Financial Education

Crossing trades internally is one way a fund manager may seek to reduce execution costs. Internal crosses occur when two of the manager’s clients take opposite positions in a trade.  This can reduce direct execution costs and eliminates any market impact.

Few managers use this technique because it is rare to have two clients that would want to take opposing positions. It is also critical to ensure that neither client benefits from the trade at the other’s expense. This can be done by using a market-based execution price.

Cash Flow Return on Investment (CFROI) is an internal rate of return (IRR) type metric measuring the return expected to be generated by a firm’s existing assets throughout their useful lives. CFROI can be calculated in five steps:

• compute the average life of assets by dividing gross assets by depreciation expense
• compute gross cash flow by adjusting net income for non-cash charges, financing expenses, operating lease payments and equity reserve accounts
• compute the gross investment as gross plant and equipment adjusted for reserves, capitalized expenses, restructuring charges, amortization and the present value of operating leases
• compute the value of any assets that will not depreciate (which will represent the future value)
• solve for IRR (or CFROI)

When used to value stocks, the residual income model separates value as the sum of two components:

• The current book value of equity (BV)
• The present value of expected future residual income [sum from time t=1 to infinity(RI/(1+r)^t)]

The model can be used to value the firm (based on total book value and residual income) or a share, using book value and residual income per share.

Like any model, residual income models are more appropriate at some times than others. They are most appropriate when:

• The subject company is non-dividend paying
• Free cash flow is unstable or negative over a reasonable forecast horizon
• Other approaches result in greater sensitivity to terminal value than the investor finds comfortable

The are less appropriate when:

• the company’s accounting practices result in significant dirty surplus
• the components of residual income (book value, ROE) are not predictable

When a company reports higher earnings than investors were expecting, the stock tends to rise. Some momentum investing strategies seek companies who are consistently exceeding earnings estimates. This earnings surprise, or unexpected earnings, is the difference between reported earnings and the expected earnings (UE = EPS – EstEPS). However, since a company beating estimates of $1.00 by $0.01 is not as favorable as beating estimates of $0.50 by $0.01, the results are typically expressed as a percentage. They are typically also scaled to reflect the amount of disagreement between various analysts (since a wide range of expectations has different implications for what is “unexpected”) by dividing the percentage earnings surprise by the standard deviation of analyst earnings forecasts.

Thus, if the earnings surprise is $0.05 and the standard deviation of analyst estimates was $0.03, the scaled earnings surprise is $0.05/$0.03 = 1.67.

Market Value Added (MVA) is the difference between the market value of a firm and its invested capital. In theory, the MVA should equal the present value of all future economic value added (EVA).

When used to value stocks, the residual income model separates value as the sum of two components:

• The current book value of equity (BV)
• The present value of expected future residual income [sum from time t=1 to infinity(RI/(1+r)^t)]

The model can be used to value the firm (based on total book value and residual income) or a share, using book value and residual income per share.

Strengths of the model include:

• Less sensitivity to estimated terminal value than other models
• Rely on readily available accounting data
• Can be used to value stocks that do not have stable dividends or cash flow
• Focus on economic, rather than accounting, profitability

Weaknesses include:

• Relies on accounting data (which can be manipulated)
• May require adjustments based on accounting methods, particularly in cases of a dirty surplus.

Arbitrageurs seek to exploit temporary market inefficiencies by buying a security they believe is underpriced and shorting a similar security they believe is overpriced. If the securities are not perfectly matched, the trade faces fundamental risks. But even if the securities are perfectly matched, the trade runs the risk that the inefficiency that produced it in the first place will continue or get worse.

For example, when Palm, Inc. shares were first spun out from 3Com investors were far more enthusiastic about Palm’s future than about 3Com’s. So much so, that Palm rose in value to the point that it was valued higher than 3Com – even though 3Com still owned most of the shares. Arbitrageurs sold Palm and bought 3Com knowing that when the remaining Palm shares were spun out they could replace the shares they had shorted and end up owning “free” 3Com shares.

However, the arbitrageurs (information traders) ran the risk that the investors who created the opportunity (noise traders) would continue to misprice the securities. If they continue to force Palm shares higher relative to 3Com, the arbitrageurs could be forced to cover their short positions early at a loss.

Trailing or forward earnings may not accurately reflect the earnings power of a company, particularly if the company’s earnings are cyclical. In such cases, a high P/E may simply reflect depressed earnings at the cycle trough, and a low P/E multiple may suggest that earnings have reached the cyclical peak. In such cases it is appropriate to normalize P/E with respect to the business cycle.

Although there are several ways to do this, a simple yet fairly robust way is to measure the ROE over the full previous cycle. Normalized EPS is then the average ROE over the cycle times the current book value. For example, if a company posted ROE of 12%, 10%, 10%, 8%, 10% during its last cycle it would have a cyclical average ROE of 10%. If its current book value per share is $23.00 its normalized earnings are $23.00 x 10% = $2.30.

An even shorter method would be to simply average the earnings per share over the full cycle, but this does not factor in any growth from one cycle to the next.

Economic Value Added, or EVA, is a proprietary residual income model developed by Stern Stewart & Company. In its basic formulation, EVA equals net operating profits after tax (NOPAT) less the dollar weighted average cost of capital ($WACC).

Given this formulation, the ways a management team could increase the firm’s EVA would be to:

• increase revenue
• minimize operating expenses needed to generate a given amount of revenue
• produce the same goods and services using less capital
• invest additional capital in opportunities that will earn more than the associated capital charge
• reduce the cost of capital

When used to value stocks, the residual income model separates value as the sum of two components:

• The current book value of equity (BV)
• The present value of expected future residual income [sum from time t=1 to infinity(RI/(1+r)^t)]

The model can be used to value the firm (based on total book value and residual income) or a share, using book value and residual income per share.

Unlike models that discount dividends or free cash flow, in which a significant portion of the estimated value is the terminal value, a residual income model tends to be front-end loaded by the reliance on book value. This can be an advantage since forecasting errors tend to magnify over time. Using only the residual income is likely to result in smaller errors and even if the error is not reduced, the future income is less significant to the overall value calculation.