We hear about Silicon Valley executives who pocket millions when they leave their companies or Wall Street traders who make a killing when the stock market moves a few points. What alchemy creates such unbelievable returns? The answer: stock options. Stock options are essentially contracts to buy or sell shares of stock at a certain price, within a certain amount of time. Options to buy stock are known as call options and options to sell stock are known as put options. In this article, we’ll review the basics of the call option which allows an investor, trader or even the fortunate executive in a company to profit from the upward movement in a company’s stock price.

Suppose you are interested in investing in Bailout Industries. Their stock is currently trading at $10 per share and you believe it could go as high as $15 per share in the next year. In order to buy 100 shares of Bailout stock, you’ll need to shell out $1,000. If the stock were to reach $15, you could sell the stock for $1,500 and pocket a cool $500 profit. Now, consider what can be achieved if you buy the call options. The December 2010 $10 call option is currently selling for $1. In other words, a contract to buy one share of stock at $10 before December of 2010 is priced at $1. With $1,000, you could buy 1,000 call options. So what happens if you buy the call options and the stock does reach $15 next December? Your position is now worth $5,000! Not bad for a $1,000 investment. Sound too good to be true? Well, it can be.

The problem with call options is that they are simply contracts. When the terms of the contract are not met, they are essentially worthless. If Bailout stock falls below $10 and remains there at the time of expiration, the options are worthless and you’ve lost your $1,000. In future articles, we will take a look at put options and option valuation.

Recently we discussed the Comparable Multiple method of valuation. In this article, we will take a look at the more complex Discounted Cash Flow (DCF) method of valuation.

The DCF method is based on the idea that a company, or any asset for that matter, is valued based on its future cash flows (or some variation of cash flow). In other words, an asset is worth the aggregate of what it produces over time. In theory, this makes sense. If you buy a beach house and plan to rent it, the value to you is based on the future rental payments. A factor that must be addressed, however, is that because of the time value of money, which we talked about in a recent article, future payments are worth less in today’s dollars than their nominal value when they’ll be received.

So what does all of this have to do with the DCF method of valuation? In a DCF model, all projected future payments are discounted using a fairly simple formula to determine present values (in today’s dollars). The more complicated part is determining the discount rate to use, and this is often very subjective. We’ll usually take into account a variety of variables, including the company’s financing costs, historical volatility of the stock price and historical returns of the stock market to name a few. Depending on which assumptions are used, the resulting values will vary considerably. Additionally, the entire model is built on the premise that a company’s value is based on its future cash flow (or some variation of it). This implies that the analyst who produces the model is capable of predicting the future. One thing the financial community has taught us is that no one can truly predict the future. So just as with the Comparable Multiple method, valuation is more art than science.

Telestrat offers valuation courses in several forms, including live online, on-demand, and in-person in major cities across the U.S. Learn about the most common valuation methods, including a number of variations, as well as the underlying concepts. We also offer many other accounting and financial courses, all taught by seasoned professionals with the rare ability to distill seemingly complicated concepts into a simple, understandable form. Sign up today!

A dollar today isn’t worth a dollar tomorrow. We know this, of course, because prices increase such that we can buy less tomorrow than we can today - this is called inflation. But even beyond inflation, money changes value over time. This is a fundamental financial concept and comes into play in many ways, including in valuation. Let’s think about how this works:

In scenario A, we receive a payment today of $100. We put the money into a savings account paying 5% interest annually, and so a year later we have $105. In scenario B, we’re owed the $100 today but we don’t receive it for a year, so in a year we have $100. If we’d received the money today, it would be worth more than it is if we receive it a year from today.

Here’s another perspective: assuming we can get 5% interest, would we prefer to receive $100 today (assuming we’re going to put it in the bank and leave it there) or $105 a year from today? We’re generally indifferent - $105 a year from now is the same as $100 today under these circumstances.

Understanding this allows us to actually calculate the value of money, depending on when we receive it, as long as we know what’s referred to as the discount rate. In the example above, the interest rate is the discount rate. If we’re investing our money then the discount rate used is our cost of capital. It’s also sometimes called the hurdle rate. More on all of this in future articles.

