75 results back to index
Valuation: Measuring and Managing the Value of Companies by Tim Koller, McKinsey, Company Inc., Marc Goedhart, David Wessels, Barbara Schwimmer, Franziska Manoury
activist fund / activist shareholder / activist investor, air freight, barriers to entry, Basel III, BRICs, business climate, business cycle, business process, capital asset pricing model, capital controls, Chuck Templeton: OpenTable:, cloud computing, commoditize, compound rate of return, conceptual framework, corporate governance, corporate social responsibility, creative destruction, credit crunch, Credit Default Swap, discounted cash flows, distributed generation, diversified portfolio, energy security, equity premium, fixed income, index fund, intangible asset, iterative process, Long Term Capital Management, market bubble, market friction, Myron Scholes, negative equity, 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, stocks for the long run, survivorship bias, 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
business cycle, correlation coefficient, discounted cash flows, double entry bookkeeping, G4S, intangible asset, iterative process, purchasing power parity, RAND corporation, shareholder value, the market place, time value of money
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.
What's Your Future Worth?: Using Present Value to Make Better Decisions by Peter Neuwirth
Chapter 10 PRESENT VALUE FOR ORGANIZATIONS AND COMMUNITIES In chapter 8, we touched on not just how individuals use Present Value but also how organizations do so. In fact, managers at many companies—particularly if they have an MBA—would say that almost all important decisions a company makes utilize Present Value, only they call it the “discounted cash flow method.”39 It’s true that, superficially, the mechanics of the discounted cash flow method and Present Value thinking are quite similar, but in fact there are some subtle—but very important—differences. For one thing, the discounted cash flow method generally focuses on just the “high likelihood” scenarios, while in Present Value thinking we try to imagine all the possibilities, recognizing that low likelihood/high impact possibilities can be very important. Nassim Taleb calls these possibilities “Black Swan” events and suggests that such “impossible to predict” scenarios are the ones that ultimately change our lives in the most important ways.40 While I agree with Taleb that these scenarios are impossible to predict, I don’t think they are impossible to imagine.
Nassim Taleb calls these possibilities “Black Swan” events and suggests that such “impossible to predict” scenarios are the ones that ultimately change our lives in the most important ways.40 While I agree with Taleb that these scenarios are impossible to predict, I don’t think they are impossible to imagine. That is why step 2 is so critical to Present Value thinking, a step that is usually given little attention in discounted cash flow analysis. In addition to the above, discounted cash flow models typically only consider financial/measurable factors, while Present Value takes into account non-financial items. Furthermore, discounted cash flow models take a pure “foregone investment” or “cost of capital” approach to setting a discount rate. We have seen before that for individuals, non-financial factors can be extremely important, and setting a discount rate only based on “foregone investments” ignores the way we as individuals inherently value things today versus the value we place on future consequences.
The shape of possible future scenarios stemming from the choice that an organization makes may be similar to that facing an individual, but since the effects are felt by more people to varying degrees, determining the “value” of each of those scenarios is more complex, and that value will vary considerably by virtue of the various stakeholders in the decision. To illustrate that complexity and the distinction between Present Value and “discounted cash flow” analysis for an organization, I want to look at a set of decisions that are being made across the country right now around an issue that is both vitally important to many people’s future and one that I believe is a textbook example of how the failure to utilize Present Value in the right way can lead to disaster. Specifically, let’s turn our attention to the state of our public employees’ retirement programs, a subject that is very much in the news these days.
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, business cycle, capital asset pricing model, collateralized debt obligation, corporate governance, credit crunch, discounted cash flows, diversification, fixed income, intangible asset, London Interbank Offered Rate, performance metric, shareholder value, sovereign wealth fund, stocks for the long run, 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).
The Dhandho Investor: The Low-Risk Value Method to High Returns by Mohnish Pabrai
asset allocation, backtesting, beat the dealer, Black-Scholes formula, business intelligence, call centre, cuban missile crisis, discounted cash flows, Edward Thorp, Exxon Valdez, fixed income, hiring and firing, index fund, inventory management, Mahatma Gandhi, merger arbitrage, passive investing, price mechanism, Silicon Valley, time value of money, transaction costs, zero-sum game
Assuming a 10 percent discount rate, the discounted cash flow (DCF) stream is shown in Table 1.1. Second, the economy goes into a severe recession and business plummets for several years. The bank works with Mr. Patel and renegotiates loan terms as described earlier. Mr. Patel has a zero return on his investment for five years and then starts making $10,000 a year in excess free cash flow when the economy recovers and booms (200 percent return every year after five years). The motel is sold in year 10 for the purchase price. Now we have a bond that pays zero interest for five years, then 200 percent for five years, and a final interest payment of 900 percent (see Table 1.2). This equates to a seven bagger—an annualized return of over 40 percent for 10 years. Table 1.1 Discounted Cash Flow (DCF) Analysis of the Best Case for Papa Patel Year Free Cash Flow ($) Present Value ($) of Future Cash Flow Excess cash 0 1 15,000 13,636 2 15,000 12,397 3 15,000 11,270 4 15,000 10,245 5 15,000 9,314 6 15,000 8,467 7 15,000 7,697 8 15,000 6,998 9 15,000 6,361 10 15,000 5,783 10 Sale price 50,000 19,277 Total 111,445 Third, the economy goes into a severe recession and business plummets.
Investing in the gas station is a better deal than putting the cash in a 10 percent yielding bond—assuming that the expected cash flows and sale price are all but assured. The stock market gives us the price at which thousands of businesses can be purchased. We also have the formula to figure out what these businesses are worth. It is simple. Table 7.1 Discounted Cash Flow (DCF) Analysis of the Gas Station Year Free Cash Flow ($) Present Value ($) of Future Cash Flow (10%) 2007 100,000 90,909 2008 100,000 82,645 2009 100,000 75,131 2010 100,000 68,301 2011 100,000 62,092 2012 100,000 56,447 2013 100,000 51,315 2014 100,000 46,650 2015 100,000 42,410 2016 100,000 38,554 2017 Sale Price 400,000 154,217 Total 768,671 Table 7.2 Discounted Cash Flow (DCF) Analysis of the 10 Percent Yielding Low-Risk Alternative Year Free Cash Flow ($) Present Value ($) of Future Cash Flow 2007 50,000 45,454 2008 50,000 41,322 2009 50,000 37,566 2010 50,000 34,151 2011 50,000 31,046 2012 50,000 28,224 2013 50,000 25,658 2014 50,000 23,325 2015 50,000 21,205 2016 50,000 17,277 2017 Capital returned 500,000 192,772 Total 500,000 When we see a huge gap between the price and intrinsic value of a given business—and that gap is in our favor—we can act and buy that business.
Even then, the probability-weighted annualized return is still well over 40 percent. The expected present value of this investment is about $93,400 (0.8 × $111,445 + 0.1 × $42,812). From Papa Patel’s perspective, there is a 10 percent chance of losing his $5,000 and a 90 percent chance of ending up with over $100,000 (with an 80 percent chance of ending up with $200,000 over 10 years). This sounds like a no-brainer bet to me. Table 1.2 Discounted Cash Flow (DCF) Analysis of the Below-Average Case for Papa Patel Year Free Cash Flow ($) Present Value ($) of Future Cash Flow Excess cash 0 1 0 0 2 0 0 3 0 0 4 0 0 5 0 0 6 10,000 5,645 7 10,000 5,131 8 10,000 4,665 9 10,000 4,240 10 10,000 3,854 10 Sale price 50,000 19,277 Total 42,812 If you went to a horse race track and you were offered 90 percent odds of a 20 times return and a 10 percent chance of losing your money, would you take that bet?
The Investopedia Guide to Wall Speak: The Terms You Need to Know to Talk Like Cramer, Think Like Soros, and Buy Like Buffett by Jack (edited By) Guinan
Albert Einstein, asset allocation, asset-backed security, Brownian motion, business cycle, business process, buy and hold, capital asset pricing model, clean water, collateralized debt obligation, computerized markets, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, dogs of the Dow, equity premium, fixed income, implied volatility, index fund, intangible asset, interest rate swap, inventory management, London Interbank Offered Rate, margin call, money market fund, mortgage debt, Myron Scholes, 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.
Warren Buffett Accounting Book: Reading Financial Statements for Value Investing (Warren Buffett's 3 Favorite Books) by Stig Brodersen, Preston Pysh
In this book, we are going to discuss two different intrinsic value calculations so you have the flexibility to choose which approach you prefer. The first calculation is called a discount cash flow calculation. The second calculation is a variant of the discount cash flow calculation and it values stocks similarly to fixed income bonds. Although both approaches might sound a little confusing, there’s no need to worry—we’ll go step by step and provide examples on the following pages. It is important to understand that every valuation technique can be boiled down to one thing: “How much money can I expect to get in return for my initial investment?” The Discount Cash Flow (DCF) Intrinsic Value Model Let’s start with the “discount cash flow” model. It consists of just six steps. Once you determine what the intrinsic value is, you’ll want to compare that value to the market price.
It is through those resources that I’ve found him repeatedly referencing the similarities between the valuation of bonds and stocks. For the next model, you’ll find that its core mathematics is based on a bond valuation formula that has been converted into a discount cash flow model for stocks. The specifics of the calculation can be found in the Appendix of this book. Since the math for this valuation technique can be a little cumbersome, I’ve tried to keep the description of the process simple in this portion of the book. Additionally, you can find this calculator on the BuffettsBooks.com website along with a video tutorial. Before using this calculator, I want to strongly emphasize the importance of finding stable and predictable companies (Principle 3). Like the discount cash flow model, without using a company that generally has predictable earnings and actions, you’ll find the calculator becomes less useful.
Overview of steps Estimate the free cash flow Estimate the discount factor Calculate the discounted value of free cash flow for ten years Calculate the discounted perpetuity free cash flow (beyond ten years) Calculate the intrinsic value Calculate the intrinsic value per share Assumptions Current free cash flow: $1,000 The first ten years’ annual growth rate of the free cash flow: 6% Discount rate: 10% Long-term growth rate: 3% Shares outstanding: 1,000 Before we go through the first step, I want to highlight that a discount cash flow calculator is provided at BuffettsBooks.com. The calculator goes through the steps you’re about to learn. On the website, there is also an instructional video that you can watch to help complement the reading. If you would like to access the calculator and the video, the Web address is: http://www.buffettsbooks.com/security-analysis/intrinsic-value-calculator-dcf.html So let’s get started with the first step. 1.
Principles of Corporate Finance by Richard A. Brealey, Stewart C. Myers, Franklin Allen
3Com Palm IPO, accounting loophole / creative accounting, Airbus A320, Asian financial crisis, asset allocation, asset-backed security, banking crisis, Bernie Madoff, big-box store, Black-Scholes formula, break the buck, Brownian motion, business cycle, buy and hold, buy low sell high, capital asset pricing model, capital controls, Carmen Reinhart, carried interest, collateralized debt obligation, compound rate of return, computerized trading, conceptual framework, corporate governance, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, cross-subsidies, discounted cash flows, disintermediation, diversified portfolio, equity premium, eurozone crisis, financial innovation, financial intermediation, fixed income, frictionless, fudge factor, German hyperinflation, implied volatility, index fund, information asymmetry, intangible asset, interest rate swap, inventory management, Iridium satellite, Kenneth Rogoff, law of one price, linear programming, Livingstone, I presume, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, market bubble, market friction, money market fund, moral hazard, Myron Scholes, new economy, Nick Leeson, Northern Rock, offshore financial centre, Ponzi scheme, prediction markets, price discrimination, principal–agent problem, profit maximization, purchasing power parity, QR code, quantitative trading / quantitative ﬁnance, random walk, Real Time Gross Settlement, risk tolerance, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, Silicon Valley, Skype, Steve Jobs, The Nature of the Firm, the payments system, the rule of 72, time value of money, too big to fail, transaction costs, University of East Anglia, urban renewal, VA Linux, value at risk, Vanguard fund, yield curve, zero-coupon bond, zero-sum game, Zipcar
/Inflation and Nominal Interest Rates 3-6 The Risk of Default Corporate Bonds and Default Risk/Sovereign Bonds and Default Risk Summary Further Reading Problem Sets Finance on the Web 4 The Value of Common Stocks 4-1 How Common Stocks Are Traded Trading Results for GE 4-2 How Common Stocks Are Valued Valuation by Comparables/Stock Prices and Dividends 4-3 Estimating the Cost of Equity Capital Using the DCF Model to Set Gas and Electricity Prices/Dangers Lurk in Constant-Growth Formulas 4-4 The Link Between Stock Price and Earnings per Share Calculating the Present Value of Growth Opportunities for Fledgling Electronics 4-5 Valuing a Business by Discounted Cash Flow Valuing the Concatenator Business/Valuation Format/Estimating Horizon Value/ A Further Reality Check/Free Cash Flow, Dividends, and Repurchases Summary Problem Sets Finance on the Web Mini-Case: Bok Sports 5 Net Present Value and Other Investment Criteria 5-1 A Review of the Basics Net Present Value’s Competitors/Three Points to Remember about NPV/NPV Depends on Cash Flow, Not on Book Returns 5-2 Payback Discounted Payback 5-3 Internal (or Discounted-Cash-Flow) Rate of Return Calculating the IRR/The IRR Rule/Pitfall 1— Lending or Borrowing?/Pitfall 2—Multiple Rates of Return/Pitfall 3—Mutually Exclusive Projects/Pitfall 4—What Happens When There Is More than One Opportunity Cost of Capital?
Instead of waiting until the end of each year before you spend any cash, it is more reasonable to assume that your expenditure will be spread evenly over the year. In this case, instead of using the annually compounded rate of 10%, we must use the continuously compounded rate of r = 9.53% (e.0953 = 1.10). Therefore, to cover a steady stream of expenditure, you need to set aside the following sum:10 USEFUL SPREADSHEET FUNCTIONS ● ● ● ● ● Discounting Cash Flows Spreadsheet programs such as Excel provide built-in functions to solve discounted-cash-flow (DCF) problems. You can find these functions by pressing fx on the Excel toolbar. If you then click on the function that you wish to use, Excel asks you for the inputs that it needs. At the bottom left of the function box there is a Help facility with an example of how the function is used. Here is a list of useful functions for DCF problems and some points to remember when entering data: • FV: Future value of single investment or annuity
We start by connecting stock prices to the cash flows that stockholders receive from the company in the form of cash dividends. This will lead us to a discounted cash flow (DCF) model of stock prices. Stock Prices and Dividends Not all companies pay dividends. Rapidly growing companies typically reinvest earnings instead of paying out cash. But most mature, profitable companies do pay regular cash dividends. Think back to Chapter 3, where we explained how bonds are valued. The market value of a bond equals the discounted present value (PV) of the cash flows (interest and principal payments) that the bond will pay out over its lifetime. Let’s import and apply this idea to common stocks. The future cash flows to the owner of a share of common stock are the future dividends per share that the company will pay out. Thus the logic of discounted cash flow suggests At first glance this statement may seem surprising.
How the City Really Works: The Definitive Guide to Money and Investing in London's Square Mile by Alexander Davidson
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, buy and hold, 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, intangible asset, interest rate derivative, interest rate swap, John Meriwether, 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, Right to Buy, 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, stocks for the long run, 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.
Value Investing: From Graham to Buffett and Beyond by Bruce C. N. Greenwald, Judd Kahn, Paul D. Sonkin, Michael van Biema
Andrei Shleifer, barriers to entry, Berlin Wall, business cycle, capital asset pricing model, corporate raider, creative destruction, Daniel Kahneman / Amos Tversky, discounted cash flows, diversified portfolio, Eugene Fama: efficient market hypothesis, fixed income, index fund, intangible asset, Long Term Capital Management, naked short selling, new economy, place-making, price mechanism, quantitative trading / quantitative ﬁnance, Richard Thaler, shareholder value, short selling, Silicon Valley, stocks for the long run, Telecommunications Act of 1996, time value of money, tulip mania, Y2K, zero-sum game
Before the arrival of the personal computer and the electronic spreadsheet, he and his partner would analyze a company by isolating its business segments and projecting revenue and expenses no more than two or three years into the future. By assuming that it would grow steadily from then on, they could calculate its current value by discounting that cash flow back to the present, using only a hand calculator. Now, with spreadsheets, they can make their projections more detailed and carry them forward further in time. Discounted cash flow analysis, a method about which we expressed some reservations in the first part of this book, is Greenberg's valuation technique of choice for all the investments he makes. Greenberg's discounted cash flow approach is bounded by a set of restrictions that keep him securely within the value investing camp. He is only interested in companies with stable earnings and relatively predictable cash flows. He subjects every investment to an "Internet test," trying to anticipate how its business might be affected by this new and disruptive technology.
