Corporate Finance
Solutions to the intangibles problem? What are major concers?
Companies are publishing more performance measures in the name of Alternative Performance Measures, Key Performance Indicates, Non-GAAP Performance Measures, etc; Data aggregators like Bloomberg and Thomson Reuters are providing more information to users timely and in multi-dimensional forms. Concerns: -To manipulate performance measures and mislead investors, by mainly adjusting earnings number upward, rather than downward. -Comparability across companies, and consistency of a company among different periods. -Should they be audited? How would they be regulated?
2 major business concerns
Companies rise and fall faster than ever how to balance between short-term growth and long-term sustainability ? Intangible assets (technology, business models) are much more valuable than traditional tangible assets. How to value these "new economy firms" ? It is increasingly difficult to evaluate a company only by looking to the financial statements of a company, because intangible assets are more important each time.
Dividend payment type I examples
Companies that do not pay dividend are NOT necessarily bad companies E.g. Berkshire Hathaway BH paid dividend only ONCE, and Buffet regretted it right after. Company shareholders did not complain at all, because the price continuously expanded. However, from a company perspective it may be counter-productive because if the per share price is too high, less investors will be able to access it (in those cases, a stock split may be the answer). In the case of BH, keeping the stock price up is actually an entry barrier for retail investors, who are more demanding on liquidity (dividend). Before Feb 2003 Microsoft did not pay any dividend. The market reaction was not good because in this case it was perceived as a signal that the company was losing its growth momentum (lack of NPV > 0 projects), transitioning to a mature company.
Financial strategy matrix: Value creation and cash deficit
Company is growing too fast and has cash deficit (e.g. Start-ups) Cut dividends and raise funds Eliminate low margin and low capital turnover products
What prompted the growth in intangible assets
Competition has intensified with the technological revolution and globalization which lead to core changes in the way we see company value. There are intangibles relates to innovation capability, HR capability and organizational capability Intangible accounting has almost completely taken over tangible accounting Intangible assets now represent over 80% of S&P 500 market value compared to 20% in 1975
empire building
Describes an Executive who has incentives to spend the excessive cash in non-productive activities, such as company perks, non-productive investments (NPV < 0).
Measures of dividend policy
Dividend payout= dividend/NI -% earnings firm pays in dividends -but if NI is negative then ratio invalid Dividend yield=Dividend per share/stock price -return investor can make on just dividends -part of expected return on investment In China there is no habit of paying cash dividend, so investors are not very bothered by them, but are bothered by the capital gain (growth of stock price). In HK, this is the opposite. One of the main challenges is how to encourage companies to pay dividends.
Four principles underlying the SCF program:
(1) Be low cost. The Bank has to be low cost bank to keep the interest rate low. The pre-negotiated interest rate with the bank is lower than the supplier accessing financing directly. (2) Don't accept supplier price increases for longer payment terms (3) Allow local teams to control the implementation rather than corporate staff. Since P&G has a lot of vendors, there is a need to use local banks. (4) Ensure funding competition by having at least two participating banks for each supplier to ensure competitive financing rates
SCF program: Benefits to suppliers
(1) Greater flexibility - suppliers could choose to be paid on either 15 or 75 days (2) Healthier balance sheet - require less external financing (reducing debt) (3) Access to capital - SCF provides a new cash stream without burdening a supplier's existing credit lines. Participation also created the possibility of a new banking relationship for the supplier with a global bank (4) Visibility - timely notification of approved invoices enhances supplier cash flow management
Evaluating risk level (for real estate companies)
(the higher the riskier) Net leverage ratio: (interest-bearing liabilities-cash)/net assets Net Assets are often underestimated due to accounting conservatism. Therefore, even if the net leverage ratio is a bit above 1, the company may not have significant financial risk. Value increase in land reserve Real estate companies often own significant land reserve for future development. Increase in land value does not show up in the balance sheet, which underestimate the net assets. If increase in land value is accounted for, it will lower the net leverage ratio. Interest coverage ratio: EBIT/interest expense (real estate companies usually have higher interest coverage ratios) Non-performing loan ratio: In 2016, average NPL ratio among real estate companies is less than 1%, compared to 4% among manufacturing companies and 6% among retail companies.
