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…

Lehman buzz is dominating the airwaves yet again nearly 18 months after the company’s spectacular collapse which arguably precipitated the stock market crash of 2008-2009. The current topic du jour stems from how Lehman may have parked “toxic” assets off balance sheet only to buy them back later. In other words, they sold bundles of mortgages
at the end of the year to make their balance sheet appear stronger, then bought them back early the next year. Essentially, they engineered a clever accounting maneuver termed Repo 105 to make their numbers appear stronger.

Over the next few months, accounting and legal experts will take a closer look at this practice to determine whether this was illegal or just highly unethical. The bigger issue, however, is why is this only surfacing now? Where were the auditors, regulators and investors when Lehman was hiding its debt? At the very least, a simple question posed on a Lehman conference call pertaining to Repo 105 may have saved billions of dollars in investor wealth and thousands of jobs. Did we learn nothing from Enron?

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.

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!

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!

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.

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!

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!

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!

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.

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