VALUATION FOR PORTFOLIO INVESTMENT

VALUATION FOR PORTFOLIO INVESTMENT

Analyzing Assets, Earnings, Cash Flow, Stock Price,Governance, and Special Situations

-Charitra Shrestha

Contents

1. Corporate Valuation for Portfolio Investment:

APhilosophicalFramework 1

ValuationDefined 2

TheImportanceofEquity 4

EquityDefined four

ArticlesofFaithUndermined:SecuritizationatRisk 5

BenefitsoftheEquityMarketplace 8

TheFlexibleNatureofEquityCapital eight

lengthy-TermSuperiorityofEquityoverDebt—witha

caution approximately Volatility 9

TheFocusedNatureofValuationforInvestment 11

TwoMainSourcesofInformationaboutEquity 12

FinancialReports:IssueswithGAAPandIFRS/IAS 12

assets of Complexityin Accountingfor CompanyValue 13

Reforming GAAPand IFRS 15

TheProblemofFairMarketValue:ReportingValues

forSecuritieswithNoCurrentMarket 17

ThreeStudies 18

TheNeedtoReadbetweentheLines 19

HumanNatureComplicates(butAlsoInforms)

equity Valuation 19

GeorgeSoros’s concept of Reflexivity 21

v

vi contents

OtherParadoxesinEquityInvesting 22

TheObserverEffect 24

HumanNatureastheKeytoEquityValue 24

NeedforExpressioninCurrencyValues 25

OnFinancialMathematics 26

In last: approximately This book 28

A Rangeof methods 30

2 ValuationBasedonAssets forty seven

Overviewof Assetsas aUnit ofValuation forty eight

AnOpeningCaveat:TheLimitationsofAccountingNumbers fifty one

AccountingNumbers:WhyAssetsasaStartingPoint? 52

Definition of anAsset fifty three

flow-Dominantvs.fee-DominantAssets fifty five

TheMarketPremiumandNonmarketDiscount 56

endure Stearns:A CautionaryTale fifty eight

TheAsset-FocusedInvestor 59

CurrentAssetValue 60

Taking Clues from belongings sixty two

The Sykes model sixty six

BeyondAssets:CluesfromLiabilitiesandEquity

ontheBalanceSheet sixty seven

TheRoleoftheAppraiserandAppraisal

Standardsin Valuing belongings sixty nine

FairMarket cost TreatmentAssets 70

FairValueofAssetsunderFASB(GAAP)andIASB(IFRS) 70

ValuingIntangibleAssetsontheBalanceSheet seventy two

ValuingIntangibleAssetsThatAreNotontheBalanceSheet 73

the usage of theMD&A forInsightson belongings seventy seven

ImprovementsinFairValueDisclosures:

A tick list for buyers seventy eight

Asset-based totally Valuation by means of enterprise 79

SpecialTopicsinAssetValuations:ValuingAssetsin

Pension Plans 83

Lens check eighty four

conclusion:Asset Values in Bailouts 86

Appendix2.1:CommonRatios,Multiples,Averages,

andAlgorithmsBasedinAssets—andExamplesofTheirUse 86

Appendix2.2:Asset-BasedApproach toBusinessValuation(American Society of Appraisers) ninety

three ValuationBasedonEarnings(earnings) 103

EarningsDefined 103

styles of income 104

operating EarningsAreKeytoValue 106

EarningsAreRelativetoRevenuesandExpenses 108

earnings AreUltimatelyBasedon assets 108

HardTimesRevealEarnings-AssetConnection 110

HowtheStandardSettersCurrentlyDefineEarnings 111

A BriefPausetoLookatOur Compass 114

TheOtherSideoftheEquation:RevenuesMinusExpenses 114

HowXBRLCanConnecttheDotsbetween

earnings and assets 116

EarningsManagementandFraud 117

earnings Caveatfrom aSage 118

The Qualityof profits 119

models to evaluate earnings 122

EarningsGuidance:AWaningTrend? 124

Consensus EarningsPrograms 124

profits Examples 126

EPS:AnEmergingStandard 128

income-BasedValuationbyIndustry 129

ImpactonIndustriesofNewGlobalAccountingStandards

for RevenueRecognition 132

IsaNewEarningsMeasureNeeded? 133

Lens take a look at 133

end 134

Appendix3.1:Hoover’sDefinitionsofBasicIncome

StatementTerms 134

Appendix3.2:RatiosandOtherValuationIndicators

the usage of income 138

Appendix3.3:NetIncomeExample 144

4 ValuationBasedonCashFlow 155

CashFlowStatements—SomethingOld,something

New for investors 156

value and Liquidity 157

CashFlow:WhattheGlobalStandardSettersSay 157

WhattheCashFlowStatementShows 158

AccountingNote:ConvertinganIndirectMethodStatement

ofCashFlowstoaDirectMethod 161

viii contents

DCF:ProjectingFutureCashFlow

163

CrystalBall:  kinds of Questions 164

SomeGeneralMethodologiesforConsideringCashFlow 168

CashFlowfromProjects:WhatInvestorsShouldKnow 172

TheWorkofAlfredRappaport

UsingMonteCarloSimulationsforFutureCashFlowEstimates 175

one hundred seventy five

UsingCashFlowtoCalculateAmortizedCost 191

IFRSImpactonCashFlow 191

CashFlowPatternsinIndustries 192

LensCheck 194

conclusion 195

Appendix4.1: AT&T instance 195

Appendix4.2:ASC230Summary 200

Appendix4.3:SummaryofIAS7 201

5 Valuation based totally on Securities charges 209

OverviewofSecuritiesPrices 210

DefinitionofStockPrice

SevenBasicPointsofDeparturetoDeterminingtheValueofaSecurity 211

213

Approach1:RatiosorFormulasThatIncludeStockPrices 214

Approach2:TechnicalAnalysisofStockPriceMovementsApproach3:AnalysisofValuesAccordingtoEfficient

marketplace–RandomWalkHypothesis 216

226

Approach4:StockValuationBasedonExpectations 228

Approach5:ValuationsImplicitinAlgorithmicTrading 229

Approach6:TheBlackSwanApproachto StockPriceValuation 230

Approach7:ReflexivityTheoryandStockValues 231

AnOverviewofChaos/ComplexityTheory 234

SecuritiesValuationasanAssetontheBalanceSheet 236

TheDuff&PhelpsValuationModel 236

RevisitingMark-to-marketplace 238

CanWeBringBacktheEquityPremium? 241

ReconnectingwiththeGoodOldCapitalAssetPricingModel 243

StockPricePatternsinIndustries 244

LensCheck 244

end 245

6 HybridTechniquesforValuation 255

Buildingvs.BuyingaModel 255

AWordaboutBuildingaModelwithinaModel 257

phrases of caution 258

Fourteen approaches 258

UsingMetricstoMeasureManagement 270

ABasicDistinction:ResidualIncomevs.Discounted

CashFlow 271

Out-of-the-container,orGeneric,ValuationModels 272

ReconcilingtheBalanceSheetandIncomeStatement 273

ReconcilingtheIncomeStatementtotheStatementof

coins Flows 275

A NewBalance SheetMetric 277

UseofHybridValuationApproachesinaKeyIndustry:

strength 278

ConcludingCaveatandaFifteenthModel 281

Appendix6.1:NationalStandardCompany:Description

of Bonus Plan Basedon EVA 282

7 MarketValue DriversofPublicCorporations:Genius,Liberty,law,Markets,Governance,andValues 291

TheNonmarketabilityDiscount 292

SixKeyElements 292

Element1:Genius 293

Element2:Liberty three hundred

Element3:law 302

Element4:Markets 306

detail 5:Governance 308

detail 6: Values 314

long-term investing 324

ANoteonValuationforDivestment 326

end 327

Appendix 7.1: RatingGovernance 328

Appendix7.2:EnhancedBusinessReportingFramework 335

Appendix7.three:TheCauxRoundTablePrinciples 339

Appendix 7.4: Trucost 343

8 SituationalValuation:EquityValuesthroughouttheCorporateLifeCycle 367

eventualities 367

ValuationofSharesunderPublicPolicyPressure:

AStory inMedias Res 368

Valuation ofSharesatPar(orNoPar) 369

ValuationofSharesinIPOsandSecondaryOfferings 369

ValuationofSharesupontheDeclarationofaDividendor

aStock break up 371

Valuationof stocks in Buybacks 371

ValuationofSharesinCompanieswithUnderfundedDefinedBenefitPensionPlans 372

TheExampleofEndowments 373

ValuationofSharesTendered,Exchanged,orRetainedin

Mergers or Acquisitions 375

ValuationofSharesinSpin-OffsandDivestitures 382

ValuationofSharesImpactedbyShareholder-LedGovernanceChanges 383

ValuationofSharesinCompaniesintheZoneofInsolvencyorFiling for bankruptcy 385

ValuationofSharesinCompaniesEmergingfrom

financial disaster 387

conclusion 388

nine end 395

want forHumilityin Valuation 395

A TrueBeauty Contest 396

No SingleDefinition forValuation 397

A phrase aboutGenius 398

RealImpact 399

A NeedforInvestorTalent four hundred

seeking out the story 401

OntheSocialImpactofCorporationsandInvestors 402

work in development 403

Appendices

A Equityvs.DebtSecurities:AGlobalDefinition 407

B BasicAccountingConceptsforCorporateValuation 411

SummaryofTentativeGlobalAccountingDecisionson

ObjectivesandQualitativeCharacteristicsofAccounting 411

AccountingPrinciples: U.S. GAAP 416

C ConvergenceofGlobalStandards:FASB,IASB,

andTheirJointStandardsasofJune1,2010 421

CurrentTechnicalPlanandProjectUpdatesforJoint

FASB-IASB Projectsin2010and 2011 421

D ReporttotheCongressionalOversightPanel RegardingFairValueofCertainSecuritiesand

WarrantsAcquiredbytheTreasuryunderTARP 427

A. introduction 428

B. EngagementOverviewandProcedures 428

C. ValuationMethodologiesOverview 430

D. SummaryofFindings 437

E. Assumptions,Qualifications,andLimitingConditions 439

Addendum 441

E TheUseofMathematicsinFinance 443

TypesofMathematicsUsedinCorporateValuation 443

records 448

Histograms 451

GeometryandTrigonometry 451

conclusion 452

SymbolsUsedinFinancialMathematics 452

F TheModigliani-MillerTheorems 461

Modigliani-MillerPropositions 462

G UniformStandardsofProfessionalAppraisal

practice(USPAP) 467

H Standard9:BusinessAppraisal,improvement

GlobalIndustryClassificationStandard(GICS) 467

SectorsandIndustryGroups 473

I DamodaranSpreadsheetsforValuation 475

J MonteCarloSimulationfor

SecurityInvestments 479

VolatilityandTimeHorizonExercise 481

okay Antivaluation!HumanValuationand

InvestmentFoibles 483

some CommonBiasesinValuationChoices 483

SomeCommonFallaciesinValuationReasoning 486

Aristotle’s13 Fallacies 487

L FairValueMeasurementofDerivatives

Contracts 491

M FinalReportoftheAdvisoryCommitteeonImprovementstoFinancialReportingtotheUnitedStatesSecuritiesandExchangeCommission

493

1.SubstantiveComplexity 493

4.DeliveringFinancialInformation 496

N Valuing Values 501

TheMethodologicalChallenge 502

EconomicValueandSocialValue 503

FinancialInvestingvs.SocialInvestingTools 508

ValuingValues 512

O XBRLGuidance 515

WhatIsXBRL?

HowCanInvestorsinCompaniesUsingU.S.GAAPLocateandUseXBRLInformation? 515

516

P PensionFundValuationGuidance 521

Q StockIndexes 525

R americaBusinessCycleExpansionsandContractions 527

S WisdomfromNorway: two SpeechesfromaNorwegianStatePensionPlanInspireaLong-TermView

531

FromOiltoEquities:KnutN.Kjær 531

InvestingfortheLongTerm:GovernorSveinGjedrem 532

RecommendedReadingonCorporateSecurities Valuation

539

Index 541

Foreword

AsmallfractionofcohortswholivedthroughtheageoftheNifty50stilltackleimportantproblems.Wedon’tknowthatthetorchhasbeenpassed,asanearlierpresidentremindedus.Weforgoshuffleboardandleisuresuitsforwritingandmountingplatformsonissuesthatwebelievetobeimportant—wherewecanbringourpersonalexperiencestobearandwhereourvoiceswillremindothersthatwebringpersonalhistory,electricity,andforesighttovexingproblems.BobMonksisthearchetypeofthegroup.

Wewillgettohiscapabilitiesshortly,butletusfirstexamineBob’scour-agetotackleareallybigtopic:thevaluationofsecurities.Itisasbigasubjectastheycome,runninginmultidimensionsfromqualitativetopsychologi-cal,fromstatic todynamic, fromonedominantmeasureto acomplexsoup,andusingmeasuresthatrangefromthosethatareinternaltotheobservertothosedeterminedbythemarkets.Hecategorizestheenduringtusslesbetweenmomentumspeculatorsandfundamentalinvestors(astheyoftenlabelthemselves)andbravelywadesintoacademeandcriticallytacklesany-one,fromNobelstopostdocs.Nothingescapeshisattention.

Manyinvestorsaspiretouniversalskills,oftenproclaimingtoberotatingspecializedinvestorsinthechangingdaysofonevaluationmodetoanother.Intruth,mostofusadoptavaluationschemethatissuitedtothenatureofourpsyche.Wesearchfornomenclaturethatproclaimsitswisdom;wequestforindicesthatillustrateourbrilliance;andwemarket...oh,wereallymarket.

InCorporateValuationforPortfolioInvestment,Bobandhisworthy

coauthor(morelater)coverthefullrangeofvaluationmethods.Weare

xiii

xiv foreword

remindedhownarrowmostofouroutlooksreallyare.Ournormalstyleasinvestorsinpublicsecurities,usuallyasfiduciariesinvestingforothers,istoexamine,select,implement,measure,andreport...withsomeingredientofhopeandjustification.ButBob’sstamponthisbookisclear.Asin life,so inthis e-book hegoesto arare and importantnextstep.Headdstheactivebehaviorofsomeonewhobehavesasifheownstheentirebusinessandsendsamessagetoinstitutionalshareholderswhotendtorelyonbuyingorsellingtoexpresstheirviewstomanagement.

HeandIreachedthesameconclusionindependentlyataboutthesametime,heasassistantsecretaryoflaborforERISA[EmployeeRetirementIncomeSecurityAct],andIwhilechairingagovernancecommitteeattheSecuritiesandExchangeCommission.Backintheprivatesectorwesharedvaluationinsights,models,andspreadsheets.Iwentthenextstepinaggressivelyvotingagainstdirectorswhosupportedprotectivemeasuresagainstshareholdersandannouncedouractions—practicesunheardofatthetime.Bobstartedaninvestmentmanagemententer-prise,theLensFund,toinvestinpotentialtargetcompanies,announc-ingplansforsometoimprovetheiraccountabilitytoowners.Whereasinstitutionalinvestorstypicallyvoteproxystatementswithmanagement,withouteven knowingthe individualpositions ofdirectors receivingtheirendorsement,Bobmakeshisviewsknown.Helaysoutaclearprogram.Heisanactiveinvestorinlargepubliclytradedsecuritiesthatneed,butnormallyfailtoget,attentionfrominvestorswhotakeapositionandthenaggressivelyattempttochangecompaniesindirectionsofgreatervalue.for this reason,hisfocusonvaluationisanaturalcomplementtohisgover-nanceactivities.Hehastoknowhowtostartatalowenoughpricetoprovideacushionforthetimeittakestoimplementhisapproach.Heisusuallyattractedtoayieldsufficienttofinancehisefforts.Hehastodevelopacogentprogramthathasnotbeenadoptedbythedirectorschargedwithjustthatjob.And,finally,hehastohavethecredibilitytomakeitwork.Thelistofmajorcompanieswhohavefelthisattentionlookslikeatypicalhigh-qualitylist,butthemembersofthatlistare

betternowinhindsightthanwhenBobandhisstafffirstvisitedthem.

Rarelydocompanieswelcometheinterferencefromsomeonewhoproposestoaltertheirclubbyatmosphere.Buthisinvestmentrecordisacluethathisideas,whenimplemented,work.Fromitsfoundingin1992untilitbecamepartoftheHermesPensionsManagementgroupin2000,activitiesoftheLensFundwerefollowedbysuchaugustpublicationsas

FOREWORD xv

Barron’sandtheNewYorkTimes.As stated intheTimes:“Lens’s investingstylepays. In six yearsof operation, thru Dec.30, 1998, it back 25.1percent ayear,onaverage,comparedwith20.5percentfortheStandard&terrible’s 500-stockindex.”well-knownshareholderactivistslikeBoonePick-ensandCarlIcahnaredisruptiveandmaketheirintentionstofireman-agementswell-recognised.Itisnotsurprisingtheywouldbemetbyvigorousobjection.BobMonks,ontheotherhand,comesinwithaplanthatcanbeimplementedbytheexistingmanagement.Hisproposalismoreaboutaccountability than disruption.Hetoo meets with objection but much less so thanothersstormingthecorporategateswithdevastatingfirepower.

Bob’scolleagueinthisendeavor,Dr.AlexandraReedLajoux,bringsherownlonghistorytothequestforbetterapproachestocorporatevaluation.Alex,whohasservedaseditorofavarietyofinfluentialbusi-nessperiodicals,istheleadauthorofTheArtofM&Aseriesofbooksand,throughtheseandhermanyotherwritings,isanardentproponentoftheoverarchingprincipleofstewardshipandlong-termsustainablevaluecreation.

BobandAlexwroteinthePreface:“Wewrotethisbooktoadvanceworldprosperitybyexplaininghowtodeterminethevalueofcorpo-rateequitysecuritiesforthepurposeofportfolioinvestment.”collectively,withrecordsofsuccessimprovingcorporateaccountabilityintheirhippockets,theyarereadytostorm—tactfully—thebarrierstofullunder-standingofwhatconstitutessustainablevalue.

Charitra Shrestha

srigstha@gmail.com

Preface

Wewrotethisbooktoadvanceworldprosperitybyexplaininghowtodeterminethevalueofcorporateequitysecuritiesforthepurposeofportfolioinvestment.

Anumberofrecentchangeshavemadethissubjectlavahot:inter-nationalaccountingconundrums,massivetransformationsmakingbothforwardandbackwardcomparisonsmeaningless,lowinflationwithrumorsofdeflation,and—now—government-createdassetsandearnings!Thesevolcanictrendshavebroughtequityvaluationnearlytoamelt-down.Yetcertaintruthsremain.

Equitycapitalprovidestwomainbenefits:aflexiblefundingoptionforcompaniesandsuperiorreturnstoinvestorscomparedtodebt.Butunlessaninvestorcanbuyeverystockandholdallstocksfordecades,thelong-time period,generalsuperiorityofequityoverdebtisoflittleuse.Totakeadvantageofequity’spower,investorsmustlearnhowtoputaprecisevalueonaspecificstockforaspecificinvestment

period.

Thisbookadvocatesamultidimensionalapproachtoequityvalue,assertingthatvalueexistsonlyinspecifictemporalandsituationalcontexts.Thissaid,the“defaultsetting”forinvestmentappropriatelyremainsanintelligentinvestorconsideringpublicequitysecuritiesasachoiceamongalternatives.

Corporatevaluationforportfolioinvestmentmeansdeterminingthepresentvalueoffutureworth.Therearetwomainsourcesofinforma-tionabouttheworthofastock:financialreportsandthestock’scurrenttradingprice.

xvii

xviii preface

Financialreportscontainriddlesthatmustbedecodedbythevaluation-mindedinvestor.Thefirststepinvaluationforinvestmentistobridgethegapbetweencurrentvaluationinfinancialreportsandthefuturevalueofthecompanyforinvestmentpurposes.Despitetheworkofnumerousgroupstoreformgenerallyacceptedaccountingprinciples(GAAP)andtheirglobalequivalent,internationalfinancialreportingstandards(IFRS),financialreportsremainonlydimmirrorsofcompanyvalue.SourcesofcomplexityinGAAP/IFRSaccountingincludevariationinaccountingmodels,scopeexceptions,mixedattri-butes,andbrightlinestandards.

Allthisrequiresreadingbetweenthelines.Andthemainmessageisthatequitysecuritiesaredifficulttovalueinpartbecausebothcompa-niesandthemarketsthattradeintheirequityarelivinghumansystemspronetoself-deceptivetraitsthatmilitateagainstpurevaluationlogic.

satirically,however,humannature,whichmakesthevaluationofequitysodifficult,isalsothefundamentalreasonforthesuperiorityofequity.price-mindedinvestorscanputafinancialvalueonthegreat-estcontributortosecurities’fee:lengthy-termcorporateactionbasedonvision.Todoso,however,requiresamultifacetedapproachtovaluation,includingbothrespectforquantitativefundamentalsandanapprecia-tionforqualitativecomplexity.

Thisbook,intendedfortheprofessionalinvestorbuildinganinvest-mentportfoliothatincludesequity,takesthereaderthrougharangeofapproaches,includingthoseprimarilybasedinassets,income,cashflow,andsecuritiesprices,aswellashybridapproaches.Italsodiscussestheimportanceofqualitativemeasuresthatwecall“governance”(goingwellbeyondGAAP/IFRS)andaddressesavarietyofspecialsituationsinthelifecycleofbusinesses,rangingfrominitialpublicofferingstobankruptcies.

Intheprocess,thebookoffersformulas,checklists,andmodelsthatweandothershavefoundusefulinmakingequityinvestments.Aslongas investorsthoughtfully useavariety of equipment tomaketheir investments,corporatesecuritieswillcontinuetogeneratewealthfortheirownersandforsocietyatlarge.

Acknowledgments

Manyindividualshelpeduswriteourtome;thechapterendnotesnamethem.Butspecialacknowledgmentgoestothosewhocorre-spondedwithusand/orconsentedtobeinterviewedduringtheactualwritingofthisbook(January2008–June2010).

MatthewBishop,bureauchiefforTheEconomist,NewYork

SteveBrown,foundingpartnerandchiefinvestmentofficer,Gover-nanceforOwners,London

Paul Druckman, chairman, executive Board of The Prince’sAccountingforSustainabilityProject,London,UnitedKingdom

RobertFerris,executivemanagingdirector,RF|Binder,NewYorkPhillipsJohnston,analyst,DawsonHermanCapital,NewYorkJohnP.M.Higgins,presidentandchiefinvestmentofficer,Ram

TrustServices,Portland,Maine

DeanLeBaron,founder,BatterymarchFinancialServices,Geneva,Switzerland

RockyLee,partnerandheadofAsiaVentureCapitalandPrivateEquity,DLAPiper,HongKong

ColinMeyer,dean,SaidSchoolofBusiness,OxfordUniversityDeborahHicksMidanek,primary,SolonGroup,NewYorkLesterMyers,professoriallecturer,GeorgetownUniversityMarkMills,director,GenerationManagement,London

PaulPacter,IASB,HongKongandLondon

AlRappaport,cofounder,LEK-AlcarConsultingGroup,LaJolla,California

xix

xx acknowledgments

AnthonyRiha,vicepresident,BowneAsia,Beijing

GeorgeSoros,founder,SorosFundManagement,NewYorkAllenSykes,economistandauthor,London

RajThamotheram,senioradviser,ResponsibleInvestment,AXAInvestmentManagers(AXAIM),Paris

SimonThomas,chiefexecutive,Trucost,LondonStephenYoung,executivedirector,CauxRoundTable

Wewouldalsoliketoacknowledgetheencouragementandguid-ancethatwereceivedfromtheBloombergPressteamthatlaunchedthisproject,includingJoAnneKanaval,StephenIsaacs,MaryAnnMcGuigan,andFredDahl.WealsothanktheprofessionalsofJohnWiley&Sons,includingBillFalloon,EmilieHerman,TiffanyChar-bonier,andToddTedesco.ArtistMaryGraham(mary@oakinsights

.com)helpedillustratesomeoftheconceptswediscussinExhibits2.1,

5.1 through5.11,and6.1.Wearegratefulforheruniquecombinationofmathematical, creative, andtechnicalgenius.Thecontributionsoftheseindividuals,aswellasmanyothers,proveanimportantpoint:publishedbooksconveyknowledgeataleveltheblogospherewillnevermatch.

BobextendsspecialthankstohiscolleaguesNellMinow,RicMarshall,SylviaAron,andChristineDeSantisfortheirusualsuperbhelp.

Alexandrathanksherfamily,pals,andcolleaguespastandpresentattheNationalAssociationofCorporateDirectors.

