Money and finances

Effects of the Business Cycle on Perceptions

What we think is important varies with our personal circumstances and the stage of the business cycle. If you talked to people three years ago – when the stock market was booming and everybody was raising money to buy dot-coms that were going to be our saviors and that were going to change everything we do in a spirit of euphoria and optimism and hope – then many would have given very different ideas about the importance of finance. Capital markets were then critical for raising money for junior companies, and transforming the economy.

However, we are now living with the implications of the excesses of the 1990s. As people have seen their personal portfolios dwindle over the last two years, they are more pessimistic about what is actually going on in equity markets. Three years ago, probably most finance people would have said that markets are efficient, period. I think what we can say now is that bond markets are efficient. We have a good handle on pricing bonds. We have a good handle on pricing derivatives. But we don’t have a good handle on pricing equities. Not only do we not have a good handle on pricing equities, but the information we use coming out of the financial statements is unreliable – it is clear that there was a lot more fraudulent activity going on and misrepresentation of data than most people expected.

This is why standard financial analysis is critically important – which is what people have forgotten. They got used to taking financial statements at face value. Enron demonstrated vividly just how far away from reality those financial statements could be, as did WorldCom. Further, they got used to letting financial analysts do their thinking for them and got a rude awakening when they realized, after the fact, that many analysts fudged their reports to generate investment banking fees and, between peers, admitted their reports were junk. In such an environment a return to the basics of due diligence and financial analysis and an understanding of stock prices in terms of the earning power of the company, rather than one-time-only financial gimmickry and stories, are the order of the day.

Many of these remarks simply reflect the impact of the recession. Whenever the economy slows, the stock market crashes, and investors get burned, we see a similar reaction. It happened in the early 1990s and early 1980s and the early 1970s, and it will happen again in about another ten years. Much of the learning, of what we think we know and what we don’t know, depends on the general state of the economy and the capital markets. Before the next crash, we will have a recovery and boom, and most of the hard learned lessons will be forgotten as they invariably are. A new set of investors will again believe financial statements and financial analysts and that the good times will continue forever, but history and common sense indicate this will not happen.

Mergers and Acquisitions

The basic message in mergers and acquisitions is that most M&A destroys value. We look at the data over and over again, and most acquisitions simply don’t pay off. Yet corporations still consistently make large-scale acquisitions. Trying to persuade senior executives not to pay 30 percent to 40 percent premiums to buy other companies is extremely difficult, but we know from all of the evidence gathered over the last 20 to 30 years that it is extremely difficult to generate enough extra profits out of the acquired company’s assets to pay for the 30 percent to 40 percent acquisition premium required to buy the company.

However, there are some rules about what types of acquisitions are more likely to make sense. Basically, big companies buying small companies in the same line of business, acting very quickly to remove unwanted senior management, integrating as quickly as possible, and creating teams to make sure the acquisition strategy still makes sense after the purchase is made – these things are key for successful acquisitions. Generally they are the rules for industry roll-ups or consolidations within the same business.

That type of successful M&A generally has a small immediate impact on the firm, since it is generally part of an ongoing strategy. The type of M&A that generally doesn’t make sense is the “one-off” blockbuster deal between dissimilar companies made in the name of synergy, that somehow one plus one equals three. In these cases, cultural differences make it difficult to integrate the two companies; there are often management succession problems, and the synergies usually fail to materialize. Yet it is these blockbuster deals that grab the headlines, since they offer a chief executive officer the chance of turning a moribund company around. What were the supposed synergies between a Marathon Oil and a US Steel or an AOL and a Time-Warner?

The fact is that to justify a 30 percent to 40 percent takeover premium, the profitability of the target’s assets has to increase significantly, ceteris paribus, by 30 percent to 40 percent, just to break even. In a roll up this can be achieved simply by removing the fixed costs of the target and consolidating production, although in two equally sized but disparate businesses, this is not possible. However, persuading a senior executive that an acquisition doesn’t make sense is difficult, particularly when everyone else involved, from the lawyers to the investment bankers, has a vested interest in generating fees from cutting a deal!

Financial Analysis and Forecasting

The most important type of financial analysis is basic ratio analysis. Every financial executive has to have a very good understanding of accounting. This is where some academic finance programs have fallen down: Collectively we have de-emphasized accounting and have emphasized economics. As Enron has reminded us, financial executives and financial academics have to have a very good understanding of accounting, both for corporate finance and for what is needed in value equity shares. The most important aspects of security analysis and of corporate finance are to understand financial analysis, which is to go through the basic Dupont formulas to understand where the profitability of a firm comes from, and then further to read the notes to the financial statements.

Generally, there is too much functional fixation on earnings per share, and not enough time is spent reading the notes to the financial statements to understand the quality of the underlying information that goes into the earnings per share calculation. Financial analysis is overwhelmingly the most important thing – apart from the time value of money – that people get out of a finance course. Financial analysis is what finance professionals need to know. Unfortunately, it is not being emphasized as much it should be in most finance textbooks.

It is critically important to be able to read a set of financial statements and realize that the earnings per share have increased simply because the company triggered the sale of an unwanted asset, rather than through increased sales; or that the sales themselves were made only through generous financing indicated by the increase in accounts receivable; or that the increased earnings per share only came about because the firm hid some expenses either through using executive stock options instead of bonuses as compensation or by stretching out depreciation schedules. WorldCom has alerted us all again that changing expenses into assets not only reduces expenses and thus increases earnings per share, but also increases the tangible asset value per share.

After financial analysis, you need to go through basic financial forecasting. Financial analysis tells us what has happened, but good financial forecasting can tip us off as to what might happen in the future. Here it is important to check cash flow from operations with net income to assess the quality of a firm’s financial statements. Profitability shortfalls that have been covered through triggering asset sales or stretching out depreciation schedules become apparent in a five-year forecast as the firm’s ability to generate cash flow dries up.

