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Valuation: Measuring and Managing the Value of Companies by Tim Koller, McKinsey, Company Inc., Marc Goedhart, David Wessels, Barbara Schwimmer, Franziska Manoury
air freight, barriers to entry, Basel III, BRICs, business climate, business process, capital asset pricing model, capital controls, cloud computing, compound rate of return, conceptual framework, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, discounted cash flows, distributed generation, diversified portfolio, energy security, equity premium, index fund, iterative process, Long Term Capital Management, market bubble, market friction, meta analysis, meta-analysis, new economy, p-value, performance metric, Ponzi scheme, price anchoring, purchasing power parity, quantitative easing, risk/return, Robert Shiller, Robert Shiller, shareholder value, six sigma, sovereign wealth fund, speech recognition, technology bubble, time value of money, too big to fail, transaction costs, transfer pricing, value at risk, yield curve, zero-coupon bond
Finally, it can be shown that even when net investment equals depreciation, the final result will be downward biased—and the larger the cost of capital, the larger the bias. This bias occurs because the method is only an approximation, not a formal mathematical relationship. Because of these inconsistencies, we recommend against discounting pretax cash flows at a pretax hurdle rate. ALTERNATIVES TO DISCOUNTED CASH FLOW To this point, the chapter has focused solely on discounted cash flow models. Two additional valuation techniques are using multiples of comparable companies and real options. ALTERNATIVES TO DISCOUNTED CASH FLOW 165 Multiples One simple way that investors and executives value companies is to value the company in relation to the value of other companies, similar to the way a real estate agent values a house by comparing it with similar houses that have recently sold. To do this, first calculate how similar companies are valued as a multiple of a relevant metric, such as earnings, invested capital, or an operating metric like barrels of oil reserves.
To compare the methods of computing continuing value, first discount a long forecast—say, 150 years:2 CV = $50(1.06)149 $50 $53 $56 + + + ... + 1.11 (1.11)2 (1.11)3 (1.11)150 CV = $999 Next, use the growing-free-cash-flow (FCF) perpetuity formula: $50 0.11 − 0.06 CV = $1, 000 CV = 2 The sum of discounted cash flow will approach the perpetuity value as the forecast period is extended. In this example, a 75-year forecast period will capture 96.9 percent of the perpetuity value, whereas a 150-year forecast period will capture 99.9 percent. 262 ESTIMATING CONTINUING VALUE Finally, use the value driver formula: ( 0.06 $100 1 − 0.12 CV = 0.11 − 0.06 CV = $1, 000 ) All three approaches yield virtually the same result. (If we had carried out the discounted cash flow beyond 150 years, the result would have been the same.) Although the value driver formula and the growing-FCF perpetuity formula are technically equivalent, applying the FCF perpetuity formula is tricky, and it is easy to make a common conceptual error by ignoring the interdependence of free cash flow and growth.
Although NOPLAT is consistently higher after adjustments for OPERATING LEASES 437 EXHIBIT 20.6 Leasing Example: Free Cash Flow and Equity Valuation $ million Free cash flow (unadjusted for leases) Free cash flow (adjusted for leases) Year 1 Year 2 Year 3 NOPLAT (Increase) decrease in invested capital Free cash flow Reconciliation Interest expense Interest tax shield Cash flows to debt Cash flows to equity Reconciliation of free cash flow Discount factor Discounted cash flow Valuation Enterprise value Debt Equity value Year 1 Year 2 Year 3 96.8 114.8 130.7 70.2 86.0 101.1 (61.3) (46.4) 477.2 NOPLAT (Increase) decrease in invested capital 8.9 39.5 578.4 Free cash flow (23.2) 49.8 7.1 (1.8) (9.8) 13.3 8.9 7.7 (1.9) (3.1) 36.9 39.5 7.9 (2.0) 131.3 441.2 578.4 0.908 8.0 0.825 32.6 0.749 433.1 Reconciliation Interest expense Lease interest expense Interest tax shield Cash flows to debt Cash flows to lease debt Cash flows to equity Reconciliation of free cash flow 7.1 35.5 (10.7) (9.8) (58.7) 13.3 (23.2) 7.7 7.9 38.5 39.4 (11.5) (11.8) (3.1) 131.3 (18.6) 787.8 36.9 441.2 49.8 1,395.7 Discount factor Discounted cash flow 0.941 (21.8) 0.885 44.1 473.7 (118.4) 355.3 Valuation Enterprise value Debt Operating leases Equity value (120.0) (65.0) 1,265.0 1,395.7 0.833 1,162.0 1,184.3 (118.4) (710.6) 355.3 leases, free cash flow is not.
Guide to business modelling by John Tennent, Graham Friend, Economist Group
140–41 capital gains tax 258 cars 131 cash 198, 202 deficits 157 surpluses 154, 157 cash breakeven point 146 cash flow 13, 33, 60, 130, 130, 136, 141, 172, 189 adjusting 153 anticipated 151 cumulative project cash flow 152 and equity value 186 forecasts 70 free (FCF) 163, 173, 173, 180 net 146 operational 147, 152 projected 257 short time intervals 180 sign convention 176 statements 156, 157, 159, 161, 169 tax and 127, 174 timing 164, 176–7, 177 cash flow cycle 140, 140, 141, 141, 202, 202 causative techniques 85 cell comments 251–2 chart wizard button 53 check boxes 223–4 circular references 159, 211 COC see cost of capital coefficients 97, 100, 103 collinearity 105 colour scheme 67 column consistency 210 column widths 69 company acquisitions 146 company law 70 company valuation model 190–92 competition 4, 15, 257 compounding 182 computers crash 36, 39 purchase 131 CONCATENATE function 44–5, 50, 263–4 conceptual errors 206 conditional formatting 52–3 Consolidate box 37–8, 38 consumers credit 78 expenditure 14 spending patterns 88 consumption proportion 131 INDEX control toolbox 222 convertibles 149, 155 corporate decision-making 13 corporate planning pyramid 12–13, 12 corporation tax 163, 164, 167, 172, 174, 258 cost of capital (COC) 204, 205 costs 147, 172, 173, 257 capital 60, 117 drivers of 123–7 fixed 122–3, 122, 123 inflexible 125, 125 operating see operating costs COUNT IF function 47, 48, 48, 264 covenants 156 CPM see Critical Path Method credit agencies 151 credit controllers 123, 123 creditor days 145, 202 creditors 145, 145, 147 critical factors 15, 16, 17, 23, 29 Critical Path Method (CPM) 11 currency 14, 46, 46, 80, 168 current liabilities 147 customer segmentation 112–13, 113, 114 cyclical component 89 D data assumptions 6, 7 collection 6, 7, 8, 22–3, 24 labels 38, 54 scenarios 61 warehousing 8 data collection manager 9 data screens 240, 240, 241 DATA VALIDATION function 53 DCF analysis see discounted cash flow analysis de minimus rule 128 debentures 148 debt 147, 150, 151, 155, 157, 204 bad 160–63 doubtful 160–61 funders 155 funding 152 instruments 157, 157 net 155 debt to equity ratios 155–6, 156, 190 debtor days 142, 162, 202 debtors 142–3, 147, 160, 161 debugging see testing and debugging decision-making analysis 1 273 INDEX choice 2 corporate 13 implementation 2 defining the outputs 12–18 alignment with the business’s overall objectives 12–13 business model output checklist 18 creating an output template 16, 17 defining the outputs required to answer the question 13–14 establish the basics 14 model outputs and corporate decisionmaking 13 real versus nominal forecasts 14 specify the time frame and period length 13–14 identifying the critical factors that determine the outputs 15 running a workshop 17–18 demand 75, 107, 108 demand curve 87 downward-sloping 86, 87 demographic shifts 18 dependencies 258 dependency ranking 242–4 depreciation 33, 34, 46, 118, 128, 129, 187, 203 other depreciation methods 131 reducing balance 130, 130, 137, 137 straight line 129–30, 130, 132, 136, 136 development log 35, 38 dialog boxes 252 discount factor 191 discount rates 45, 180, 183 discounted cash flow analysis 172, 181, 185, 188 company valuation example 190–92 EBITDA exit multiples 189 growth rate models 188–9 terminal values 188 valuation range 190 discounted cash flow theory 179–82 discounted cash flows 34, 182–3 discounting 182 distribution 117, 133–4 divide by zero 51 dividend cover 204 dividends 147, 180 documenting the model documentation outside the model contents of a typical user’s guide 255 continuing user support 255 fit for the purpose 253 good document form design 253–4, 254 structure 254 training material 255 user’s documentation 254 documentation within the model 251–3 cell comments 251–2 dialog boxes 252 macro comments 252–3, 253 specific help software 252 text boxes 252 need for documentation 250 when to document 250 where to document 250–51 Du Pont 11, 199 dynamic effects 59 dynamic links the CONCATENATE function 44 multiple models 36–7 E earnings per share 204 EBITDA (earnings before interest, tax, depreciation and amortisation), multiples 187–8, 189, 190, 192, 203, 257 economic added value (EVA) 204 economy of scale 119, 120, 120, 175, 176, 200 Edit Links box 37, 37 endogenous variables 22 enterprise value (EV) 186, 188 environmental risk 249 equity 147, 150, 151, 155, 157, 204 equity value 186 Excel Scenario Manager 248 exchange rates 15, 53, 70, 150, 167, 168, 258 behaviour 80–81 definition and uses 80 modelling approach 81–3 seed 80 exit options 257 exit screens 239–40 exogenous variables 22 EXP function 264 extrapolation techniques 85 eyeball lines 55 F FIFO (first in first out) basis 139 file folder structure 36, 36 file-naming convention 35 finance calculations 34 financial performance 18 FIND 210–11 firm value 186 fixed asset turnover 201 274 fixed assets see under capital expenditure and working capital fixed costs see under operating costs fonts 67 for and next loops 234–6 FORECAST function 95, 95, 96 forecasting, revenue see revenue forecasting forecasts 13 nominal 14 real 14 foreign exchange calculations 167–70 generic approach to modelling foreign exchange gains and losses 168 modelling foreign exchange gains and losses on overseas financing 169–70, 170, 171 modelling foreign exchange gains and losses on overseas revenue and costs 169 principles of foreign exchange accounting 167–8 format painter 50–51 formatting 67–9 colours 67 column widths 69 fonts 67 lines 67, 68 macros 218–19 number styles 68 Forms toolbar 221–5 formula bar 41, 41 formulae, deconstructing complex 208–9, 209 free cash flow (FCF) 163, 173, 173, 180, 186, 191, 205 free-form development 32 FREEZE PANES command 229–30, 230 funding see modelling funding issues G Gantt chart 10, 11 GDP see gross domestic product gearing 155, 156, 190, 245 GO TO function 53 GOAL SEEK function 242–4 goal statement 18 Gordon Growth Model 189, 190, 192 graphs 53–8, 60, 261–2, 262 eyeball lines 55 fixed cost 122, 122 improving the appearance of 54 market value 129, 129 one graph suits all 55–8, 56 triangulation 126 variable costs 119, 119 INDEX gridlines 54 gross additions/connections 88, 93, 97, 97, 98, 98, 104 gross domestic product (GDP) 15, 76, 84, 189 behaviour 71–2 definition and uses 70–71 modelling approach 72–4 seed 71 group sheet function 39 growth 205, 258 GROWTH function 106 growth rate 45, 71, 72, 74, 74, 75 H hard coding 38, 60 hedging techniques 150 HELP function 51 hiding information 69 hyperlinks 226–7, 227 I IF function 45–6, 47, 51, 65, 73, 74, 77, 120, 145, 211, 223, 264 implementation 2, 6, 7, 9 income distribution 15 levels 15 INDEX function 46, 101, 103, 103, 104, 108, 264–5 inflation 14, 15, 53, 70, 75, 132, 258 inflation rate behaviour 75–6 definition and uses 75 modelling approach 76–7 seed 75 inflexible costs see under operating costs information, hiding 69 input sheets 59–65, 60, 61, 72, 72 input timelines 29, 29, 30, 31 inputs additional 29 alternative 22 analysis 23, 24 extreme 213 inflation 76, 76 seed 19 strategic 30 uncertainty/impact 23–4, 23, 25 validation 66 variables 6, 7 interest 147, 156, 180 interest calculations 157 interest costs 131 INDEX interest income and charges alternative approaches to modelling interest income 159–60, 159, 160 interest rate assumptions 158 issues in modelling interest income and charges 158 modelling interest income and circular references 158–9 interest rates 14, 15, 53 assumptions 158 base see base interest rates interface sheets 36 internal rate of return (IRR) 13, 172, 183–5, 183, 184, 245, 257 more than one 184–5, 185 investment commencement of 258 investment funding 203 net 157 overseas 150–51 reinvestment ratio 203 investment control 149 investor measures dividend cover 204 earnings per share 204 IRR see internal rate of return IRR function 265 ISDATE function 240 ISERROR function 46, 51, 211, 213, 265 ISSER function 265 J J curve 146, 146, 152, 154 joint ownership 149 judgmental techniques 85 L land residual value 132 leases 149 operating (rents) 147 LEN function 265 lending rates 152 leverage 155 lines, in formatting 67–8, 68 LINEST function 100–101, 101, 102, 103, 104, 108, 266 list box 224, 225 LN function 266 loans 149, 152, 156 losses 163, 165, 168 M macroeconomic factors 15, 70–84 275 base interest rates 78–80 exchange rates 80–83 gross domestic product 70–75 inflation rate 75–7 other macroeconomic variables 84 population 83–4 macroeconomic forecasts 8 macroeconomics 70 macros 216–21 calculation 233, 233 comments 252–3, 253 editing the macro code 218 macros for repeated tasks 218–21 creating a personalised toolbar 221 formatting macros 218–19 personal macros 218 protecting the model 219–21 Monte Carlo 245, 246 multiplication tables 234–6, 234, 235 print macro 231, 231 recording simple 216 running the macro 218 viewing macro code 216–17, 217 manual code review 208 market growth 15 market liberalisation 18 market size 15 market value 129, 129, 130, 132 mathematical operations 209–10 MAX function 45, 125, 135, 179, 196, 266 mean square error (MSE) 99 media 19 microeconomic variables 15 microeconomics 70 Microsoft Excel 2, 4, 37, 40, 50, 51, 53, 90, 106, 180, 183, 210, 216, 218, 227, 234, 235, 236, 237, 239 milestones 10, 258 MIN function 45, 139, 154, 196, 266–7 mission statement 18 mobile telecommunications industry bottom-down/top-up forecasting 88 critical factors 15, 16 decomposition of revenue 86 penetration 105, 106, 107, 109, 111, 111 product cycle life 106, 107 regression analysis 97, 106 segmentation 112 third-generation mobile data services 88 total revenue 115, 116 MOD function 50, 125, 134 model developer 9 model development process management 32–9 276 best practice in model development avoiding some common pitfalls 39 the basics of quality control 35–8 the model development process create workings pages for all main sections and develop calculations 33 develop the user interfaces and conduct user testing 34 set up output and input templates 33 test and debug 33 transfer results to output pages 33 a model development project plan 34 establishing a modelling charter 34 using material from the modeller’s library 34 populate input templates with base or test data 33 styles of development 32 free-form development 32 model layout 59–60, 59 model outputs 13, 17, 259–62 model ownership 35 modeller’s toolbox 40–58 naming sheets 40 range names 40–44 useful features conditional formatting 52–3 divide by zero 51 format painter 51–2 macros for repeated tasks 218–21 one graph suits all 55–8 shortcut keys 50–51 using graphs 53–5 useful functions AND and OR 46–7 AVERAGE 50 CONCATENATE 44–5 MIN, MAX or IF statements 45–6 MOD 50 OFFSET 49–50, 49 SUM IF and COUNT IF 47–9, 48 modelling funding issues 146–57 cost of funding 151–2 debt to equity ratios 155–6, 156 funding strips 152–4 identifying the cash flow to be funded 147 operating environment 150–51 project control 149–50 putting the funding cost back in the model 156–7 balance sheet 157 cash flow statement 157 profit and loss account 156–7, 157 INDEX time periods 154–5, 154 types of funding 147–9 weighted average cost of capital 152 modularisation 63 Monte Carlo analysis 245–8 moving average 90, 91, 92 MSE see mean square error multiplicative model 96 multiple models and dynamic links 36–7 multiple regression 85, 87, 101–4, 102, 103, 104, 105 N naming sheets 40 navigation see under spreadsheet applications NCF see net cash flow net book value 130, 138, 139, 140, 140 net cash flow (NCF) 182 net debt 155 net operating profit after tax 204 net present value (NPV) 13, 172, 179, 182, 183, 184, 184, 189, 190, 194, 242, 243, 245, 257 nominal forecasts 14 NPV see net present value NPV function 267 number styles 68–9 numbers for an output 4 negative 4 within a formula 4 O OFFSET function 49–50, 49, 57, 119, 125, 134, 135, 138, 224, 248, 267 operating costs 29, 31, 60, 117–27, 161 completeness of operating costs 117, 117–18 cost behaviour 118 drivers of costs 123–7 inflation 126–7 inflexible costs 125, 125 tax 127 triangulation 126, 126 fixed costs 122–3, 122, 123, 125, 126, 200 variable costs 118–22 operating environment 19, 149, 150–51 operating profit 186 operational risk 248, 249 options 148 OR function 46–7, 267–8 ordinary shares 148 output sheets 33, 60, 63, 63, 64, 248 output template 16, 17, 18 277 INDEX outputs 6, 7, 23, 29 presenting model 259–62 overdrafts 149 overheads, allocated 175 overseas investments 150–51 P P/E ratios 186–7, 188 packaging 117 payback 172, 177–9, 245, 257 payroll cost 126, 203 PBT see profit before tax PED see price elasticity of demand penetration 105, 106, 107–12, 109, 114, 115 total 114 period ends 14 period length 14 PERT (Performance Evaluation and Review Technique) 10–11 PEST analysis 21 plant residual value 131–2 utilisation 258 PLC see product life cycle population 70 behaviour 83 definition and uses 83 growth 15 modelling approach 83–4 seed 83 post-project review 6, 7 PPP see purchasing power parity preference shares 148 prepayments 141, 141, 142 present value 182 price elasticity of demand (PED) 86–7, 87, 115 prices constant 14 fall in 4 print ranges 231 probability models 19 product life cycle (PLC) 106, 107, 107, 189 product prices 53 profit and loss 33, 60, 164, 257 profit and loss account 129, 141, 143, 156–7, 157, 161, 162, 163, 167, 169, 173 profit before tax (PBT) 181 profit flow 172 profit margin 199–200 profits 14 operating 186 programming