CHAPTER1

CorporateValuationforPortfolioInvestment:AnalyzingAssets,income,CashFlow,StockPrice,Governance,andSpecialSituations

byRobertA.G.clergymen,AlexandraReedLajouxCopyright©2011byRobertA.G.MonksandAlexandraReedLajoux.

CorporateValuationforPortfolioInvestment

APhilosophicalFramework

Equitysharesmustbevalued—buthow?Itmayseemthatsophisticatedfinanciershavetakenovervaluation.Thephrase“equityvaluation”mayconjureupvisionsoffinancialspecialistsfeedingnumbersintoalgorith-micprograms,relentlesslymakingbuy,sell,orholddecisionsunrelatedtotheoperatingrealitiesofbusinessesortounderstandableeconomicconceptssuchasreplacementvalue.1

Agreatdealofcontroversysurroundsthemathematiciansandphysicists(aka“quantjocks”)onWallStreet.Someblamethemfortheeconomicproblemsofthefirstdecade,notingtheircomplextrad-ingprogramsthat,onceautomated,accelerateddoomsdayeventsformarkets.2Otherssaythatthequantjocksboostedtheoverallintelli-genceofthemarketbyintroducingnewandsensiblewaysoflookingat risk and go back,pointingoutthattheywereamongthefirsttowarnagainstthecrisis.3Infact,sophisticatedtradingprogramsdohavearoletoplay,buttheprogramsmustbebasedonsoundprinciples.Sophisticatedtradingactivitiesarethesymptom,notthesubstance,of stockvaluation.

Infact,valuationbeginsfromthehouracompany’sleadersfindequityinvestorswhobelievesostronglyinthecompany’seconomicprospectsthattheyarewillingtoprovidecapitalforit,nostringsattached.Thisbelief ina organisation’sfuture—ina phrase,hope—iswhatmakesthevalueofthestocksomethingmorethanthecurrentvalueofallitsassets,ifsoldinafiresale.Combinedwiththeinvestor’sowntimehorizonforareturn,hopeisthekeytosecuritiesvaluation.Visionandtimearethealphaandomega.

1

Valuablevisioniswhatpropelsacompany’sstockintothemarketplace;itiswhatpreservesthevalueofthestockinspiteofmarketchaos.Understandingthisconceptrequiresanintegratedtheoryofvaluationthatincludesconsiderationofassetsoffsetbyliabilities,ofincome,ofcash(liquidity),ofsecuritiesmarketdynamics,andofcomparablepricing.Understandingalsorequiresconsiderationofwhatwecallstories—meaningfulinformationbeyondthefinancialstatementsandmarketprices.Thisbookisstructuredaccordingly.

Ofcourse,notallinvestorsbasetheirtradesonsuchanintegratedframeworkforvaluation.Someareindexinvestors,somearealgorithmictraders,andsome arefundmanagerswho purchase assets based on instructions ofrisk.Infact,fewerthanhalfofallinvestorsactuallychooseaninvest-mentbased onthequalityofaparticularcompany.4Itisfor those happyfewvolitional,price-mindedinvestorsthatthisbookisintended.

ValuationDefined

Valuationmeansdeterminingavalueforsomething.Thisbooksetsforthalltheelementsofacompanythataretobevaluedandoffersguidanceonhowtodeterminethosevalues.

➤Corporatevaluationdeterminestheworthofacorporationtoday

(itspresentvalue);valuationforportfolioinvestmentjoinsthat

presentvaluewithafuturevalue.AsAlRappaportsaidsosuccinctlyinExpectationsInvesting,thekeytosuccessfulinvestingis“toestimatethelevelofexpectedperformanceembeddedinthecurrentstockpriceandthentoassessthelikelihoodofarevisioninexpectations.”7

➤Expectationisindeedafittingwordfortheprocessofvaluation

forinvestment.“Valuation”comesfromtheLatinwordvalere—tobeworthsomethinginanexchange.eight“funding”derivesfromvestire—toclothe.Itmeansexchangingmoneynowforsomethingthatmayoffermoremoneyinthefuture.

Valuationaloneisrelativelysimple;corporatevaluationforportfolioinvestmentiscomplex.ValuationalonesaysAisworthXtoday.ButvaluationforinvestmentsaysAisworthXtodayandmaybeworthYatafuturedate.Valuationforinvestmentmeansdeterminingthepresentvalueoffutureworth.

Valuationisnotaone-timeevent.Itisaprocess.Thereisnoonesetofstepstovalue the stockof an existing publiccompany,butit is generallyagreedthatthevaluationjourneyproceedswiththefollowingsteps:

1. Selecttheitemtobevalued(thesecurity).

2. Identifyitscurrentprice(e.g.,nowadays’sclosingprice).

3. Evaluatewhetherthecurrentpriceislow,correct,orhigh.

4. Make a corresponding buy, maintain, or promote decisionbased at the inves-tor’sowncircumstances—includingliquidityneedsandthetimingof thoseneeds.

Aspartofstep3,theinvestorcanadjustthevaluesofprice(step2)basedonsix valuationmatrices:

1. Time—Shorttermversuslongterm

2. vicinity—Marketversusnonmarket

3. Slope—Levelversusskewedplayingfield

four. Volition—Degreeofwillingnessorunwillingnessofthebuyerorseller

5. application—purpose(e.g.,wealthversusliabilitycollateralforafund)

6. high-quality—Levelofcertaintyofreturn(excessive,medium,orlowgrade)basedoninvestingstandards

Togetrealvalue,oneneedstopasseachvaluationthroughthesesixlenses.Thisparadigmappearsthroughoutthisbook.

TheImportanceofEquity

Fewfinancialtopicsmattermorethanequityvaluation.Withoutthepossibilityofplacingareasonablyaccuratevalueonequitysecurities,therecouldbenoequitymarketplace.Andwithoutanequitymarket-vicinity,societywouldnothavesuchadiversityofproductsandservices.Somecorporateundertakingsaresolongtermandexpensivethat onlyequitycapital—asopposedtooperatingcapitalordebtcapital—canfundthem.9Societalcommitmentssuchaspaymentsmadeoutofdefinedpensionplanssimplycannotbehonoredunlesstheobligatedpayor(thecompanyorunionofferingthepension)hasaccesstofundingthatcanbeatinflationatthelevelthatequitieshaveachievedhistorically.10Itisnocoincidencethatthesefinancialinstrumentsarenicknamed“stock.”Foranequitymarkettofunction,theeconomyatlargemust“putstock”(accept as true with)inequitiesandcontinually“takestockof”(degree)theirvalue.

Thepresenceofthefederalgovernmentasaninvestor(discussedinChapter2)raisesnewissuesinequityvaluation:astheholderoftheshares,willagovernmententity’sfocusbeonfinancialreturn,asinthepast,oronmattersofbroadsocialsignificance,suchasjobs?Thereissomeprecedentforthisconcernatthestatelevel.Publicpensionplanshaveattimesmadepoliticalratherthaneconomicdecisions.11Ingeneral,but,theequityinvestmentdecisionsofpensionplansarebasedonuniversallyrecognizedfinancialprinciples.Oneofthepurposesofthisbookistoarticulatethoseprinciplessothatequityvaluationmain-tainsitsintegrityasadiscipline.

EquityDefined

FirstinventedbyDutchandEnglishtraderssome500yearsago,theterm“equity” or “inventory”as a form ofcorporate financing has beenpartofthebusinessworldforhalfamillennium.12Equityiscreatedwhencompaniesofferownershipstaketobuyers,givingstockcertificatesinreturnforcash.Thevalueofacompany’sequity(thenumberofsharestimesthecurrentpricepershare)isitsmarketvalue.

Thereisanotherkindofequity.It’stheaccountingkind,namelythedollar-valuenumberremainingonthebalancesheetafterliabilitiesaresubtractedfromassets.Thisversionofequityisalsoknownas“networth”or“bookvalue.”Theaccountingnumberisusuallymuchlowerthanmarketvalue,butitcanbeusedasacheckonitbecauseitisfarlessvolatile.thirteen

Regulatorshave performed agooddealof hand-wringingover whatequityisasopposedtodebt.(SeeAppendixA.)Inbrief,equityrepresentsownership withpotential for returns,even as debtrepresents aclaim enti-tlingtheholdertoguaranteedpayments.14

Theissuanceofequitysecuritiesbringstwodistinctvaluestoaneconomy.Forthecompany’smanagement,thesaleofequitysecuritiescanbringpatientcapital—fundsthatsupportgrowthwithoutmakingfixeddemandsforreturn.Tothecompany’sinvestors,thepurchaseofsecuritiescanbringreturns—ashareinacompany’stotalworththatgrowsin fee as the companydoes.

Growthinsharepricesdoesnothappenineachandeverycom-pany,butitiscommonforallcompanies’stocksasanettotaloveranygiven10-yearperiod.Basedonthisgeneraltrend,NobelPrizewinnersFrancoModiglianiandMertonMillerassertedthatthepaymentofdivi-dendsdoesnotchangethefirm’smarketvalue:itchangesonlythemixofelementsinthefirm’sfinancing.TheModigliani-Millertheoremhasbeentruehistorically,butisit true nowadays?Ifinvestors, through the years,can-notcountonsharepriceappreciation,thenthetheoremwouldnothold;dividendswouldbecomeindispensableforequityinvestors.

ArticlesofFaithUndermined:SecuritizationatRisk

Whenmarketssustainshocksorexperiencelongdeclines,itishardforinvestorstomaintainareasonableexpectationofsharepriceappreciation.Sucheventsnotonlyunderminesuchexpectations,buttheyalsodiminishfaithinsecuritiesmarkets—andunderstandablyso.

Take,forexample, theturn-of-the-millennium scandalsof Enron andWorldCom.Theirsharepricedeclinewassorapidandunexpectedthatitfooledevenfairlysophisticatedinvestors.15Inthespaceofhalfayear,twogiants—largeinmarketcapitalization,bookvalue,andrevenues—lostalmostalltheirvaluevirtuallyovernightupondeclaringsurprisebankruptciesinlate2001andmid-2002,respectively.16

Adecadelater,anewseriesofgiantshasfallen,includingseveralWallStreettitansfelledby thedevaluationofsecuritiesbackedbyweakmort-gagesthatwentintodefault—theso-calledsubprimemortgagecrisis.Following extremefinancial strain, BearStearns becamepartofJPMorganChase,andMerrillLynchpart of BankAmerica.LehmanBrothers maintain-ingssoldoffmultiple divisions and declaredbankruptcy.EvenGoldmanSachsgotheatfromthemeltdownwhenSECmadeallegationsoffraudinanApril2010lawsuit,triggeringshareholderlawsuitsandsparkingasubpoenafromtheFinancialCrisisInquiryCommission(FCIC).17ByJune2010,Goldman’sstockwastradingattwo-thirdsitsprevious52-weekhigh,showingtheheavytollthatcompaniespayforscandal.18

TheeventsfromEnrontoGoldmanbookendwhathasbeencalledthe“worstdecadeeverforequities,”withanoverallnegativereturnof–three.3percent,accordingtoonestudy.19Inthiscrisis,marketpricesexperiencedbothartificialinflationanddeflation,dependingoncircumstances.Thesecuritiesofmanycompaniesthatappearedtohavehighlevelsofcapitali-zation,property,andrevenuesshouldhavebeentradingatlowerprices,giveneconomicrealities.Conversely,inatleastonecase(BearStearns),shortsellerrumors(borderingonillegalactivity)causedthefirm’ssecu-ritypricetoplummet,eventhoughthetruevalueofthosesecurities,absentfalserumors,wasarguablyhigherthantheirtradingprice.20

It’sawell-knownstatisticthatU.S.equitieslostmorethanathirdoftheirvaluein2008.21Then,in2009,thecrisiscontinued foronequarter,draggeddownbyglobalfinancialstocks,andthenbeganaslowrecoverythatcontinuedinto2010.22

Butthisrecoverywaspunctuatedwithcaution.InareportdatedMay 7,2009,4 key bankingregulators launched theresults ofa “stresstest”administeredto19majorbanks.Thereportshowedthatmorethanhalfofthemneededadditionalcapitaltoinsulatethemselvesagainstadversescenarios.Thisnewswasnotasbadasmanyinvestorshadfeared—sharesroseinresponse—butgloomaboutthefinancialsys-tempersisted,weakeningconfidenceinequitysecurities,notonlythoseoffinancialinstitutionsbutofothercompaniesaswell.23In2010,theEuropeanUnionfollowedwiththepublicationoftheirownbankingstresstestresults.24

Thesubprimecrisisanditsseemlyendlessaftermathunderminedconfidenceinequitysecuritiesingeneral.Longanengineofliquidityand

growthinfreeeconomies,securitizationiscomingunderunprecedentedscrutinytoday.establishedfinance,oncethedarlingoffinancialeconomists,isgettingabadname.25

Speakingbeforethe Council ofInstitutionalInvestors in April 2009,FederalReserveBoardGovernorKevinWarshcalledthemortgagebankingcrisisaclassiceconomic“panic.”Hisrivetingspeechdistin-guishedbetweenrecessionsandpanics:

fear.Breakdowninconfidence.Marketcapitulation.Financialturmoil.Thesewordsare...indicativeofpanicconditions.Inpanics,oncefirmlyheldtruthsarenolongerreliedupon.Articlesoffaithareupended.Andtheveryfoundationsofeconomiesandmarketsarecalledintoquestion.26

Afootnoteinhispreparedremarkselaborated:“Apanicinvolvesamoreinsidioussetofeventsinwhichriskaversionrapidlydisplacesconfidenceandindividualsandinstitutionsareforcedtoreexaminefundamentallytheirworldviews.”27

AndinaWallStreetJournalop-edthatsamemonth,mutualfund

guruJohnBoglecastaspersionsonsecuritizationbyincludingitinalistofallegedcausesof the economiccrisis, mentioning that it“severed thetradi-tionallinkbetweenborrowerandlender.”28Boglemaynothavemeanttotaralltypesofsecuritieswiththesamebrushheintendedformortgage-backedbonds.nonetheless, his widelyreadcolumn helpedmakesecuri-tizationataboo14-letterword.

Whethertheirconcerninvolvesdollarsandcentsorbroaderissuesofgovernance,by2010investorswerestillshyingawayfromequities,despitetheprotectionsofamassivefinancialreformbillpassedinJuneofthatyear.29

Tobesure,equitiesdidnotsuffergreatlyinsomeeconomies.Forexample,thelossofequityvaluesinScandinaviancountrieswaslessprecipitousthaninother places.Butwhy?Doesasocietal elementcomeintoplay?Arecertainsocialconditionsassociatedwithfragileequityvalues?30

Thisbookhelpsinvestorsaskandanswersuchquestionsastheyanalyzethevalueofcorporatesecurities—startingwithalook,rightnow,attheveryraisond’êtreforequitysecuritiesinthefirstplace.

BenefitsoftheEquityMarketplace

Theissuanceofequitysecuritiesbringstwodistinctvaluestoaneconomy.Forthecompany’smanagement,thesaleofequity securitiescanbringpatientcapital—fundsthatsupportgrowthwithoutmakingfixeddemandsforreturn.Tothecompany’sinvestors,thepurchaseofsecuritiescanbringreturns—ashareinacompany’stotalworththatgrowsinvalueasthecompanydoes.Itmaybeusefultoelabo-rateoneachofthesepoints.

➤Flexiblefunding.Withoutequitycapital,allcompanieswouldbeforcedtooperateatasustainedlevelofprofitabilityorseekdebtfunding,pledgingregularrepaymentaccordingtothetermsoftheirloansorbondofferings.Thistypeofdisciplinecanbegoodforcompanies,butitlimitstheirflexibility.Equitysecuritiesmar-ketsprovideauniquelyflexiblesourceofcapitalforcompanieswithlong-termvision,enablingthemtoemployandrewardpeopleforcreatingnewtechnologies,merchandise,andservicesthatrequirealongstart-upphase.Thankstotheabilitytosellequitytochoice-pushed(oralgorithm-pushed),thinkinginvestors,31companiescangeneratetheextrafundstheyneedovertimeandunderchangingcircum-stancestopursuelong-termgoals—goalstheymightnotbeabletofundbymakingaprofitontheirsales,takingoutloans,issuingbonds,or,pretty,sellingtroubledassetstothegovernment.

➤Superiorreturnstoshareholders.Atthesametime,equity(orstock)

investmentsrepresentaspecialfinancialopportunityforinvestors,especiallyinstitutionalinvestorsthatneedtogeneraterelativelyhighreturnsoverlongperiodsoftimeinordertoovercometherav-agesoftime,32especiallyduringperiodsofhighinflation.33Ifinsti-tutionalfundswerelimitedtoinvestmentsindebtsecurities,theywouldhavelessofachanceforhighreturnsovertime.Althoughsomedebtsecuritieshaveafeaturethatguaranteesapercentagereturnthatexceedstherateofinflation,notalldo,andreturnsfromsuchvehiclesarestillrelativelylow.34

TheFlexibleNatureofEquityCapital

Theflexibilityofequitycapital(comparedtotheobligationsofdebtcapital)maybetakenforgrantedaftermorethan500yearsofuse,however

itisaremarkablypositivefeaturefromacompany’s angle.Considerthatcompaniesthatsellstockareundernolegalobligationtopaybackthecapital,muchlessofferareturnonthestock.Infact,whencompaniesreorganizeduetoinsolvency,shareholdersarelegallyamongthelastinlinetobepaid.indeed,thisback-of-the-linecreditorstatusisfunda-mentaltotheverydefinitionofequity.35

Theflexibilitythatequityofferstoissuingcompaniesdoesnotcomewithoutstringsattached:inmanycountries,suchastheUnitedStates,equityissuersmustadheretoarigorousdisclosureregime.Amyriadoffederalandstatesecuritieslaws,stocklistingrequirements,anddomes-ticandglobalaccountingstandardsrequireU.S.publiccompaniestodiscloseagreatdealofdetailedinformationtoinvestorsinordertohelpthemdeterminethevalueofthesecuritiestheyarebuying,holding,orselling.Thereareevenaccountingstandardsfordisclosinginforma-tionabout“securitieswithinsecurities,”thatis,aboutthemarketvalueofothercompanies’securitiesheldbyacompanythatitselfisissuingsecurities.

long-TermSuperiorityofEquityoverDebt—withaCautionaboutVolatility

Theflexibilityofequitymakesitmoreattractivethandebtasasourceoffundsforcompanies.Ifeconomicsweremerelyamatteroftrade-offs,theequityadvantageforcompanieswouldtranslateintoanequitydisadvantageforshareholders.Butthisisnotthecase.mockingly,equityseemstoprovidestrongerreturnsovertimethandebt.

Theexplanationforthisparadoxiscomplex.36Obviously,timeisacriticaldimension. Ifyou can’t waita hundred yearsfor areturnon yourinvestment,youwon’tcareaboutthehundred-yearaveragereturn.Ontheotherhand,itisabsurdtocompareasingleday’sreturnsfromtwotypesofinvestmentandexpecttolearnanything.

permit’slook attherecord ofequity as opposed to debtover differenttimeperi-odsindifferentregions.Giventhevarietyofstudiesavailable,wecancreateakindofpatchworkquiltoffindingsthatpointtoatleastonegeneralprinciple:itmakessensetoinvestinbothdebtandequity.

Inanygivenregionorperiod,debtsecuritiesmayofferequalorsuperiorreturnsandwithlessvolatility.Whenin2008,united states of americaequitieslostmorethanone-thirdoftheirvalue,theirperformancewasobviously

inferiorto the positive2.2percent charge paid byone-yearTreasurybondsthatyear.37Thiswasnotafluke.Therehavecertainlybeenperiodsoftimewhenbondsdoaswellorbetterthanstocks—withoutthevolatilityassociatedwithequitysecurities.38

Atthesametime,despitetheplungeinequitytradingpricesseenbyinvestorsin2008andearly2009,thereisstrongevidencethatoverthelong attain of records,stocks outperform bonds. Thisis no longer to saythatstockswillbeatbondsby“divineright”;thistheoryiseschewedbyevenJeremyGrantham,notedforkeepingalevelheadaboutthevalueofequitywhen others panic.39Acentury-and-decade-longtime horizon(forwhatitmaybeworth)putsequityintheleadoverdebt.TheCreditSuisseGlobalInvestmentReturnsYearbook2010showsthatfrom1900throughtheendof2009,globalstocksaveragedanannualrealreturnof5.4percent,comparedwith1.7 percent forbonds and0.nine percentage forbills.40(Australiahasbeenthebestperformingequitymarketoverthe110yearssince1900,witharealreturnof7.5percentperyear,withSouthAfricaandSwedenalsoperformingwell, withrealreturns of7.2percentand6.2, respectively,onaveragesince1900.)41All threemarketshaveoutperformedtheUnitedStatesovertime;theaveragerealreturnonU.S.equitiessince1900is6.2percent.ButyouwillseemostlyU.S.examplesinthisbook,becausenearlyhalfofallequities(41percent)aretradedinU.S.markets.forty two

reputedly,asinglebadyearisadropinthebucketwhenitcomestoacentury.ThustheCreditSuisse109-yearfindingisnotmuchlowerthanstudiesthatendedtwoyearsearlier:

➤From1900to2007,theCowlesCommissionindex,linkedtotheStandardandPoor’sCompositeIndex(S&P500),showsanaver-agerealequityreturnof6.0percentperyear,comparedtoarealbillreturnof1.6percentperyearandareallong-termgovernmentbondreturnof1.8percentperyear.43Fromthestartof1941totheendof2007,equityreturnsaveraged6.9percentperyear,billreturns1.4percentperyear,andbondreturns1.1percentperyear.Similargapsbetweenstockandbondandbillreturnshavetypicallyexistedinotherlong-termperiods.44

➤Researchconductedfortheauthorsbyaresearcherwithinthe

TreasuryofSwedenindicatesthatfrom1900to2007,realreturnsfromthesharesof18majoreconomieshaverangedfrom2.5percent(BelgiumandItaly)to7.9percent(Australia),withSwedenclose

behindat7.8percent.AlsobeatingtheCowlesCommissionaveragewereSouthAfrica(7.5percent),theUnitedStates(6.5percent), Canada(6.3percent),andtheUnitedKingdom(five.5percent).45

Soevenif weincludethe disastrousyear2008,long-termreturns forequitylookgood.Theproblemisthatmostinvestorsdon’tholdstockforacenturylong—andstocksarevolatileovertime.Anotherproblemisthatthereturnsincludereinvesteddividends.Ifdividendsarespentratherthanreinvested,returnsaremuchlower—only1.7percent.46

Caveaton Volatility

Eventhoughreturnsfromequitymaybestrong,theyarenotpredict-in a position.Recentresearchhasshowntheannualized30-yearvariancefromstocksis1.5timesgreaterthantheone-yearvariance,duetovariouskindsofuncertaintyfacinginvestors.forty seven

Themainengineofvolatilitymaybestockdeclinesduetooverlever-getting old.Recentresearchshowsaneconomicreasonforthenegativecor-relationbetweenvolatilityandstockreturns:Stockreturnvolatilityisafunctionofthelevelofthestockprice,whichdependsonthevalueofthefirm.Asafirm’sstockvaluedeclines,thefirm’sleverageratioincreases;hencetheequitybecomesmoreriskyanditsvolatilityincreases.48

TheFocusedNatureofValuationforInvestment

Thegeneralsuperiorityofequityoverdebtisonlyalong-termaverage,ofcourse,anddoesnotapplytoallcases.glaringly,ifonebuysstocksthatperformunderthemarketaverage,returnswillbelowerthanthemarketaverage.Thehopeofthevalue-mindedinvestoristoselectoneormorestocksthatwillperformbetterthanthemarketaverage.Amid-dlecourseistobuyarandomselectionofstocksthroughafundorindex andtoatleastkeepupwiththemarketaverage.49Thisisthebasicideabehindmutual finances or different budget that preserve various shares.

Someprofessionalinvestorsuseindexesthatarerandominnature,butotherswanttoexercisechoice,selectingspecificcompanystockswithareasonableprospectofpositivereturnovertime—fromthepresenttosomespecificfuture.Whethertheyhand-selectstocks basedoncarefulresearch,asmanyspecialpurposefundsdo,50oruseanalgorithmicprogram,thesevolitional investorsapplysomechoicetotheir purchases.

TwoMainSourcesofInformationaboutEquity

Therearetwomainsourcesofinformationabouttheworthofastock:financialreportsaboutthecompanyissuingthestockandthecurrenttradingpriceofthestock.Eachposeschallenges:

➤Financialreportsarewrittenusingconventionalaccountingstan-dards—e.g.,internationalaccountingstandards(IAS)toberequiredworldwideby2014),orgenerallyacceptedaccountingstandards(GAAP)allowablecurrentlyintheUnitedStates).Butmanyoftheseprincipleshavebecomearcane;theymustbedecodedbythevaluation-minded investor. (FinancialreportingissuesarediscussedinChapters2through4.)

