Archive for August, 2007

Tobin’s q

Tobin’s q is a valuation measure closely related to Price-to-book (P/B) and residual income models. It expresses the ratio between the market value of the firm (debt and equity) and the replacement value of its assets.

q = (MV Debt + MV Equity)/(Replacement cost of assets)

Although Tobin’s q is a similar concept to Price/Book, there are important differences. First, the numerator includes both debt and equity and thus measures the total firm value rather than the value of equity. For consistency, the denominator includes total assets rather than merely net assets. A further difference is that the assets are measured at current, rather than historic value.

A higher value for Tobin’s q indicates that assets are being used more effectively. In practice, it is difficult to measure Tobin’s q due to limited availability of information concerning replacement value of assets.

Posted on 31st August 2007
Under: Investing in Stocks, Valuation | No Comments »

Residual Income

Accounting-based income statements are prepared to reflect the earnings available to owners. As such, they deduct the cost of debt (interest expense). Dividends and opportunity costs for equity holders are not deducted. The concept of residual income is that a certain level of earnings is necessary merely to cover the cost of providing equity capital. Only earnings above this level (the residual) actually increase the value of the investment.

For example, consider a company with a book value of $1 million and earnings of $50,000. There are positive earnings, but are they sufficient for investors? If the required return on a similar equity investment is 10%, then earnings would have to be at least $100,000 to justify the risk. Otherwise the investor should find an alternative investment that can satisfy the return requirement.

Residual income, then, is the difference between accounting net income and the required income as calculated by multiplying book value per share by the required return on equity.

Posted on 30th August 2007
Under: Adjusting Reported Financial Statements, Investing in Stocks, Investment Returns, Valuation | No Comments »

Computing Free Cash Flow to Equity from Free Cash Flow to the Firm

Free cash flow to equity (FCFE) represents the cash flow a company generates after necessary expenses and expenditures and after satisfying the claims of debtholders. It can be calculated from Free cash flow to the firm (FCFF) as follows:

FCFE = FCFF – After-tax interest expense + Net borrowing.

If the company borrows more in a year than it repays it will have additional funds that could be distributed to shareholders, which is why net borrowing is added to FCFF in order to determine FCFE. Obviously, though, investors would want to consider whether continued borrowing to pay dividends is a sustainable practice.

Posted on 28th August 2007
Under: Accounting, Financial Statement Analysis, Fundamental Analysis, Investing in Stocks | No Comments »

Accounting for Debt Retirement

When a company retires debt prior to its scheduled maturity, the difference between the carrying amount and the amount repaid is considered a gain or loss from continuing operations. However, investors may want to consider the gain or loss separately.  The primary difference between carrying value and the amount repaid is likely due to shifts in market interest rates. If rates rise, the value of debt declines and companies could buy back their existing loans at less than face value. However, if they were to replace the loans with new debt they would have to pay the higher current market rate.

If the company is retiring debt and reissuing new debt, investors may want to ignore any resulting gains or losses because they do not reflect the underlying economic condition. At the same time, if new debt is not being issued then the gains or losses are unlikely to recur. Again, it may make sense to ignore the gain or loss for analysis purposes.

Posted on 27th August 2007
Under: Accounting, Financial Statement Analysis, Fundamental Analysis, Investing in bonds | No Comments »

The Sustainable Growth Rate

Although companies can grow at extremely rapid rates for some time, such growth cannot typically be sustained. Valuation methods such as the Gordon growth model and other discounted cash flow models require a growth estimate than can be sustained for many years – often it is assumed to be a perpetual growth rate.

If a company can earn a 15% return on equity (ROE), it can grow 15% simply be reinvesting earnings in new opportunities. In order to grow faster, the company would have to invest more capital than its own earnings by using debt or equity financing. If the company pays part of its earnings as dividends, it would have a lower potential growth rate without issuing new debt or equity.

Thus, the sustainable growth rate can be estimated as g = b x ROE, where b is the percentage of earnings retained (not paid out as dividends.)

