Telestrat is a worldwide leader in continuing education seminars. Our Telestrat MBA Seminar Series has brought the world of finance, accounting, and business strategy to professionals in the U.S. and Europe.

The Price to Earnings (PE) ratio seems to get all the attention but it’s the lesser-known little sibling, the Price to Earnings Growth (PEG) ratio that is gaining momentum. The PEG ratio moves the PE ratio to the next level by helping to determine whether a company is undervalued, overvalued, or fairly valued.

The PE ratio is typically calculated by dividing a company’s stock price by it’s earnings per share. High PE ratios indicate stronger growth stocks while lower PE ratios indicate lower growth stocks. In other words, an investor is willing to pay more for $1 of earnings if the company is expected to grow at a healthy rate. The bigger issue, however, is whether or not the company is overvalued. Enter the PEG ratio.

The PEG divides a PE ratio by the company’s earnings growth rate. A PEG greater than one indicates an overvalued company and a PEG less than one indicates an undervalued company. While far from perfect, the PEG ratio offers a reasonable answer to the question “Is this company overvalued.”

With MF Global’s recent bankruptcy, we ask ourselves how something like this can happen yet again. It seems as though bank, brokerage and fund collapses are becoming a regular occurrence. So how do we protect ourselves from ending up among the many casualties as either consumers or investors? I present you with the “Don’t Get Fooled Again Checklist.”

1. Read every piece of financial disclosure. Balance sheets, income statements, cash flow statements, oh my! It can be daunting but take the time to read them. Analyze changes in liquidity, profitability and cash flow to get a better sense of company performance. Most of all, make sure you understand what is behind each change. Not knowing can be a red flag.

2. Don’t believe the hype. Management will always tell you that things are good. That’s what they get paid to do. However, it pays to be skeptical. Remember, Enron’s management was touting the company’s stock only a few months before the company went under.

3. Who’s the boss? Make certain you know who runs the business and how they performed in the past. A company is only as good as its leadership so make sure you know who calls the shots and what they have done in the past.

Follow these three simple rules and you just might avoid the next MF Global.

Financial reform has been a hot topic of discussion since the start of the financial crisis. Recently, attention has shifted to the Volcker Rule, a section of the Dodd-Frank Financial Reform Act. The Volcker Rule has yet to take affect but has already emerged as one of the most contentious aspects of the reform movement.

The Volcker Rule is designed to curb excess risk taking by banks.  Specifically, it prohibits proprietary trading in securities and derivatives. In other words, banks will face serious restrictions when trading for their own accounts. Additionally, the rule prohibits banks from investing in hedge funds and private equity funds. In essence, the rule seeks to minimize the use of bank capital for investment purposes.

So where do Wall Street and Washington go from here? The rule is shrouded in controversy as it could reshape the Wall Street business model by increasing costs and decreasing returns. On the other hand, without the rule Wall Street banks could continue to engage in the kinds of risky trades that ultimately led to the financial crisis. Bottom line: no easy solution here.

Each quarter, earnings season sparks interest in corporations large and small. Analysts eagerly await the financial overview offered by senior managers by way of conference call. The managers cover general strategic developments followed by a detailed review of the income statement. Sales, costs, expenses and earnings are closely examined with the final performance tally culminating in net earnings. Unfortunately, these calls tend to downplay, if not ignore, the cash flow statement. Given the economic challenges facing companies today, the cash flow statement may prove to be a useful performance indicator for the company and more specifically, the management team.

The cash flow statement details the amount of cash generated from a company’s operations, investing activities and financing activities. In other words, it addresses the company’s ability to generate cash segmented by various business activities. It can indicate whether the cash is a product of a growing business or clever financial engineering. And most of all, it often serves as a good indicator of solid business management. When a company effectively generates consistent cash increases from business operations while deploying cash judiciously for growth related initiatives, it signals a management team on the right track.

Lately, talk of an economic recovery has shifted to talk of a double dip recession. Since the emergence of this new discussion, the stock market has dropped significantly and companies are gradually moving back to lockdown mode. The American consumer seems to be losing confidence in the economy and consumer spending is likely to abate as a result.