techniques with Visual Basic 232–6 project appraisal and company valuation 172–92 conventions for setting out the cash flows 176–7 sign convention 176 timing 176–7, 177 discounted cash flow theory 179–82 calculating the discount rate 180 calculating the WACC 181 dicounted cash flow decision rule 182 discount rate 180 risk premium 179 short time intervals 180 time value of money 179 discounting cash flows in practice 182–3 evaluating companies 185–92 techniques for valuing companies 186–8 using DCF analysis in practice to value companies 188–92 identifying the relevant project cash flows 172–6 the cash effect of change 174–5 dealing with allocated overheads 175 group versus project 176 relevant costs and capital expenditure 174 relevant revenues 174 relevant taxes 174, 174 internal rate of return 183–5, 183, 184 more than one IRR 184–5, 184 payback 177–9 project appraisal and valuation techniques 172 project control 149–50 project manager 8, 9, 10 Project Plan see under business modelling process property space requirement 123, 124, 124 utilisation of 258 protecting the model see under spreadsheet applications purchase, timing of 132 purchase cost 131 purchase tax 127 purchasing power parity (PPP) 80, 81 R R2 value 97, 98, 102 radio (option) buttons 222–3, 223 range names 4, 40–44, 158, 159, 164, 191 accessing the named inputs and rows 44 common range names 43–4 defining several individual names 42, 42 278 naming one cell 41 naming one cell where the cell name is displayed to the left of reference value 41, 41 naming several values at once 42–3, 42 naming whole rows 43 range test the model 212–13 RANK function 268 ratios 60 the Du Pont pyramid of ratios 199–203 balance sheet management 201–2 further analysis 202–3 percentage of sales measures 201 profit margin and asset turnover 199–201 external analysis 194 internal analysis 194–5 internal ratio analysis 195 interpreting 196–7 average 196 high and low values 196 rank 196 useful ratios to calculate return on average capital employed (ROACE) 198 return on equity (ROE) 199 return on net assets (RONA) 197–8, 198, 199, 200, 201, 204 real forecasts 14 recalculation 69 reducing balance 130, 130 regression equation 98, 98 regression techniques see under revenue forecasting regulatory environment 70 rents 147 replicating actual results 212 report style 259 research agencies 8, 70 residual (“disturbance”) component 89 residual value 132 retail price index 75 return on average capital employed (ROACE) 198 return on capital employed (ROCE) 242, 243, 245, 257 return on equity (ROE) 199 return on net assets (RONA) 197–8, 198, 199, 200, 201, 204 return on sales (ROS) 257 revenue 14, 30, 53, 60, 64, 117, 147, 172, 173 decomposition 86 derivation of 29 total 86, 115–16, 116 INDEX revenue forecasting 14, 85–116 approaches to bottom-up versus top-down forecasting 87–8 classification of forecasting methodologies 85 decomposition of revenue 86 price elasticity of demand 86–7, 87 time frame 88 long-term forecasting 105–11 fitting a product life cycle curve 107–11 the product life cycle 107, 107 regression techniques 96–105 estimating the coefficients 97–9, 97, 98 forecasting using the TREND function 100, 100 limitations of regression analysis 105 the LINEST function 100–101, 101 multiple regression 101–4, 102, 103, 104, 105 regression analysis 96–7 the TREND function 99, 100 segmentation 112–16 business segment 114–15, 114, 115 consumer segment 112–13, 113, 114 mix effects 116 total revenue 115–16, 116 time series analysis 85, 87, 88–96 additive and multiplicative models 89–90, 90 components of a time series 89 estimating the trend and seasonal factors manually 91–4, 92, 93, 94 estimating the trend using the built-in moving average function 90–91, 91 forecasting using the trend, seasonal factors and the additive model 94–5, 95 limitations of time series analysis 96 the multiplicative model 96 time series data 88, 89 revenue multiples 188 revenue tax 163 ripple effect 51 risk 149, 150, 151, 155 assumption 248, 249 commercial 257 environmental 249 operational 248, 249 premium 179 ROACE see return on average capital employed ROCE see return on capital employed ROE see return on equity RONA see return on net assets INDEX ROS see return on sales ROUND function 154, 268 rounding 65–6, 65, 66, 259 ROUNDOWN function 268 ROUNDUP function 123, 133, 268 row consistency 210 rows versus columns 261, 261 S sales forecast 55 tax 127, 163–4 saving the model regularly 36 scenario development 25–31 scenario planning benefits 20 the development of 20 stage 1: identifying high impact, highly uncertain inputs 20, 21–4 stage 2: identify alternative development paths for key inputs 20, 25–6, 25–6 stage 3: select the three or four most informative scenarios 20, 26–8, 27 stage 4: develop the scenario stories 20, 28–30 stage 5: develop the business strategy 20, 30 scenarios 20 scheduling 258 scroll bars 225, 225 seasonal component 89 seasonal factors 89–90, 90, 91, 93, 94, 94, 96 seed 19, 60, 62, 71, 75, 78, 80, 83 segmentation see under revenue forecasting sensitivity analysis 147, 241–2, 241 shareholder value 193–5, 194, 199 ratio analysis 194–5 short period rate 180 shortcut keys 50–51 sign convention 66, 176 simple modified exponential trend curve 108 SIN function 268–9 SINE curve 71, 76 SMART goals 9 social trends 70 socio-economic shifts 18 specific help software 252 spin buttons 225 splash screens 237–9, 238 spreadsheet applications appearance consistency 229 freezing the screens 229–30, 230 placement of macro buttons 230 279 removing the gridlines 230 simple layout 229 basic programming techniques with Visual Basic 232–6 Forms toolbar 221–5 navigation attaching a macro to a button 228–9, 229 basic navigation 226 creating a menu using Visual Basic 227–8, 227, 228 hyperlinks 226–7, 227 recording simple macros 216 viewing macro code 216–17, 217 printing 231 creating a print macro 231, 231 setting print ranges 231 protecting the model 219–21 spreadsheet functions 263–70 spreadsheets 2, 11 advantages and disadvantages of using 3 and model ownership 35 see also input sheets; output sheets; working sheets start of trade 133, 258 stock 143–4, 144, 202 stock days 143, 144, 202 strategic plan 12, 18, 31 style and outline 59–69 alternative model layout 63–4 formatting 67–9 colours 67 column width 69 fonts 67 lines 67–8, 68 number styles 68–9 making the model intelligible 64 making range names work 64–5, 64 model layout 59–60 recalculation 69 retaining consistent logic by having the same formulae every year 65 rounding to invisible 65–6, 65, 66 sheet layout: inputs 60–61, 60, 61 sheet layout: outputs 63, 63 sheet layout: working 61–2 sign convention 66 some things to avoid, recalculation 69 things to avoid, hiding information 69 sum of the digits 131 SUM function 269 SUM IF function 47–8, 48, 269 supply chain 176 280 SWOT (strengths, weaknesses, opportunities and threats) analysis 257 synergy 176 T tables of data 259–61, 260 tactical plans 18 tasks 10 tax shield on financing 181 taxation 33, 34, 127, 173, 258 the challenges of modelling taxation 163 forms of taxation 163–4, 163 generic approach to corporation taxation workings 164–5, 165, 166–7 technical errors 206 technical obsolescence 131 technological change 70 templates 11, 13, 16, 17, 33 terminal value 14, 189, 258 testing and debugging 33, 34, 206–15 the importance of 206 testing strategy 207–15 step 1: eliminate technical and conceptual flaws 208–12, 214 step 2: range test the model 212–13, 215 step 3: stress test the model 213, 215 step 4: user testing 214, 215 types of errors conceptual errors 206 technical errors 206 user errors 206 text boxes 252 third-party forecasts 70 tick box 43, 43 time frame 13–14, 88 time periods 154–5, 154 time series analysis see under revenue forecasting time value of money 179 top-down forecasting 87–8 total revenue 86, 115–16, 116 trace error button 51 transport trends 15 trend curves, exponential, Gompertz and Logistic 108 TREND function 99, 100, 101, 105, 269 trend see under revenue forecasting trendline 55 regression 98 triangulation 126, 126 U uncertainty, scenario planning and model inputs 19–24 INDEX business model input checklist 24 defining the inputs 19 examining different approaches to uncertainty 19 scenario-based forecasting approach 20 stages of a scenario-based forecasting approach 20, 20 stage 1: identifying high impact, highly uncertain inputs 21–4 analyse variables according to uncertainty and impact 23–4, 23 identify all the variables that influence the business 21–2, 21 identifying the relationships between variables 22 review the data collection requirements 22–3 understanding the nature of uncertainty 19 uncertainty/impact matrix 23–4, 23, 24, 25, 29 units 14 upper asymptote 107, 108, 108 urbanisation 15 useful economic life 131 users documentation 254 errors 206 interfaces 34 support, continuing 255 testing 214 using the model 241–9 dependency ranking 242–4 displaying the assumption dataset on the output sheet 248 Excel Scenario Manager 248 GOAL SEEK 242–4 Monte Carlo analysis 245–8 risk and its management 248–9 sensitivity analysis 241–2 V valuation 60 see also project appraisal and company valuation valuation approaches see project appraisal and company valuation valuation range 190 value-added tax 127 variable costs see under operating costs variables 21–2, 21 dependent 96 endogenous 22 exogenous 22 281 INDEX independent (explanatory) 96–7, 100 uncertainty/impact 23–4, 23 variance analyses 13 version control 35 versions of the model, retaining 35–6 vertical analysis 201 vision statement 18 Visual Basic 216, 232–6 Visual Basic Editor 216–17, 217, 218, 240 VLOOKUP function 121, 122, 269–70 W WACC see weighted average cost of capital warrants 148 warranty 118 weighted average cost of capital (WACC) 152, 167, 180, 181, 190 wind-farm operators critical factors for 15, 16 develop the scenario stories 28–30, 29 Gantt chart 10, 11 impact/uncertainty matrix 23–4, 23 input timelines 29, 29 output template 17 potential input development paths 25–6, 25–6 revenue model 29–30 strategic inputs 30 variables influencing 21, 22 withholding tax 258 working capital see under capital expenditure and working capital working capital turnover 201–2 working sheets 60–5 workshops 17–18 writing and presenting the business plan key issues to address in a business plan 256 presenting the model outputs 259–62 graphs 261, 262 rounding 259 rows versus columns 261 tables of data 259–60 report style 259 typical content of a business plan document assumptions 257–8 commercial risk 257 economic 258 executive summary 257 financial 257 manning 258 market 257 milestones 258 safety, health and environment 258 sensitivity 258 strategic importance 257 taxes 258 technical 258 Z zero, set all inputs to 211 zero book value 136
It fails to consider cash flows beyond the payback period (for example, the project could make $2,000,000 in year 6 and its payback would still be 2 years 4 months), and therefore says nothing about the scale of the project. It also ignores the time value of money, which is explained in the next section. However, it remains one of the most popular project appraisal techniques used by companies. DISCOUNTED CASH FLOW THEORY Typical projects normally involve a sequence of cash outflows followed by a sequence of cash inflows. Discounted cash flow or dcf analysis calculates the net cash flow as if all the future cash outflows and inflows occurred simultaneously at the same point in time, which is normally the first day of the project. The result is called the net present value or npv. Future cash flows, however, must be adjusted to allow them to be compared on an equivalent basis with cash flows that take place at the start of the project.
The discount rate must therefore reflect the average required return for both types of financier. This average is based on a weighted average cost of capital or wacc calculation. 181 Discounted cash flow theory Calculating the WACC In order to calculate the wacc a number of assumptions need to be made: A is the proportion of the project financed by equity E is the cost of equity in nominal terms B is the proportion of the project financed by debt R is the cost of debt in nominal terms T is the tax rate If the cost of equity is the discount rate that would be used to discount the cash flows only to equity holders and the cost of debt is the discount rate used to discount cash flows only to debt holders, the wacc would be written as: WACC⫽(A*E)⫹(B*R*(1⫺T)) The important element of the equation to examine is the cost of debt.
Investment Banking: Valuation, Leveraged Buyouts, and Mergers and Acquisitions by Joshua Rosenbaum, Joshua Pearl, Joseph R. Perella
asset allocation, asset-backed security, bank run, barriers to entry, capital asset pricing model, collateralized debt obligation, corporate governance, credit crunch, discounted cash flows, diversification, fixed income, London Interbank Offered Rate, performance metric, shareholder value, sovereign wealth fund, technology bubble, time value of money, transaction costs, yield curve
SPREAD KEY STATISTICS, RATIOS, AND TRANSACTION MULTIPLES STEP IV. BENCHMARK THE COMPARABLE ACQUISITIONS STEP V. DETERMINE VALUATION KEY PROS AND CONS ILLUSTRATIVE PRECEDENT TRANSACTION ANALYSIS FOR VALUECO CHAPTER 3 - Discounted Cash Flow Analysis STEP I. STUDY THE TARGET AND DETERMINE KEY PERFORMANCE DRIVERS STEP II. PROJECT FREE CASH FLOW STEP III. CALCULATE WEIGHTED AVERAGE COST OF CAPITAL STEP IV. DETERMINE TERMINAL VALUE STEP V. CALCULATE PRESENT VALUE AND DETERMINE VALUATION KEY PROS AND CONS ILLUSTRATIVE DISCOUNTED CASH FLOW ANALYSIS FOR VALUECO PART Two - Leveraged Buyouts CHAPTER 4 - Leveraged Buyouts KEY PARTICIPANTS CHARACTERISTICS OF A STRONG LBO CANDIDATE ECONOMICS OF LBOs PRIMARY EXIT/MONETIZATION STRATEGIES LBO FINANCING: STRUCTURE LBO FINANCING: PRIMARY SOURCES LBO FINANCING: SELECTED KEY TERMS CHAPTER 5 - LBO Analysis Financing Structure Valuation STEP I.
., those that have occurred within the previous two to three years) are the most relevant as they likely took place under similar market conditions to the contemplated transaction. Potential buyers and sellers look closely at the multiples that have been paid for comparable acquisitions. As a result, bankers and investment professionals are expected to know the transaction multiples for their sector focus areas. Chapter 3: Discounted Cash Flow Analysis Chapter 3 discusses discounted cash flow analysis (“DCF analysis” or the “DCF”), a fundamental valuation methodology broadly used by investment bankers, corporate officers, academics, investors, and other finance professionals. The DCF has a wide range of applications, including valuation for various M&A situations, IPOs, restructurings, and investment decisions. It is premised on the principle that a target’s value can be derived from the present value of its projected free cash flow (FCF).
As shown in the football field in Exhibit 2.37, the valuation range derived from precedent transactions is relatively consistent with that derived from comparable companies. The slight premium to comparable companies can be attributed to the premiums paid in M&A transactions. EXHIBIT 2.37 ValueCo Football Field Displaying Comparable Companies and Precedent Transactions CHAPTER 3 Discounted Cash Flow Analysis Discounted cash flow analysis (“DCF analysis” or the “DCF”) is a fundamental valuation methodology broadly used by investment bankers, corporate officers, university professors, investors, and other finance professionals. It is premised on the principle that the value of a company, division, business, or collection of assets (“target”) can be derived from the present value of its projected free cash flow (FCF).
Albert Einstein, asset allocation, asset-backed security, Brownian motion, business process, capital asset pricing model, clean water, collateralized debt obligation, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, equity premium, fixed income, implied volatility, index fund, interest rate swap, inventory management, London Interbank Offered Rate, margin call, market fundamentalism, mortgage debt, passive investing, performance metric, risk tolerance, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, statistical model, time value of money, transaction costs, yield curve, zero-coupon bond
Related Terms: • Federal Funds Rate • Federal Open Market Committee • Monetary Policy • Interest Rate • Prime Rate Discounted Cash Flow (DCF) What Does Discounted Cash Flow (DCF) Mean? A valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them (most often by using the weighted average cost of capital method) to arrive at a present value, which is used to evaluate the investment’s potential. If the value arrived at through CF1 CF2 CFn DCF = + +...+ DCF analysis is higher than the (1 + r )1 (1 + r )2 (1 + r )n current cost of the investment, CF = Cash Flow the opportunity may be a good r = discount rate (WACC) one. It is calculated as follows: Investopedia explains Discounted Cash Flow (DCF) There are many variations in what can be used for cash flows and the discount rate in a DCF analysis.
There are two main deficiencies with the payback period method: (1) It ignores any benefits that occur after the payback period and therefore does not measure profitability. (2) It ignores the time value of money. Because of these factors, other methods of capital budgeting, such as net present value, internal rate of return, and discounted cash flow, generally are preferred. Related Terms: • Cost of Capital • Internal Rate of Return—IRR • Return on Investment • Discounted Cash Flow—DCF • Opportunity Cost 222 The Investopedia Guide to Wall Speak Penny Stock What Does Penny Stock Mean? A stock that trades at a very low share price and market capitalization; usually it trades off a major market exchange. These types of stocks generally are considered highly speculative and risky because they lack liquidity, have large bid-ask spreads, are small capitalization, and have limited analyst coverage and disclosure.
