gross margin reveals that your costs of procuring or producing the product is low relative to its sale price. Contribution margin goes a step further by incorporating other variable costs into the equation. It’s based in the equation:
Contribution margin = Sales – cost of goods sold – other variable costs
With contribution margin, you will better understand your real cost of procuring or producing the product.
Suppose you’re in the business of selling plastic sandals. Each pair sells for $20. Materials cost $8, labor $2, machine operation $1. Your contribution margin would be $20 less the material cost, labor cost, and machine operation cost, or $9. If your fixed costs total $9,000, you must sell 1,000 plastic molded sandals before you generate a profit. After selling these 1,000 sandals, each additional pair sold will boost your profit by $9.
As you can see, contribution margin reframes the profit picture by allowing you to determine how many units you need to sell before you are able to cover your fixed costs.
Transfer Pricing
Transfer pricing is the price at which one division sells goods and services to another division. This is important because it affects divisional performance and may have tax consequences as well. For example, if pricing is too low, the division may sell externally. If the division is in a higher tax bracket comparatively, it may make sense to price high to maximize the tax benefit to the company.
Suppose Car-E-Oki requires a key part for its next generation Car-E-Oki machine. The part currently costs $20 per unit. If the company were to manufacture the part, the unit cost would drop to $10. However, manufacturing the part in-house would require fixed costs of $200,000 to purchase equipment needed to produce the part. So does the company build or buy? This all depends on how many machines it would expect to sell. A simple, one-term analysis can help answer this question. Consider the following:
1. Unit savings from manufacturing the part = $10/unit
2. Fixed cost needed to acquire the machine to manufacture the part = $200,000 (assume costs for running the machine are variable and included in the $10/unit cost)
To answer the question, we use the following equation:
Fixed cost to purchase equipment/cost savings per unit =
total units to achieve breakeve
$200,000/$10 = 20,000 units must be sold to achieve the same profit as buying the part In other words, if the company expects to sell more than 20,000 machines, it makes sense to buy the machine and manufacture the parts in-house.
Activity-based Costing (ABC)
Imagine you own a business that makes muffins and cupcakes. Each month, you sell 200 muffins and 200 cupcakes. At the end of the month, you receive a $400 bill from the utility company, mostly for powering the ovens that bake the goods. So, how would you divide this bill between the muffins and cupcakes? One way is to divide the $400 bill by the total number of baked goods (400), resulting in $1 per item. However, if baking a muffin requires more power than a cupcake, say $1.50 for a muffin and $0.50 for a cupcake, it becomes tricky to allocate the costs. By knowing that muffins use three times the power of cupcakes, we can manage our business more efficiently by determining the cost per item and making better pricing decisions.
Operations Management
One of the more intriguing areas of managerial accounting focuses on inventory production. While inventory production analysis falls under the broader umbrella of operations management, certain production measures are part of managerial accounting. Inventory can prove costly, and the sooner the inventory is sold, the sooner the company benefits from it.
In order to understand the managerial accounting measures used in analyzing inventory processes, it’s important to first understand key terminology. Throughput is the number of units flowing through a business over a given period of time. For example, a business would have throughput of 10 cupcakes per hour if that is the average number of cupcakes produced each hour. Flow time, a concept related to throughput, is the total amount of time that a unit spends in a particular business process. And finally, inventory, in the context of operations management and managerial accounting, is the number of units in any given time in a process.
Work in process (WIP):
Inventory = throughput x flow time
PART 2: FINANCE
Chapter 8: Cost of Capital
What is the cost of capital? That depends on the context. For example, a simple definition pertains to the rate required or charged for the use of funds. If you go to the bank and take out a loan, your cost of that loan is what you pay in interest. Therefore, interest rates are a good example of the cost of capital.
The question now arises: How do you decide on that appropriate opportunity cost of capital? Opportunity cost of capital depends on the risk involved in the project. In fact, investors typically expect a higher rate of return if they deem a project to be riskier than any other opportunity in the market. The simple reason for this is that they want to be compensated for the higher risk involved.
Cost of capital is useful in the world of finance for two primary reasons:
• It serves as an effective performance benchmark.
• It enables the calculation of present values of future payments—something extremely useful in valuation analysis.
As a performance benchmark, cost of capital is useful in determining how much a company must earn on its assets to meet the expectations of investors and creditors. As a valuation variable, cost of capital will affect the overall value of a company when based on future returns (cash flows, EBITDA, etc.)
Cost of Equity
The cost of equity is essentially the return expected by the shareholders of a company. Unlike debt, where the debt holders are promised a certain rate, equity offers no clearly defined return. As a result, there are several ways to calculate this. The two methods examined here are among those more commonly used by Wall Street analysts and bankers. The first is called the dividend growth model, and the second is called the capital asset pricing model commonly referred to as the CAPM.
Dividend Growth Model
The dividend growth model is considered the easiest way to estimate the cost of equity capital. It is predicated on the notion that the firm’s dividend will grow at a constant rate. The dividend growth model is written as follows:
rₑ = (D₁/P₀) + g
where
rₑ = return on equity (cost of equity)
D₁ = D₀ × (1 + g)
D₀ = most recent dividend payment
P₀ = current stock price
g = estimated dividend growth (use historical rates or analysts’ forecasts)
There are a couple of ways to estimate dividend growth. One method is simply to look at historical rates and take an average of the past several years. Another method involves analysts’ forecasts for the company or might even involve the forecast for the entire industry.
To understand this, look at this sample problem:
A utility company paid a dividend of $2 per share last year, which is expected to grow at 6 percent per year indefinitely. If the company has a current share price of $60, what would its return on equity be, based on the dividend growth model? (Answer: 9.5%)
However, a number of problems arise with this approach. For one thing, it is applicable only to companies that pay dividends. Furthermore, the dividends must grow at a constant rate, and the result is highly sensitive to that growth rate. Finally, risk, which is a key measure of return on equity, is not considered explicitly. To account for these shortcomings, an alternative method—the capital asset pricing model—often is used to calculate the cost of equity.
Capital Asset Pricing Model
The capital asset pricing model (CAPM) is useful in measuring the cost of equity because it measures risk explicitly. It is also applicable to companies that may not have steady dividend growth.
The CAPM is fairly difficult to grasp initially, but with some work, it should become manageable soon. Here is the formula for the CAPM:
rₑ = rf + β(rₘ – rf)
where
rₑ = return on equity (cost of equity)
rf = risk-free rate
β = beta
rₘ = return on the market
■ Risk-Free Rate
A risk-free security is a security whose rate of return is guaranteed. Specifically, there is no risk of default on these payments because the payments have no associated risks aside from inflation. Typical risk-free securities are government securities such as Treasury bills, Treasury notes, and Treasury bonds. Usually, Treasury bills are considered the safest because they have very little to no risk of interest rate fluctuation, unlike their T-note and T-bond counterparts. These securities are considered risk-free because the US government has never defaulted on its debt … at least not yet. Therefore, a good risk-free rate would be the rate on Treasury bills.
■ Market Rate
To understand the market rate, it is necessary to understand the concept of a market portfolio. A market portfolio is designed to cover all the securities in the market or to be a representation of the securities in the market. This provides a clear benchmark for overall market performance. A typical market portfolio would be the S&P 500 index. Although only 500 companies are included in this index out of several thousand publicly traded companies, those 500 account for a substantial portion of the value of all stocks traded. For that reason, the S&P 500 index often is used to represent the market portfolio. Thus, the market rate would be based on this.
■ Beta
Beta measures the correlation of the returns on individual stocks relative to the returns on the overall market. It is assumed that the beta of the overall market is 1. Stocks with betas greater than 1 would tend to amplify market movements. Stocks with betas between zero and 1 would tend to move in the same direction as the market, but not by as much.
Beta is derived through some complex calculations. Statisticians and some portfolio managers actually calculate beta by taking the covariance between the return on the stock and the overall market and dividing it by the variance on the overall market return: β = SₛSₘ/Sₘ²
where
SₛSₘ = covariance between the return on stock S and the overall market return
Sₘ² = variance of the market return
Weighted Average Cost of Capital
To reach an assessment of what the overall cost of capital is for a firm, you must use what is called the weighted average cost of capital (WACC). This is the most commonly used method to measure the overall cost of capital. The major advantage of the weighted average cost of capital is that it takes into account financing decisions—the mix of debt and equity and, more specifically, their weighted averages. Furthermore, the WACC also takes into account the fact that interest payments are tax-deductible, and therefore it is important to look at the cost of capital on an after-tax basis.
In Chapter 9, you will see just how important the cost of capital is in valuing companies.
Chapter 9: Valuation
Valuation basics
Time Value of Money
The time value of money states that $1 received today has a different value from $1 received a year ago or $1 received a year from now. For example, a firm receives a $100 payment on January 1. It deposits the payment in an interest-bearing account that pays 5 percent. On December 31 that account is worth $105. It has earned 5 percent interest, or $5.
Present Value
Present value is the concept that money spent tomorrow must be worth less today because of the time value of money. The present value amount is calculated by using the formula:
PV = CF/(1 + r)ⁿ
where
PV = present value
CF = cash flow for the period
r = discount rate
ⁿ = period
Methods of valuation
There are numerous uses for valuation. A few of the more common ones are:
• Venture capital
• Initial public offerings
• Mergers and acquisitions
• Leveraged buyouts
• Estate and tax settlements
• Divorce settlements
• Capital raising
• Partnerships
• Restructurings
• Real estate
• Joint ventures
• Project finance
Replacement Method
The replacement method of valuation tends to be the simplest to explain but the most time-consuming to produce. It is based on a target company or asset that is valued by estimating the cost to create an exact duplicate. In other words, it seeks an answer to the question, What would this cost to build from scratch?
Those costs might include:
• Land
• Buildings
• Machinery
• Equipment
• Working capital
These costs are summed and then used as a proxy for fair value of the asset or business. Major drawbacks include difficulty in gathering complete information and, more important, difficulty valuing intangibles such as brand name, intellectual property, and perhaps customer loyalty.
Capitalization of Earnings
One of the more common and relatively straightforward methods of valuation is the capitalization of earnings method. Essentially, this method uses a risk rate to assess the value needed to generate the same amount of income as the business being valued.
