Sunday, February 24, 2013

Executive Compensation Linked To Stock Performance

Citigroup gave its CEO Michael Corbat $11.5 million for 2012, but Corbat's compensation going forward may be more closely tied to shareholder performance. After Citigroup lost its vote on say-on-pay last year, the company announced that it would link its executive pay to stock performance and return on assets. As one shareholder advocate group said, the new measure was "far from perfect, or even good, but it's less terrible than it used to be." Two of the reasons we would agree are the use of ROA and the exclusion of a risk measure. ROA is an accounting measure, which allows for leeway in calculating the inputs. Additionally, the plan does not account for risk, an important variable when examining returns.

The Grande Latte Index

By now, we hope that you are familiar with the Big Mac Index compiled by The Economist. Now, The Wall Street Journal has developed the Starbucks grande latte index, a measure of the price of a grande latte in dollars across various countries to examine purchasing power parity. Of course, we have the same dollar purchasing power parity problem since a grande latte costs $4.30 in New York and $3.55 in Detroit and San Francisco. As with any financial or economic estimate, there can be a great deal of disparity on the answer. In this case, one expert estimates the value of the yen will fall to ¥120/$, while another argues that the yen is already devalued 12 percent from its fair value of ¥84/$.

Saturday, February 23, 2013

Spreadsheets And GIGO

JPMorgan Chase's recent $6 billion trading loss was viewed as a huge error in judgement. However, the company laid the blame for a portion of the loss on an error in a spreadsheet. Spreadsheets are a valuable tool in Finance, but the old adage of "Garbage in, garbage out" (GIGO) still applies. Software has helped improve the accuracy of spreadsheets. When you consider that companies may have 50,000 or more spreadsheets, you should recognize the sheer number of possible errors. And, if you are not sure why you should learn to use Excel, consider one number in the article: More than 59 percent of Finance employees spend more than one-half of their time working with spreadsheets.

Board Term Limits

While term limits for Congress are often discussed, voters do not get a choice on whether to implement term limits. In corporate governance, GE shareholders will be allowed to vote on term limits for the company's board of directors. The proposal would limit the term of an individual on the board to 15 years. Opponents have argued that the proposal is aimed at board members Andrea Jung and Ann Fudge.

Receivables Factoring

Many small business are strapped for cash. Banks are often reluctant to lend money to a company with an unproven track record and few assets, and while venture capital may be available, it is generally expensive. For online advertiser EQAL, the choice was to factor receivables. Even in the factoring market, EQAL faced problems because many factors like recurring receivables, which the company did not have. Fortunately, EQAL was able to find a factor that was comfortable enough with its business model. The cost of factoring for EQAL is a more than a bank loan, but less than venture capital, and has given the company access to cash flow.

Wednesday, February 20, 2013

Gold's Death Cross

Technical analysts believe that markets are not efficient and look for patterns in price charts in an effort to make abnormal returns. One technical trading tool is the "death cross" where the 50-day moving average falls below the 200-day moving average. The 50-day moving average is the average price over the past 50 days. The chart for gold prices is nearing a death cross. The last time there was a death cross in gold's price chart, gold declined about nine percent.

Seven The Hard Way

The Revel Casino, with about $1.5 billion in debt, is expected to file a prepack bankruptcy in the next several weeks, less than a year after the casino opened. The company's lenders are expected to have a significant equity position in the company when it emerges from bankruptcy, but will have much less in debt. The casino was originally started by Morgan Stanley, but the bank abandoned the project and wrote off its $1.2 billion investment.

Tuesday, February 19, 2013

Regulated Corporate Governance

Norges Bank Investment Management (NBIM), which manages $650 billion in assets, recently condemned the state of corporate governance, but not in a way in that most people would expect. Many of the recent regulations enacted to regulate corporate governance have arisen from the 1992 UK code of governance. This code was a statement of good governance practices. NBIM argues that converting the original code into laws and regulations is misguided because it changes guidelines for best practices into hard and fast rules that limit the direction of corporate governance. In short, NBIM believes that regulations are prescribing a one size fits all process for corporate governance that is unduly restrictive.