➤Stockpricesshowthedollarvaluesoftradesatspecificpointsin

time,indicatingwhatinvestorsthink(orhavethought)oftheequitiesatgivenmomentsintime.Theseinvestoropinionsareinfluencedbymanyfactors,which includefinancialreports.(Formoreonthevaluationofequities,seeChapter5.)

FinancialReports:IssueswithGAAPandIFRS/IAS

employerfinancialstatementsarepreparedaccordingtoU.S.GAAPand itsinternational counterpart,IFRS, or,extra globally,IAS. Botharebasedinprinciplesconsideredtobeuniversal.(SeeAppendixB.)

americaGAAPstandardsareformulatedbytheFinancialAccountingStandardsBoard(FASB)andavailableatitswebsite,FASB.org,whichisoverseenbytheSecuritiesandExchangeCommission(SEC)andpubliclyfundedvialeviesfrompubliccompanies.51FASBstandards,recognizedasauthoritativebytheSECandtheAmericanInstituteofCertifiedPublicAccountants(AICPA),coversome90generalareas,52suchaswhenacompanyrecognizesrevenueorlosses.GAAPcurrentlyhas2,000pronouncements,whichithascodifiedtomakethemeasiertouse.ThiscodificationismakingiteasiertoalignGAAPwithInter-nationalFinancialReportingStandards(IFRS)standardsastheworldmovestowarda globalstandard.

AcontinualcomplaintagainstU.S.GAAPhasbeenthatitdiffersfromprevailingstandardsoutsidetheUnitedStates.Forexample,untiltheturnofthemillennium,u.s.GAAPpermittedaspecialaccountingtreatment,called“pooling”accounting(differentfromregularso-known as

purchaseaccounting)forcertaincorporateacquisitionsthatusedstockasacurrency.TheFASBabolishedpooling,andnowalltransactionsmustbeaccountedforaspurchases.nonetheless,otherdifferencesbetween

united states of americaandnon-united statesaccountingprincipleshaveremained.SotheFASBandtheInternationalAccountingStandardsBoards(IASB)havejoinedtogethertoharmonizestandards.

TheFASBandtheIASBareworkingon“animprovedcommonconceptualframeworkthatprovidesasoundfoundationfordevelop-ingfutureaccountingstandards.”Theorganizationswanttodevelopstandardsthatare“concepts-based,internallyconsistent,andinterna-tionallyconvergedandthatleadtofinancialreportingthatprovidestheinformationcapitalprovidersneedtomakedecisionsintheircapacityascapitalproviders.”TheConceptualFrameworkproject haseightphases,includingnotablymeasurement—arguablythemostimportantforthepurposes of valuation.53

Aswegotopress,thegoalofaninternationalaccountingstandardsisbeingachieved,onestandardatatime.(SeeAppendixC.)

SourcesofComplexityinAccountingforCompanyValue

SourcesofcomplexityinGAAPandIFRSaccountingincludevariation inaccountingmodels,exceptionstorules,mixedattributes,andbrightlinestandards.

VariationinAccountingModels

Accountingmodelscomplicatematters—sosaysanSECgroupthatstudiesaccountingcomplexity.54Examplesofcompetingmodelsare:

➤Differentmodelsforwhentorecognizeimpairmentofassetssuch asinventory,goodwill,lengthy-livedassets,financialinstruments,anddeferredtaxes.

➤Differentlikelihoodthresholdsforrecognizingcontingentliabilities,

suchasprobabilityforlegaluncertaintiesversusmore-possibly-than-notfortaxuncertainties.

➤Differentmodelsforrevenuerecognitionsuchaspercentageof

completion,completedcontract,andprorata(modelsalsovarybasedonthenatureoftheindustry,asdiscussedinothersections).

➤Variousstandardsfor“derecognition”ofliabilities(i.e.,takingthemoffthebalancesheet).

➤Differentmodelsfordeterminingwhetheranarrangementisa

liabilityorequity.fifty five

ExceptionstoRules,or“ScopeExceptions”

Ifaccountingruleswereapplieduniversally,itwouldberelativelyeasytousethem.Butmanyruleshaveimportantexceptions.TheSecuri-tiesandExchangeCommission’sComplexitySubcommittee(yes,thereisone)hasidentifiedsuchso-calledscopeexceptionsasproblematic.Forexample,usingtheFASB’snewAccountingStandardsCodification(ASC)followedbythepre-codifiednameofthestandard:

➤ASC815,DerivativesandHedging(SFAS133),excludescertainfinancialguaranteecontracts,employeeshare-basedpayments,and contingent attention froma commercial enterprise combination,amongothers.

➤ASC820,FairValueMeasurementsandDisclosures(SFAS157),

requiring mark-to-market accounting for positive fairness holdings bycorporations,excludesemployeeshare-basedpaymentsandleaseclassificationandmeasurement,amongothers.

➤ASC810,ConsolidationofVariableInterestEntities(FIN46R),

excludesemployeebenefitplans,qualifyingspecial-purposeentities,certainentitiesforwhichthecompanyisunabletoobtaintheinfor-mation important to use FIN 46R, and positive agencies, amongothers.56

Scopeexceptionsariseforanumberofreasons,includingcost-benefitconsiderations,theneedfortemporarymeasurestoquicklyminimizetheeffectofunacceptablepractices(ratherthanwaitingforafinal“best”standardtobedeveloped),avoidanceofconflictswithstan-dardsthatwouldotherwiseoverlap,andpoliticalpressure.

MixedAttributes

AnotheraccountingconundrumnotedbytheSECComplexitySubcom-mitteestemsfrommixedaccountingattributes.Thecarryingamounts ofsomeassetsandliabilitiesaremeasuredathistoriccost,othersat

decrease of price or marketplace, andstillothersat fair cost.SeveralmeasurementattributescurrentlycoexistinGAAP.Theyresultincombinationsandsubtotalsofamountsthatmakenorealeconomicsense(or,astheComplexitySubcommitteesaysmoretactfully,“arenotintuitivelyuseful”).Thiscomplexityiscompoundedbyrequirementstorecordsomeadjust-ments(tothevalueofanasset)inearnings,whileothersarerecordedinequity.Inpreparingacomprehensiveincomestatement,anissuermaychooseamongtheseapproaches.fifty seven

BrightLines:“either/Or”

Anothercomplexityintroducedbyaccountingisthenotionofstrictpass-failthresholdsthatachieveanall-or-nothingrecognitionofanasset.Take,forexample,leaseaccounting.Undercurrentrequirements,thelesseeaccountsfortheleaseinoneoftwosignificantlydifferentways:both(1)reflectanassetandaliabilityonitsbalancesheet,asifitownstheleasedasset,or(2)reflectnothingonitsbalancesheet.Theaccount-ingconclusiondependsontheresultsoftwoquantitativetests,whereamere 1 percent distinction in the results of thequantitative tests leads toverydifferentaccounting.Thefour-partpass-failstandardforrecogni-tionofrevenuefromsoftwareinsomecasesleadstozerorecognitionwheninfactpartialrevenueisreceived.

TheSEC’sComplexitySubcommitteenotesthatbrightlinesmakefinancialreportslesscomparable.Theaccountingisnot“faithfultoatransaction’ssubstance.”Brightlinesproducelesscomparabilitybecausetwosimilartransactionsmaybeaccountedfordifferently.

ReformingGAAPandIFRS

investors, creditors,auditors,andothersallhaveopportunities toweighinonstandardsthroughacommentprocessorothermeans.Since2005,theFASBhassponsoredanInvestorTaskForce(ITF)madeupofthe united states of america’slargest institutionalinvestors.58Taskforcemembers assignindustryanalystsattheirfirmstoadvisetheFASBonstandard-settinginitiatives.

Despitethe presenceof investorsinthesetting ofstandards,GAAPisstillpronetoinvestorcriticism.Inrecentyears,someinvestorshavecomplainedthatGAAPstandardsforreportingfailtocapture

theinformationinvestorsneedtomakeinvestmentdecisions.TheAmericanInstituteofCertifiedPublicAccountants,theFASB,andothershavebeentakingstepstocorrectthisgap—alongwithglobalstandardsetters.

EnhancedBusinessReporting(EBR)

In2001,theAICPAlaunchedtheEnhancedBusinessReporting(EBR)initiative,toproposeadditionstofinancialreporting,tobeadoptedonavoluntarybasis bycompanies. Thisinitiative grewoutof workinitiallydone bytheAICPA(theso-called“Jenkinsreport”).59

Therecommendationsofthisgroupcanhelpthevaluation-mindedinvestor.EBRsuggestswaystoreportimportantintangiblefactorssuchasstrategy,innovation,people,customerloyalty,marketshare,leader-ship,technologicalchange,R&D,whatcompetitorsaredoing,logo,patents,reputationrisks—allobviouslyimportantcontributorstothevalue of acompany.

MuchoftheinformationenvisionedfordisclosureundertheEBRframeworkisalreadyrequiredforU.S.SECregistrantsintheManage-ment’sDiscussionandAnalysisofFinancialConditionandResultsofOperations, the“MD&A”requiredunderRegulationS-okay. ButtheEBRframeworkcontainsusefulclassifications—taxonomies—forqualitativeinformation.ThedisclosurerequirementscontainedwithintheMD&Acategories—liquidity,capitalresources,resultsofoperations,off-stability-sheet preparations, andcontractualobligations—doin fact cover manyvalue-criticalactivities,butthisinformationcangetlostintheprose.TheEBRinitiativecreatesareportingframeworkthatorganizesbothquantitativeandqualitativeinformationinrationaland consistentstruc-ture.Infact,theEBRgrouphasalreadycreatedataxonomyforuseinthenewfinancialreportingsoftwareXBRL(awayoftaggingelectronicrecordssothattheycanbetotaled,as compared,grouped,andotherwisetreatedasdata).60(FormoreonEBR,seeChapter7.)

EmergingIssuesTaskForce(EITF)

TheFASBhasanEmergingIssuesTaskForce(EITF)composedofrepresentatives ofmajoraccountingfirmsandcorporations.This groupstrivestokeeptheFASBintouchwitheconomicreality.IfissuesarisethatdonotseemtobereceivingpropertreatmentunderGAAP,the

EITF holds meetingsto discussthemandpublishesthefindings.subsequently,EITFfindingsmaketheirwayintorules.Issuesundergodebatethatoftenpitsaccountingtheoryagainstreal-worldconcerns.ObserversnotethatsomeEITFmembers,asusersofthestandards,haveconflictsofinterest.Onequestionis,dotheseconflictsofinterestpreventthestandardsfrombeingfairforandusefultoallusers?

TheProblemofFairMarketValue:ReportingValuesforSecuritieswithNoCurrentMarket

Problemswiththetwomainsourcesofinformationaboutasecurity—financialreports(whichcanbearcane)andmarkettradingprices(whichcanbesubjective)—increasegeometricallywhencompanieshavetoreport the fee of theothercompanies’securities they hold.And theseproblemsrelatetothedreadedconceptoffairmarketvalue.Duringtimesofextrememarketvolatility,determiningsuchavalueisadifficulttask,tosaytheleast.

Duringthe2008–2009financialcrisis,thefederalgovernmenttookownershipofsecuritiesheldbytroubledfinancialinstitutions,undertheTroubledAssetReliefProgram(TARP)initiatedunderPublicLaw110–343,amultipartpieceoflegislationthatincludeda$700billiontorepurchasetroubledfinancialassetsundertheEmergencyEconomicStabilizationActof2008.61 TARPcastgovernmentintotheroleofalenderandinvestor,providingcapitalintheformof$1.5tril-lioninloansandpurchasesofgovernment-sponsoredenterprise(GSE)securities.Thegovernmentwantedtobeabletovaluethesecuritiesitwasgoingtohold.SotheCongressionalOversightPanelaskedDuff&Phelps,asecuritiesratingagency,tovaluepreferredstockandwar-rantsundertheprogram,resultinginareportpublishedinFebruary

BecausetheTARPpreferredstockandtheTARPwarrantsarenotpubliclytraded,Duff&Phelpsuseddatafromthepublicdebt,equity,andderivativesmarketstoestimatediscountrates,volatility,anddefaultassumptions.InChapter5,onvaluationusingstockprices,wewillpresentDuff&Phelps’findingsonthenarrowbutimportantissueofvaluingaspecificsetofsecuritiesheldbyacompany.(SeealsoAppendixD.)63

TheDuff&Phelpsvaluationworkgavethegovernmentause-fulbenchmarktouseinitsnewroleasanequityinvestor.Intheend,

even though,TARPprogramprovidedgreaterproofforequityvaluation’sdifficultythanforitsease.Whereasthegovernmenthadprojectedheavylosses fromitsinvestments,bymid-2010 itwasmakinggains.sixty four

ThreeStudies

ValuationstudiesliketheDuff&Phelpsvaluationreportarewellandgood,butanequallyimportantquestionishowcompaniesare“valuing”themselveson an ongoing foundation as an instance, howdo forums of directorsdefineperformancewhencreatinglong-termincentivepayplanslinkedtolong-termcorporateperformance?Thisisanimportantquestion,becausepaybenchmarksreflectvalues.IfaboardsaystoaCEO,“youwillreceiveabonusifyouincreaseoperatingprofits,”thisimplies(orshouldimply)abeliefthatthevalueofthecompanystems fromits profits.

In2010,threeorganizations(anassociationandtwocompensationconsultingfirms)publishedsurveysonmetricsusedtodeterminepay.Allthreestudiesshowprofitsasthedominantfinancialmetric,withvariableuseofothers.also,allthreestudiesshowedthatcompaniesrewardexecutivesformorethanfinancialresults.

Herearerepresentativeresultsfromoneofthestudies,the2010NACDPublicCompanyGovernanceSurveypublishedbytheNationalAssociationofCorporateDirectors.65Thetwolistsshowwhatresults,financialandnonfinancial,arebeingrewardedinpayplans(Multipleanswersaccepted.):

Financialresults:

➤profits66percent

➤Revenues41percent

➤cashflow36percent

➤Stockprices 31 percentage

➤Ratiosbasedinearningsorreturns31percent

➤Hybridformulas(e.g.economicvalueadded)16percent

➤Assets10percent

Nonfinancialresults:

➤patron delight 54 percent

➤Legalcompliance41percent

➤Employeemorale38percent

➤Productquality34percent

➤place of work safety30 percentage

➤Employeeretention19percent

➤Workplacediversity14percent

the opposite twosurveys showeda comparable rangeof responses.66

Investorsapparentlyseecorporatevaluedifferently.Astudyofinves-torviewsofperformancemetricsshowedthatthenearerameasureistocash flow,the moreinvestorsconsiderita legitimate measureofcorporateperformance.67

TheNeedtoReadbetweentheLines

Thecumulativeeffectofthesechallengesistomakefinancialreportslesstransparentwithregardtovalue.Investorsmusttherefore“readbetweenthelinesandconductadditionalresearchtodiscovertherealdriversofandthreatstovalue.Onepurposeofthisbookistoshowinvestorshowtoseektheadditionalcompanyinformationtheyneedtodeterminethetruevalueofasecurity.

HumanNatureComplicates(butAlsoInforms)EquityValuation

Equitysecuritiesaredifficulttovalue,inpartbecausebothcompaniesandthemarketsthattradeintheirequityarelivinghumansystems pronetoself-deceptivetraitsthatmilitateagainstpurevaluationlogic.Thehumanelementrunsdeeperthanjustthemarketitself,affecting theinstrumentsthemarketisvaluingallalongthevaluesupplychain.

Beforeanequitysecuritycanbevaluedinamarket,thesecurityandthemarketmustcometoexist.Andforthistohappen,anumberofpeoplemustdecideoragreetodoanumberofthings.Oneormorepersonsmust:

1. Conceiveofaproductorservice(entrepreneursormanagement).

2. Expendeffortproducing,handing over,and/orsellingtheproductorservice(managementandlabor).

3. Providecapitalforexpandingtheseactivities,includingbuyingandsellingsecurities(banks,traders,andventurecapitalists).

Thesethreegroupsarereminiscentoftheclassicaleconomiccatego-riesofentrepreneurship, labor,andcapital.Theyformacontinuumofvaluation.Ateachstepalongtheway,thepeopleinvolvedmakeajudg-mentaboutvalue.Howwiseiseachjudgment?Ineachcase,onlytimewilltell.

Itmaybehelpfultorevisitthe1934editionofIntroductiontoSecu-

rityAnalysisbyBenjaminGrahamandDavidDodd.Liketheauthorsand readersofthatclassic,theauthorsofthisbookhadtoponderacrashedstockmarket.How couldpeopleattributehighvaluetostocksonedayandlittlevaluethenext?Certainlyhumannatureplaysanenormousrole.WequotetwosectionsfromtheIntroductiontothe1934text,whichcouldhavebeenwrittenyesterday:

Oneofthestrikingfeaturesofthepastfiveyearshasbeenthedomi-nationofthefinancialscenebypurelypsychologicalelements....The“newera”doctrine—that“properly”stocks(or“bluechips”)weresoundinvestmentsregardlessofhowhighthepricepaidforthem—wasatbottomonlyameansofrationalizingunderthetitleof“investment”thewell-nighuniversalcapitulationtogamblingfever.Wesuggestthatthispsychologicalphenomenoniscloselyrelatedtothedominantimportanceassumedinrecentyearsby intangiblefactorsofvalue,viz.,proper-will,management,expectedearningpower,and many others.Suchvaluefactors,whileundoubtedlyreal,arenotsusceptibletomathematicalcalculation;hencethestandardsbywhichtheyaremeasuredaretoagreatextentarbitraryandcansufferthewidestvariationsinaccordancewiththeprevalentpsychology.[Emphasisadded.]

Then,inasectionaptlytitled“NoAutomaticRelationshipbetweenValueandPrice,”Graham andDoddopine:

ThereareanumberofotherfactorsinvolvinghumannatureinWallStreettowhichrecentexperienceshouldleadustopay...seriousattention...Investmenttheoryshouldrecognizethatthemeritsofanissuereflectthemselvesinthemarketpricenotbyanyautomaticresponseormathematicalrelationshipbutthroughthemindsanddecisionsofbuyersandsellers.similarly,theinvestors’mentalattitudenotonlyaffectsthemarketprice butisstronglyaffectedbyit. . .Henceinselectinganinvestment...reasonableallowancemustbemadeforsuchpurelymarket-priceelementsascanbeascertained,inadditiontothemoreprimaryconsiderationwhichispaidtofactorsofintrinsicvalue.[Emphasisadded.]

Theimportantpointisthatthetradingpriceofsecuritiescanbeaffectedbyinvestors’attitudesandinturnaffectthem.Equityvaluesriseandfallwithmarkettides,aseveryinvestorknows.Thevalueofasecuritymaybeinfluencedbymovementsinthestockmarketingeneral—wellbeyondthescopeofthecompanyanditsindustries.68

GeorgeSoros’sConceptofReflexivity

global-magnificencefinancierGeorgeSoroshasatermfortheeffectofhumanbehavioronvaluation:reflexivity.Hesaysthatinvestorsareinherentlybiased(notobjective)abouttheirinvestmentsbecausetheyareinvolvedininvesting,andtheirinvolvementinturnchangesthevalueofwhat theyinvestin.Morephilosophically:

Thinkingparticipantscannotactonthebasisofknowledge.Knowledgepresupposesfactswhichoccurindependentlyofthestatementswhichrefertothem;butbeingaparticipantimpliesthatone’s decisionsinfluencetheoutcome.therefore,thesituationparticipantshavetodealwithdoesnotconsistoffactsindepen-dentlygivenbutfactswhichwillbeshapedbythedecisionoftheparticipants....Reflexivityis,ineffect,atwo-wayfeedbackmechanisminwhichrealityhelpsshapetheparticipants’thinking

andtheparticipants’thinkinghelpsshaperealityinanunendingprocessinwhichthinkingandrealitymaycometoapproacheachotherbutcanneverbecomeidentical.sixty nine

Complicatingmatters isthefactthatthecompany basics thatinvestorsmayconsiderinsettingabuy,promote,orholdpriceforstockarethemselvescomplex.Eventheformulasinvestorsusetosettheirexpecta-tionsforreturnsareinfluencedbysubjectivity.Soroswrites:

profits,dividends,assetvalue,freecashflow:alltheseyard-sticksarerelevant,aswellasmanyothers,buttherelativeweightgiventoeachissubjecttoinvestors’judgmentsandisthereforesubjecttotheirbias.70

Settinganexpectationforreturnisultimatelysubjective,andpeoplecanmoveinpacks.Sorosattributesboom-bustcyclestoaflawedperceptionoffundamentalsthatisself-reinforcinguntilitbecomessooutoftouchwithrealitythatitmustreverseitself.

OtherParadoxesinEquityInvesting

Reflexivityisnodoubtthegreatestparadoxhauntingequityinvestment,butitisnottheonlyone.Mathematiciansversedingametheoryhave identifiedmanyothers.JohnPaulos,abrilliantmathematicianwholosthisshirtinvestinginWorldCom,blameshisownhumannatureasaninvestor—notWorldCommanagersorregulators!We highlyrecommendhisbook,AMathematicianPlaystheStockMarket.seventy one

Herearejustafewoftheparadoxesthatmadeitdifficultforthisgeniustoinvestprofitably:

1. Keynesianbeautycontest.JohnMaynardKeyneshassaidthattheshort-terminvestorislikeavoterinabeautycontestwhowillwin bypickingnotthemostattractivecontestant,buttheoneselectedbymostothers.ResearchbyW.BrianArthurattheSantaFeInstitute,usingadifferentexperiment,hasproventhatthebeautycontestapproachleadstomediocreresults.72

2. Thewinner’scurse.Inopeningbidding,somebuyerswillover-

estimatethevalueofanitem,andsomewillunderestimateit.The

higher bidderwillusuallybeonewhooverestimatedit.consequently,thewinnerismorelikelytooverpay.

three. Cognitivebias.Peopletendtobebiasedtowardinformationthat

isavailable(availabilitybias).Theyalsotendtopayattentiontoinformationthatconfirmsratherthanrefutestheirbias(confirma-tionbias).Theytendtopreferwhattheyalreadyhave,ratherthananewalternative(statusquobias,andacorrelativeendowmenteffect—“It’smystockandIloveit”).Peopletakefarmorerisksandspendfarmoremoneytoavoidlossesthantoachievegains.

4. Lossaversionbias.Thiskindofbiasrelatestotheso-calledShubik’s

public sale,namedafterYaleUniversityProfessorMartinShubik,who auctionsdollarsforhigheramountsinclasstoprovethepointthatpeoplewouldratherrisklosinglargeamountsofmoneyinordertoavoidlosingthanwalkawayafterasmallloss.

five. Factoringoutfailure(survivorshipbias).Instudyingtheperform-

anceofanygroup(forexample,agroupofpubliclylistedcompanies),thestudymayleaveoutcompaniesthathavefailedandnolongerexist.Thisinflatestheaverageperformanceofthegroupbyweedingoutfailures.73

6. Theprisoner’sdilemma.Thetwoplayersinthegamecanchoose

betweentwomoves:eithercooperateordefect.Eachplayergainswhenbothcooperate,butifonlyoneofthemcooperates,theone whodefectswillgainmore.ThisdilemmawasdiscoveredbyPrinc-etonmathematicianJohnNash,subjectofthebookandmovieABeautifulMind.Hisdiscoveriesapplytostockmarketinvesting.Paulosarguesthatifeveryinvestorwouldcooperatebyfocusingonfundamentals,wewouldallbebetteroff.Butitishumannatureto“disorder”fromthis modelbyfinding andexploitingan part,evenifthat facet,bybecomingcommonknowledge,benefitsonlythefirstinvestorwhofindsit.