See Dollar cost averaging (DCA) DCF. See Discounted cash flow (DCF) DD. See Due diligence (DD) DDM. See Dividend discount model (DDM) Dead cat bounce, 65 Dealer. See Broker-dealer Debenture, 65-66 Debt, 66, 167-168 Debt financing, 66-67. See also Leverage; Liability; Mortgage Debt ratio, 67, 117-118 Debt/equity ratio, 67-68, 118, 168 Debt-to-capital ratio, 68-69 Default, 4, 58, 289 Default risk. See Counterparty risk Defined-benefit plan, 69-70, 153-154, 241 Defined-contribution plan, 70, 153-154, 241 Deflation, 70 Deleverage, 71 Delta, 71-72, 117 Delta hedging, 72 Demand, 73, 156 Depreciation, 73-74 Depression, 29, 120, 131-132 Derivative, 74, 319, 366. See also Option Diluted earnings per share (diluted EPS), 74-75 Dilution, 31, 75, 112, 262 Discount broker, 76 Discount rate, 76-77, 143, 227 Discounted cash flow (DCF), 77 Discounted value.
accounting loophole / creative accounting, algorithmic trading, asset allocation, asset-backed security, bank run, banking crisis, barriers to entry, Big bang: deregulation of the City of London, capital asset pricing model, central bank independence, corporate governance, Credit Default Swap, dematerialisation, discounted cash flows, diversified portfolio, double entry bookkeeping, Edward Lloyd's coffeehouse, Elliott wave, Exxon Valdez, forensic accounting, global reserve currency, high net worth, index fund, inflation targeting, interest rate derivative, interest rate swap, London Interbank Offered Rate, Long Term Capital Management, margin call, market fundamentalism, Nick Leeson, North Sea oil, Northern Rock, pension reform, Piper Alpha, price stability, purchasing power parity, Real Time Gross Settlement, reserve currency, shareholder value, short selling, The Wealth of Nations by Adam Smith, transaction costs, value at risk, yield curve, zero-coupon bond
The EV/EBITDA ratio takes debt and cash into account, which the P/E ratio does not, and it is used to ﬁnd attractive takeover candidates, helpfully showing how much debt the acquirer would have to take on. Like the P/E ratio, the lower the enterprise value, the better the value of the company, although the ratio tends to be higher in high growth industries, and comparisons should be made against the sector. The most widely used tool of analysts, and arguably one of the most dangerous in the wrong hands, is discounted cash ﬂow analysis. ________________________________________ HOW TO VALUE SHARES 39 Discounted cash ﬂow analysis Discounted cash ﬂow (DCF) analysis translates future cash ﬂow into a present value. It starts with the net operating cash ﬂow (NOCF). You ﬁnd this by taking the company’s earnings before interest and tax, deducting corporation tax paid and capital expenditure, adding depreciation and amortisation, which do not represent movements in cash, and adding or subtracting the change in working capital, including movements in goods or services, in debtors and creditors, and in cash or cash equivalents.
This book is for still for you, To celebrate a wonderful childhood and to look forward to what is to come, With love THIS PAGE INTENTIONALLY LEFT BLANK vi THIS PAGE INTENTIONALLY LEFT BLANK vii THIS PAGE INTENTIONALLY LEFT BLANK viii Contents Acknowledgements Introduction 1 The City of London Introduction The City deﬁned Financial markets The City as a world leader No gain without pain Markets are people The future The next step xlvii 1 4 4 4 5 5 6 8 9 9 2 The Bank of England Introduction Origin Role today Monetary policy Lender of last resort International liaison 10 10 10 11 12 15 17 3 Commercial banking Introduction History Commercial banks today Building societies Raising ﬁnance 18 18 18 19 22 23 THIS PAGE INTENTIONALLY LEFT BLANK x THIS PAGE INTENTIONALLY LEFT BLANK xi THIS PAGE INTENTIONALLY LEFT BLANK xii THIS PAGE INTENTIONALLY LEFT BLANK xiii THIS PAGE INTENTIONALLY LEFT BLANK xiv THIS PAGE INTENTIONALLY LEFT BLANK xv THIS PAGE INTENTIONALLY LEFT BLANK xvi THIS PAGE INTENTIONALLY LEFT BLANK xvii THIS PAGE INTENTIONALLY LEFT BLANK xviii _________________________________________________ CONTENTS xix Credit collection Bad loans and capital adequacy 25 26 4 Introduction to equities Introduction Shares Market indices Stockbrokers The next step 29 29 29 32 33 34 5 How to value shares Introduction Analysts’ forecasts Ratios Discounted cash ﬂow analysis Market inﬂuencers 35 35 35 36 39 40 6 New share issues Introduction Capital raising 42 42 42 7 Investment banking Introduction Overview The initial public offering Specialist types of share issue Bond issues Mergers and acquisitions Disclosure and regulation 47 47 47 47 54 56 56 58 8 Introduction to derivatives Introduction Cash and derivatives Four types of derivative transaction On-exchange versus OTC derivatives Clearing and settlement Hedging and speculation Problems and fraud 60 60 60 61 63 65 67 67 9 Derivatives for retail investors Introduction 69 69 THIS PAGE INTENTIONALLY LEFT BLANK xx THIS PAGE INTENTIONALLY LEFT BLANK xxi THIS PAGE INTENTIONALLY LEFT BLANK xxii THIS PAGE INTENTIONALLY LEFT BLANK xxiii THIS PAGE INTENTIONALLY LEFT BLANK xxiv ________________________________________________ CONTENTS xxv Options Futures Warrants Financial spread betting Contracts for difference 69 71 72 73 76 10 Wholesale market participants Introduction Banks Investors Inter-dealer brokers 78 78 78 79 79 11 Interest rate products Introduction Overview of money markets Debt securities Repos Interest rate derivatives Government bonds 81 81 81 82 84 85 86 12 Credit products Introduction Overview Bonds Credit derivatives The future 89 89 89 90 96 98 13 Commodities Introduction Overview Hard commodities Soft commodities The investment case for commodities Regulation 99 99 99 102 106 107 108 14 Foreign exchange Introduction Global overview In the City The participants Exchange rates 109 109 109 112 113 115 THIS PAGE INTENTIONALLY LEFT BLANK xxvi THIS PAGE INTENTIONALLY LEFT BLANK xxvii Visit Kogan Page online www.kogan-page.co.uk Comprehensive information on Kogan Page titles Features include: � complete catalogue listings, including book reviews and descriptions � sample chapters � monthly promotions � information on NEW and BEST-SELLING titles � a secure shopping basket facility for online ordering Sign up to receive regular e-mail updates on Kogan Page books at www.kogan-page.co.uk/signup.aspx and visit our website: www.kogan-page.co.uk THIS PAGE INTENTIONALLY LEFT BLANK xxix THIS PAGE INTENTIONALLY LEFT BLANK xxx ________________________________________________ CONTENTS Supply and demand Transaction types Electronic trading Default risk Further research XXXI 115 115 117 119 120 15 The London Stock Exchange and its trading systems Introduction Overview Trading facilities Users 121 121 121 122 127 16 Share trading venues and exchanges Introduction Overview Exchanges Multilateral trading facilities Systematic internalisers Dark liquidity pools Consolidation 130 130 130 131 134 137 138 138 17 Post-trade services Introduction Overview Clearing Settlement Safekeeping and custody Cross-border activity The future 140 140 140 141 142 143 144 150 18 Investors Introduction Retail investors Institutional investors 151 151 151 155 19 Pooled investments Introduction Investment funds Investment companies Exchange-traded funds Hedge funds 159 159 159 164 169 169 THIS PAGE INTENTIONALLY LEFT BLANK xxxii THIS PAGE INTENTIONALLY LEFT BLANK xxxiii THIS PAGE INTENTIONALLY LEFT BLANK xxxiv _______________________________________________ CONTENTS xxxv 20 Analysts and research Introduction The analyst Others 172 172 172 177 21 Financial communications Introduction Public relations Investor relations Corporate information ﬂow Journalists 179 179 179 183 185 185 22 Financial services regulation Introduction Overview History of regulation The current regime 190 190 190 190 192 23 Financial fraud Introduction Overview Fraud busters The future 200 200 200 208 215 24 Money laundering Introduction Overview Know your client Action against money launderers The size of the problem 216 216 216 217 217 222 25 Overview of corporate governance Introduction The concept The Cadbury Code The Greenbury Committee The Combined Code The Turnbull Report OECD Principles of Corporate Governance Directors’ Remuneration Report Regulations Higgs and Smith 223 223 223 224 224 225 225 226 226 227 THIS PAGE INTENTIONALLY LEFT BLANK xxxvi THIS PAGE INTENTIONALLY LEFT BLANK xxxvii THIS PAGE INTENTIONALLY LEFT BLANK xxxviii _______________________________________________ CONTENTS The Revised Combined Code Listing Rules The Myners Report Developments across Europe The future XXXIX 227 228 229 230 230 26 Accounting and governance issues Introduction Accounting scandals The Sarbanes–Oxley Act European auditing and disclosure rules Business review International Financial Reporting Standards 232 232 232 233 234 235 237 27 Insurance: the London companies market Introduction Overview London Types of business The underwriting process Regulatory developments Market reform The future 239 239 239 240 240 241 243 245 245 28 Insurance: Lloyd’s of London Introduction Overview How Lloyd’s works Boom to bust More about Lloyd’s today The future 246 246 246 247 250 252 258 29 Reinsurance Introduction Overview Reinsurance contracts Retrocession Financial reinsurance Reinsurance reassessed Capital markets convergence The Reinsurance Directive 260 260 260 261 262 263 264 264 266 THIS PAGE INTENTIONALLY LEFT BLANK xl Visit Kogan Page online Comprehensive information on Kogan Page titles Features include: � complete catalogue listings, including book reviews � sample chapters � monthly promotions � information on NEW and BEST-SELLING titles � a secure shopping basket facility for online ordering Sign up to receive regular e-mail updates on Kogan Page books at www.kogan-page.co.uk/signup.aspx and visit our website: www.kogan-page.co.uk THIS PAGE INTENTIONALLY LEFT BLANK xli THIS PAGE INTENTIONALLY LEFT BLANK xlii _________________________________________________ CONTENTS xliii Offshore reinsurance collateral requirements in the United States Dispute resolution 267 268 30 Retail insurance, savings and domestic property Introduction Overview Products How the products are sold Complaints and compensation The future 269 269 269 273 277 279 280 31 Pensions in ﬂux Introduction Overview The basic state pension Occupational and personal pensions Annuities and unsecured pensions 282 282 282 283 284 288 A word to investors 291 Appendix 1: Useful websites Appendix 2: Further reading 292 297 Index Index of advertisers 302 308 THIS PAGE INTENTIONALLY LEFT BLANK xliv THIS PAGE INTENTIONALLY LEFT BLANK xlv THIS PAGE INTENTIONALLY LEFT BLANK xlvi Acknowledgements This book owes everything to the City professionals who gave freely of their valuable time in providing interviews, source material and other help.
2 HOW THE CITY REALLY WORKS ___________________________________ You will read about how capital markets work. A new chapter on new issues looks at the choice of markets in London. In another chapter, we focus on how investment banks bring companies to the market. Analysts are a link in the chain, but regulatory developments have placed restrictions on them, and we will see where they stand in a new chapter. We will cover valuation techniques such as discounted cash ﬂow analysis and EBITDA, and I will explain the City’s dependence on earnings per share. The book provides an overview of technical analysis. We explore how the big institutional investors as well as private investors work. We cover hedge funds and how they move markets. We delve into some of the more esoteric areas of the City such as shipping and metals. In the City today, derivatives are becoming increasingly sophisticated, and are used for both speculating and hedging.
Getting a Job in Hedge Funds: An Inside Look at How Funds Hire by Adam Zoia, Aaron Finkel
backtesting, barriers to entry, collateralized debt obligation, commodity trading advisor, Credit Default Swap, credit default swaps / collateralized debt obligations, discounted cash flows, family office, fixed income, high net worth, interest rate derivative, interest rate swap, Long Term Capital Management, merger arbitrage, offshore financial centre, random walk, Renaissance Technologies, risk-adjusted returns, rolodex, short selling, side project, statistical arbitrage, systematic trading, unpaid internship, value at risk, yield curve, yield management
Credit Suisse/Tremont Fund Indexes www.hedgeindex.com Greenwich Alternative Investments www.greenwichai.com Provides hedge fund–related investment products and services, including research, indexing, investment management, and advisory services Hedge Fund Consistency Index www.hedgefund-index.com Profiles and ranks hedge funds, available to qualified investors Hedge Fund Research www.hedgefundresearch.com The Hennessee Group www.hennesseegroup.com MSCI Hedge Fund Indices www.mscibarra.com/products/indices/hf/press.jsp bapp01.indd 159 1/10/08 10:58:52 AM bapp01.indd 160 1/10/08 10:58:52 AM Appendix B SAMPLE RESUMES 161 bapp02.indd 161 1/10/08 10:59:49 AM bapp02.indd 162 1/10/08 10:59:50 AM Resume A Profile Pre-MBA: Bulge-Bracket Banker Lands at a Distressed Debt Fund (see CASE STUDY 1) Recruiter’ s Perspect ive • Top nam e school • Solid SA Ts/GPA • M&A ex perience • Worked on large d eals Pluses Interested in investin g EXPERIENCE BULGE-BRACKET INVESTMENT BANK New York, NY Financial Analyst, Mergers & Acquisitions, Investment Banking Division July 2005 – February 2006 • Performed detailed financial analyses on potential acquisitions, leveraged buyouts, and divestitures • Constructed valuation models, including discounted cash flow, comparable company, and precedent transaction analysis • Assessed the effects of multiple operational scenarios and capital structure alternatives on potential mergers • Created client presentations illustrating strategic alternatives • Worked closely with management to prepare offering materials, including management presentations • Evaluated companies’ defense profiles for vulnerabilities for both hostile buy-side and hostile defense transactions • Became familiar with multiple industries and subsectors SELECTED WORK EXPERIENCE • Advised a company on the acquisition of a supplier - Created a dynamic, bottom-up financial model for valuation based on public information and key metrics, incorporating sum-of-the-parts discounted cash flow, leveraged buyout, and pro forma merger analyses - Performed potential interloper analysis, analyzing the accretion/dilution and value impact on numerous possible bidders - Organized materials to prepare an indicative bid • Advised company on the sale of approximately $1.5 billion in assets - Created a full pro forma model capable of multiple operating scenarios, as well as LBO and DCF analyses - Performed due diligence on assets, and incorporated research and analysis into modeling effort • Advised company on the divestiture of approximately $3 billion in assets - Created a model to value the assets using both base-case metrics and bidders’ implied assumptions, particularly those revolving around the valuation of a major outstanding pension liability - Managed the flow of information between the company and interested parties • Advised company on hostile defense planning - Analyzed pro forma accretion/dilution impact to potential bidders based on internal company financials and public information - Prepared management presentation describing detailed financial and qualitative analysis of potential bidders and potential synergies as seen by bidding parties - Worked with the client to establish measures to defend against a hostile bid MAJOR AUTOMOTIVE COMPANY Summer Financial Analyst Summer 2004 • Built financial model to more accurately account for ocean freight shipments from overseas suppliers to Fortune 5 company • Worked closely with suppliers and company’s in-house technology department to create a new system to facilitate Sarbanes-Oxley compliance EDUCATION IVY LEAGUE UNIVERSITY B.S. with Honors; GPA: 3.91/4.00 Dean’s List Spring 2002 through Fall 2004 SAT: Math – 800, Verbal – 780; National Merit Finalist August 2001–May 2005 OTHER • Certified General Securities Registered Representative (Series 7) and Uniform Securities Agent (Series 63) • High level of skill with Microsoft Excel; background in C++, Stata, and Business Objects • Course work in Finance, Investments, Econometrics, Intermediate Accounting, Computer Science, Linear Algebra, Multivariable Calculus, and Group Theory • Ivy League recruiting team.
Assisted with on-campus events, selection, and calls to candidates • Language: Proficient in Spanish • Activities & Interests: Hockey, investing, chess, economics, mathematics, and writing 163 bapp02.indd 163 1/10/08 10:59:50 AM Resume B ive s Perspect Recruiter’ e school • Top nam Ts/GPA • Solid SA perience finance ex g • Levera ed e fund at a hedg ) • Worked sity athlete ar (v nded • Well rou nity • VP frater Profile Pre-MBA: Getting In from a Second-Tier Bank (see CASE STUDY 2) PROFESSIONAL EXPERIENCE MID-TIER INVESTMENT BANK, New York, NY Investment Banking Analyst – Leveraged Finance Group June 2005 – Nov. 2006 • Analyzed transactions by providing capital structure/valuation advice and assessing viability of business plans/forecasts, barriers to entry, and market competitiveness • Presented and defended proposed transactions in capital commitment committees • Participated in deal teams to advise clients on leveraged buyouts, recapitalizations, strategic alternatives, and equity and debt capital raising • Constructed financial models, including leveraged buyouts, recapitalizations, mergers and acquisitions, and discounted cash flow • Examined company, industry, and market dynamics to evaluate potential acquisitions and divestitures for clients • Transaction experience: Sole Book Running Manager on $170 million of Senior Notes and $25 million of Senior Subordinated Discount Notes Represented three private equity firms in bid for major media company SMALL HEDGE FUND, Greenwich, CT May 2004 – August 2004 Summer Analyst • Evaluated potential investment opportunities in the small-cap high-yield bond market • Performed company and industry research • Assisted in managing relationships with investors • Analyzed the effectiveness of the firm’s hedging positions by running scenarios based on historical market events, such as 9/11 and the Russian debt default • Examined the usefulness of different hedging strategies EDUCATION IVY LEAGUE UNIVERSITY Bachelor of Arts: Major – Political Science • Cumulative GPA 3.6/4.0 • Relevant Coursework Included: Accounting, Micro- and Macroeconomics, International Trade Theory and Policy, Politics and Markets, and Multivariable Calculus • Men’s Varsity Swimming (2001–2004) • Vice President, Fraternity (2005) PRIVATE BOARDING SCHOOL • SAT: 1,480 (770 Math, 710 Verbal) • Graduated with distinction in Math, Chemistry, and Physics • Tri-varsity athlete 2005 2001 164 bapp02.indd 164 1/10/08 10:59:51 AM Resume C Recruiter’ s Perspect ive • Top nam e school • Solid GPA – distinction graduated with • Worked at M&A-fo cused bou • Well rou tique nded (varsi ty athlete, H.S. record holder) • Founded fraternity Profile Pre-MBA: Making It with a Liberal Arts Degree (see CASE STUDY 3) EXPERIENCE BOUTIQUE INVESTMENT BANK New York, NY July 2005 Investment Banking Analyst to July 2007 • Performed financial and operational modeling to evaluate the accretion/dilution, cash flow, and leverage effects of mergers, acquisitions, leveraged buyouts, and corporate restructurings • Participated in client meetings, due diligence, and internal committee meetings • Managed the due diligence and site visits associated with sell-side transactions • Drafted management presentations and company profiles Selected transaction experience: • Advised a major corporation on its proposed reorganization (six mergers) and eventual Initial Public Offering - Built a valuation model in order to properly value the stand-alone regions singularly and on a pro forma basis in order to merge six of the regions into one entity and pursue a global float - Worked with company Board of Directors, company executives, and management in order to accurately gauge the impact of legal liability and drafted materials proposing an adequate financial structure to maximize value and mitigate forthcoming legal liabilities • Advised manufacturing company on its $1 billion+ acquisition of rival - Conducted stand-alone valuation, accretion/dilution, and noncore asset valuation for the purchase - Maintained a purchase price spread analysis during the ongoing regulatory approval period • Advised a financial buyer on the acquisition of natural gas pipeline assets (approx. $250mm) - Constructed an operating model, discounted cash flow analysis, and LBO to project revenues associated with the processing of natural gas and sale of natural gas products - Participated in due diligence and site visits on behalf of the client • Advised company on its sale to another company - Constructed a working capital model to project final adjustments made to the purchase price - Drafted and organized materials for the Management Presentation along with coordinating the data room May 2004 LEADING INVESTMENT BANK New York, NY to August 2004 Investment Banking Summer Analyst • Valued companies and their comparables using discounted cash flows • Gauged demand for potential equity transactions and helped price equity deals • Tracked market conditions and gauged the proper size for potential equity transactions • Built and maintained a database of venture capital sponsored Initial Public Offerings since 1999 Selected transaction experience: • Pitch for Bank IPO • Entertainment Company Follow-on Offering ($200mm) Washington, DC May 2003 NOT-fOR-PROFIT to August 2003 Visiting Fellow • Compiled research on the interaction between informal markets and financial institutions • Wrote and published an internal working paper EDUCATION IVY LEAGUE UNIVERSITY Bachelor of Arts, May 2005.