Unfortunately, such risk-free situations rarely exist. Thus, with increased risk, a higher capitalization rate would have to be assessed to estimate fair value. These rates vary, and some might argue that they are entirely arbitrary. Regardless of the methodology, the result will prove highly sensitive to this rate. As a result, many analysts believe the capitalization of earnings method is problematic.
Excess Earning Method
A variation on the capitalization of earnings method is the excess earning method. The major difference is that this method separates return on assets from the excess earnings.
Discounted Cash Flow Valuation
The discounted cash flow (DCF) method of valuation is one of the most commonly used methods. Most investment bankers know this method better than they know their own spouses, which probably explains a lot. The reason DCF models tend to be so complicated and time-intensive has little to do with the actual DCF calculations and much more to do with the research involved in creating projections.
In fact, the entire process can be condensed into four steps:
1. Calculate projections for future cash flows.
2. Calculate the cost of capital, or as it’s referred to here, the discount rate.
3. Calculate the present value for each year’s cash flow.
4. Finally, take the total of those present value cash flows.
Comparable Multiple Valuation
The final method of valuation is the most commonly used and probably the easiest to use as well. It is based on benchmarking one company against an industry-average multiple such as the price-to-earnings ratio.
Generally speaking, if a company’s price-to-earnings ratio is greater than the industry average, it is fair to say that the company is overvalued. If the company’s P/E ratio is less than the industry average, it is fair to say that the company is undervalued.
Lose Customers, Lose Value
Nowadays, collecting customer data is just as important to a business as selling products to its customers. After all, knowledge is power, and power is value.
Customers had entrusted the company with some of their most guarded personal information. When that trust was breached, customer confidence was lost. Who wants to provide a social security number or bank account information when there’s a chance it will be stolen?
The moral to this story: for a business, your customer information is your most valuable asset. Lose it and you can lose your business. A loss of business means a loss of profit. And a loss of profit means a loss of value. This is what investors were thinking as they scrambled to assess the damage and estimate the loss of future profits.
Net Present Value
A common measure that often is used in the world of investment banking is net present value (NPV). NPV is derived from basic principles of discounting future returns.
NPV is calculated by using this simple formula:
NPV = present value of future returns – investment
When NPV is positive, the entrepreneur probably will move forward with the company. If NPV is negative, it will not make sense to move forward. Bankers like this measure because it reveals a return in cash and factors in risk based on a discount rate.
Investors such as venture capitalists, by contrast, tend to look at the internal rate of return (IRR), the maximum rate of interest that could be paid for capital employed over the life of an investment in order for it to break even. This definition takes an already complicated concept and makes it more complicated. A more informal definition of IRR, which is the discount rate at which the sum of present values of future cash flows equals the initial investment. The IRR is useful in preference decisions. For example, a venture capitalist might review hundreds of proposals per month but may determine that only the ones with an IRR exceeding the firm’s hurdle rate are worth investing in. Again, no decision should be based exclusively on IRR or any other single performance measure, but IRRs do provide a reasonable starting point.
Chapter 10: Wall Street Basics: Stocks and Bonds
The balance sheet helps us understand the overall financial health of a company. A major factor in determining financial health is the company’s underlying capital structure. A question that arises in many discussions about the balance sheet is, What is the best way to capitalize a company? Is it equity or debt? The answer is that it depends, as both debt and equity have their advantages.
Debt offers the following advantages:
• First, lenders have no direct claim on future earnings, and so debt can be issued without worries about a claim on earnings. As long as the interest is paid, the company is fine.
• Second, the interest paid on debt can be deducted for tax purposes.
• Third, most payments, whether they are interest or principal payments, are usually predictable, and so a company can plan ahead and budget for them.
• Fourth, debt does not dilute the owner’s interest, and so an owner can issue debt and not worry about a reduced equity stake.
• Fifth, interest rates are usually lower than the expected return. If they are not, a change in management can be expected soon.
Debt securities can take a number of different forms, the most common being bonds. Bonds are obligations secured by a mortgage on company property. Bonds tend to be safer from the investors’ standpoint and therefore pay lower interest. Debentures, in contrast, are unsecured and are issued on the strength of the company’s reputation, projected earnings, or growth potential. Debentures, being far riskier, tend to pay more interest than do their more secure counterparts.
Equity has the following advantages.
• First, equity does not raise a company’s breakeven point, and so a company can issue equity and not have to worry about achieving performance benchmarks to fund the equity.
• Second, equity does not increase the risk of insolvency, and so a company can issue equity and not have to worry about any subsequent payments to service that equity. Equity is essentially capital with unlimited life, and so a company can issue equity and not have to worry about when it comes due.
• Third, there is no need to pledge assets or offer any personal guarantees when equity is issued.
Equity can take a number of different forms. A simple form of equity is common stock. This type of stock offers no limits on the rate of return and can continue to rise in price indefinitely. Preferred stock entitles the holders to receive dividends at a fixed or adjustable rate of return and ranks higher than common stock in a liquidation. In fact, preferred stock may have antidilution rights so that in a subsequent stock offering, preferred stockholders may maintain the same equity stake. Convertible securities are highly structured in nature and are based on certain parameters; also, as the word convertible indicates, they may convert into other securities. Among the most common are warrants and options. Warrants and options stand for the right to buy a stated number of shares of common or preferred stock at a specified time for a specified price. There are also convertible notes and preferred stock, which refer to the right to convert these notes to some common stock when the conversion price is more favorable than the current rate of return.
Bonds
The strategies that corporations employ to manage their debt can drive a company’s overall performance. Bonds, or what generally are referred to as secured debts, have a number of distinguishing features. Here is a brief explanation of each one:
• Amount (of issue): how much was raised from the offering
• Date (of issue): the day of sale
• Maturity: when the principal will be repaid
• Face value: denomination of the bond
• Offer price: the percentage of the face value
• Coupon: the percentage of interest paid to bondholders (usually stated in annual terms)
• Coupon payment dates: dates of interest payments
• Call provision: whether the com pany retains the right to repay the bond before maturity
• Call price: if there is a call provision, the price at which the company can buy the bond back (usually above the bond’s value, thus offering a premium for early repayment)
Types of Bonds: Corporate and Government
■ Corporate bonds can take many forms, but for the most part, an issuance of long-term debt to the public by a company is considered a corporate bond offering. A corporate bond will be traded in the open market, both on and off the major exchanges. Most of these bonds will be rated by one of the major rating agencies, such as Standard & Poor’s or Moody’s. Those ratings will be based on the creditworthiness of the issuer, which will factor in a number of variables used to determine the probability of default. The higher the likelihood of default, the lower the rating. The bond prices are highly sensitive to these ratings. The ratings range from AAA (S&P) and Aaa (Moody’s) to D (S&P) and C (Moody’s). A bond’s ratings will affect its pricing. When a company falls to a rating of BB (S&P) or Ba (Moody’s), it is called junk (known as high yield in more refined circiles).
■ Government Bonds
Most countries around the globe finance a portion of their activities through the issuance of bonds. In many of these countries, though, payback will never happen. The US government issues Treasury bills, notes, and bonds to finance its activities, with maturities on the latter two ranging from 2 to 30 years.
Like the federal government, state and local governments issue municipal (muni) bonds. These bonds can have higher levels of risk and often are related to a specific project, such as the construction of a dam. Furthermore, they are usually callable. The most appealing quality of these bonds to the investor is the fact that they are exempt from federal tax. Because of the tax benefit of these bonds, their yields tend to be significantly lower than those of corporate bonds.
Types of Bonds: Zero Coupon, Fixed Rate, and Floating Rate
■ Zero Coupon Bonds
Zero coupon bonds are priced at a discount to par, with the difference accounting for the interest that will be paid.
■ Fixed- and Floating-Rate Bonds
Fixed-rate bonds make a payment that is based on a fixed rate of interest. If that rate is 5 percent, a $1,000 bond will pay $50 per year. Floating-rate bonds, by contrast, make payments that are based on a variable rate of interest that usually is tied to an interest index such as Treasury rates or LIBOR (London Interbank Offering Rate).
■ Bond Pricing and Valuation
Now comes the tricky part: bond pricing. Here is a bond quote for the company Car-E-Oki as it would appear in the newspaper:
| BOND | CURRENT | YIELD | CLOSE | CHANGE |
|---|---|---|---|---|
| CEO | 8¹/² 20 | 8.6 | 98.53 | -0.42 |
This bond pays 8.5 percent of its face value in interest and matures in 2020. With a face value of $1,000, the bond will pay $85 in interest per year. This bond closed at 98.35, or 98.35 percent of its face value of $1,000, which would be $983.50. The closing price dropped 0.42 percent, or $4.20, since yesterday’s close.
What drives that bond price and, correspondingly, the yield? In other words, how are these bonds valued? A number of factors influence this. Among them are the following:
• Interest rates
• Inflation
• Credit risk
• Liquidity
Inflation and interest tend to work in tandem. If an outlook of high inflation is prevalent, interest rates will increase to compensate for it. Credit risk has to do with the creditworthiness of a company.
Junk Bonds
Junk bonds grew in popularity as corporations experienced a drop in credit quality resulting from a change in business or financing conditions. As more statisticians and financial analysts began to study the returns on junk bond portfolios, they soon determined that the risk-adjusted returns on a portfolio of junk bonds were higher than the risk assumed.
Stocks
Just as important as bond valuation is stock valuation:
Discounted Cash Flows
As was shown in Chapter 9, the value of a company can be assessed on the basis of the sum of the present value of future cash flows. Therefore, an equity analyst will build out these detailed cash flow models, come up with a discount rate, take the present value of these projected cash flows, and add them all up. The final step, barring any adjustments, is to divide the company value by the number of shares outstanding to determine a value on a per-share basis. This will form the basis of the price target assessed by the analyst.
Dividend Method
Another method of assessing stock values is to project a stream of dividends and discount them to present value. The idea is that dividends represent the return on a stock. Thus, these dividends can be treated the same way projected cash flows would be treated. If the dividend is assumed to grow at a constant rate, the stock price would be modeled as follows:
As far as forecasting the dividend goes, there are a number of ways to do this. The simplest, of course, is to assume that it does not change. In that case, a simple perpetuity calculation could be used, which would look something like this:
P = D/r
Also, assume that the dividend grows at a constant rate using the formula for a perpetuity with growth. In this case, a dividend would be used instead of a cash flow:
P = D/(r – g)
Short Selling
Short sellers make a bet that the price of a company’s stock will fall. To do that, they borrow shares of a traded stock (usually held by a brokerage house) and sell it with the intent of buying it back at a lower price. When the price drops, the short seller can buy the stock back and earn a profit on the difference between the sale price and the purchase price.
