Security Analysis Quiz

March 26, 2020 News

"The Labor Department's weekly report on new unemployment claims showed the growing toll of the coronavirus on the economy. New claims skyrocketed to a record 3.283 million, far more than consensus economists expected and far above the levels seen after the 2008 financial crisis. Q: How did the market respond to this news? The S&P 500 Index was UP more than 6%. As we learned in class, the market has a long-term focus.

Two recent examples of stock market mis-pricings

(1) The internet bubble in 1999-2000 and (2) The 2007-2008 credit bubble. - The high-tech bubble: was a valuation bubble, in which the stock market priced firms at levels that were unjustified by underlying performance and growth; expectations of future cash flows were totally unrealistic. - The credit bubble: was not a valuation bubble but an earnings bubble. Given the preceding performance and growth of firms, stock market values were not unreasonable. Unfortunately, that level of underlying performance was unsustainable - a fact that the markets did not sufficiently take into account.

How ROIC and Growth Drive Value?

- All else equal want ↑ growth and ↑ ROIC - The best value creation combines (1) high ROIC ( > WACC) and (2) high growth (bottom right) - Firms with growth < ROIC are not creating value they are losing it (left column) → destroying value and can't survive

Revenue Growth Decay Trends

- As Exhibit 7.9 shows, revenue growth decay happens very quickly; high growth is not sustainable. - Within 3 years, the difference across portfolios reduces substantially, and by year 5, the highest-growth portfolio outperforms the lowest-growth portfolio by less than 5 percentage points. - Revenue growth converges + crosses → winners won't always be winners

Home Depot Example of TRS Expectations

- Background: internet bubble high in 1999 → HD was connected to this in the sense that it connected to economic expansion - Home Depot reached high expectations point in 1999. In early 1999, Home Depot had a stock market valuation of $132 billion. - Using a DCF model that assumes constant margins and ROIC, HD would have had to increase revenues by 26% per year over the 15 years to maintain its lofty stock price. What do you think happened next? - Although Home Depot had actual revenue growth of 13% per year through 2006 (great numbers for a large firm), it was far below expectations. - Over this period, Home Depot underperformed the S&P 500 index by 8% per year. Ouch.

Pattern of ROIC mean reversion

- Each year, a portfolio of firms with ROIC > 20%, between 15-20%, between 10- 15%, between 5-10%, and less than 5% are created. The 5 portfolios are then tracked over the next 15 years. The median ROIC value of each portfolio is reported in the exhibit. Although the median ROIC of the < 5% portfolio is less than the median ROIC of the other portfolios, it is closer. Notice also that the high ROIC portfolio has its median ROIC drop from 29% to 15% over the 15-year period; it is still well above the aggregate median value of 10%. - Hence, basing a continuing value on the economic concept that ROIC will approach WACC is overly conservative for the typical firm generating high ROICs. - Point: convergence but never cross → winners will stay winners but goes down (people can copy business plan) → bottom goes up because the company either fixes the problem or disappears

Netscape - Internet Bubble

- Example of a poor gauge of value - 1995: Netscape had an IPO → sales were only $85 million but their market cap was $6 billion - 1995-2000: tons of firms went public because they saw these price to sales ratios - Stat: The Nasdaq Index went from 2,010 in January 1997 to 5,047 in March of 2000. By December of 2001, it was 1,945. As of January 2021, it was 12,700. - Point: during the internet bubble many executives and investors ignored fundamental rules of economics - During the bubble, many firms and investors thought that getting big faster than your competition would result in enormous profits. - Example: eToys.com? In Oct. 1999, eToys had a value of $10.7 billion (more than 3 times the value of larger Toys 'R' Us). At the time, eToys' sales were less than 1% of the sales of Toys 'R' Us. - Internet: the internet has changed the way we show but has not created a new economy → it has just made what we know about prices more transparent → intensified old-style market competition in real markets

non-operating assets

- Free cash flow from operations should NOT include cash flows from non-operating assets - Excess cash is an example of a non operating asset - Non Operating assets must be valued separately. - When valuing liquid non operating assets, use their most recent balance sheet value, rather than the discount future non operating flows.