So if we know the proper discount rate to use, then we can determine how much a sum of money that we receive at one point in time is worth at some other point in time. Above, it was a simple matter to determine how much that $100 will be worth in a year, knowing that the discount rate is 5%. It’s only a little harder to know that at 5%, $105 we receive in a year is worth $100 today, and just a little more complicated when we take into account that we need to compound the rate every year. We’ll continue to explore these concepts in future articles, as well as at our many seminars - sign up today!

Ever wonder why two investment analysts will have conflicting views on a particular stock? One says the stock is undervalued while the other says it is overvalued. The answer has to do with the fact that valuation is more art than science. Financial analysts across the globe employ sophisticated financial models to determine what the fair value of a company’s stock price should be, but ultimately it is the underlying assumptions that determine the end result. To gain a better understanding, let’s consider one of the two widely used valuation models, the Comparable Multiple model.

The Comparable Multiple model is one of the most user-friendly valuation models. The beauty of it is its simplicity. In fact, a CEO can sit down with an investment banker and craft a plan to sell a company…all on a cocktail napkin. Here’s how it works: Alpha Co.’s CEO is meeting with a banker from an esteemed Wall Street bank. Alpha’s CEO mentions to the banker that the Alpha board is interested in a sale. The banker says, “Good idea. We can sell your company for $24 per share. Given that you have one million shares outstanding, we should be able to sell the entire company for $24 million.”

The CEO asks, “How can you be so sure?”

The banker replies, “Simple: comparables.”

So what just happened? The banker simply did a quick and dirty Comparable Multiple analysis. To understand this type of model, it is important to consider its components: industry competitors, stock price for each competitor, earnings per share (or some variation on earnings) for each competitor and current earnings per share (or variation on earnings) for Alpha Co. The banker, based on his extensive knowledge of the industry, is aware that Alpha Co.’s competitors have average price to earning (P/E) multiples of 12. In other words, their stock prices are 12 times their earnings per share. The banker then applies this multiple to the earnings per share number for Alpha, which happens to be $2. In order for Alpha to trade in line with the industry, its stock price should be $24. Multiplying that number by the total shares outstanding, in this case one million, gives us the expected company value of $24 million.

Stay tuned for Part II in which we discuss the other popular method of valuation, the Discounted Cash Flow model.

There are many ratios commonly used for the financial analysis of a company, and perhaps the best known is the Price/Earnings (PE) ratio. Ratios are powerful tools because rather than considering some number on its own, they allow us to evaluate a number in the context of another number. Let’s see how this works.

Imagine there are two companies, A and B. Both earned (i.e. made a profit of) $1 million last year - will they have the same value? Suppose A is in an industry that’s dying out and B is in a growth industry – (assuming that both companies have the same number of outstanding shares) which will have the higher stock price? B has the brighter future, the higher likelihood of providing long-term value, so it will have a higher stock price. So given the same earnings, B has the higher price and therefore the higher price/earnings ratio. Thus, the PE ratio is a measure of investors’ optimism about future growth.

Normally we wouldn’t compare companies in different industries. Since different industries have different growth prospects, we would not expect companies across those industries to necessarily have similar PE ratios. But companies within an industry are all subject to the same market forces, so we would generally expect them to have the same growth expectations, and therefore the same ratio of their current price relative to their current profits (earnings). What if we find a company that has a PE ratio that’s higher than the industry average? What might we wonder? This company’s price is higher relative to its earnings than everyone else in the industry (on average) so perhaps that price is too high and this company is overvalued. Or maybe there’s a good reason for investors to be more optimistic. And, of course, if a company has a PE ratio lower than the industry average, then maybe they’re undervalued and a good buy. Or maybe there’s a good reason why their price should be lower. Ratios such as this don’t provide a final decision; they’re just a potential flag to take a further look.

Speaking of taking a further look, next time we’ll take a different look at the PE ratio and how it might be used to determine a company’s value. Better yet, take one of our seminars to learn about many other powerful yet simple analytical ratios!

In a past article we considered the various expenses a company incurs related to financing, as well as “costs” that aren’t expenses. More recently we recognized the fact that when we talk about revenue and expenses, we’re simply talking about items that affect Retained Earnings, except for one.