Chapter 11: Wall Street Part Deux: Arbitrage, Derivatives, and Hedge Funds
Arbitrage
Arbitrage is the simultaneous purchase and sale of an asset or security to capitalize on the price differentials that exist between different marketplaces or exchanges. In other words, it is an opportunity to earn a return on a transaction without assuming any risk.
Currency Arbitrage
Currency arbitrage is one of the most profitable forms of arbitrage. Suppose the exchange rate between British pounds (GBP) and US dollars (USD) is 2, and so one could trade £5 for $10. The USD-to-GBP rate would be 0.5. However, what happens if the USD-to-GBP rate is 0.6 for a moment? One then could trade $10 for £6. In this process, £1 is earned. In theory, the market will correct soon, but for a fleeting moment, a class of arbitrageurs has done its best to exploit this difference.
In many cases of arbitrage, hefty transaction costs preclude traders from executing the transaction. As a result, currency arbitrage tends to be more common than other types as a result of the lower transaction costs.
Merger Arbitrage
Merger arbitrage is the simultaneous purchase and sale of two companies involved in a proposed merger. A merger arbitrageur analyzes the probability of the merger not closing within the stated time frame or at all. Because of this uncertainty, the target company’s stock price trades at a slight discount to the acquirer’s offer price. Therefore, the merger arbitrageur might assess that there is a high probability that the deal will close and try to profit from the price differential.
Index Arbitrage
Sometimes stock traders find minor discrepancies in the pricing of index funds and the individual stocks that compose them. In such instances, traders may buy the index and simultaneously short the individual stocks. These trades tend to be more complex and often involve dealing with several dozen or more individual stocks.
Convertible-Debt Arbitrage
With these instruments, you might have the option to convert your debt to common stock at a certain price. In rare instances, you might be able to convert at one price and then sell at a different market price.
Derivatives
Derivative securities are securities based on the movement of an underlying security or index. This might include stocks, bonds, commodities, currencies, or even indexes. Derivatives were created to hedge against market risk, and today there is an abundance of such instruments. The more common ones include options, warrants, and swaps.
Options
An ordinary option grants the holder the right to buy or sell something at a specified price within a specified period. The most basic forms of options are calls and puts.
■ Call Options
A call option gives the holder the right, but not the obligation, to buy the underlying security at the strike price on or before expiration. A call option will therefore become more valuable as the underlying security rises in price (calls have a positive delta).
■ Put Options
Opposite to call options, a put gives the holder the right, but not the obligation, to instead sell the underlying stock at the strike price on or before expiration. A long put, therefore, is a short position in the underlying security, since the put gains value as the underlying’s price falls (they have a negative delta). Protective puts can be purchased as a sort of insurance, providing a price floor for investors to hedge their positions.
■ Option Valuation
Option valuation is a tricky business. There are a number of ways to value these options, but most option models consistently factor in the following:
• Strike price
• Expected option life
• Current stock price
• Expected dividends
• Volatility
• Risk-free rate
The most commonly used method is the Black-Scholes model. Back in the early 1970s, two guys by the names of Fischer Black and Myron Scholes wrote a paper in which they detailed a mathematical model that could be used to value options.
First, the model is driven heavily by historical movements of a stock, which may not depict expected future developments accurately. Second, the model is mathematically complex. Third, long-term, nontraded stock options would not be covered by such a model.
Although alternatives to Black-Scholes exist, most financial managers prefer this method. The binomial lattice model (also known as Cox, Ross, Rubinstein) uses more inputs and thus is seen as more accurate. Nonetheless, Black-Scholes remains the preferred method because of its long history and, more than anything else, concern over changing internal controls. Most CFOs would be reluctant to adopt a new standard because of the time and cost associated with development and training.
■ Option Arbitrage
As we saw earlier in this chapter, arbitrage can be an effective way to profit from pricing discrepancies. Sometimes options create such opportunities. Suppose you notice that Company ABC is trading at $50 per share. The call option to buy one share of ABC at $30 is trading at $10. You can buy the option for $10, exercise the call for $30, and sell the stock that you now own for $50. You have paid $10 for the option plus $30 for the stock for a total cost of $40, and so you walk away with a $10 return. Such instances are extremely rare, although it is possible for an active options trader to pick up a discrepancy of a few basis points on a similar trade. If you are trading millions of dollars, this can amount to a nice return.
Warrants
Warrants are similar to options, with the largest differences stemming from duration. Aside from that, the differences are minor, as you can see here:
Swaps
Swaps are a type of derivative in which two parties enter into an agreement to exchange their streams of cash flows. One of the more common types of these is interest rate swaps. Often, a company that pays a fixed rate of interest on corporate debt seeks to protect these payments from a fall in interest rates. These simple swaps are known as vanilla interest swaps. Typically, such an arrangement will involve two loans of the same denomination that pay interest on the same dates. One loan pays a fixed rate, and the other pays a floating rate.
Normally, vanilla interest rate swaps are quoted on the basis of the fixed rate, and so the difference between the fixed rate and the corresponding floating rate (US Treasuries, LIBOR) will be quoted as the swap rate. Swaps are used not only by financial managers but by bond traders as well. A trader betting on a rise in interest rates might enter into a pay-fixed swap.
Forwards
A forward contract is an obligation to transfer an asset at a specific price on a specific date. It is an effective hedge, especially in the commodities markets, which can be quite volatile and subject to forces outside the market. The party that will sell the asset is called the short party, and the party that buys it is called the long party. When the deal is structured, no funds actually change hands.
Futures
Futures are contracts to buy or sell an underlying asset on a particular date. Futures generally are traded for commodities such as oil, gold, wool, and frozen concentrated orange juice. When one buys a future contract, one is agreeing to buy a certain commodity or index on a certain date, and when one sells a future contract, one agrees to sell the underlying commodity or index on a certain date. The cash settlement that occurs on that date is based on the movement in price of the underlying commodity or index.
Futures can be used to do the following:
• Hedge a portfolio position to protect it in the event of a market downturn.
• Achieve leveraged returns with a small investment, potentially leading to sizable returns.
• Capitalize on market declines; if the market should turn south, an investment could be protected and recognize sizable gains through the use of futures.
Futures and Valuation
Futures are valued on the basis of market demand rather than a fixed or predetermined price. Futures traders do their best to assess a fair value by using a calculation that is loosely equal to the underlying asset plus a premium, referred to as the cost of carry. The cost of carry pertains to any expenses incurred while holding that position. Consider the following example:
The NASDAQ is currently at 2,000. Interest rates are at 4 percent. There are 180 days until maturity for this futures contract. The average dividend yield on stocks in this index is 2 percent.
To calculate the fair value, use the following formula:
Fair value = current level of NASDAQ + cost of carry
= 2,000 + [2,000 × (4% – 2%) × 180/365]
= 2,019.73
As with options, this premium will decrease as the maturity date approaches.
Hedge Funds
With exotic securities and innovative investing strategies on the rise, hedge funds are a popular means of achieving strong returns for high-net-worth individuals. These funds are formed through a managed portfolio that takes aggressive positions in what are often highly speculative opportunities. Most of these funds are limited to a small pool of individual investors, usually no more than 100. Hedge funds are generally unregulated, because it is assumed that the people investing in them are sophisticated investors. Investing strategies might involve derivatives, swaps, arbitrage, leverage, and short selling. They often take exceptionally large amounts of risk in an effort to produce astronomical returns. Most hedge fund managers will argue that they diversify against stock market risk by taking on complex positions.
Chapter 12: Mergers and Acquisitons
Types of Mergers
Generally speaking, most mergers fall into three categories.
■ Horizontal Merger
This occurs between two companies in the same industry. For example, two oil companies may decide to merge because they believe they can create efficiencies within the company and thus eliminate costs and improve profitability. This inevitably causes valuation to increase because profitability is a key driver of valuation. In doing this, the two companies have achieved some synergy, and this type of horizontal merger makes sense.
■ Vertical Merger
This occurs between two companies involved in different stages of production. Suppose two companies in the media production industry decide to merge. One produces content, and the other owns a network with vast distribution capabilities. This results in the perfect formula for a successful vertical merger, with content and delivery now offered by one company. Ultimately, the different stages of production delivery combine to create more efficiency, more productivity, more profitability, and, of course, more value.
■ Conglomerate Merger
This occurs between companies in often unrelated industries that seek to create a diversified portfolio of companies intended to hedge against risk. This type of merger can create some operating efficiencies resulting from the combination of redundant departments.
Why Merger?
The goal of any merger is ultimately to create additional value for shareholders. Some of the specific opportunities that might lead to this are detailed here.
■ Utilize Surplus Funds
Cash-rich firms may use cash to fund acquisitions in an effort to generate long-term growth. It is a means by which they can rid themselves of excess cash while creating additional growth opportunities. At the same time, cash-rich firms often become targets of takeovers from larger firms that are seeking to build steady, consistent cash flows.
■ Eliminate Management Inefficiencies
The need or the decision to merge often stems from the goal of eliminating management inefficiencies. Acquisition often creates opportunities to eliminate certain management teams and replace them with new ones. In doing this, the expectation is that bringing on new management with fresh ideas will eliminate old inefficiencies. Quite often, the simple public relations impact of such a move is enough to create additional value for publicly traded companies.
■ Increase Revenues
Increases in revenue can arise from a number of sources, including better distribution, a diversified product mix, access to new markets, and access to new sales channels. Ultimately, anything resulting in a boost to the top line can be justification for a merger.
■ Decrease Costs and Expenses
A decrease in costs and expenses is the goal of virtually any type of merger. The decreases result from the greater efficiencies that occur through the consolidation of certain services. In many cases, the efficiencies arise from the consolidation of back-office operations such as office management, accounting, public relations, and marketing. By combining entities, companies very often eliminate inefficiencies and decrease overhead.