Capital Efficiency

- If my firm can obtain more sales per dollar than my competitors, I have a capital efficiency advantage. - - - The aircraft of Southwest Airlines can land, deplane, board, and take off in less than an hour. American and United average over two hours in turnaround time per flight. Hence, Southwest Airlines spends more time in the air and less time on the ground.

Importance of Value

- Importance: firm's ability to create value for its shareholders and the amount of value it crates are the main measures by which it is judged - Principle: the guiding principle of value creation is that companies create value by investing capital they raise from investors to generate future cashflows at rates above the cost of capital i.e. ROIC > WACC - Value creation is long term → competition erodes competitive advantages

Webvan and eBay example of ROIC & growth

- In 2000, eBay (market value $23 billion) and Webvan ($8 billion) were both newcomers. Why did eBay prosper while Webvan (online grocery delivery business) fail? Ebay's core business is online auctions, thus it did not need to put much capital into invested capital (inventory or receivables). Since eBay's marginal cost to adding a customer was almost zero, it had increasing returns to scale. Webvan was in a capital-intensive business needing lots of warehouses, inventory, and trucks. Webvan did not have increasing returns to scale. - Marginal cost is key → eBay's is close to 0

Ex: Financial Engineering → Sale-Leaseback transaction

- In a sale-leaseback transaction, a firm sells an asset (i.e., an office building) that it owns but wants to keep on using to a buyer who immediately leases the building back to the firm. - Since the asset is sold, it is removed from the firm's balance sheet. - With the cash from the sale, the firm could pay down its debt. - After the sale-leaseback, the firm now has fewer assets and less debt. - If the firm intends to use the asset for its remaining life by renewing the lease as it expires, then no value is created. - Although the firm appears less capital-intensive and to have less debt, other creditors and rating agencies will view the lease as a debt equivalent. - No value is created because a lease is a debt equivalent - The book believes that managers should focus on increasing cash flows rather than finding gimmicks that make reported results look better. - Executives should also be wary of proposals that claim to create value ... If you cannot pinpoint the tangible source of value creation, you are probably looking at an illusion, and you can be sure that is what the market will think, too.

LIFO vs FIFO Earnings Impact

- In periods of rising prices, changing from FIFO to LIFO results in lower earnings, which lead to lower taxes. LIFO leads to a higher after-tax cash flow than FIFO, despite reporting lower earnings! Why? What is the empirical evidence on the announcement effect of firms changing from FIFO to LIFO in periods of rising prices? - Researchers have examined the announcement impact when a firm changes inventory methods. The accounting method predicts that switching from FIFO to LIFO should lower a firm's stock price due to lower future earnings in periods of rising prices. - The evidence is that stock prices increase when firms move from FIFO to LIFO. - This is consistent with a DCF explanation. Recall that moving from FIFO to LIFO as an inventory accounting method results in higher cash flows. - Notice how COGS inversely affects inventory. High COGS implies low inventory. Low COGS implies high inventory.

In the first decade of the 2000s, what did numerous banks do?

- In the first decade of the 2000s, numerous banks moved assets and the debt that financed them off the balance sheet into special investment vehicles (SIVs). Since SIVs are structured as separate legal entities, the originating banks are not contractually responsible for the debt. Yet to regain trust with bank clients who lent the SIV money, many banks decided to repurchase the assets and guarantee the corresponding debt. In November 2008, Citicorp's stock price dropped 23% when it announced that the firm had repurchased $17 billion in SIV-owned assets - Cardinal sin of banking = putting stuff off balance sheet.

The Purchase Method for Goodwill

- Is now the only method in which mergers and acquisitions can be accounted for in the United States. - FASB argued that the use of only one method to account for business combinations would allow for better transparency for investors. In your forecasting models, it is best to assume that goodwill will remain constant over time.

Long-term Performance expectations and their role in share prices

- Long-term Performance expectations drive share price, median abnormal returns on earnings announcements, 2007 - appears that the market cares more about long term expectations than short term EPS

Market Wide Price Deviations are short/long lived?