The investment still looks unsound even though the index has beaten the great majority of active money managers for many years. Only the future will tell us with any certainty whether these multiples will be sustained. If they are not, then the index's status as a brilliant investment choice diminishes. Discounted Cash Flow in Practice: A Diversified Energy Company To perform better than the S&P 500 index, Greenberg and his partners have had to do a superior job in valuing a company. Though they may test other approaches, they only will invest if a discounted cash flow analysis indicates that the shares are available at an attractive price. They applied it to a diversified energy company operating largely in Canada in order to determine a price at which they would be willing to buy the shares. The process is straightforward but requires a substantial amount of work.
Someone looking to earn 15 percent had plenty of opportunity to purchase the stock, and, except at the high end of its price movement, with a substantial margin of safety. The real value of doing all the work required for a full discounted cash flow analysis is that it forces the investor to think long and hard about all the factors that will affect the future of the business, including the risks it may face that are currently unexpected and unforeseen. If Greenberg ran money with 200 names in his portfolios, he would not have the time-nor would it be worth the effort-to do all this work. But because of his concentrated approach and his determination not to lose his clients' money, he can't afford the luxury of a casual relationship with his companies. The discounted cash flow approach requires that all crucial assumptions about the future, such as rates of production or the price of energy, be made explicit.
The End of Accounting and the Path Forward for Investors and Managers (Wiley Finance) by Feng Gu
active measures, Affordable Care Act / Obamacare, barriers to entry, business cycle, business process, buy and hold, Claude Shannon: information theory, Clayton Christensen, commoditize, conceptual framework, corporate governance, creative destruction, Daniel Kahneman / Amos Tversky, discounted cash flows, disruptive innovation, diversified portfolio, double entry bookkeeping, Exxon Valdez, financial innovation, fixed income, hydraulic fracturing, index fund, information asymmetry, intangible asset, inventory management, Joseph Schumpeter, Kenneth Arrow, 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.
Mathematics of the Financial Markets: Financial Instruments and Derivatives Modelling, Valuation and Risk Issues by Alain Ruttiens
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, Satyajit Das, 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.
Fred Schwed's Where Are the Customers' Yachts?: A Modern-Day Interpretation of an Investment Classic by Leo Gough
Albert Einstein, banking crisis, Bernie Madoff, corporate governance, discounted cash flows, diversification, fixed income, index fund, Long Term Capital Management, Northern Rock, passive investing, Ralph Waldo Emerson, random walk, short selling, South Sea Bubble, The Nature of the Firm, the rule of 72, The Wealth of Nations by Adam Smith, transaction costs, young professional
When using them, you should always check that: you define the ratio clearly; you apply it in the same way to all the companies; you know what ratio values are typical for the industry you are looking at; and that you are comparing companies that are similar. Remember, also, that the results you get are only educated guesses – they are not absolute facts – and you should only use them to get a ‘feel’ for the nature of the firms. 43 DISCOUNTED CASH FLOW ‘The more financial predictions you make the more business you do and the more commissions you get.’ DEFINING IDEA… I don’t want a lot of good investments; I want a few outstanding ones. ~ PHILIP FISHER, GROWTH INVESTOR Discounted Cash Flow (DCF) is based on the idea that the value of anything, whether an asset or a company, is the sum total of the cash it can generate in the future, adjusted for the present value of that cash. DCF analyses a company in detail from the bottom up, unlike the ratios we looked at in the previous chapter, which analyse from the top down.
DON’T INVEST ON A HIGH 29. COMPANIES DON’T OFTEN TURN AROUND 30. RIDE THE WINNERS 31. THE TROUBLE WITH TRANSACTION COSTS 32. CROOKS 33. AVOIDING THE BIG COLLAPSES 34. COUNTER-CYCLICAL INVESTMENT 35. GLOBALISATION 36. NUMERACY REQUIRED 37. SHORT SELLING 38. THOSE CRAZY REGULATORS 39. COLLECTIVE INVESTMENTS 40. MERGERS AND ACQUISITIONS 41. MASSAGING THE FIGURES 42. LOOKING FOR BARGAINS 43. DISCOUNTED CASH FLOW 44. STOCK MARKET NEWSLETTERS 45. LIFE PLAN 46. HEDGE FUNDS 47. SOME IMPORTANT BASICS 48. BEHAVIOURAL FINANCE 49. BUSINESS IS HARD 50. LOSS 51. THE ‘FAT, STUPID PLEASANT’ APPROACH 52. BOOKS ON THE STOCK MARKET INDEX INTRODUCTION In 1940 Fred Schwed, a stockbroker whose father had lost everything as a short seller on Wall Street during the Roaring Twenties, published this timeless classic on how the stock market really works.
A Abramovich, Roman 112 accounts, comparing 36–7 AIM (Alternative Investment Market) 70 analysis fundamental analysis 54–5 technical analysis (TA) 40–1 analysts 95, 96 annual reports 36–7 annuities 61 Aristotle 26 Arthur Andersen 53 assets, living off 22–3 astrology, use in predicting share prices 41 Austen, Jane 22 average performance 34–5 average returns 105 B bankers and financial crisis 28–9 banks, merger activity 89 bargains, finding 92–5 Barlow Clowes affair 74, 75 Baruch, Bernard 76 ‘bear raiders’ 82–3 behavioural finance 104–5 benchmarks 35, 87 Bernard, Claude 34 Black Scholes model 32–3 blue chip companies 51, 53 Bogle, John 110 ‘bond washing’ 75 bonds investing in 10–11, 50–2, 53 in the US 80 book value 92 books about the stock market 112–13 booms 18–19 dot.com 30 excessive borrowing in 29 mergers and acquisitions in 88–9 regulators in 85 selling in 76–7 borrowing and the financial crisis 29 British Rail 66–7 Brown, Gordon 18 Buffett, Warren 13, 32, 48, 50, 52, 54, 62, 64, 66, 68, 70, 83, 90, 96, 100, 105, 110 bull markets, new issues in 57 businesses, start-up 106–7 business failure 106 buying high 64–5 C capital raising 24–5 spending 22–3 car manufacturers 67 charting 40–1 China, government bonds 51 ‘churning’ 71– 2 Cisco Systems 90 ‘closed-end’ funds 86 collapses 74–5 collective investment 86–7 companies mergers 88–9 raising capital 24–5 under threat 66–7 compensation for collapses 74–5 compound interest 102 compounding 111 costs of transactions 70–1 counter-cyclical investments 76–7 crashes 28–9 reacting to 108 regulators in 85 credit card debts, during a boom 19 crooks 72–3 see also fraud cycles, economic 19 D debts, during a boom 19 deflationary periods 103 derivatives 32–3, 85 descendants entrusting with money 59 investing for 16–17 Discounted Cash Flow (DCF) 94–5 diversification 48–9 dividend discount model 95 dot.com boom 30 Dow Jones Industrial Average (DJIA) 35 Duttweiler, Rudolph 42 E earnings management 90 Ebbers, Bernard 73 economic cycles 19 economy, growth rate 42–3 Einhorn, David 83 Einstein, Albert 102 Enron 53 equity investment 80–1 estimating returns 80–1 execution-only brokers 71 executives, benefitting from mergers 89 F fact finds 98 false information 72–3, 90, 91 family, building 99 fees, transaction 70–1 Fibonacci numbers 40 figures, ‘managing’ 90–1 financial crisis, who to blame 28–9 financial professionals 96, 98 commissions 72 and investment skills 47, 54–5 risk aversion 58 see also fund managers financial statements 91 Fisher, Irving 56 Fisher, Philip 94, 113 fluctuations in share prices 38–9 Foreman, George 60 Franklin, Benjamin 10 fraud 73, 74–5 and blue chip companies 53 FSA (Financial Services Authority) 14, 74, 83, 84 FTSE 100 64–5 fund managers 35, 54–5, 101 and tracker funds 62 see also financial professionals fundamental analysis 54–5 fundamentals 110 G Garland, Judy 98 ‘gilts’ 50–1 globalisation 78–9 Goldstein, Phil 82 Goldwyn, Sam 40 good stories about companies 42–3 government bonds 10–11, 50–2 in the US 80 Graham, Benjamin 92, 104, 113 growth rate of economies 42–3 Grubman, Jack 73 ‘gurus’ 96–7 H ‘head and shoulders’ pattern 40 hedge funds 33, 82–3, 100–1 Hendrix, Jimi 16 I Icelandic banks 11 income from capital 22–3 index investing 34–5, 62–3, 110, 111 Indonesia 76–7 government bonds 10–11 Industrial Revolution 78 inflation 61 and rate of return 103 Initial Public Offerings (IPOs) 56–7 innovations, investing in 30–1 insurance for investments 74 insurance companies 72 annuities 61 interest calculating 103 on interest 102 rates 11 international diversification 49 international investment 79 internet, investing in 30–1 investment mergers before88–9 collective 86–7 income 10–11 and inflation 61 international 79 long term 16–17, 64–5, 98–9, 102, 111 popular 30–1 risks in 44–5 short term 63 skill in 20–1 trusts 35, 48–9, 58–9, 86 IPOs (Initial Public Offerings) 56–7 J Johnson, Ross 89 K Keynes, J.
The Future of Money by Bernard Lietaer
agricultural Revolution, banks create money, barriers to entry, Bretton Woods, business cycle, clean water, complexity theory, corporate raider, 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 Future of Employment, the market place, the payments system, Thomas Davenport, 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 Einstein of Money: The Life and Timeless Financial Wisdom of Benjamin Graham by Joe Carlen
Albert Einstein, asset allocation, Bernie Madoff, Bretton Woods, business cycle, business intelligence, discounted cash flows, Eugene Fama: efficient market hypothesis, full employment, index card, index fund, intangible asset, invisible hand, Isaac Newton, laissez-faire capitalism, margin call, means of production, Norman Mailer, oil shock, post-industrial society, price anchoring, price stability, reserve currency, Robert Shiller, Robert Shiller, the scientific method, Vanguard fund, young professional
Fortunately, one of Graham's other formulas enables one to determine the implied value of this future (and hence, by definition, undetermined) growth-rate variable: G = (P/2 – 8.5)/2 P = Current stock price Regarding this formula, Graham cautioned readers of The Intelligent Investor that he provided one “because of the inescapable necessity in security analysis to project the future growth rate for most companies studied. Let the reader not be misled into thinking that such projections have any high degree of reliability.”19 Graham's words regarding the growth-rate formula apply equally to the valuation formula presented above. However, it still has some value as a filter with which to determine whether a stock is worthy of further consideration. DISCOUNT CASH FLOW (DCF) METHOD A more common method for estimating intrinsic value is the discount cash flow (DCF) method, which Graham employed regularly, as does Buffett. Through this method, all future per-share earnings, discounted to their present value, are aggregated to arrive at a “net present value” that can serve as a defensible intrinsic value. In other words, the intrinsic value of the share of the business represented by the stock is equal to the proportional share of the business’ future cash flows.
As the acclaimed young value investor and author Pat Dorsey writes in his book The Five Rules for Successful Stock Investing, Unfortunately, there is no precise way to calculate the exact discount rate that you should use in a discounted cash flow (DCF) model, and academics have filled entire journal issues with nothing but discussions about the right way to estimate discount rates.20 For example, the discount rate applied to a small company with a history of uneven earnings should be somewhat higher than that applied to a large company with a history of stable and fairly predictable earnings. Indeed, there are a number of steps, of varying levels of nuance and complexity, involved with calculating intrinsic value through the discount cash flow method. Fortunately, there are now a number of free online resources (like Guru Focus's Fair Value Calculator, at http://www.gurufocus.com/fair_value_dcf.php) that have automated this process.
Examples include short-term debt and accounts payable. diluted earnings: A stringent earnings metric, diluted earnings is calculated by dividing total earnings by a fully diluted base. This includes common stock, preferred stock, and unexercised convertible securities (unexercised stock options, warrants, and some forms of convertible bonds). discount cash flow method: A valuation method that discounts all future per-share earnings projections to their present value, the discount cash flow (DCF) method is widely used among value investors. The aggregate result is considered to be the intrinsic (present) value of the stock, which can then be compared with the current stock price to weigh its attractiveness as an investment. dividend yield: The dividend yield is calculated by dividing per-share dividends by the stock's current market price.
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, commoditize, David Heinemeier Hansson, 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, zero-sum game, 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.
More Than You Know: Finding Financial Wisdom in Unconventional Places (Updated and Expanded) by Michael J. Mauboussin
Albert Einstein, Andrei Shleifer, Atul Gawande, availability heuristic, beat the dealer, Benoit Mandelbrot, Black Swan, Brownian motion, butter production in bangladesh, buy and hold, capital asset pricing model, Clayton Christensen, clockwork universe, complexity theory, corporate governance, creative destruction, Daniel Kahneman / Amos Tversky, deliberate practice, demographic transition, discounted cash flows, disruptive innovation, diversification, diversified portfolio, dogs of the Dow, Drosophila, Edward Thorp, en.wikipedia.org, equity premium, Eugene Fama: efficient market hypothesis, fixed income, framing effect, functional fixedness, hindsight bias, hiring and firing, Howard Rheingold, index fund, information asymmetry, intangible asset, invisible hand, Isaac Newton, Jeff Bezos, Kenneth Arrow, Laplace demon, Long Term Capital Management, loss aversion, mandelbrot fractal, margin call, market bubble, Menlo Park, mental accounting, Milgram experiment, Murray Gell-Mann, Nash equilibrium, new economy, Paul Samuelson, Pierre-Simon Laplace, quantitative trading / quantitative ﬁnance, random walk, Richard Florida, Richard Thaler, Robert Shiller, Robert Shiller, shareholder value, statistical model, Steven Pinker, stocks for the long run, survivorship bias, The Wisdom of Crowds, transaction costs, traveling salesman, value at risk, wealth creators, women in the workforce, zero-sum game
Shorter product and process life cycles undermine the usefulness of historical multiples (especially price/earnings, which weren’t very useful to begin with), because the basis of comparison is different. I believe there has been a trade-off: higher economic returns for shorter periods are increasingly replacing lower economic returns for longer periods. Whether or not I am right, simplistic valuation assumptions invite danger. Another possible valuation pitfall comes with terminal valuations in discounted cash-flow models. Many discounted cash-flow models assume perpetual growth beyond an explicit forecast period, hence embedding an assumption of long-term value creation. In a world of shortening sustainable advantages, such an assumption appears particularly inappropriate.10 Clockspeed also has implications for portfolio turnover. Just as companies must string together a series of competitive advantages, optimal portfolio turnover is higher today than in the past.
Since product life cycles are short, adaptation is more important than optimization.10 Companies that compete in coarse fitness landscapes quite logically need to find a blend between short and long jumps. Indeed, models show that this mix is the best search strategy for a correlated landscape.11 Tools of the Trade-Off Just as a different mix of short and long jumps is appropriate for different fitness landscapes, so too are different financial tools and organizational structures. Traditional discounted cash flow analysis is well suited for businesses that compete in stable fitness landscapes. A centralized management approach is effective, as industry activities are often clearly defined. A coarse fitness landscape requires a blend of traditional cash flow tools and strategic options. Strategic options are the right, but not the obligation, to pursue potentially value-creating business opportunities.12 Finally, companies that compete in roiling industries must lean more on strategic options to assess their current and potential fitness.
Strategic options are the right, but not the obligation, to pursue potentially value-creating business opportunities.12 Finally, companies that compete in roiling industries must lean more on strategic options to assess their current and potential fitness. Further, these companies are well served to adopt a “strategy by simple rules” approach. This decentralized approach has agreed-upon decision rules but lets individuals make decisions at the local level as they see fit.13 Fitness landscape Financial tool Organizational structure Stable Discounted cash flow Centralized Coarse DCF plus strategic options Loose centralization Roiling Strategic options Decentralized Tiger Woods showed that change, while sometimes painful in the short term, is necessary to improve fitness in the long term. Fitness landscapes can help you evaluate whether a company is pursuing the right potential strategies and has the appropriate organization. The analysis also points to the appropriate financial tools to assess various businesses. 24 You’ll Meet a Bad Fate If You Extrapolate The Folly of Using Average P/Es For past averages to be meaningful, the data being averaged have to be drawn from the same population.