■ Create Production Efficiencies
Companies often seek a competitive advantage by optimizing the production process, and a merger is frequently the best way to achieve this. This can be facilitated through the efficient coordination of the administration or delivery of a certain business product or business unit.
■ Realize Tax Benefits
Of course, tax benefits often result from mergers. Tax gains provide powerful incentives, especially for multibillion-dollar corporations. Firms with net tax losses can be attractive targets for an acquirer with a significant tax burden. These tax losses or even tax credits can be used to offset the tax burden of the acquirer. Also, a firm with unused debt capacity can be an attractive takeover target because of the tax savings that result from additional debt financing. Also, sometimes there is an opportunity to write up certain depreciable assets. As was shown earlier in this book, tax deductions often are generated through additional depreciation.
■ Reduce Capital Expenditures
Mergers can reduce combined capital expenditure. If Firm A needs new manufacturing facilities and Firm B has excess manufacturing capacity, a merger may eliminate Firm A’s capital requirements to build or expand. Mergers also can create working capital efficiencies for both firms. The merger may create more liquidity that could be used to pay off short-term debt or invest in much-needed infrastructure. Such moves could create additional value.
■ Lower Financing Costs
Mergers can lead to lower financing costs. When a company with a strong credit rating is acquired, the credit rating of the new entity will be better than that of the acquier company. Therefore, this will help lower the overall cost of financing.
Valuation
When cost savings and revenue enhancements resulting from a merger are projected, a detailed financial model can make the case for the merger. For example, in determining whether there is a justifiable reason to merge, the bean counters would look at present values for the proposed merged entity. The first step would be to forecast cash flows for the merged entity. If the present value of the merged entity’s cash flow exceeds the current market values for the individual companies, they’ve got a good case for a merger.
Another way to assess the viability of a merger from a financial standpoint is to take the projected additional cash flows that would result from the merger and discount them to present value. The sum of those discounted cash flows is subtracted from the investment amount needed for the acquisition.
Defenses
Company managers often consider the following options in crafting a defensive strategy.
■ Poison Pills
Poison pills work when existing shareholders are issued rights to purchase additional shares of stock in a company at a bargain price during a takeover attempt. This effectively creates a dilutive impact on the number of shares outstanding and makes it difficult for the acquiring company to take over the target company at a reasonable price.
■ Poison Puts
Poison puts occur when bondholders demand repayment if there is a change of control as a result of a hostile takeover. This effectively raises the overall price of the acquisition.
■ Golden Parachutes
Golden parachute payouts offer hefty compensation packages to corporate managers. This can dissuade a cost-conscious acquirer.
■ Supermajority
Supermajority provisions push a simple majority requirement for merger approval to upward of 80 percent of outstanding voting rights to approve a merger.
Merger Obstacles
Invariably, mergers face a number of obstacles, including compliance with regulatory bodies and the overriding difficulties of integrating distinct business cultures.
■ Legal Issues
One of the biggest impediments to an effective merger is the web of legal issues that can slow, if not halt, the entire merger process. Among other things, corporations must address the following issues when engaged in a merger:
• Compliance with federal, state, or local statutes regarding antitrust issues. In the United States, the Clayton Act prohibits a corporation from acquiring the assets of another company if that substantially “lessens competition or tends to create a monopoly.”
• Compliance with the DOJ and FTC. Both the Department of Justice and the Federal Trade Commission can take an active role in determining whether a proposed merger could lead to issues of anticompetitiveness.
• SEC filings. All proper documentation must be filed with the SEC in order for publicly traded companies to complete a merger or acquisition.
• Employee benefits. Because employee benefits often are altered in a merger or acquisition, the proper legal protocol must be observed to ensure that employees receive their granted benefits. Oversights in this area can lead to costly lawsuits.
• Foreign ownership. Federal law restricts ownership of certain assets by non-US entities. In particular, certain aircraft manufacturers, telecom facilities, newspapers, nuclear power plants, and defense businesses are subject to this regulation.
■ Integration Issues
Integrating a merger often creates insurmountable problems. Integration issues, in fact, have contributed to the failure of several large corporate mergers. It is not uncommon for a new merged entity to exhibit the following:
• Clashes among managers
• Loss of key employees
• Unforeseen costs
• Drop in employee morale
• Difficulty with systems integration
Leveraged Buyouts
Leveraged buyouts (LBOs) are essentially an extension of mergers and acquisitions, with the difference being that LBOs are acquisitions that are heavily financed through large amounts of debt. The goal of such transactions was that through an LBO, the target company could achieve some cost benefit or some level of efficiency. This strategy evolved over time to the point where the goal of an LBO became simply to achieve the highest return on investment in the shortest period. Nowadays, large private equity firms, or LBO shops, acquire distressed assets through the issuance of heavy amounts of debt with the intention of either revitalizing these assets or, quite often, selling them off piece by piece for higher returns at some point in the future.
LBOs traditionally were financed with high-yield (junk) bonds, which were at the time an easy source of financing, albeit a costly one. Typically, LBOs are financed with more than 50 percent senior bank debt, with a lesser portion of public debt and an even lesser portion of equity. In most LBOs, management not only takes an active interest in the structuring of the deal but often is involved in the ongoing management of the company.
■ The LBO Model
The LBO financial model involves some of the following inputs, among which is the purchase price of the overall asset. This is a key driver of the distribution between debt and equity. Unlike any other type of financial model, the actual split between debt and equity becomes increasingly important because it dictates how much is returned to the investors.
The LBO model is used to address the following questions:
• How much is a reasonable price to offer for the business?
• What percentage of the deal makes sense for the buyer?
• How sensitive are returns to performance targets?
• How will negative performance affect bank deals?
• If the business plateaus, how will this affect the overall returns?
Assume that a company has the opportunity to acquire a new store. This store costs $100 million. It is expected that this investment will generate cash flows of $8 million a year for the next five years. Further assume that this real estate value is expected to increase in value at a rate of 3 percent per year for each of the next five years. Finally, assume a discount rate of 10 percent. Based on these assumptions, what is the net present value (NPV) of this opportunity? Figure 12-1 shows the calculation.
In calculating NPV, first observe the cash flows in Figure 12-1. The acquiring company has a negative cash flow of $100 million in the current year. This is the amount of its initial investment. In subsequent years, there is the $8 million in cash flow achieved in years 1 through 5, plus the projected value of the store in year 5, which yields a total cash flow in year 5 of $124 million. A present value calculation can be based on a discount rate of 10 percent. In doing this, the resulting year 1 cash flow in present value terms is $7.3 million; year 2, $6.6 million; year 3, $6.0 million; year 4, $5.5 million; and year 5, the $8 million in cash flow plus the sale price of that real estate, which works out to a present value of $76.9 million. When these present value cash flows are added and the difference between the initial investment and these cash flows is taken, the net present value is $2 million.
Once the third variable, leverage, is introduced, the model is complete. What happens now if the acquirer can borrow 80 percent of the purchase price at an interest rate of 5 percent? Figure 12-2 shows the numbers. After that debt has been serviced, the net cash flow is reduced to $4 million per year. However, the initial investment is now only $20 million. Thus, the net present value increases to $17 million. This reflects the power of leverage, which is a key driver in such transactions.
Chapter 13: Currency
From investment banking to corporate management, currency is involved in nearly all international financial decisions. As the global economy becomes more complex, currency issues will continue to evolve.
This chapter will discuss the following:
• Currency exchange rates
• Exchange rate systems
• Currency trading
Curency Exchange Rates
Determining the Exchange Rate
The exchange rate of any currency is its price. In other words, it indicates how much of one currency is needed to buy one unit of another currency.
A currency’s price is based on the price at which demand for that currency equals supply of that currency. This is known as the equilibrium exchange rate. Simply put, supply and demand curves determine this, and where supply meets demand is where we find the equilibrium exchange rate.
The demand curve for the currency is downward-sloping, meaning that buyers tend to demand more of something when its price is lower. In other words, when the value of yen is lower, buyers of yen demand more, and when the value of yen is higher, buyers should demand less. For example, Americans would be more likely to exchange their dollars for yen when the value of the yen is lower. This enables American consumers and corporations to buy more Japanese products at a lower price. Of course, when the value of yen is higher, demand for yen will be lower as Americans are less likely to exchange their dollars for yen as Japanese products are now more expensive.
Currency Quotes
Currency exchange rates are quoted in terms of a bid price and an ask price.
USD/JPY
Last Trade: 80.1
Change: 0.1800 (0.22 percent)
Bid: 80.0100
Ask: 80.2200
Previous close: 79.92000
Open: 80.3300
Day’s range: 79.9650–80.4050
52-week range: 76.5700–91.6254The quote in this box lists the following:
• Last trade: the most recent trade price
• Change in price: the increase or decrease from the prior day’s close
• Bid: the highest price the buyer is willing to pay to purchase the currency
• Ask: the lowest price the seller is willing to accept for the currency
• Previous closing price: yesterday’s closing price
• Open price: today’s open price
• Day range: high and low prices for the day
• 52-week range: high and low prices for the year
Cross Exchange Rates
A cross rate is a foreign currency exchange transaction between two currencies that are both valued against a third currency. In the foreign currency exchange markets, the U.S. dollar is the currency that is usually used to establish the values of the pair being exchanged.
Factors That Affect Currency Exchange Rates
■ Relative Inflation
Consider what might happen if the United States experiences higher inflation relative to Japan. US goods become more costly than Japanese goods, and as a result, American consumers will demand Japanese substitutes. This will increase the demand for Japanese yen needed to purchase Japanese products. At the same time, the supply of yen for sale probably will decrease as Japanese holders of yen are less likely to buy American products, which are now more expensive. The increased demand for yen and the decreased supply of yen will push the price of yen higher.
■ Interest Rates
If US interest rates rise relative to Japanese interest rates, the supply of yen for sale will increase as more holders of yen will want to purchase dollars to earn more interest in dollars. As a result, the value of yen will decrease. Furthermore, the demand for yen should decrease because investors would rather deposit their money in American banks and therefore will demand dollars more than yen. The decrease in demand combined with the increase in supply will cause a drop in the value of yen as a result of rising interest rates in the United States.
■ Income
If income levels in the United States increase while income levels in Japan remain unchanged, demand for Japanese goods should increase along with yen. The shift in relative income is not likely to affect the supply of yen as a change in US income levels will do little to incentivize Japanese yen holders to exchange more yen for dollars. The increase in demand therefore should raise the exchange rate as American consumers probably will buy more Japanese products overall.