The great value of financial forecasting is in the ability to build a spreadsheet model and do “what if” analysis. We can do this in spreadsheets very easily. What tends to happen is that professionals vary the sales levels by plus or minus 2 or 3 percent. They change the cost of goods sold or the fixed cost and then assess the impact on cash flow and earnings. The hidden flaw in much of this analysis is a failure to understand the linkages between different spreadsheet variables. There is too much extrapolation, simply because spreadsheets allow you to extrapolate, and not enough smart modeling.

The key idea that has been rediscovered in finance is what is now called real options. The insights of Black and Scholes into pricing derivatives have been very important, but their insights have also reemphasized that in any spreadsheet, you can’t simply extrapolate numbers. You have to consider that if certain numbers change significantly – say, sales increase by 5 or 10 or 15 percent – then there may be other changes that are going on, as well. For example, the increase in sales may cause scale economies to lower unit costs or increase the gross margin. Similarly, if sales decline by 5 or 10 or 15 percent, the firm may change some of its actions and actually change the underlying cash flows. This is actually an old message in finance. We used to talk about it in terms of decision trees. For example, a price decline of 20 percent may cause the gross margin to turn negative, forcing the firm to close that line of business to avoid incurring more losses. Similarly, a price increase may cause the firm to switch production from one line to another. In either case, a simple extrapolation in a spreadsheet doesn’t fully capture the dynamism of the firm’s response to certain situations. The incorporation of the idea of real options into spreadsheet design offers the benefit of more accurate and realistic financial forecasting.

A few financial terms

Present value is the current value to an individual of the stream of cash flows generated by a particular security. It is essentially a personal value reflecting the time and risk value of money to an individual or corporation. When the resulting present value is estimated and compared to the cost of the security or investment, it determines whether the security of investment should be bought or sold.

Financial statements are balance sheets, income statements, and cash flow statements prepared by the firm to reflect its operations.

Return is the rate of return received on an asset – the percentage increase or decrease in value received from an investment. The risk of the investment is the uncertainty attached to receiving that rate of return; that is, risk is the probability of unfortunate events occurring so that you don’t earn the rate of return you expect.

Capital structure is the firm’s choice between debt and equity financing and its choice between short- versus long-term debt. It is the choice a firm makes in its long-term financing.

Dividend is the decision the firm makes on how much of its cash it retains within the firm to reinvest and how much it distributes to stockholders. The cash can either be distributed as a cash dividend or be used to repurchase the firm’s stock.

Mergers and acquisitions together are the decision a firm makes to either buy the assets owned by another corporation – which is an acquisition – or combine its operations with those of another firm – a merger. As well as referring to acquiring assets, M&A more generally refers to corporate restructuring, including the spinning off or sale of assets the firm no longer needs and changes in the form of corporate organization.

The Option Pricing Theory is the pricing of underlying securities where the payoff, or what you receive, depends upon certain events occurring. The classic example is a call option where you have the right, but not the obligation, to buy shares at a fixed “exercise” price. If the price goes above the exercise price, you buy; if it stays below it, you throw away your option. Option Pricing Theory received a huge boost when Fischer Black and Myron Scholes developed the Black-Scholes model to value options. The ideas have been extended to a whole series of other types of options.

International finance is the extension of standard finance problems to cover foreign securities or foreign corporations. For example, it is the implication of exchange rates for domestic corporations involved in the trade, purchase, and management of foreign assets; it is the acquisition and divestiture of foreign corporations; and the asset allocation decision as to what proportion of foreign securities to hold in a portfolio.

The simplest test of market efficiency is whether or not you can make money in the stock market by using simple decision rules and publicly available data. For example, believers in the “dogs of the Dow” theory trust that you can outperform the stock market by buying the ten stocks in the Dow with the largest dividend yields. Efficient market theory would argue that this cannot happen. There are more rigid interpretations of efficient markets, but the simplest one is: “Can you use publicly available information to outperform a simple buy-and-hold strategy of holding bonds and equities?”

Risk-return tradeoff is the pricing of risk in the capital market. We know equities are riskier than bonds, but how much extra can we expect to earn on equities given this riskiness? Historically the answer is about 5 percent, which is the standard estimate of the market risk premium.

Default risk is the risk of non-performance on financial contracts. This risk exists with any financial contract except those issued by the Federal government, which are termed default-free. Default risk is rated by the major credit rating agencies, such as Standard and Poors (S&P): AAA, the highest, down to D for in default. Professionals have to be able to understand the pricing of credit risk because so many contracts are not with AAA credits or with the government; they are with people where there is a risk of nonperformance. So credit risk, particularly at a stage when we have a slow economy recovering from recession, is a very important factor in most personal investment decisions.

A term of obvious importance is time value of money, which is the most basic concept in finance, but it consistently confuses people, even some in the finance business. The fact is that the value of a dollar in five years’ time is not equivalent to the value of a dollar today, since it is always possible to invest a dollar today to get more than a dollar in five years. Many misrepresentations are due to failing to understand or report fully the implications of the time value of money. For example, a few years back people were taken to court for misrepresenting the value of Florida land. The deal seemed excellent – you spent $10,000 for a piece of land in Florida, and also got a $10,000 bond backed by the U.S. government. This was marketed as a “risk-free” investment. What the ads forgot to mention was that the land was largely under water, and so essentially worthless, and the $10,000 bond didn’t pay off for 25 years. The present value of the bond was a few thousand dollars, so people paid $10,000 for something actually worth a few thousand dollars – in practice, just throwing $7,000 or $8,000 away. Tricks played with time value of money in terms of discounting are still the fundamentals of finance.