- Market-wide price deviations are short-lived: over the past 40 years, the market corrected itself within a few years to valuations consistent with economic fundamentals. - Managers should continue to make decisions based on discounted cash flow. - Even when the market is irrational, smart managers can detect and perhaps exploit these market deviations. - Managers can go to great lengths to achieve analyst's expectations of EPS or to smooth earnings from quarter to quarter. - However, the evidence shows clearly that stock markets reward neither predictable nor smooth earnings.

Historical financial performance for more than 5,000 non-financial firms over the past 50 years:

- Median ROIC during 1963-2000 was around 10% and then increased to 17% after 2010 where it has remained since. The industry switch to tech and Pharma caused this recent spike. Part of what happened: Manufacturing? - ROICs differ by industry but not by firm size. - There are large variations in rates of ROIC between and within industries. There are examples of firms earning attractive returns in industries where the median return is low (i.e., Wal-Mart and Intel) and vice versa. - Rates of ROIC tend to remain fairly stable. Two-thirds of firms that earned ROICs greater than 20% in 1995 were still earning at least 20% 10 years later.

Time Warner Impairment Example

- On January 7, 2002, Time Warner said that it would write-off $54 billion in goodwill. That is a huge number. Q: What effect do you think that the announcement had on the market? - Everyone who followed Time Warner knew that the goodwill listed on their balance sheet did not exist. It was pretend. - The firm had already lost 37% of its value in the 6 months prior to the announcement. - The stock price of Time Warner actually went up a little bit on the announcement. - Despite significant changes in reported earnings caused by the changes in accounting from goodwill, there was no immediate impact on the stock price.

Most recent financial meltdown's illustration of the conservation of value

- One of the fundamental flaws in the decisions made by participants in the securitized mortgage market relates to believing that using leverage to make an investment in itself creates value. - Leverage by itself does not create value because it does not increase the cash flows from an investment (conservation of value). Leverage in Banks - Many banks used large amounts of short-term debt to fund their illiquid long-term assets (securitized mortgages). - This debt did not create long-term value for shareholders in those banks. - On the contrary, the leverage increased the risks of holding their equity. (higher WACC) Mismatch in maturities → red flag

The conservation of value

- States that anything that does not increase cash flows does not create value. - That is, when a firm issues debt to buy its own shares, it simply changes the ownership of its cash flows. Since this action does not increase total available cash flows, that is value is conserved, no value is created.

Sustaining Growth is Difficult because:

- Sustaining high growth is much more difficult than sustaining ROIC, especially for larger firms. Sustaining growth is difficult because most product markets have natural life cycles. Given the natural life cycles of products, the only way to achieve consistently high growth is to consistently find new product markets and enter them successfully in time to enjoy their more profitable high-growth phrase. - Ultimately, a firm's growth and size are constrained by the growth and size of its product markets and the number of product markets in which it competes.

Executive stock options's illustration of conservation of value

- The battle over how firms should account for executive stock options shows the extent to which managers continue to wrongly believe that the stock market is unaware of the conservation of value. - Even though there is no cash effect when executive stock options are issued, they obviously reduce the cash flows available to existing shareholders by diluting their ownership when the options are exercised. - Why give manager stock options → incentive → even though you dilute other holdings it is a good incentive for managers - Under accounting rules from the 1970s, firms could exclude the implicit cost of executive options from their income statements. - As executive options became bigger, FASB (Financial Accounting Standards Board) in 2004, changed the rules and required firms to record an expense for the value of the options when they are issued. - Some venture capitalists thought that the market would be spooked if options were brought onto the income statement. - Despite dire predictions, the stock prices of firms did not change when the new accounting rules were implemented, because the market already reflected the cost of the options in its valuations of firms. - As an analyst stated "I don't care whether they are recorded as an expense or simply disclosed in the footnotes. I know what to do with the information."

LIFO vs FIFO

- The change from last-in-first-out (LIFO) to first-in-first-out (FIFO) inventory accounting can swing share prices, not because of the change in reported earnings, but because of the tax implications of the move. - U.S. tax rules require that the accounting method used for financial reporting also be used for calculating taxable income. - As a result, the choice of accounting methods (LIFO or FIFO) affects both earnings and cash flows.

