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With all the talk about swap regulation these days, we can’t help but ask, “what the heck are swaps?” Swaps are financial instruments used either to hedge against risk or to profit through speculation. Like other types of instruments of this sort, called derivatives, they are simply contracts between two parties, and their value is derived from the underlying security or market index on which the contract is based. Some are based on movements in interest rates, currency exchange rates or commodity prices.

A common swap is the interest rate swap. Consider a company that issued floating rate bonds - they have essentially borrowed money at a rate of interest tied to some interest rate benchmark such as LIBOR or prime. The company that issued the bonds is at risk of paying more to service its debt if interest rates were to rise. In order to protect itself, the company could structure a swap agreement allowing it to swap its floating rate payments for a higher fixed rate payment. It has removed the variability and risk of the floating rate bond. Essentially, the company has found a simple way to refinance its debt.

These days, there is a great deal of discussion on swaps because they have been virtually unregulated for many years. The concern is that without proper guidelines for valuation and disclosure, companies and the investing public are at great risk as corporations and investment houses use swaps on a regular basis. Stay tuned…

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!

Ever wonder why certain public companies meet or beat the earnings number predicted by Wall Street research analysts? GE, Microsoft, Apple are just a few of many corporate behemoths that tend to impress analysts and investors quarter after quarter. So how are they able to consistently able to beat these numbers, even in a slow economy? Two factors contribute to this:

1. Guidance
2. Profit Smoothing

As much as we would like to believe that the stars align for such companies, the reality is that managing earnings is more a product of skill than divine intervention.

When it comes to guidance, corporate managers tend to under-promise and hope to over-deliver. It works something like this: Company X just released its quarterly earnings report and beat the consensus earnings number. The consensus number is the average of analysts’ prediction for net earnings (also referred to as net income, net profit or the bottom line). Company X was pleased to report that due to aggressive cost cutting, they were able to beat the consensus number by one penny per share (total net earnings divided by total shares of stock outstanding). Beating the estimate is always a good thing and will often drive the stock price higher. While analysts and investors rejoice, the corporate management pats itself on the back for achieving strong results.

So how did they pull this off? At the conclusion of last quarter, Company X purposely issued very conservative earnings guidance even though there were several large sales likely to close before the end of the quarter. To play it safe, they sought to keep expectations low knowing they could easily surpass them and push the stock price higher.

As it turned out, several of the planned sales fell through. Time to bring in the heavy artillery. In this case, the heaviest of all is profit smoothing. Company X can adjust the assumptions on non-cash gains and expenses to make the earnings number beat expectations. Still too low? Why not lower the charge against a bad loan portfolio? How about changing the depreciation schedule to lower the expense taken in the near term? Through some combination of non-cash adjustments, Company X is able to generate the right earnings number. Unfortunately, once in a while no amount of profit smoothing will save a company from a bad earnings number which is what happened to GE a few quarters ago. And when that happens, look out below!

As the nation slips deeper into the depths of economic turmoil, virtually every media pundit and politician seems to have a theory as to why this happened and who is responsible. The newsrooms and congressional chambers are filled with banter about collateralized debt obligations, mark-to-market accounting and swap spreads. The problem is that invoking these terms in the context of such discussions is not the same as understanding them. As evidenced by recent congressional hearings, it is clear that our nation’s leaders have less than a basic understanding of finance and accounting. If they are truly committed to solving these problems, they will have to educate themselves as quickly as possible.

In the last several months, we have witnessed the former and current heads of the Federal Reserve Bank, US Treasury and some of the largest financial institutions testify before congress. In the standard questioning process, there seems to be a recurring theme. A question is asked by a member of congress that relates to some aspect of the financial crisis and as the response is offered, more confusion seems to arise. In a recent discussion between Fed Chairman Bernanke and a notable congressional leader, Mr. Bernanke was lambasted for injecting capital into several of our nation’s largest banks. The members of congress were irate over the fact that taxpayers are paying to bailout these institutions. Mr. Bernanke tried to explain that this was a capital injection and not an expenditure. Its intent was to solidify the company’s balance sheet and allow them to lend money. Exasperated by the puzzled looks from the congressional leaders, he sought to clarify the difference between capital injections and expenditures, something that fell on deaf ears. Former Fed chairman Greenspan also encountered widespread consternation recently when attempting to explain the complexities of derivative structures and their role in the crisis. Recognizing the daunting nature of this task, he too conceded limited understanding of these structures.

My professional experiences have taught me that even some of the most accomplished professionals have difficulty distinguishing between income and cash flow let alone recognizing derivative structures. Our leaders in Washington need to acknowledge their deficiencies in this area and do their best to correct them. Given the magnitude of the current crisis and the role our leaders play in maneuvering it, perhaps it is time we consider devoting a portion of the stimulus package to financial education for our leaders. We at Telestrat are prepared to heed the call.

Reuben Advani is a former investment banker, founder of Telestrat Education and author of The Wall Street MBA (McGraw-Hill). 

To explore these and related issues, join us for one of our in-person courses (in major U.S. cities) inAccounting and Financial Statements or Corporate Finance and Valuation, or one of our webinars inUnderstanding Financial Statements, Financial Analysis, Stocks, Bonds, Options Online - Securities Basics for Lawyer, or Valuation, or one of our On-Demand programs (available 24/7) including our Financial Markets Update, which explains what brought on our current market issues.