The Doomsday Calculation: How an Equation That Predicts the Future Is Transforming Everything We Know About Life and the Universe by William Poundstone
Albert Einstein, anthropic principle, Any sufficiently advanced technology is indistinguishable from magic, Arthur Eddington, Bayesian statistics, Benoit Mandelbrot, Berlin Wall, bitcoin, Black Swan, conceptual framework, cosmic microwave background, cosmological constant, cosmological principle, cuban missile crisis, dark matter, digital map, discounted cash flows, Donald Trump, Doomsday Clock, double helix, Elon Musk, Gerolamo Cardano, index fund, Isaac Newton, Jaron Lanier, Jeff Bezos, John Markoff, John von Neumann, mandelbrot fractal, Mark Zuckerberg, Mars Rover, Peter Thiel, Pierre-Simon Laplace, probability theory / Blaise Pascal / Pierre de Fermat, RAND corporation, random walk, Richard Feynman, ride hailing / ride sharing, Rodney Brooks, Ronald Reagan, Ronald Reagan: Tear down this wall, Sam Altman, Schrödinger's Cat, Search for Extraterrestrial Intelligence, self-driving car, Silicon Valley, Skype, Stanislav Petrov, Stephen Hawking, strong AI, Thomas Bayes, Thomas Malthus, time value of money, Turing test
But it gets more interesting when you consider the long-standing puzzle of how to value stocks. Accept discounted cash flow, even as an inexact rule of thumb, and you discover something remarkable. The future lifespan of a company ought to matter in stock valuations, and it ought to matter a lot. Ben Reynolds, who has examined Warren Buffett’s investing in the context of the Lindy effect, gave this example. Suppose a stock pays a dividend of $1 a year now, and this dividend grows 6 percent a year until the company abruptly goes bust and its stock becomes worthless. You have a discount rate of 7 percent, meaning, say, that you can get 7 percent as a risk-free return elsewhere. With discounted cash flow, here’s what the stock ought to be worth to you right now: • $9.47 if the stock survives another ten years before going bust • $18.03 if it survives another twenty years • $39.10 if it survives fifty years • $62.76 if it survives one hundred years • $100 if it survives forever In Reynolds’s example the dividend grows almost fast enough to make up for the time value of money.
After a 1996 merger it took the name Stora Enso, and it is still in business. Lindy in the Stock Market John Burr Williams was a Harvard economist who sought to understand the 1929 stock market crash. Stocks had not been worth what investors of the Roaring Twenties thought they were. In The Theory of Investment Value (1938), Williams maintained that the value of any asset resides in its future income stream, discounted to present value. This is known as the discounted cash flow model. According to Williams, a dividend-paying stock is worth the sum of all its future dividend payments, suitably adjusted. Suppose Coca-Cola pays a dividend of $1.59 a share and will pay that same yearly dividend for the next hundred years. The total would be $159. These dividends must be adjusted to reflect the time value of money. A $1.59 dividend now is worth more than a $1.59 dividend to be paid a hundred years from now.
It would take an infinite future of dividends to be worth $100 to an investor right now. No one can predict the next quarter, much less dividend payouts of coming decades. Fair enough. Lindy’s law assumes the near-complete unpredictability of corporate lifespans. It is that unpredictability that leads to the prediction that old companies as a group have a longer future than new companies as a group. As we’ve seen, this prediction is supported by data. So, by discounted cash flow, the valuation of long-lived companies like Coca-Cola ought to be multiple times that of the latest start-up or IPO. They’re not! The highest-valued companies are often new ones that are burning cash. They have no earnings, pay no dividends, and have short track records. Investors think these new companies represent the future and have limitless upside. Established older companies are considered to be at risk of obsolescence.
Deep Value by Tobias E. Carlisle
activist fund / activist shareholder / activist investor, Andrei Shleifer, availability heuristic, backtesting, business cycle, buy and hold, corporate governance, corporate raider, creative destruction, Daniel Kahneman / Amos Tversky, discounted cash flows, fixed income, intangible asset, joint-stock company, margin call, passive investing, principal–agent problem, Richard Thaler, riskless arbitrage, Robert Shiller, Robert Shiller, Rory Sutherland, shareholder value, Sharpe ratio, South Sea Bubble, statistical model, The Myth of the Rational Market, The Wealth of Nations by Adam Smith, Tim Cook: Apple
The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase—irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought. Williams’s discounted cash flow theory of intrinsic value is the foundation of modern finance, and forms the intellectual basis for a variety of valuation models. Buffett took William’s discounted cash flow theory and extended it to properly value growth in a business. According to Buffett, measures traditionally used in business valuation—book value, earnings, and growth—were flawed in their application. Intrinsic business value was “the measurement that really counts,” Buffett emphasized in his 1983 Chairman’s Letter: Book value’s virtue as a score-keeping measure is that it is easy to calculate and doesn’t involve the subjective (but important) judgments employed in calculation of intrinsic business value.
Shortly after Graham published Security Analysis in 1934, John Burr Williams published his 1938 masterpiece The Theory of Investment Value.44 Williams’s discounted cash flow theory of intrinsic value is the bedrock of modern valuation and forms the intellectual basis for a variety of valuation models, including, for example, Gordon’s growth model, which we saw earlier. The models all require an estimate for future cash flows, earnings, or dividends, making allowance for any growth, and out to perpetuity. Money has a time value—a dollar today is worth more than a dollar in a year—so we must then discount back to today those future cash flows at the appropriate discount rate. While the theory is sound, the slip ’twixt cup and lip is in its practical application. The three variables—future cash flows, the growth rate, and the discount rate—are all sources of potential forecast error. Discounted cash flow models are extremely sensitive to discount rates, which can lead to large errors, but the real problem is that the model assumes we have some way of forecasting future cash flows and the growth rates embedded in them.
., 34 China, 87–88 cigar butt stocks, 24–25, 38, 162–167, 189–191 Cities Service, 155–160 Citizens and Graziers Life Assurance Company Limited, 123 Clarke, Toni, 184 Clayman, Michelle, 134–137, 148 closed-end fund arbitrage, 2 Common Stocks and Uncommon Profits, 39, 41, 52 Compagnie du Midi, 126 conglomerate, 102–104, 106–107, 171 Conrad, Joseph, 99 contrarian value, 127–141, 145 portfolio, 128–133 convertible arbitrage, 2 Cook, Tim, 207–210 corporate raider, 3–4 corrective forces, 31–32 Cowin, Dan, 162–167 Cowles, Alfred III, 108 D Damodaran, Aswath, 64, 68, 75, 139–140, 146, 148 De Angelis, Anthony, 38–39 De Bondt, Werner, 81–85, 88, 96–97, 114–115, 127–128 deep value activism, 205–210 Deep Value Investing and Unexpected Returns, 148 deep value stocks, 198–205 defenestration, 151 Demptset Mill Manufacturing Company, 15 Denner, Alex, 171–172 Devil Take the Hindmost, 106–107, 116 Devito, Danny, 16 Dietrich, Noah, 100 Dimson, Elroy, 87, 97 discounted cash flow, 112 diversification, 205 Dodd, David, 17, 20, 33, 52, 75, 116, 149, 186, 215 Douglas, Michael, 16 Doyle, Arthur Conan, 119 The Drunkard’s Walk, 110, 117 Durer, Albrecht, 89–90 INDEX E earnings, 45, 85 earnings growth, 81–85 earnings yield, 56–57, 59–63 EBIT, 55–56, 64–69 EBITDA, 64–69 economic franchise, 48–49 Edwards, Jim, 170, 184 Einhorn, David, 189, 205–210, 214 Electro Dynamics Corporation, 100 Eli Lilly and Company, 173 enterprise multiple, 63–74 Enzon Pharmaceuticals, 173 Equity and Law Life Assurance Society PLC, 125–126 ergot, 99 Europe, 59, 62 Evans, Thomas Mellon, 14–16, 20 excellent stock, 134–141 F Fairchild Camera, 12 Fama, Ken, 63, 75, 95 Feinberg, Andrew, 215 Feuerstein, Adam, 184 Finance Corporation of New Zealand, 122 finance, mean reversion and, 80–85 first-class businesses, 47–49 first-class management, 49–51 Fisher, Philip, 41, 52 Flintkote, 12 Flom, Joe, 155 Fontevecchia, Augustino, 214 Fooling Some of the People All of the Time, 214 Forest Laboratories, 177 Fortuna, 77–79 The Fortune Sellers, 113, 117 Fox, Justin, 117 free-form management, 101–102 French, Eugene, 63, 75, 95 Friedman, Steven, 74 From Capitalism, Socialism and Democracy, 52 G Galton, Francis, 79, 97 gambler’s fallacy, 80, 114 Gecko, Gordon, 16 219 Index The General Theory of Employment, Interest, and Money, 81, 97 Genzyme Corporation, 169–177 George, Bill, 185 Gere, Richard, 16 glamorous stock, 128–133, 140–141 value vs., 107–115 glamour value stocks, 201–202 The Golden Rule of Predictive Modeling, 141 Goldstein, Jacob, 185 Goldstein, Robert, 57 Gordon model, 96 Gotham Asset Management, 57 governance, 205–206 Graham-Newman, 14–15, 36 Graham, Benjamin, 12–19, 25–36, 40–41, 51–53, 70–79, 88, 96–97, 106, 112, 116, 127, 142–147, 152, 183, 186–191, 204, 210–212, 215 Gray, Wes, 57–58, 75 Greenblatt, Joel, 53–58, 62–63, 75, 195–196 Greenlight Capital, 189 greenmail, 5–6 Gulf Oil, 156–160, 188 H H.
Ethics in Investment Banking by John N. Reynolds, Edmund Newell
accounting loophole / creative accounting, activist fund / activist shareholder / activist investor, banking crisis, collapse of Lehman Brothers, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, discounted cash flows, financial independence, index fund, invisible hand, light touch regulation, 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, zero-sum game
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
Investment: A History by Norton Reamer, Jesse Downing
activist fund / activist shareholder / activist investor, Albert Einstein, algorithmic trading, asset allocation, backtesting, banking crisis, Berlin Wall, Bernie Madoff, break the buck, Brownian motion, business cycle, buttonwood tree, buy and hold, 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, dogs of the Dow, 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, information asymmetry, 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, money market fund, moral hazard, mortgage debt, Myron Scholes, negative equity, Network effects, new economy, Nick Leeson, Own Your Own Home, Paul Samuelson, 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, survivorship bias, 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).
Secrets of Sand Hill Road: Venture Capital and How to Get It by Scott Kupor
activist fund / activist shareholder / activist investor, Airbnb, Amazon Web Services, asset allocation, barriers to entry, Ben Horowitz, carried interest, cloud computing, corporate governance, cryptocurrency, discounted cash flows, diversification, diversified portfolio, estate planning, family office, fixed income, high net worth, index fund, information asymmetry, Lean Startup, low cost airline, Lyft, Marc Andreessen, Myron Scholes, Network effects, Paul Graham, pets.com, price stability, ride hailing / ride sharing, rolodex, Sand Hill Road, shareholder value, Silicon Valley, software as a service, sovereign wealth fund, Startup school, Travis Kalanick, uber lyft, VA Linux, Y Combinator, zero-sum game
It’s really tough to do this for an early-stage startup given that the financial forecasts for the business are probably not worth more than the Excel spreadsheet on which they were created. VCs often joke that “we can make the spreadsheet say whatever we want.” More significantly for startups—for those of you familiar with discounted cash flow models—because they tend to consume cash in the early years and (hopefully) generate cash in the mature years, most of the value in a discounted cash flow model will come from the far-out years, where the certainty of forecasts gets even more fuzzy. In addition to all these challenges, the comparable company and discounted cash flow analyses also suffer from the fact that they don’t account for dilution in the VCs’ equity holdings resulting from future financings. Huh? When a VC invests in a startup company, she hopes that may be the last money the company ever needs to raise, but knows in her heart that that is highly unlikely.
None of these questions is insurmountable, but they do go to the heart of whether “comparables” are in fact comparable. This analysis is doubly hard as applied to startups because (we hope) startups are by definition unique, and the ability to forecast revenue is inherently unpredictable. So even if we get the comparables right, who knows if we will get our revenue forecast right—garbage in, garbage out. Discounted Cash Flow Analysis Financial theory says—and who are we to argue with it—that over the long run, the value of a company equals the present value of its future cash flows. That is, whatever annual cash a company can generate in the future, if we discount that cash to present-day values, an investor should be willing to pay no more than the current value of that stream of future cash. How do we do this in practice?
., 26–29 and winding down the company, 246 Decimalization and Regulation NMS (National Market System), 107 deflationary hedges, 59, 63 Delaware, 174 difficult financings, 232–246 and Bloodhound case, 236–239 and bridge financing, 233 and fiduciary duty questions, 232, 236, 237 reducing/eliminating liquidation preferences, 234–236 and reverse splits of stock holdings, 235–236 success following, 239–242 and winding down the company, 243–246 See also down-round financing; recapitalizations dilution of equity about, 120 and antidilution provisions in term sheet, 165–167, 193–196, 280–281 balancing incenting against, 146–147 and down rounds, 165–166, 167, 237 and employee option pools, 240 and pro rata investments, 178–180 and reverse splits of stock holdings, 235–236 Dimon, Jamie, 133 discounted cash flow analyses, 150–153 discount rates, 150–151 distribution of returns for venture capital, 30–32, 31, 35, 38, 40 diversification, 36 dividends, 154–155, 279 Dixon, Chris, 48 “DLOM” (discount for lack of marketability), 77–78 Doerr, John, 43, 112 domestic equities, 61–62 Dorsey, Jack, 133 dot.com boom/bust and buyout investors, 16–17 general outlook during, 9–11 initial public offerings during, 9–10, 15 and LoudCloud, 12–18 and Nasdaq index, 10–11, 15 pace of VC investment during, 10 and public markets, 10–11 and Yale University endowment, 64–65 double-trigger acceleration, 186–187, 250–251 down-round financing and Bloodhound case, 237 defined, 165 and dilution of equity, 165–166, 167, 237 and fiduciary duty questions, 232, 236, 237 and management incentive plans, 241–242 purpose of, 234 success following, 234, 239–242 and winding down the company, 234 drag-along provisions in term sheets, 182–183, 252, 284 dual-class stock, 160, 168–169 dual fiduciaries, 201–202, 212 duty of candor, 215 duty of care, 211–212, 215, 217 duty of confidentiality, 212–215 duty of loyalty, 212, 215, 218 early-stage financing/investors (angels or seed investors) and convertible notes, 28, 144 emergence of, 271 of Horowitz and Andreessen, 19 and Silicon Valley community (2007), 19 as source of referrals for VCs, 125 and valuation of startups, 153 economic impact of venture-backed companies, 3–4, 41 Edison, Thomas, 53–54 Edison General Electric, 53–54 egomania in founders, 47–48 Electronic Data Systems (EDS), 18 emerging growth companies (EGCs), 261–263 employee option pools, 103–106 board’s role in managing, 205 and capitalization tables, 190–191 following difficult financings, 240–241 size of, 154, 177, 205 employees cash-equity tradeoff of, 184, 185 and common stock, 93 compensation of, 244 and employment offers in acquisitions, 251, 256 and non-disclosure agreements, 187, 285 rights to technologies created by, 187, 285 and vacation policies, 244–245 and valuation, 121–122 and vesting, 183 and WARN statutes, 243–244 and winding down the company, 243–245 endorsement of a company, venture capital as, 43–44 endowments, 54–55 entire fairness rule, 218–220, 222, 226–229, 237 entrepreneurs and declining capital requirements for startups, 20, 270–271 equity held by, 145 goals/objectives of, 5 and information asymmetry, 5, 140, 275 power balance with VCs, 20–21 role of, in venture capital, 29 See also founders E.piphany, 12 equity financing, 26–29 equity partners agreement, 88–89 escrow accounts, 252–253 evaluation of early-stage companies, 42–52 and company vs. product-first companies, 44–45 and good ideas that look like bad ideas, 48 and idea maze of founders, 49, 135 and limited/imperfect data, 34, 42 and market size, 50–52 people/team considerations in, 43–48 and products, 48–50 evolution of venture capital industry, 270–273 exclusivity periods, 253 exiting options of venture-backed companies, 2.
