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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…

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!

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!

There are many misconceptions about the Balance Sheet and its purpose. For example, the moment that one learns that assets on the Balance Sheet are generally valued at “historical cost” (i.e. what we paid for them) rather than “fair market value” (the current market price) for many may be the moment that they begin to give up on accounting. “The Balance Sheet doesn’t have the actual asset values on it? Then how do I know what the business is worth?” is a common refrain. In fact, not only are asset values on the balance sheet typically not updated to fair market value, but the values of other items such as the company’s brand(s), their relationships with suppliers and customers, and other intangible assets are generally not included at all. The complaints are correct: the Balance Sheet is generally not used to determine the value of a company. There are instead a variety of other valuation tools available, which we discuss in our Valuation programs.

Then is the Balance Sheet some antiquated holdover from less sophisticated times, a necessary evil but one that provides little utility?

If you look no further than determining valuation, you’ll miss out on the compelling story that the Balance Sheet tells about a company. The most important thing to understand about the Balance Sheet, and Accounting in general, is that it’s about dollars. Dollars that have come in to the company (and from where), and where they are now. Actual dollars as well as potential dollars the company expects to receive, such as from customers who purchased on credit. Under Liabilities and Owners’ Equity we find the sources of the dollars in the company - some dollars came from Equity, including dollars invested and profits earned, and some came from Debt and buying on credit. And what did we do with these dollars? Some dollars are still cash, some were “loaned” to our customers (so they could buy our products and services - those same dollars we expect to collect), and some were used to buy assets such as inventory and property, plant, and equipment.

So the Balance Sheet tells us the company’s financial condition at a given moment in terms of dollars - how many have come in and from where, and where they are now; how many of those dollars the owners can claim and how many dollars are owed to creditors. This is just part of the story, of course - join us for one of our upcoming live and online programs for much more.

Question: How does an obscure accounting rule find its way to the top of a new president’s agenda?

Answer: By creating the worst financial crisis in over 70 years.

Indeed, folks, a topic previously discussed by CPA’s and CFO’s is making front page headlines. Why? Well, to put it mildly, the fate of our banking system may depend on a method of accounting known as mark-to-market accounting. Mark-to-market is used to assign value to an asset based on its current market price. The idea came about in the 19^th century when future traders used it in an effort to mark their positions to the current market price. In other words, futures as well as other derivative instruments, are often traded on and off exchanges. While they may simply serve as contracts to buy or sell something at some point in the future, they maintain some value during their life. 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).

To illustrate the way mark-to-market accounting has been applied in recent history, imagine this: you purchased a home for $100,000 ten years ago. Three years ago, in the height of the real estate boom, your home’s value was assessed to be $200,000. If you were to use mark-to-market accounting, you would list this increase in value on your personal financial statements and specifically, show an increase in your non-cash income. Did you benefit from this increase? Not directly. It doesn’t impact your household income or available cash as you have not sold the home. However, it does help your net worth on paper which means that in theory, you might be able to borrow more. In fact, you could likely obtain a larger home equity loan or line of credit based on this increase in net worth. Having access to this capital appears to place you in a stronger financial position.

Let’s consider another scenario: the home you purchased ten years ago for $100,000 is worth $70,000 today due to a major collapse in the housing market. Using mark-to-market accounting, your non-cash income would be reduced based on the drop in market value and more importantly, your net worth has dropped as a result. Although your household income is not affected and this represents no significant change to your lifestyle, your ability to borrow could be diminished. This may present some problems should you be in need of a home equity loan or some other source of capital.

Fortunately, we have little need for mark-to-market accounting in personal finance but what happens when some of the largest corporations in the world use this technique? That is what happened in 2007 when financial institutions were required by the Financial Accounting Standards Board (FASB) to use this method in an effort to disclose the values of various financial instruments. Some of these instruments, such as mortgage backed securities, were quite complex in that they were based on massive bundles of other instruments such as home mortgages. Quantifying their values became increasingly difficult when such instruments were not actively traded. In other words, when such instruments are actively traded, assigning a mark-to-market value is relatively simple. It becomes the price that buyers and sellers agree on. But what happens when these instruments are no longer traded? Then you have the makings of a major financial crisis at hand. As the appetite for these instruments waned in late 2007, financial institutions found it difficult to sell them. Without a liquid market, these institutions were forced to use broad based estimates to determine their values. In essence, they moved from mark-to-market accounting to mark-to-model accounting. The results were ugly. As the housing market collapsed, the values determined by these financial models were shockingly lower than in past quarters. As a result, major banks around the world were writing down these assets at a rapid pace while lowering their profits and eroding investor confidence. As investors lost confidence based on these massive write-downs, stock prices fell to reflect this.

Where does this leave us today? The world is divided on mark-to-market account. There are those in favor of it as it increases transparency in financial disclosure. As the argument goes, if something loses value the financial statements should reflect that. 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. Perhaps this dilemma is best summarized by the greatest punk band ever (and prescient market forecasters), The Clash. To paraphrase:

Should it stay or should it go? If it goes there will be trouble, and if it stays it will be double. So come on and let me know, should it stay or should it go.

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, or one of our On-Demand programs (available 24/7) including our Financial Markets Update, which explains what brought on our current market issues.

There is a great deal of discussion and speculation about the current stock market. “Where is it headed?” is the question most of us are asking. Well, don’t look to me for precise answers because if I knew, I wouldn’t be writing this entry or doing anything work related for that matter. In fact, the only thing I do know for certain is that no one can predict what will happen in the stock market at this point. Now, more than ever, this holds true.

In the last few years, analysts and investors were able to offer substantive predictions with relative ease. Why? Economic growth was strong, consistent and predictable. Based on macroeconomic data, companies could effectively predict demand increases for their products and services. And with solid demand forecasts, costs and expenses could be budgeted as well. Put them all together and what you have is a well defined profit forecast for the next year.

With credible profit projections, a company’s stock price generally adjusts to fall in line with the industry average PE multiple (price to earnings). The PE multiple for a company is its stock price divided by its earnings per share. PE multiples for an industry are based on an average of PE multiples for all companies in the industry. When a company offers a projected earnings number for the next year, the company’s stock price should adjust to align with the industry average multiple. So in theory, this allows one to not only predict where a company’s stock will be trading at in the future but where the entire market will be trading at. This is because the market is an aggregation of individual stocks. Consider the following example:

Company ABC projects its earnings for 2009 to be $2 per share. If the industry average PE multiple is 15, then ABC’s stock price should reach $30 by year end in order for it to be in line with the industry. So if the current stock price is $20, we can predict a 50 percent increase in stock price over the next year.

In 2009, stock market predictions will be as accurate as those pertaining to a Vegas craps table. There are two reasons for this. First, companies are having a difficult time projecting their earnings. Given that we will likely remain in the throes of the Great Recession, it will be difficult to determine how consumer and corporate spending patterns will react. This will make it challenging to forecast earnings and, consequently, stock prices. Second, investors large and small have been scared away by the recent market tumult and may very likely keep their cash tucked securely under the mattress. It’s unclear when their confidence will be restored and more specifically, when their funds will return to the market.

What we are facing is a paradigm unlike any we have seen in a very long time, if ever. Therefore my prediction for the stock market in 2009 is as follows: it may go up or it may go down.

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, or one of our On-Demand programs (available 24/7) including our Financial Markets Update, which explains what brought on our current market issues.