So what is happening? We are allowing our fears to create a recession, which is usually how recessions form. Indeed, the global economy is under pressure as corporations and individuals undertake the massive deleveraging process. But this is something that started three years ago and will likely continue for quite some time. Let’s get used to it.

Does all of this mean that the economy must sputter along and periodically stall in the midst of this process? Perhaps. But what we must avoid as individuals and organizations is overanalyzing the economic data that surfaces on a daily basis. Let’s work hard, pay our bills and pay off our debts. Maybe then we just might avoid another recession.

It’s hard to ignore the headlines. The S&P credit downgrade of US government debt has clearly shaken the financial markets. But does it really matter? Unfortunately, credit ratings do matter in that the perception of weakness can often become a reality.

The recent downgrade will likely cause interest rates to increase, which affects consumers and businesses. At a time when the economy is on unstable ground, even a slight increase in interest rates can ripple through the economy by raising borrowing costs. Corporations will pay more to service corporate debt and consumers will pay more on their credit cards and mortgages. Given that austerity is all but a foregone conclusion, rising financing costs could force further cutbacks.

Now, the fear factor. If investors believe these things could happen, they start selling stocks. An increase in corporate financing costs and a cutback in consumer spending can mean one thing: a drop in corporate profits. And nothing drives corporate valuation, and in turn stock price, more than profits. Of course, all of this is based on what can happen when fear takes grip of the financial markets. The hope is that cooler heads will prevail and the real impact of a credit downgrade will be muted. Stay tuned…

These days, currency exchange rates are having a significant impact on global financial markets. To understand why a movement in currency can affect stock prices, consider the effect of a strengthening dollar. If the dollar appreciates against the Euro, American companies now pay less for goods and services purchased in Europe. If an American company has a large manufacturing plant in Germany, its costs of production can benefit. However, if the goods are ultimately sold in dollars, foreign buyers now perceive the products as more expense given the strength of the dollar. This could eat into profits and in turn, the stock price. On the other hand, if the dollar weakens against the Euro, American goods become more affordable and therefore more attractive to European consumers. This could lead to a sizeable bump in exports and hopefully sales.

So the trillion-dollar question is which is better for a company, a weak home currency or a strong home currency? The answer: it depends. A weak currency can mean stronger export volume and a strong currency can mean increased buying power overseas. Of course, one can offset the other so ultimately it depends on how a company is structured, where it produces its goods/services and where it sells them.

The IPO (initial public offering) market is showing signs of life with several high profile deals scheduled to launch in the coming weeks. After a multi-year slump, a rebound of sorts is in the works. Company managers are tapping into an equity market as strong as it has been since the start of the Great Recession. While a public offering provides some compelling benefits to a company, it’s not all fun and games. Let’s consider the pros and cons of going public:

Pros

1. Access to additional capital — Without access to public investors, a private company must raise funds from private equity investors and venture capitalists, who typically require a much higher return than do the public equity markets. Plus, once a company has gone public, it can continue to access the equity markets for additional capital.
2. Prestige — For corporate managers, a public company is the gold standard.
3. Proxy for value — The market value of a public company is easy to determine by multiplying the total shares outstanding by the share price.
4. Compensation — Stock grants and stock options can become a convenient way to compensate key employees.
5. Acquisition — A company can expand by acquiring other companies through stock swaps.

Cons

1. Regulatory requirements — All eyes are on the policies and procedures of a public company. It is estimated than a public company spends, on average, $1.4 million per year just to be in compliance with Sarbanes-Oxley.
2. Reporting — Managers often find themselves spending more time producing financial statements than developing strategies.
3. Subject to market forces — A good company can experience a significant drop in value due to a global event.
4. Pressure from Wall Street — Public companies live and die by their quarterly numbers and more importantly, their ability to impress Wall Street analysts.
5. Cost — The costs of going public can range from $500,000 to well over $1 million, so it makes sense to weigh the options.

Going public is not what it used to be but when timed well, it can create significant benefits for a company.

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!