The Personal MBA: A World-Class Business Education in a Single Volume by Josh Kaufman
Albert Einstein, Atul Gawande, Black Swan, business cycle, 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 Heinemeier Hansson, David Ricardo: comparative advantage, Dean Kamen, delayed gratification, discounted cash flows, Donald Knuth, double entry bookkeeping, Douglas Hofstadter, en.wikipedia.org, Frederick Winslow Taylor, George Santayana, Gödel, Escher, Bach, high net worth, hindsight bias, index card, inventory management, iterative process, job satisfaction, Johann Wolfgang von Goethe, Kevin Kelly, Kickstarter, Lao Tzu, lateral thinking, loose coupling, loss aversion, Marc Andreessen, 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, Vilfredo Pareto, 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.
Mastering Private Equity by Zeisberger, Claudia,Prahl, Michael,White, Bowen, Michael Prahl, Bowen White
asset allocation, backtesting, barriers to entry, Basel III, business process, buy low sell high, capital controls, carried interest, commoditize, corporate governance, corporate raider, correlation coefficient, creative destruction, discounted cash flows, disintermediation, disruptive innovation, distributed generation, diversification, diversified portfolio, family office, fixed income, high net worth, information asymmetry, intangible asset, Lean Startup, market clearing, passive investing, pattern recognition, performance metric, price mechanism, profit maximization, risk tolerance, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, Silicon Valley, sovereign wealth fund, statistical arbitrage, time value of money, transaction costs
Assessing EV and equity value at entry and exit allows a PE investor to determine an expected return for the investment opportunity and assess whether it aligns with the riskiness of the opportunity and the mandate and target return of the fund. It should be noted that strategic investors employ different valuation methods, as they emphasize the long-term value of acquisitions as well as potential synergies with their existing business. As a result, strategic investors favor the discounted cash flow (DCF) valuation method, which uses future free cash flow projections and discounts them to arrive at an estimate of present value.3 PE investors mostly consider the output from a DCF valuation—and at times more exotic valuation techniques, such as real option pricing—only in a complementary manner or to assess how other parties may value the target. We will now show how these techniques are applied to value early-stage companies (VC targets) and mature companies (growth equity and buyout targets).
While GPs exercise a degree of judgment in determining the unrealized value in their unlisted investments, preference is given to methodologies that draw on market-based measures of risk and return that are minimally influenced by accounting techniques. In addition to metrics from comparable businesses and recent transactions, fair value also takes current market conditions into account, yet rules out abnormally high or low valuations resulting from temporary market imbalances or distressed sales. Techniques used to determine fundamental value, including discounted cash flow or real option valuation, may also inform fair value and can balance market-based assessments. Various academic studies have highlighted the controversy and potential conflicts of interest between GPs and LPs when determining unrealized value in unlisted portfolio company investments. For example, a recent study2 suggested that at times the valuation of unrealized investments had been used to smooth out interim fund performance, particularly by overstating portfolio company valuations during bear markets.
PRICING: Pricing LP interests is arguably one of the most contentious steps of a traditional secondary transaction. Prices are typically based on a fund’s NAV at a given point in time, and are quoted at a discount or premium to NAV. The two most common valuation methods are (1) the top-down valuation method, which applies comparable transaction multiples and/or trading multiples to arrive at the value of an LP interest, and (2) the bottom-up valuation method, which uses a discounted cash flow model to calculate the intrinsic value of the fund’s underlying assets. Top-down valuation employs information from comparable secondary market transactions to determine the pricing of an LP interest. A common multiple used in secondary market transactions is the ratio of the price paid and fund’s NAV in a given transaction (price/NAV). Pricing can also be determined by looking at historical trading values of listed PE funds.
Buy Then Build: How Acquisition Entrepreneurs Outsmart the Startup Game by Walker Deibel
barriers to entry, Clayton Christensen, commoditize, deliberate practice, discounted cash flows, diversification, Elon Musk, family office, financial independence, high net worth, intangible asset, inventory management, Jeff Bezos, knowledge worker, Lean Startup, Mark Zuckerberg, meta analysis, meta-analysis, Network effects, new economy, Peter Thiel, risk tolerance, risk/return, rolodex, software as a service, Steve Jobs, supply-chain management, Y Combinator
This is the lowest possible value a company could have and is experienced only in occurrences of bankruptcy auctions. LV is an important calculation for turn-around experts looking to acquire underutilized opportunities, but you won’t see any Offering Memorandums highlighting liquidation values. 151 CASH FLOW BASED VALUATION Cash flow based valuation has two common methods: Discounted Cash Flow (DCF) and Valuation Multiple. DISCOUNTED CASH FLOW Discounted Cash Flow is the most common valuation method for transactions at investment banks. The approach starts with projecting the future earnings of a company by looking at prior history, industry projections, and a dozen assumptions, then discounting those future earnings by applying a weighted average cost of capital to a value that it would be worth today. It’s great in theory because it’s attempting to apply a valuation on future cash flow, but in practice it’s an academic exercise that is full of assumptions and significantly more effective in large, publicly traded firms, or, more specifically, eternally profitable, cash-cow type companies.
The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments by Pat Dorsey
Airbus A320, barriers to entry, business process, call centre, creative destruction, credit crunch, discounted cash flows, intangible asset, knowledge worker, late fees, low cost airline, low cost carrier, Network effects, pets.com, price anchoring, risk tolerance, risk/return, rolodex, shareholder value, Stewart Brand
Although investing remains an art, we’ve attempted to make identifying companies with moats more of a science. Moats are a crucial element in Morningstar’s stock ratings. We have more than 100 stock analysts covering 2,000 publicly traded companies across 100 industries. Two main factors determine our ratings: (1) a stock’s discount from our estimated fair value, and (2) the size of a company’s moat. Each analyst builds a detailed discounted cash flow model to arrive at a company’s fair value. The analyst then assigns a moat rating—Wide, Narrow, or None—based on the techniques that you’ll learn about in this book. The larger the discount to fair value and the larger the moat, the higher the Morningstar stock rating. We’re seeking companies with moats, but we want to buy them at a significant discount to fair value. This is what the best investors do—legends like Buffett, Bill Nygren at Oakmark Funds, and Mason Hawkins at Longleaf Funds.
Invest, Don’t Speculate There are three types of tools for valuing companies: price multiples, yields, and intrinsic values. All three are valuable parts of the investing toolkit, and the wise investor will apply more than one to a prospective purchase. I’ll go over price multiples and yields in the next chapter. (Intrinsic values are a bit more complicated, and generally require a somewhat technical method called discounted cash flow, which is a bit beyond the scope of this book.6) However, understanding price multiples and yields will be easier if we first detour briefly into what drives stock returns. Over long stretches of time, there are just two things that push a stock up or down: The investment return, driven by earnings growth and dividends, and the speculative return, driven by changes in the price-earnings (P/E) ratio.
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 cycle, business process, butterfly effect, carbon footprint, Carmen Reinhart, clockwork universe, collapse of Lehman Brothers, complexity theory, conceptual framework, credit crunch, different worldview, 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, liberation theology, 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.
Stocks for the Long Run 5/E: the Definitive Guide to Financial Market Returns & Long-Term Investment Strategies by Jeremy Siegel
Asian financial crisis, asset allocation, backtesting, banking crisis, Black-Scholes formula, break the buck, Bretton Woods, business cycle, buy and hold, buy low sell high, California gold rush, capital asset pricing model, carried interest, central bank independence, cognitive dissonance, compound rate of return, computer age, computerized trading, corporate governance, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, Deng Xiaoping, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, dogs of the Dow, equity premium, Eugene Fama: efficient market hypothesis, eurozone crisis, Everybody Ought to Be Rich, Financial Instability Hypothesis, fixed income, Flash crash, forward guidance, fundamental attribution error, housing crisis, Hyman Minsky, implied volatility, income inequality, index arbitrage, index fund, indoor plumbing, inflation targeting, invention of the printing press, Isaac Newton, joint-stock company, London Interbank Offered Rate, Long Term Capital Management, loss aversion, market bubble, mental accounting, money market fund, mortgage debt, Myron Scholes, new economy, Northern Rock, oil shock, passive investing, Paul Samuelson, Peter Thiel, Ponzi scheme, prediction markets, price anchoring, price stability, purchasing power parity, quantitative easing, random walk, Richard Thaler, risk tolerance, risk/return, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, stocks for the long run, survivorship bias, technology bubble, The Great Moderation, the payments system, The Wisdom of Crowds, transaction costs, tulip mania, Tyler Cowen: Great Stagnation, Vanguard fund
Corporate History Sector Rotation in the S&P 500 Index Top-Performing Firms How Bad News for the Firm Becomes Good News for Investors Top-Performing Survivor Firms Other Firms That Turned Golden Outperformance of Original S&P 500 Firms Conclusion Chapter 9 The Impact of Taxes on Stock and Bond Returns Stocks Have the Edge Historical Taxes on Income and Capital Gains Before- and After-Tax Rates of Return The Benefits of Deferring Capital Gains Taxes Inflation and the Capital Gains Tax Increasingly Favorable Tax Factors for Equities Stocks or Bonds in Tax-Deferred Accounts? Conclusion Appendix: History of the Tax Code Chapter 10 Sources of Shareholder Value Earnings and Dividends Discounted Cash Flows Sources of Shareholder Value Historical Data on Dividends and Earnings Growth The Gordon Dividend Growth Model of Stock Valuation Discount Dividends, Not Earnings Earnings Concepts Earnings Reporting Methods Operating Earnings and NIPA Profits The Quarterly Earnings Report Conclusion Chapter 11 Yardsticks to Value the Stock Market An Evil Omen Returns Historical Yardsticks for Valuing the Market Price/Earnings Ratio and the Earnings Yield The Aggregation Bias The Earnings Yield The CAPE Ratio The Fed Model, Earnings Yields, and Bond Yields Corporate Profits and GDP Book Value, Market Value, and Tobin’s Q Profit Margins Factors That May Raise Future Valuation Ratios A Fall in Transaction Costs Lower Real Returns on Fixed-Income Assets The Equity Risk Premium Conclusion Chapter 12 Outperforming the Market The Importance of Size, Dividend Yields, and Price/Earnings Ratios Stocks That Outperform the Market What Determines a Stock’s Return?
The anchorperson of one of the major financial networks excitedly proclaims: “Intel just out with its earnings! It ‘beat the Street’ by 20 cents, and its price has jumped $2 in after-hours trading.” Earnings drive stock prices, and their announcements are eagerly awaited by Wall Street. But exactly how should we calculate earnings, and how do firms turn these earnings into stockholder value? This chapter addresses those questions. DISCOUNTED CASH FLOWS The fundamental source of asset values derives from the expected cash flows that can be obtained from owning that asset. For stocks these cash flows come from dividends or from cash distributions resulting from earnings or the sale of the firm’s assets. Stock prices also depend on the rate at which these future cash flows are discounted. Future cash flows are discounted because cash received in the future is not valued as highly as cash received in the present.
See Great Depression Developed economies age wave in, 63 distribution of world equity in, 195–196 emerging economies and, 68 GDP in, 197 real GDP in, 67 retiree-to-worker ratios in, 60–64 stock returns in, 199 Developing countries. See also Emerging economies distribution of world equity in, 195–196 GDP in, 197 stock returns in, 199 DIA ticker symbols, 273 Diamonds, 273 Difference between expectation/actuality, 258–261 Dimson, Elroy, 89–90 Discounted cash flows, 143–144 Discounts, 278 Distilling & Cattle Feeding, 116 Diversifiable risk, 176 Diversification, 198–205 The Dividend Investor , 182 Dividends of bonds vs. stocks, 157–159 discounting, 149 Gordon growth model for, 147–149 history of, 144–145 outperforming the market and, 179–183 payout ratios for, 147–149 per share, 145 DJIA (Dow Jones Industrial Average). See Dow Jones Industrial Average (DJIA) Dodd, David Buffett on, 363 on dividends, 179–180 on gambling fever, 3 on price/book ratios, 185 on price/earnings ratios, 183–184 on security analysis, 173, 176 on speculation, 157 on technical analysis, 311 value-oriented approach of, 11 Dodd-Frank Wall Street Reform and Consumer Protection Act, 53–55 Dodd, Senator Christopher, 53 “Dogs of the Dow,” 181–182 Dollar.
Financial Statement Analysis: A Practitioner's Guide by Martin S. Fridson, Fernando Alvarez
business cycle, corporate governance, credit crunch, discounted cash flows, diversification, Donald Trump, double entry bookkeeping, Elon Musk, fixed income, information trail, intangible asset, interest rate derivative, interest rate swap, negative equity, new economy, offshore financial centre, postindustrial economy, profit maximization, profit motive, Richard Thaler, shareholder value, speech recognition, statistical model, time value of money, transaction costs, Y2K, zero-coupon bond
Existing shareholders’ interest is likewise diluted if the company issues new stock at a price below book value. In this circumstance, a dollar invested by a new shareholder purchases a larger percentage of the company than is represented by a dollar of net worth held by an old shareholder. discount rate. The interest rate used to equate future value (see) with present value (see). Also referred to as cost of capital (see). discounted cash flow. A technique for equating future cash flows to a present sum of money, based on an assumed interest rate. For example, $100 compounded annually at 8 percent over three years will cumulate to a sum of $125.97, ignoring the effect of taxes. This figure can be calculated via the equation where P = Principal value at beginning of period (Present value) r = Interest rate n = Number of periods F = Principal value at end of period (Future value) In this case, $100 × (1.08)3 = $125.97.
For example, $100 compounded annually at 8 percent over three years will cumulate to a sum of $125.97, ignoring the effect of taxes. This figure can be calculated via the formula where P = Principal at beginning of period r = Interest rate n = Number of periods In this case, $100 × (1.08)3 = $125.97. (This formula implicitly assumes that cash interest received will be reinvested at the original rate of interest throughout the period.) (See also discounted cash flow, net present value, and present value.) GAAP. Generally accepted accounting principles (see). GDP. Gross domestic product (see). generally accepted accounting principles. Rules that govern the preparation of financial statements, based on pronouncements of authoritative accounting organizations such as the Financial Accounting Standards Board, industry practice, and the accounting literature (including books and articles).
The sum that, if compounded at a specified rate of interest, or discount rate (see), will accumulate to a particular value at a stated future date. For example: To calculate the present value of $500, five years hence at a discount rate of 7 percent, solve the equation: where F = Future value r = Interest rate n = Number of periods p = Present value In this case $500/(1.07)5 = $356.49. (See also discounted cash flow, future value, and net present value.) pro forma. Describes a financial statement constructed on the basis of specified assumptions. For example, if a company made an acquisition halfway through its fiscal year, it might present an income statement intended to show what the combined companies’ full-year sales, costs, and net income would have been, assuming that the acquisition had been in effect when the year began.
Competition Demystified by Bruce C. Greenwald
additive manufacturing, airline deregulation, AltaVista, asset allocation, barriers to entry, business cycle, creative destruction, cross-subsidies, deindustrialization, discounted cash flows, diversified portfolio, Everything should be made as simple as possible, fault tolerance, intangible asset, John Nash: game theory, Nash equilibrium, Network effects, new economy, oil shock, packet switching, pets.com, price discrimination, price stability, selective serotonin reuptake inhibitor (SSRI), shareholder value, Silicon Valley, six sigma, Steve Jobs, transaction costs, yield management, zero-sum game
The commitments in question are large, they involve the overall direction of the enterprise, and they have long-term consequences. The most common method for evaluating alternative courses of action in these areas is a business case analysis consisting of detailed projections of future distributable cash flows discounted back to the present. But discounted cash flow, as we have argued in chapter 16, is by itself a critically flawed tool for making decisions of this sort. The values calculated to justify initiatives depend on projections, into the distant future, of growth rates, profit margins, costs of capital, and other crucial yet highly uncertain variables. Also, a typical discounted cash flow analysis rests on a number of critical assumptions about the nature and intensity of future competition that are rarely explicit and generally untested. The strategic framework we have developed in this book, especially the view that the most important determinant of strategy is whether an incumbent firm benefits from competitive advantages, applies directly to issues of corporate development.
The strategic framework we have developed in this book, especially the view that the most important determinant of strategy is whether an incumbent firm benefits from competitive advantages, applies directly to issues of corporate development. In fact, the utility of this approach in clarifying decision making in this area is an important test of its worth. At a minimum, clarifying the competitive environment in which new initiatives will succeed or fail should provide an essential check on whether the conclusions of a discounted cash flow–based business case are reasonable. MERGERS AND ACQUISITIONS Decisions about mergers and acquisitions are essentially large-scale investment choices. They are based on an investment approach that has two main features. First, an acquisition is by definition a concentrated investment in a single enterprise or, in those cases where a conglomerate is being acquired, in a limited collection of enterprises.