Strategic Finance

One thing we would caution you against as a Finance student is not to become caught up in numbers, but to also consider the strategic options available in a company and its projects. You should continually evaluate a company's projects from both a financial and strategic perspective. If you read this article, it sounds like a strategic analysis of the company, but much of the article has financial underpinnings. For example, the $30 million of value created by the cruise ship is the NPV of the ship. As for the strategic options, "the assets that create the most value should be strongly emphasized" simply means accept the projects with the highest NPVs. Further on, "those destroying value should be fixed, shut down, or sold" is the option to abandon. Finance matters and is an important part of any company's operations, but aligning the numbers to help guide the company's strategy going forward is an important component of success.

What's Wrong With Merger Valuation

As with any capital budgeting analysis, the valuation of a target company for an acquisition is a difficult task. A recent article argues that there are common reasons a company may overpay for an acquisition. We would like to discuss two assumptions in the article. First, using the example in the article, is that the two year loan interest rate is inappropriate since it is not possible to repay the two year loan with the cash flows from the target company. Using the two year loan violates the matching principle of capital structure, namely, that long-term assets should be funded with long-term liabilities and short-term assets funded with short-term liabilities. Although we don't doubt that a mistake has been made, it should not be made if the acquisition is viewed holistically, which is what the author is arguing. Second, we would take offense to the statement "There’s another assumption in finance theory that Adhikari questions that’s worth noting, and it’s also related to debt: that’s the belief that the target’s industry doesn’t matter." Obviously, this statement is incorrect. Suppose Company B, with a WACC of 8 percent, is considering acquiring Company T, with a WACC of 11 percent. What is the correct cost of capital to discount the cash flows from the acquisition? If you have been following this chapter (and the textbook as a whole), you would know that in general, the correct required return is 11 percent. The cost of capital depends on the use of funds, not the source of funds, even in an acquisition. The statement that finance theory ignores the target's industry is incorrect unless you are following incorrect finance theory.

DSO Interpretation

While the textbook discusses a cross sectional comparison of the components of the operating and and cash cycles, a recent article discusses a method to examine accounts receivable (AR) and days' sales outstanding (DSO) in a time series. For example, if AR is growing more quickly than DSO, the company could be offering credit terms that are too generous, or is attempting to book sales at the end of the quarter to make its performance look better. The examination of health care education company Healthstream in the article indicates neither of those. Two things we would like to point out in the article: The author points out that he likes to use end-of-quarter numbers rather than average receivables in his calculations. Remember, ratios can be calculated a number of different ways, and each has its own interpretation. So, if you are using ratios calculated by someone else, make sure you know how the ratio was calculated. Second, the author cautions that an investor should look into the root causes of the changes in ratios, which is always an important step any time you are examining financial ratios.

Thursday, February 14, 2013

Stock Yields

Stock returns include a dividend yield, but Chris Brightman, head of investment management at Research Affiliates, argues that the yield should include a buyback yield. His logic is that if a company maintains its profits and the price earnings ratio remains constant, if the company buys back 2 percent of its stock, the stock price should increase at 2 percent as well. This is similar to the dividend discount model in which the stock price grows at the dividend growth rate. Unfortunately, Brightman's math indicates that the stock market return going forward is only about 6 percent, significantly below the historical average. 

Financial Romance

Often, people outside finance view financial professionals as number crunchers, lacking emotion and feeling. We disagree with this idea, and further would argue that financial professionals are very romantic.

Wednesday, February 13, 2013

S&P 500 Dividends

A recent article geared toward investors yields some interesting dividend information. For example, over the past 10 years, the dividend payout ratio for the S&P 500 Index as a whole has been as low as 50.76 percent in 2002 and as high as 107.47 percent in 2008. Over this 10 year period, 18 S&P 500 companies have been able to reduce the payout ratio by more than five percent per year, but more impressively, eight of those companies have actually increased dividends by more than seven percent per year. These companies have been able to reduce the payout ratio but increase dividends, an indication of the fast earnings growth in these eight companies.