Before we get there, let’s review. We’ve now recognized the fact that the whole point of having a company, from a financial perspective at least, is to pay out dividends and/or increase Retained Earnings. But wait - isn’t the point of the business to make a profit? The answer, of course, is yes – the profit that we make is EXACTLY the sum of our change in Retained Earnings and the dividends that we pay out. Which is why the Income Statement (or P&L or Statement of Earnings - it has many names) is simply an itemization of all of the changes to Retained Earnings EXCEPT dividends.

In other words, we can think of it this way: during a given period, we operate the business - we increase Retained Earnings when we have revenue and we decrease Retained Earnings when we have expenses. Then we may choose to pay a dividend. Before we account for dividends, our change in Retained Earnings is equal to our Net Income (i.e. profit). THEN we may choose to distribute some of those earnings (i.e. profits) to the owners (i.e. pay out a dividend). Paying a dividend doesn’t reduce our profit; it just reduces the profit that we’ve kept in the company (i.e. the Earnings that we’ve Retained). When it comes to tax time, we pay taxes on our profits, which is simply the difference between our revenue and our expenses. Just because we decided to distribute some of those profits (i.e. paid a dividend) rather than retain them doesn’t mean that we didn’t earn them, and so of course we don’t include dividends on the Income Statement. So if dividends don’t reduce our profit (i.e. they aren’t expenses), then by definition they are not tax-deductible.

Explore these concepts and more at one of our upcoming live and online/on-demand seminars. All of our seminars are taught by Wharton and Harvard MBAs with the rare ability to distill seemingly complex concepts in simple, understandable, and very useful terms. Sign up today!

You didn’t have to go to business school to know that profit is the difference between how much we sell something for and how much it cost, and our overall business profit is total revenue minus expenses. In recent articles we’ve discussed the nature of various expenses. Now we’ll take a look from a different perspective.

Let’s consider the way we account for sales. Though intuitively we think of a sale as an exchange of our inventory for money (or an IOU), from an accounting perspective these are two separate transactions. First we handle the sale. Because we use Double-Entry Accounting (more on that another time or in one of our seminars), every transaction will affect at least two accounts on the Balance Sheet in order to maintain a balance between the two “sides” of our business. It’s a cash sale, so cash increases and what else happens? No other assets change - all that’s really happened to assets is we’ve received cash (remember - we’ll handle the inventory change later), so it must be something on the other “side” of the Balance Sheet. We don’t owe creditors more money because we’ve sold something, and nor does it mean that owners have invested more capital. By making a sale we’ve increased Retained Earnings - which makes sense since it means that selling increases the value of our Owners’ Equity. Next let’s address our having sold some inventory. Inventory decreases on the Balance Sheet and what else? Retained Earnings goes down. We no longer have the inventory and so the value of our business is diminished.

How about paying the rent? Cash and Retained Earnings both decrease. Same when we pay utilities or other bills. When we make a loan payment, our cash asset is reduced and on the other side liabilities go down by the amount of the principal payment and Retained Earnings goes down by the amount of the interest. When we Depreciate assets, Retained Earnings and Accumulated Depreciation go down by the same amount.

So looking at things from this perspective we can see that the Income Statement (a/k/a Profit & Loss or P&L) is simply a list of all of the items that affect Retained Earnings, and by “profit” we mean the net change in Retained Earnings since the prior Balance Sheet - except for one: Dividends. Learn more about that in a future article - and, of course, at one of our many upcoming seminars - sign up today!

Depreciation - one of the most interesting topics in Accounting. Of course, by interesting we mean “Accounting” interesting, not necessarily “interesting” interesting… Depreciation is interesting because there are many ways to think about it. And it’s a lot more than just an Accounting or Tax fiction.

Let’s back up for a moment. Recently we talked about the fact that buying assets isn’t an expense. In addition to coming from paying for some service (utilities, rent, etc), expenses come from using up our assets (selling inventory or using some of the useful life of equipment). But the portion of the life of an asset (or inventory) that we haven’t used yet remains and has not become an expense. As we use up the life of the asset, we recognize that it has (at least theoretically, perhaps) lost some market value, and so we recognize it as a Depreciation expense.