Quantitative Value: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors by Wesley R. Gray, Tobias E. Carlisle
activist fund / activist shareholder / activist investor, Albert Einstein, Andrei Shleifer, asset allocation, Atul Gawande, backtesting, beat the dealer, Black Swan, business cycle, butter production in bangladesh, buy and hold, 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, Edward Thorp, Eugene Fama: efficient market hypothesis, forensic accounting, hindsight bias, intangible asset, 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, survivorship bias, 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 cycle, business process, butter production in bangladesh, buy and hold, buy low sell high, capital asset pricing model, centre right, collateralized debt obligation, commoditize, computerized markets, corporate governance, correlation coefficient, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, discounted cash flows, disintermediation, diversification, Donald Knuth, Edward Thorp, 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, Myron Scholes, Nick Leeson, P = NP, pattern recognition, Paul Samuelson, 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 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.
Young Money: Inside the Hidden World of Wall Street's Post-Crash Recruits by Kevin Roose
activist fund / activist shareholder / activist investor, Basel III, cognitive dissonance, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, discounted cash flows, Donald Trump, East Village, eurozone crisis, fixed income, forward guidance, glass ceiling, Goldman Sachs: Vampire Squid, hedonic treadmill, jitney, knowledge worker, new economy, Occupy movement, plutocrats, Plutocrats, Robert Shiller, Robert Shiller, selection bias, shareholder value, side project, Silicon Valley, Skype, Steve Jobs, The Predators' Ball, too big to fail, urban planning, We are the 99%, young professional
The result—which he estimated was something like $16 an hour, after taxes—was much more than minimum wage, but not nearly enough for Ricardo to be able to justify the punishment he’d been taking. Ricardo’s main task that spring had been making Excel model after Excel model. There were several kinds of models that banks used to value companies they were recommending as merger or acquisition candidates for their clients—including “discounted cash flows,” or DCF, a type of widely used model that used a company’s projected cash flows to estimate what it was worth on the open market. I’d learned how to make these models in my Training the Street seminar. It’s a fragile, delicate process that involves inputting long strings of numbers, linking cells to other cells, and cross-referencing each output so that when one input is updated, the rest of the model updates automatically.
“He lived in Windsor Court, a massive apartment complex in Murray Hill”: The New York Times described Windsor Court as a place where “recent college graduates can find themselves among fellow alumni, meet up for familiar drinking rituals and flock to the frozen-yogurt shops and sushi bars that help them stay fit and find a mate for the next stage of life.” (Joseph Berger, “In Murray Hill, the College Life Need Never End,” January 18, 2011.) “abbreviations: DCF, CIM, LBO, VIX, and hundreds more”: If you’re curious: discounted cash flow, confidential information memorandum, leveraged buyout, and CBOE Volatility Index. “bars like Joshua Tree…and the Patriot Saloon are considered first-year watering holes”: For more establishments in the same vein, see Business Insider’s “The Most Obnoxious Bars on Wall Street” slideshow (Linette Lopez, August 3, 2012.) “Most large investment banks block…social media services in their offices”: William Alden, “On Wall St., Keeping a Tight Rein on Twitter,” New York Times (DealBook), March 21, 2012.
How to Be the Startup Hero: A Guide and Textbook for Entrepreneurs and Aspiring Entrepreneurs by Tim Draper
3D printing, Airbnb, Apple's 1984 Super Bowl advert, augmented reality, autonomous vehicles, basic income, Berlin Wall, bitcoin, blockchain, Buckminster Fuller, business climate, carried interest, connected car, crowdsourcing, cryptocurrency, Deng Xiaoping, discounted cash flows, disintermediation, Donald Trump, Elon Musk, Ethereum, ethereum blockchain, family office, fiat currency, frictionless, frictionless market, high net worth, hiring and firing, Jeff Bezos, Kickstarter, low earth orbit, Lyft, Mahatma Gandhi, Mark Zuckerberg, Menlo Park, Metcalfe's law, Metcalfe’s law, Mikhail Gorbachev, Minecraft, Moneyball by Michael Lewis explains big data, Nelson Mandela, Network effects, peer-to-peer, Peter Thiel, pez dispenser, Ralph Waldo Emerson, risk tolerance, Robert Metcalfe, Ronald Reagan, Rosa Parks, Sand Hill Road, school choice, school vouchers, self-driving car, sharing economy, short selling, Silicon Valley, Skype, smart contracts, Snapchat, sovereign wealth fund, stealth mode startup, stem cell, Steve Jobs, Tesla Model S, Uber for X, uber lyft, universal basic income, women in the workforce, Y Combinator, zero-sum game
We lived in a small apartment in Soldiers Field Park, where Jesse slept in a chest drawer. After business school, I took a half venture capital, half investment banking job with Alex. Brown & Sons, a boutique investment bank in San Francisco (with regular trips to Baltimore). Under the tutelage of Steven Brooks and Don Dixon for banking and Bruns Grayson for venture capital, I got some good training, but I mostly calculated discounted cash flow projections on spreadsheets, and I lasted about one year. Origin Story In July of 1985, I was 27 years old, just a year out of Harvard Business School, when I informed Melissa that I was going to start my own venture capital firm. She was very concerned. We had a child then and one on the way, and taking this kind of a risk with their future was scary for her. For me, it was exhilarating!
A wealthy society is a liquid society, and any limitation to that liquidity puts a serious damper on the jobs, wealth and prosperity of the people in that society. Our government allows, even encourages, people to play the lottery while they carefully control, monitor and restrict those same people from investing in private companies that could become major engines of progress. It is time our regulations let private companies trade. The value of a company is determined by what the investors believe the discounted cash flows of a given company will be over time. Investors do tend to suffer groupthink in that they celebrate together and panic together. When investors are optimistic about the future, short-term cash flows and short-term profitability don't matter as much to them as future prospects. When investors become more pessimistic, they fly to 'quality.' which means that they focus purely on historic numbers to determine company value.
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, business cycle, buy and hold, buy low sell high, capital asset pricing model, capital controls, Carmen Reinhart, central bank independence, collateralized debt obligation, commoditize, 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, G4S, George Akerlof, global reserve currency, Google Earth, high net worth, hindsight bias, Hyman Minsky, implied volatility, income inequality, incomplete markets, index fund, inflation targeting, information asymmetry, interest rate swap, invisible hand, Kenneth Rogoff, laissez-faire capitalism, law of one price, London Interbank Offered Rate, 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, Myron Scholes, negative equity, New Journalism, oil shock, p-value, passive investing, Paul Samuelson, 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, selection bias, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stochastic volatility, stocks for the long run, survivorship bias, 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, zero-sum game
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.
The Big Secret for the Small Investor: A New Route to Long-Term Investment Success by Joel Greenblatt
If our estimate of value can change dramatically with even small changes in our guesses about the proper earnings growth rate to use or the proper discount rate, how meaningful can the estimates of value made by “experts” really be? The answer to #4 above is—“not very.” As it turns out, there actually are 24-hour locksmiths in the Bronx—unfortunately, they are not available now. 1. These concepts involve a discussion of the time value of money and discounted cash flow. If you are already very familiar with these (and can’t possibly see how I can make them funny), feel free to look at the pretty pictures and then skip ahead to the chapter summary! 2. In reality, we should look for how much cash we receive from the business over its lifetime. For our purposes, we will assume that earnings are a good approximation for cash received. Every morning on my way to work, I am confronted by an inspiring message from, of all places, the U.S.
Early Retirement Extreme by Jacob Lund Fisker
8-hour work day, active transport: walking or cycling, barriers to entry, buy and hold, clean water, Community Supported Agriculture, delayed gratification, discounted cash flows, diversification, dogs of the Dow, don't be evil, dumpster diving, financial independence, game design, index fund, invention of the steam engine, inventory management, lateral thinking, 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).
The Accidental Investment Banker: Inside the Decade That Transformed Wall Street by Jonathan A. Knee
barriers to entry, Boycotts of Israel, call centre, cognitive dissonance, commoditize, corporate governance, Corrections Corporation of America, discounted cash flows, fear of failure, fixed income, greed is good, if you build it, they will come, iterative process, market bubble, market clearing, Menlo Park, new economy, Ponzi scheme, pre–internet, risk/return, Ronald Reagan, shareholder value, Silicon Valley, technology bubble, young professional, éminence grise
Although analogous to or modeled on more conventional methods, the precise contours of these mysterious valuation techniques were known only to a close-knit group of technology bankers fully immersed in these dark arts. At bottom, traditional valuations are based on some assessment of current earnings or cash flow and future prospects. Current earnings are, by definition, more certain than future, so methods grounded in the former are less speculative than those grounded in the latter. For this reason, the least precise of traditional valuation methods is the “discounted cash flow” or DCF, which estimates the present value of cash flows projected five or even ten years out. DCF valuations can swing wildly based on relatively minor changes in assumptions on growth and interest rates. Typically, the majority of the DCF value is found in the “terminal value”—the value assigned the last, and thus most speculative, year of projections. The value is calculated by multiplying the projected cash flow in that year by a factor—called the “terminal” multiple—that implies a view on the ability of the cash flows to continue to grow in perpetuity at a certain rate.
See also specific firms Curry, Christian, 128–29, 192, 193 Curry, William, 128 Czinger, Kevin, 14–15, 16, 32, 33–34, 37–38, 55 “Dare to be Great” speech, 10 Davison, Todd, 162 Dean Witter Discover culture of, 189 merger with Morgan Stanley, 113, 188–92, 197 “The Death of the Banker” (Chernow), 226–27 De Baubigny, Andre, 141 Dell, 172 DePuy, Chris, 139 Deutsche Bank, 92, 169 Deutsche Morgan Grenfell (DMG), 148, 149 Deutsche Telecom, 25–26 DEVA (discounted equity valuation analysis), 124 “Digital Media Conference,” 142 Dillon, Clarence, 46 Dillon Reed, 92 discounted cash flow (DCF), 124 Discover and Co., ix Discover Card, 189, 200, 223 Dobkin, Eric, 36, 38–39 Donaldson, Lufkin and Jenrette (DLJ) and CSFB, 89–90, 92, 174, 190 IPO investments, 24 junk bond activities, 22, 24 Knee’s offer from, 86, 88, 89 Don Tech, 160, 170 Dow Jones, 192 downturn in the market, 157, 172–73, 178–83, 201, 203. See also layoffs The Drama of the Gifted Child (Miller), 155–56 Dresdner Bank, 90 dress codes, 205 Drexel Burnham, 22 Drexel Lambert, xvii Drill, Elena, 130–32 Dun and Bradstreet, 160 eBay, 123 EBITDA, 67, 176 economy, 229.
Super Thinking: The Big Book of Mental Models by Gabriel Weinberg, Lauren McCann
affirmative action, Affordable Care Act / Obamacare, Airbnb, Albert Einstein, anti-pattern, Anton Chekhov, autonomous vehicles, bank run, barriers to entry, Bayesian statistics, Bernie Madoff, Bernie Sanders, Black Swan, Broken windows theory, business process, butterfly effect, Cal Newport, Clayton Christensen, cognitive dissonance, commoditize, correlation does not imply causation, crowdsourcing, Daniel Kahneman / Amos Tversky, David Attenborough, delayed gratification, deliberate practice, discounted cash flows, disruptive innovation, Donald Trump, Douglas Hofstadter, Edward Lorenz: Chaos theory, Edward Snowden, effective altruism, Elon Musk, en.wikipedia.org, experimental subject, fear of failure, feminist movement, Filter Bubble, framing effect, friendly fire, fundamental attribution error, Gödel, Escher, Bach, hindsight bias, housing crisis, Ignaz Semmelweis: hand washing, illegal immigration, income inequality, information asymmetry, Isaac Newton, Jeff Bezos, John Nash: game theory, lateral thinking, loss aversion, Louis Pasteur, Lyft, mail merge, Mark Zuckerberg, meta analysis, meta-analysis, Metcalfe’s law, Milgram experiment, minimum viable product, moral hazard, mutually assured destruction, Nash equilibrium, Network effects, nuclear winter, offshore financial centre, p-value, Parkinson's law, Paul Graham, peak oil, Peter Thiel, phenotype, Pierre-Simon Laplace, placebo effect, Potemkin village, prediction markets, premature optimization, price anchoring, principal–agent problem, publication bias, recommendation engine, remote working, replication crisis, Richard Feynman, Richard Feynman: Challenger O-ring, Richard Thaler, ride hailing / ride sharing, Robert Metcalfe, Ronald Coase, Ronald Reagan, school choice, Schrödinger's Cat, selection bias, Shai Danziger, side project, Silicon Valley, Silicon Valley startup, speech recognition, statistical model, Steve Jobs, Steve Wozniak, Steven Pinker, survivorship bias, The Present Situation in Quantum Mechanics, the scientific method, The Wisdom of Crowds, Thomas Kuhn: the structure of scientific revolutions, transaction costs, uber lyft, ultimatum game, uranium enrichment, urban planning, Vilfredo Pareto, wikimedia commons
When you cast this fee as a percentage, it effectively becomes an “interest rate,” called the discount rate (in the example above, it would be 25 percent, since $80 × 125% = $100). Like any interest rate, it can compound, but instead of compounding positively as we discussed earlier, the discount rate compounds negatively. This negative compounding discounts payments out into the future more and more, since you won’t be able to access them until much later. The discount rate is the cornerstone of the discounted cash flow method of valuing assets, investments, and offers. This model can help you properly determine the worth of arrangements that involve future payments, such as investment properties, stocks, and bonds. For example, let’s say you win the lottery and are offered a choice between getting one million dollars each year, forever, or a lump-sum payment today. How high does that lump-sum payment need to be before you will accept it?
., 201 diet, 1, 87, 102, 103, 130 Difficult Conversations (Stone, Patton, and Heen), 19 Diffusion of Innovation (Rogers), 116 diffusion of responsibility, 259 digital photography, 308–10 Dilbert, 140 diminishing returns, 81–83 diminishing utility, 81–82 dinosaurs, 103 diplomacy, 231 directly responsible individual (DRI), 258–59 disclosure law, 45 disconfirmation bias, 27 discounted cash flow, 85 discounting, hyperbolic, 87 discounting the future, 85–87 discount rate, 85–87, 180–82, 184, 185 discoveries, multiple, 291–92 Disney World, 96–97 dispersion, 147 disruptive innovations, 308, 310–11 distribution, see probability distributions distributive justice versus procedural justice, 224–25 divergent thinking, 203 diversity debt, 57 diversity of opinion, 205, 206, 255 divide and conquer, 96 divorce, 231, 305 Dollar Shave Club, 240 domino effect, 234–35, 237 done, calling something, 89–90 Donne, John, 209 don’t bring a knife to a gunfight, 241 drinking, 217, 218 drunk drivers, 157–58 drugs, 236 DuckDuckGo, 18, 32, 68, 258, 278 Dubner, Stephen, 44–45 Dunbar, Robin, 278 Dunbar’s number, 278 Dunning, David, 269 Dunning-Kruger effect, 268–70, 317 Dweck, Carol, 266, 267 early adopters, 116–17, 289, 290, 311–12 early majority, 116–17, 312 Eastman Kodak Company, 302–3, 308–10, 312 eBay, 119, 281, 282, 290 echo chambers, 18, 120 Ecker, Ullrich, 13 economies of scale, 95 Economist, 14–15 economy, 122, 125 inflation in, 179–80, 182–83 financial crisis of 2007/2008, 79, 120, 192, 271, 288 recessions in, 121–22 Edison, Thomas, 289, 292 education and schools, 224–25, 241, 296 expectations and, 267–68 mindsets and, 267 school ranking, 137 school start times, 110, 111, 130 selection bias and, 140 textbooks in, 262 see also college effective altruism, 80 egalitarian versus hierarchical, in organizational culture, 274 80/20 arrangements, 80–81, 83 Einstein, Albert, 8, 11 Eisenhower, Dwight, 72 Eisenhower Decision Matrix, 72–74, 89, 124, 125 elections, 206, 218, 233, 241, 271, 293, 299 Ellsberg, Michael, 220 email spam, 161, 192–93, 234 Emanuel, Rahm, 291 emotion, appeal to, 225, 226 emotional quotient (EQ), 250–52 empathy, 19, 21, 23 ruinous, 264 employee engagement survey, 140, 142 endgame, 242, 244 endorsements, 112, 220, 229 endpoints, 137 ends justify the means, 229 energy: activation, 112–13 potential, 111–12 engineering, 247 Enron, 228 entrepreneurs, 301 cargo cult, 316 entropy, 122–24 entry, barriers to, 305 environmental issues, 38 climate change, 42, 55, 56, 104, 105, 183, 192 EpiPen, 283 EQ (emotional quotient), 250–52 equilibrium, 193 Ericsson, K.