We have also seen some global macro funds take people directly out of undergraduate school, as those types of funds do not use a bottom-up approach to picking stocks and can therefore bring on people without financial modeling experience. Quantitative funds have also been known to hire undergraduates, but would focus exclusively on individuals with exceptional mathematics and programming abilities. Some funds that may need execution-only traders could also be willing to bring on and train a raw person. The thinking is that traders don’t need the same skills as researchers—for example, how to build a discounted cash flow (DCF) model—and therefore wouldn’t necessarily have to go through an investment banking program. Notwithstanding the types of funds mentioned, when bringing on junior staff most firms focus on individuals with some investment banking and/or investing experience. Remember, most hedge funds are smaller organizations as compared to investment banks and don’t have the infrastructure to train graduates themselves.
Affordable Care Act / Obamacare, barriers to entry, business process, Claude Shannon: information theory, Clayton Christensen, conceptual framework, corporate governance, Daniel Kahneman / Amos Tversky, discounted cash flows, diversified portfolio, double entry bookkeeping, Exxon Valdez, financial innovation, fixed income, hydraulic fracturing, index fund, inventory management, Joseph Schumpeter, knowledge economy, moral hazard, new economy, obamacare, quantitative easing, quantitative trading / quantitative ﬁnance, QWERTY keyboard, race to the bottom, risk/return, Robert Shiller, Robert Shiller, shareholder value, Steve Jobs, The Great Moderation, value at risk
In Devon’s case, our calculation shows that with proved (2014) reserves of 2,754 million Boe and reported 2014 production of 673,000 Boe per day, or 242.3 million Boe per year, the reserve life index is: 2,754 million Boe divided by 242.3 million Boe to give 11.37 years. Thus, Devon’s end-of-2014 proved reserves would last 11.37 years, under current production level and no new acquisitions. Changes in the discounted cash flows from the proved reserves are an important forward-looking indicator of company value and growth potential, unique to extractive industries. These changes are affected by varying estimates of future energy prices, in addition to acquisitions, production, and disposals. Interestingly, despite the decrease in the quantity of proved reserves during 2014, Devon reported a 31 percent increase in discounted cash flows. Obviously, this indicator is very sensitive to changes in underlying assumptions. Yet another important indicator of the potential value-creation of the company’s properties is the extent of its productive (energy extraction) activities, measured by the number of wells and rigs operating on the properties, and classified by oil and gas, as well as by geographic areas.
Similarly, long-term efforts at cost containment, crucial for maintaining competitive advantage, are reflected in financial reports after a considerable delay, and important business relationships, such as joint ventures with other companies and contracts with governments—major value-creating assets in the industry—aren’t flagged on the balance sheet. The accounting system is simply unable to capture the intricacies of the oil business.2 True, specific oil and gas regulations by the FASB and the SEC, requiring disclosure (though not the audit) of proved (proven) reserves and their discounted cash flows, as well as data on productive wells, among other information items, are definitely helpful but insufficient for a comprehensive strategic assessment by investors of the operations of oil and gas companies and their growth potential. This became clear from our detailed examination of the earnings conference calls and investor day presentations of the 10 oil and gas companies, large and small, that we have studied.
The top line—mineral acreage—presents the total area (in thousands of acres) controlled by the company through owning or leasing, and classified by developed (2,317) versus undeveloped (3,926) thousands of acres. Thus, 186 SO, WHAT’S TO BE DONE? Minerals I. Mineral Acreage (000) Developed 2014 2013 2,317 4,328 % –46.5 Undeveloped 3,926 8,411 –53.3 Total 6,243 12,739 –51.0 By major geographical areas: U.S. 4,666 5,805 Canada 1,577 6,934 Energy type: Oil II. gas unconventional Proved Reserves (million Boe) 2,754; 2,963 (−7%) Discounted Cash Flows (billions) $20.5; III. $15.7 (31%) Total Productive Wells and Rigs (2014) Rigs Wells Oil Gas 7,165 X 11,124 X By geographical areas: X X (X) Refining Capacity and Usage Patents and Trademarks Key Governmental Agreements and Inter-Company Alliances FIGURE 15.2 Strategic Resources Strategic Resources & Consequences Report: Case No. 4 187 Devon’s footprint (acreage) at the end of 2014 decreased significantly (51 percent) from a year earlier, likely as part of the reorganization.
algorithmic trading, asset allocation, asset-backed security, backtesting, banking crisis, Black Swan, Black-Scholes formula, Brownian motion, capital asset pricing model, collateralized debt obligation, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discounted cash flows, discrete time, diversification, fixed income, implied volatility, interest rate derivative, interest rate swap, margin call, market microstructure, martingale, p-value, passive investing, quantitative trading / quantitative ﬁnance, random walk, risk/return, Sharpe ratio, short selling, statistical model, stochastic process, stochastic volatility, time value of money, transaction costs, value at risk, volatility smile, Wiener process, yield curve, zero-coupon bond
This growing rate is probabilistic, with some deterministic part and some volatility around it. These deterministic methods do not incorporate the volatility component of the growth rate, that is, the discounting is made in a deterministic environment. Here, the stock value is rather: S = a form of discounted cash flows + the PV of growing uncertainty, that is, a call option premium on the measurable potential Example: Tiscali The IPO was launched in November 1999, @ €4.60, as the result of the discounting cash flows method. Adding an option premium on the hypothesis that Tiscali foresees capturing 20% of the Italian e-com until 2003 (+ about 4 years), the calculation gives €6.70. On top of that, adding an option on cash flows brought by the third generation of cellular phones, the initial stock price goes to €30.90.
collars collateralized debt obligations (CDOs) color sensitivity commodities commodity futures backwardation contango market price non-financial producers/users trading calculations conditional swaps Conditional VaR (C-VaR) confidence levels constant maturity swaps (CMSs) contango continuous interest compounding continuous interest rates continuous time continuous variables contracts contracts for difference (CFD) contribution, performance convenience yield conversion factors (CFs) convertible bonds (CBs) bond floor CB premium conversion ratio Hard Call protection outcome of operation pricing graph risk premium stock price parity convexity adjustments see also bond convexity copper prices copulas correlation basket options credit derivatives implied Portfolio Theory Spearman’s coefficient VaR calculations volatility counterparty risk futures see also credit risk counter-value currency (c/v) Courtadon model covered period, FRAs Cox, Ingersoll and Ross model Cox–Ross–Rubenstein (CRR) model credit default swaps (CDSs) on basket cash settlement with defined recovery rate market operations variants credit derivatives CDSs credit risk main features valuation application example basket derivatives binomial model CDO pricing correlation measures credit risk models useful measures Merton model “credit events” credit exposure credit risk behind the underlying components data use dangers default rates Merton model models in practice quantification recovery rates credit VaR crossing CRR see Cox–Ross–Rubenstein model CRSs see currency rate swaps crude oil market CTD see cheapest to deliver cubic splines method currencies futures options performance attribution spot instruments currency rate swaps (CRSs) c/v see counter-value currency C-VaR see Conditional VaR D see discount factors DCF see discounted cash flows method decision-making deep ITM (DITM) deep OTM (DOTM) default rates default risk see credit risk delta delta-gamma neutral management delta-normal method, VaR derivatives credit valuation problems volatility Derman see Black, Derman, Toy process deterministic phenomena diff swaps diffusion processes Dirac functions dirty prices discounted cash flows (DCF) method discount factors (D) duration D forward rates IRSs risk-free yield curve spot rates yield curve interpolations discrete interest compounding discrete time discrete variables DITM see deep ITM DOTM see deep OTM drift duration of bonds see bond duration duration D dVega/dTime dynamic replication see delta-Gamma neutral management dZ Black–Scholes formula fractional Brownian motion geometric Wiener process martingales properties of dZ(t) standard Wiener process economic capital ED see exposure at default effective duration, bonds efficient frontier efficient markets EGARCH see exponential GARCH process EONIA see Euro Over-Night Index Average swaps equities forwards futures Portfolio Theory stock indexes stocks valuation EUR see Euros EURIBOR rates CMSs EONIA/OIS swaps FRAs futures in-arrear swaps IRSs quanto/diff swaps short-term rates Euro Over-Night Index Average (EONIA) swaps European options basket options bond options caplets CRR pricing model exchange options exotic options floorlets Monte Carlo simulations option pricing rho Euros (EUR) CRSs forward foreign exchange futures spot market swap rate markets volatility Euro Stoxx EWMA see exponentially weighted moving average process Excel functions MA process Monte Carlo simulations excess return exchange options exotic options basket options Bermudan options binomial pricing model Black–Scholes formula currency options exchange options interest rates Monte Carlo simulations options on bonds options on non-financial underlyings PFCs pricing methods see also second generation options exotic swaps see also second generation swaps expected credit loss expected return exponential GARCH (EGARCH) process exponentially weighted moving average (EWMA) process exposure at default (ED) fair price/value “fat tails” problem financial models ARCH process ARIMA process ARMA process AR process GARCH process MA process MIDAS process finite difference pricing methods fixed leg of swap fixed rate, swaps floating rate notes/bonds (FRNs) floating rates floorlets floors forecasting ARIMA ARMA process AR process MA process foreign exchange (FX) see currencies; forex swaps; forward foreign exchange forex (FX) swaps forward foreign exchange 1 year calculations forex swaps forward forex swaps forward-forward transactions forward spreads NDF market operations forward rate agreements (FRAs) forwards Black–Scholes formula bonds CFDs CRSs equities foreign exchange FRAs futures vs forwards prices options PFCs rates swaps volatility forward zero-coupon rate 4-moments CAPM fractional Brownian motion FRAs see forward rate agreements FRNs see floating rate notes/bonds futures bonds commodities currencies equities forwards vs futures prices IRR margining system market price option pricing pricing settlement at maturity short-term interest rates stock indexes theoretical price future value (FV) bond duration short-term rates spot rates zero-coupon swaps FX see foreign exchange; forex swaps gain-loss ratio (Bernardo Ledoit) gamma gamma processes GARCH see generalized ARCH process Garman–Klass volatility Gaussian copulas Gaussian distribution Gaussian hypothesis generalized ARCH (GARCH) process EWMA process I/E/MGARCH processes non-linear models regime-switching models variants volatility general Wiener process application fractional Brownian motion gamma processes geometric Wiener process Itô Lemma Itô process jump processes volatility modeling see also standard Wiener process geometric average geometric Wiener process German Bund see Bund (German T-Bond) global VaR Gordon–Shapiro method government bonds Greece Greeks see sensitivities Hard Call protection Heath, Jarrow and Morton (HJM) model Heaviside function hedging bond futures delta-gamma neutral management futures 129–30 immunization vs hedging money market rate futures stock index futures heteroskedasticity hidden layers, NNs high frequency trading “high” prices historical method, VaR historical volatility HJM see Heath, Jarrow and Morton model Ho and Lee model Hull and White model Hurst coefficient IGARCH see integrated GARCH process immunization implied correlation implied repo rate (IRR) implied volatility definition historical volatility surface volatility curves volatility smiles in-arrear swaps indexes basket options capitalization-weighted price/value-weighted see also stock indexes inflation-linked bonds inflation swaps Information Ratio (IR) initial margin in the money (ITM) caps convertible bonds deep ITM options innovation term, AR instantaneous returns integrated GARCH (IGARCH) process interbank rates see EURIBOR rates; LIBOR rates interest rate options BDT process Black and Karasinski model caps collars floors forward rates HJM model LMM model single rate processes swaptions yield curve modeling interest rates day counting discount factors futures FV/PV interest compounding IRSs options short-term spot rates term structure see also yield interest rate swaps (IRSs) bond duration and CRSs fixed/floating rates pricing methods prior to swap pricing method revaluation vanilla swaps yield curve see also constant maturity swaps intermediate period, FRAs International Swaps and Derivatives Association (ISDA) intraday margining settlements intraday volatility investor decision-making IR see Information Ratio IRR see implied repo rate IRSs see interest rate swaps ISDA see International Swaps and Derivatives Association ITM see in the money Itô process Itô’s Lemma Japanese yen (JPY) Jarrow, Robert A.
This should lead to an average that generalizes the above average life formula as follows, where ci is the coupons paid on year i: Another step further, we could take into account that a cash flow paid in year i should not be considered today as equivalent to a cash flow paid on another year j. To cope with this, the cash flows in (pi + ci), or ai, would better be actualized, at the YTM y: (3.6) This ratio is called the duration D, that is, the average of the discounted cash flows weighted by their maturities. The denominator of Eq. 3.6 is nothing other than the bond price B (cf. Eq. 3.3), so that D can be expressed as (3.7) Physical Approach of the Duration A “physical” approach of the duration facilitates the understanding of some of its properties. Let us take a kind of Roberval balance7 and align small containers on it. Let us work with a 7-year bullet bond, with a 5% yearly coupon.
The Future of Money by Bernard Lietaer
agricultural Revolution, banks create money, barriers to entry, Bretton Woods, clean water, complexity theory, dematerialisation, discounted cash flows, diversification, fiat currency, financial deregulation, financial innovation, floating exchange rates, full employment, George Gilder, German hyperinflation, global reserve currency, Golden Gate Park, Howard Rheingold, informal economy, invention of the telephone, invention of writing, Lao Tzu, Mahatma Gandhi, means of production, microcredit, money: store of value / unit of account / medium of exchange, Norbert Wiener, North Sea oil, offshore financial centre, pattern recognition, post-industrial society, price stability, reserve currency, Ronald Reagan, seigniorage, Silicon Valley, South Sea Bubble, the market place, the payments system, trade route, transaction costs, trickle-down economics, working poor
Understanding the relationship between interest rates and time perception will be accomplished in the three following steps: . comprehend how capital allocation decisions are generally made through the financial technique of 'Discounted Cash Flow'; · how such discounting of the future is one of the key underlying causes which create a direct conflict between financial criteria and ecological sustainability under our present money system; · and how the discount rate used in the Discounted Cash Flow technique is directly affected by the interest rate of the currency used in the cash flow analysis. 'Discounted Cash Flow' = ‘ Discounting the Future’ 'Discounted Cash Flow' is the financial technique generally used to decide on whether to invest in a given project, or to compare different projects. It is presented in full detail in any finance textbook.
When a homeowner decides it is too expensive to install solar panels for heating the household water, she is implicitly saying that the cost of purchasing electricity or gas from the grid in the long run discounted to today is cheaper than the initial capital outlay required. When we build a house cheaply without appropriate insulation, we are really making the trade-off between the higher heating costs in the future discounted to today and the higher construction costs. Relationship with interest rates In the explanation of the Discounted Cash Flow technique, we made an assumption that the discount rate used is identical to the interest rate of the currency. In reality, the discount rate, which should be used, is the 'cost of capital of the project'. Without getting unduly technical, there is not one but three components to that cost of capital: · the interest rate of the currency involved; · the cost of equity; · and an adjustment reflecting the uncertainty about the cash how of the project itself.
From a financial perspective, a demurrage charge on money is mathematically equivalent to a negative interest rate. For reasons that will become clear soon, I will call this time-related charge a ‘sustainability fee'. Now, what would such a sustainability fee or demurrage charge do to the eyesight of our financial analyst? The project described in Figure 8.3 would suddenly appear to him as described in Figure 8.5. This is not just true because of a mechanical application of the equations of Discounted Cash Flow. Even if it looks strange at first sight, even if it contradicts what we are used to with our normal currencies, it still makes perfect financial sense. Let us assume that I give you a choice between 100 units of an inflation- proof currency charged by a sustainability fee, today or a year from now. If you do not need the money for immediate consumption, and you have guarantees about my creditworthiness over the next year, you should logically prefer the money a year from now.
The Automatic Customer: Creating a Subscription Business in Any Industry by John Warrillow
Airbnb, airport security, Amazon Web Services, asset allocation, barriers to entry, call centre, cloud computing, discounted cash flows, high net worth, Jeff Bezos, Network effects, passive income, rolodex, sharing economy, side project, Silicon Valley, Silicon Valley startup, software as a service, statistical model, Steve Jobs, Stewart Brand, subscription business, telemarketer, time value of money, Zipcar
In my experience, the most common methodology used to value a small to mid-size business is called discounted cash flow. This methodology forecasts your future stream of profits and then “discounts” it back to what your future profit is worth to an investor in today’s dollars given the time value of money. This investment theory may sound like MBA talk, but discounted cash flow valuation is something you have likely applied in your own personal life without knowing it. For example, what would you pay today for an investment that you hope will be worth $100 one year from now? You would likely “discount” the $100 by your expectation for a return on investment. If you expect to earn a 7% return on your money each year, you’d pay $93.46 ($100 divided by 1.07) today for an investment you expect to be worth $100 in 12 months. Using the discounted cash flow valuation methodology, the more profit the acquirer expects your company to make in the future—and the more reliable your estimates—the more your company is worth.