■ Speculation
Speculators can cause dramatic movements in currency prices. They may base their trades on economic predictions or in some cases on expectations of what other high-volume traders will do next. As more market participants move in tandem, currency values are often driven less by economic fundamentals and more by momentum traders.
■ Government
By imposing trade barriers and foreign exchange barriers, governments can affect currency values indirectly. They do this by making it more difficult for foreign businesses to engage in import and export activity, which in turn will affect supply and demand for currency. At the same time, a government can buy or sell its country’s currency, which will affect its supply and ultimately its value. Government policy changes, however, may not achieve the desired outcome when it pertains to currency … or anything else for that matter.
Exchange Rate Systems
Floating Exchange Rate System
A floating exchange rate system is based on the notion that market forces, as opposed to government policy, determine currency exchange. Buyers and sellers of a currency determine the price, with the bid price being the price at which the currency can be sold and the ask price being the price at which it can be purchased. Buyers and sellers can include traders, fund managers, banks, multinational corporations, and governments.
Fixed Exchange Rate System
A fixed rate currency system is one in which exchange rates are static or move within a very tight range. To facilitate this, the central bank of a country must adjust monetary policy frequently to prevent major shifts in its currency’s value. In extreme cases, the central bank may revalue or devalue (increase or decrease the value of) the currency. The advantages of a fixed system include the fact that it minimizes speculation and enables businesses conducting transactions in that currency to do so without the risk of major fluctuations. Importers and exporters can structure transactions with foreign counterparts without fear of currency fluctuations undermining the economics of the transaction. Investors allocating funds to a foreign country need not worry about their returns eroding because of currency fluctuations. Overall, the theory behind the fixed rate system is that it stimulates economic activity by minimizing the risk of significant fluctuations in exchange rates.
With the good comes the bad. A major problem with a fixed system is that it may not reflect the real value of a currency relative to another currency accurately. This can cause economic problems to spread. If inflation runs rampant in a country where the currency exchange rate is fixed against another country’s currency, major economic disruptions can occur.
Other Systems
The fixed and floating currency systems generally explain the broader framework of currency exchange. A pegged system is based on fixing the home currency value to another currency or an index of currencies. A managed float system is a floating system that allows for occasional government intervention. In other words, it’s a “have your cake and eat it too” system. Of course, the simplest system is the dollarized one in which the dollar replaces the local currency. This system allows a country to outsource the currency management process to the United States of America.
Currency Trading
Currency can be traded much like securities or as derivatives. The purposes for trading vary but generally can be distilled down to either speculation or hedging.
Currency Speculation
Currency speculation can be a lucrative pursuit for skilled traders. By analyzing macroeconomic variables such as inflation, interest rates, income levels, and governmental policies, currency traders can place bets on a currency with the hope of profiting from them. Currency speculation can be complicated by the combination of market forces, the outcome of which can be difficult to predict.
Currency Hedging
Currency hedging is a practice that can be employed by anyone taking a relatively large speculative position in a currency or by a business seeking to manage risk. Several protective hedging strategies discussed in Chapter 11 present themselves: options, forwards, futures.
Currency Arbitrage
Chapter 11 introduced the topic of arbitrage, which allows an investor or trader to capitalize on pricing discrepancies. Arbitrage is used widely in the currency markets and usually takes on the following forms.
■ Locational Arbitrage
Locational arbitrage is based on the idea that one can buy currency at one location and sell it immediately at another location, instantaneously locking in a profit. In other words, a pricing discrepancy in the market allows for this.
Assume that you’re a trader who wishes to trade the USD GBP currency pair. Here the base currency (the currency you sell) is the USD and the quote currency (the currency you purchase) is the GBP. So, if the exchange rate of the USD GBP currency pair is currently at 1.45, then you’re required to pay 1.45 USD to purchase 1 GBP.
Moving on, you approach a bank named ABC who quotes a bid ask spread of 1.43/1.45 for the USD GBP currency pair. Here, the bid value refers to the amount that the bank is willing to pay to purchase 1 GBP from you. And the ask value refers to the amount that you’re required to pay to purchase 1 GBP from the bank.
Simultaneously, you approach another bank named XYZ who quotes a bid ask spread of 1.47/1.49 for the same USD GBP currency pair. See how there’s a minor difference in the bid ask spreads between two different banks for the same currency pair? Here’s where you can successfully employ a location arbitrage.
To employ the locational arbitrage strategy, all you need to do is buy the GBP from bank ABC for 1.45 USD and immediately sell the GBP to bank XYZ for 1.47 USD. This way, you can make a profit of 0.02 USD for this trade. One of the advantages of this trade is that it is virtually risk-free.
■ Triangular Arbitrage
Triangular arbitrage is the result of a discrepancy between three foreign currencies that occurs when the currency’s exchange rates do not exactly match up. These opportunities are rare, and traders who take advantage of them usually have advanced computer equipment and/or programs to automate the process.
Let’s say you have $1 million and are provided with the following exchange rates: EUR/USD = 1.1586, EUR/GBP = 1.4600, and USD/GBP = 1.6939. Now, you want to see if there is a triangular arbitrage opportunity, so you calculate the following:
Sell dollars to buy euros: $1 million x 1.1586 = €1,158,600
Sell euros for pounds: €1,158,600 ÷ 1.4600 = £793,561.64
Sell pounds for dollars: £793,561.64 x 1.6939 = $1,344,214.06
Subtract the initial investment from the final amount: $1,000,000 – $1,344,214.06 = -$344,214.06
From these transactions, you would receive a loss of $344,214.06 (assuming no transaction costs or taxes), so there is no triangular arbitrage opportunity. If the result had been positive, there would have been an arbitrage opportunity.
Chapter 14: Real Estate
Real Estate Valuation
Real estate is one of the broadest areas of investing, incorporating elements from many other areas of finance. It distills finance down to its most basic components, which in the aggregate can be highly complex. To understand what drives real estate finance, it’s important to consider the ways to value real estate. Market value ultimately boils down to what someone is willing to pay for something. This certainly holds true in real estate. As is the case with most assets, the question becomes: How does one arrive at the point of agreement? Real estate valuation is similar in many aspects to most other areas of valuation.
Cost Method
The cost method of valuing real estate is very similar to the cost method used in valuing any asset. It seeks an answer to the question, What would it cost me to build this from scratch? In real estate, one might consider the cost of land, construction labor, materials, and so on to determine the overall project cost. This method falls short because it fails to consider what the market might perceive the value to be. Clearly, the completed project is worth more than the sum of its parts. This method, however, can be helpful in determining a project’s breakeven point. In other words, if the total cost of a project is $1 million, a developer probably will consider how long it would take to return that amount to investors on the basis of what the project is expected to earn.
Comparable Multiple Method
Perhaps the fastest way to gauge the value of a property is to consider what similar properties sell for. If you decide to sell your home, the first step in determining an offer price is to consider what your neighbor just sold her home for. Careful attention must be paid to building a truly comparable list. To build a solid set of comparables, items such as location, size, and amenities should be consistent within the mix.
Income Capitalization Approach
This is one of the most popular methods for valuing income-generating properties. The most important variable in this model is what is called the capitalization rate (cap rate), which is net operating income (NOI) divided by property value. NOI in real estate is like operating income in any business. It generally is based on a property’s income before interest and taxes. Income-generating properties can be measured on the basis of multiples of NOI.
Cap Rate = NOI/Property Value
For example, suppose NOI is on average approximately 10 percent of recent sale prices in a particular neighborhood (similar properties report NOI that amounts to 10 percent of their value). To put it another way, the cap rate gives us the expected rate of return on our property. If the annual NOI on a target property is $20,000, its value would be $200,000 ($2,000/0.10).
Discounted Cash Flow Method
The discounted cash flow (DCF) method in real estate is based on the idea that to value a piece of property, you must calculate the present value of future cash flows. If we consider an apartment building that generates rental income, we can value it on the basis of projected NOI. To form those projections, we might consider variables such as monthly rents, occupancy rates, and expenses, to name a few. We also might assume a sale of the property at some point in the future. The assumptions will form projections that ultimately will produce a NOI number for each year. This number will be discounted to present value by using the present value formula:
PV = NOI/(1 + r)ⁿ
The sum of these present values is the value of the building. Consider the following example: You are interested in purchasing Building A, which has the following attributes:
Monthly rent: $1,000 (with a 3 percent annual increase)
Number of units: 25
Average yearly occupancy: 75 percent
Operating expenses: 40 percent of gross rents
Required rate of return/discount rate: 7 percent
Terminal value: year 5 NOI/cap rate (assumes you sell the property at the price determined by this multiple)Using these assumptions, we will project five years of NOI. In the fifth year, we will assume that the building is sold on the basis of the projected cap rate. Each year’s NOI number, along with the sale amount, is discounted to present value, and the sum of the present values offers a good indication of the building’s value.
There are a number of problems associated with this method, such as the following:
1. Real estate is cyclical, and projecting rent increases can be problematic.
2. The discount rate often is based on market rates at times when market conditions shift.
3. It can be difficult to form projections because unforeseen capital improvements invariably arise.
Nonetheless, this method is helpful in that it provides another means of price comparison. If nothing else, it can create dialogue between buyer and seller at the deal table and allow them to reach an agreement.
| YEAR 1 | YEAR 2 | YEAR 3 | YEAR 4 | YEAR 5 | *TERMINAL VALUE | |
|---|---|---|---|---|---|---|
| Monthly Rent/Unit ($) | 1,000 | 1,030 | 1,061 | 1,093 | 1,126 | |
| Annual Rent/Unit ($) | 12,000 | 12,360 | 12,732 | 13,116 | 13,512 | |
| Number of Units | 25 | 25 | 25 | 25 | 25 | |
| % Occupancy | 75% | 75% | 75% | 75% | 75% | |
| Total Rent ($) = Annual Rent x Units x %Occupancy | 225,000 | 231,750 | 238,725 | 245,925 | 253,350 | |
| Operaing Expense ($) = 40% x Total Rent | 90,000 | 92,700 | 95,490 | 98,370 | 101,340 | |
| NOI ($) = Total Rent – Operating Expenses | 135,000 | 139,050 | 143,235 | 147,555 | 152,010 | 1,689,000 |
| Present Value = NOI/(1+r)ᵗ | 126,168 | 121,452 | 116,568 | 112,569 | 108,381 | 1,204,234 |
| Sum of PV Cash Flows | 1,789,726 | |||||
| Terminal Value Cap Rate Year 5 | 9% | |||||
| Discounted Rate/Required Rate of Return | 7% |
*Terminal value (TV) is the value of an asset, business, or project beyond the forecasted period when future cash flows can be estimated. Terminal value assumes a business will grow at a set growth rate forever after the forecast period. Terminal value often comprises a large percentage of the total assessed value.
