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Monday, February 6, 2012

Corporate Finance-some complied loose ends for analysts and managers

NYU Stern Professor Ashwath Damodaran's homepage is full of material(notes, spreadsheets, ratios, data) which he generously supplies for free. This post is a humble effort to cull some insights from that, which I feel relevant for analysts, whether equity or credit.While they are inspired by what I read there, do note that they often include my original insights also, and so one may not get
  1. Long term accounts receivables:-In long term contracts(like IT industry), this pattern is seen. If analysts narrowly define accounts receivables as only short term ones, they may miss poor quality earnings, as happened in some earlier USA dot com crashes in telecom space.
  2. Alpha or model error? Outperformance may be just error in risk/return model, for example understating the risk in the small stocks in CAPM model. 
  3. Multiples in valuation:-Either use one with best explanatory power(high R-square) OR one most logical given the value creation/measurement in the sector
  4. Inherent valuation model assumptions:-a perception that markets are inefficient and make mistakes in assessing value • an assumption about how and when these inefficiencies will get corrected. In an efficient market, the market price is the best estimate of value. The purpose of any valuation model is then the justification of this value.
  5. Where variability can INCREASE value:-Instead of incurring penalty under DCF models(higher risk premium), In cases where an asset is deriving it value from its option characteristics, for instance, more risk or variability can increase value rather than decrease it. And as As Damodaran puts it, The rights to a “bad” project can still have value
  6. Real options:-Things like right of first refusal, vacant land etc can be valued using the real options framework. And even for content libraries, that is a useful valuation method. As Damodaran puts it, "Having the exclusive rights to a product or project is valuable, even if the product or project is not viable today. The value of these rights increases with the volatility of the underlying business.  The cost of acquiring these rights (by buying them or spending money on development - R&D, for instance) has to be weighed off against these benefits".
  7. Excess capacity DOES have an opportunity cost:-Sounds very counter intuitive but as explained by Prof Rajendar Patel and Damodaran, using excess capacity means we may run out of capacity faster. Hence, a suggested framework is If I do not add the new product, when will I run out of capacity?If I add the new product, when will I run out of capacity When I run out of capacity, what will I do?
    1. Cut back on production: cost is PV of after-tax cash flows from lost sales
    2. Buy new capacity: cost is difference in PV between earlier & later investment
  8. The golden median in peer comps:-Especially for companies in fragmented industries, this is a good principle to apply because outliers may distort the mean, and weighting by assets/marketcap/sales may induce another kind of bias. Of course, median has equal weighting, and should be carefully checked with mean to see for skewness in the ratios.
  9. Trailing price averages more reliable? Like how we use Trailing Twelve Months(TTM) earnings, it is time to use trailing 12 months stock price as well to see long term P/E ratio trend? That data is much more difficult to compute as not routinely available hence would need manual work. But to avoid getting entirely deceived in boom/bust market, that seems an idea.
  10. EBITDA is NOT FCF:-Firms seldom mention their FCF in those snazzy investor relations presentations, and there is good reason for that. EBITDA does not cover the capex spend, which can be substantial. Hence, investors should look at the FCF metric, which is cashflows from assets,
    prior to any debt payments but after firm has reinvested to create growth assets. Some companies may create fancy proforma metrics excluding those very payments for growth assets(content costs, capex etc) but investors should not be fooled. Another reason to distrust EBITDA and prefer FCF is that if companies classify operating expenses as capex, that inflares EBITDA but nullified in FCF.  For companies with doubtful financial integrity/asset intensive ones, FCF is a useful sanity check.

1 comment:

Bose said...

I absolutely agree, and very well written.Corporate Finance Career