Toward Rational Exuberance: The Evolution of the Modern Stock Market by B. Mark Smith
bank run, banking crisis, business climate, business cycle, buy and hold, capital asset pricing model, compound rate of return, computerized trading, credit crunch, cuban missile crisis, discounted cash flows, diversified portfolio, Donald Trump, Eugene Fama: efficient market hypothesis, financial independence, financial innovation, fixed income, full employment, income inequality, index arbitrage, index fund, joint-stock company, locking in a profit, Long Term Capital Management, Louis Bachelier, margin call, market clearing, merger arbitrage, money market fund, Myron Scholes, Paul Samuelson, price stability, random walk, Richard Thaler, risk tolerance, Robert Bork, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, stocks for the long run, the market place, transaction costs
Instead, in his words, most stocks were “cold sober,” although a few did show signs of “overindulgence.” His conclusion: “not much of an orgy.” The most recent book published on the 1929 crash is The Causes of the 1929 Stock Market Crash, written by Harold Bierman, Jr., a professor at Cornell University. Bierman applies modern standards of market valuation to analyze 1929 stock prices. First, he calculates that the market P/E ratio in 1929 was 16.3 to 1. Then, using the discounted cash-flow model developed many years after the 1929 crash (which will be discussed in detail in later chapters; see definition on page 156), he finds that an annual rate of dividend increase of 3.6% would have been sufficient, by later standards, to support the 1929 market P/E. In fact, the rate of dividend increases throughout the 1920s was significantly higher than 3.6%, and even conservative estimates of future dividend growth were at least as great.
consumer spending; and crash of 1929; on credit; during World War II Cooke, Jay, & Company Coolidge, Calvin Cornell University corners; of silver market, see silver crisis Cornfeld, Bernard Corn Products Corrigan, Gerald cost-push inflation Council of National Defense covariance Cowles, Alfred Cox, Albert Crane, Burton crashes; of 1837; of 1929, ; of 1962; of 1987; see also panics Cuban missile crisis customer stock purchase plans Cutten, Arthur Darvas, Nicholas Darwin, Charles Day and Night Bank DeAngelis, Anthony De Bondt, Werner Defense Department, U.S. defined-benefit pension plans defined-contribution pension plans Democratic party democratization of stock market depressions; fear of; of 1920–21; see also Great Depression Detroit Law School Dewey, Thomas Dillon, Douglas Dines, James discounted cash-flow model; see also Dividend Discount Model; present value, determination of Disney Dividend Discount Model Dodd, David Douglas, William O. Dow, Charles Dow Jones Industrial Average; and crash of 1962; and crash of 1987; and Eisenhower administration; graphs of ; during Great Depression; and Kennedy administration ; and Kennedy assassination; and “October Massacre,” ; effect of Federal Reserve policies on; launching of; mutual fund performance compared with; New Era advocates and; during World War I; during World War II Dow theory Drew, Daniel Drexel Burnham Lambert Duer, William Du Pont Corporation Eastman Kodak Eccles, Marriner Eckert-Mauchly Computer Corporation Eckstein, Otto efficient market theory; arbitrage and; behavioralist critique of; and crash of 1987 Eisenhower, Dwight D.
Zero to One: Notes on Startups, or How to Build the Future by Peter Thiel, Blake Masters
Airbnb, Albert Einstein, Andrew Wiles, Andy Kessler, Berlin Wall, cleantech, cloud computing, crony capitalism, discounted cash flows, diversified portfolio, don't be evil, Elon Musk, eurozone crisis, income inequality, Jeff Bezos, Lean Startup, life extension, lone genius, Long Term Capital Management, Lyft, Marc Andreessen, Mark Zuckerberg, minimum viable product, Nate Silver, Network effects, new economy, paypal mafia, Peter Thiel, pets.com, profit motive, Ralph Waldo Emerson, Ray Kurzweil, self-driving car, shareholder value, Silicon Valley, Silicon Valley startup, Singularitarianism, software is eating the world, Steve Jobs, strong AI, Ted Kaczynski, Tesla Model S, uber lyft, Vilfredo Pareto, working poor
Investors expect Twitter will be able to capture monopoly profits over the next decade, while newspapers’ monopoly days are over. Simply stated, the value of a business today is the sum of all the money it will make in the future. (To properly value a business, you also have to discount those future cash flows to their present worth, since a given amount of money today is worth more than the same amount in the future.) Comparing discounted cash flows shows the difference between low-growth businesses and high-growth startups at its starkest. Most of the value of low-growth businesses is in the near term. An Old Economy business (like a newspaper) might hold its value if it can maintain its current cash flows for five or six years. However, any firm with close substitutes will see its profits competed away. Nightclubs or restaurants are extreme examples: successful ones might collect healthy amounts today, but their cash flows will probably dwindle over the next few years when customers move on to newer and trendier alternatives.
The Monk and the Riddle: The Education of a Silicon Valley Entrepreneur by Randy Komisar
Apple's 1984 Super Bowl advert, barriers to entry, belly landing, discounted cash flows, estate planning, Jeff Bezos, Network effects, new economy, Pepto Bismol, Sand Hill Road, Silicon Valley, Silicon Valley startup, Steve Jobs
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.
Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen
activist fund / activist shareholder / activist investor, algorithmic trading, Andrei Shleifer, asset allocation, backtesting, bank run, banking crisis, barriers to entry, Black-Scholes formula, Brownian motion, business cycle, buy and hold, 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, money market fund, mortgage debt, Myron Scholes, 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, selection bias, shareholder value, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stocks for the long run, stocks for the long term, survivorship bias, 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.
Obliquity: Why Our Goals Are Best Achieved Indirectly by John Kay
Andrew Wiles, Asian financial crisis, Berlin Wall, bonus culture, British Empire, business process, Cass Sunstein, computer age, corporate raider, 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, lateral thinking, Long Term Capital Management, Louis Pasteur, market fundamentalism, Myron Scholes, Nash equilibrium, pattern recognition, Paul Samuelson, purchasing power parity, RAND corporation, regulatory arbitrage, shareholder value, Simon Singh, Steve Jobs, Thales of Miletus, 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.
Quality Investing: Owning the Best Companies for the Long Term by Torkell T. Eide, Lawrence A. Cunningham, Patrick Hargreaves
air freight, Albert Einstein, backtesting, barriers to entry, buy and hold, cashless society, cloud computing, commoditize, Credit Default Swap, discounted cash flows, discovery of penicillin, endowment effect, global pandemic, haute couture, hindsight bias, low cost airline, mass affluent, Network effects, oil shale / tar sands, pattern recognition, shareholder value, smart grid, sovereign wealth fund, supply-chain management
Despite this optically expensive multiple, investing at almost any point during the decade would have been lucrative. Financial analysts’ models routinely underestimated the earnings growth driven by Novo’s attractive and stable financial and corporate characteristics. The Novo example, one of many, illustrates the rationality of prioritizing analysis of corporate quality over valuation. Typical valuation models, such as discounted cash flow (DCF), are riddled with limitations, even for companies with predictable cash flows. Most strikingly, DCF models are constrained by a powerful anchoring effect of prevailing market prices. If analysis indicates a valuation significantly different from market price – say 30% above or below – you can be sure the sell-side analyst will return to the drawing board and adjust some assumptions.
The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness by Morgan Housel
"side hustle", airport security, Amazon Web Services, Bernie Madoff, business cycle, computer age, coronavirus, discounted cash flows, diversification, diversified portfolio, Donald Trump, financial independence, Hans Rosling, Hyman Minsky, income inequality, index fund, invisible hand, Isaac Newton, Jeff Bezos, Joseph Schumpeter, knowledge worker, labor-force participation, Long Term Capital Management, margin call, Mark Zuckerberg, new economy, Paul Graham, payday loans, Ponzi scheme, quantitative easing, Renaissance Technologies, Richard Feynman, risk tolerance, risk-adjusted returns, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, Stephen Hawking, Steven Levy, stocks for the long run, the scientific method, traffic fines, Vanguard fund, working-age population
An idea exists in finance that seems innocent but has done incalculable damage. It’s the notion that assets have one rational price in a world where investors have different goals and time horizons. Ask yourself: How much should you pay for Google stock today? The answer depends on who “you” are. Do you have a 30-year time horizon? Then the smart price to pay involves a sober analysis of Google’s discounted cash flows over the next 30 years. Are you looking to cash out within 10 years? Then the price to pay can be figured out by an analysis of the tech industry’s potential over the next decade and whether Google management can execute on its vision. Are you looking to sell within a year? Then pay attention to Google’s current product sales cycles and whether we’ll have a bear market. Are you a day trader?
The Golden Passport: Harvard Business School, the Limits of Capitalism, and the Moral Failure of the MBA Elite by Duff McDonald
activist fund / activist shareholder / activist investor, Affordable Care Act / Obamacare, Albert Einstein, barriers to entry, Bayesian statistics, Bernie Madoff, Bob Noyce, Bonfire of the Vanities, business cycle, business process, butterfly effect, capital asset pricing model, Capital in the Twenty-First Century by Thomas Piketty, Clayton Christensen, cloud computing, collateralized debt obligation, collective bargaining, commoditize, corporate governance, corporate raider, corporate social responsibility, creative destruction, deskilling, discounted cash flows, disintermediation, disruptive innovation, Donald Trump, family office, financial innovation, Frederick Winslow Taylor, full employment, George Gilder, glass ceiling, global pandemic, Gordon Gekko, hiring and firing, income inequality, invisible hand, Jeff Bezos, job-hopping, John von Neumann, Joseph Schumpeter, Kenneth Arrow, Kickstarter, London Whale, Long Term Capital Management, market fundamentalism, Menlo Park, new economy, obamacare, oil shock, pattern recognition, performance metric, Peter Thiel, plutocrats, Plutocrats, profit maximization, profit motive, pushing on a string, Ralph Nader, Ralph Waldo Emerson, RAND corporation, random walk, rent-seeking, Ronald Coase, Ronald Reagan, Sam Altman, Sand Hill Road, Saturday Night Live, shareholder value, Silicon Valley, Skype, Social Responsibility of Business Is to Increase Its Profits, Steve Jobs, survivorship bias, The Nature of the Firm, the scientific method, Thorstein Veblen, union organizing, urban renewal, Vilfredo Pareto, War on Poverty, William Shockley: the traitorous eight, women in the workforce, Y Combinator
Students were taught to consider the administrative process as the unity of all six, with Control being “the use of figures in the choice of courses of action and in the appraisal of actual performance.”18 Robert Anthony, a former student of Walker who later became his research assistant and eventually a member of the faculty, took the mantle from his mentor and put the prevailing Control philosophy in textbook form with his 1956 book, Management Accounting: Text and Cases. In doing so, he also extended it to include the first HBS endorsement of the concept of discounted cash flow, or DCF, for use in management decision making as a superior approach to internal rate of return, or IRR. It was that addition, according to one commentator, that made the book influential, in that it prompted large multidivisional corporations around the country to adopt DCF in their budgeting and capital allocation decisions.19 As Rice University’s Stephen Zeff points out, the notion of attuning management to the fact that in accounting information could be found the seeds of future policy naturally led to increased interest by management in the choice of accounting policy itself, particularly when Generally Accepted Accounting Principles “did not give a definitive answer.”
There was the takeover of top corporate positions by the financial types, who knew little about the fundamentals of the businesses they ran. And then there was this: “[Some] financial yardsticks that managers rely upon so much in deducing whether to make investments may yield results that are badly distorted in the current period of high inflation. The validity of some of these yardsticks, like ‘discounted cash flow’ or virtually indecipherable formulas for figuring ‘return on investment,’ is being called into question to some extent.” Meaning: Not only were business schools churning out too many numbers people; they were telling them to look at the wrong numbers to boot. “It may be that some of the basic tools we’ve been teaching in business schools for 20 years are inordinately biased toward the short term, the sure payoff,” Lee J.
The history reaffirmed HBS’s commitment to its case method—by 1980, the School’s $15 million research budget exceeded the overall budget of any other graduate business school in the world,7 and in 1980–81, HBS shipped almost 100 million pages of materials from its case inventory of 18,000 to more than 6,000 customers.8 (By 1995, the research budget had topped $44 million.9) But that commitment aside, by the end of the 1980s, A Delicate Experiment represented not much more than an historical artifact, a story of the way things used to be. In 1986, BusinessWeek put McArthur on its cover, under the title “Remaking an Institution: The Harvard B-School.”10 The biggest change was the rise of the finance faculty, Michael Jensen foremost among them. The new science of managerial decision making was encapsulated in the capital asset pricing model and discounted cash flow, models that had no space for questions like customer loyalty and responsibility to one’s employees. It was no coincidence that the School finally dropped its Trade Union Program early in the decade. The rhetoric coming out of HBS about finance sounded as if it had been written by the financial services lobby itself. And it might as well have been. When the School launched its Global Financial System (GFS) project in 1992, its advisory board included executives from the likes of J.
The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success by William Thorndike
Albert Einstein, Atul Gawande, Berlin Wall, Checklist Manifesto, choice architecture, Claude Shannon: information theory, collapse of Lehman Brothers, compound rate of return, corporate governance, discounted cash flows, diversified portfolio, Donald Trump, Fall of the Berlin Wall, Gordon Gekko, intangible asset, Isaac Newton, Louis Pasteur, Mark Zuckerberg, NetJets, Norman Mailer, oil shock, pattern recognition, Ralph Waldo Emerson, Richard Feynman, shared worldview, shareholder value, six sigma, Steve Jobs, Thomas Kuhn: the structure of scientific revolutions
It is hard to overstate the significance of this change. Buffet was switching at midcareer from a proven, lucrative investment approach that focused on the balance sheet and tangible assets, to an entirely different one that looked to the future and emphasized the income statement and hard-to-quantify assets like brand names and market share. To determine margin of safety, Buffett relied now on discounted cash flows and private market values instead of Graham’s beloved net working capital calculation. It was not unlike Bob Dylan’s controversial and roughly contemporaneous switch from acoustic to electric guitar. This tectonic shift played itself out throughout the 1970s in Berkshire’s insurance portfolios, which saw an increasing proportion of media and branded consumer products companies. By the end of the decade, this transition was complete, and Buffett’s portfolio included outright ownership of See’s Candies and the Buffalo News as well as large stock positions in the Washington Post, GEICO, and General Foods.
Mastering the VC Game: A Venture Capital Insider Reveals How to Get From Start-Up to IPO on Your Terms by Jeffrey Bussgang
business cycle, business process, carried interest, digital map, discounted cash flows, hiring and firing, Jeff Bezos, Kickstarter, Marc Andreessen, Mark Zuckerberg, Menlo Park, moveable type in China, pattern recognition, Paul Graham, performance metric, Peter Thiel, pets.com, risk tolerance, rolodex, Ronald Reagan, Sand Hill Road, selection bias, shareholder value, Silicon Valley, Skype, software as a service, sovereign wealth fund, Steve Jobs, technology bubble, The Wisdom of Crowds
(“You were able to raise money at a ten-million-dollar pre? Life isn’t fair. I had to struggle to get to a four-million pre and I have a prototype and real customers!”) Determining the pre-money valuation is an art, not a science, and many entrepreneurs get frustrated with what seems like an opaque process. Unlike what you learn in a finance class in business school, where you calculate discounted cash flows and apply a weighted average cost of capital, there is no magic formula. The valuation for entrepreneurial ventures is set in a back-and-forth negotiation based on three factors: (1) the amount of capital that the entrepreneur is trying to raise in order to prove out the first set of milestones; (2) the VC’s target ownership (often 20-30 percent); (3) how competitive the deal is (that is, if the entrepreneur has numerous VCs chasing them, they can drive up the price.