Calculating Real Estate Returns
Cash on Cash
Cash on cash returns assess the return on investment on the basis of the amount of cash invested to purchase the property. It usually is based on the following formula:
Cash on cash ROI = pretax cash flow/cash investment
Pretax cash flow in real estate can be based on NOI minus the mortgage payment, although some real estate analysts may use a variation of this. The cash invested is the amount of cash invested to purchase the property (not including the amount financed).
Consider the following:
We purchase a property for $1,000,000.
Our cash investment is $200,000, and our mortgage is $800,000.
Suppose our annual NOI is $135,000 and our annual mortgage payment (principal and interest) is around $40,000.
This number will be sensitive to the duration of the mortgage, the monthly payments, and the interest rate. In most conventional mortgages, the monthly payment remains constant. In our example, we would subtract the $40,000 principal and interest from the NOI, which would give us our pretax cash flow of $95,000. Since we invested $200,000, our cash on cash ROI would be as follows: cash on cash ROI = $95,000/$200,000 = 47.5 percent.
Total Return on Investment
Total ROI offers a more comprehensive overview of what a property returns by incorporating not only pretax cash flows but proceeds from the property sale as well.
The formula is:
Total ROI = (pretax cash flow + sales proceeds – initial cash investment)
/initial cash investment
Let’s assume that we sold the property for $1,200,000 three years from now. At that point, our mortgage balance would be around $762,000. Our selling expenses, including taxes and broker fees, would amount to about 8 percent of the sale price, or $96,000 (=$1,200,000 x 8%). Our net sales proceeds would be: $342,000 ( = $1,200,000 (sale price) – $762,000 (mortgage balance) – $96,000 (selling expenses)). Finally, let’s assume that total pretax cash flow for the three years is $285,000 ($95,000 NOI/year × 3 years). Our Total ROI would be the following: total ROI = [$285,000 (pretax cash flow) + $342,000 (sales proceeds) – $200,000 (initial investment)]/$200,000 = 213.5 percent. Not a bad return for three years.
Keep in mind that several aspects of this deal proved favorable.
• First, the appreciation over three years was substantial.
• Second, NOI was relatively stable.
• Third, the cost of financing was low.
All in all, this proved to be a lucrative deal and the type that most real estate investors dream of. The reality, however, is that any number of factors can hurt the total ROI.
REITs
Real estate investment trusts (REITs) are real estate investment vehicles designed to avoid double taxation. Generally, REITs are investment funds that purchase income-producing properties. Each year, a REIT must distribute a substantial percentage of its taxable income to shareholders in the form of a dividend. This structure reduces or eliminates corporate income taxes. The shareholder pays tax on the distribution, and the REIT itself pays little to no tax and therefore maximizes returns.
REITs are similar in nature to mutual funds, with the primary difference being that mutual funds invest in stocks and REITs invest in real estate. In Figure 14-3, we can review the performance of a REIT at three points in time based on the following performance metrics:
• Net asset value (NAV). NAV is based on the notion that the book value will not necessarily reflect market value in real estate. As a result, NAV seeks to capture the market value by first dividing the NOI by the cap rate. From there, any debt outstanding is subtracted to come up with NAV. NAV then can be divided by the total number of shares outstanding to come up with the fair value of the common shares (the actual share price should be close to this).
• Funds from operations (FFO). FFO is calculated by taking net income and adding back depreciation and subtracting any gains on the sale of property. In real estate, depreciation is included in various income calculations, but when it comes to FFO, the belief is that property rarely loses value. Whether you believe this is up to you, but as it stands, FFO is the primary performance measure when it comes to REITs.
• Cash available for distribution (CAD). CAD is based on FFO minus any recurring capital expenditures. This forms a general approximation of cash on hand and could be distributed to shareholders in the form of a dividend.
Mortgage-Backed Securities
It’s no secret that the financial world developed elaborate ways to profit from a booming global real estate market. The advent of mortgage-backed securities proved an effective way to capitalize on that boom. Investment bankers around the world were eager to structure complex financial instruments backed by pools of mortgages. Those instruments, as was discussed in Chapter 11, sometimes were termed collateralized debt obligations (CDOs) and were traded across the financial world. When they were actively traded, assigning a value to them was easy to do as they generally were based on the most recent purchase price. However, when signs of a housing collapse emerged, the appetite for CDOs dissipated, leaving far fewer buyers than sellers. At that point, valuing them became more a function of bold assumptions used in financial models and less a function of what the market believed those instruments were worth.
Chapter 15: Commodities
Commodity Types
The most widely traded commodities are those listed here:
• Energy: Gas, Oil
• Metals: Aluminum, Copper, Gold, Lead ,Nickel, Palladium, Platinum, Silver, Tin, Zinc
• Agricultural: Cattle, Cocoa, Coffee, Corn, Cotton, Hogs, Soybeans, Sugar, Wheat
Commodity Trading
■ Spot Market
The spot market, also called the cash market, implies that the actual commodity is delivered immediately after the completion of the transaction and the current market price of the commodity becomes the transaction price.
■ Forward Market
Two parties can agree on the delivery amount and price for a particular commodity on a future date. This allows both parties to avoid the painful possibility of a price disruption if something changes between the current date and the delivery date. The forward contract allows them to achieve these goals by locking in a sale price in spite of what might happen to the spot price over time. One party may miss out on gains if the spot price moves in its favor, but such is life in the forward market.
■ Futures
Just buy the futures! When it comes to commodities, futures offer an efficient means of trade. A future is ultimately a legally binding contract that specifies the price, amount, and delivery date for a particular commodity. There is no immediate transfer of the commodity involved, thus minimizing transaction costs. Anyone can trade commodities without ever possessing them. A standard futures contract for most commodity types usually lists some, if not all, of the following:
• Ticker symbol: symbol referencing the commodity type
• Contract quality: describes the grade of the commodity; after all, you need to know whether you are buying ground chuck or top sirloin
• Exchange: notes the exchange where the commodity is traded
• Trading hours: lists the hours of operation for the exchange
• Units: specifies the unit of measure for the commodity
• Contract size: specifies the size of the contract based on the standard commodity unit
• Contract months: lists the delivery months for the commodity
• Price change minimum: lists minimum price movement for purchase or sale of a futures contract
• Daily trading limit: notes the amount the exchange has set to prevent major price changes
Futures Movements: A standard futures curve begins with the spot rate and then slopes upward or downward, depending on the future price. If you take a long position one year out, you agree to pay that price in a year. If the curve were inverted, the futures price would be less than the spot price. The curve may invert if there was some benefit in holding on to it. When the futures price is trading above the spot price, it is called contango. This probably would be due to costs associated with the commodity such as insurance and storage. In other words, the spot price is lower than the future price because if you purchased the commodity today, you would incur additional future costs, including storage, insurance, and interest. Contango also may occur if traders believe that future demand will exceed supply, meaning that prices could trend higher. As a result, they would be willing to pay a premium for the future price over the spot price. If the spot price is $20 and the future price is $30, contango exists. Backwardation occurs when the future price is lower than the spot price. If the spot price is $20 and the future price is $10, backwardation exists. This may occur if the prevailing belief is that the future supply of a commodity may be restricted, and so one would rather have it today.
OIL
Oil, whether we like it or not, is one of the most important commodities in the world. Fortunes are made in it, wars are fought over it, and ecosystems can be destroyed by it. Oil prices are a major force in the economy; that is why understanding the factors that affect them is as important as understanding any set of variables in global finance.
Factors That Affect the Price of Oil
■ Supply
The supply of oil plays a major role in determining its price. One of the most important organizations that determine this is the Organization of Petroleum Exporting Countries (OPEC). OPEC sets a quota for oil and regulates the output of oil (see the following sections).
■ Weather
Winter storms, hurricanes, and other natural disasters are just a few of my least favorite things. Not only can they take a catastrophic toll on humanity, they can affect the price of oil through supply disruptions.
■ The Economy
Economic booms and busts affect how much people spend on travel, which will affect the demand for oil.
■ Geopolitical Forces
Anytime the threat of war surfaces within oil-producing nations, fears of oil supply disruptions abound.
■ OPEC
OPEC was formed in 1960 by several oil-producing countries to form an alliance aimed at regulating the supply and ultimately the price of oil. Today, representatives from its 12 member countries (Algeria, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela) meet regularly to determine oil output, and this has a direct impact on supply and, to a large degree, price. OPEC faces the challenge of maximizing pricing without lowering demand. If oil prices reach lofty heights, it may affect consumer demand, which could prove costly to these countries. Higher prices can incentivize oil-consuming nations to seek out other sources of oil and, over the long run, alternative energy sources. The United States stores nearly a billion barrels of oil in the Strategic Petroleum Reserve, which is tapped when there is extreme demand for oil, such as after a natural disaster or when the threat of political upheaval in OPEC nations presents itself.
■ Measuring Oil
The price of oil generally is based on the spot, or current, price and measured off WTI/light crude traded on the New York Mercantile Exchange (NYMEX) or Brent crude futures traded on the Intercontinental Exchange (ICE). Oil is quoted in terms of barrels, with a barrel holding 42 US gallons or 159 liters. The price of oil reflects its price per barrel (i.e., $80/bbl). BPD stands for barrels per day and measures output or consumption. For example, a country might consume 1 million BPD and a field might produce 10,000 BPD.
■ Trading Oil
Oil traders seek to profit from anticipated movements in oil prices by bidding on futures. Projected supply and demand clearly play a role in the price of futures. Herein lies the oil futures paradox: if traders bid up the price of oil futures, oil will become more expensive and speculation becomes reality. Many believe the oil asset bubble that peaked in 2008 was a product of such rampant speculation. At the time, oil prices hit $147 a barrel.