Strategies for dilution without founders losing control
- 2 class shares structure: it separates voting rights (B) / dividend rights (A). China did not allow it until 2019. - Agreement among the founders to have an unanimous vote decided by CEO.
Dividend payout policy as a signaling mechanism
Dividends are rarely decreased since: (a) managers believe that investors prefer stable dividends with sustained growth (b) managers desire to maintain a long-term target level of dividends Thus firms raise their dividends only when they perceive a long-term sustainable increase in the expected level of future earnings, and cut them only as a last resort. If firms smooth dividends, the firm's dividend choice will contain information regarding management's expectations of future earnings. -An increase in dividend sends a positive signal to investors that management expects to be able to afford the higher dividend for the foreseeable future; vice versa -Alternative message? Lack of investment opportunities
Earnings persistence
Earnings persistence is defined as the continuity and durability of the current earnings. You should buy groups/firms with high earnings persistence and get rid of those with low EP
What is the appropriate value for short term valuation of a company?
Economic profit a.k.a. the economic value added Economic profit: accounting profit - cost of capital
Example of economic vs accounting profit in history
Enron's accounting profit in 1999-2000 was 0.9 and 1 billion dollars but economic profit was -0.33 and -0.65
Cash Dividend vs. Stock Dividend
Firm can pay another type of dividend that does not involve cash: stock dividend Stock dividends and splits: -If a company declares a 10% stock dividend, each shareholder will receive one new share of stock for every 10 shares already owned -Stock dividends of 50% or higher are referred to as "stock splits". A 50% stock dividend = 3:2 stock split; A 100% stock dividend = 2:1 stock split (2 shares for every 1 share you have) -No change in the total market value of firm's equity, only change is the number of shares outstanding -> stock price will fall -Value of investor holdings do not change, and stock splits are not taxed, thus there is no real consequence to a stock dividend -In theory, market cap will remain stable after stock split. In practice, this will likely increase the market price.
CEO/CFOs in China and economic value added incentives
Focusing on long-term value creation will have a greater impact on EVA compared to short-term focus. Logically, a CFO should find the balance between short and long-term value creation. In China CEO/CFOs tend to stay only 5-6 years which unfortunately creates an for short-term investements.
Why hard to maintain good level of working capital
For example, having a large volume of inventories will have two effects, firstly there will never be stock outs but it means that money has been spent on acquiring the inventories, which is not generating any returns (i.e., inventories is a non- productive assets), there are holding costs (i.e., warehouse space, insurance etc.)
Forms of expropriation of minority shareholders
Fund controlling shareholder's occupation with intercorporate loans: IPO company A takes money from bank, and then loans part of it to company B at zero interest... company B, in the end, fails to repay the debt after bankruptcy. The problem is that this transaction is not necessarily visible in the Financial statements of company A (public), they are only written in contingent liabilities. In China, the reported liabilities is usually smaller than the real liabilities Buying assets at high premiums from the controlling shareholder Selling high quality assets at cheap price to the controlling shareholder Provide loan guarantee when the controlling shareholder or its subsidiary firms borrow from banks
What is going concern?
Going concern is an accounting term for a company that has the resources needed to continue operating indefinitely until it provides evidence to the contrary. This term also refers to a company's ability to make enough money to stay afloat or to avoid bankruptcy. If a business is not a going concern, it means it's gone bankrupt and its assets were liquidated. The concept of going concern is an assumption in accounting. It is assumed that the entity has neither the intention, nor the need, to liquidate or curtail materially the scale of its operations.