The Wisdom of Finance: Discovering Humanity in the World of Risk and Return by Mihir Desai
activist fund / activist shareholder / activist investor, Albert Einstein, Andrei Shleifer, assortative mating, Benoit Mandelbrot, Brownian motion, capital asset pricing model, carried interest, Charles Lindbergh, collective bargaining, corporate governance, corporate raider, discounted cash flows, diversified portfolio, Eugene Fama: efficient market hypothesis, financial innovation, follow your passion, George Akerlof, Gordon Gekko, greed is good, housing crisis, income inequality, information asymmetry, Isaac Newton, Jony Ive, Kenneth Rogoff, longitudinal study, Louis Bachelier, moral hazard, Myron Scholes, new economy, out of africa, Paul Samuelson, Pierre-Simon Laplace, principal–agent problem, Ralph Waldo Emerson, random walk, risk/return, Robert Shiller, Robert Shiller, Ronald Coase, Silicon Valley, Steve Jobs, Thales and the olive presses, Thales of Miletus, The Market for Lemons, The Nature of the Firm, The Wealth of Nations by Adam Smith, Tim Cook: Apple, transaction costs, zero-sum game
., 175–77 Socrates, 168 Stevens, Wallace, xi, 7, 32–34, 170 disorder and chaos, 33–34 insurance executive, 32–33 T talent, etymology of, 58–59, 74 “Tale of Beryn” (Chaucer), 74 Talmud, 52 Thales of Miletus, 7, 42–43, 162, 177 Tiger Moms, 95 Tolstoy, Leo, 9, 162–64 tontines, 28–30 Tontine Coffee House, 28 Tootsie Roll Industries, 78–80, 83–85 transaction cost approach to mergers, 115 Trilogy of Desire (Dreiser), 165 Trollope, Anthony, 7, 38, 175 Trump, Donald, 127, 152 Turner, Ted, 108 “Two Cultures” (Snow), 175 “Two Tramps in Mud Time” (Frost), xiii Tynan, Kenneth, 96 U Ulysses (Joyce), 91–92 V Vaillant, George, 138–39 value creation and valuation, 7, 59 accounting vs. finance, 64 alpha generation or getting paid for beta, 71–73 destruction of value, 63 discounted cash flows, 65 measuring value creation, 64–67 stewardship and, 61–63, 74 terminal values, 66–67 weighted average cost of capital, 65 value of education, 65–66 value of housing, 66 van Doetechum, Lucas, 58 (illus.), 59 van Eyck, Jan, 97 (illus.), 103 Vega, Joseph de la, 5–6, 43–44 venture capital, 73, 82 Vishny, Robert, 77 W Wall Street (film), 165, 166 Warhol, Andy, 129 Washington, George, 142–43, 145 Watson, Thomas, 138 Wealth of Nations, The (Smith), 121 Weaver, Sigourney, 97–98 Wells Fargo, 80 Wesley, John, 63 West, Kanye, 99 Wheel of Fortune (TV show), 17–18 White, Vanna, 18 Whitney Museum of Modern Art, 140 Wilder, Gene, 94 Wilson, E.
Blitzscaling: The Lightning-Fast Path to Building Massively Valuable Companies by Reid Hoffman, Chris Yeh
activist fund / activist shareholder / activist investor, Airbnb, Amazon Web Services, autonomous vehicles, bitcoin, blockchain, Bob Noyce, business intelligence, Chuck Templeton: OpenTable:, cloud computing, crowdsourcing, cryptocurrency, Daniel Kahneman / Amos Tversky, database schema, discounted cash flows, Elon Musk, Firefox, forensic accounting, George Gilder, global pandemic, Google Hangouts, Google X / Alphabet X, hydraulic fracturing, Hyperloop, inventory management, Isaac Newton, Jeff Bezos, Joi Ito, Khan Academy, late fees, Lean Startup, Lyft, M-Pesa, Marc Andreessen, margin call, Mark Zuckerberg, minimum viable product, move fast and break things, move fast and break things, Network effects, Oculus Rift, oil shale / tar sands, Paul Buchheit, Paul Graham, Peter Thiel, pre–internet, recommendation engine, ride hailing / ride sharing, Sam Altman, Sand Hill Road, Saturday Night Live, self-driving car, shareholder value, sharing economy, Silicon Valley, Silicon Valley startup, Skype, smart grid, social graph, software as a service, software is eating the world, speech recognition, stem cell, Steve Jobs, subscription business, Tesla Model S, thinkpad, transaction costs, transport as a service, Travis Kalanick, Uber for X, uber lyft, web application, winner-take-all economy, Y Combinator, yellow journalism
Implicitly, this technique prioritizes correctness and efficiency over speed. Unfortunately, this cautious and measured approach falls apart when new technologies enable a new market or scramble an existing one. Chris earned his MBA from Harvard Business School in the late 1990s, during the dawn of the Networked Age. Back then, his MBA training focused on traditional techniques, such as using discounted cash flow analysis to make financial decisions with greater certainty. Chris also learned about traditional manufacturing techniques, such as how to maximize the throughput of an assembly line. These methods focused on achieving efficiency and certainty, and the same emphasis was reflected in the broader business world. The world’s most valuable company during that time, General Electric, was beloved by Wall Street analysts for its ability to deliver consistent and predictable earnings growth.
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, Ben Horowitz, bioinformatics, bitcoin, Black Swan, blockchain, Burning Man, business intelligence, business process, call centre, chief data officer, Chris Wanstrath, Clayton Christensen, clean water, cloud computing, cognitive bias, collaborative consumption, collaborative economy, commoditize, corporate social responsibility, cross-subsidies, crowdsourcing, cryptocurrency, dark matter, Dean Kamen, dematerialisation, discounted cash flows, disruptive innovation, distributed ledger, Edward Snowden, Elon Musk, en.wikipedia.org, Ethereum, ethereum blockchain, game design, Google Glasses, Google Hangouts, Google X / Alphabet X, gravity well, hiring and firing, Hyperloop, industrial robot, Innovator's Dilemma, intangible asset, Internet of things, Iridium satellite, Isaac Newton, Jeff Bezos, Joi Ito, Kevin Kelly, Kickstarter, knowledge worker, Kodak vs Instagram, Law of Accelerating Returns, Lean Startup, life extension, lifelogging, loose coupling, loss aversion, low earth orbit, Lyft, Marc Andreessen, Mark Zuckerberg, market design, means of production, minimum viable product, natural language processing, Netflix Prize, NetJets, Network effects, new economy, Oculus Rift, offshore financial centre, PageRank, pattern recognition, Paul Graham, paypal mafia, peer-to-peer, peer-to-peer model, 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, Travis Kalanick, Tyler Cowen: Great Stagnation, uber lyft, urban planning, WikiLeaks, winner-take-all economy, X Prize, Y Combinator, zero-sum game
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.
Finding Alphas: A Quantitative Approach to Building Trading Strategies by Igor Tulchinsky
algorithmic trading, asset allocation, automated trading system, backtesting, barriers to entry, business cycle, buy and hold, capital asset pricing model, constrained optimization, corporate governance, correlation coefficient, credit crunch, Credit Default Swap, discounted cash flows, discrete time, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, financial intermediation, Flash crash, implied volatility, index arbitrage, index fund, intangible asset, iterative process, Long Term Capital Management, loss aversion, market design, market microstructure, merger arbitrage, natural language processing, passive investing, pattern recognition, performance metric, popular capitalism, prediction markets, price discovery process, profit motive, quantitative trading / quantitative ﬁnance, random walk, Renaissance Technologies, risk tolerance, risk-adjusted returns, risk/return, selection bias, sentiment analysis, shareholder value, Sharpe ratio, short selling, Silicon Valley, speech recognition, statistical arbitrage, statistical model, stochastic process, survivorship bias, systematic trading, text mining, transaction costs, Vanguard fund, yield curve
Institutional Research 101: Analyst Reports189 6M 5M 4M 3M 2M 1M 0M –1M 2007 2008 Figure 24.9 2009 2010 2011 2012 2013 2014 2015 2016 Performance of alpha using earnings-call data6 their ratings and forecasts, and this effect is stronger for analysts with industry experience. Alpha researchers can learn a lot about methodology from analysts’ work. For instance: Valuation methodologies vary across industries. Constructing a discounted cash flow model may be very different for the manufacturing sector compared with consumer cyclical firms, noncyclicals, and other sectors. Analysts may focus on different valuation metrics, such as the price–earnings ratio for one industry and the price– book ratio for another. For the alpha researcher, it is important to understand the underlying reasons for these differences in order to normalize and compare data appropriately for the universe of tradable stocks.
Infonomics: How to Monetize, Manage, and Measure Information as an Asset for Competitive Advantage by Douglas B. Laney
3D printing, Affordable Care Act / Obamacare, banking crisis, blockchain, business climate, business intelligence, business process, call centre, chief data officer, Claude Shannon: information theory, commoditize, conceptual framework, crowdsourcing, dark matter, data acquisition, digital twin, discounted cash flows, disintermediation, diversification, en.wikipedia.org, endowment effect, Erik Brynjolfsson, full employment, informal economy, intangible asset, Internet of things, linked data, Lyft, Nash equilibrium, Network effects, new economy, obamacare, performance metric, profit motive, recommendation engine, RFID, semantic web, smart meter, Snapchat, software as a service, source of truth, supply-chain management, text mining, uber lyft, Y2K, yield curve
Others worthy of consideration as well include: Douglas Hubbard’s “applied information economics” methodology strictly for measuring the decision value of information.15 Bill Schmarzo’s “data economic valuation” approach also strictly for measuring information’s contribution to decision making.16 Paul Strassman’s macroeconomic method of comparing the competitive gains of organizations with similar tangible assets, after accounting for all other valuation premium factors.17 Dilip Krishna’s methods for attributing business outcomes to specific information initiatives (Business Impact Model); an adapted discount cash flow model (a Monte Carlo simulation method); and a comparative analysis approach similar to Strassman’s but using a pure-play information company for comparison.18 Tonie Leatherberry’s and Rena Mears’s “net business value” method that considers information’s present and discounted future value to each department, various risks, and total cost of ownership.19 Robert Schmidt’s and Jennifer Fisher’s promising but loosely defined and abandoned patent application for an amalgam of information cost, accuracy, and other quality factors, along with information usage/access.20 Mark Albala’s conceptual valuation model, similar to that of Schmidt and Fischer, in which information value is based on information requests, usage (royalties), and outcomes.21 Dave McCrory’s concept and formula for what he calls “data gravity” that defines the proximal relationship among data sources and applications.22 As well, software and services companies such as Schedule1, Pimsoft, Everedge, ThreatModeler, Alex Solutions, Datum, Alation, and Real Social Dynamics (RSD) [in collaboration with the Geneva School of Business Administration] have developed exclusive approaches for measuring information value and/or risk in economic terms specific to their core offerings.
Concentrated Investing by Allen C. Benello
activist fund / activist shareholder / activist investor, asset allocation, barriers to entry, beat the dealer, Benoit Mandelbrot, Bob Noyce, business cycle, buy and hold, carried interest, Claude Shannon: information theory, corporate governance, corporate raider, delta neutral, discounted cash flows, diversification, diversified portfolio, Edward Thorp, family office, fixed income, high net worth, index fund, John von Neumann, Louis Bachelier, margin call, merger arbitrage, Paul Samuelson, performance metric, random walk, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, survivorship bias, technology bubble, transaction costs, zero-sum game
He notes that it is a problem for companies that, as they get bigger and bigger, it becomes harder and harder to have the same kind of percentage growth, but regards Nike as a candidate for sustained long‐term growth. He continues to keep Nike in his universe to buy, but maintains discipline on the price. “Over time,” says Simpson, “the nice thing about a good business is it becomes worth more and more so you have to constantly evaluate your targets.”144 On this point he agrees with Buffett that the most important thing is to figure out the future economics of the business. This allows an approximate discounted cash flow valuation. While a current valuation based on the past record is a simple matter, it’s not easy to figure out the future economics of the business. However, some businesses are easier than others. Coca‐Cola, for example, is easier to figure out than those businesses that have to deal with government regulation. While that won’t hurt some businesses, particularly those with a strong presence outside the United States, it won’t help, and it’s not good for overall market valuations.
The Art of Scalability: Scalable Web Architecture, Processes, and Organizations for the Modern Enterprise by Martin L. Abbott, Michael T. Fisher
always be closing, anti-pattern, barriers to entry, Bernie Madoff, business climate, business continuity plan, business intelligence, business process, call centre, cloud computing, combinatorial explosion, commoditize, Computer Numeric Control, conceptual framework, database schema, discounted cash flows, en.wikipedia.org, fault tolerance, finite state, friendly fire, hiring and firing, Infrastructure as a Service, inventory management, new economy, packet switching, performance metric, platform as a service, Ponzi scheme, RFC: Request For Comment, risk tolerance, Rubik’s Cube, Search for Extraterrestrial Intelligence, SETI@home, shareholder value, Silicon Valley, six sigma, software as a service, the scientific method, transaction costs, Vilfredo Pareto, web application, Y2K
The company has had a number of scalability related incidents with its flagship HRM product and Christine determines that the current CTO (in AllScale’s case, the CTO is the highest technology management position in the company) simply isn’t capable of handling the development of new functionality and the stabilization of the existing platform. Christine believes that one of the issues with the executive previously in charge of technology was that he really had no business acumen and could not properly explain the need for certain purchases or projects in business terms. The former CTO simply did not understand simple business concepts like returns on investment and discounted cash flow. Furthermore, he always expected the business folks to understand the need for any of what business peers believed were his pet projects and would simply say, “We either do this or we will die.” Although the technology team’s budget was nearly 20% of the company’s $200 million in revenue, systems still failed 35 36 C HAPTER 2 R OLES FOR THE S CALABLE TECHNOLOGY O RGANIZATION and the old CTO would blame unfunded projects for outages and then blame the business people for not understanding technology.
As such, we are going to focus our build versus buy discussions along the paths of decreasing cost and increasing revenue through focusing on strategy and competitive differentiation. Focusing on Cost Cost focused approaches center on lowering the total cost to the company for any build versus buy analysis. These approaches range from a straight analysis of total capital employed over time to a discounted cash flow analysis that factors in the cost of capital over time. Your finance department likely has a preferred method for helping to decide how to determine the lowest cost approach of any number of approaches. Our experience in this area is that most technology organizations have a bias toward building components. This bias most often shows up in an incorrect or F OCUSING ON S TRATEGY incomplete analysis showing that building a certain system is actually less expensive to a company than purchasing the same component.
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, commoditize, complexity theory, corporate governance, corporate raider, currency peg, Daniel Kahneman / Amos Tversky, discounted cash flows, diversified portfolio, endowment effect, equity premium, fixed income, global village, hedonic treadmill, hindsight bias, Kenneth Arrow, Long Term Capital Management, loss aversion, mandelbrot fractal, mental accounting, meta analysis, meta-analysis, Myron Scholes, Paul Samuelson, quantitative trading / quantitative ﬁnance, QWERTY keyboard, random walk, Richard Feynman, road to serfdom, Robert Shiller, Robert Shiller, selection bias, shareholder value, Sharpe ratio, Steven Pinker, stochastic process, survivorship bias, 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.
The Misbehavior of Markets: A Fractal View of Financial Turbulence by Benoit Mandelbrot, Richard L. Hudson
Albert Einstein, asset allocation, Augustin-Louis Cauchy, Benoit Mandelbrot, Big bang: deregulation of the City of London, Black-Scholes formula, British Empire, Brownian motion, business cycle, buy and hold, 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 Meriwether, John von Neumann, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, market bubble, market microstructure, Myron Scholes, new economy, paper trading, passive investing, Paul Lévy, Paul Samuelson, 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, Vilfredo Pareto, 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.
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, fixed income, 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.
Understanding Asset Allocation: An Intuitive Approach to Maximizing Your Portfolio by Victor A. Canto
accounting loophole / creative accounting, airline deregulation, Andrei Shleifer, asset allocation, Bretton Woods, business cycle, buy and hold, 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, John Meriwether, law of one price, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low cost airline, market bubble, merger arbitrage, money market fund, new economy, passive investing, Paul Samuelson, price mechanism, purchasing power parity, risk tolerance, risk-adjusted returns, risk/return, Ronald Reagan, selection bias, shareholder value, Sharpe ratio, short selling, statistical arbitrage, stocks for the long run, survivorship bias, the market place, transaction costs, Y2K, yield curve, zero-sum game
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.