GOLD
Gold is unlike any other commodity. It can be a store of value, an economic indicator, or an adornment worn by your friend from the Jersey Shore. It can bring a nation to its knees and a bride-to-be to tears. Despite its complexity and cross functionality, it becomes the lowest common denominator in times of economic crisis.
Factors That Affect the Price of Gold
Overall, three primary factors can affect the price of gold:
1. Demand for the physical commodity. Whether it’s jewelry or industrial parts, gold will appreciate in value if people use it more.
2. The value of the dollar. Gold generally is priced in dollars, so if the value of the dollar decreases, the price of gold should increase. In other words, it will take more dollars to purchase the same amount of gold, thus reflecting a higher price in gold.
3. Safe haven. When there is a war or an economic meltdown, people turn to gold when panic sets in.
Reasons for Investing in Gold
There are many reasons to invest in gold, a few of which are listed here:
■ Hedge Against Dollar Drop
When the dollar declines, gold tends to appreciate. The dollar is the world’s reserve currency, and a drop in its value can send investors and governments alike running for cover. Gold can hedge against this.
■ Hedge Against Inflation
As history has shown, when inflation rises, so do gold prices. Investors will bid up the price of gold as they see prices in general increasing. As a result, buying gold when inflationary pressures are mounting is a popular hedging strategy. If inflation takes shape, the increase in gold prices can offset the economic challenges associated with inflation.
■ Hedge Against Declining Stock Market
The stock market can decline for many reasons, but this generally results from fears about the economy or an actual economic slowdown. In some cases, these market downturns are short-lived and can be related to a correction in an overheated sector. Nonetheless, this will hurt stock market indexes and probably stimulate buying of gold as a hedge. When investors are scared, gold seems like the only safe port in the storm.
■ Hedge Against Geopolitical Uncertainty
Again, fear surfaces and gold seems like a safe bet. Geopolitical uncertainty, if nothing else, creates fear that can lead to panic selling. One thing is for certain: investors don’t like uncertainty. When a global event threatens economic stability, gold becomes a popular investment option.
■ Store of Value
Currencies come and go, but as a means of financial exchange, gold is timeless. Need I say more?
CORN
Whether you choose to believe it or not, it is corn that makes the world go around. Corn is one of the most important food commodities in the world. In addition to being a source of food for much of the world’s population, it is used in feed as well as ethanol, which is mixed with gasoline. Ethanol generally is considered the least expensive biofuel. Corn is measured by the bushel.
Factors That Affect the Price of Corn
Overall, four primary factors can affect the price of corn:
1. Demand for the physical commodity. Clearly, demand for corn and corn products will affect price. Population growth or a global trend toward more breakfast consumption could lead to an increase in price.
2. Weather. Weather extremes include too much rain, sun, snow, and so on. Those extremes certainly affect crop size and in turn the price of corn.
3. Demand for biofuel. When ethanol demand increases, it will affect the price of corn.
4. The value of the dollar. A weakening of the dollar against another major currency means American corn is priced relatively cheaper. This should increase demand for corn and push prices higher. This relationship between the dollar and corn prices is widely accepted, but it has been known to stir up a fair amount of debate. If you plan on trading corn, don’t quote me on it.
Who Suffers When Corn Prices Are High?
• Beverage companies. Corn affects major beverage producers. When corn prices are high, beverage companies suffer as corn is used to make high-fructose corn syrup, a sweetener used in most soft drinks.
• Livestock companies. Corn is used in in feed, and higher corn prices mean higher feed costs.
• Snack food and cereal companies. Crackers, chips, and breakfast cereals are made from corn. Rising corn prices means lower profits for these companies.
• Consumers. When commodity prices are high, any price increases are passed on to the consumers, whether they are purchasing gas or cereal.
Who Benefits When Corn Prices Are High?
• Farmers. Higher corn prices usually mean better profits. Of course, if prices become too high, demand could be affected.
• Fertilizer companies. Farmers use more fertilizer to yield more crops.
• Corn seed companies. Genetically engineered seeds produce quality ethanol, and farmers will purchase more as they seek to profit from higher corn prices.
Chapter 16: Portfolio Theory
Expected Return
Expected return in a portfolio is based on the weighted average expected returns on individual assets within a portfolio. In other words, if one asset weighs heavily on the portfolio and is expected to produce outsized returns, the overall portfolio expected return would be higher than if the asset returns were more in line with those of the other assets.
The total expected return formula can be written as:
Let us take another example of an investment with 5 stocks in the portfolio. The rate of return and weight for each stock are as follows:
Stock A:
Rate of return = 20%, Weight =10%
Stock B:
Rate of return = 10%, Weight = 20%
Stock C:
Rate of return = 8%, Weight = 30%
Stock D:
Rate of return = 6%, Weight = 20%
Stock E:
Rate of return = -4%, Weight = 10%
The rate of return for the entire portfolio would be: 20%x10% + 10%x20% + 8%x30% + 6^x20% + (-4%)x10% = 7.2%
Modern Portfolio Theory
At the heart of modern portfolio theory is the idea that investors are risk averse and therefore prefer the highest return with the lowest risk. Intuitively, this makes sense. A few key points to keep in mind about modern portfolio theory include:
1. The goal is to maximize expected return for a given level of risk
2. Risk is based on variance
3. The risk pertaining to an individual asset should relate to how it impacts the overall portfolio
Standard Deviation and Variance
Standard deviation and variation are popular concepts in statistics as well as finance. The basis for each is the mean of a set of data. Variance examines the extent to which each data point differs from the mean. Standard deviation, which is the square root of variance, is used to measure volatility and, in turn, risk. The lower the company’s standard deviation, the less risky the company’s stock. Let’s look at how we calculate standard deviation for Jimi’s Experiential Learning Software Company.
In the case of Jimi’s Software, standard deviation is 3.77 percent. Assuming the company offers the same expected return as other companies in the industry but has a lower standard deviation than others, it would prove the better investment choice. Lower risk and comparable return is what one should aspire to in portfolio theory.
Covariance
Covariance reveals the extent to which two assets in a portfolio move in tandem. A positive covariance means that the returns move in the same direction, and a negative covariance means the returns move in opposite directions. The reason this is important in modern portfolio theory is because it allows portfolio managers to reduce variance and, in turn, risk.
Based on this covariance, we can observe that the stock portfolio and bond portfolio move in opposite directions.
Efficient Frontier
Portfolio managers can determine an optimal portfolio by plotting what is called the efficient frontier. The efficiency portfolio compares individual portfolios based on standard deviation and expected return. The goal of this nifty graph is to illustrate the highest expected return for a prescribed level of risk (or the lowest level of risk for a prescribed level of return).
Alpha and Beta
We’ve already discussed beta in our cost of capital section in Chapter 8, so let’s start with alpha. Alpha is a measure of performance relative to the market. If the S&P 500 returns 12 percent and your portfolio returns 16 percent, your alpha would be 4 percent. Alpha is the portion of your return that is not tied to market performance. Alpha performance is often driven by active portfolio strategies that affect the timing of investments and how funds are allocated. Nowadays, these types of decisions can be driven by a portfolio manager, an algorithm, or some combination of the two.
Beta represents the extent to which an investment’s returns move relative to the market. A passive investment strategy would involve analyzing these expected returns based on their beta. Active management, however, will look at alpha, which measures returns beyond the market return. Maximizing a portfolio’s alpha requires a thoughtful approach to the selection of individual securities within the portfolio.
Risk Management
One of the fastest-growing sectors of finance today is risk management. Why? Risks can prove costly. And more important, avoiding losses is just as important and creating gains. Finance comes with high rewards, and as we learned earlier in the book, high rewards create high risks. Many of the greatest investment managers in the world have attributed their success to one factor above all others: managing risk. No matter how great an opportunity may appear to be or how significant its upside may be, risks always persist. To mitigate these risks, risk management tools have developed over the years. Let’s examine some of these risks and how the financial community manages them.
Diversification
Diversification is one of the most important principles in all of finance. Portfolio diversification allows one to effectively manage risk. In other words, it’s the “don’t place all your eggs in one basket” theory of finance. The goal is to reduce overall portfolio risk while still maintaining the same expected return. To manage this risk, it makes sense to diversify the portfolio such that overall expected returns are maintained but correlations may differ. In other words, the portfolio is somewhat insulated against movements affecting any one asset component.
Smart Beta
Smart beta combines the best of passive and active investing. Ultimately, it seeks to increase alpha by minimizing risk, maximizing returns, and minimizing costs. That’s the goal of any investment strategy, right? Smart beta has created a focused movement around this novel idea and seeks to quantify it. Here’s how it works. Smart beta seeks the efficiencies of passive investing while incorporating active investment strategies based on variables such as volatility, momentum, and fundamentals. Smart beta strategies will vary from manager to manager but afford one the opportunity to capitalize on mispricing or inefficiency. For example, a portfolio manager may recognize that small-cap and large-cap stocks behave differently. A simple industry or index exchange-traded fund (ETF) would give more weight to larger-cap companies than smaller-cap companies. A smart beta ETF might incorporate additional fundamental factors to assess weighting. For example, a small-cap company with a low PE multiple might weigh more heavily on the ETFs pricing than a large-cap company with a high PE multiple. In other words, smart beta ETFs incorporate additional variables into the construct and weighting of the fund, which hopefully translates to better performance and lower risk.
Chapter 17: The Business of Finance
The Sell Side of Finance
It encompasses nearly every type of transaction. Much of what falls within the realm of banking involves selling services, which is why it’s termed the “sell side” in the financial services world.
Commercial Banking
Commercial banks make their money by securing deposits and lending the money. As long as the rate of interest paid to depositors is lower than the rate of interest charged to the borrowers, the bank makes money. The lifeblood of the commercial banking industry in the United States is the federal funds rate. This is the rate at which banks and credit unions lend money overnight to other banks. The rate is determined by the Federal Reserve Bank’s Federal Open Market Committee, which meets eight times per year and sets this rate. The banks are able to borrow at this rate and, in turn, lend to consumers and businesses at a higher rate. It’s that simple. Easy money.
Investment Banking
Investment banking has been around almost as long as the idea that you should always invest with other people’s money. Investment banks have mastered the fine art of making money, regardless of whether or not their clients make money.