Posted on 26th August 2007
Under: Financial Statement Analysis, Fundamental Analysis, Investing in Stocks, Investment Returns, Valuation | 2 Comments »

Translating Foreign Subsidiary Balance Sheet – Illustrating the Temporal Method

Unlike the all-current method, the temporal method requires that most assets and liabilities be valued using the exchange rate in effect at the time the asset or liability was created. Only those assets and liabilities with fixed foreign currency values (monetary assets and liabilities) are translated at the current exchange rate.

Consider a business that starts a foreign subsidiary on July 30 with the following assets, liabilities and equity:


At the time the foreign subsidiary is established, the exchange rate is one foreign unit per dollar. Unfortunately, the company has poor timing and overnight the exchange rate plummets such that the foreign currency is only worth $0.50. If the company consolidates its foreign subsidiary’s results using the temporal (or remeasurement) method, the results will be adjusted as follows:


The value of inventory and fixed assets did not change. Theoretically, the change in exchange rates would not affect the value of such assets – they would simply be worth more units of the foreign currency. Since all liabilities in this simple example are monetary, they are all affected by the change in exchange rates. What is interesting is that the value of the assets falls by less than the value of the liabilities – so the parent company actually translates the change as a net gain.  This can vary on a case by case basis depending on the size of the change in rates, the direction of the change, and the relative proportions of non-monetary assets and liabilities held.

Since assets and liabilities are affected in different ways, using the temporal method can result in changes to certain financial ratios as the balance sheet is converted into parent currency. In this case, before translation the subsidiary’s current ratio was 2.67 and debt as a percentage of assets was 42%. After translation, the parent would report the subsidiary’s current ratio as 3.67 and the debt/assets ratio as 26%.

Posted on 26th August 2007
Under: Accounting, Financial Statement Analysis, Fundamental Analysis | No Comments »

Projected Benefit Obligation (PBO)

When measuring the potential liability of a pension fund, there are several relevant measures. The Projected Benefit Obligation (PBO) represents the present value of all benefits employees are expected to earn during employment.  For businesses that are assumed to be going concerns, this measure is the most appropriate estimate of the total future liability.

Posted on 25th August 2007
Under: Accounting, Financial Statement Analysis, Fundamental Analysis | No Comments »

Top Down Investing

A Top-Down approach to investing describes investors who base their research on macroeconomic factors or investment themes more than on the fundamentals of a particular company. A top down investor might start with themes affecting the global economy, then anticipate how those themes might affect various economic sectors and industries. After taking into account currency issues, the investor would finally pick individual stocks in the industries and sectors most likely to benefit.

Posted on 24th August 2007
Under: Active Management, Investing in Stocks, Portfolio Management | No Comments »

Reference Points

Consider an investor who buys a stock for $100 and sees it rise to $150 at the end of the year. The following year, the stock closes at $125. Whether the investor is likely to interpret the investment as a gain or loss depends on the reference point used. In general, investors tend to use relatively recent reference points, with some research indicating that investors favor the 52-week high.  This theory is supported by a study showing that employee stock option exercises nearly doubles when the stock rises past the previous 52-week high.

Source: Psychology of Investing, The (2nd Edition)

Posted on 23rd August 2007
Under: Behavioral Finance, Investing in Stocks, Portfolio Management, Research | No Comments »

Computing Free Cash Flow to the Firm from the Statement of Cash Flows

Free cash flow to the firm (FCFF) represents the cash flow that a company generates in an accounting period, after paying operating expenses and making necessary expenditures. This cash flow represents the return to all providers of capital, whether debt or equity. It can be used to pay off debt, repurchase shares, pay dividends or be retained for future growth opportunities.

FCFF can be calculated from the statement of cash flows as follows:

FCFF = Cash flow from operations + After-tax interest expense – Capital expenditures

Depending on the company being analyzed, investors may want to deduct acquisitions as well as capital expenditures. Essentially acquisitions are a means of buying capacity that could othewise be built through capex.

Posted on 22nd August 2007
Under: Accounting, Financial Statement Analysis, Fundamental Analysis, Investing in Stocks | 5 Comments »