The role of R&D on stock prices

- The market rewards R&D & advertising initiatives because they are long-term investments i.e. investors like R&D - In general, the stock market rewards R&D and advertising initiatives despite their negative impact on short-term earnings. Further, investors reward R&D spending only if companies are expected to create value from it. - Announcements of capital expenditure increases and strategic investments usually boost share prices, even though such moves typically depress cash flow and earnings. - Stock markets generally react positively to write-offs of bad investments despite their impact on short-term earnings. Why? - Overall, the evidence shows that the stock market is highly sophisticated in interpreting earnings announcements. Investors base their buy, sell, or keep decisions on a good deal more information and analysis than just a glance at the bottom-line earnings numbers. Pharma Example: - If my pharmaceutical firm announces a big increase in R&D, shouldn't my stock price fall? - During 1984-2001, for 40 large pharmaceutical firms, the mean amount of time from clinical time to FDA approval was over 8 years (median of 8.88). - The cost of getting a single drug approved is about $800 million. - In 2019, Merck spend about $8.7 billion on research and development. - In the pharmaceutical industry, announcements relating to products under development can affect share prices far more than quarterly earnings announcements. - Market prices react strongly to pipeline announcements (both negative and positive) even when there is no impact on current earnings.

Sustaining Competitive Advantage

- To generate a high stock market value, a firm must sustain its competitive advantage over the long term. - Consider Microsoft. The complexity of Windows strongly discourages users from switching to 42 Linux (a low-cost competitor with 1.5% of the market as of 2015). Since I have spent years learning all the minor tricks and details of Windows, I do not want Notre Dame to drop the platform.

Creating Value

- You create value by earning a return on your invested capital greater than its opportunity cost → The faster a firm can grow and deploy more capital at attractive rates, the more value it can create. - Value a firm creates is governed by its return on invested capital (ROIC), revenue growth, and its ability to sustain both over time. - Growth, ROIC, and cash flows (as represented by the Investment Rate) are all tightly linked. Growth = ROIC * Investment Rate Thus, Investment Rate = Growth / ROIC

Continuing Value

- assuming that economic profits are zero (ROIC = WACC), = discounted value of invested capital in the last year of valuation. Think of this as a liquidation value (i.e., going forward, no positive cash flows are going to be generated by the firm).

Trend in pension plan assets/projected pension obligations

- economic slowdowns of 2001 and 2008 negatively affected the pension funding. - declines in discount rates since 2006 have caused projected pension obligations to sharply increase (discounted with lower # makes for a higher obligation & higher life expectancy = higher obligation). - The Society of Actuaries recently issued new mortality tables projecting longer life expectancies that will result in higher post-retirement benefit obligations for U.S. companies. - For General Electric, the new mortality assumptions increased their principal pension plans' benefit obligations by $3,953 million (wow!) on December 31, 2014. - exhibit shows they are majorly unfunded → companies with defined benefit plans were probably successful companies in the 1960s

NOPAT (Net Operating Profits after Taxes)

- represents the profits generated from the company's core operations after subtracting the income tax related to core operations.

Unfunded retirement liabilities

- should be treated as debt-equivalents - can make a huge impact when calculating equity value (especially for older firms with an aging union workforce) - Only defined benefit plans are relevant

Defined-benefit plans

- the firm is obliged to provide specific retirement benefits to employees irrespective of the actual performance of the plan's funds. - If there is a surplus add it to entity value on an after-tax basis. If there is a deficit, it should be subtracted from entity value on an after-tax basis.

Value of Major Types of Growth

1. Above Average: - convincing existing customers to buy more product (TVs) - Create new markets through new products (Music Streaming) 2. Average: - Bolt-on Acquisitions (Pharma) - Gain market share in fast growing market 3. Below Average: - Large Acquisitions (expensive & hard to integrate) - Gain share from rivals through incremental innovation, product promotion, and pricing (not long-lasting/easily copied)

If you see Goodwill, what are the 4 things you know?