Allthese assets ofbias andotherslead traders topaint themselvesintocognitivecorners.Attheheightofthefinancialmeltdownof2007–2009,onepsychiatristwasabletobuildapracticeworkingwithhedgefundtraderstohelpthemstayoutoftheir ownway,thatis,toavoidlossaversionandotherfoibles.74Butthefoiblesthatcameoutinthemeltdownare undying.Irrationalinvestmentbehaviorissoprevalentandpersistentthatithasbecomeabranchofeconomics,calledbehavioralfinance.75

Whenyouadditallup,asonetheoreticalphysicistobserved,“theeconomydoesnotcompute.”Itisnowonderthatthegreatestmindsofourdayareurgingtheuseofcomputersimulationstounderstandmarketbehavior.76

TheObserverEffect

Thereissomethingveryhumanaboutallthis—toacosmicdegree.WeareallfamiliarwiththeuncertaintyprincipleofHeisenberg,whichsetslimitsonhowpreciselywemaymeasurethepositionandmomentumofaparticleatthesametime.(Byincreasingtheprecisioninmeasuringonequantity,oneisforcedtoloseprecisioninmeasuringtheother.seventy seven)

Butamorerelevantprinciplefromphysicsistheso-calledobservereffect,whichstatesthattheactofobservationwill changethephenom-enonbeing found.Anumberofphysicists, together with John D.BarrowandFrank J.Tipler,MaxTegmark,andthelate JohnArchibaldWheeler,havenotedthenecessityofobservationfortheveryexistenceoftheuniverse!(Seeingisnotonlybelieving;itisbeingitself.)78

HumanNatureastheKeytoEquityValue

Ifstockmarketsexemplifyreflexivity,andreflexivityexemplifieslifeintheuniverse,thestudyofstockmarketbehaviorcanrevealkeystohumanprosperity.Attheveryleast,thestudyofthestockmarketwilltellusalotabouthumannature,andviceversa.

mockingly,humannature,whichmakesthevaluationofequitysodifficult, may alsobethefundamentalcauseofthe superiority of fairness.Thinkaboutit.Thefinancialpunditssaythatgreaterriskbringsgreaterreturns,butthisisn’treallyagiven.Riskismerelytheuncertaintyofloss,astheinsurerssay;79there’snothingintrinsicallyrewardingaboutthat.Knowingarisklevel—oraproxyforit,suchasaratiooutoflinewithpeers—cangiveyouadiscountlevel,butitcan’thelpyouassessreturns.Assetswithsimilarrisklevelscanbringdissimilarrewards,asfinancialeconomistWilliamSharpehasnoted.80

Certainlyinaworldofunknowables,theequityinvestor’swilling-nesstoaccepttheriskofopen-endedreturnsorlossesdeservesthehigherreturnsaccordedtoequities.however,again,thiswillingnessdoesnotnecessarilycausethereturns.Certainlycompaniesmaytakebold

dangers toprovidegenerousreturns toshareholders,but those dangers donotalwayspayoff.

Thefinancialreturnsfromequityaremadepossiblebymultiplevariablesbeyondthecontrolofcompanymanagers,includingstockmarkettrendsandmacroeconomicfactorssuchasinterestrates.81Butthemostimportantvariableisinthehandsofmanagement.It’scorpo-rategeniusinaction—or,moreexplicitly,lengthy-termasset-enhancingvisionrealizedthroughinformedstrategy,effectivelyimplemented.

Buthowcanthevalueofvisionbeexpressedintermsofdollarsandcents?Thisleadstotheimportanttopicofmonetization.

want for Expression in foreign money Values

Everythinginfinancialreportingisexpressedincurrencyamounts(e.g.,dollars,euro,oryen).Thismakesitpossibletocompareamountsfromcategorytocategory.Commonlanguagesolvesmanyproblems,butitalsocreatessome.Somevaluesaredifficulttoexpressincurrencyamountsbecausetheydonotinvolveacashtransaction.Andevenwhenacashtransactionisinvolved,theamountrecordedbelongstothepastratherthantothefuture.unavoidably,thedollaramountsoncompanyfinancialsonlyapproximatevalueandsometimesdosopoorly.Themark-to-marketrequirement,mentionedearlier,hasattemptedtocorrectthisproblemwithrespecttosecuritiesonbalancesheets,butwhen marketsareinturmoil,this isnotalwaysaviablesolution. Infact,somehavearguedthatmark-to-market-accountingcontributedtothe2007–2009financialcrisis.82Beingavalue-mindedinvestormeansbeingabletothinkintermsofdollarsandaskingcompaniestomakeagreaterefforttoquantifyelementsofvalue.Inthelongterm,investorswant thisquantificationtooccurunderGAAP/IFRS.Intheshortterm,inves-torscananddoaskcompaniestoreportonitvoluntarily—thewayfirmslikeGeneralElectrichavedone(morelater).

Thevaluationofoptionsisagoodexampleofputtingadollarnumberonanintangible—ineffect,monetizingavaluethathasnotpreviouslybeenexpressedinacurrencyamount.Priortoaccountingstandardsthatforcedexpensingofoptions,companiesdidnotbookoptionsasexpensesonthegroundsthattheirvaluewasimpossibletoquantify.Butsoonvari-ousmethodstoquantifyoptionscametothefore,suchastheBlack-Scholesmethod.Todaythequantificationofoptions isarequirementunder GAAP.

Tosome,theconceptofexpressingvaluesintermsofmoneymayseemlikeanaffronttodecency.Whocanputadollarvalueonthethingsthatreallymatter,suchaslife,liberty,orthepursuitofhappiness?Yetsuchvaluesarequantifiedeverydayincourtsoflaw.

Onegoalofenhancedbusinessreporting(ERB)andsimilarmovements,suchasintellectualcapital,socialresponsibilityreporting,andthelike,istoquantifyinformationthatwaspreviouslyconsiderednonquantitative.Becauseaccountingmustreporteverythinginmoney(asdiscussed),ERBtriestohelpinthisregard.

OnFinancialMathematics

Valuation-mindedinvestorswhowishtoputnumbersoninformationneedtoknowhowmathematicsareusedinvaluation.Onegoalofenhancedbusinessreportingistoprovidequantitativefinancialmea-suresforitemsthatarenottraditionallyexpressedasmoneyamounts, andmathematicscanhelp.

Somebelieve thatthe use ofadvanced mathematics in investingoverthelast40yearshasgonetoofar,leavingcommonsensebehind.83Thephenomenonofsecuritizationhascreatedinstrumentsofwealththataretoodistantfromthewealth-generatingsourcesunderlyingthem.Theriseandfallofsecuritiesbackedbysubprimemortgagesisagoodexampleofadeparturefromcommonsense.

Eventhebestofformulasfailifthevaluesputintothemareflawed.Valuationismorethanformulas;itinvolveshumanjudgment.None-theless, it isimportant to understandhow mathis utilized in theequitymarketplace,notonlybyinvestorsbutalsobytraders.

Mathmatters,evenifitissomethingassimpleasaside-with the aid of-sidecomparisonofanumberorsetofnumbers—theprecursorofaratio.Noteverydecisionmakerwantstomakethejumpfromcomparisontoratio,butintheworldofinvestmentfinance,suchaleapisobligatory—atleastforprofessionalinvestors.84

Basedonourexperienceinvaluation,thereseemstobeahierarchyofcomplexityformathematicaltoolsusedinvaluationbyaninvestor,progressingfromaninformal,intuitiverealmintoamoreformal,mathe-maticalrealm.

Fromlowesttohighestcomplexity,thestagesare

➤Integers—Numbersexpressingavalue—suchas$2billion(in, say,operatingearnings).

➤Ratios.Relationalcomparisonsoftwoormoredifferentitems

throughasinglefractionormultiplier—e.g.,earningspershareorpricetoearningspershare.

➤Multiples.Numbersderivedfromratios.

➤Averages(of ratios or multiples). Averagesof many ratios ormultiples.

➤Algorithms.Formulascomposedofmorethanoneratio—oftenyieldingabuy/selloryes/nodecision;sometimesexpressedasdecisionallogicratherthanasaformula.

Ratiosandmultiplesweightoneelementofvalueagainstanother,andusethiscomparisontoindicatevalue.Aratioormultiplebyitselftellsinvestorslittleornothing,butiftheycomparethatsameratioacrossanindustry,theycanbegintoscopeoutvalue.

Knowingthesetoolsishelpfultoinvestorsvaluingacompanyastheymove fromonefinancialstatementto some other.therefore,the discussionofthesevaluationtoolswillfollowthemovementfromonefinancialstatementtoanother.Forexample,thediscussionofthedebt-to-equityratioinChapter2focusesontheassetsonthebalancesheet,whiletheinterestcoverageratioisintroducedinChapter 3, whichdiscussesearn-ingsandtheincomestatement.Andobviouslyaratiosuchasfreecashflowtooperatingcashflowbelongsinthediscussionofthecashflowstatement—allcomingup.

Toolsthatcombineattributesfrommultiplesources—balancesheet,earnings assertion,coinsflowstatement,and/ormarket price—appearinChapter6.

(Formoreontheuseofmathin valuation,seeAppendixE.)

InClosing:AboutThisBook

Thisbookisintendedprimarilyforusebyinstitutionalinvestors—pro-fessionalswhobuyandsellequitysecuritiesonbehalfofinstitutions.Atthesametime,wehopethatothersmayfinditofinterestaswell.Wewouldbehonoredifprofessorsoffinancechosetorecommendthisbookalongtheotherclassicsonvaluationwerecommendattheendofthisbook,suchasGrahamandDodd’sSecurityAnalysis.moreover,webelievethatsecuritiesvaluationisabroad-basedcompetencyneededbyallparticipantsinfinancialmarkets,includingnotonlythosewhobuysecuritiesbutalsothosewhoseworkgivessecuritiestheirvalue—manag-ersandotheremployees.certainly,investorsandmanagersspeakacommonlanguagewhenitcomestovaluation:Theybothwanttoknowwhattheywillgetforwhattheywillgive.Riskandrewardconsiderationsapplytoboth.

Thecoauthorshopetoofferasetofvaluationtoolsthatcombinetwoequallyimportantaspectsofvaluationforinvesting:fundamentalsandcomplexity.

basics

Thisbookcontainsallthenecessaryfundamentalsforvaluationanalysis.It takesthereader throughthemajorfinancial statementsofacompanyandshowshowtoassesskeyelementsofvaluewithinthem.Althoughacertainlevelofreadersophisticationisassumed,thecoauthorsknowthatindividualshavevariedbackgrounds.Somereadersmaybeextremelysophisticatedinequityinstrumentsbuthavegapsintheirknowledgeofdebtmarkets—orviceversa.Othersmaybefinancialaccountantsbutlackagraspofeconomics,oraninvestortrainedineconomicsmayfindpronouncementsoftheFASBtobenothingshortofGreek.consequently,withapologiestothefewreaderswhomayinfactknowallthefunda-mentals,thebookispackedwithbasics.Ifyoualreadyknowsomething,justskipoverit.

Complexity

Thebookshouldmakeitsgreatestcontributionbybringingdisciplineandmeaningtothenotionofcorporatesynergy—theundeniablefactthatthecorporationismorethanthesumofitsparts.Fundamentalscangoonlysofarinhelpinginvestorsassessthevalueofaninvestmentinasecurity.Investorscancalculatethemarketvalueofeveryasset,tangibleand intan-gible,reportedandnonreported.Theycanscrutinizetheincomestate-mentsovertimefortrendsinprofitability.Andtheycanmakecashflowstatementstheirfocusandgainanappreciationforthesustainabilityofcashflowingintotheenterprise.Butbeyondallthesefundamentals(presentedchapterbychapter),theinvestormustbeawareofotherdimensionsofcorporatevalue.Thatiswhythisbook,inadditiontoexplainingfunda-mentals,willofferwindowsofinsight—presentedasboxedtext—enablinginvestorstostretchbeyondlogicintootherrealmsofpossibility.Thisvisualdeviceismeanttoconvertexperienceintointuitionforthereader.

TheAuthors

Theseniorauthor,RobertA.G.monks,hasspentalifetimemakingsenseofvaluationforinvestment—acomplexsetofmovingtargets.ManyinthebusinessworldknowBobMonksbestasashareholderactivistwhofoundedInstitutionalShareholderServicesandtheLensFundafterworkingonprivatepensionfundissuesattheU.S.depart-mentofLabor.Inhismuchearlieryears,hewasasecuritiesrunnerfor

Paine&Webberinthesummerof1950;servedasaprincipalinhisfamilymoneymanagementbusiness,GardnerAssociates(amoneymanage-mentfirm);andeventuallybecamechairmanoftheBostonCompanyandBostonSafeDeposit&TrustCo.Manyofthewindowsonvaluationcomefromhisvastexperienceasadirectrisk-takingparticipantintherough-and-tumbleoffinancialmarkets.

Thebook’scoauthor,AlexandraLajoux,hasspentthreedecadesmakingtechnicalfinancialmaterialunderstandabletoprofessionalaudiencesthroughherownbooksorthroughbooksandreportspre-paredwithand for others,includingavarietyof expertsandtask forcesconcernedaboutquestionsof corporatevalue.Hertaskinthisbookhasbeentoconstructitsfundamentalframeworksothatitsnewwindowsonvaluationcanletinthemostlight.

ARangeofApproaches

Investorsneedtouseafullspectrumofvaluationapproaches.Atone endtherearethetire-kickingskillsoftheold-fashionedappraiser—thevalueinvestor.Attheotherendofthevaluationspectrumarethegamblinginstinctsofthosewhocananticipatemarketmoves—thetech-nicalinvestor.Thebestvaluationpracticesspanthisfullrange,forgoodreason.Asnotedearlier,stockpricesbothreflectandinfluencethevalueofthesecuritiesbeingpriced.

➤Tire-kicking.Thereisanentireprofessionofbusinessappraiserswhofocusonthevalueofassetsandwhobasevaluationestimateslargelyonthosevalues.Theseprofessionalsoftenserveasexpertwitnessesincasesconcerningthevalueofprivatelyheldenterprisesforwhichthereisnosecuritiesmarket.Asset-basedvaluationofthiskindisusedinvaluingnaturalresourcecompanies.Forexample,acrudeoilproducersuchasPetrobras(NYSE:PBR)maybevaluedbased on the value of its present day validated reserves, minus a reduction forthecostsandrisksofextraction(suchasanoilspill),and a forestindustrycompanysuchasWeyerhauser(NYSE:WY)mightbevaluedbasedonthevalueofthetimberitcontrols.eighty five

➤gambling.Thenotionofaneconomythatoperateslikeacasino

forinvestorsemergedoutoftheworldwideGreatDepressionfol-lowingthe1929stockmarketcrash.EconomistJohnMaynard

Keyneswrote,“Speculatorsmaydonoharmasbubblesonasteadystreamofenterprise,butthepositionisseriouswhentheenterprisebecomesthebubbleonawhirlpoolofspeculation.Whenthecapitaldevelopmentofacountrybecomesaby-productoftheactivitiesofacasino,thejobislikelytobeill-finished.”86

➤Valueliessomewherebetweenthesetwoextremesofabsoluteand

relativevalue—or,ifyouwill,betweeneconomicvalueandmarketvalue.Throughoutthisbook,thecoauthorssteeramiddlecourse.Theterribleconsequencesofvaluationextremeshavewornonallofusinrecentyears.Mayyouinvestwithinthegoldenmeanandmaythisbookbeahelpfulguidealongtheway.

Notes

1. Tobin’sQratioisanexample.Thisratio,inventedbythelateJamesTobinofYaleUniversity,iscalculatedasthemarketvalueofacompanydividedbythereplacementvalueofthefirm’sassets.ProfessorTobin,aNobellaureateineconomics,theorizedthatthecombinedmarketvalueofallthecompaniesonthestockmarketshouldbeapproximatelyequaltothesum oftheirreplacementcosts.

2. TheroleofalgorithmictradingwasafocusfortheFinancialCrisisInquiryCommission(FCIC),chairedbyformertreasureroftheStateofCalifornia,PhilAngelides.Formedinlate2009,theCommissionhasplanstodeliveritsfinalreportinDecember2010.SeeremarksChairmanAngelidesmadeJune 2, 2010, at http://www.fcic.gov/hearings/pdfs/2010-0602-Angelides

.pdf. ForquestionsRobertA.G.Monkshasposedto theAngelidesCom- project,seehiswebsite,RAGM.com.

three. Forabalancedviewontheroleofalgorithmictrading,includingareadinglistofbooksonthesubject,seeDennisOverbye,“TheyTriedtoOutsmartWallStreet,”NewYorkTimes,March9,2009.Interestingbloggingandlivelycom-mentaryappear atDiscover magazine’sweb website:http://blogs.discoverma-gazine.com/cosmicvariance/2009/03/22/the-physicists-killed-wall-road/.

four. SeeRobertA.G.monks,“TheReturnoftheShareholder,”HarvardLawSchoolForumonCorporateGovernanceandFinancialRegulation,February2,2009,http://blogs.regulation.harvard.edu/corpgov/2009/02/02/the-return-of-the-shareholder/.

5. S&PStrategyindexes.

6. Sharperatio.In1966,andlaterin1977, Professor WilliamSharpeintroducedareward-to-variabilityratiotomeasuretheperformanceofmutualfunds. AlowSharperatiomeanshighvolatility.Ina1994article,“TheSharpe

Ratio”(seeJournalofPortfolioManagement,Fall1994,athttp://www

.stanford.edu/~wfsharpe/art/sr/sr.htm),heexplainedhowtousetheratiobeforemaking aninvestment (exante):“let Rfrepresent thereturnonfundFintheforthcomingperiodand RBthereturnonabenchmarkportfolioorsecurity.Intheequations,thetildesoverthevariablesindicatethattheexactvaluesmaynotbeknowninadvance.Defined,thedifferentialreturn,as:

dR R

(1)

F B

Letd-bar

betheexpectedvalueofdandsigmadbethepredictedstandarddeviationofd.TheexanteSharpeRatio(S)is:

d

S (2)

d

TheSratioindicatestheexpecteddifferentialreturnperunitofriskassoci-atedwiththedifferentialreturn.”

Duringthe2007–2009financialcrisis,theSharperatiocameunderquestioning, assomefundswithahighSharperatio(lowvolatility)failed(seeThe Economist, http://www.economist.com/enterprise-finance/displaystory

.cfm?story_id 12948575); and SeekingAlpha.com, http://seekingalpha

.com/article/171438-spotlight-on-the-sharpe-ratio-part-i).

7. AlfredRappaportandMichaellJ.Mouboussin,ExpectationsInvesting:ReadingStockPricesforBetterReturns(Boston:HarvardBusinessSchoolPress,2001),xv.

8. Foraninterestingdiscussionofvalue,seeMichaelEldred,“question-ingtheEarth’sValue—IncludingaProposalforaCapitalistCarbonSinkIndustry,”attheConferenceonClimate&Philosophy,UniversityofSouthFlorida,September14–sixteen,2006,enterprise(http://www.webcom.com/artefact/untpltcl/qstnerth.html#one, delivered at1st worldwide).Henotes,“Theverb‘valere’islinked(viaanIndo-Europeanroot*ual-)totheGerman‘walten’because of this ‘to succeed,’ once more from L. prævalere ‘to be very able,’‘to have more energy or worth,’‘to be successful’.... [Thus] there isan intimateinterconnectionbetweenthepowersofexchange(change-fee)andproductivepowers/powersinuse(use-price).”

9. Foradefinitionofequitysecuritiesversusdebtsecurities,seeAppendixA.

10. historically, atleasthalfofallcorporatefundshasbeeninvestedinpublicequity.Inthelastpartofthefirstdecade,thisproportionhaschanged,withsome plans reducingtheir fairness investments fromhalf to athird. See

MarkAnson,“One-TwoPunchtoPensionFunds,”Pensions&Investments,January22,2009.also,startingin2000,pensionfundsbeganinvestinginprivateequityandhedgefunds,aswellasintraditionalstocksandbonds.See“DefinedBenefitPensionPlans,”GovernmentAccountabilityOffice,http://www.gao.gov/new.gadgets/d08692.pdf.

11. StevenMalanga.“PublicPensionFundsBecomePoliticalPlaythings,”actual

ClearMarkets,April22,2009,http://www.realclearmarkets.com/articles/2009/04/public_pension_funds_become_po.html.

12. Forcommentaryonthehistoryofstock-issuingcorporations,seethebooksbyRobertA.G.MonkspostedatRAGM.com.

13. Thegrowth(ordecline)inbook-valueequitycanbemeasuredthroughtheimpactofeventsthathavechangedthebookvalueofan investor’sinterestinabusinessfromthestartofafinancialperiodtotheendoftheperiod.Hereistheformula:

Shareholders’equityatbeginningofperiod(pershare)

Dividendspaid(pershare)

Sharesbuybacks(premiumoverbookvaluepershare)

Sharebuybacks(premiumoverbookvaluepershare)

Comprehensiveincome(pershare)

Shareholders’equity,endofperiod(pershare)

14. Someinstrumentsdonotfallneatlyintoeithercategory,eveniftheyhavethenameequityorstock.Forexample,considerpreferredstockinstrumentssuchasprivateinvestmentinpublicequities(PIPES).Foradiscussionofthistypeofinstrument,see“PIPES:WhatIssuersAreThinkingAboutPreferredStock Investments,” Deloitte &Touche,June 2009. http://www.deloitte

.com/belongings/Dcom-UnitedStates/neighborhood%20Assets/documents/MA/us_ma_Insights_PIPEs_102309.pdf.SeealsoAppendixA.

15. SeeJohnAllenPaulos,AMathematicianPlaystheStockMarket(NewYork:

MJFBooks,2003).

sixteen. TheEnronexamplefromDecember2001isparticularlycompelling.Thiswasacompanywithamarketcapitalizationof$70billion,equityof$11.5billiononbookedassetsof$sixty five.5billion,andrevenuesofover$100billion.AllthesenumbersplummetedassoonasEnrondeclaredbankruptcyandinvestorsgotthechancetoseewhatwasreallygoingon(suchasques-tionableaccountingpracticesthatinsomeinstancesamountedtofraud).Enron’sstockwentfrom$90to$15pershareinamatterofweeks,andtodayEnronisashellcorporationwithvirtuallynovaluebyanymeasure.To realign dollars with fee, regulators focused on governance and disclosurereforms.TheU.S.CongresspassedtheSarbanes-OxleyAct,theSecuritiesandExchangeCommissionpassedsome50newrulesinterpretingthis

law, andthemajorstockexchangessetforthnewgovernancestandardsforlistedcompanies.Thepost-Enroneralasteduntil2008,whenafinancialpanicbroughtaboutanewsetofreformsevenmorecomprehensivethanSarbanes-Oxley.

17. FormoreontheAngelidesCommission,seenote2.ForinsightsontheGoldmanSachsmatter,see“GoldmanSachs’RoleinCrisisatStake,DefendsValuationsthatHelpedPutAIGinBind,”WallStreetJournal,July2,2010.

18. AtthecloseoftradingJune23,2010,GoldmanSachs(GS)closedat

$one hundred thirty five.07, downfromits 52-weekhighof $193.60.

19. CharlesJones,NorthCarolinaStateUniversity,citedinDanBurrows,“AfterEquities’WorstDecadeEver,the2010sGottaBeBetter,proper?”DailyFinance,http://www.dailyfinance.com/story/investing/after-equities-worst-decade-ever-the-2010s-gotta-get-better-r/19298144/.

20. AnApril2008clientletterfromWeil,Gotshal&Mangesnotes:“Spreadingfalserumorsinordertoinduceotherstotradeinacompany’ssecuritiesmayconstitutemarketmanipulationunderSections9and10(b)oftheSecuritiesExchangeActof1934.OntheSelf-RegulatoryOrganizationfront,NYSERule435(5)anditsFINRAcorollaryprohibitmemberfirmsfromcirculating‘inanymannerrumorsofasensationalcharacterwhichmightreasonablybeexpectedtoaffectmarketconditionsontheExchange’”(“RegulatorsAnnounceInves-tigationandEnforcementPrioritywithRespecttoFalseRumorSpreadingbyShortSellers,or‘ShortandDistort’activities,”Weil,Gotshal&Manges,April3,2008,http://www.weil.com/news/pubdetail.aspx?pub6465).

21. JonathanBurton,“TheYearofInvestingDangerously,”WallStreetJour-

nal,January5,2009,http://www.marketwatch.com/story/after-brutal-2008-beating-inventory. notice: The maximum dramatic losses befell within the fall of2008.FromSeptember15,2008,toJuly15,2009,theDowJonesIndustrialssufferedanetlossof3,062.50points.Itclosedat11,421.99onSeptember14,2008,andat8,359.49onJuly17,2009,aftermuchvolatilityandaspringrallythatcontinuedthroughout2009.

22. TheDow Jones globalindex fell15 percentage fromJanuary 1, 2009,thru March31,2009,andglobalfinancialinstitutionindexesalsofell:theUnitedKingdom’sFTSE350bankindex(down27percent),Japan’sNikkei500bankindex(down12percent),andtheDowJonesEuroStoxxBanks.Thenlossesseemedtoleveloff.IntheUnitedStatesduring2009,theDowJones IndustrialIndexstartedat8,776,plungedinJanuaryandFebruary,butclimbedbackuptotop10,000bytheendoftheyear.Asofmid-2010,theDowJonesIndustrialStockswerestillatthe10,000mark.