., 150–51 communication, 185–87 Conscious Box, 35–36, 86, 95–96, 164 Constant Contact, 18, 136–37, 183–84 consumables model, 81–90 Consumer Intelligence Research Partners, 11 ContractorSelling.com, 35, 49 cost of goods sold (COGS), 132 counseling, 75–77 Cratejoy, 86, 96–97 Crisara, Joe, 35 cross-selling, 191–93 Cue, 100 customer acquisition cost (CAC), 128–30, 138, 139, 143, 146, 151, 189 Ancestry.com and, 136 cash up front and, 148–51 Constant Contact and, 137 HubSpot and, 133–34, 149–50 Mosquito Squad and, 138 payback period and, 140–43 Crystal Cruises, 50 DanceStudioOwner.com, 49–52, 197 Dance Teachers’ Club of Boston, 49 Danielson, Antje, 109, 113 data, 20–21, 22, 96–97 Daugherty, Gordon, 141–42, 173 demand, 33–34 De Nayer, Pierre, 158 Desk.com, 77 destination clubs, 68–70 Diapers.com, 15, 84–86 discounted cash flow, 28 distribution channels, 20 DocuSign, 140 Dollar Shave Club, 81–83, 84, 87–89, 157, 175–76, 192–93 Dorco, 88–89 Dream of Italy, 48–49 Driesman, Debbie, 101 Dropbox, 100 Dubin, Michael, 81–83, 87 e-commerce: consumables model, 81–90 surprise box model, 91–98 Economist Intelligence Unit, 25 Elaguizy, Amir, 86–87, 96 elevator business, 40–41 Entitle, 59 entrepreneurs, 129 eReatah, 59 evergreen subscriptions, 193–94 Everything Store, The: Jeff Bezos and the Age of Amazon (Stone), 85 Exclusive Resorts, 68–69 Facebook, 2, 19, 108, 146n New Masters Academy and, 61, 62 Family Circle, 179 Financial Times, 17, 48 first mover advantage, 146n float, 118–19 flower stores, 32–33, 34, 158–59, 195–96 H.Bloom, 33, 34, 39, 158–59, 197 Foot Cardigan, 165 For Entrepreneurs, 129 Forrester Research, 150–51, 192 Founders Investment Banking, 29–30 freemium model, 161–62, 164 free trials, 161–64 FreshBooks.com, 27, 144–48, 162–63, 164, 189 Fried, Jason, 144, 145–46 Fried, Jesse, 147 front-of-the-line model, 73–79 GameFly, 59, 155 Gartner and Forrester Research, 5, 24 Gates, Bill, 67 Generally Accepted Accounting Principles (GAAP), 127 Genius Network, 66–67, 155 Gerety, Suzanne Blake, 50–52, 197 Ghirardelli, 93 gifts: happiness bombs, 187–88 subscriptions as, 164–66 Gladwell, Malcolm, 71 Godiva, 93 Goodies Co., 20–21, 35 Goodman, Gail, 136, 183–84 Google, 55, 92 Apps, 24 Grano Speaker Series, 70–71, 159 Gray, Andrew, 168–70 Griffith, Scott, 109–10, 111, 113 Griffiths, Rudyard, 70 GrooveBook, 156–57 Hackers Conference, 47 Handler, Brad, 69 Handler, Brent, 69 Hansson, David Heinemeier, 144 happiness bombs, 187–88 Harland Clarke, 178 Hassle Free Home Services, 101–3, 173, 181, 194 H.Bloom, 33, 34, 39, 158–59, 197 Hearst, William Randolph, 16 Herbal Magic Weight Loss & Nutrition Centers, 24–25 Holland, Anne, 52–54 home ownership, 18 Hassle Free Home Services and, 101–3, 173, 181, 194 security businesses and, 4, 31, 116 Honda, 117 HubSpot.com, 131–36, 149–50, 180–81 Hunt, Sean, 37 Hunt, Stuart, 37 Hyssen, Alex, 24–25 Hyssen, James, 24–25 IBM, 126 inertia, 175, 180–81 information, 47–48 Infusionsoft, 176 Inspirato, 69–70 insurance companies, 117–19 International Air Transport Association, 175 Internet, 16, 137 reliability of, 19 Internet-based messaging services, 2 WhatsApp, 1–2, 108–9, 113, 157 iPhone, 1, 19 Islam, Frank, 101 iTunes, 57–58, 154 JackedPack, 91 Jacobo, Joshua, 59–62, 155 J.
Investment: A History by Norton Reamer, Jesse Downing
Albert Einstein, algorithmic trading, asset allocation, backtesting, banking crisis, Berlin Wall, Bernie Madoff, Brownian motion, buttonwood tree, California gold rush, capital asset pricing model, Carmen Reinhart, carried interest, colonial rule, credit crunch, Credit Default Swap, Daniel Kahneman / Amos Tversky, debt deflation, discounted cash flows, diversified portfolio, equity premium, estate planning, Eugene Fama: efficient market hypothesis, Fall of the Berlin Wall, family office, Fellow of the Royal Society, financial innovation, fixed income, Gordon Gekko, Henri Poincaré, high net worth, index fund, interest rate swap, invention of the telegraph, James Hargreaves, James Watt: steam engine, joint-stock company, Kenneth Rogoff, labor-force participation, land tenure, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, margin call, means of production, Menlo Park, merger arbitrage, moral hazard, mortgage debt, Network effects, new economy, Nick Leeson, Own Your Own Home, pension reform, Ponzi scheme, price mechanism, principal–agent problem, profit maximization, quantitative easing, RAND corporation, random walk, Renaissance Technologies, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sand Hill Road, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spinning jenny, statistical arbitrage, technology bubble, The Wealth of Nations by Adam Smith, time value of money, too big to fail, transaction costs, underbanked, Vanguard fund, working poor, yield curve
Let us restate this maximum value principle in an alternative form, thus: one option will be chosen over another if its income possesses comparative advantages outweighing (in present value) its disadvantages.”7 Fisher instructs the investor to discount future cash ﬂow streams and be aware that while some investment opportunities 232 Investment: A History may have higher cash ﬂows in particular years, it is essential to have a broader view and look at all of the discounted cash ﬂows as the basis of comparison. Last, Fisher deﬁnes rate of return over cost as the discount rate that equalizes two possible investments in terms of present values.8 New investment can occur when this rate of return over cost is greater than the interest rate. The formula was simple, but powerful: one could assess the soundness of an investment project by ﬁnding the net present value of its future cash ﬂows. Discounted Cash Flow Models Fisher helped devise the theory of discounted cash ﬂow for any asset, but it was John Burr Williams who advanced this theory signiﬁcantly. Williams spent his undergraduate years at Harvard studying mathematics and chemistry, and this mathematical frame of mind would serve him well in the years to come.
Williams also received the disapprobation of his thesis committee for sending the work to publishers before it was reviewed and accepted by the committee itself as degree worthy.11 Despite being met with this initial displeasure, Williams set the stage for the modern school of ﬁnancial academics who think in terms of cash ﬂows and a discount factor to value stocks. In some ways, what Williams did was take a known idea of valuing a traditional asset, such as real estate or a bond, as the sum of discounted cash ﬂows and apply it to the stock market, where dividends represented the cash ﬂows. A simple application in retrospect, perhaps, but it was the forward march of intellectual progress. The Effect of Capital Structure on Asset Pricing Franco Modigliani and Merton Miller analyzed a rather different question relating to asset pricing: how does the capital structure affect the value of a ﬁrm? In other words, how does the breakdown of different forms of capital, like debt and equity, affect valuation?
The stockbroker seemed to suggest that Markowitz think about the portfolio selection problem in the context of linear optimization, and Marschak later agreed to his doing just that.27 Markowitz was the man for the job; he knew the linear optimization methods, having studied with George Dantzig at the RAND Corporation.28 Philosophically, Markowitz realized that the theory of asset pricing was incomplete without a corresponding theory of risk. Markowitz reasoned that one can indeed perform a calculation of dividends (in truth, proxies for discounted cash ﬂows), but those future dividends themselves are uncertain. And yet, the risks are not captured by the concepts of net present value of Fisher or the dividend discount model of John Burr Williams.29 Markowitz offered a technical solution. To give a slightly more modern version of some of his ideas, his approach involves plotting all of the assets available on a graph where the left axis is the expected return and the horizontal axis is the excess volatility, as measured by the standard deviation of returns of the asset (see ﬁgure 7.1).
Ethics in Investment Banking by John N. Reynolds, Edmund Newell
accounting loophole / creative accounting, banking crisis, capital controls, collapse of Lehman Brothers, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, discounted cash flows, financial independence, index fund, invisible hand, margin call, moral hazard, Nick Leeson, Northern Rock, quantitative easing, shareholder value, short selling, South Sea Bubble, stem cell, the market place, The Wealth of Nations by Adam Smith, too big to fail
Arranging finance would consist of preparing presentations to potential funders and securing financing (normally debt, but this can also include additional sources of equity finance) Bait and switch: investment banking practice of marketing a (senior) team of bankers to a client and then replacing them with more junior bankers once a mandate has been awarded Big cap: a quoted company with a large market capitalisation or share value Business ethics: an ethical understanding of business, applying moral philosophical principles to commerce Capital markets: collective term for debt and equity markets; reference to the businesses within an investment bank that manage activity in the capital markets Casino capitalism: term used to describe high-risk investment banking activities with an asymmetric risk profile Categorical imperative: the concept, developed by Immanuel Kant, of absolute moral rules CDS: credit default swap, a form of financial insurance against the risk of default of a named corporation CEO: chief executive officer, the most senior executive officer in a corporation viii Glossary ix Church Investors’ Group (CIG): a group of the investment arms of a number of church denominations, mainly from the UK and Ireland Code of Ethics: an investment bank’s statement of its requirements for ethical behaviour on the part of its employees Compensation: investment bankers’ remuneration or pay Compliance: structures within an investment bank to ensure adherence to applicable regulation and legislation Conflict of interest: situation where an investment bank has conflicting duties or incentives Corporate debt: loan made to a company Credit rating: an assessment of the creditworthiness of a corporation or legal entity given by a credit rating agency CSR: Corporate Social Responsibility DCF: discounted cash flow Debtor in Possession finance (DIP finance): secured loan facility made to a company protected from its creditors under chapter 11 of the US bankruptcy code Derivative: a security created out of an underlying security (such as an equity or a bond), which can then be traded separately Dharma: personal religious duty, in Hinduism and Buddhism Discounted cash flow valuation: the sum of: • the net present value (NPV) of the cash flows of a company over a defined timescale (normally 10 years); • the NPV of the terminal value of the company (which may be the price at which it could be sold after 10 years); and • the existing net debt of the company Distribution: the marketing of securities Dodd–Frank Act: the Dodd–Frank Wall Street Reform and Consumer Protection Act Downgrade: a reduction in the recommended action to take with regard to an equity; or a reduction in the credit rating of a corporation Duty-based ethics: ethical values based on deontological concepts EBITDA: Earnings Before Interest Tax Depreciation and Amortisation EIAG: the Ethical Investment Advisory Group of the Church of England Encyclical: official letter from the Pope to bishops, priests, lay people and people of goodwill x Glossary Enterprise value (EV): value of an enterprise derived from the sum of its financing, including equity, debt and any other invested capital, which should equate to its DCF value ERM: the European Exchange Rate Mechanism, an EU currency system predating the introduction of the euro ETR: effective tax rate EV:EBITDA: ratio used to value a company Exit: sale of an investment Free-ride: economic term for gaining a benefit from another’s actions Financial adviser: see Adviser Glass–Steagall: the 1933 Act that required a separation of investment and retail banking in the US Golden Rule: do to others as you would have them do to you Hedge fund: an investment fund with a specific investment mandate and an incentivised fee structure (see 2 and 20) High yield bond: debt sold to institutional investors that is not secured (on the company’s assets or cash-flows) HMRC: Her Majesty’s Revenue and Customs, the UK’s authority for collecting taxes Hold-out value: value derived from the contractual right to be able to agree or veto changes Ijara: Shariah finance structure for project finance Implicit Government guarantee: belief that a company or sector benefits from the likelihood of Government intervention in the event of crisis, despite the fact that no formal arrangements are in place Initial Public Offering (IPO): the initial sale of equity securities of a company to public market investors Insider dealing: trading in shares in order to profit from possessing confidential information Insider trading: see Insider dealing Integrated bank: a bank offering both commercial and investment banking services Integrated investment bank: an investment bank that is both active in capital markets and provides advisory services Internal rate of return (IRR): the annualised return on equity invested.
The UK Government provided guidance as to the meaning of “promoting the success” of a company. Lord Goldsmith stated at the Lords Grand Committee on 6 February 2006 that “For a commercial company, success will normally mean long term increase in value.”7 Defining the long-term value of a company is not straightforward, especially for a large company with multiple businesses and assets. Value can be analysed using discounted cash flow analysis (DCF), although this has a number of subjective inputs, both in terms of methodology (e.g., discount rate) and in terms of business assumptions (e.g., market share), resulting in diverse outcomes. Value can also be assessed on the basis of comparisons with peers, where these are available, or on the basis of financial ratios, such as P:E (Price:Earnings) or multiples of enterprise value to EBITDA or cash flow (although multiple-based analysis tends to be cruder than DCF).
