Financial Education

U. S. GAAP considers inventory cost at the time it was placed in inventory, whereas International Accounting Standards base the cost on the order in which the products are sold. When possible, international standards prefer that the specific identification method be used.

When it is not practical to track inventory costs on a unit basis, international standards permit either the first-in, first-out (FIFO) method or the weighted average cost method. Lifo is not permitted, as it is under U.S. standards. Fortunately, U.S. standards require companies using LIFO to report the FIFO inventory value, and thus it is generally possible to adjust the U.S. financial statements for comparability with firms that do not use LIFO.

Both standards require inventory to be stated at the lower of cost or market value, and inventory that has declined in value must be written down. Under U.S. standards these writedowns cannot be reversed even if the inventory subsequently rises in value. International standards do permit reversal of inventory writedowns.

The dividend discount model values a stock on the basis of dividends paid, growth in dividends and a required return. If the company is not expected to grow, the rational response would be to pay out all earnings as dividends. In such circumstances, the value should reflect the current earnings divided by the required return, or E/r. This is the no-growth value per share.

Since we know what the value of a stock should be if it does not grow, we can also infer how much value the market is assigning to future growth opportunities. The total value must is V = E/r + PVGO where E/r is the no-growth value and PVGO is the present value of growth opportunities.

Consider, for example, a stock earning $1.00 per share with an 8% required return. If the stock is currently trading at $20.00 per share, we can compute a no-growth value of $12.50 and a PVGO of $7.50.

Yogi Berra said it’s tough to make predictions, especially about the future. Since many of the forecasts go wrong, it is not surprising that the forecasters have developed some standard replies. In a 2005 Dresdner Kleinwort research report, James Montier laid out the following popular defenses of flawed forecasts.

The “if only” defense says their forecast would have been correct if the advice or analysis they had provided had been followed. This defense is popular because it cannot be proven wrong since historical events will seldom follow a specific analysis. However, the basis of the original forecast was presumably to predict the likely outcome, not the outcome if a certain set of actions occurs. A conditional forecast should also outline the consequences of conditions varying from those set out.

The “ceteris paribus” defense says something interfered with the original forecast. “They would have gone bankrupt but their competitor bought them out.”

The “I was almost right” defense says the forecast almost happened. This applies primarily to averted catastrophes. “Long-term Capital Management’s collapse almost brought down the entire financial system.” If one was predicting the collapse of the financial system, close doesn’t count.

The “it just hasn’t happened yet” defense says the next hedge fund collapse will be the one that brings down the financial system. Either that, or the one following it.

The “single prediction” defense acknowledges that the conditions of the forecast were met but the prediction was still incorrect. However, forecasts are pointless so don’t hold it against the analysis that led to the forecast.

The dividend discount model and other discounted cash flow approached define the value of a stock as a function of the current cash flow, growth and a required rate of return. Normally these models are used to derive a valuation, which is then compared to the current stock price to determine whether the stock is “overvalued” or “undervalued.” The determination will be affected by the assumptions made regarding required return and growth.

An alternative is to reverse the model and use the current stock price to determine the average assumptions being implicitly made by investors. For example, consider a stock with a current share price of $20.00 and an expected annual dividend of $1.00 per share. An investor who calculates the required return (perhaps using the Capital Asset Pricing Model) as 10% can calculate the growth rate implied by the current valuation.

The Gordon growth model says Value = D1/(r-g).  Substituting what is known, we get $20.00 = $1.00/(0.1- g). We can then solve for g and get an implied growth rate of 0.05, or 5%.

Many investors find it more intuitive to evaluate whether the market as a whole is making realistic assumptions regarding growth than to develop a possibly complicated and error-prone procedure for estimating the growth itself.

Theoretical asset valuation models such as the Capital Asset Pricing Model and Arbitrage Pricing Theory do not always work in practice. In 2002 the telecom bubble was beginning to burst, and the bonds for heavily leveraged telecom companies started to signal financial distress, with yields to maturity (YTM) rising to 20% or more. At the same time, equity analysts were frequently valuing the stocks on the basis of the CAPM and a cost of equity of perhaps 15%.

Since equity holders have a residual claim equity investors are assumed to demand a higher return than bondholders. Therefore, a 15% required equity return when bonds are yielding 20% does not make economic sense. Instead, the results of the CAPM model could have been checked against the bond YTM and adjusted to reflect a risk premium to the same company’s publicly traded bonds.

Historical equity to bond premia have been 3-4%, though investors may want to use a higher premium in times of financial distress.

The concept of the franchise factor is similar to that of residual income. It is a recognition that the value of a firm consists of its current value and its future investments in positive net present value (NPV) projects. In other words, it must generate a return higher than its Weighted Average Cost of Capital (WACC).

The franchise P/E breaks down the observed P/E into these two components: a base P/E equal to the value of ongoing business and a franchise P/E equivalent to the market’s expectations for future profitable opportunities. In other words:

Franchise P/E = Observed P/E – Base P/E where the base P/E is defined as the reciprocal of the market discount rate (the required return on the company’s equity.) For example, if the market requires a 9% return from an investment in the company’s stock, the base P/E for the stock would be 1/0.09, or approximately 11x. If the actual P/E is 18x, the Franchise P/E is 18x – 11x = 7x.

One way to reduce transaction costs is to find another investor that wants to take the opposite position. Electronic networks have made this process relatively efficient for most institutional investors. By crossing the trade, both parties can avoid causing a market impact and are also frequently able to reduce direct transaction costs.

Even with electronic networks, however, there is still a potential opportunity cost from trying to cross trades. An investor may have to wait a long time trying to find a suitable offset to the trade, particularly for a large block.

The value of any asset must equal the present value of its future cash flows, discounted at a rate that reflects its inherent risk. Since neither the future cash flows nor the appropriate discount rate can be known with certainty, valuation is inherently an estimation.

The discount rate should reflect both the time value of money and the risk of the particular investment.  The time value of money is manifest in the risk free rate – typically a measured by a default-free (government) bond with a time horizon equal to the investment time horizon. To this must be added a risk premium to arrive at the required rate of return for an asset – the minimum return the asset should generate for an investor to want to acquire it.

Exchange Traded Funds, or ETFs, are portfolios that trade on a stock exchange like shares of any company. They can be traded throughout market hours, sold short and margined. They are generally designed to track an index and offer an easy way to broadly diversify personal holdings.

ETFs are open-ended funds with special characteristics. Since most exchanges of the shares in the secondary market occur between two individuals rather than an individual and the fund, the manager needn’t worry about redemptions.  Although brokers can redeem large blocks of the shares, the redemption can be made “in kind,” leaving the risks of disposing of the portfolio holdings in the hands of the redeemer. Further, since the fund can exchange the most highly appreciated stocks without tax consequences, ETFs tend to have a tax advantage over other types of mutual funds. Finally, there is a management cost advantage because the fund manager does not have to keep track of who owns the shares.

An important factor in whether a firm can be profitable is the attractiveness of the industry in which it operates. A company’s ability to earn at least its cost of capital is strongly influenced by the competitive dynamics of its industry. Porter’s Five Forces Model is a conceptual approach to examining industry dynamics that can be useful in determining industry attractiveness.

Porter’s model says that five factors influence an industry’s profitability because they influence the prices, costs and investments required of industry participants. These five forces are:

1. Buyer bargaining power
2. Supplier bargaining power
3. Availability of substitute products
4. Threat of new entrants
5. Intensity of rivalry between existing firms

The collective strength of these five forces determines the ability of firms in the industry to earn average rates of return that exceed their cost of capital.