23. DavidEnrich,RobinSidel,andDeborahSolomon,“FedSeesUpto$599BillioninBankLosses:Worst-CaseCapitalShortfallof$75Billionat10BanksIsLessThanManyFeared;SomeSharesRiseonHopesCrisisIs

Easing,”WallStreetJournal,May8,2009.Seealso“JointStatementbySecretaryoftheTreasuryTimothyF.Geithner;ChairmanoftheBoardofGovernorsoftheFederalReserveSystemBenS.Bernanke;ChairmanoftheFederalDepositInsuranceCorporationSheilaBair;andComptrolleroftheCurrencyJohnC.Dugan:TheTreasuryCapitalAssistanceProgramandtheSupervisoryCapitalAssessmentProgram,”May6,2009,http://www.federalreserve.gov/newsevents/press/bcreg/20090506a.htm.

24. JanStrupczewski,“EUtoPublishBankStressTestResultsinJuly,”Reuters,June17,2010.http://www.reuters.com/article/idUSLDE65G23720100617.

25. JoshuaD.Coval,JakubW.Jurek,andErikStafford,“TheEconomicsofStructuredFinance,”HarvardBusinessSchoolFinanceWorkingPaperNo.09-060:“Theessenceofstructuredfinanceactivitiesisthepoolingofeconomicassets(e.g.loans,bonds,mortgages)andsubsequentissuanceofaprioritizedcapitalstructureofclaims,knownastranches,againstthesecollateralpools.Asaresultoftheprioritizationschemeusedinstructuringclaims,manyofthemanufacturedtranchesarefarsaferthantheaverageassetintheunderlyingpool.Weexaminehowtheprocessofsecuritizationallowedtrillionsofdollarsofriskyassetstobetransformedintosecuritiesthatwerewidelyconsideredtobesafe,andarguethattwokeyfeaturesofthestructuredfinancemachineryfueleditsspectaculargrowth.Atthecoreoftherecentfinancialmarketcrisishasbeenthediscoverythatthesesecuri-tiesareactuallyfarriskierthanoriginallyadvertised.”[Emphasisadded.]

26. KevinWarsh,governor,FederalReserveBoard,“TheFederalReserveAgenda,”KeynoteLuncheonSpeechofApril6,2009,atCouncilofInsti-tutional investors. http://www.cii.org/activities/2009_spring_meeting.

27. Ibid.

28. JohnBogle’spointisthat“[t]heproximatecausesofthecrisisareusuallysaidtobeeasycredit,bankers’cavalierattitudestowardrisk,’securitiza-tion’(which severed the conventional hyperlink among borrowerand lender), theextraordinaryleveragebuiltintothefinancialsystembycomplexderiva-tives,andthefailureofourregulatorstodotheirjob.Butthelargercausewasourfailuretorecognizetheseachangeinthenatureofcapitalismthatwasoccurringrightbeforeoureyes.Thatchangewasthegrowthofgiantbusinesscorporationsandgiantfinancialinstitutionscontrollednotbytheirownersinthe‘ownershipsociety’ofyore,butbyagentsoftheowners,whichcreatedan‘agencysociety.’”RobertA.G.Monkshasbeensayingthisinbooks,articles,andspeechesformorethan20years.

29. TheWallStreetReformandConsumerProtectionActof2010hasbeenhailedasthemostsignificantpieceoffinanciallegislationsincethe1933SecuritiesActand1934SecuritiesExchangeAct,althoughitdoesnotreplacethoselawsorevenmodifythemtoanygreatextent.Thelaw

wouldstrengthentheregulationofderivativesecurities,hedgefundadvisors,imposestricteroversightofcreditratingagencies,andexpandSECenforcementpowersandfunding.

30. SeeCarmenM.ReinhartandKennethS.Rogoff,“TheAftermathofFinancialCrisis,”MoneyScience,January27,2009,http://www.moneyscience.com/Finance_Focus/Research_-_The_Aftermath_of_Financial_Crises.html.ProfessorReinhartisattheUniversityofMarylandandProfessorRogoffis withHarvardUniversity.

31. Thewordthinkingmerelyemphasizesthefactthatinvestorsmakechoices.Itdoesnotsuggestthattheirchoicesarealwayscorrect.Seethediscussionofirrationalitylaterinthischapter.

32. TheU.S.TreasurydefinestheinflationrateasthepercentagechangeintheConsumerPriceIndexforallUrbanConsumers(CPI-U)overasix-monthperiodendingpriortoMay1andNovember1ofeach year, http://www.treasurydirect.gov/paperwork/savpdp0039.pdf.

33. Inflationratescanbemild(4percentorless),mild(5to9percent),orsevere(10percentormore).

Aswegotopress,theinflationrateintheUnitedStatesis3.2percent,basedontheConsumerPriceIndex,atargetmeasure(http://www.statistics

.gov.united kingdom/cci/nugget.asp?ID19).

34. TheU.S.TreasurystatesthattheLong-TermRealRateAverage(theunweightedaverageofbidrealyieldsonalloutstandingTIPSwithremain-ingmaturitiesofmorethan10years)canbeaproxyforlong-termrealrates,http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-fee/real_ltcompositeindex.shtml.

35. DuringtheirdeliberationsontheFinancialInstrumentswiththeCharac-teristicsofEquityinApril2007andforthefollowingyear,thejointmeetingoftheInternationalAccountingStandardsBoard(IASB)andFinancialAccountingStandardsBoard(FASB)proposedthat“thedistinc-tionbetweenequity(riskcapital)andliabilitiesisbasedexclusivelyontheabilityorinabilityofcapitaltoabsorblossesincurredbytheentitywithlossesbeingtentativelyunderstoodasaccountinglosses.”but,atthejointboardmeetinginOctober2008,theIASBusedanewdefinitionofequitybasedontheperpetualapproach(thatis,nosettlementfeatureandentitlementtoproratashareonliquidationoftheissuingentity)andthebasicownershipapproach(thatis,mostsubordinatedinstrumentandenti-tlementtopercentageofnetassets),http://www.iasplus.com/schedule/liabequity.htm.Formoredetailsonequityversusdebt,seeAppendixA.

36. Researchershavefound“nonlinearityintherelationshipbetweenU.S.excessstockandbondreturnsandmacroeconomicpredictorvariables,findingevidenceofmultipleregimesandtimevaryingcovariancesand

demonstratethesuperiorout-of-samplepredictiveaccuracyofsuchamodeltoacomparable,single-statelinear[valueatrisk]”(MassimoGuidolin,StuartHyde,DavidMcMillan,andSadayukiOno“Non-LinearPredictabilityinStockandBondReturns:WhenandWhereIsItExploitable?”WorkingPaper2008-010A,April2008,FederalReserveBankofSt.Louis,ResearchDivision,http://research.stlouisfed.org/wp/2008/2008-010.pdf).

37. TheDowJonesdropped36.2percent,thebiggestdeclinesince1931whenaftershocksfromthe crashof 1929sent stocksdown 40.6percent (JoeBelBruno,“WallSt.ClosesOuton2008,YearofRecordLosses,”AssociatedPress,December28,2008).

38. IntheG7countries,between1979and2007,bondreturnswerecompa-rabletostockreturnsandyetdisplayedconsiderablylowervolatility—thesamebangforasmootherbuck.Duringthe1900–2007period,united states of americaequityreturnsweresubjecttoastandarddeviationof20percent,forexample,withmostmajornationshavingevenhighervolatility.according toresearchconductedfortheauthorsbyasourcewithintheTreasuryofSweden,stan-dard deviationsin thatperiodwere UnitedKingdom,19.eight percentage;UnitedStates,20.0percent,Italy,28.9percent,Japan,29.8percent,andGermany

32.3percent—thelastthreenodoubtaffectedbylosingWorldWarII.Accordingtoonestudy,bondshavelowervolatility.SeeMassimoGuido-linetalia,“Non-linearPredictabilityinStockandBondReturns:WhenandWhereIsItExploitable?,”InternationalJournalofForecasting,25,Issue2,April-June2009.standard,fortheperiodfrom1900to2009,volatilityofequityinvestmentsperyearfortheaveragecountrywas23.5percent.CreditSuisseResearchInstitute,CreditSuisseGlobalInvestmentReturnsYearbook2010,February2010,http://www.london.edu/newsandevents/news/2010/02/Credit_Suisse_Global_Investment_Returns_Yearbook_2010_1077.html.

39. Granthamcallstheideathatequityautomaticallyreturnsmorethandebt“dangerous,”dismissingitasnobetterthanthetheoryof“divineright”thatoncesupportedinheritedmonarchies,http://www.scribd.com/doc/21673022/Jeremy-Grantham-1/3-quarter-2009-Letter.

forty. CreditSuisseResearchInstitute,CreditSuisseGlobalInvestmentReturns

Yearbook2010,February2010p.47,Figure3.http://information.morningstar

.com/pdfs/CS_Year_Book.pdf.Theintroductiontothissourcenotesthatitsindexes“representthelong-runreturnsonagloballydiversifiedportfoliofromtheperspectiveofaninvestorinagivencountry.ThechartsoppositeshowthereturnsforaU.S.globalinvestor.TheworldindexesareexpressedinU.S.dollars;realreturnsaremeasuredrelativetoU.S.inflation;andtheequitypremiumversusbillsismeasuredrelativetoU.S.treasurybills.”

forty one. Ibid.

forty two. Ibid.

forty three. J.BradfordDeLongandKonstantinMagin,“TheU.S.EquityReturnPre-mium:beyond,PresentandFuture,”ColemanFungRiskManagementResearchCenter,PaperCFRMRC07-010,February1,2008,http://repositories.cdlib

.org/iber/cfrmrc/CFRMRC07-010orhttp://www.j-bradford-delong.net/2008_pdf/20080228_jep_submit.pdf.

44. DeLongandMagin(seenote41),citingRanjishMehra(2003reportsanannualequity go back premiumof four.6 percentin post–WorldWarII Britain,

three.3percentinJapansince1970,and6.6percentand6.3percentrespec-tivelyinGermanyandBritainsincethemid-Seventies.Mehra’spaper,“TheEquityPremium:WhyIsItaPuzzle?”FinancialAnalystsJournal,January/February2003,pp.54–69,receivedaFinancialAnalystsFoundationGrahamandDoddScrollforexcellenceinfinancialwriting.

forty five. CreditSuisseGlobalInvestmentReturnsYearbook2010.

46. CreditSuisseGlobalInvestmentReturnsYearbook2010.

47. “Conventionalwisdomviewsstocksaslessvolatileoverlonghorizonsthanovershorthorizonsduetomeanreversioninducedbyreturnpredictability.In contrast, we find stocksare substantiallymore unstable overlonghorizonsfromaninvestor’sperspective.Thisperspectiverecognizesthatparametersareuncertain,evenwithtwocenturiesofdata,andthatobservablepre-dictorsimperfectlydelivertheconditionalexpectedreturn.Wedecomposereturnvarianceintofivecomponents,whichincludemeanreversionandvariousuncertaintiesfacedbytheinvestor.Althoughmeanreversionmakesastrongnegativecontributiontolong-horizonvariance,itismorethanoffsetbytheothercomponents.Usingapredictivesystem,weestimateannualized30-yearvariancetobenearly1.5timesthe1-yearvariance”(LubosPastorandRobertF.Stambaough, “AreStocksReallyLessVolatileintheLongRun?”SocialScienceResearchNetwork,May22,2009,http://papers.ssrn.com/sol3/papers.cfm?abstract_id1136847.word:PastoriswithUniversityofChicago–BoothSchoolofBusiness,theCentreforEconomicPolicyResearch[CEPR],andtheNationalBureauofEconomicResearch(NBER).StambaughiswiththeUniversityofPennsylvania–TheWhartonSchoolandtheNationalBureauofEconomicResearch[NBER].).

forty eight. SeeRobertGeskeandYiShou,“CapitalStructure results on fees ofFirmStockOptions:TestsUsingImpliedMarketValuesofCorporateDebt,”SocialScienceResearchNetwork,November2007,revisedJanuary2009,http://papers.ssrn.com/sol3/papers.cfm?abstract_id1341993.

forty nine. Itisnoteasytogetarandomsampleofstock,asnotedbyEugeneFama,in“RandomWalksinStock-MarketPrices,”GraduateSchoolofBusiness,UniversityofChicago,http://www.chicagogsb.edu/school/selectedpapers/sp16.pdf.TheclassicarticlebyFisherandLorieonequitystockreturns

wasnotfromarandomsample;theyactuallymeasuredtherateofreturnforeachandeverystockintheirsample(commonstockslistedontheNewYorkStockExchangeforvarioustimeperiodsfrom1926to1960).Thebasicassumptioninalltheircomputationsisthatatthebeginningofeachperiodstudied,theinvestorputsanequalamountofmoneyintoeachcommonstocklistedatthattimeontheExchange.Thisamountstorandomsamplingwherethesamplingis,ofcourse,exhaustive.(L.FisherandJ.H.Lorie,“RatesofReturnonInvestmentsinCommonStocks,”JournalofBusiness37,no.1(January1964):1–21,http://www.crsp.com/50/pics/ratespercent20of%20returnp.c20paper.pdf.)

50. Theauthorsinterviewedrepresentativesfromseveralfundsthatputexten-siveresearchintostockselections.Foracompletelistofinterviewsubjects,pleaseseetheAcknowledgments.

fifty one. The Sarbanes-Oxley Actrequires  public  organizations  topay  manda-toryfeestofundtheFASB.previous tothis federally mandated investment,FASBwasfundedbyvoluntarycontributions,makingitpronetospecialinterests.Forthishistory and its implications  foraccounting policies, seeJackCoffee,Gatekeepers:TheProfessionsandCorporateGovernance(Oxford:OxfordUniversityPress,2006).there is a few challenge thatIASBwillbepronetothesameconflicts,sincetheIASBisnotpubliclyfunded.SeeWilliamW.BrattonandLawrenceA.Cunningham,“treat-mentDifferencesandPoliticalRealitiesin the GAAP-IFRS,”April  28,2009,AcceptedPaperSeries,http://papers.ssrn.com/sol3/papers.cfm?abstract_id1375617.

52. Theprincipleshavedevelopedovertimeasneeded.Nowtheyarebeingorganizedintoacodifiedschemeforeasieruse.Thesubjectsinthecodifica-tionschemewillbecometagsfordatamanagementunderXBRLlanguage,discussedelsewhereinthischapterandinChapter7.FormoreabouttheGAAP codification,seehttp://www.fasb.org/challenge/codification&retrieval_project.shtml.

53. ThephasesoftheprojectareA:ObjectivesandQualitativeCharacteris-tics;B:ElementsandRecognition;C:size;D:ReportingEntity;E:PresentationandDisclosure;F:PurposeandStatus;G:ApplicationtoNot-for-seasonedfitEntities;andH:RemainingIssues.Asoflate2009,PhasesAthroughDhavebegun,whereasphasesEthroughHarepending,http://www.fasb.org/project/conceptual_framework.shtmlandhttp://www

.iasplus.com/agenda/schedule.htm.

54. http://edocket.access.gpo.gov/2008/E8-11276.htm.

55. Sourcefordiscussionofcompetingmodels:http://sec.gov/policies/other/2008/acifr-scsupdate-050208.pdf.Formoreaboutequityversusdebtsecurities,seeAppendixA.

 

56. TheFASBAccountingStandardsCodification(ASCorthe“Codification”),whichorganizesU.S.GAAPinto90generaltopics.Eachtopiccontainsatleastonesubtopic;subtopicshavesectionsandsectionshaveparagraphs.FullFASBcitationstylerequirestopic,subtopic,phase,andparagraph.Howeverinthisbookweareusingashortformofcitation,namelythenewname(topiconly)followedbytheoldname.notice:EffectiveJuly1,2009,changestothesourceofauthoritativeU.S.GAAP,theFASBAccountingStandardsCodification™(FASBCodification),arecommunicatedthroughanAccountingStandardsUpdate(ASU).AsofJune25,2010,theFASBhadissued36updates.be aware:ThisnewnomenclaturedoesnotaffectthenumberingofFASBStatements.AlthoughtheAmericanInstituteofCer-tifiedPublicAccountantshascodifiedthem(CodificationofStatementsonAuditingStandards,February2010),theirnamesremainsthesame.Seehttp://www.cpa2biz.com/AST/principal/CPA2BIZ_Primary/AuditAttest/AuditPreprationandPlanning/PRDOVR~laptop-057205/computer-057205.jspAnumberoforganizationshavepreparedchartsjuxtaposingthenewandoldnomenclature.See,forexample,thisonefromtheGBQauditfirm,http://www.gbq.com/SiteObjects/2C7663414A9BA0AC4EBFA488512D857C/Codificationp.c20Quickp.c20Referencep.c20092009.pdf.

fifty seven. ComprehensiveincomeisdefinedbytheFASBas“thechangeinequity[netassets]ofabusinessenterpriseduringaperiodfromtransactionsandothereventsandcircumstancesfromnonownersources.Itincludesallchangesinequityduringaperiodexceptthoseresultingfrominvestmentsbyownersanddistributionstoowners.”(FASBStatement130,report-ingComprehensiveIncome,June1997.)Inotherwords,comprehensiveincomeisthesumofnetincome,andotheritemsthatcannotbeincludedintheincomestatementbecausetheyhavenotbeenrealized.Theyunrealizedholdinggainsorlossesfromavailable-for-salesecuritiesorforeigncurrencytranslationgainsorlosses.AccordingtoASC220(SFAS130),ComprehensiveIncome,threealternativeformatsareallowedforpresentingOCIandtotalcomprehensiveincome:

➤Belowthelinefornetincomeinatraditionalincomestatement(asa

combinedstatementofnetincomeandcomprehensiveincome).

➤Inaseparatestatementofcomprehensiveincomethatbeginswith theamountofnetincomefortheyear.

➤Ina statementof changesin stockholders’ equity.

UnderASC220,FASBencouragesreportingentitiestodisplaythecom-ponentsofOCIandtotalcomprehensiveincomeusingthefirstorsecond oftheseformats.CumulativetotalOCIfortheperiodshouldbepresentedonthebalancesheetasacomponentofstockholders’fairness,separatefromadditionalpaid-incapitalandretainedearnings.SeeGaneshJ.Panditt

 

andJeffreyJ.Phillips,“ComprehensiveIncome:ReportingPreferencesofPublicCompanies,”CPAJournal,November4,2004,http://www.nysscpa

.org/cpajournal/2004/1104/essentials/p40.htm.

58. CurrenttaskforcemembersareTheCapitalGroupCompanies,FidelityInvestments,GeneralElectricAssetManagement,MellonFinancialCorpo-ration,PutnamInvestments,T.RowePrice,andWellingtonManagement.

59. Seehttp://www.aicpa.org/ProfessionalResources/AccountingandAuditing/BRAAS/EBR.htmlandhttp://www.aicpa.org/ProfessionalResources/Accounting   and   Auditing/Accounting   standards/ibr/chap1

.htm.

60. FortheSEC’snewrule,seehttp://www.sec.gov/rules/final/2009/33-9002.pdf.

61. EmergencyEconomicStabilizationActof2008(DivisionAofPub.L.a hundred and ten-343,enactedOctober3,2008).http://www.gpo.gov/fdsys/pkg/PLAW-110publ343/content-element.html.

62. ValuationReport:CongressionalOversightPanel,DuffandPhelps,February

four,2009.http://cop.senate.gov/files/cop-020609-document-dpvaluation.pdf

sixty three. SeeAppendixD,“Duff&PhelpsFebruary2009ReporttotheCongres-sionalOversightPanel.”

64. “Totalbankinvestmentsof$245billioninFY2009thatwereinitiallypro-jectedtocost$76billionarenowprojectedtobringaprofit.Taxpayershavealreadyreceivedover$16billioninprofitsfromallTARPprogramsandthatprofitcouldbeconsiderablyhigherasTreasurysellsadditionalwarrantsintheweeksahead.”(“TreasuryReceives$45BillioninRepay-mentsfromWellsFargoandCitigroup—TarpPaymentsNowTotal$165Billion,”December22,2009,http://www.financialstability.gov/today's/pr_12232009b.html.)

For2010performance,see“SecretaryoftheTreasuryTimothyF.GeithnerWrittenTestimonybeforetheCongressional Oversight Panel,”June22,2010(TG754).http://www.treas.gov/press/releases/tg754.htm.

sixty five. SurveysbytheNationalAssociationofCorporateDirectors(NACD),anassociationof10,000corporatedirectorsandboardadvisors,showthatboardsareconcernedaboutcorporatefinancialperformance,whichranksalongwithstrategyasatopboardconcernyearafteryear.In2010,NACDincludedaquestionaboutcorporateperformancedefinitioninitsannualsurvey.TheNACDalsoconvenedaBlueRibbonCommissiononperfor-mancemetricsthatyear.SeeReportoftheNACDBlueRibbonCommissiononCorporatePerformanceMetrics(Washington,DC:NACD,2010).

sixty six. Thefindingsfromtheothertwosurveys,regardinglong-termperformancemeasures,wereasfollows:

PM&POnPoint:2010ExecutivePay-for-PerformanceSurvey,Pearl

Meyer &partners,2010.

 

➤seasonedfitsorearningsratios62percent

➤Revenues48percent

➤Ratios showingreturns45 percentage

➤seasonedfitratios31percent

Thissurveyalsospecifiedcustomersatisfaction/experienceasacrite-

rion,citedbymorethanonequarterofrespondents.

Studyof2008PerformanceMetricsAmongTop200S&PCompanies,JamesRedaandAssociates,February2010.

➤seasonedfitsorprofitratios49percent

➤Totalshareholderreturn44percent

➤Returnratios 29percent

➤Revenue15percent

➤coinsflow8percent

This survey also mentioned first-rate guarantee and client satisfaction as metrics.

67. JanBarton,BowHanson,andGracePownall,“WhichPerformanceMea-suresDoInvestorsValuetheMost—andWhy?”“Afactorcapturingnear-nesstocashflowsispositivelyassociatedwithaperformancemeasure’svaluerelevance;afactorreflectingthemeasure’spersistence,predictability,smoothnessandconservatismisnegativelyassociated.”January23,2009.http://ssrn.com/abstract1230562.

sixty eight. Foranadvancedmathematicaldiscussionofthisfact,seePerFrederiksen,FrankS.Nielsen,andMortenOrregaardNielsen,“LocalPolynomialWhit-tleEstimationofPerturbedFractionalProcesses,”CenterforResearchofEconometricStudiesofTimeSeries,CREATESResearchPaper2008-29,ftp://ftp.econ.au.dk/creates/rp/08/rp08_29.pdf.

sixty nine. GeorgeSoros,“TheTheoryofReflexivity,”lecturedeliveredApril26,1994,MITDepartmentofEconomicsWorldEconomyLaboratoryConference,Washington,D.C.

70. Soros, note 60.

seventy one. JohnAllenPaulos,AMathematicianPlaystheStockMarket(NewYork:MJFBooks,2003).

seventy two. W.BrianArthur,“InductiveReasoningandBoundedRationality(TheElFarolProblem),”StanfordUniversityandSantaFeInstitute.PapergivenattheAmericanEconomicAssociationAnnualMeetings,1994Session:Com-plexityinEconomicTheory,chairedbyPaulKrugmanandpublishedinAmericanEconomicReview (PapersandProceedings),84(1994), 406–411.

seventy three. occasionally,toavoidsurvivorshipbias,analystscanovercorrect,leadingtoreversesurvivorshipbias,arguesJuanniT.Linnainmaain“ReverseSurvivor-shipBias,”November26,2009,http://faculty.chicagobooth.edu/workshops/finance/pdf/RSB20091126.pdf.

 

seventy four. JosephA.Giannone,“HedgeFundShrinkSaysSuccessIsAllinYourHead[profiling psychiatristAriKiev],”Reuters,March19, 2009.

seventy five. See,forexample,AndrewLo,“ReconcilingEfficientMarketswithBehav-ioralFinance:TheAdaptiveMarketsHypothesis,”http://net.mit.edu/alo/www/Papers/JIC2005_Final.pdf.

seventy six. SeeMarkBuchanan,“ThisEconomyDoesNotCompute,”NewYork

instances,October1,2008.MarkBuchanan,atheoreticalphysicist,wrotethisfromNotre-Dame-de-Courson,France.