., 73 conflicts of interest in, 112–14 cardinal virtues, 37 Caritas in Veritate (Benedict), 6, 52 cash compensation, 132, 134 casino capitalism emergence of, 43 in investment banking, 3 speculative, 16, 93 categorical imperative, 34, 59, 69 Caterpillar, 48 Central Finance Board of the Methodist Church (CFB), 54, 59 chief executive officer (CEO), 116 Christianity, 52–4 Anglican Communion, 53 Methodist Church, 53 Roman Catholic Church, 53 Christian Old Testament, 34 Church Investors’ Group (CIG), 135 Church of England, 9, 53, 58 Citigroup, 19, 112 claiming credit, 134 clients confidential information, 120 conflicts of interest, 105–10 171 duty of care, 105 engagement letters, 122–3 fees, 115–18 financial restructuring, 119–20 hold-out value, 120–1 honesty, 101–5 margin-calls, 121 practical issues, 110–15 promises, 100–1 restructuring fees, 121–2 syndication, 118–22 truth, 101–5 Code of Ethics, 47–50, 147–51 for Goldman Sachs business principles, 46 in investment banking, 47–9 Revised, 47 collatoralised debt obligations (CDOs), 30, 42, 75 command economies, 13 commercial banking, 19–21, 25 communication within markets, 88 Companies Act 2006, 27 compensation cash, 132, 134 defined, 132 for employees, 135 internal issues on, 8 for junior bankers, 136 levels of, 132–3, 138 objectivity of, 144 political issues with, 6, 137 restrictions on, 10 competitors, 113 compliance corporate, 20 danger of, 20 frameworks for, 68, 146 regulatory, 18 requirements of, 6 confidential information, 120 conflicts of interest, 105–10, 158 with capital markets, 109–10 with corporate finance, 107–8 personal, 47 with pre-IPO financing, 110 with private equity, 110 172 Index conflicts of interest – continued reconciling, 68–70 of trusted advisers, 108–9 consequentialist ethics, 36–7, 42 corporate compliance, 20 Corporate/Compliance Social Responsibility (CSR), 7 corporate debt, 17 corporate entertainment, 128–9, 159 corporate finance, 107–8 Corporate Sustainability Committee, 152 Costa, Ken, 9 Cox, Christopher, 96–7 creative accounting, 12 credit crunch, 17 credit default swap (CDS), 71 credit downgrade, 17, 76 Credit Lyonnais, 12 creditors, restricted, 121 credit rating, 75–7 calculating, 76 inaccurate, 5 manipulating, 75, 156, 158 unreliability of, 17 credit rating agencies, 76 Crisis and Recovery (Williams), 53 culture, 46, 136, 151 customers, 69 Daily Telegraph, 84 Debtor in Possession finance (DIP finance), 80 debts bank, 82–3, 120 corporate, 17 junior, 118 rated, 77 senior, 118 sovereign, 17 deferred equity, 5 deferred shares, 133 Del Monte Foods Co., 107 deontological ethics, 34–6 stockholders, 41–2 trust, 40–1 derivative, 27, 30 dharma, 63–4 Dharma Indexes, 57 discounted cash flow (DCF), 27 discount rate, 27 discriminatory behaviour, 129–31 distribution, 15, 35, 66 Dodd–Frank Wall Street Reform and Consumer Protection Act, 25 dotcom crisis, 94 dotcom stocks, 17 Dow Jones, 55–6 downgrade credit, 17, 76 defined, 76 multi-notch, 17, 76 duties, see rights vs. duties duty-based ethics, 66–8 duty of care, 105 Dynegy, 8 Earnings Before Interest Tax Depreciation and Amortisation (EBITDA), 27 economic free-ride, 5, 21 economic reality, 137 effective tax rate (ETR), 140 emissions trading, 14 employees, compensation for, 135 Encyclical, 52 engagement letters, 122–3, 159 Enron, 8, 12, 17, 20, 76 enterprise value (EV), 27 entertainment adult, 56 corporate, 128–9, 159 sexist, 159 equity deferred, 5 private, 2–3, 12, 110 equity research, 88–9, 113–15 insider dealing and, 83–4 ethical behaviour, 38–9 Ethical Investment Advisory Group (EIAG), 53, 58 ethical investment banking, 145–7 ethical standards, 47 Index ethics consequentialist, 36–7, 42 deontological, 34–6 duty-based, 66–8 exceptions and, effects of, 89–90 financial crisis and, 4–8 in investment banking, 1 in moral philosophy, 1 performance and, 8–10 rights-based, 66–8 virtue, 37–8, 43–4 see also business ethics; Code of Ethics Ethics Helpline, 48 Ethics of Executive Remuneration: a Guide for Christian Investors, The, 135 European Commission, 89 European Exchange Rate Mechanism (ERM), 17 exceptions, 89 external regulations, 19, 31 fair dealing, 45 Fannie Mae, 43 Federal Home Loan Mortgage Corporation, 43 Federal National Mortgage Association, 43 fees, 115–18 advisory, 107, 116 restructuring of, 121–2 2 and 20, 13 fiduciary duties, 27–8 financial advisers, 109 Financial Conduct Authority (FCA), 26 financial crisis, business ethics during CDOs during, 90 CDSs during, 90 ethics during, 4–8, 12–34 investment banking and, necessity of, 14–15 market capitalism, 12–14 necessity of, 14–15 non-failure of, 21 positive impact of, 18 problems with, 15–17 reality of, 16 speculation in, 91 173 Financial Crisis Inquiry Commission, 76 Financial Policy Committee (FPC), 25 financial restructuring, 119–20 Financial Services Modernization Act, 19 Financial Stability Oversight Council, 25 firm price, 67 Four Noble Truths, 57 Freddie Mac, 43 free-ride defined, 26 economic, 5, 21 in investment banking, 24 FTSE, 55 Fuhs, William, 8 General Board of Pension and Health Benefits, 54, 59 German FlowTex, 12 Gift Aid, 141 Glass–Steagall Act, 19 Global Settlement, 113 golden parachute arrangements, 133 Golden Rule, 35, 150 Goldman Sachs, 7, 16, 45, 63 Business Principles, 45–6 charges against, 78 Code of Business Conduct and Ethics, 45, 68 Code of Ethics for, 47–8 Goldsmith, Lord, 27 government, 59 business ethics within, 60 guarantees of, 24 intervention by, 22–3 government bonds, 23 greed, 4–5 Green, Stephen, 8–9 gross revenues, 59 Hedge fund behaviour of, 12 failure of, 21 funds for, raising, 2 investment fund, as type of, 3 rules for, 133 174 Index Hennessy, Peter, 42 Her Majesty’s Revenue and Customs (HMRC), 140–1 high returns, 28, 110 Hinduism, 56–7 Hobbes, Thomas, 36 hold-out value, 120–1 honesty, see trust hospitality, 128–9 hot IPOs, 94 hot-stock IPOs, 94 HSBC, 9, 28, 152 Ijara, 55 implicit government guarantee, 22–3 Independent Commission on Banking, 25 inequitable rewards, 6 informal authorisation, 81, 98 Initial Public Offering (IPO), 7 of dotcom stocks, 17 hot, allocation of, 94 hot-stock, 94 insider dealings, 83–4, 155 equity research and, 83–4 ethics of, 66, 70 laws on, 84 legal prohibition on, 82 legal restrictions on, 10 legal status of, 82 legislation on, 74 restrictions on, 83 rules of, 82, 90 securities, 70 insider trading, 12 insolvency, 24–5 institutional greed, 4 integrated bank, 28 integrated investment banking, 2, 30, 67, 106, 108 interest payments, 59–60 interest rate, 60 internal ethical issues, 126–43 abuse of resources, 127–8 corporate entertainment, 128–9 discriminatory behaviour, 129–31 hospitality, 128–9 management behaviour, 131–2 remuneration, 132–9 tax, 139–41 internal review process, managing, 134 investment banking, 94 casino capitalism in, 3 Code of Ethics in, 47–9 commercial and, convergence of, 20–1 defined, 2 ethics in, 1 free-ride in, 24 integrated, 2, 30, 67, 108, 112 in market position, role of, 65–6 moral reasoning and, 38 necessity of, 14–15 non-failure of, 19–20 positive impact of, 18 recommendations in, 94–7 sector exclusions for, 58–9 investment banking adviser, 121 investment banking behaviours, 3 investment banking ethics committee, 151–3 investment bubbles, 95 investment fund, 3 investment grade bonds, 118 investment grade securities, 76 investment recommendations, 94 investments personal account, 128, 156 principal, 15, 28 proprietary, 29 IRS, 140 Islam, 54–5 Islamic banking, 6, 54–5 Jewish Scriptures, 34 Joint Advisory Committee on the Ethics of Investment (JACEI), 54 JP Morgan, 16 Judaism, 56 junior bankers, 139 junior debt, 118 junk bond, 118 “just war” approach, 38 Index Kant, Immanuel, 35, 69 karma, 57 Kerviel, Jérôme, 44, 80 Krishna, 57 Law Society, 19 Lazard International, 9 leading adviser, 41 Leeson, Nick, 12, 44, 81 legislative change, 25–6 Lehman Brothers, 5–6, 15, 21, 23, 31, 43, 76 lenders, 26, 131 lending, 59–60 leverage levels of, 25 over, 75, 80, 119 Levin, Carl, 17, 63–4, 68 light-touch regulations, 4 liquidity market, 95 orderly, 25 withdrawal of, 24 loan-to-own, 80 Locke, John, 34 London Inter-Bank Offered Rate (LIBOR), 23 London School of Economics, 43 London Stock Exchange, 65, 71, 84 long-term values, 147 Lords Grand Committee, 27 LTCM, 23 lying, 101 MacIntyre, Alasdair, 38 management behaviour, 131–2 margin-calls, 121 market abuse, 14, 70, 75, 86–8, 155 market announcements, 88 market behaviours, 74 market capitalism, 12–14 market communications, 88 market liquidity, 95 market maker defined, 65–7 investment bank as, 66 primary activities of, 65 175 market manipulation, 75 market position, role of, 104 market rate, 117 markets advisory, 73 capital, 73, 117–18, 158 communication within, 88 duties to support, 71–2 primary, 103 qualifying, 70, 82 secondary, 103 market trading, 41 Maxwell, Robert, 12 Meir, Asher, 56 mergers and acquisitions (M&As), 41, 79 Merkel, Angela, 93 Merrill Lynch, 8, 16 Methodism, 53 Methodist Central Finance Board, 59 Methodist Church, 54 Midrash, 56 Milken, Michael, 12 Mill, John Stuart, 36 Mirror Newspaper Group, 12 misleading behaviours, 86, 105 mis-selling of goods and services, 77–9, 155 modern capitalism, 54 moral-free zones, 31 moral hazard, 22, 70 moral philosophy, 1 moral reasoning, 38 moral relativism, 38–9, 49, 68 Morgan Stanley, 47 multi-notch downgrade, 17, 79 natural law, 34, 37 natural virtues, 37 necessity of investment banking, 14–15 New York Stock Exchange (NYSE), 65, 71 New York Times, 8 Noble Eightfold Path, 57 Nomura Group Code of Ethics, 47 normal market trading, 71 Northern Rock, 43 176 Index offer price, 64 off-market trading, 71–3, 90, 155 Olis, Jamie, 8 on-market trading, 70–1 oppressive regimes, 61 option value, 121 Orderly Liquidation Authority, 25 orderly liquidity, 25 out-of-pocket expenses, 127–8 over-leverage, 75, 80, 119, 158 overvalued securities, 155 patronage culture, 131, 142 Paulson, Henry M., 86 Paulson & Co., 78 “people-based” activity, 67 P:E ratio, 27 performance, 8–10 personal abuse, 159 personal account investments, 128, 156 personal account trading, 128 personal conflicts of interest, 45 pitching, 102, 159 Plato, 37 practical issues, 110–15 competitors, relationships with, 113 equity research, 113–15 pitching, 111 sell-side advisers, 111–13 pre-IPO financing, 110 prescriptive regulations, 31, 145 price tension, 79, 113 primary market, 103 prime-brokerage, 2 principal investment, 15, 28 private equity, 2–3, 12, 110 private trading, 94 Project Merlin, 133, 141 promises, 100–1 proprietary investment, 29 proprietary trading, 15, 25, 66, 150, 155 Prudential Regulation Authority (PRA), 26 public ownership, bonus pools in, 136–9 “pump and dump” strategy, 86 qualifying instruments, 70, 87 qualifying markets, 70, 82 quality-adjusted life year (QALY), 36 Quantitative Easing (QE), 23 Queen Elizabeth II, 42 Qu’ran, 54 rated debt, 77 rates attrition, 132 discount, 27 interest, 60 market, 117 tax, 140 rating agencies, 76 Rawls, John, 35, 136 recognised exchanges, 71 Regal Petroleum, 84 regulations banking, 16 compliance with, 28 external, 19, 31 light-touch, 4 prescriptive, 31, 145 regulatory changes and, 18–20 securities, 114 self, and impact on legislation, 19 regulatory compliance, 18 religion, business ethics in, 51–62 Buddhism, 56 Christianity, 52–4 Governments, 59 Hinduism, 56–7 interest payments, 59–60 Islam, 54–5 Judaism, 56 lending, 59–60 thresholds, 60 usury, 59–60 remuneration, 132–9 bonus pools in public ownership and, 136–9 claiming credit, 134 ethical issues with, 142–3 internal review process, managing, 134 1 Timothy 6:10, 135–6 Index research, 156 resources, abuse of, 127–8 restricted creditors, 120 restructuring of fees, 121–2 financial, 119–20 syndication and, 118–22 retail banks, 16 returns, 28, 156 Revised Code of Ethics, 47 right livelihood, 57 rights-based ethics, 66–8 rights vs. duties advisory vs. trading/capital markets, 73 conflict between, reconciling, 68–70 duty-based ethics, 66–8 off-market trading, ethical standards to, 71–2 on-market trading, ethical standards in, 70–1 opposing views of, 63–74 reconciling conflict between, 68–70 rights-based ethics, 66–8 Roman Catholic Church, 52 Royal Dutch Shell, 85 Sarbanes–Oxley Act, 20 Schwarzman, Stephen, 20 scope of ethical issues, 7–8 secondary market, 103 sector exclusions for investment banking, 58–9 securities investment grade, 76 issuing, 103–5 overvalued, 155 Securities and Exchange Commission (SEC), 7, 16 Goldman Sachs, charges against, 78 rating agencies, review by, 77 short-selling, review of, 96–7 securities insider dealing, 70 securities mis-selling, 77–9 securities regulations, 114 self-regulation, 19 sell recommendation, 115 177 sell-side advisers, 107, 111–13 Senate Permanent Subcommittee on Investigations, 46 senior debt, 118 sexist entertainment, 159 shareholders, 27–9 shares, deferred, 133 Shariah finance, 55 short-selling, 94–7, 154–5 Smith, Adam, 14, 35–6 social cohesion, 53 socially responsible investment (SRI), 56 Société Générale, 44, 80 solidarity, 53 Soros, George, 17 South Sea Bubble, 90 sovereign debt, 17 speculation, 91–4, 155 in financial crisis, 93 traditional views of, 91–3 speculative casino capitalism, 16, 91 spread, 21 stabilisation, 89 stock allocation, 94–7 stockholders, 41–2 stocks, dotcom, 17 Strange, Susan, 43 strategic issues with business ethics, 30–1 syndication, 119 and restructuring, 118–22 systemic risk, 24–5 Takeover Panel, 109 Talmud, 56 taxes, 139–41 tax optimisation, 158 tax rates, 140 tax structuring, 140 Terra Firma Capital Partners, 79, 112 Theory of Moral Sentiments, The (Smith), 14 3iG FCI Practitioners’ Report, 51 thresholds, 60 1 Timothy 6:10, 135–6 178 Index too big to fail concept, 21–7 ethical duties, and implicit Government guarantee, 22–3 ethical implications of, 26–7 in government, 22–3 insolvency, systemic risk and, 24–5 legislative change, 25–6 Lehman, failure of, 23 systemic risk, 24–5 toxic financial products, 5 trading abusive, 93 emissions, 14 insider, 12 market, 41 normal market, 71 off-market, 71–83, 90, 155 on-market, 70–1 personal account, 128 private, 94 proprietary, 15, 25, 66, 150, 155 unauthorised, 7 “trash and cash” strategy, 86 Travellers, 19 Treasury Select Committee, 26 Trinity Church, 53 Trouble with Markets, The (Bootle), 4 trust, 40, 53 trusted adviser, 108–9, 125 truth, 101–5 bait and switch, 102–3 misleading vs. lying, 101 securities, issuing, 103–5 2 and 20 fee, 13 UBS Investment Bank, 9 unauthorised trading, 7, 80–1, 155 unethical behaviour, 68 UK Alternative Investment Market, 89 UK Business Growth Fund, 133 UK Code of Practice, 141 UK Independent Banking Commission, 4, 22 United Methodist Church, 54, 59 United Methodist Investment Strategy Statement, 59 US Federal Reserve, 24, 25 US Financial Crisis Inquiry Commission, 4 US Open, 126 US Senate Permanent Subcommittee on Investigations, 64, 73 US Treasury Department, 132 universal banks, 2, 21, 28, 67 untoward movement, 85 usury, 59–60 utilitarian, 84 utilitarian ethics, 49, 84, 139 values, 9, 46, 119–21, 148 Vedanta, 57 victimless crime, 82 virtue ethics, 37–8, 43–4 virtues, 9, 34 virtuous behaviours, 37 Vishnu, 57 Volcker, Paul, 25 Volcker Rule, 2, 25 voting shareholders, 29 Wall Street, 12, 19, 53 Wall Street Journal, 20 Wealth of Nations, The (Smith), 14 Wesley, John, 53 Wharf, Canary, 18 Williams, Rowan, 53 Wimbledon, 127 WorldCom, 12, 17, 20, 76 write-off, 80 zakat, 55 zero-sum games, 118–22
Albert Einstein, Atul Gawande, Black Swan, business process, buy low sell high, capital asset pricing model, Checklist Manifesto, cognitive bias, correlation does not imply causation, Credit Default Swap, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, Dean Kamen, delayed gratification, discounted cash flows, double entry bookkeeping, Douglas Hofstadter, en.wikipedia.org, Frederick Winslow Taylor, Gödel, Escher, Bach, high net worth, hindsight bias, index card, inventory management, iterative process, job satisfaction, Johann Wolfgang von Goethe, Kevin Kelly, Lao Tzu, loose coupling, loss aversion, market bubble, Network effects, Parkinson's law, Paul Buchheit, Paul Graham, place-making, premature optimization, Ralph Waldo Emerson, rent control, side project, statistical model, stealth mode startup, Steve Jobs, Steve Wozniak, subscription business, telemarketer, the scientific method, time value of money, Toyota Production System, tulip mania, Upton Sinclair, Walter Mischel, Y Combinator, Yogi Berra
The Pricing Uncertainty Principle says the price could be anything—you have to set it yourself, since houses don’t come with built-in price tags. Let’s also assume you’d prefer to sell the house for as much as possible. How would you go about setting the largest price a customer will actually accept? There are four ways to support a price on something of value: (1) replacement cost, (2) market comparison, (3) discounted cash flow/net present value, and (4) value comparison. These Four Pricing Methods will help you estimate just how much something is potentially worth to your customers. The Replacement Cost method supports a price by answering the question “How much would it cost to replace?” In the case of the house, the question becomes “What would it cost to create or construct a house just like this one?” Assume a meteorite scored a direct hit on the house, and there’s nothing left—you have to rebuild the house from scratch.
They’re probably not exactly the same (maybe they have an extra bedroom or bathroom, a little less square footage, etc.) but they’re close enough. After you adjust for the differences, you can use the sale prices of those “comparable” houses to create a supportable estimate of how much your house is worth. Market Comparison is a very common way to price offers: find a similar offer and set your price relatively close to what they’re asking. The Discounted Cash Flow (DCF) / Net Present Value (NPV) method supports a price by answering the question “How much is it worth if it can bring in money over time?” In the case of your house, the question becomes “How much would this house bring in each month if you rented it for a period of time, and how much is that series of cash flows worth as a lump sum today?” Rent payments come in every month, which is quite handy: you can use the DCF/NPV formulas2 to calculate what that series of payments over a certain period of time would be worth if you received it in one lump sum.
For example, the Time Value of Money can help you figure out the maximum you should be willing to pay for a business that earns $200,000 in profit each year. Assuming an interest rate of 5 percent, no growth, and a foreseeable future of ten years, the “present value” of that series of future cash flows is $1,544,347. If you pay less than that amount, you’ll come out ahead as long as your assumptions are correct. (Note: this is the “discounted cash flow method” we discussed in the Four Pricing Methods.) The Time Value of Money is an extremely versatile concept, and a full exploration is beyond the scope of this book. For a more in-depth examination, I recommend picking up The McGraw-Hill 36-Hour Course in Finance for Nonfinancial Managers by Robert A. Cooke. Compounding Improve by 1% a day, and in just 70 days, you’re twice as good.
Rethinking Money: How New Currencies Turn Scarcity Into Prosperity by Bernard Lietaer, Jacqui Dunne
3D printing, agricultural Revolution, Albert Einstein, Asian financial crisis, banking crisis, Berlin Wall, BRICs, business climate, business process, butterfly effect, carbon footprint, Carmen Reinhart, clockwork universe, collapse of Lehman Brothers, complexity theory, conceptual framework, credit crunch, discounted cash flows, en.wikipedia.org, Fall of the Berlin Wall, fear of failure, fiat currency, financial innovation, Fractional reserve banking, full employment, German hyperinflation, happiness index / gross national happiness, job satisfaction, Marshall McLuhan, microcredit, mobile money, money: store of value / unit of account / medium of exchange, more computing power than Apollo, new economy, Occupy movement, price stability, reserve currency, Silicon Valley, the payments system, too big to fail, transaction costs, trickle-down economics, urban decay, War on Poverty, working poor
Today’s money is created through bank debt, as explained in the last chapter, and it requires the payment of interest. In other words, every dollar, peso, or euro that exists today is someone’s debt, whether incurred by a state, corporation, or individual. This means that interest is a built-in feature of the monetary system. Furthermore, as known to anyone familiar with the discounted cash flow (DCF) technique used in financial decision making, the readiness to make long-term investments depends, to a significant extent, on the current and anticipated interest rates. Discounted cash flow analysts know that interest is one of the three factors in discounting any future cash flow. (The other two factors are the intrinsic risk of the investment project and the cost of equity capital.) With the issue of interest, however, an entrepreneur, for example, can put her capital in a bank instead of investing it.