1. Acquisition 2. Purchase method 3. Paid more than the book value 4. No impairment

Three Managerial Implications of Conservation of Value

1. Although share repurchases can mechanically increase a firm's EPS, conservation of value states that because the total cash flow of the business has not increased, share repurchases by themselves cannot increase value. - Repurchases do not equal value creation 2. Acquisitions create value only when the combined cash flows of the two companies increase due to cost reductions, higher revenue growth, etc - Average acquisition premium = 30% → tells you most acquisitions will fail because they are so expensive 3. Financial engineering can include the use of derivatives, structured debt, securitization, and off-balance-sheet financing. - Some of these activities can create value, most do not.

Sources of Competitive Advantage → Four Sources of Cost and Capital Efficiency

1. Innovative business method: Difficult-to-copy business method that contrasts with established industry practice. 2. Unique resources: Advantage resulting from inherent geological characteristics or unique access to raw materials. Ex: South African gold much deeper than American 3. Economies of scale: Efficient scale or size for the relevant market. 4. Scalable product/process: Ability to add customers and capacity at negligible marginal cost Ex: eBay where marginal cost is nothing

Sources of Competitive Advantage → Five Sources of Price Premium

1. Innovative products: Difficult-to-copy or patented products, services, or technologies (e.g., Apple's iPod). 2. Quality: Customers willing to pay a premium for a real or perceived difference in quality over and above competing products (e.g., BMW). 3. Brand: Customers willing to pay a premium based on brand, even if there is no clear quality difference (e.g., Cheerios). 4. Customer lock-in: Customers unwilling or unable to replace product or service they use with a competing product (e.g., Bloomberg terminals). 5. Rational price discipline: Lower bound on prices established by large industry leaders through price signaling or capacity management (e.g., airlines & OPEC).

Three key conditions for market deviations

1. Irrational investor behavior. 2. Systematic patterns of behavior across different investors. 3. Limits to arbitrage in financial markets. Sometimes it is difficult to short stocks (i.e., noise trader risk). - Example: 152% GME short → hard to short because you have to pay for the right to short a stock

Four things to do if the market is inefficient

1. Issue equity when the market value is high relative to intrinsic value. - Reaction: stock price goes down (around 2%) because this signals management thinks it is overvalued 2. Repurchase shares when the value is lower than the intrinsic value. - Reaction: stock goes up (around 2%) because this signals management thinks it is undervalued 3. Pay for acquisitions with shares instead of cash when the market overprices the shares relative to intrinsic value. - As an insider (i.e. you're the target) do you want cash or stock? → tax implications for cash Q: would buying/acquiring in stock signal overvalue or undervalue 4. Lastly, divesting particular businesses at times when trading multiplies in that sector are higher than can be justified by underlying fundamentals.

Breakdown of The Three Main Components of Revenue Growth. - Compounded annual growth rate (CAGR) for 416 large global firms, 1999-2006:

1. Portfolio momentum = 6.6% 2. Market share performance = 0.4% 3. M&A = 3.1% Total = 10.1 -Can see from this that it is almost impossible to steal shares i.e. Increases in market share that come at the expense of established competitors rarely create much value for long unless they push smaller competitors entirely out of the market.

The Three Main Components of Revenue Growth

1. Portfolio momentum: This is the organic revenue growth a firm has because of overall expansion in the market segments represented in its portfolio. 2. Market share performance: This is how much the firm has gained or lost share in any particular market. 3. Mergers & acquisitions (M&A): This represents the inorganic growth a firm achieves when it buys or sells revenue through acquisitions or divestments.

Three Drivers of Earnings Growth

1. Revenue growth (especially organic growth) is a powerful driver of value as long as ROIC > WACC. Example: GM was the #1 seller of cars when it went bankrupt 2. Margin improvements that come from cost-cutting are not sustainable in the long-run; these cuts in R&D and marketing might hurt future value creation. - Can save $ cutting R&D but that is the future 3. Share repurchases will increase EPS, but they are often funded with higher debt levels or lower firm cash holdings. - Great earnings growth often is associated with firms that create value. - Importantly, not all earnings growth creates value for shareholders. Three main drivers of EPS growth: revenue growth, margin improvements, and share repurchases.