77. Theuncertaintyprinciplesaysthatyoucan’tmeasurepositionandmotionatthesametime.Theamountbywhichameasurementerrsiscalledtheobservereffect;thelowerlimittothaterroriscalledtheuncertaintyprin-ciple.Amathematicalstatementoftheuncertaintyprincipleisthateveryquantumstatehasthepropertythattheroot-suggest-rectangular(RMS)deviationof the positionfromits mean (the standarddeviation of theX-distribution)

X

timestheRMSdeviationofthemomentumfromitsmean(thestandarddeviationofP)

P

can neverbe smallerthan asmall fixedfraction ofPlanck’s steady:

XP2

Any dimension of the location with accuracy   X collapses (reducestoasinglestate)thequantumstate,makingthestandarddeviationofthemomentum  Plargerthanh¯/2x.

SeeW.Heisenberg,“ÜberdenanschaulichenInhaltderquantenthe-oretischenKinematikundMechanik[Ontheactualcontentsofquantumtheoreticalkinematicsandmechanics],”ZeitschriftfürPhysik,forty three(1927):172–198,andW.Heisenberg,ThePhysicalPrinciplesofQuantumTheory[translationofPhysikalischePrinzipienderQuantentheorie](Chicago:UniversityofChicagoPress,1930).

seventy eight. Onewaytoasserttherelationshipbetweenlifeandobservationistoimaginelifewithoutobservation.AccordingtoMaxTegmark:“abstract:Somesuper-stringtheorieshavemorethanoneeffective low-energylimitcorrespondingtoclassicalspacetimeswithdifferentdimensionalities.Wearguethatallbut

 

the(31)-dimensionalonemightcorrespondto‘deadworlds,’devoidofobservers,inwhichcaseallsuchensembletheorieswouldactuallypredictthatweshouldfindourselvesinhabitinga(31)-dimensionalspacetime.Withmoreorlessthanonetimedimension,thepartialdifferentialequa-tionsofnaturewouldlackthehyperbolicitypropertythatenablesobserverstomakepredictions.Inaspacewithmorethanthreedimensions,therecanbenotraditionalatomsandperhapsnostablestructures.Aspacewithlessthanthreedimensionsallowsnogravitationalforceandmaybetoosimpleandbarrentocontainobservers.”(MaxTegmark,“OntheDimensionalityofSpacetime,”magnificence.QuantumGrav. 14(1997):L69–L75.)

seventy nine. Thisdefinitionhasbeenaroundforatleast40years.SeeRobertI.MehrandEmersonCammack,PrinciplesofInsurance(Homewood,unwell.:Richard

D.Irwin,Inc.,1961).

80. TheSharperatio,orreward-to-variabilityratio,isnamedafterfinancialeconomistWilliamSharpe.Itmeasuresexcessreturn(orriskpremium)perunit of danger in an funding. The handiest model ofit is

 

E⎡⎣RR⎤⎦

 

 

E⎡⎣RR⎤⎦

 

whereR isthereturnonthetargetinvestment,Rfisthereturnon a bench-markasset,suchastherisk-freerateofreturn(suchasaT-bill),E[RRf]istheexpectedvalueofexcessoftheassetreturnoverthebenchmarkreturn,andpisthestandarddeviationoftheassetexcessreturn.TheSharperatioshowshowwellthereturnofanassetisexpectedtocompensatetheinvestorfortherisktakenbyinvestingintheasset.Whencomparingtwoassets,eachwiththeexpectedreturnE[R],againstthesamebenchmarkwithreturnRf,theassetwiththehigherSharperatiogivesmorereturnforthesamerisk.buyers areoftenadvisedtopickinvestmentswithhighSharpe ratios.

eighty one. Whenitcomestomacroeconomicvariables,“interestratesarethemostcon-sistentandreliablepredictorsofstockreturns,”sayresearchers.SeeMassimoGuidolin,StuartHyde,DavidMcMillan,andSadayukiOno,“Non-LinearPredictabilityinStockandBondReturns:WhenandWhereIsItExploit-able?”FederalReserveBankofSt.Louis,ResearchDivision,WorkingPaper2008-010A,April2008,http://research.stlouisfed.org/wp/2008/2008-010.pdf.

eighty two. SeeChrisChiovacco,“PetRocksandMark-to-MarketAccounting,”March13,2009,http://www.ciovaccocapital.com/sys-tmpl/petrocks/.

83. “Theonce‘gentlemanly’businessoffinancehasbecomeagamefor‘gamers.’Theseplayersareincreasinglytechnicallysophisticated,typicallyhavingPhDsinanumeratediscipline.Therootsofthistransformation

 

havetheirfoundationinthe1970s.Sincethenthefinancialworldhasbecomemoreandmorecomplex.sadly,asthemathematicsoffinancereacheshigherlevelssothelevelofcommonsenseseemstodrop. Therehavebeensomewell-publicizedcasesoflargelossessustainedby companiesbecauseoftheirlackofunderstandingoffinancialinstruments.Inthisarticlewelookatthehistoryoffinancialmodeling,thecurrentstateofthesubjectandpossiblefuturedirections.Itisclearthatamajorrethinkisdesperatelyrequirediftheworldistoavoidamathematician-ledmarketmeltdown.”(PaulWilmott,“TheUse,MisuseandAbuseofMathematicsinFinance,”PhilosophicalTransactions:Mathematical,PhysicalandEngi-neeringSciences358,no.1765(2000):sixty three–73.)

eighty four. Thisverysimpleapproachisfavoredbymanydecisionmakers.SeeShih-KungLai,“AnEmpiricalStudyofEquivalenceJudgmentsvs.RatioJudgmentsinDecisionAnalysis,”DecisionSciences(April2001):“Twocommonlyusedelicitationmodesonstrengthofpreference,equivalenceandratiojudg-ments,werecomparedinanexperiment.Theresultfromtheexperimentshowedthatratiojudgmentswerelesseffectivethanequivalencejudgments.Basedonaniterativedesignforelicitingmulti-attributepreferencestruc-tures,equivalencejudgmentsoutperformedratiojudgmentsinestimatingsingle-attributemeasurablevaluefunctions,whilebeingnearlymoreeffec-tivethanratiojudgmentsinassessingmulti-attributepreferencestructures.Theimplicationsoftheresultsfromtheexperimentarethatmulti-attributedecision-makingtechniquesshouldtakeadvantageofthedecisionmaker’sinclinationofmakingeffectiveequivalencetrade-offjudgments,andthatusefultechniquesshouldbedevisedtoincorporatedifferentcommonlyusedtechniques,suchasmulti-attributeutilitytheoryandtheAnalyticHierar-chyProcess, to elicitand consolidate equivalence alternate-off judgments.”Lai’shypothesis:“Ratiojudgmentsonattributegainsaremore difficulttoexpressthanequivalencejudgmentsbecausetheformerpresumablyrequirethedecisionmakerfirsttotransformtheattributelevelsintostrengthofprefer-ence values ina converted characteristic space, and then make ratio judgmentsbasedonthetransformedscale,whichneedsmorecognitiveeffortthanthelatterthatrequireonlytrade-offjudgmentsintheoriginalattributespace.”similarly,“strengthofpreferencejudgmentswithinattributesareeasiertomakethanthoseamongattributesbecausenotrade-offjudgmentsacrossattributesareneededintheformercase.”Forthesetworeasons,investorsdon’t alwaysuse rigidratios or formulasto maketheirdecisions.

85. ThisexampleisbasedononegiveninJohnD.Stowe,EquityAssetValua-

tion(Hoboken,NewJersey:JohnWiley&Sons,2007),20.

86. JohnMaynardKeynes,TheGeneralTheoryofEmployment,hobby,andMoney(NewYork: Harcourt,Brace&Jovanovich,1936).

 

 

CHAPTER2

 

CorporateValuationforPortfolioInvestment:AnalyzingAssets,income,CashFlow,StockPrice,Governance,andSpecialSituations

byRobertA.G.priests,AlexandraReedLajouxCopyright©2011byRobertA.G.MonksandAlexandraReedLajoux.

 

ValuationBasedonAssets

Buyingahouseisnotthesameasbuyingahouseonfire.

—JamesDimon,chiefexecutiveofficer,JPMorganChase,testifyingbeforetheSenateBankingCommitteeApril3,2008,aboutMorgan’spurchaseofBearStearnswithsupportfromthefederalgovernment

Corporatevaluationbeginswithanunderstandingofassetsheldbythecorporationbeingvalued.Thisisthemoststraightforwardwayofvaluingacorporationandinsomeregions,suchasAsia,themostwidelyacceptedway.1

Tobesure,fewinvestorsorcorporateleadersconsiderassetstobeaprimaryindicatorofcorporatevalue.however,thisdoesnotdimin-ishtheimportanceofthiscorporateelement.Ifaccountingstandardscouldrecognizethefullextentoftrueassets,thenbalancesheetswouldbecomeamoreimportantpointoffocusforinvestors—andforcorpo-rateboards.2

Assetvaluesareshroudedinmystery.Someassetsarereportedonthebalancesheet;manyarenot. nonetheless, astuteinvestorsstrivetounder-stand howkeyassets power the valueof theequitiestheybuy. Intheory,apropervaluationofallassets,includingthevalueofunreporteditemssuchascorporatereputationandculture,equalsthevalueofthecom-pany.Dividingthatvalueintototalsharesoutstandingshouldyieldthemaximumpricetopaypershare.Butthequestionis,howmuchtimeandmoneywouldittaketostudyallassetsinordertodeterminethat

47

 

rate?Thecostofanalysiscannotexceedtheinvestmentreturnsitmakespossible.

Tosave the analyst timeandtosetsensibleboundariesonanalysis,thischapterprovidesaprimeronassetfundamentals.Itidentifiesthelocationofassetsinthebalancesheet,thenmovesontoacaveatandcau-tionarytale.Aftersuggestingaworkingdefinitionofassets,thevaluationofassetsisreviewedinagoingconcernversusaliquidation.Othertopicsinthischapterincludetheroleoftheappraiserinvaluingassetsandhowtovaluesecuritiesandotherintangiblesonandoffthebalancesheet,usinginternationalstandards.Closingthechapterisadiscussionofspe-cialissuesinassetvaluations,especiallythosethatareindustryspecific.Thegoalsaretoincreasetheinvestors’understandingoftheassetvaluesembeddedinsecurities,toofferrulesofthumbforassessingthosevalues,andtoprovidetoolstoimproveanalysiswhentheinvestor’s

timeandfundspermit.

 

OverviewofAssetsasaUnitofValuation

Thevaluationofassetsorofanyotherelementsreportedonafinancialstatementbeginswithanunderstandingoftheaccountingstandardused torecordthevalue.Forratiosfocusedonassetvalues,seeAppendix2.1attheendofthischapter.Forguidanceonwhentouseanasset-basedapproach,seeAppendix2.2.

currently,globalbusinessesarecopingwith the convergenceoftwodominantsystemsforaccounting(seeAppendixC).Thevaluation-mindedinvestorneedstounderstandwhatstandardisbeingusedtovalueanasset—includingassetsnotreflectedinthebalancesheet.

 

Theclassicaccountingformulaforthebalancesheetis

belongings    Liabilities    equity

Thevalueofassetsisoffsetbyliabilities;theremainingvalueisequity(alsoknownas“networth”).Herearethedefinitions:

➤Themostauthoritativeglobaldefinitionofassets—froma2008jointtaskforceoftheFinancialAccountingStandardsBoard(FASB)andtheInternationalAccountingStandardsBoard(IASB)—saysthatanassetisa“presenteconomicresourcetowhichanentityhasapresentrightorotherprivilegedaccess.”three

➤Accordingtothesameglobalstandard,“aliabilityofanentityisa

presenteconomicobligationforwhichtheentityistheobligor.”four

➤sooner or later,theglobalstandardsaysthatequityis“theresidualinterestintheassetsoftheentityafterdeductingallitsliabilities.”5

Thesedefinitionsofassets,liabilities,andequity,alongwiththebasicequationforthebalancesheet,have aninternallogic.Account-ingtheoreticianscallthis“primacyofassets”(asopposedtoearnings)asavaluationconcept.6

 

(persevered)

 

(endured)

 

Theasset/liabilityapproach,emphasizingthebalancesheetoverotherstatements,presentstwochallenges.Oneistemporal,theotherspatial.

➤Thetemporalchallengewiththebalancesheetistwofold:

➤First,abalancesheetinitstotalityisonlyonemomentin

time—closeofbusinessthelastdayofthefinancialyear.Thisfreeze-frameclasheswiththeinherentlyproteannatureofassetvalues,whichchangeovertime.Howcancompaniesandtheirinvestorsstaycurrentwiththechanges?Themark-to-marketmandatehasmetwithmixedsuccessandsomeback-lash.7The verynotionofthemarketvalue ofassetsisfraughtwithdifficulty.

➤2d,eachofthevaluesreportedonthebalancesheetis

basedonvaluationsconductedpriortothepointintimestud-ied.Eventhoughthesecuritiesheldonthebalancesheetaremarkedtomarket(howeverimperfectly),otherassetsarenot. Sothebalancesheetisforeveroutofdate.

➤Thespatialchallengewiththebalancesheetisevenmorefun-

damental.Thepurposeoffinancialreports,bythestandardset-ters’ownadmission,isnottoreportvalues.alternatively,itistoreport

 

economictransactionsaccordingtoa consistentmethodologythatmayilluminatevalue.Thusthelocationofthosetransactionvaluationsisnotwheretheentityisoperatingnowasagoingconcern,butratheralltheplacesithasbeenwhenengagingineconomictransactions.

Insummary,thebalancesheetpresentsauniversethatisparallelto,butnotidentical with,securitiesvalue.Thetimeand spaceofwhatthebalancesheetdescribesare fundamentallydifferentfrom whatthecompanyis.value-mindedinvestorsneedtoknowhowtointerpretinformationfromaccountingnumbers—asaconsistentlyappliedsystem—intorevenue-producingvaluesforthefuture.

consequently,thischapterbeginswithacaveatandacautionarytale.

 

AnOpeningCaveat:TheLimitationsofAccountingNumbers

Inthetwolifetimesofexperienceinequitymarkets(asaninvestorandresearcherrespectively),thecoauthorshaveseendirt-floorbase-mentoperationsgrowtobecomeskyscrapingmultinationals,andtheyhaveseenthosesamegiantmultinationalsimplodetodust.Eitherphe-nomenonexemplifiesthelimitationsofaccountingnumbers,which,whenlookedbackuponforacertaindayorperiod,canunderreportrisingworthand/oroverreportdecliningworth.Inmanycases,thepriceinvestorspaidforacompany’ssecuritiesgivesabetterindica-tionofacompany’spresentassetvaluesthandoaccountingnumbers.Yetthere’snoescapingreportedassetvaluesbecausesecurityprices

 

oftenfactorthemin.Thisisthechicken-and-eggsituation.Onemustconsiderboth.

Assetvaluesreportedinthebalancesheetprovidecluestocompanyvalue.indeed,assetsarefeaturedinmanypopularfinancialratios(seeAppendix 2.1).Butinvestorsneedtounderstandthenatureofaccount-ingnumbers,aswellastheinformationtheycontainaboutthevalueofthecompanyasagoingconcernandthevalueofitsassets.

Steponeinthisunderstandingistorealizethatreportedassetsandtheratiosbasedonthemshouldbeviewedwithcaution.Thegapbetweenaccountingnumbersandmarketvaluesisgreat,nomatterwhatconsistentlyappliedsystemisapplied.ThesystemmaybeU.S.generallyacceptedaccountingprinciples(GAAP)asdeterminedbytheFASB.Orthesystemmaybeinternationalfinancialreportingstandards(IFRS)asdeterminedbytheIASB.8Lastbutnotleast,thesystemcouldbetheintegratedglobalstandardtheIASBisdevisingnowaswegotopress.

Whateversystemischosen,itisboundtomissvaluebyamile;thechallengeistomeasurethatmile.

Thevaluesassignedtoacorporation’sassetsbyaccountantsusuallyerronthesideofpessimism.Byprofessionaloath,accountantsmustbeconservative.Theyrecordtheactualcostofpurchaseofanassetanddonotmarkituptohighermarketvalueexceptundercertainconditions(e.g.,securitiesheld).additionally,theymustabidebycertainaccountingcon-ceptsandconventionsthattendtodepressnetincome.nine

Butconservatisminreportingassetsismorethana  worst-casecalculation.It’sastateofmind.10Accountantsstandinthepresent,appearance-ingtowardthepast;therefore,theyalwaysfallshortofcapturingallthetruevalueofthecompanyforinvestors,whobynaturelooktothefuture.11Intangiblevalues—suchasbrandvalues—notassociatedwithaparticularrecordabletransactiondonotgetreflectedonthebalancesheetunderaccountingrules.

AccountingNumbers:WhyAssetsasaStartingPoint?

Assetsarenotthebe-allandend-allofvaluation,noteveninasset-intensiveindustries(asdescribedattheendofthischapter).Ifanyelementhasthatdistinction,itwouldhavetobecashflow.Yetwhatiscashbutanasset?Andhowdoesanenterpriseattractcashifnotthroughits

 

belongings,boththoserecognizedinfinancialstatementsandthosereflected(orignored)instockprices?Giventheirteleologicalimportance,assetsprovideourstartingpoint.

Anotherreasontostartwithassetsisthattheyarefundamentaltotherecognitionofrevenues.Infact,asofmid-2010,theFASBandIASBareworkingona jointprojecttoadoptanew“belongings and liabilitiesapproach”torevenuerecognition.Amajorprojectisinprocesstoproviderevisedstandardforrevenuerecognitionbasedonbalancesheetchanges.12

And thereisyetanotherreason that abookonvaluationforinvest-mentshouldbeginwithassets.Shareholdersownsharesinacorpora-tion,buttheydonotownitsassets,whichareownedbythecorporation.it is a well established precept of organisation regulation that only theboardofdirectorshastheauthoritytodirectthecorporationtosellallorpartoftheassetsitowns.13So,oneimportantreasonshareholdersvalueandusetheirvotingrightsisforcontrolofassets.Theywanttovotefornewpoliciesorvoteinnewboardmembersinordergetthegreatestpossiblebenefitoutofthoseassets.

 

DefinitionofanAsset

Whatexactlyisanasset?Asstatedearlier,accordingtothecurrentdefi-nitionfromtheIASB,anassetisa“presenteconomicresourcetowhich anentityhasapresentrightorotherprivilegedaccess.”14

 

AccordingtotheIASB,anassetofanentityhasthreeessentialcharacteristics:

1. Thereisaneconomicresource.

2. Theentityhasrightsorotherprivilegedaccesstotheeconomicresource.

3. Theeconomicresourceandtherightsorotherprivilegedaccessexistatthefinancialstatementdate.

Intheory,ifmanagerscouldaccessalltheeconomicresourcesownedbytheircompany,andifassetswerevaluedaccordingly,thenthetotalvalueoftheassetswouldapproximatethetruevalueofthecorporation.

Theproblemisthatmanagersdonotalwaysaccessalltheirassetsand(asemphasizedearlier)cannotalwaysrecognizetheminfinancialstatements.nonetheless,thenotionofassetvalueisanimportantcheckagainstothermethodsofvaluationthataremoresusceptibletomanipulationthanthesimpletruthofhistorictransactionprice.Inthecaseofincome,forexample,therelevantformulaisRevenues–

ExpensesIncome.Managershavesomediscretioninhowtheyrec-ognizerevenues,reportexpenses,andcalculateincome;thisiscalled“income management.”(SeeChapter3formoreon profits-basedvaluation.)

Comparedtotherulesforreportingearnings,therulesforvaluingassetsleavelittleroom forcreativeaccounting.Assetsarerarelyreportedasexceedingtheirtruevalue,exceptintheraresituationofliquidation;typically,theirreportedvalueislowerthantheirrealvalue.Particularlywhenvaluingfixedassets,orassetswithlongdepreciablelivessuchasaircraft,the realities of inflation make itcertain that carryingvalueswillbebelowmarket.

Companiescandoonlysomuchto“talkup”theirassets,forfearofrunningafoulofaccountingprinciples,notablytheconservatismconcept.additionally,followingthecrashofthestockmarketin1929duetoinflatedstockvalues,securitiesexchangesaroundtheworldhaveputforthrulesdiscouraginganykindofforward-lookingstatementwithoutadisclaimer.for that reason,althoughthevalueofanyassetreallydoeslieinitsfutureuse,acompanycansayonlysomuchaboutthatusewithoutlook-inglikeit’s sellingsnakeoil.

 

 

float-Dominantvs.price-DominantAssets

TheIASBiscurrentlyworkingonanewstandardthat,ifapproved,willdistinguishbetweentwotypesofassetsforthepurposeofvaluation.Thedistinctionisslightlydifferentfromtheolddistinctionbetweenintangibleandtangibleassetsorevenbetweensoftandhardassets. rather,thisnewdefinitionisbasedondifferingcorrelationstocashflow:indirectforflowdominantanddirectforvaluedominant.

➤go with the flow-dominantassets.Fortheseassets,thecurrentvalueislessimportantthanthecashflowstheygenerate.Suchassetsareoftenusedinconjunctionwithotherstobenefittheentity.Iftheseassetsare measured atcurrent values,the coinsflows and valuechangesattributabletothemneedtobeseparatedinthestatementofcomprehensiveincome.15

➤cost-dominantassets.Theseassetsproducecashflowsbybeing

collectedorsold;theflowsproducedaredirectlyrelatedtothevalueofthoseassetsinmarketexchanges.Mostliabilitiesarevaluedominantbecausetheirvaluesaredirectlyrelatedtothecashflowsrequiredtoextinguishthem.sixteen

Thenewaccountingtreatmentoftheassetswilldependnotonlyontheassetitselfbutalsoonhowitisused.Amachinethatisbeingusedinproductionisaflow-dominantasset.Amachinethatisboxedupandwaitingtobesoldisavalue-dominantasset.drift-dominantassetscanbevaluedatalevelhigherthantheirmarketvalue.17

 

TheMarketPremiumandNonmarketDiscount

Thenotionofflow-dominantversusvalue-dominantassetsmayleadtobettervaluecapture.Atpresent,however,valuesreportedaretypicallylow;asprofessionals,accountantshavedoneagoodjobofkeepingalidofvalue—possibly too gooda process. Theprimary proof of thisis the marketpremium,whichisthegapbetweenaccountingnumbers(balancesheetequity)andmarketvalue(Priceofsharestimesnumberofsharesout-status  Marketequity).Asecondaryproofisintheconverse,calledthenonmarketdiscount.

MarketPremium

Attheheightofthemostrecentbullmarket,intellectualcapitalmadeuparound80percentofthevalueofaStandard&terrible’s(S&P)500company.18Thatis,thereportedequityvalueonthecompany’sbalancesheetwasworthonaverageonly20percentofmarketcapitalization.19Witha$10valueonevery$2,thiswasapremiumof500percent,oramultipleof5!

Thispremium/multipledroppedwiththehalvingofmarketpricesduringthebearmarketperiodpriortothepublicationofthisbook.here’showitworked.Stockswitha$1bookvaluecantradefor$5inabullmarket; so 80 percentofthevalueofsuch astock is inintellectualcapital($4outofevery$five).Butwhenthosesamestocks,withthesamebookvalues,aretradingfor$2ratherthan$five,thepercentageoftheintellectualcapitalcomponentmustberecalculated.Assumingthatthebookvaluestaysthesame(anddoesnotgetdiscounted),thepremiumdropsfrom80percentto50percent($1outofevery$2).every now and then,whenthemarketvalueisactuallytradingbelowbookvalue,thereisnopremium.honestly,thetypicalmarketpremiumpaidoverbookvaluereflectsgeneralmarketconditions,whichfluctuate.

TheEnhancedBusinessReporting(ERB)initiative (seeChapter1)featuresthischecklistofassetsandcompetencies:

➤Keyprocesses

➤Customersatisfaction

➤humans

➤Innovation

 

➤Supplychain

➤Intellectualproperty

➤Informationandtechnology

➤Financialassets

➤Physicalassets

price-mindedinvestorscanandshouldconsidertheseelements,eventhoughtheydonotappearonthebalancesheet.Thesecanhelpexplainthediscrepancybetweenmarketpricepershareandbookvaluepershare. (SeeChapter7 for theentireERB framework.)

NonmarketDiscounts

Nonmarketdiscountsaretheconverseofthemarketpremium:theyfocusonthelesserofthetwovalues(reductions),ratherthanonthehigherone(charges).Buttheyarenotaperfectconverse:Theyaremakingadifferentpoint.

Whereasthepeoplewhotalkaboutmarketpremiumsattributethedifferencebetweenbookandmarketequitytointellectualcapital,thepeoplewhotalkaboutmarketdiscountsattributethedifferencetotheexistenceofanactivemarket—inotherwords,liquidity.