Notice something about how this works. We pay the cash now for an asset (yes, we might be financing it, but from an Accounting perspective the loan is independent from the actual purchase) and we expense it over the life of the asset, which may be 20 years or more (depending on the schedule used for this “asset class”). So most of the expense will happen long after we actually paid for the asset – it will be a non-cash expense. That doesn’t make it a fiction (though the schedule may be somewhat subjective) - it just means that instead of recognizing the whole cost as an expense immediately, for all the reasons above, we’re spreading out that cost over the expected life of the asset.

Speaking of spreading things out over time, that’s what amortizing means (think of amortizing a loan – we spread out the repayments over time). Some of the assets that we amortize are tangible, so that the spreading out of the costs is at least potentially related to its loss of value in the market. Intangible assets such as licenses and other contracts are also amortized, but since we don’t relate these expenses to some reduction in market value, we refer to them simply as Amortization, not Depreciation, but they work exactly the same way.

“Interesting?” Then why miss out on so much more fun? Sign up for one of our in-person, live online, or on-demand seminars!

An expense reduces our profit in recognition of some business cost. Simple enough. The tricky thing is what do we consider business costs?

Let’s take inventory for a moment. Is buying inventory a business cost? It does cost us some money (now, or later if we’ve purchased on credit). However, we still have the inventory once it’s been purchased, and it is listed as an asset on our Balance Sheet. Though we’ve converted money into inventory, we don’t consider it a cost because we still have the inventory. It becomes a cost when we actually use the inventory - it’s the Cost of Goods Sold expense. Similarly, when we buy a piece of equipment, we still have it. A year later, the equipment is (likely) still in operation. We don’t consider the purchase of the equipment to be a cost. We consider the actual usage of the equipment (or simply the fact that it has become a year older) to be the expense. More on this in a future article.

What if we pay for a multi-year service contract? Same concept applies - it becomes an expense when we actually use up the contract. When we buy the contract, its value becomes an asset on our Balance Sheet, which is then reduced as we use (and actually expense) the service.

Let’s go one step further. What if we’re paying employees (or contractors, etc) to build something for us. Perhaps it’s a building. Maybe it’s an improvement to an existing building. Or it may be software that we’ll be using for years to come. We’re paying people - sounds like a wage expense, right? But like the items above, we still have these assets after we’ve paid for them. And like the items above, they’ll become expenses as we use up their useful life. In the meantime, we capitalize these expenses; in other words, we treat them just like the purchase of any other assets, and they are listed on our Balance Sheet.

Soon we’ll discuss the sort of expenses these types of assets create, as well as the true nature of expenses. If you find these pointers to be useful, imagine the value you’ll get from taking one of our courses!

Now we’re not making any sense, right?  Liabilities and expenses are both things you have to pay for – why aren’t they the same, you might wonder. 

Recently we have been taking a look at expenses - what they are (costs of operating the business), how they may be used to…adjust…corporate earnings (by varying estimates and accounting choices), and how they relate to loan payments (paying down principal is NOT an expense, but interest is an expense).  So what about liabilities?

Liabilities are what we owe - to lenders and anyone who has sold us goods or services on credit - suppliers, professionals, etc. If we pay for our expenses when they come due, or in advance (we pay the rent when it’s due, we buy inventory for cash, we prepay for insurance), then those expenses never become liabilities.  If we’ve paid for them on credit, then those expenses generate liabilities because we still owe them, not simply because they are expenses.  And if we have a liability because we need to repay money we’ve borrowed, then as discussed in a recent article, those repayments are not expenses.

Looking at it another way, expenses are items that happen in time and liabilities are persistent.  An expense happens in a moment - the rent comes due, interest comes due, we use a service, or it’s payday.  We then add the expenses to our Income Statement (a/k/a P&L Statement, or Profit & Loss).  If we pay for them at the time, or prepaid for them, then that’s it – they never become liabilities.  If we haven’t paid for them yet, then they create liabilities related to those expenses – but those liabilities are not the expenses themselves.  Liabilities persist for a period of time – they’re created when the bill comes due, or we borrow money, and they go away once the bills are paid or the debt is repaid.

More confused than ever?  We hope not! It sounds a lot more complicated than it really is.  Stay tuned as we look further at Expenses vs. Capitalization and the true nature of expenses.  Better yet, sign up for one of our upcoming live, online, or on-demand courses for a more complete understanding!