Monday, February 11, 2013

Spin-Off Value

The anti-merger, or spin-off, seems to be benefiting investors. The Bloomberg Spin-Off Index (BSOI) is up 41 percent in the past year compared to the 12 percent increase in the S&P 500. For the past 17 years, spin-offs have outperformed the S&P 500 by 13 percent in the year following the spin-off. There are structural reasons that this anomaly might exist including: the new management is forced to run the new business more efficiently, the new company lacks analyst coverage resulting in forced sales by index funds and investors who didn't buy the stock directly, and a soft landing set up by the by the parent, who might undervalue the spin-off to lower expectations on the new company.

Merger Valuation

A recent article in CFO outlines potential pitfalls in mergers. For example, the article advises avoiding over-optimism about the company, a flaw discussed in behavioral finance. The article also argues that the bidder should not pay for synergies unless they are well defined. For example, one CFO said that his company paid for synergies in one acquisition because the target would be rolled into a current division, which allowed for cost savings from eliminating part of the existing management, the board of directors, and other expenses that the target incurred. However, he would not include synergies if the target were in an entirely new business. The last pitfall we would like to mention here is to keep financial models honest. Logical errors are much more common than mathematical errors. For example, if margins are increasing, this cannot be infinite. After all, you can never get a 100 percent margin, and something a lot lower is more reasonable. 

Friday, February 8, 2013

1 + 1 = 3

Recently David Einhorn, the Greenlight Capital hedge fund manager, has suggested that Apple should issue preferred stock as a way of reducing the company's cash balance and increasing shareholder value. Einhorn argues that by giving the preferred stock to current shareholders, the market price of the preferred plus the new reduced price of the common stock (there would be a price drop since cash available to common shares would decrease) would be greater than the current stock price. In essence, Einhorn is arguing against M&M's pie model of the corporation. While we believe that excess cash does not create shareholder value, the idea that market participants can be fooled by adding preferred stock to a company's capital structure seems doubtful. 

Thursday, February 7, 2013

Shareholder Wealth Maximization And Ethics

A recent article in The Wall Street Journal discusses the role of ethics in business education. While we don't want to take a side on the general discussion, we would like to take a strong stance against one particular quote:

"Though maximizing shareholder returns isn't a bad goal in itself, focusing on that at the expense of customer satisfaction, employee well-being or environmental considerations can be dangerous."

In our view, maximizing shareholder wealth is the only goal of a corporation, period. The examples used in the WSJ article show a general misunderstanding of shareholder wealth maximization. For example, nowhere does our goal say that the company should not be concerned with customer satisfaction. Dissatisfied customers lead to reduced sales, profits, and cash flows, which reduces shareholder wealth. But, a company should not focus on customer satisfaction to the detriment of wealth maximization. Shareholder wealth maximization also does not state that employee well-being is not important. Employee satisfaction can increase shareholder wealth, but only to a point. Employees who make minimum wage would be more satisfied making six-figure salaries, but customers would not be able to afford to buy any of the company's products. In short, ethical decisions are generally necessary to maximize shareholder wealth. 

U.S. Floating Rate Notes

The Treasury Department is continuing the discussion of floating rate Treasury notes it intends to begin issuing within the next year. One of the items still open for discussion is the choice of the index to which the coupon rate will be tied. Industry representatives seem to prefer the repo rate, which is calculated using repurchase agreements. Repurchase agreements are the simultaneous sale of a security with the agreement to buy the security back in the future at a higher price. Repos are generally short-term, often overnight. The second choice for the index appears to be three-month Treasury bills. The Treasury bill rate is less volatile and more transparent. Given the recent problems with LIBOR and EURIBOR rates, Treasury bill rates offer less opportunity for similar market manipulation.