Median rate of revenue growth during 1965-2017

4.9%.

Total Returns to Shareholders (TRS)

= Dividends + Capital Gains TRS: The performance of firms and that of their management are frequently measured by total returns to shareholders (TRS). - This measure combines the amount of shareholders gain through any increase in the stock price over a given period and the sum of dividends paid to them over the period. - Improving TRS is much harder for managers leading an already successful firm than for those leading a company with substantial room for improvement. - The reason is that a firm's progress toward performance leadership in any market will attract investors expecting more of the same, pushing up the stock price. - *Managers then have to pull off herculean feats of real performance improvement to satisfy expectations and continue improving TRS. * (prof likes this slide) - Thus, their predicament is the "expectations treadmill." - The real danger for firms whose shareholders already have really high expectations is that in their quest to achieve above-peer group TRS, management may resort to misguided actions. These actions could be pushing for unrealistic earnings growth or risky major acquisitions.

Equity Value

= Entity Value - Value of Debt

Economic Profit

= Invested Capital * (ROIC - WACC) - economic profit is 0 when ROIC = WACC (used in continuing value calculations - Q: Example, if the ROIC-WACC spread is 8% and invested capital is $40 million, then economic profit is $3.2 million. - If the firm closes their low-returning stores, ROIC would increase to 20% from 16%. Should they close the lower ROIC stores even though all their stores have ROIC > WACC? As long as the particular stores have ROIC > WACC, the firm should keep the lower ROIC stores open. Importantly, the firm should seek to maximize economic profit, not ROIC, over the long-run.

Net Investment

= Invested Capitalt+1 - Invested Capitalt

Free Cash Flow

= NOPAT - Net Investment = NOPAT - (NOPAT * IR) = NOPAT * (1 - Investment Rate) = NOPAT * (1 - (g/ROIC)) = after-tax operating earnings of the company less investments in operating working capital, property, plant and equipment, and other assets. Does not include interest expense or dividends. = is the cash flow generated by the core operations of the business after deducting investments in new capital.

ROIC

= NOPAT / Invested Capital = (1-Tax Rate)*(Price per Unit - Cost per Unit) / Invested Capital per Unit = (capital turn)(profit margin)(1-tax rate) - Is the return the firm earns on each dollar invested in the business. - If a firm has a competitive advantage, it earns a higher ROIC, because it either charges a price premium or produces its products more efficiently (at a lower cost or lower capital per unit), or both. - Example: Double ROIC → value 1.5x bigger Not even double growth → value 3x bigger Point: g is the best way to jack up the value As g approaches WACC value explodes

Midyear Adjustment Factor

= PV of Cash Flows * (1+discount factor)^1/2

Growth

= ROIC * IR - Is the rate at which the firm's NOPAT and cash flow grows each year. - Growth creates value only when a firm's new customers and projects generate ROIC greater than the cost of capital. - Example: Double ROIC → value 1.5x bigger Not even double growth → value 3x bigger Point: g is the best way to jack up the value As g approaches, WACC value explodes

Capital Turn

= Sales / Invested Capital - want higher capital turn

Value of Operations

= Value of Business Units

Entity Value

= Value of Operations + Non operating Assets

Value

= [NOPATt=1 * (1 - (g/ROIC)) ] / (WACC - g) = FCFt=1 / (WACC-g) - This assumes that the firm's sales and NOPAT grow at a constant rate and that the firm reinvests the same proportion of NOPAT each year. - A firm's value depends on its return on invested capital (ROIC) and its ability to grow. All other considerations (i.e., gross margins, cash tax rates, collection periods, and inventory turns) are just details.

Investment Rate (IR)

= g / ROIC = Net Investment / NOPAT = Investment / Earnings - IS the portion of NOPAT invested back into the business.

Upward bias in growth expectations by the media and Wall Street analysts

Analyst forecasts of one-year aggregate earnings growth for the S&P 500 are systematically overoptimistic, exceeding actual earnings by 10% or more.