■ Underwriting
One of the primary functions of the investment bank is to offer underwriting services to its clients. Suppose company XYZ needs capital to expand. The investment bank will gladly analyze the market to determine where the best opportunities lie to raise the most capital at the lowest cost. The bank will then look at the debt markets to gain a sense of what the cost of debt would be for a client with this credit rating. Additionally, the bank will consider interest rate trends and the debt market outlook for the coming years. Next, the bank will examine the equity markets to determine whether an equity offering might make more sense. Of course, selling shares of stock will dilute the existing shareholders, so the bank will have to make a determination as to whether the additional capital, without any direct financing cost, will outweigh the dilutive effects of the stock offering. The best part about all of this is that the investment bankers will make a hefty commission on the transaction.
■ Mergers and Acquisitions
Bankers often advise clients on buying and selling companies. Much of the banker’s work revolves around valuation. Whether the banker values a company for sale or for purchase, valuation will form the cornerstone of the transaction. And as we learned earlier, valuation is more art than science. That being said, it’s necessary nonetheless.
■ Sales and Trading
Many large investment banks have sales and trading groups. Traders will buy and sell securities in blocks and earn commissions on each trade. Since the traders are dealing with large allocations of securities, they will rely on salespeople to pitch the trade idea to large institutions. The trader can add value by finding the best price, which often entails parceling out individual blocks of the trade or dividing it into smaller portions.
While sales and trading desks are often segmented between equity and fixed income (or stocks and bonds for the sake of simplicity), other asset classes often have their own dedicated sales and trading teams. Currency, commodities, and derivatives are only a few additional asset classes where traders and salespeople will develop asset specific skills. Exceling in these areas requires a keen understanding of the marketplace as well as an outlook for price trends. Most of all, it requires key relationships with the right players in the space.
■ Equity Research
One of the most powerful influences in the world of finance is equity research. Equity research analysts will research entire industries as well as individual companies that form these industries. The goal of the research analyst is to provide value-added market insights that allow customers who subscribe to the research to make smart investment decisions. For example, a research analyst who covers consumer products will research the entire industry and articulate changes to key industry drivers. The equity research analyst will produce colorful reports that seek answers to questions such as:
• Where are key commodity prices headed, and how will they influence the cost of producing the products?
• What do demographic shifts mean for consumer buying trends?
• What do demographic shifts mean for the broader economy?
• Will trend shifts impact purchases in this space?
• Will a recession spark a slowdown or uptrend in this space?
• If I use a larger font in my report, will I increase my page count and make my boss happy? (Okay, I made this one up.)
Answering these questions allows the research analyst to form a solid, qualitative assessment of the industry.
The equity research analyst will also research individual companies and offer a buy, hold, or sell recommendation. Much of this will be driven by the macro overview offered in the industry report, with the remainder of the report focused on the individual factors driving the company itself. Questions addressed in a company-specific report would include:
• Is the company gaining market share?
• Is the company expanding to new markets?
• Is the company planning to acquire a competitor?
• Is the company facing cost increases that could affect profits?
Ultimately, the answers to these questions form the basis for the inputs that feed into a detailed valuation model. More often than not, the model is built off of valuation methodologies discussed in Chapter 9, including the comparable multiple method and the discounted cash flow method. The end result from this rather elaborate valuation mosaic will be a target price per share.
The best part about equity research is the economics. Top-tier research analysts charge a hefty sum for their reports. It’s not unheard of for individual reports to sell for thousands of dollars each. It also allows the bank to offer these reports to marquis clients from whom the bank may generate millions of dollars in advisory and underwriting fees.
Retail Brokerage
In the world of investments a broker is someone who acts as the middleman between buyers and securities sellers. Brokers are typically required to register with the Securities and Exchange Commission and with a self-regulatory organization, such as the Financial Industry Regulatory Authority. Brokers who work primarily with institutional investors are referred to as institutional brokers, while those who serve the needs of individual investors are called retail brokers.
The Buy Side of Finance
Mutual Funds
A mutual fund is managed by a professional money manager who receives investments from many investors. The pool of funds formed from these investments is invested in various assets or securities of companies within an industry. Mutual funds afford the investor an opportunity to diversify while achieving economies of scale.
A mutual fund takes the hassle out of this process while minimizing the transaction fees. The downside, of course, is that mutual funds can charge relatively steep management fees when compared with other investment vehicles.
Exchange-Traded Funds
Exchange-traded funds (ETFs) are a nice alternative to mutual funds as they offer similar diversification and economies of scale at a fraction of the cost of mutual funds. ETFs are traded on an exchange, much like a stock, and often track an index. For example, one could buy an ETF that tracks a major stock, bond, or commodity index. Since an index fund is usually easy to manage (hint: you buy all the securities in the index), it involves little to no effort in selecting which securities to purchase. In fact, much of this can be done by a computer.
An ETF is a low-cost way of buying a basket of individual assets such as stocks, bonds, or commodities. This could mean buying each of the major companies in a particular sector or perhaps buying an entire index.
Investing this way has made portfolio management and diversification a breeze. One can build a portfolio based on a mix of high-growth stocks, low-risk debt, commodities, real estate, and money market instruments. In other words, the cost of balancing the portfolio and diversifying risk is low. If stocks go up, bonds may go down.
Hdege Funds
Hedge funds are pools of money, usually from accredited investors and institutions. Hedge fund managers are given license to invest in just about anything, although they tend to stick with liquid assets such as stocks and bonds. In many cases, they will employ leverage by borrowing against their capital base. This allows them to earn outsized returns when things go well and, of course, suffer big losses when things don’t go so well. The best part about hedge funds, at least for the managers, is the fee structure. Normally, hedge fund managers collect a 2 percent management fee based on assets under management (AUM) plus 20 percent of the returns. If a fund has one billion dollars in assets, the management fee alone is 20 million dollars per year. Now, if the fund returns 10 percent, the fund manager earns 20 percent of that 10 percent, which would be another 20 million dollars.
Private Equity Funds
Private equity funds invest in less liquid investments than their counterparts. They to buy large stakes in companies, actively manage these companies, and sell their stake several years later. Their fee structures vary but tend to mimic hedge fund economics. Additionally, private equity funds will rely heavily on debt to fund the acquisition of companies and in this manner utilize leverage to capture strong gains.
Venture Capital Funds
Let’s suppose you just invented the time machine. You actually have to raise capital to build a business around your invention. Venture capitalists manage funds that invest in early stage companies. The typical private equity fund will buy an equity stake in your company with the hopes that through its capital and strategic guidance, your time machine invention will turn into a successful company with many customers and strong profits. Assuming your business continues to grow, at some point, perhaps years from now, the venture capital firm will sell its stake to another venture capital firm, a large corporation seeking to acquire your business, or cash out through an IPO. Of course, the venture capitalist will have to contend with customers traveling back in time to invent their own time machine before you did, which won’t bode well for your company’s valuation.
Pension Funds
Pension funds are built around the idea of providing retirement income to the individuals who have contributed to the funds. These funds can be extremely large and can take on various forms. The most common pension plan is a defined benefit plan in which employees receive payments based on a percentage of their salary from their last years on the job. The amount is largely tied to how long the employee worked at the company. Pension fund fees can be hefty and may include setup charges, annual management charges, platform charges for individual discretion over what to buy, transaction fees, and exit fees. These charges can add up.
FinTech
Financial technologies, FinTech for short, has transformed the way financial service firms conduct transactions, afforded greater access to a broader base of customers, and increased the speed at which information is disseminated. All in all, it seems pretty exciting and continues to expand.
Crowdfunding
Most any entrepreneur with a good idea and a solid business plan can turn to crowdfunding to raise seed capital. Crowdfunding allows entrepreneurs to access smaller investors en masse without some of the costs and restrictions associated with a traditional angel round of fund-raising.
Blockchain
Blockchain represents one of the most significant developments in the world of finance. In the financial world, blockchain is the technology that drives distributed ledgers. Distributed ledgers form a database that can be shared across networks or geographies. As the name implies, a chain of blocks is linked together and secured using something called cryptography. Cryptography uses a series of computer-based algorithms to ensure security. A blockchain stores data across a network, which means the data is decentralized and, more important, verified by others in the network
Blockchain technology is presenting numerous disruptive possibilities for the world of finance. Digital currencies allow for secure, low-cost transactions that eliminate the financial middleman. The transaction ledgers are open and verifiable, which lowers the risk of fraud. Real estate and other transactions will likely utilize blockchain technology for purposes of record verification and to minimize administrative costs.
Artificial Intelligence
Artificial intelligence (AI) is reshaping everything from compliance to valuation. AI, by definition, is the use of technology systems to replace tasks normally managed by humans. An AI system can seamlessly parse the volumes of data in a nanosecond to determine with a high level of accuracy whether a bank is complying with a specific regulation.
■ Banking Chatbots
One of the most intriguing developments in the realm of AI is the chatbot. Through the use of natural language processing and machine learning algorithms, chatbots help you manage your savings. They can do this by analyzing your spending and savings patterns to determine what, and when, you should be saving. Based on this, they even make deposits into your bank account when appropriate. In essence, they serve as your own personal money manager.
■ Algorithmic Trading
When I was a bright-eyed Wall Street analyst, I was taught that there were two ways to analyze a company’s stock: fundamental analysis and technical analysis. Fundamental analysis involved reviewing a company’s financial statements and measuring performance based on various financial ratios. From there, valuation models could be built.
Technical analysis was based on analyzing trading patterns around a company’s stock. Often called a chartist, a technical analyst would review stock price movement over time to determine when it would be time to buy, hold, or sell a stock.
■ Big Data
Many of the FinTech initiatives described in this chapter are made possible through the advent of big data. Thanks in part to dramatic increases in data storage space and computing power, big data is nearly ubiquitous. You would be hard-pressed to find a new company that does not incorporate data analytics into its value proposition. If knowledge is power, big data is the switch that unleashes that power and does this on a massive scale. Gone are the days of manually entering numbers into a spreadsheet and using the sort function to determine data subsets and trends. Big data has increased the ability to parse data by orders of magnitude. Imagine the Millennium Falcon trudging through an asteroid field. That was old data. Now imagine jumping to light speed. That is big data.
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