See also Bankruptcy Defection, 196–197 Deflation, 167, 235n12 Democracy: in Bali, 187–188, 190–191; civic and, 147–148; concentration of wealth and, 21–22, 52– 53; in principled society, 193–194; regio and, 191; social capital and, 46 Demurrage: BONUS and, 171; on Chiemgauer, 88; concentration of wealth and, 67– 68; conceptual framework for, 176; saber and, 155; sustainability and, 67, 206; on Terra, 136, 138–139, 206; velocity and, 64, 68– 69; on wära, 179; on Wörgl, 176–177 Denver, 11–12 Development, 33 Disaster relief, 167, 169, 169–172 Discounted cash flow (DCF), 45– 46 Distance tax, 89 Diversity, 32– 33, 62– 63, 70 Divine right of kings, 24 Dixie Dollar, 113 Doctors without Borders, 17–18 Domestic care, 34 Drill and kill, 156, 220–221 Dual currency system, 65– 66, 99–102, 103–107, 162 Earthquake, 167, 169 Earthship model, 165 Ecological disaster, 34, 188 Eco-money, 235n12 Economic Literacy Program, 184 Economics, school of, 28, 35 Economic treadmill, 43, 52 Ecosystem, 32– 33 Ecosystem, monetary, 59– 60, 145, 199–202, 220 Education, 14, 16; for computers, 83; Creative Currencies Project and, 153–155; knowledge exchange network, 184; learning currency, 153–155, 201; in Mae Hong Son, 205; mentoring, 254 INDEX Education (continued) 153–154, 171–172; paradigms in, 220–221; in Paraná, 143–144; Patch Adams Free Clinic and, 165; in principled society, 193; Prussian model of, 216; standards, 43; Time dollars and, 82– 83; university, 153–154, 193, 226–227n13; wispos and, 156–157.
Quantitative Value: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors by Wesley R. Gray, Tobias E. Carlisle
Albert Einstein, Andrei Shleifer, asset allocation, Atul Gawande, backtesting, Black Swan, capital asset pricing model, Checklist Manifesto, cognitive bias, compound rate of return, corporate governance, correlation coefficient, credit crunch, Daniel Kahneman / Amos Tversky, discounted cash flows, Eugene Fama: efficient market hypothesis, forensic accounting, hindsight bias, Louis Bachelier, p-value, passive investing, performance metric, quantitative hedge fund, random walk, Richard Thaler, risk-adjusted returns, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, statistical model, systematic trading, The Myth of the Rational Market, time value of money, transaction costs
In this chapter, we consider the academic research on sustainable high returns, and examine some simple metrics that help to identify firms with franchises. THE CHAIRMAN'S SECRET RECIPE One of the bedrocks of modern corporate finance theory is that the value of any security is the present value of its future cash flows. This simple principle was first described in 1934 by John Burr Williams in his Theory of Investment Value.4 Williams's principle gives us the discounted cash flow (DCF) analysis, which allows us to calculate intrinsic value by taking a series of growing future cash flows and discounting them back to the present at a rate of return that takes into account the time value of money and the particular risk of the business analyzed. More recently, academics and practitioners alike have come to recognize the significance of Buffett's observation that the value of a business depends on its ability to generate returns on invested capital in excess of its cost of capital.5 Businesses expected to produce returns on invested capital in excess of market rates of return are worth more than the capital invested in them, and the market price of the stock should in time exceed its asset value.
The strategy has tended to outperform over rolling 5- and 10-year periods, beating out the other investors around two out of every three rolling 5-year periods, and between six and nine out of every 10 rolling 10-year periods. Machine, it seems, beats man. BEATING THE MARKET WITH QUANTITATIVE VALUE Value investing is a highly effective, well-studied method of investing. It is a broad church, encompassing investors who take positions in liquidations, special situations, undervalued assets, and undervalued businesses, using a variety of valuation methods, from simple price ratios, to detailed discounted cash flow analyses, and intricate sum-of-the-parts valuations that seek current market values for long-term and fixed assets. While the investment styles and valuation methods run the gamut, all are united by Benjamin Graham's simple notion that price and value are distinct quantities, and that, where the two are sufficiently far apart to provide a margin of safety, an opportunity exists to invest.
How I Became a Quant: Insights From 25 of Wall Street's Elite by Richard R. Lindsey, Barry Schachter
Albert Einstein, algorithmic trading, Andrew Wiles, Antoine Gombaud: Chevalier de Méré, asset allocation, asset-backed security, backtesting, bank run, banking crisis, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, Brownian motion, business process, buy low sell high, capital asset pricing model, centre right, collateralized debt obligation, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, discounted cash flows, disintermediation, diversification, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, full employment, George Akerlof, Gordon Gekko, hiring and firing, implied volatility, index fund, interest rate derivative, interest rate swap, John von Neumann, linear programming, Loma Prieta earthquake, Long Term Capital Management, margin call, market friction, market microstructure, martingale, merger arbitrage, Nick Leeson, P = NP, pattern recognition, pensions crisis, performance metric, prediction markets, profit maximization, purchasing power parity, quantitative trading / quantitative ﬁnance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Richard Feynman, Richard Feynman, Richard Stallman, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, sorting algorithm, statistical arbitrage, statistical model, stem cell, Steven Levy, stochastic process, systematic trading, technology bubble, The Great Moderation, the scientific method, too big to fail, trade route, transaction costs, transfer pricing, value at risk, volatility smile, Wiener process, yield curve, young professional
While the dispute was ongoing, Exxon could either pay the disputed amount or wait until the final settlement to pay. If Exxon paid now and then won, the United States would pay back the disputed amount with interest; if Exxon didn’t pay, it would have to pay the disputed amount plus interest. Exxon had two methods of analyzing projects: If it was an investment, it discounted cash flows at their cost of capital; if it was a financing, Exxon discounted cash flows at their cost of debt. Exxon was evaluating the tax dispute as an investment. If it gave the money to the United States, it would only earn at the statutory interest rate, while its cost of capital was 16 percent. According to Exxon’s policies, since the outcome of the dispute was uncertain, it was an investment, not a financing. I wrote one of those memos, explaining why Exxon should pay now and reduce its after-tax cost, since Exxon had a lower cost of debt than the federal rate for disputed tax amounts.
When I graduated from business school in 1983, I was offered a job in the treasurer’s department at Exxon. It was a dream come true. At the time, Exxon’s treasurer’s department was considered one of the spots in finance. Exxon managed much of its pension fund internally, including a large S&P500 index fund. It had also begun to issue its own debt, bypassing Wall Street bankers and fees. Exxon had global operations and had applied the latest thinking in project analysis using discounted cash flow methods and was analyzing and hedging the impact of currency changes on its operations. It should have been exciting. All in all, there couldn’t have been a more stifling place to work. JWPR007-Lindsey 180 April 30, 2007 18:1 h ow i b e cam e a quant Exxon had layers and layers of management. All decisions were made through the editing of memos. As an analyst you would write a memo on a subject, making a recommendation.
Expected Returns: An Investor's Guide to Harvesting Market Rewards by Antti Ilmanen
Andrei Shleifer, asset allocation, asset-backed security, availability heuristic, backtesting, balance sheet recession, bank run, banking crisis, barriers to entry, Bernie Madoff, Black Swan, Bretton Woods, buy low sell high, capital asset pricing model, capital controls, Carmen Reinhart, central bank independence, collateralized debt obligation, commodity trading advisor, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, deglobalization, delta neutral, demand response, discounted cash flows, disintermediation, diversification, diversified portfolio, dividend-yielding stocks, equity premium, Eugene Fama: efficient market hypothesis, fiat currency, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, framing effect, frictionless, frictionless market, George Akerlof, global reserve currency, Google Earth, high net worth, hindsight bias, Hyman Minsky, implied volatility, income inequality, incomplete markets, index fund, inflation targeting, interest rate swap, invisible hand, Kenneth Rogoff, laissez-faire capitalism, law of one price, Long Term Capital Management, loss aversion, margin call, market bubble, market clearing, market friction, market fundamentalism, market microstructure, mental accounting, merger arbitrage, mittelstand, moral hazard, New Journalism, oil shock, p-value, passive investing, performance metric, Ponzi scheme, prediction markets, price anchoring, price stability, principal–agent problem, private sector deleveraging, purchasing power parity, quantitative easing, quantitative trading / quantitative ﬁnance, random walk, reserve currency, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Robert Shiller, Robert Shiller, savings glut, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stochastic volatility, systematic trading, The Great Moderation, The Myth of the Rational Market, too big to fail, transaction costs, tulip mania, value at risk, volatility arbitrage, volatility smile, working-age population, Y2K, yield curve, zero-coupon bond
By reading both chapters, you may also find that the debate between the efficient market camp and the behavioralists remains healthy and has deepened our understanding of financial markets. Certainly, neither side has a monopoly on “the whole truth”. 5.1 THE OLD WORLD At the core of finance is always the present value relation that an asset’s market price should equal its expected discounted cash flows. Investors set prices so that the marginal cost of an asset (its price) equals its expected marginal benefit (its expected discounted future payoff):(5.1) There are different types of expected cash flows. The most common are promised coupons and principal payments of bonds, and dividends of equities:• Government bonds are typically assumed to be default free; thus their expected cash flows equal promised cash flows.
In the new thinking on expected returns, multiple systematic factors, time-varying risk premia, skewness and liquidity preferences, supply–demand effects, market frictions, and investor irrationalities can all play a role . (No single model can capture all of these features. Theoretical models need to be analytically tractable and they should be parsimonious. My survey will be neither.) Despite the diversity of new models, at least the rationally oriented academic literature retains one key idea in its core, albeit subtly different than in the old world. The asset price still equals expected discounted cash flows, but in a world of uncertainty and time-varying expected returns, equation (5.1) needs to be generalized. Using the new terminology:(5.3) where SDF is the stochastic discount factor; and x is the payoff (cash flow) for asset i . The term “stochastic” in SDF emphasizes the uncertainty in time-varying discount rates. But the great intuition is that SDF is an index of “bad times” and that the required risk premium for any asset (or a risk factor) reflects its covariation with bad times.
If most current holders bought the stock well above current market levels (so that they have large unrealized capital losses), disposition-biased investors will be slow to sell assets and any bad news will travel slowly (into the market price). Conversely, if most current holders bought the stock well below current market levels (so that they have large unrealized capital gains), disposition-biased investors will be quick to sell assets and any good news will travel slowly. 6.4 CONCLUSION Behavioral finance implies that market prices do not only reflect the rationally expected discounted cash flows from an asset. Shifting asset demands from irrational investors influence market prices and expected returns. If there is some mispricing—overvaluation or undervaluation—then that should disappear over time. Active investors can exploit such mispricing and earn alpha through security selection across assets and maybe also through market timing over time. Five points are worth noting:• First, because we cannot directly observe expected returns, there has been considerable debate as to how much time series or cross-sectional predictability of returns really exists.
Early Retirement Extreme by Jacob Lund Fisker
8-hour work day, active transport: walking or cycling, barriers to entry, clean water, Community Supported Agriculture, delayed gratification, discounted cash flows, diversification, don't be evil, dumpster diving, financial independence, game design, index fund, invention of the steam engine, inventory management, loose coupling, market bubble, McMansion, passive income, peak oil, place-making, Ponzi scheme, psychological pricing, the scientific method, time value of money, transaction costs, wage slave, working poor
While college means different things to different people--whether it's a place for higher learning, a two-to-four-year binge party, or simply a brand name admission ticket required by the job market--the increasing demand for education and resulting higher cost mean that many students take on debt. Student loans are often considered an investment in one's future. What most students forget is that the only way that they can sell this asset is by working off their debt. Also, except for possibly MBA students, few people do a discounted cash flow analysis to verify that their "investment" actually has a sufficient internal rate of return. It's perhaps surprising that many trade schools have higher rates of internal returns than college educations. They cost (much) less, have shorter times to graduation, and due to the overproduction of people with college degrees, the latter no longer bestows as much economic benefit compared to the trades as it used to.
For these reasons, and because it tends to pay well due to the large number of hours worked, salaried work is the preferred method for accumulating a fund for financial independence (see Financial independence and investing). There's plenty of advice out there, the most important piece of which is, in my opinion, to pursue something you're good at rather than something you're passionate about--these are not necessarily the same thing--and consider the typical placement rates (unemployment levels), and in particular the cost of any kind of educational requirement, using either a discounted cash flow or internal rate of return analysis to see if it's worthwhile. Nonsalaried work Nonsalaried work though it may involve contracting with a single employer, technically a client, shouldn't be considered employment (see this figure), but it still qualifies as a job. Such a job involves either providing services or making products directly (see The working man) or involves running a business turning assets into income (see The businessman).
Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen
algorithmic trading, Andrei Shleifer, asset allocation, backtesting, bank run, banking crisis, barriers to entry, Black-Scholes formula, Brownian motion, buy low sell high, capital asset pricing model, commodity trading advisor, conceptual framework, corporate governance, credit crunch, Credit Default Swap, currency peg, David Ricardo: comparative advantage, declining real wages, discounted cash flows, diversification, diversified portfolio, Emanuel Derman, equity premium, Eugene Fama: efficient market hypothesis, fixed income, Flash crash, floating exchange rates, frictionless, frictionless market, Gordon Gekko, implied volatility, index arbitrage, index fund, interest rate swap, late capitalism, law of one price, Long Term Capital Management, margin call, market clearing, market design, market friction, merger arbitrage, mortgage debt, New Journalism, paper trading, passive investing, price discovery process, price stability, purchasing power parity, quantitative easing, quantitative trading / quantitative ﬁnance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, systematic trading, technology bubble, time value of money, total factor productivity, transaction costs, value at risk, Vanguard fund, yield curve, zero-coupon bond
Lastly, to determine the intrinsic value at the current time t, it might seem that we need to estimate the intrinsic value next time period, t + 1. However, rather than doing that, we use the valuation equation repeatedly to arrive at This equation shows mathematically what the Buffett quote above says in words, namely that the intrinsic value is the expected discounted value of all future dividends paid to shareholders. This equation is called the dividend discount model (and it is also called the discounted cash flow model and the present value model). Computing the intrinsic value is easier said than done, easier in principle than in practice.2 To compute the intrinsic value, one must estimate all future dividends, all future discount rates, and the co-movement of future dividends and discount rates. To simplify this task, equity traders often assume a constant discount rate so that kt = k for all t.
See hedge ratio (delta, Δ) demand pressure: bond yields and, 252; derivative prices and, 7t; need to identify source of, 266; option prices and, 46, 240; providing liquidity to, 45–46 demand shift, as catalyst of trend, 210 demand shocks, 5, 194–96, 195f, 195t derivatives: binomial model for value of, 236–38, 237f, 237n; Black–Scholes–Merton formula for value of, 7t, 238–40, 262, 263, 270, 272, 288; defined, 235; in efficiently inefficient markets, 7t; exchange-traded, 80; key markets for, 241; leverage achieved with, 74, 76, 80; in neoclassical finance, 7t; over-the-counter (OTC), 80; prime brokerage of, 80; volatility trades with, 262. See also futures; options; subprime credit crisis; swaps derivatives clearing merchants, 26 directional volatility trades, 262 discounted cash flow model. See dividend discount model discount rate, 89–90, 100, 102 discretionary equity investing, viii, 9, 10, 11, 87–88, 95–108; Asness on quantitative investing versus, 162–63. See also Ainslie, Lee S., III; dedicated short bias hedge funds; fundamental analysis; quality investing; value investing discretionary macro hedge funds, 185 Dish Network, 318 disposition effect, 106 distressed convertible bonds, 282f, 283 distressed investments, 14, 291, 311–12; Paulson on, 319–20 diversification: beta risk and, 28; of carry trades, 188, 188t; of convertible bond portfolio, 283; CTA investments as source of, 228; in event-driven investment, 292; as form of risk management, 59; hedge funds as source of, 26; by market neutral hedge fund, 21, 28; in merger arbitrage, 295, 303–4, 306, 317–18; portfolio optimization and, 55, 57; in quantitative equity investing, 133, 134, 144, 162; of time series momentum strategy, 209 dividend discount model, 89–92; fundamental analysis using, 97; margin of safety and, 98; quality and, 100; residual income model derived from, 92 dividend growth, 176, 177, 178 dividends: book value and, 92; early conversion of bond and, 276; in merger arbitrage, 296; recapitalization and, 314; on short equity position in convertible bond arbitrage, 277.
Andrew Wiles, Asian financial crisis, Berlin Wall, bonus culture, British Empire, business process, Cass Sunstein, computer age, credit crunch, Daniel Kahneman / Amos Tversky, discounted cash flows, discovery of penicillin, diversification, Donald Trump, Fall of the Berlin Wall, financial innovation, Gordon Gekko, greed is good, invention of the telephone, invisible hand, Jane Jacobs, Long Term Capital Management, Louis Pasteur, market fundamentalism, Nash equilibrium, pattern recognition, purchasing power parity, RAND corporation, regulatory arbitrage, shareholder value, Simon Singh, Steve Jobs, The Death and Life of Great American Cities, The Predators' Ball, The Wealth of Nations by Adam Smith, ultimatum game, urban planning, value at risk
But that does not mean that these firms were any more capable of formally calculating the outcome of their activities than was Beckham, or that attempting to emulate them will be any more rewarding than emulating Beckham. In both cases, we don’t know enough about what they do for such emulation to succeed. ICI might have made calculations in the 1950s that estimated the market capitalization its pharmaceutical division could have achieved by the year 2000. The company could then have put that number into a discounted-cash-flow calculation to estimate a return on the company’s early investment in its pharmaceutical business. I would have been delighted to build that model for them. But no one would or should have taken such a calculation seriously. ICI could never have computed the likely effect of the company’s initiative, but that does not mean the activity was random or undirected. Far from it—it was an intelligent action in pursuit of the high-level objective of the responsible application of chemistry in industry.
The accoutrements of established businessesthe company cafeteria, the clerical support, the illusory job security, the pension plans, and everything else a large organization can provideare inconsistent with Valley startup mentality. Page 36 "I'm not concerned about it," Lenny shot back. "We have a good plan, and we know how to work a plan." I thumbed through the material. It was a fairly polished presentation: market description, customer need, product strategy, competitive positioning, launch schedule, sales projections, expense forecasts, IRR and other rates of return, investment required, discounted cash flow. All the numbers you'd want. Year one. Year two. Year three. Everything worked out with an inevitable logic. Lenny had outlined in some detail how he planned to run this business. But how would he react when reality swept over his PowerPoint slides? It was becoming clear that he believed his task was to raise money and then follow his plan. As far as he was concerned, the answers were all there.