Want A Big Mac? Stay Away From Venezuela

The Economist has come out with the January 2013 Big Mac Index. Leading the way is Venezuela, whose currency is overvalued by more than 100 percent according to the the index. The map with the currency valuations relative to the U.S. dollar is interesting since many of the undervalued currencies are in Asia and Eastern Europe. The average price of a Big Mac in the U.S. was $4.37, while it was only $2.57 in China. Both the Indian rupee and South African rand were undervalued by more than 50 percent.

Wednesday, February 6, 2013

The Option To Contract

The U.S. Post Office announced its intention to take advantage of the option to contract when it announced that it would eliminate Saturday delivery. By eliminating Saturday mail delivery, the Post Office expects to save $2 billion per year.

Risk Management In Name Only

One of the causes mentioned as starting the financial crisis that began in 2008 was the bankruptcy of Lehman Brothers. Lehman had a chief risk officer (CRO), Madelyn Antoncic, who was well qualified for the role. In fact, Antoncic warned Lehman senior management about the risk of the mortgage-backed securities that made up a significant percentage of the company's assets. Instead of listening to the warning and adjusting the company's risks, management took another route to solve the problem: They fired Antoncic.The replacement CRO had no formal risk management training. While Lehman was ultimately undone by taking excessive risk, it also appears that the company was undone by ignoring the person responsible for monitoring the corporate risk profile.

Tuesday, February 5, 2013

Justice Department Sues S&P

The Justice Department (DOJ) announced that it was suing credit rating agency S&P for "Knowingly and with the intent to defraud, devised and participated in and executed a scheme to defraud investors." in the company's rating of mortgage backed securities. S&P argued that not only did it not intend to defraud, but that Moody's and Fitch, which were not sued, had similar ratings on the bonds. The absence of Moody's and Fitch from the lawsuit has led to speculation that the S&P lawsuit is payback for the downgrade of U.S. government bonds by S&P in August 2011. The DOJs lawsuit argues that S&P should have updated its computer models to LEVELS 6.0 from LEVELS 5.6, which would have reduced the credit rating for at least some of the bonds.

Monday, February 4, 2013

Executive Pay And Bond Ratings

So what determines a bond's credit rating? There are a lot of factors including the debt-equity ratio, liquidity ratios, industry forecasts, etc. The Jeffries Group recently paid its top executives a total of $78 million, including $19 million to chief executive Richard B. Handler. In general, bond ratings are not directly affected by executive compensation. However, in this case, Moody's warned that the Jeffries Group bond rating was "credit negative," meaning that the pay could result in a downgrade on the company's bonds. Moody's felt that the pay could result in excessive risks at the company.

Sunday, February 3, 2013

Capital Ratio

In the text, we discuss a number of financial ratios. These are only some of the most common ratios and, in fact, there are many different financial ratios. For example, the capital ratio, or capital adequacy ratio, is used by banks, regulators, and investors to determine a bank's ability to meet its liabilities. The ratio is calculated as the bank's core capital divided by its risk weighted assets. Banks will soon be required to reveal more about how the calculation is done by the bank. As with any ratio, it is possible to manipulate the outcome. For example, even though Deutsche Bank lost €2.5 billion ($3.4 billion), its capital ratio increased because the bank changed the method it used to calculate the risk weighted assets. The moral of the story: The interpretation of any ratio depends on how it is calculated. To understand the ratio, you must know exactly how the numbers used in the calculation are derived.

Friday, February 1, 2013

Pension Writeoffs

Low interest rates have caused large noncash charges at AT&T ($10 billion), Verizon Communications ($7 billion), and UPS ($3 billion). The low market interest rate caused the present value of pension liabilities to increase. In AT&T's case, a one percent change in the discount rate resulted in a $12 billion loss, which was partially offset by an increase in the value of the pension assets. The losses are accounting charges, which other than tax effects, will not directly affect cash flows.