How should managers create value

Creating value for shareholders means managers should not take actions to increase today's share price if those actions will hurt the firm down the road. Examples include: shortchanging product development, reducing product quality, or skimping on safety. Mistaken Stort-term EPS focus - A Survey of 400 CFOs found that 80% would reduce discretionary spending on potentially value-creating activities such as marketing and R&D in order to meet their short-term earnings targets. - Sadly, 39% said they would give discounts to customers to make purchases this quarter rather than the next one, in order to meet quarterly EPS targets. This is a poor way to run a business.

LIFO vs FIFO Deflationary Environment

Deflationary Environment: COGS → FIFO > LIFO Net Income → FIFO < LIFO Taxes → FIFO < LIFO Inventory → FIFO < LIFO Cash Flows→ FIFO > LIFO

Extremely Large Firms (Fortune 50) growth fact

Extremely large firms have trouble growing, on average. Excluding the first year, firms entering the Fortune 50 grow at an average of only 1% above inflation over the following 15 years.

Is UPS or FedEx investing more in the future?

FedEx, this is shown by lower FCFs

Financial Markets

Financial markets do a great job with public information, but markets are not all-knowing. Financial markets cannot price information that they do not have.

High growth rate decay breakdown

Firms growing faster than 20% (in real terms) typically grow at only 8% within 5 years and 5% within 10 years.

The Pooling Method for Goodwill

In early 2001, FASB eliminated the use of the pooling of-interest (pooling) method of accounting for business combinations. The pooling method: take two companies and pool together → i.e. no goodwill created

Goodwill

In the United States, a merger/acquisition transaction accounted for as a purchase requires that the difference between the price paid for the target and the book value (assets minus liabilities) of its shareholder equity be recorded as goodwill (an asset). - I.e. difference between the price paid & Book Value (A-L)

LIFO vs FIFO Inflationary Environment:

Inflationary Environment: COGS → FIFO < LIFO Net Income → FIFO > LIFO Taxes → FIFO > LIFO Inventory → FIFO > LIFO Cash Flows→ FIFO < LIFO

Momentum

Momentum: is a phenomenon in which positive returns for stocks over the past several months are typically followed by several months of continued positive returns. - Momentum is relatively short-term in nature (measured in months not years). - Momentum might be explained by systematic under-reaction.... That is, overly conservative investors are too slow in adjusting their expectations after new information becomes available. - The result is that stock prices do not instantaneously react to good or bad news. This could give rise to short-term momentum in stock returns.

Do Cross-listings affect market values?

NO - Although listing shares on multiple exchanges in the past may have been beneficial (in terms of cost of capital and higher stock price), those gains are no longer present in today's more liquid and integrated financial markets. - Since 2002, the number of cross-listings by firms based in the developed world has been steadily declining in key capital markets (like New York and London). - Not surprisingly, the book found no significant impact on shareholder value when a sample of 229 firms delisted from US and UK stock exchanges since 2002. - The announcement by Dutch telecom player KPN that it planned to delist from the NYSE was barely commented on in the Dutch newspapers.

Does the market care about earnings volatility?

NO - The market does not care about earnings volatility - Rational investors focus on the firm's returns and risk in terms of cash flows, not earnings. - The book states that in 30 years of US profit data, there is no correlation between variability of EPS and a firm's market value. - The book also points out that smooth earnings growth is a myth. - Since investors value substance over form, managers need not worry about whether their shares are split into smaller shares, trade on one or multiple venues, or are included in a large stock market index. None of these measures will make any material difference to the share price, as they too leave the underlying economics of the firm unchanged. - *conservation of value → implies stock splits don't affect value and implies choosing which exchange to trade on doesn't make a difference

Change in Goodwill Accounting Effect

Q: What effect did the change in accounting for goodwill have on stock prices? What if we focused on the firms with a substantial amount of goodwill on their balance sheet? Firms with a lot of goodwill on their balance sheets will see a sharp increase in EPS following the 2001 announcement. That is because these firms will stop amortizing goodwill (an expense on the income statement). A good test of long term concern: if we have investors concerned about earning, stock price should go up after FASB announcement BUT: - Three-day returns at the FASB announcement of SFAS 142 for a sample of 1,056 US firms with stock price > $10 and non-zero Goodwill. - * no effect → long term means it doesn't change value → goodwill + amortization have no tax effect - Hence, the stock market realized that goodwill amortization does not affect stock prices.