Mathematics for Finance: An Introduction to Financial Engineering by Marek Capinski, Tomasz Zastawniak
Black-Scholes formula, Brownian motion, capital asset pricing model, cellular automata, delta neutral, discounted cash flows, discrete time, diversified portfolio, interest rate derivative, interest rate swap, locking in a profit, London Interbank Offered Rate, margin call, martingale, quantitative trading / quantitative ﬁnance, random walk, short selling, stochastic process, time value of money, transaction costs, value at risk, Wiener process, zero-coupon bond
At time 1 we evaluate the bond prices by adding the coupon to the discounted ﬁnal payment of 101.00 at the appropriate (monthly) money market rate: 0.521% in the up state and 0.874% in the down state. The results are 101.4748 and 101.1213, respectively. The option can be exercised at that time in the up state, so the cash ﬂow is 0.1748 and 0, respectively. Expectation with respect to the risk-neutral probabilities of the discounted cash ﬂow gives the initial value 0.06598 of the option. 11.12 The coupons of the bond with the ﬂoor provision diﬀer from the par bond at time 2 in the up state: 0.66889 instead of 0.52272. This results in the following bond prices at time 1: 101.14531 in the up state and 100.9999 in the down state. (The latter is the same as for the par bond.) Expectation with respect to the risk-neutral probability gives the initial bond price 100.05489, so the ﬂoor is worth 0.05489.
The Misbehavior of Markets by Benoit Mandelbrot
Albert Einstein, asset allocation, Augustin-Louis Cauchy, Benoit Mandelbrot, Big bang: deregulation of the City of London, Black-Scholes formula, British Empire, Brownian motion, buy low sell high, capital asset pricing model, carbon-based life, discounted cash flows, diversification, double helix, Edward Lorenz: Chaos theory, Elliott wave, equity premium, Eugene Fama: efficient market hypothesis, Fellow of the Royal Society, full employment, Georg Cantor, Henri Poincaré, implied volatility, index fund, informal economy, invisible hand, John von Neumann, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, market bubble, market microstructure, new economy, paper trading, passive investing, Paul Lévy, Plutocrats, plutocrats, price mechanism, quantitative trading / quantitative ﬁnance, Ralph Nelson Elliott, RAND corporation, random walk, risk tolerance, Robert Shiller, Robert Shiller, short selling, statistical arbitrage, statistical model, Steve Ballmer, stochastic volatility, transfer pricing, value at risk, volatility smile
It “gave an early warning that the situation was very unstable,” they reported. You cannot beat the market, says the standard market doctrine. Granted. But you can sidestep its worst punches. 10. In Financial Markets, the Idea of “Value” Has Limited Value. Value is a touchstone to most people. Financial analysts try to estimate it, as they study a company’s books. They calculate a break-up value, a discounted cash-flow value, a market value. Economists try to model it, as they forecast growth. In classical currency models, they input the difference between U.S. and Euro zone inflation rates, growth rates, interest rates, and other variables to estimate an ideal “mean” value to which, over time, they believe the exchange rate will revert. All this implies that value is somehow a single number that is a rational, solvable function of information.
accounting loophole / creative accounting, airline deregulation, Andrei Shleifer, asset allocation, Bretton Woods, buy low sell high, capital asset pricing model, commodity trading advisor, corporate governance, discounted cash flows, diversification, diversified portfolio, fixed income, frictionless, high net worth, index fund, inflation targeting, invisible hand, law of one price, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, market bubble, merger arbitrage, new economy, passive investing, price mechanism, purchasing power parity, risk tolerance, risk-adjusted returns, risk/return, Ronald Reagan, shareholder value, Sharpe ratio, short selling, statistical arbitrage, the market place, transaction costs, Y2K, yield curve
A company’s stock that is growing earnings and/or revenue faster than its industry or the overall market. hedge fund A fund, usually used by wealthy individuals and institutions, that is allowed to use aggressive strategies unavailable to mutual funds. Includes selling short, leverage, program trading, swaps, arbitrage, and derivatives. They are also exempt from many of the rules and regulations governing other mutual funds. high-yield bonds A debt instrument issued for a period of more than one year with high rates of return because there is a higher default risk. hurdle rate-of-return The required rate of return in a discounted cash flow analysis, above which an investment makes sense and below which it does not. index In economics and finance, an index (for example, a price or stockmarket index) is a benchmark of activity, performance, or evolution in general. Consumer price indexes (an inflation measurement), or a country’s gross domestic product (GDP) index (an economic growth measurement) can be used to adjust salaries, Treasury bond (T-bond) interest rates, and tax thresholds.
Exponential Organizations: Why New Organizations Are Ten Times Better, Faster, and Cheaper Than Yours (And What to Do About It) by Salim Ismail, Yuri van Geest
23andMe, 3D printing, Airbnb, Amazon Mechanical Turk, Amazon Web Services, augmented reality, autonomous vehicles, Baxter: Rethink Robotics, bioinformatics, bitcoin, Black Swan, blockchain, Burning Man, business intelligence, business process, call centre, chief data officer, Clayton Christensen, clean water, cloud computing, cognitive bias, collaborative consumption, collaborative economy, corporate social responsibility, cross-subsidies, crowdsourcing, cryptocurrency, dark matter, Dean Kamen, dematerialisation, discounted cash flows, distributed ledger, Edward Snowden, Elon Musk, en.wikipedia.org, ethereum blockchain, Galaxy Zoo, game design, Google Glasses, Google Hangouts, Google X / Alphabet X, gravity well, hiring and firing, Hyperloop, industrial robot, Innovator's Dilemma, Internet of things, Iridium satellite, Isaac Newton, Jeff Bezos, Kevin Kelly, Kickstarter, knowledge worker, Kodak vs Instagram, Law of Accelerating Returns, Lean Startup, life extension, loose coupling, loss aversion, Lyft, Mark Zuckerberg, market design, means of production, minimum viable product, natural language processing, Netflix Prize, Network effects, new economy, Oculus Rift, offshore financial centre, p-value, PageRank, pattern recognition, Paul Graham, Peter H. Diamandis: Planetary Resources, Peter Thiel, prediction markets, profit motive, publish or perish, Ray Kurzweil, recommendation engine, RFID, ride hailing / ride sharing, risk tolerance, Ronald Coase, Second Machine Age, self-driving car, sharing economy, Silicon Valley, skunkworks, Skype, smart contracts, Snapchat, social software, software is eating the world, speech recognition, stealth mode startup, Stephen Hawking, Steve Jobs, subscription business, supply-chain management, TaskRabbit, telepresence, telepresence robot, Tony Hsieh, transaction costs, Tyler Cowen: Great Stagnation, urban planning, WikiLeaks, winner-take-all economy, X Prize, Y Combinator
Micro-transactions will drive orders-of-magnitude increases in the sheer number of transactions needing to be processed, tracked and audited. Crowdfunding / crowdlending New ways of getting financed for products or services by leveraging the crowd (e.g., Gustin, Kickstarter, angels and Lending Club), especially to demonstrate market demand for a product or service. Cash flow measurement Discounted Cash Flows will be replaced by Options Theory as a preferred mechanism. We are seeing an overall unbundling of the financial arena, and the digital payments sector is particularly ripe for transformation. Quicken and Quickbooks have both had a major impact on traditional accounting firms. Now, similar to Mint for personal finance, Wave Accounting offers 100-percent-free small business accounting, although its real business model is to mine the data buried within those transactions.
Platform Revolution: How Networked Markets Are Transforming the Economy--And How to Make Them Work for You by Sangeet Paul Choudary, Marshall W. van Alstyne, Geoffrey G. Parker
3D printing, Affordable Care Act / Obamacare, Airbnb, Amazon Mechanical Turk, Amazon Web Services, Andrei Shleifer, Apple's 1984 Super Bowl advert, autonomous vehicles, barriers to entry, big data - Walmart - Pop Tarts, bitcoin, blockchain, business process, buy low sell high, chief data officer, clean water, cloud computing, connected car, corporate governance, crowdsourcing, data acquisition, data is the new oil, discounted cash flows, disintermediation, Edward Glaeser, Elon Musk, en.wikipedia.org, Erik Brynjolfsson, financial innovation, Haber-Bosch Process, High speed trading, Internet of things, inventory management, invisible hand, Jean Tirole, Jeff Bezos, jimmy wales, Khan Academy, Kickstarter, Lean Startup, Lyft, market design, multi-sided market, Network effects, new economy, payday loans, peer-to-peer lending, Peter Thiel, pets.com, pre–internet, price mechanism, recommendation engine, RFID, Richard Stallman, ride hailing / ride sharing, Ronald Coase, Satoshi Nakamoto, self-driving car, shareholder value, sharing economy, side project, Silicon Valley, Skype, smart contracts, smart grid, Snapchat, software is eating the world, Steve Jobs, TaskRabbit, The Chicago School, the payments system, Tim Cook: Apple, transaction costs, two-sided market, Uber and Lyft, Uber for X, winner-take-all economy, Zipcar
All these terminological changes reflect the fact that marketing messages once disseminated by company employees and agents now spread via consumers themselves—a reflection of the inverted nature of communication in a world dominated by platforms.2 Similarly, information technology systems have evolved from back-office enterprise resource planning (ERP) systems to front-office consumer relationship management (CRM) systems and, most recently, to out-of-the-office experiments using social media and big data—another shift from inward focus to outward focus. Finance is shifting its focus from shareholder value and discounted cash flows of assets owned by the firm to stakeholder value and the role of interactions that take place outside the firm. Operations management has likewise shifted from optimizing the firm’s inventory and supply chain systems to managing external assets the firm doesn’t directly control. Tom Goodwin, senior vice president of strategy for Havas Media, describes this change succinctly: “Uber, the world’s largest taxi company, owns no vehicles.
Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets by Nassim Nicholas Taleb
Antoine Gombaud: Chevalier de Méré, availability heuristic, backtesting, Benoit Mandelbrot, Black Swan, complexity theory, corporate governance, currency peg, Daniel Kahneman / Amos Tversky, discounted cash flows, diversified portfolio, endowment effect, equity premium, global village, hindsight bias, Long Term Capital Management, loss aversion, mandelbrot fractal, mental accounting, meta analysis, meta-analysis, quantitative trading / quantitative ﬁnance, QWERTY keyboard, random walk, Richard Feynman, Richard Feynman, road to serfdom, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, Steven Pinker, stochastic process, too big to fail, Turing test, Yogi Berra
Shiller Redux Much of the thinking about the negative value of information on society in general was sparked by Robert Shiller. Not just in financial markets; but overall his 1981 paper may be the first mathematically formulated introspection on the manner in which society in general handles information. Shiller made his mark with his 1981 paper on the volatility of markets, where he determined that if a stock price is the estimated value of “something” (say the discounted cash flows from a corporation), then market prices are way too volatile in relation to tangible manifestations of that “something” (he used dividends as proxy). Prices swing more than the fundamentals they are supposed to reflect, they visibly overreact by being too high at times (when their price overshoots the good news or when they go up without any marked reason) or too low at others. The volatility differential between prices and information meant that something about “rational expectation” did not work.
Market Risk Analysis, Quantitative Methods in Finance by Carol Alexander
asset allocation, backtesting, barriers to entry, Brownian motion, capital asset pricing model, constrained optimization, credit crunch, Credit Default Swap, discounted cash flows, discrete time, diversification, diversified portfolio, en.wikipedia.org, implied volatility, interest rate swap, market friction, market microstructure, p-value, performance metric, quantitative trading / quantitative ﬁnance, random walk, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, statistical arbitrage, statistical model, stochastic process, stochastic volatility, transaction costs, value at risk, volatility smile, Wiener process, yield curve
Starting with basic definitions and notation, we provide a detailed understanding of matrix algebra and its important financial applications. An understanding of matrix algebra is necessary for modelling all types of portfolios. Matrices are used to represent the risk and return on a linear portfolio as a function of the portfolio weights and the returns and covariances of the risk factor returns. Examples include bond portfolios, whose value is expressed as a discounted cash flow with market interest rates as risk factors, and stock portfolios, where returns are represented by linear factor models. Matrices are used to represent the formulae for parameter estimates in any multiple linear regressions and to approximate the returns or changes in price of non-linear portfolios that have several risk factors. Without the use of matrices the analysis becomes extremely cumbersome.
In the Plex: How Google Thinks, Works, and Shapes Our Lives by Steven Levy
23andMe, AltaVista, Anne Wojcicki, Apple's 1984 Super Bowl advert, autonomous vehicles, book scanning, Brewster Kahle, Burning Man, business process, clean water, cloud computing, crowdsourcing, Dean Kamen, discounted cash flows, don't be evil, Douglas Engelbart, El Camino Real, fault tolerance, Firefox, Gerard Salton, Google bus, Google Chrome, Google Earth, Googley, HyperCard, hypertext link, IBM and the Holocaust, informal economy, information retrieval, Internet Archive, Jeff Bezos, Kevin Kelly, Mark Zuckerberg, Menlo Park, optical character recognition, PageRank, Paul Buchheit, Potemkin village, prediction markets, recommendation engine, risk tolerance, Sand Hill Road, Saturday Night Live, search inside the book, second-price auction, Silicon Valley, skunkworks, Skype, slashdot, social graph, social software, social web, spectrum auction, speech recognition, statistical model, Steve Ballmer, Steve Jobs, Steven Levy, Ted Nelson, telemarketer, trade route, traveling salesman, Vannevar Bush, web application, WikiLeaks, Y Combinator
Schmidt provided an excellent summary of deal making in Internet time, embodying the Google principles of speed, scale, and minimizing opportunity cost. This is a company with very little revenue, growing quickly with user adoption, growing much faster than Google Video, which is the product that Google had…. In the deal dynamics, the price, remember, is not set by my judgment or financial model, or discounted cash flow. It’s set by what people are willing to pay. And we ultimately concluded that $1.65 billion included a premium for moving quickly and making sure we could participate in the user success in YouTube. If Google had been inclined toward remorse about the price, such worries were surely mitigated by a letter sent by Rupert Murdoch’s Twentieth Century Fox as the deal was closing. It declared that whatever Google was paying, Fox would pay more.
Derivatives Markets by David Goldenberg
Black-Scholes formula, Brownian motion, capital asset pricing model, commodity trading advisor, compound rate of return, conceptual framework, Credit Default Swap, discounted cash flows, discrete time, diversification, diversified portfolio, en.wikipedia.org, financial innovation, fudge factor, implied volatility, incomplete markets, interest rate derivative, interest rate swap, law of one price, locking in a profit, London Interbank Offered Rate, Louis Bachelier, margin call, market microstructure, martingale, Norbert Wiener, price mechanism, random walk, reserve currency, risk/return, riskless arbitrage, Sharpe ratio, short selling, stochastic process, stochastic volatility, time value of money, transaction costs, volatility smile, Wiener process, Y2K, yield curve, zero-coupon bond
We will take the N=1 case of the BOPM using the example provided below. The question is, how do we determine the option OPTION PRICING IN DISCRETE TIME, PART 1 447 value C0 at time 0? A little option pricing history is useful here. Much of what we know as ﬁnance would respond that the solution is obtained by using standard discounting techniques. Let’s explore this potential avenue to pricing options. The standard discounted cash ﬂow (DCF) approach has two steps, Step 1 Calculate the expected value of the option’s payoffs using the actual probabilities p and 1–p of up and down moves respectively in the Binomial process. Step 2 Discount the result of Step 1 by an appropriate risk-adjusted discount rate (RADR). Note that, in order to accomplish this, one needs the option’s risk premium, since an option is a risky asset.
Den of Thieves by James B. Stewart
discounted cash flows, diversified portfolio, fudge factor, George Gilder, index arbitrage, Internet Archive, margin call, Ponzi scheme, rolodex, Ronald Reagan, shareholder value, South Sea Bubble, The Predators' Ball, walking around money, zero-coupon bond
Wilkis was still puzzled; he thought only gangsters had Swiss bank accounts. "So what?" he asked. But Levine refused to say more. "If you don't get it, I'm not going to spell it out." He seemed disappointed at Wilkis's lack of enthusiasm. Levine had a glaring weakness, however, that soon became apparent once he started work in the M&A department: his math skills were dismal. M&A work requires detailed calculations of discounted cash flow. Various kinds of valuations of business segments are necessary to arrive at the correct price for often huge transactions. Most of this work is done by junior M&A people. But Hill noticed that Levine invariably organized his team so that someone else had to do the math. Levine was a fast talker, and cut a swath through the fledgling department; but increasingly Hill sensed that Levine was, in his terms, a "bullshit artist."
The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal by Ludwig B. Chincarini
affirmative action, asset-backed security, automated trading system, bank run, banking crisis, Basel III, Bernie Madoff, Black-Scholes formula, buttonwood tree, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discounted cash flows, diversification, diversified portfolio, family office, financial innovation, financial intermediation, fixed income, Flash crash, full employment, Gini coefficient, high net worth, hindsight bias, housing crisis, implied volatility, income inequality, interest rate derivative, interest rate swap, labour mobility, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low skilled workers, margin call, market design, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, mortgage debt, Northern Rock, Occupy movement, oil shock, price stability, quantitative easing, quantitative hedge fund, quantitative trading / quantitative ﬁnance, Ralph Waldo Emerson, regulatory arbitrage, Renaissance Technologies, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, Sharpe ratio, short selling, sovereign wealth fund, speech recognition, statistical arbitrage, statistical model, systematic trading, The Great Moderation, too big to fail, transaction costs, value at risk, yield curve, zero-coupon bond
That pushes the mark-to-market price to a very low value, even when the price would be much higher without the investor panic. As with VaR measurements, the market would be better off with marks that consider fundamental value. Some businesses go through predictable cycles. For these, a fair asset valuation might involve two sets of numbers: the mark-to-market value and the expected present discounted cash-flow value over a longer horizon. In 2008, bank capital wasn’t sufficient to withstand a major crisis, though most banks had the minimum Basel ratios. Different banks computed Basel ratios in different ways, so it was difficult to compare institutions. Banks also lacked sufficient liquidity cushions. There are still no standardized, reliable measures for liquidity risk. Banks need better liquidity risk measures, especially during times of crisis.