As I write this, stock markets around the world are teetering on the verge of major collapse. What only a few weeks ago was a topic of interest for Wall Street bankers and academics has become a global contagion affecting everyone. In previous blog postings, I discussed several topics including mark-to-market accounting and short selling, each of which has played a role in this crisis. But what is now at the forefront of both the diagnosis and treatment of this malady stems from simple human psychology: confidence. Few deny that the overriding lack of confidence in our financial system and leaders exacerbates the current economic crisis. But how has this lack of confidence brought us to where we are today?

Let’s recap what we know so far: banks loaned money to borrowers under very aggressive terms predicated on the notion that housing prices always go up. New home construction reached unprecedented levels causing an excess of inventory. As home values started to decline due to this buildup of inventory, home values started to decline. This created problems for home owners who financed their mortgages with nominal down payments. As interest rates started to rise, it became even more difficult to make the required mortgage payments. At this point, confidence started to erode in the housing market driving down home values in most markets.

What about the banks? With the banks buying and selling complex financial instruments that are based on home prices, concerns started to mount that perhaps the banks would soon feel the pressures of the housing market decline. Sure enough, thanks in part to an obscure accounting rule known as FAS 157, major financial institutions were forced to estimate the loss of value on these financial instruments and record any drop as a charge against earnings. This raised bigger questions: how were they determining these values and more importantly, were they underestimating them. This created a further crisis of confidence among the clients of these banks as well as the investors in these banks. As clients started to close accounts, investors started to sell shares of stock in these companies. These factors worked in tandem to literally collapse several major banks in a matter of days as they no longer had the ability to meet their required capital obligations.

With housing collapsing and the banks collapsing, equity investors grew fearful that businesses would no longer have access to capital. Furthermore, consumers would curb spending out of fear that their most valued tangible asset, their home, wasn’t worth what they thought it was. And more importantly, businesses in turn would curb spending out of fear that consumers would buy few products. Most of all, businesses would have difficulty gaining access to capital due to problems with the banks. All of this ultimately stems from a lack of confidence in the spending ability of institutions as well as individuals.

So here we are in the midst of one major crisis of confidence. How do we fix it? Simple, restore confidence. To do that, the government (Congress, the Treasury and the Fed) has:

1.) passed the $700 billion rescue package which will, among other things, allow financial institutions to sell their distressed mortgage-based instruments to the government and
2.) agreed to loan money directly to companies by purchasing their commercial paper.

Unfortunately, these steps have done little but further undermine confidence in our financial system and leaders. What happens next? Stay tuned. I have a feeling another blog entry will be posted sooner rather than later.

To explore these and related issues, join us for one of our in-person courses (in major U.S. cities) in Accounting and Financial Statements or Corporate Finance and Valuation, or one of our webinars in Understanding Financial Statements, Financial Analysis, Stocks, Bonds, Options Online - Securities Basics for Lawyer, or Valuation.

One week ago, the stock market surged, Wall Street was dominated by four large investment banks, and the largest insurance company in the world was enjoying a spike in stock price.

What a difference a week makes. One week later, the market saw its worst day in eight years, Wall Street is left with only two stand-alone investment banks, and the once largest insurance company in the world is fighting for its life. If you fell asleep at your desk last week and just awoke, I’ve got some news for you: the world has changed.

So what happened? Well among other things, companies have now been thrown to the market wolves, or bears in this case, and left to fend for themselves. Essentially, short sellers have taken hold of financials and continue to drive the market lower. How did so few become so powerful? Let’s consider the dynamics of 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. Of course, if the price of the stock goes up, the short seller may have to close the position by buying shares of the stock to replace the borrowed shares at a higher price thus recognizing a loss. For example, a short seller sells shares of Lehman, the most recent market casualty, short at $4 per share. When the share drops to $.10 after the bank declares bankruptcy, the short-seller buys the shares to replace the borrowed ones at $.10 earning a $3.90 profit. Of course, had the stock gone up to say $10, the short seller may close the position by purchasing the shares at that price suffering a $6 loss.

Short-sellers are as much a part of an efficient market as the people who buy and hold shares of stock for an extended period of time. Unfortunately, the rules governing short-selling allow for short-sellers to push a stock to unprecedented lows in a very short period of time. This has created two contentious points:

1.)   The SEC’s standards for enforcement of “naked” short-selling are lax. Naked short selling means someone can sell short without even borrowing shares. In theory, it can allow a large short sale order to be placed which in and of itself, could push the stock price lower. As more, larger sell orders are placed, a stock price will collapse.

2.)   The uptick rule required that a short sale must be entered at a price higher than the last trade. The idea behind this is that it prevents the compounding downward pressure of progressively lower sell orders. The uptick rule was eliminated in 2007.

Short selling adversaries argue that there is a lack of regulation allowing for short sellers to essentially gang up and beat a stock down to nothing. Unfortunately, a falling stock price, while a technical problem, can easily become a fundamental problem in sectors such as financial services and insurance. In these sectors, a drop in stock price can trigger a ratings downgrade which can prompt liquidity concerns. If these issues are not checked, a complete collapse of a company can occur. 

To explore these and related issues, join us for one of our in-person courses (in major U.S. cities) in Accounting and Financial Statements or Corporate Finance and Valuation, or one of our webinars in Understanding Financial Statements, Financial Analysis, Stocks, Bonds, Options Online - Securities Basics for Lawyer, or Valuation.