Therearetwocommonwaystogeneratemarketdiscountdata.Onewayistocomparebeforeandafterinaninitialpublicoffering(IPO),whenoneseesthevalueofsharesforacompanyriseoncetheyareinthemarketplace.Anotheristostudythedifferenceinvaluebetweenshareswithandwithouttradingrestrictions(restrictedversusnonre-strictedshares).

Taxcourtrulingsonvaluationsfocusonnonmarketdiscounts—withtheIRStryingtogivearelativelylowdiscount(andsocollectmoretaxes).Taxpayershaveusedexpert witnessestoestablish higherdiscounts,andhavegenerallyprevailed,withdiscountsrangingfrom30percentto50percent.20

Empiricalstudieshaveshownevensteeperdiscountsforlackofmarketability.21Ingoing-privatecases,thebuyerandsellerhavetodeter-mineavalueofthecompanyinordertotakeitoutofpublicmarketsatapricethatisfairtoallshareholders.ThereisagreatdealofusefulinformationinSecuritiesandExchangeCommission(SEC)filingsongoing-privateissuers.22

 

TheMessageinthePremiumor bargain

Themessageofmarketpremiumandnonmarketdiscountisthesame.Whensharesaresoldtothepublic,theygainvalue,bothfromthevalu-ationprovidedbyinvestors(thevaluetheyseeinthecompanyoverandabovewhataccountantshavebooked)andfromliquidity(itissimplymorevaluabletoownsharesthatpeoplewillbuyorsellonanopenmarket).

Butneitherthemarketcapitalizationtheorynorthenonmarketdis-counttheoryreallygetsatthetruevalueofsecurities.Eachismerelyaruleofthumb,whichisusefuliftimeandfundsarescarce.Butifaninvestorcanafforddoingso,researchingthecomplexrealityofacompanyisalwayspreferable.23

Analystsneed to get awayfromrulesof thumbandanalyzetheactualcompany,asmuchastimeandmoney allow.Attheveryleast,theassess-mentofassetshelpstodetermineliquidationvalue,whichcanbeimpor-tantascollateralandthusasasafetynet.Liquidationvaluetendstobelowerthanbookvalue,justasmarketvaluetendstobehigherthanbookvalue—andforthesamereason:Thewholeofabusinessisgreaterthanthesumofitsparts.Buthowmuchgreater?Thisisthechallengeofvaluation.

 

BearStearns:ACautionaryTale

In2008,atthedawnofthefinancialcrisis(or“Panic,”perFederalReserveBoardGovernorKevinWarsh24),onemajorfinancialfirm—BearStearns—diedaquickdeathduetoalackofliquidity.Valuationofassetswasattherootofthatproblem.

 

InpreparedtestimonybeforetheHouseFinancialServicesCommittee,AlanSchwartz,presidentandchiefexecutiveofficerofBearStearns,explainedwhathitthefirm:“Eventhoughthefirmwasade-quatelycapitalizedandhadasubstantialliquiditycushion,unfoundedrumorsandattendantspeculationbegancirculatinginthemarketthatBearStearnswasinthemidstofaliquiditycrisis....Duetothestressedconditionofthe creditmarketas awholeandthe unprecedentedspeedatwhichrumorsandspeculationtravelandechothroughthemodernfinancialmediaenvironment,therumorsandspeculationbecameaself-fulfillingprophecy....Therewas,simplyput,arunonthebank.”

Infact, earlier than this“runonthebank,”BearStearnshadabookvalueofsome$12billion.Whenaskedwhethersomeassets(suchasmortgage-backedsecurities)mightbecarriedatartificiallyhighvalues,Mr.Schwartzreadilyagreed,buthealsopointedoutthatotherassetswereinfactworth

morethantheirbookvalue,citingthefirm’srealestateholdings.25

InplainEnglish,assetvaluationcanbealloverthemap.Inthecaseofmortgage-backedsecurities,valuationsweretoohigh,despitetheclearguidanceofmultitieredaccountingrulesthatguidedcompaniesonassetvaluation(asdiscussedlaterinthischapter).Ontheotherhand,thestreetvaluationofBearStearnssharesbeforethefire-salemergerwas toolow,basedonSchwartz’stestimony.

AsthenSECChairmanChristopherCoxsaidinthehindsightofDecember2008,“Theseeventsillustratejusthowcriticalnotjustcapi-tal,butliquidityistotheviabilityoffinancialfirmsandhowtheevapo-rationofmarketconfidencecanleadtoliquiditybeingimpaired.”26

Itisuptoinvestorstoconducttheirownvaluations,sothattheyarenotvulnerabletomarketpanic.Developingastrongunderstandingofthevalueandliquidityoffirmassetscanhelpsloworevenpreventany“runonthebank”thatmayoccurtothedetrimentofall.

TheAsset-FocusedInvestor

Mostvaluationsforinvestmentgiveassetsonlyasmallroleintheirvalu-ationapproaches.Forexample,asdiscussedlaterinthisbook,earnings,cashflow,andstockpriceplaylargerrolesinmanymethods.

Yetassets ought to notbe disregarded; certainly,someinvestorsconsiderthemmoreimportantthananyothersinglefinancialindicator.Althoughmostinvestorsseestockpricesasthemainindicatorofvalue,acontrarian

 

school,called“valueinvesting,”findsmorecluesinfinancialstatementsthaninstockprice.27Andonecorporatephilosopher,AdrianSlywotsky,hassaidthatassets,consideredintheirfullestsense,aretheultimateexpressionofvalue.The“modernvaluechain”beginswithcustomerpriorities,movesthroughchannels,and,ultimately,producesnothingmoreorlessthan“assetsandcorecompetencies.”28

So-calledasset-primarily basedfinancingusuallyreferstosecuritiesbasedonfinancialinstruments suchasloansorleases.The latest creditcrisistaintedtheword“asset”becauseinthoseloans,theunderlyingassets(defaultedmortgages)hadlowvalue.Butinabroadersense,asset-primarily basedfinancingreallymeansanyfinancinggroundedincollateral.IthasbeensaidthatIslamicfinancing,basedinSharialaw,isasset-based,asopposedtocurrencybased.29

Whenacompanyhasaconcentrationofsalable,tangibleassets,suchascarfleets30 orplantsandequipment,itisasuperiorcandidateforagoingprivatetransactionfundedbydebt—akaleveragedbuyout.Forapartialinvestorinequity,thisassetconcentrationisnotparamount,butitisaconsiderationasafallbackvalue.Behindtheassetintensityisliquidationvalue.

CurrentAssetValue

Intheir classicwork on SecurityAnalysis, BenjaminGraham and DavidDoddwriteaboutthe“SignificanceofCurrent-AssetValue.”Theydefinecurrent-assetvalueasthesumofallcurrentassets(includingcash,worth100percentofitsbookvalue;receivables,worth70to90 percentoftheirbookvalue;andinventories,worth50to75percentoftheirbookvalue),plusallfixedandmiscellaneousassets(generallyworth1to50percentoftheirbookvalue).Fromthere,withthelessonsofthe1929stockmarketcrashinmind,theymakethesethreepoints:

1. Thecurrent-assetvalueisequivalenttotheliquidationvalue.

2. Sometimescompanystockssellforlessthantheircurrentassetvalue.

three. Thisisillogicalandindicatesanerrorinthejudgmentofthestockmarket,thepoliciesofcompanymanagement,and/ortheattitudeofstockholderstowardtheirproperty.31

 

Ofcourse,liquidationvalueisthelastthinganinvestorwantstocontemplatebecauseitistypicallymuchlowerthanmarket valueexceptinextremelydepressedmarkets(theillogicGrahamandDoddcriticized).

GrahamandDoddnotethatcashandcashequivalentshavealiqui-dationvalueidenticaltowhatiscarriedonacompany’sbooks.Butnota-bly,especiallyintheaftermathofthemeltdownintheauctionmarkets,fewerandfewernoncashitemscansafelybecalledcashequivalents!Toqualify, theymust beshort-term,highlyliquid investmentsthatarebothreadilyconvertibletoknownamountsofcashandthatareneartheirmaturity(threemonthsorless),sothattheirvaluecan’tchangegreatly duetoshifts ofinterestrates.This includesgenerallyTreasurybills,commercialpaper,moneymarketfunds,andfederalfundssold(foranentitywithbankingoperations).32

Noncashassetsmayhavealowervaluethanbookinaliquidation.Oncethegoingconcernstopsgoing,itsinventorydropsinvalue.Ontheotherhand,whenabusinessisoperating(notliquidating),assetsaretypicallyworthmorethantheirhistoricvaluerecordedonthebal-ancesheet.Andthemoredynamicthecompany’ssynergyis,thehigher

thetruevaluewillbeofthoseassets.

 

 

TakingCluesfromAssets

Therearejustninebasickindsofassetstoreport:33

1. Cashandcashequivalents

2. Receivables

three. Investments—debtandequitysecurities

4. Investments—equitymethodandjointventures

5. Investments—other

6. inventory

7. Deferredcostsandotherassets

eight. Intangibles—goodwillandother

9. belongings,plant,andequipment

Thestandardsettershaveextensiverulesonhowtoaccountforeach.Thejoboftheinvestoristounderstandthoserulesandtobeabletoseethewholepictureaswellbecauseallthesetypesofassetsinteractwithoneother.

Sohereishowtoreadbetweenthelinesofreportsontheseele-ments.CommentaryisbasedinpartonIASstandards.

CashandCashEquivalents

“Cashandcashequivalents”generallymeanscashonhandanddemanddeposits,togetherwithshort-term,highlyliquidinvestmentsthatarereadilyconvertibletoaknownamountofcashandthataresubjecttoaninsignificantriskofchangesinvalue.Aninvestmentnormallymeetsthedefinitionofacashequivalentwhenithasamaturityofthreemonthsorlessfromthedateofacquisition.Equityinvestmentsarenormallyexcluded.34

Moneymarketsecuritiesnolongerhaveautomaticstatusascash.ThisstandardchangedwhenReserveManagementCompany’sPrimaryFund“brokethebuck,” causingthefund’s sharepriceto beworthlessthan$1.35Thechillingannouncementreadasfollows:

ThevalueofthedebtsecuritiesissuedbyLehmanBrothersHold-ings,Inc.(facevalue$785million)andheldbythePrimaryFundhasbeenvaluedatzeroeffectiveasof4:00pmNewYorktime

 

these days.Asaresult,theNAVofthePrimaryFund,effectiveasof4:00PM,is$0.97pershare.

ThiszerovaluationcamethedayafterLehmanBrothers,whichhadsolddebtsecuritiestotheReserveManagementCompany’sPrimaryFund, introduced thatit mightfileforbankruptcy.36In2009,theSECsuedtheReserveManagementCompany,allegingthatitsmanagershadknownaboutthisandothervulnerabilitiesbeforeitsSeptember16break-the-buckannouncement.today,giventhisevent,moneymarketsecuritiesarenolongerconsideredasgoodascash.

Receivables

Receivablesandpayablesarerecordedinitiallyatfairvalue.37Subse-quentmeasurementisstatedatamortizedcost.38Inmostcases,tradereceivablesandtradepayablescanbestatedattheamountexpectedtobereceivedorpaid,butpayableswithlongcreditperiodsshouldbediscounted.39Ifareceivableisdelayed,itscarryingamountiswrittendowntoitsrecoverableamount,whichisthehigherofvalueinuseanditsfairvalue,lesscoststosell).Valueinuseisthepresentvalueofcashflowsexpectedtobederivedfromthereceivable.forty

Investments—DebtandEquitySecurities

Companiesandfundsinvestindebtandequitysecuritiesandmustreporton the value of these investments, and reporting turns into difficultwhenmarketschange.(ForadiscussionbyNorgesBank,see“NorgesBankonValuationofBankInvestments.”)ThedefinitionoffinancialinstrumentunderIAS39encompassesinvestmentsinbothequityanddebt contraptions, aswell asloans andreceivables. ASC320 (SFAS115)alsodealswithinvestmentsindebtandequitysecurities,classifiedinthesamewayasIAS39exceptthatitputsloansandreceivablesina separate trendy.forty one

Investments—EquityMethodandJointVentures

Underproportionateconsolidation,thebalancesheetoftheventurerincludesitsshareoftheassetsthatitcontrolsjointlyanditsshareoftheliabilitiesforwhichitisjointlyresponsible.Theincomestatementof

 

NorgesBankonValuationofBankInvestments

Thefollowingisthefootnoteexplanationforthecarryingvaluesofassetswithoutaclearmarketvalueduringthefinancialturmoilof2008:

Equityinvestmentsareconsideredrelativelyeasytovalue,asthereareofficialandobservablemarketpricesbasedonanactivetransactionmarketforalmostallpositionsintheport-folio.Whenitcomestoholdingsofbonds,thepriceuncertainty picture is rather more complex.The pricing of governmentbondsandliquidgovernment-guaranteedbondsisbasedonobservablemarketpricesinanactivemarketwithquotesandfrequenttransactions.Corporatebonds,coveredbondsandsomegovernment-guaranteedandgovernment-relatedbonds,but,arepricedusingmodelswithobservabledatapoints.Exposureisconsideredparticularlyuncertainintermsofpricingtotaled74.2billionNorwegiankroners[NOK]attheendoftheyear.Thisconsistedalmostexclusivelyofasset-backedsecurities no longer guaranteedbyU.S. federalagenciessuchasFannieMae,FreddieMacandGinnieMae.Thisrep-resentedadecreaseinexposureofNOK29.1billionsincetheendof2007,whentherewasexposureofNOK92.5billiontoasset-backedsecuritiesandNOK10.8billiontostructuredinvestmentvehicles(SIVs).Thedecreasewasdueprimarilytofallingpricesforasset-backedsecurities,butalsotoinstrumentsmaturingandrepaymentsofprincipal.WhenitcomestotheremainingexposuretoSIVs,onlyexposureofNOK0.4billionwasconsideredparticularlydifficulttopriceattheendof2008.AnadditionalNOK2.1billionofSIVexposurewasreclassifiedintothecategoryformodelpricingwithobservabledatapoints.

TheremainderofthedecreaseinexposuretoSIVsin2008wasdueprimarilyto repayments onmaturity.

Followinganumberofanalysesanddiscussionswithvari-ousplayersinthemarket(priceproviders,brokersandexter-nalmanagers),simplevaluationmethodshavebeendevelopedtotakeaccountofthisadditionaluncertainty.Thesemethodsmeanthatthevalueofsometypesofinstrumenthasbeenadjusteddownwardsbymeansofaliquiditydeductionfrom

 

 

theventurerincludesitsshareoftheincomeandexpensesofthejointlycontrolledentity.42

Investments—different

Fornoncontrollinginvestments(of20percentorless),thecostmethodisused.Thatis,thevalueoftheassetiswrittenasthepurchaseprice(costmethod).

stock

ThevalueofinventoryiscoveredinIAS2(seeAppendixC).Invento-riesinclude:

➤Assetsheldforsaleintheordinarycourseofbusiness(finishedgoods).

➤Assetsintheproductionprocessforsaleintheordinarycourseof

enterprise(workinprocess).

➤materials and elements which might be consumed in production (raw materials).

however,IAS2doesnotinclude:

➤Workin manner springing up underneath creation contracts (coveredunderIAS11,ConstructionContracts).

 

➤monetary   devices   (blanketed   under    IAS 39,FinancialInstruments).

➤Biologicalassetsrelatedtoagriculturalactivityandagriculturalpro-duceatthepointofharvest(coveredunderIAS41,Agriculture).

DeferredCostsandOtherAssets

Deferredacquisitioncostsareatypeofdeferredassetcommoninanindustrythathaslargeup-frontcostsinobtainingnewbusiness,suchasinsurance.IAS39allowsacompanytodeferthecostofacquiringanewcustomeroverthedurationoftheinsurancecontract.Itallowsonlydirect,incrementalcoststobedeferredratherthanallacquisitioncosts.Thedeferredcostisconsideredanasset.

Intangibles—GoodwillandOther

Anintangibleasset(coveredunderIAS38.12)isidentifiablewhenit:

➤Isseparable(capableofbeingseparatedandsold,transferred, certified,rented,orexchanged,eitherindividuallyoraspartofa package);or

➤Arisesfromcontractualorotherlegalrights,regardlessofwhether

thoserightsaretransferableorseparablefromtheentityorfromotherrightsandobligations.

Examplesofintangibleassetsarecomputersoftware,patents,reproduction-rights,motionpicturefilms,customerlists,mortgageservicingrights(ofquestionablevaluein2009),licenses,importquotas,franchises,cus-tomerandsupplierrelationships,andmarketingrights.

belongings,Plant,andEquipment

Theseassets(coveredunderIAS16)areacquiredforuseinnormalbusi-nessoperations,arelong-terminnature,andpossessphysicalsubstance.

TheSykesModel

TheauthorsmetwithAllenSykesinLondonforanextendedconversa- tionaboutvaluation.Hiswisdomextendsbroadlythroughoutthisbook.

 

Exhibit2.1ClassicEconomicValuationTheory

 

 

Butthegreattreasurefromthemeetingwasasimplechartonthreemeth-odsforvaluation(seeExhibit2.1).Itshowedthattherearethreemainwaystovalueanasset:

1. Calculatethepresentvalueofitsfutureeconomicbenefits.

2. Calculatethecost(andinconvenience)ofreplacingit.

three. Calculatethenetresalevalue(proceedslesscostsofdisposing).

IntheexampleshowninExhibit2.1,netpresentvaluehasthehighestvalueonday1butquicklydeclinesovertimeastheassetdepreciates.Replacementcostalsodeclines,butnotassteeply.Theflattestcurvecomeswithresalevalue.Astimegoeson,themostadvan-tageousstrategyforourinvestorchanges.Atfirst,thehighestvalueisnetpresentvalue,however,attheendofthe line, replacementvalueisthehighest.

BeyondAssets:CluesfromLiabilitiesandEquityontheBalanceSheet

Tothispointinthischapter,wehavebeenfocusingontheleftsideofthebalancesheet—belongings.Everythingreportedmusthaveacorre-spondingentryontheotherside,eitherasaliabilityorasequity.

 

Exhibit2.2DisplayofEquityInstrumentsThatMayBeSettledwithCashorOtherAssets

Period1 Period2

Totalassets $1,300 $1,six hundred

Totalliabilities $    450 $    450

equity

Mandatorilyredeemablebasicownershipinterests $    2 hundred $    two hundred

Cumulativechangeincurrentredemptionamount — $ 50

Redeemableequity $    two hundred $    250

Nonredeemablebasicownershipinterests $  500 $    500

Retainedearningsa $    one hundred fifty $    four hundred

Nonredeemableequity $    650 $    900

— —

Totalliabilitiesandequity $1,300 $1,600

aRetainedearningsincreasedby$250,whichis$300innetincomelessthe$50changeinthecurrentredemptionamount.

source:“FinancialInstrumentswithCharacteristicsofEquity,”Novmeber2008.http://www

.fasb.org/draft/pv_liab_and_equity.pdf.

permit’srecaptheFASB-IASBdefinitions:

➤Anassetisa“presenteconomicresourcetowhichanentityhasapresentrightorotherprivilegedaccess.”43

➤Aliabilityofanentityisapresenteconomicobligationforwhich

theentityistheobligor.”forty four

➤Anequityis“theresidualinterestintheassetsoftheentityafterdeductingallitsliabilities.”forty five

TheFASBhasproducedsome60studiesonthisissueandhasrecentlyconsolidatedthoseviews.46Exhibit2.2presentsanexampleofhowequityshouldbebrokenout.Thisisadisplay,intheequitysectionofthestatementoffinancialposition,ofequityinstrumentsthatmaybesettledwithcashorotherassets.Theassumptionsareasfollows:

➤Mandatorilyredeemablebasicownershipinterestswereissuedat theendofperiod1atatransactionpriceof$two hundred(themarketpriceonthatdate).

 

➤Themandatorilyredeemablebasicownershipinterestsareredeem-ableatfairvalueontheredemptiondate.

➤Redemptionwillnotoccuruntilaftertheendofperiod2.

➤Theentity’snetincomeforperiod2was$three hundred.

➤Thefairvalueofthemandatorilyredeemablebasicownershipinterests(thecurrentredemptionamount)increasedby$50duringperiod2.

Althoughthischapterfocusesonassetsasreportedinthetraditionalbalancesheet,thereremain,of path,theequallyimportantandnec-essarytopicsofliabilitiesandequity.(ThosesubjectsaretreatedinChapter8andinAppendixF.)

TheRoleoftheAppraiserandAppraisal StandardsinValuingAssets

Anentireprofessionhasgrownuparoundtheappraisalofassets,especiallyassessingthevalueofcollateralforloans.Assetapprais-ersfollowUniformStandardsofProfessionalAppraisalPractice(USPAP),publishedbyanindependentAppraisalFoundationcom-posedofsome80appraisalorganizations.TheFinancialInstitu-tionsReformRecoveryandEnforcementActof1989(FIRREA),passedafterthesavingsandloanlendingcrisisinthe1980s,requiresUSPAPtobeusedintheappraisalofrealestateinfederallyrelatedtransactions.

Sohowisthisusefulinthevaluationofapubliclyheldcompany?incredibly,thestandardcanbeuseful.Take,forexample,thenotionofhighestandbestuseforanasset.TheUSPAPstandardsetsasavaluationstandardacertainlevelofuseforanasset:“Thereasonablyprobableandlegaluseofapropertythatisphysicallypossibleappropri-atelysupported,andfinanciallyfeasible,andthatresultsinthehighestvalue.”forty seven

Tobevaluedaccurately(listingthetestsinorder),theuseoftheassetmustbe:

➤Legallypermissible

➤Physicallypossible

 

➤Financiallyfeasible

➤Maximallyproductive

Thisdefinition,interpretedbroadly,couldwellbeappliedtothejobofthecorporateboardandmanagement,whichshouldinfactbelookingforthehighestandbestuseoftheassetsofthecorporationonbehalfofinvestors.Thevalueofthecompanycanbeseenastheamountofmoneyonewouldhavetospendtoreproducethesamecompanyfromscratch,andthatapproachassumesputtingassetstobestuse.

FairMarketValueTreatmentAssets

Oneveryimportantkindofassetfortheinvestortoanalyzeisthefinan-cialasset.Formanyyears,financialassetsandfinancialliabilitieswerecarriedoncompanybooksattheiroriginalvalueswhenbooked.Inrecentyears,therehasbeenamovementtoaccountforthemusingfair marketvalue.ThetwomainapplicablestandardsareASC820(SFAS157)and825–10(SFAS159).48

ASC,FairValueMeasurementsandDisclosurescoversanyfinan-

cialassetnotcoveredunder825–10,TheFairValueOptionforFinancialAssets andFinancialLiabilities(describedinthenextsection).TheASC820standardisparalleltothemorestringentoneinIAS39,FinancialInstruments:RecognitionandMeasurement.49

FairValueofAssetsUnderFASB(GAAP)and IASB(IFRS)

BothFASBandtheIASBhaveputforwardpronouncementsonthefairvalueofassets.

ASC820andASC825–10

TheFairValueMeasurementsstandardexplainshowacorporationshouldvaluefinancialassetsforwhichthereisnoclearmarket.Itsetsforthahierarchybasedonvaluationinputs,ratherthanmethods.Itgivesthehighestpriority(Level1)toquotedpricesinactivemarketsandthelowestpriority(Level3)towhatarecalled“unobservableinputs.”50

 

Level2inputsarebetweenthesetwolevelsandinclude,forexample, quotedpricesforsimilarassetsinanactivemarketoridenticalassetsinnonactivemarkets.fifty one

ThestandardforTheFairValueOptionforFinancialAssetsand

FinancialLiabilitieselaboratesonthisforthemostliquidfinancialassets.Itpermitscompaniestomeasurethefinancialassetsontheirbooks(cashandcash-likeinstruments)atfairvalue.Thestatementappliestomostrecognizedfinancialassetsandfinancialliabilities,withsomeexceptions.52Afinancialassetisdefinedas:

➤coins;

➤Evidenceofanownershipinterestinanentity;or

➤Acontractthatconveystooneentityarighttoreceivecashoranotherfinancialinstrumentfromasecondentityortoexchangeotherfinancialinstrumentsonpotentiallyfavorabletermswiththesecondentity.fifty three

Thisislikeastorywithinastory.Thevaluation-mindedinvestorlooksatacompanyandtriestovaluethatcompany’sequities.Theinvestorismentallysecuritizingtheassetsofthecompany.Conversely,though,whenlookingattheequitiesheldbythatcompany,theinvestordoesjusttheoppositementally.Theinvestordesecuritizestheequityinanefforttoseewhatassetsarereallybehindthepaper.