The Reckoning: Financial Accountability and the Rise and Fall of Nations by Jacob Soll
accounting loophole / creative accounting, bank run, Bonfire of the Vanities, British Empire, collapse of Lehman Brothers, computer age, corporate governance, creative destruction, Credit Default Swap, delayed gratification, demand response, discounted cash flows, double entry bookkeeping, financial independence, Frederick Winslow Taylor, God and Mammon, High speed trading, Honoré de Balzac, inventory management, invisible hand, Isaac Newton, James Watt: steam engine, joint-stock company, Joseph Schumpeter, new economy, New Urbanism, Nick Leeson, Ponzi scheme, Ralph Waldo Emerson, Scientific racism, South Sea Bubble, The Wealth of Nations by Adam Smith, Thomas Malthus, too big to fail, trade route
Walpole had come to support the South Sea Company as a way of helping the Bank of England and the sinking fund to alleviate state debt. That way, there were three operations working to lower the debt, something that would prove crucial when the crash came. Hutcheson’s calculations went beyond accounting into the new realm of financial analysis. South Sea stock value was based on profit assumptions. Using present values (the value of past and future money at its calculated present value), discounted cash flow (discounting the value of future money, which loses its value) and annuity tables (how much a payment will be worth over time or at a given time), Hutcheson calculated the shortfall between necessary company profit and the stock’s value, on which now depended £43 million of government debt. His calculations illustrated that when the government was paid via new subscriptions, it made money, as did those who invested early and cheaply.
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, Alvin Roth, 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 cycle, business process, buy low sell high, chief data officer, Chuck Templeton: OpenTable:, clean water, cloud computing, connected car, corporate governance, crowdsourcing, data acquisition, data is the new oil, digital map, discounted cash flows, disintermediation, Edward Glaeser, Elon Musk, en.wikipedia.org, Erik Brynjolfsson, financial innovation, Haber-Bosch Process, High speed trading, information asymmetry, Internet of things, inventory management, invisible hand, Jean Tirole, Jeff Bezos, jimmy wales, John Markoff, Khan Academy, Kickstarter, Lean Startup, Lyft, Marc Andreessen, market design, Metcalfe’s law, 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, Robert Metcalfe, 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, Travis Kalanick, two-sided market, Uber and Lyft, Uber for X, uber lyft, winner-take-all economy, zero-sum game, 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.
The Global Money Markets by Frank J. Fabozzi, Steven V. Mann, Moorad Choudhry
asset allocation, asset-backed security, bank run, Bretton Woods, buy and hold, collateralized debt obligation, credit crunch, discounted cash flows, discrete time, disintermediation, fixed income, high net worth, intangible asset, interest rate derivative, interest rate swap, large denomination, locking in a profit, London Interbank Offered Rate, Long Term Capital Management, margin call, market fundamentalism, money market fund, moral hazard, mortgage debt, paper trading, Right to Buy, short selling, stocks for the long run, time value of money, value at risk, Y2K, yield curve, zero-coupon bond, zero-sum game
For the Enron ﬂoater we used in previous illustrations, the adjusted total margin is: Adjusted total margin 100 100 ( 100 – 99.90031 ) = -------------------------------------------------------- + 45 + 100 ( 100 – 99.90031 )0.05 ------------------------99.90031 0.9583 = 55.957 basis points In Exhibit 7.1, Bloomberg’s adjusted total margin is 55.957 which is obtained from the “MARGINS” box. Discount Margin One common method of measuring potential return that employs discounted cash ﬂows is discount margin. This measure indicates the average spread or margin over the reference rate the investor can expect to earn over the security’s life given a particular assumption of the path the reference rate will take to maturity. The assumption that the future levels of the reference rate are equal to today’s level is the usual assumption. The procedure for calculating the discount margin is as follows: Step 1.
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, fixed income, 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, Thomas Bayes, transaction costs, value at risk, volatility smile, Wiener process, yield curve, zero-sum game
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.
The Innovation Illusion: How So Little Is Created by So Many Working So Hard by Fredrik Erixon, Bjorn Weigel
"Robert Solow", Airbnb, Albert Einstein, American ideology, asset allocation, autonomous vehicles, barriers to entry, Basel III, Bernie Madoff, bitcoin, Black Swan, blockchain, BRICs, Burning Man, business cycle, Capital in the Twenty-First Century by Thomas Piketty, Cass Sunstein, Clayton Christensen, Colonization of Mars, commoditize, corporate governance, corporate social responsibility, creative destruction, crony capitalism, dark matter, David Graeber, David Ricardo: comparative advantage, discounted cash flows, distributed ledger, Donald Trump, Elon Musk, Erik Brynjolfsson, fear of failure, first square of the chessboard / second half of the chessboard, Francis Fukuyama: the end of history, George Gilder, global supply chain, global value chain, Google Glasses, Google X / Alphabet X, Gordon Gekko, high net worth, hiring and firing, Hyman Minsky, income inequality, income per capita, index fund, industrial robot, Internet of things, Jeff Bezos, job automation, job satisfaction, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Maynard Keynes: technological unemployment, joint-stock company, Joseph Schumpeter, Just-in-time delivery, Kevin Kelly, knowledge economy, laissez-faire capitalism, Lyft, manufacturing employment, Mark Zuckerberg, market design, Martin Wolf, mass affluent, means of production, Mont Pelerin Society, Network effects, new economy, offshore financial centre, pensions crisis, Peter Thiel, Potemkin village, price mechanism, principal–agent problem, Productivity paradox, QWERTY keyboard, RAND corporation, Ray Kurzweil, rent-seeking, risk tolerance, risk/return, Robert Gordon, Ronald Coase, Ronald Reagan, savings glut, Second Machine Age, secular stagnation, Silicon Valley, Silicon Valley startup, Skype, sovereign wealth fund, Steve Ballmer, Steve Jobs, Steve Wozniak, technological singularity, telemarketer, The Chicago School, The Future of Employment, The Nature of the Firm, The Rise and Fall of American Growth, The Wealth of Nations by Adam Smith, too big to fail, total factor productivity, transaction costs, transportation-network company, tulip mania, Tyler Cowen: Great Stagnation, uber lyft, University of East Anglia, unpaid internship, Vanguard fund, Yogi Berra
Professionals get overburdened by performance measurements; and with a study showing that doctors in emergency rooms clicked the computer mouse up to 4,000 times in total during a busy ten-hour shift, spending 44 percent of their time entering data and only 28 percent with patients, it is hard to disagree.68 Consider how many companies, when investing, rely on quantitative valuation tools such as the net present value of an investment, calculated for instance by using discounted cash flow models. Qualitative approaches carry little weight, even if it is known that the qualitative aspects of an investment are at least equally as important as the quantitative ones. This is perhaps to be expected; at the least, it makes investment decisions easier, or rather less open to criticism. However, the risk is that ignoring nonquantifiable objectives pushes companies to make the wrong investment choices: that overlooking becomes too mechanical, and that is a particularly acute problem when dealing with investments in innovation.
Triumph of the Optimists: 101 Years of Global Investment Returns by Elroy Dimson, Paul Marsh, Mike Staunton
asset allocation, banking crisis, Berlin Wall, Bretton Woods, British Empire, buy and hold, capital asset pricing model, capital controls, central bank independence, colonial rule, corporate governance, correlation coefficient, cuban missile crisis, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, equity premium, Eugene Fama: efficient market hypothesis, European colonialism, fixed income, floating exchange rates, German hyperinflation, index fund, information asymmetry, joint-stock company, negative equity, new economy, oil shock, passive investing, purchasing power parity, random walk, risk tolerance, risk/return, selection bias, shareholder value, Sharpe ratio, stocks for the long run, survivorship bias, technology bubble, transaction costs, yield curve
The real risk free rate has fallen back from 4–5 percent in the mid- and late-1990s to the current level of around 3 percent, as revealed in Figure 15-1 by the yield on inflation-indexed bonds. At the same time, the equity risk premium has either fallen or is perceived to have fallen. With a decline in real interest rates, in the estimated equity premium, and in inflation, required returns are likely to be lower than many companies’ capital budgeting systems demand. Large corporations generally claim to base investment decisions on discounted cash flow analysis (Bruner, Eades, Harris, and Higgins, 1998). If the discount rates they use are excessive, they are likely to reject potentially worthwhile projects that should, in fact, be accepted. We have documented a fall in the expected equity risk premium that captures what we believe is really happening in financial markets. If that opinion is accepted, it is probable that some companies will run the risk of underinvesting in profitable projects.
How Money Became Dangerous by Christopher Varelas
activist fund / activist shareholder / activist investor, Airbnb, airport security, barriers to entry, basic income, bitcoin, blockchain, Bonfire of the Vanities, California gold rush, cashless society, corporate raider, crack epidemic, cryptocurrency, discounted cash flows, disintermediation, diversification, diversified portfolio, Donald Trump, dumpster diving, fiat currency, fixed income, friendly fire, full employment, Gordon Gekko, greed is good, interest rate derivative, John Meriwether, Kickstarter, Long Term Capital Management, mandatory minimum, mobile money, mortgage debt, pensions crisis, pets.com, pre–internet, profit motive, risk tolerance, Saturday Night Live, shareholder value, side project, Silicon Valley, Steve Jobs, technology bubble, The Predators' Ball, too big to fail, universal basic income, zero day
Mike’s first assignment was with Barbara Heffernan, a very smart managing director, tough, intimidating, yet known for being just and reasonable. The client was a young Mexican entrepreneur, Bernardo Dominguez. He was interested in buying Westin Hotels, but no one could tell how serious he was. Barbara told Mike to do the analysis and determine if it was a good deal. She asked Mike for a DCF (a discounted cash-flow analysis), but Mike didn’t know what that was. She wanted comps and an engagement letter, and Mike was likewise stumped. She presumed that he knew what he was doing. Despite Mike’s total ignorance, he did understand the importance of making a good impression this early in his time at Salomon, so he dove in hard, barely sleeping for three days. When he was done, he thought he might have created the Mona Lisa of finance.
Radical Uncertainty: Decision-Making for an Unknowable Future by Mervyn King, John Kay
"Robert Solow", Airbus A320, Albert Einstein, Albert Michelson, algorithmic trading, Antoine Gombaud: Chevalier de Méré, Arthur Eddington, autonomous vehicles, availability heuristic, banking crisis, Barry Marshall: ulcers, battle of ideas, Benoit Mandelbrot, bitcoin, Black Swan, Bonfire of the Vanities, Brownian motion, business cycle, business process, capital asset pricing model, central bank independence, collapse of Lehman Brothers, correlation does not imply causation, credit crunch, cryptocurrency, cuban missile crisis, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, demographic transition, discounted cash flows, disruptive innovation, diversification, diversified portfolio, Donald Trump, easy for humans, difficult for computers, Edmond Halley, Edward Lloyd's coffeehouse, Edward Thorp, Elon Musk, Ethereum, Eugene Fama: efficient market hypothesis, experimental economics, experimental subject, fear of failure, feminist movement, financial deregulation, George Akerlof, germ theory of disease, Hans Rosling, Ignaz Semmelweis: hand washing, income per capita, incomplete markets, inflation targeting, information asymmetry, invention of the wheel, invisible hand, Jeff Bezos, Johannes Kepler, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Snow's cholera map, John von Neumann, Kenneth Arrow, Long Term Capital Management, loss aversion, Louis Pasteur, mandelbrot fractal, market bubble, market fundamentalism, Moneyball by Michael Lewis explains big data, Nash equilibrium, Nate Silver, new economy, Nick Leeson, Northern Rock, oil shock, Paul Samuelson, peak oil, Peter Thiel, Philip Mirowski, Pierre-Simon Laplace, popular electronics, price mechanism, probability theory / Blaise Pascal / Pierre de Fermat, quantitative trading / quantitative ﬁnance, railway mania, RAND corporation, rent-seeking, Richard Feynman, Richard Thaler, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Coase, sealed-bid auction, shareholder value, Silicon Valley, Simon Kuznets, Socratic dialogue, South Sea Bubble, spectrum auction, Steve Ballmer, Steve Jobs, Steve Wozniak, Tacoma Narrows Bridge, Thales and the olive presses, Thales of Miletus, The Chicago School, the map is not the territory, The Market for Lemons, The Nature of the Firm, The Signal and the Noise by Nate Silver, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Bayes, Thomas Davenport, Thomas Malthus, Toyota Production System, transaction costs, ultimatum game, urban planning, value at risk, World Values Survey, Yom Kippur War, zero-sum game
Pension models In 1991 the ebullient fraudster Robert Maxwell disappeared from his yacht in the Canaries and was found to have looted the Daily Mirror pension funds to support his crumbling business empire. Far more extensive regulation of occupational pensions followed. ‘Defined benefit’ schemes promise pensions based on past earnings rather than on past contributions. The UK 2004 Pensions Act requires these schemes to compute a ‘technical valuation’ of their liabilities. This requires a discounted cash flow calculation using projections of prices, earnings and investment returns over the life of the scheme, which by its nature will exceed fifty years. The trustees of the scheme must compare this number with the current assets of the scheme, and take steps to eliminate any deficit. Of course, no one has any idea what prices, earnings and investment returns will be in fifty years’ time. Unavoidably ignorant of all but a few of the numbers they need to complete their spreadsheet, the actuaries who advise these schemes invent all the numbers (technically the responsibility for verifying their assumptions lies with the scheme trustees, who have even less idea what the relevant numbers might be).
Order Without Design: How Markets Shape Cities by Alain Bertaud
autonomous vehicles, call centre, colonial rule, congestion charging, creative destruction, cross-subsidies, Deng Xiaoping, discounted cash flows, Donald Trump, Edward Glaeser, en.wikipedia.org, extreme commuting, garden city movement, Google Earth, Jane Jacobs, job satisfaction, Joseph Schumpeter, land tenure, manufacturing employment, market design, market fragmentation, megacity, new economy, New Urbanism, openstreetmap, Pearl River Delta, price mechanism, rent control, Right to Buy, Ronald Coase, self-driving car, Silicon Valley, special economic zone, the built environment, trade route, transaction costs, transit-oriented development, trickle-down economics, urban planning, urban sprawl, zero-sum game
For instance, if the buses are too slow and result in very long trips, corrective action could be taken, for instance, by improving the design of road intersections and the traffic management along the route. Economic Rate of Return By combining the results of the input and impact indicators, it is possible to calculate the internal economic rate of return of the project. The economic rate of return will calculate the present value of a discounted cash flow of the expenditures and the benefits (the additional flow of income coming to the neighborhood because of newly employed workers). For instance, in the example depicted in figure 8.2, in addition to the economic rate of return, it will be possible to calculate what the capital and yearly recurring cost of the strategy is per new employed worker. It may then be found that either the selected strategy provides a high economic return on the municipal investment, or possibly that the return is very low and alternative strategies should be explored that would increase the welfare of the citizens at a lower cost.
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, Donald Knuth, Douglas Engelbart, Douglas Engelbart, El Camino Real, fault tolerance, Firefox, Gerard Salton, Gerard Salton, Google bus, Google Chrome, Google Earth, Googley, HyperCard, hypertext link, IBM and the Holocaust, informal economy, information retrieval, Internet Archive, Jeff Bezos, John Markoff, Kevin Kelly, Kickstarter, Mark Zuckerberg, Menlo Park, one-China policy, optical character recognition, PageRank, Paul Buchheit, Potemkin village, prediction markets, recommendation engine, risk tolerance, Rubik’s Cube, Sand Hill Road, Saturday Night Live, search inside the book, second-price auction, selection bias, 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, turn-by-turn navigation, undersea cable, 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, correlation coefficient, 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, Myron Scholes, Norbert Wiener, Paul Samuelson, 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, yield curve, zero-coupon bond, zero-sum game
FIGURE 13.8 European Call Option Valuation at Expiration (E=100) 13.4.2 Step 2, Pricing the Option Currently (time t=0) This is the hard part. We will take the N=1 case of the BOPM using the example provided below. The question is, how do we determine the option 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.
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, business cycle, 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, John Meriwether, Kickstarter, 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, Mitch Kapor, money market fund, moral hazard, mortgage debt, Myron Scholes, negative equity, 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, Sam Peltzman, Sharpe ratio, short selling, sovereign wealth fund, speech recognition, statistical arbitrage, statistical model, survivorship bias, 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.
Den of Thieves by James B. Stewart
corporate raider, creative destruction, discounted cash flows, diversified portfolio, fixed income, fudge factor, George Gilder, index arbitrage, Internet Archive, Irwin Jacobs, margin call, money market fund, 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."