Between 1985 and 2012, Walgreens and General Mills had similar shareholder returns but vastly different earnings growth. How is that possible?

ROIC → Walgreens after-tax operating profits grew 13% vs General Mills 9% - General Mills (despite 30% slower growth) could create the same value as Walgreens because General Mills had an ROIC of 29% compared to 13% ROIC for Walgreen

Reversals

Reversal: means that high-performing stocks of the past years typically become low-performing stocks over the next few years. - Reversals are long-term in nature. - Behaviorists say → That the reversal is caused by investors overreaction ... That is, investors put too much weight on companies' recent performance. - Example: When eBay has done well in the past, investors are inclined to extrapolate that success into the future. - As a result, share prices increase too much, and when cash flows fail to meet projections, investors adjust their expectations, bringing on a reversal. The same effect may also be responsible for well-known patterns such as low returns some companies demonstrate following their IPOs and seasoned offerings.

Volume and Value Inc. Example of ROIC importance

Since Value Inc. and Volume Inc. have the same sales and net income, they should have the same value, right? Why does Value Inc. generate higher cash flows? - Value Inc. generates higher cash flows with the same earnings because it invests only 25% of its profits to achieve the same profit growth as Volume Inc. (which invests 50% of its profits). Value Inc.'s lower investment rate results in 50% higher cash flows. - Assuming a 10% cost of capital, Value Inc. has a PV of $1,500 compared to $1,000 for Volume Inc. - Value Inc. generates higher cash flows because it doesn't have to invest as much as Volume Inc., thanks to its higher rate of ROIC. - Value Inc. has an investment rate of 25% ($25 investment/$100 of earnings). Its return on new capital is 20% ($5 additional profits divided by $25 investment). The growth in earnings is 5% ($100 to $105). - Investment Rate = Growth / ROIC, for Value Inc. 25% = 5% / 20%. - For Volume Inc., it has an Investment Rate of 50%, a growth rate of 5%, and a 10% ROIC. - Notice that 50% = 5% / 10%.

The Role of Risk - what was the average cost of equity capital for large non-financial firms mid 2014?

The book states that the average cost of equity capital in mid-2014 for large non-financial firms was about 9.5%. Most large firms' cost of equity capital is in the range of 8% to 10%. The range is small because investors purposely avoid putting all their eggs in one basket.

Has UPS created value in the past?

UPS in the past has created a lot of value (ROIC > WACC) (WACC ` 8%)

WACC

Weighted average cost of capital (WACC) is the rate of return that investors expect to earn from investing in the firm. That is, WACC is the appropriate discount rate for the free cash flow. The cost of capital is not a cash cost; it is an opportunity cost.

Can a company have + market value with no profit?

YES - Sirius Satellite Radio had a market value of $4 billion as of September 2004. ($27 billion in Jan of 2021). - Yet, the firm had reported sales of $30 million and was still not profitable → possible because of long term expectations Amazon.com had a market capitalization of $23 billion in October of 1999. Since Amazon was reporting accounting losses at that time, this is another clear evidence that the financial markets have a long-term focus. Please note that Amazon.com, in Jan 2021, had a market cap of $1.6 trillion. * it is possible for companies to have high valuations while making zero profits because of long term expectations - During 1999-2000, numerous young internet companies had valuations in the billions with little in sales and often negative earnings. - In July of 2000, Corvis Corp. went public (lead bank: CSFB). Total revenue since inception of $0. Market value right after the IPO was over $30 billion - On February 12, 2008, GM recorded a $38.7 billion loss for the prior fiscal year. Before the announcement, GM had a market value of about $15 billion. How did the stock market react to this huge loss (over 250% of its value)? GM was slightly up on the news of reporting the largest annual loss ever for an automotive company → Thus, the market wasn't disappointed with the huge loss i.e. market already knew Clearly, the market focused on the long-run prospects of these firms to get the high valuations

Invested Capital

represents the cumulative amount the business has invested in core operations (i.e., property, plant, and equipment and working capital).