 

 

StandardIAS39andBeyond

TheIASBhasbeendevelopingguidanceonfairvalue,lookingforwardtoaglobalstandard.Inapreliminarypaper,IAASBChairSirDavidTweedienoted:

Theuseoffairvalueinfinancialreportingisofgreatinteresttopreparers,auditors,usersandregulators.Webelievethatanessentialground-clearingstepinthedebateistoestablishaclearinternationaldefinitionoffairvalueandaconsistentframeworkformeasuringit.[Emphasisadded.]

TheIASB,hesays,wantstocodify,clarify,andsimplifytheguidancethatisatpresentdispersedwidelyinIFRSs(includingIASsthathavenotbeenrepealed).55

Therearetwointernationalstandardsforfairvalue:IAS39andIFRS

7.Inearly2009,theIASBvotedtousetheexistingfairvaluehierarchyinIAS39,whichrepresentswhatsomeentitiesaredoinginpracticetocomplywithbothIAS39andIFRS7’sdisclosurerequirements.

ValuingIntangibleAssetsontheBalanceSheet

TheFASB has formedtheValuation aid Groupto deal with issuesrelatingtovaluationforfinancialreporting.ThegrouphasbeenmeetingperiodicallysinceOctober1,2007,todiscussavarietyofissuessurround-ingtheimplementationoffairvalueaccountingintheUnitedStatesandglobally.56

Theissuesdiscussedinmeetingsinclude:

➤Definitionofanactivemarket

➤Assetsandliabilitieswithoutmarkets

➤Definitionof“legallypermissible”

➤Valuationofintangibleassetsusing“currentreplacementcost”

➤Accountingforanassetthatanentitydoesnotintendtouseorintendstousedefensively—no longer“highestandbestuse”forvaluation

Mostintangibleassetshavetobeacquiredtoberecognized,althoughtheacquisitionneednotbeintheformofabusinesscombination.a few-timesintangibleassetsthatareacquiredindividuallyorwithagroupof

 

assetsinatransactionotherthanabusinesscombinationmaywinduponthebooks.57

ValuingIntangibleAssetsThatAreNotontheBalanceSheet

Asignificantpercentageofthevalueofsomecompaniesresidesinthebrandvalueofthenameofthecompanyoritsproducts(suchasanasso-ciatedcolor,sound,shape,ordesign,includinglogos).

In2002,theFASBbeganaprojecttovalueintangibles“toestablishstandardsthatwillimprovedisclosureofinformationaboutintangibleassetsthatarenotrecognizedinfinancialstatements.”Theprojectwasgoingtoconsiderassetsthataredevelopedinternally(suchasbrandnamesandcustomerrelationships),aswellasthosethatareacquiredandwrittenoffimmediately(acquiredin-processresearchanddevelopment).InJanuary2004,theFASBremovedthisprojectfromitsagenda,appar-entlyfrustratedbytheclassicchallengeofreconcilinghighrelevanceandlowreliability.

AboutBrands

Theterm“emblem”hasnoaccountingorlegaldefinition.rather,abrand

ismadeupofmanycomponents,such as:

➤call(protectedbyservicemark)

➤logo(protectedbytrademark)

➤Designandcolor,shape,sound,andotherattributes(protectedbydesignright)

➤Tradesecrets,suchasarecipe(protectedbycontractlaw,not unusual

regulation,andcodesofpractice)

Thevalueofthebrandorcomponentsisusuallyhigherthanthebookedvalueofthelegalinstrumentprotectingthebrand(e.g.,trademark).GAAPsetsstandardsforwhenanintangibleassetsshouldbeseparatelymeasuredandwhentheyshouldberecognizedasagroup.58

Specifically,atthedateofacquisition,theacquirermustallocatethecostofthebusinesscombinationbyrecognizingtheacquiredcompany’sidentifiableassets,liabilities,andcontingentliabilitiesattheirfairmarketvalue.Thisrequiresthedisclosureofspecificcategoriesofintangible

 

assetsthatareseparatelyidentifiableassourcesoffutureeconomicbenefitsthatcanbereliablymeasured.Assetsmaybeartistic,marketingrelated,customerrelated,contractbased,ortechnologybased.fifty nine

ThejournalBrandFinanceconductedaGlobalIntangiblesStudyofallcompaniesquotedontheworld’smajorstockmarkets.60Thestudyshowedthatonaveragealmost70percentoftotalenterprisevalue(asreflectedinthecompany’smarketvalue)wasrepresentedbyunreportedintangibleassets.Theproportionofintangibleassetvaluevariedfromsectortosector.Over90percentofglobaltechnologycompanyvalua-tionswereintangible,andmostsectorsdisplayedintangiblevaluesinexcessof 50percentofenterprisevalue.Thedominantintangibleassetclass additionally variesfromindustrytoindustry.Thefollowingisa listfromBrandFinance:

➤Consumergoods—brandtrademarks

➤Filmindustry—creativecopyrights

➤ITindustry—softwareintellectualpropertyrights

➤prescribed drugs—molecularpatents

Valuingthebrandnameforacompanyorproductmeansassessingtherevenue-generatingabilityofthesenames.

Agoodbrandnameaffectscashflowbyincreasingsalesvolume.Itcompelsmoreconsumerstobuythebrandeditemsandtopayahigherpriceperitem.(Thesamemultipliereffectappliestothevolumeandpriceofthecompany’ssecurities.certainly,certainblue-chipstockshaveabrandappealamonginvestorsthatisinadditiontothebrandappealthattheircompanies’productsmayhave.)Astrongbrandcanalsocreatenewsourcesofrevenuesifthecompanyextendsthebrandtonewitemsorlicensesit.

Insendingoutstockofferingprospectusestothegeneral,companieshavetodiscloserisks.Onecommonlydisclosedriskisthatthecompany’snamebrand,orthebrandsthecompanyowns,maybecomeimpaired.AsSanWestInc.notedinitsJune2010prospectus,

Promotionandenhancementofouronlinestorewillalsodependonoursuccessinconsistentlyprovidinghigh-qualityproductstoourcustomers.Sincewerelyonsupplierstodirectlyshipprod-uctspurchasedto  ourcustomers,ifoursuppliersdonotship

 

speedy,orifourconsumersdonotperceivetheproductsweofferassuperior,thevalueoftheourSanWestbrandcouldbe harmed.Anybrand impairment or dilution may want to decreasetheattractivenessofSanWesttooneormoreofthesegroups,which couldharmourbusiness, resultsofoperations andfinancialcondition.sixty one

CaseLesson:BeSuretheCompanyOwnstheBrand

WhenVWboughtRollsRoyceMotorCarsfromVickers in1998,itpaid

£493millionforthebusiness—threetimesthe agency’sbookvalue.Soitbookedtwo-thirdsofthesumasgoodwill(thedifferencebetweenacquisitionpurchasepriceandbookvalue).Butitturnsoutthatanothercompany,RollsRoycePLC,ownedthetrademarksandsoldthemtoanotherautomobilecompany(BMW)foramere$40million.

Atthispoint,thevaluehunterneedstoaddanotherelementtotheequationfor determiningthetruevalue ofall property:management.Forabrandtohavevalue,itneedstobeprotectedandmined.Thisrequiresstrongmanagementofintellectualproperty.

CaseLesson:AnticipateWrite-OffsforGoodwill

companies bring goodwill on their books as an asset. It used to be amor-tizedovertime,butnowunderASC350(SFAS142)itiscarriedatfullvalue.now and again,followinganacquisition,thecarriedgoodwillamountroughlyequalsthevalueofthecompany’sbrands(totheextentthattheabove-bookpremiumpaidbytheacquirerispaidinrecognitionofthevalueofthebrand.Butdependingonhowwellanacquirermanagesbrandsafteradeal,thevalueofthebrandscanerodeandthegoodwillcanlosevalue.

UnderGAAPandIASstandards,acquirersmustestimatetheusefullifeofalltangibleassets.Ifnolifespanisgiven,theownermustputtheasset throughan annualimpairment text. Ifa brandlosesvalue after amerger,thismaytriggerawrite-off.

Astraightforward description of this processappearsinarecentproxy,specificallyinmanagement’sdiscussionandanalysisoffinancialconditionandresultsofoperationsMD&A)ofAmericanSuperconductorCorp.sixty two

Goodwill.Goodwillrepresentstheexcessofcostovernetassets ofacquiredbusinessesthatareconsolidated.Inaccordancewith

 

[ASC350]SFAS142,“GoodwillandOtherIntangibleAssets,”goodwillisnotamortized.Inlieuofamortization,weperformanimpairmentreviewofourgoodwillatleastannuallyorwheneventsandchangesincircumstancesindicatetheneedforsuchadetailedimpairmentanalysis.Goodwillisconsideredimpairedwhenthecarryingvalueofareportingunitexceedsitsestimatedfairvalue.Inassessingtherecoverabilityofgoodwill,wemakeassumptionsregardingestimatedfuturecashflowsandotherfactorstodeterminethefairvalueofthereportingunit.Todate,wehavedeterminedthatgoodwillisnotimpaired,butwecouldinthefuturedeterminethatgoodwillisimpaired,whichwould resultinachargetoearnings.

ThisapproachisconsistentwithIFRS3,issuedbytheIASB.Com-paniesmayelecttoapplyIFRS3fromanychosendate,buttheymustapplyitconsistentlytoallbusinesscombinationsafterthatdate.IAS36,ImpairmentofAssets,andIAS38,IntangibleAssets,mustbothbeappliedfromthesamedateasIFRS3.Theadoptionprocessmust,ofcourse,beaudited.

ThemostfamousexampleofbrandimpairmentwasQuakerOatsCompany’sSnapple.In1993,Quakerpaid$1.7billionfortheSnapplebrand.Overthenextfouryears,thebrandlostvalue.In1997,QuakersoldSnappletoTriarcBeveragefor$300million,andthenthebrandgainedvalue.In2000,TriarcsoldthebrandtoCadburySchweppes for

$1billion.

Impairmentschargescanoccurforavarietyofreasons.ObservershavecitedbrandimpairmentasalikelyoutcomeoftheBPoilspillin

Butbrandimpairmentcancomefromlesscatastrophicevents,asthe followingexamples show:

➤Gannettreportedanimpairmentchargeof $72.0million(pretax)in2007toreducethevalueofcertainmastheads“duetothecur-rentbusinessenvironmentandexpectedoperatingresultsforsomerecentacquisitionsintheU.S.andintheUK.”

➤AmericanItalianPastareportedimpairmentof$89.2millionfor

2005,notingthat“inthecourseofcompletingitsfinancialstate-mentsforitsfiscalyearendingSeptember30,2005,thecompanyperformed its annualimpairmentanalysis of itsbrands as ofthe fourth

 

quarteroffiscal2005.Thereviewshowedthatsomeofthecompany’spastabrandscontinuedtoexperiencedeclinesinsalesvolumeand relatedrevenuesresultingincorrespondingdeclinesinmarketshareandprofitability,andoperatingtrendsandtheforecastedfutureperformanceforthesebrandsdifferedsignificantlyfromcompany’searlierexpectations.”

➤BritishAmericanTobacco(BAT)reportedbrandimpairmentin

2005of£49million(netoftax)“followingtheimplementationofareviewofbrandstrategiesresultingfromthecombinationofR.J.ReynoldsandBrown&Williamson.”64BAT,apubliccompany,soldtheAmericanpartofitsBrown&WilliamsonsubsidiarytoR.J.Reynolds,whichatthistimeisprivatelyowned(followingavariedownershiphistory).

UsingtheMD&AforInsightsonAssets

Astheseexamplesshow,brandsareassetsofgreatvalue,eventhoughtheyarenotona balancesheet.happily,companiesarenotlimitedtostan-dardaccountingreportsincommunicatingtoinvestors.Manycompaniesgobeyondtheserequirements,andinvestorsneedtobeattunedtotheseimportantmessages.Forexample,management’sdiscussionandanalysisoffinancialconditionsandresultsofoperationsintheproxystatementoftencontainsausefuldescriptionofthecompany’smainassetsandtheriskstothem.Althoughthereisnoabsoluterequirementtolistkeyassets,manycompanies do—particularlycompanies inthe miningor explorationindustries,whichlisttheirdrillingsites.Inassessingacompany’svalue,investorsneedtobeonthelookoutfortheseobviousMD&Aclues.

Hereisanexamplefromthe2008annualreportofFortsum:

Keyassets

• Acriticalmassofmorethan24,000clients,primarilyinQuébecwithothersspreadacrossCanada;

• Ateamofaccomplishedprofessionals;

• ThestrategicpositioningofAcombaintheQuébecmarketplace;

• Anunparalleledstructureofhighlyefficienttechnicalsupportandbusinessofficehelpdesks;

• Multi-platformaccountingtechnologyandexpertiseinsecureandautomateddatatransmission;

 

• ExistingpartnershipswithMicrosoft,SageAccpacandSAPBusinessOne;

• validated understanding with most important industry partners, governmentagenciesandaccountingfirms.sixty five

NotethattheMD&Ausestheterm“property”todescribetheseele-ments,eventhoughtheydonotappearonabalancesheet.Accordingtotheaccountingconceptofmoneymeasurement,anassetneedstobeexpressedincurrency(money)toberecorded.Thisshouldbenoproblem.66Professionalappraiserscanputadollarvalueonanyassets.(SeeAppendix Gfortheground rules theyuse.)Theproblemisnotsomuchthemoneymeasurementconceptasthetotalityofalltheconceptsandconventionsofaccountingthatfavoratangibles-orientedapproachtovalue.67Thepointisthat,invaluingacompany,theasset-mindedinvestorcanidentifyandvalueallassets,includingassetslikethese.

ImprovementsinFairValueDisclosures: AChecklistforInvestors

Amongacompany’smanyassets,securitiesheldforinvestmentrankhighinimportance,butascertainingtheirvalueisnotalwayseasy.MD&Asalsoincludeassessmentsofsecurities’fairvalue.TheSEChasissuedguidancetocompaniesinaseriesof“DearCFO”letters.68Amongothertips,theguidanceurgescompaniesto:

➤Provideasensitivityanalysisforhowtheirvaluationsmay range.69

➤Explaintheiralternativevaluationtechniquesforsecurities.70

➤Givemoredetailonthecollateralunderlyingmortgage-backedsecurities,collateralizeddebtobligations,collateralizedloanobli-gations,andthelike.

➤disclose(withnumbers)theeffectsofthecompany’sowncredit

riskand  counterpartycreditrisk—e.g.,effectsofcreditriskonderivatives’fairvalue.71

➤Disclosemoreabouthowilliquiditywastakenintoaccount.

Asthislevelofdisclosuredetailbecomesmorecommon,itwillbecomeeasierforinvestorstoassessthevalueofthesecuritiesonthebalancesheetsofcompaniestheyhavechosenasinvestmenttargets.

 

Asset-BasedValuationbyIndustry

Takenbyitself,abalancesheetdoesnotcontainalotofusefulinforma-tion.Comparedtomanyotherbalancesheetsinitsindustry,however,itcanprovidealotofinformation.Thevalue-mindedinvestoranalyzesfinancialstatementsdifferently,basedonthecompany’sindustry.

Ageneralsenseofindustryorientationcanhelpintheassessmentofanycompany.TheGlobalIndustryClassificationStandard(GICS)recognizestenbasicindustrygroups.72Ofthese,themostassetinten-siveareenergy,substances,industrials,consumerdiscretionary(e.g.,cars),andconsumerstaples(e.g.,consumergoodsretail).Theremainingindustries(healthcare,financials,informationtechnology,telecommunicationservices,andutilities)derivemorevaluefromservicesand/orideas;sotheyarelessdependentonassetvalues.(ForalistofGICClassifications,seeAppendixH.)

Oneresearchorganization(ICONGroupInternational)preparesverticalanalysesbypoolingstatisticsontensofthousandsofcompaniesacrossmorethanfortycountriesandappliesaseven-stagemethodology:

(1)identificationofindustryclassifications,(2)firm-leveldatacollectionandaggregation,(three)standardizationofrawstatistics,(4)filteringout-liers,(five)calculationofglobalnorms,(6)projectionofdeviationsandgaps,and(7)projectionofranksandpercentiles.Sofar,theprojecthasfocusedonchemicalcompanies,buttheapproachcanbeusedinothersectors.Withsuchareadysourceavailable,itmaynotmakesenseforinvestorstoconducttheirownresearch.

Valuationprecisionimprovesasanalysisbecomesmorespecialized,focusing,forexample,notjustonmaterials(overlybroad)butonchemi-cals,orevenmorenarrowlyonfertilizersandagriculturalchemicals.Theinvestorwishingtoanalyzethevalueofanagriculturalchemicalscompany,suchasArcherDanielsMidlandorBungeLimited,wouldreadwithinterestananalystreportthatpredictsariseinthepriceofagriculturalchemicals.Solet’stakeaquicklookatasset-basedvalua-tionsinafewindustries,startingwithchemicals.

chemicals

Thedemandforvarioustypesofchemicalsdependsoneconomiccon-ditions.consequently,thevaluationofchemicalscompaniesvariesgreatly.Asoflate2009,forexample,therewasstrongdemandfromtheU.S.

 

agriculturalsectorbutweakdemandfromtheconstructionandindustrysectors—offsetbysomedemandoverseas.73Companieswithavarietyofchemicalsdobetterinsuchanenvironmentthanthosewithasinglechemicalproductthatisalignedwithaweakeconomicsector.Agoodexampleofarecession-proofchemicalcompanyisDupont,whichoper-atesinanumberofareas,includingagriculture,biology,chemistry,industrialbiotechnology,materialsscience,andmanufacturing.Inter-estingly,although,therelativelystrongperformanceofDupontstockcanbeattributedinparttostrongmanagementatthecompany,ratherthanmerelytoitsproductportfoliostrategy.SeeChapter7forourobserva-tionsonmanagementasafactorinequityvaluation.

preferably,aninvestorshouldcompareachemicalcompany’sbalancesheetstructurewithglobalbenchmarks.Doesthecompanyholdmorecashandshort-termassets,ordoesitconcentrateitsassetsinphysicalplantandequipment?Doesithaveahigherpercentageofpayablescomparedtothebenchmarks?Doesitholdahigherconcen-trationoflong-termdebt?Doesithavearelativelyhighercostofgoodssold,operatingcosts,incometaxes,orprofitmarginscomparedtoglobalbenchmarks?luckily,thereisaresourceforthislevelofstudy,aseriesofreportsfromaprofessoratINSEAD.74

 

power(OilandGasExplorationandProduction)Companiesinvolvedinoilandgasexplorationandproduction(E&P)offerasolidinvestmentopportunityforinvestorsdrawntothesecurityofcommodities.AsnotedbyJPMorganChaseanalysts,E&Pstocksrepre-

senta“pureplay”investmentonoilandgasprices.75Such“resourceplayproducers”havevaluerootedintangibleassets.AstheJPMorganstudynotes,muchasfallinginterestratespushupthevalueoflong-duration

 

bonds,risingcommoditypricesandlowerdiscountrateshavedrivenupthevalueoflong-livedunconventionalassets.

Inoilandgascompanies,cashflowisbasedonanasset:provenreserves.TheSECrequiresE&Pproducerstoprovideastandardizedmeasureofdiscountedfuturenetcashflows,knownastheSECPV-10calculation,orPV-10forshort.AstheJPMorganstudynotes,thecalculationmeasuresthepresentvalueofestimatedfuturecashflows(revenueslessdevelopmentcosts,productioncosts,andtaxes)fromthecompaniesprovedreserves,discountedat10percent.

TheJPMorganstudynotesthat“[t]hePV-10calculationissomewhatsubjectiveinthatcompaniesprovidetheirownassumptionsregardingfuturedevelopmentcosts,futureproductioncosts,howfasttheproduc-tionbaseisdeclining,andothervariables.furthermore,companiesmusttakewhatevertheprevailingcommoditypricesandcostswereattheendofareportingperiodandassumetheselevelsareheldcon-stantthroughoutthelifeofthereserves.Thisvariabilityleadstosignifi-cantvolatilityinthePV-10calculationfromoneyeartoanothersimplybecauseoffluctuatingcommodityprices.ThePV-10valueisoftenreferredtoasthe‘liquidationvalue,’”anditcanbemoresignificantthanearningsinthetypicalE&P.(FormoreonE&PValuation,seeChapters3and6.)

 

Banks

Thehotissuenowforbankvaluationpertainstoassets,specificallyloanlossreserves.ThisisakeyissueinSECcasesintheaftermathofthe2008–2009financialmeltdownsinthemortgagebankingsector.76

Moregenerally,inassessingthebalancesheetofanybank,thevaluation-mindedinvestorcanbenefitfromusingsomeofthestresstesttechniquesfromtheU.S.FederalResourceBoard’sSupervisoryCapitalAssessmentProgram(SCAP),atestadministeredto19major

 

bankholdingcompanies(BHCs).Thefocuswouldbeontheallowanceforloanandleaselosses(ALLL),whichappearsonthebalancesheet.77Inawhat-ifexercise,theBHCshadtoestimatetheirpotentiallosses

onloans,securities,andtradingpositions,aswellaspreprovisionnetrevenue(PPNR)andtheresourcesavailablefromtheALLLundertwoalternativemacroeconomicscenarios.Eachparticipatingfirmhadtoprojectpotentiallossesonitsloan,funding,andtradingsecuritiesportfolios,includingoff-balance-sheetcommitmentsandcontingentliabilitiesandexposuresoverthetwo-yearhorizonbeginningwithyear-end2008financialstatementdata.

Firmsusedacommonsetof indicative lossrateranges(providedbytheFederalReserveBoard[FRB])forspecificloancategoriesundercon-ditionsofthebaselineandthemoreadverseeconomicscenarios.(Firmscoulddivergefromtheindicativelossrateswhentheycouldshowthatotherswereappropriate.)Inaddition,thelargestfirmshadtoestimatepotentialtrading-relatedmarketandcounterpartycreditlossesunderaprovidedmarketstressscenario(whichwassimulatedandbasedonmar-ketshocks thatoccurredinthe second halfof 2008).Thetest askedthebankstoprojecttheresourcestheywouldhaveavailabletoabsorblossesoverthetwo-yearhorizonundereachscenario.Theseresourcescon-sistofPPNR—netinterestincome,expenses,andothernoninterestincome,internet ofnoncredit-relatedexpenses—andreserves alreadyestablishedforprobableincurredlossesatDecember31,2008.PPNRandtheALLL,combinedwithexistingcapitalovertheamountsufficienttoexceedmini-mumregulatorycapitalstandards,areresourcesthatthefirmwouldhaveavailabletoabsorbsomeoftheirestimatedlossesunderthescenarios.78

 

coverage

InMay2008,the FASBissuedanewruleonAccountingforFinan-cialGuaranteeInsuranceContracts.Statement163requiresthat

 

aninsuranceenterpriserecognizeaclaimliabilitypriortoadefault(insuredevent)whenthereisevidencethatcreditdeteriorationhasoccurredinaninsuredfinancialobligation.Italsorequiresthattheinsurerdisclosewhatitisdoingtoforeseesuchanevent,includingitsrisk-managementactivitiesandany“watchlist”itmayhave.

 

SpecialTopicsinAssetValuations:ValuingAssetsin Pension Plans

Valuation-mindinvestorslookingforassetvaluesneedtounderstandsomefundamentalfactsaboutpensionplans.RobertA.G.clergymen,coau-thorofthisbook,servedasfoundingtrusteeoftheFederalEmployees’RetirementSystembyappointmentofPresidentRonaldReagan,andasadministratoroftheOfficeofPensionandWelfareBenefitsAdministra-tion,DepartmentofLabor,inchargeoftheprivatepensionsystemintheUnitedStates.80

Retirementplanssetupbycompaniesareusuallydefinedbenefitplansordefinedcontributionsplans.

Adefinedbenefitplangivesfixedmonthlyretirementbenefitsstart-

ingatretirementage(e.g.,age65).Benefitsarebasedonaformulareflectingaparticipant’stotalcompensationandyearsemployed.Thecompany’scontributiontotheplanistheamountactuariallyrequiredtofundexpectedplanbenefits. Theseamountsarecarriedonthe com-pany’s books as liabilities,andthe assetsofthe plansthemselvesarecarriedasassets.Whenassetsexceedliabilities,plansarefunded.Whentheyfallbelowliabilities,theyareunderfundedorunfunded.

A defined contribution plan contributes fixed monthly amounts into

aretirementaccountstartingfromthedateofemployeeeligibility.Thecompanydoesnotguaranteeany particularendingvalueforthe