Depreciation for High-Tech Companies
A key problem for high-tech companies is whether or not to capitalize/expense the R&D. Before 2007 in China all R&D had to be fully expensed, thus reducing the earnings. This desincentivizes R&D.After 2007, to encourage more innovation, and as of today, there is a distinction between Research (Expense) and Development (Capitalization). The costs of Development can be capitalized under the assumption that there is an intangible asset that will generate future profit (which is actually the definition of asset). Another problematic consideration about new e-commerce business is that the more the use of an asset, the more value of the asset (contrarily to depreciation), because of the network effects due to the near-monopoly power. Thus, in reality the more use, the more value of intangible assets.
Expropriate minority shareholders
A shift in wealth from the minority shareholders to the controlling shareholder. Expropriation is a more general term defined as the process of using one's control powers to maximize own welfare and redistribute wealth from others.
OPM model and small/large vendors along the supply chain
A successful OPM strategy can only be developed by companies with high bargaining power (big companies or companies with a unique advantage). For instance, pharma does not have bargain power in China because the client is the government. Small vendors have lower liquidity due to customers' OPM strategy and they face high financing costs as they are fiscally opaque (no disclosure in financial statement) and are small with little collateral and short credit history.
Going forward, can companies recycle outstanding accounts receivables?
ABS = Asset Backed Securities. The idea behind ABS is that companies with a lot of AR that have low bad debt risk, they can securitize those AR to package a new financial product. What is backing the security is the AR. This security can be issued to others that contribute with cash. When the clients start to pay the AR, then it will start repaying. ABS are very complex financial instruments that can package different types of AR from one or multiple companies.
Why use accelerated depreciation or straight line depreciation?
Accelerated depreciation will be used if the performance is expected to decline at the end of the period, so that depreciation partially compensate this future loss. If the company expects better performance in the future than in the near-term, then straight line may be used. Heavy asset companies may also extend the depreciation time in order to increase profit.
Importance of the distinction between economic and accounting profit.
Accounting profit would account only for explicit costs like COGS while accounting profit considered implicit costs like cost of capital (opportunity cost of capital). Economic profit says value is created periodically only if increase in earnings is more than enough to cover the cost of capital. This makes the cost of capital visible to managers and more frequently used in measurements of internal corporate performance.
Example China reaction to no dividends
After 9 years giving constant generous dividend, GREE stopped giving dividend in order to increase investment. AS a result, 9% stock decrease made the company lose a lot of money. In the US too. If you are a mature company that gives constant dividend, stop giving dividend will give a very bad signal to investors.
retail vs institutional investors
An institutional investor is an entity like mutual funds, an insurance company, etc. On the other hand, a retail investor is a person who interacts with trading. Retail investors only invest for themselves, but an institutional investor invests on behalf of someone else, such as organizations or a shareholder.
What does not go into COGS?
Any fixed costs
What's the goal of cash management?
Avg cash holding by non-state owned companies in china is 20% Every company has to hold cash, but the key is to determine how much in order to achieve a balance between RISK HEDGING or UTILIZATION EFFICIENCY. Companies survive on cash and grow on net income. In the US many bankrupt firms had positive NI but negative cashflow
measure of OPM model effectiveness
Cash conversion cycle is a measure of OPM model effectiveness. The cash conversion cycle focuses on the time between payments made for materials and labor and payments received from sales: cash conversion cycle= inventory conversion period+ receivables collection period- payables deferral period we want low inventory turnover, high AP, low AR and the more negative the cash conversion cycle, the more OPM model.
Financial strategy matrix
Cash deficit or surplus on one axis then value creation EVA>0 or value destruction EVA<0 on the other
problems with holding too much cash
Cash itself does not generate wealth for the company. Cash is a tool to convert into new assets that can result in new wealth creation. May forego new investment opportunities, incentives for empire building (agency problem I). Agency problem II: Too much cash (e.g. post-IPO) may have incentives to "tunnel" cash to the controlling shareholders that may have more difficulties in financing in the markets. ie Apple has a lot of cash, but much of it is actually offshore to avoid taxation in the US. Apple has been criticized by shareholders, who demanded the cash to be used for additional value creation, or to be returned as dividends.
channel stuffing
Channel stuffing refers to the practice of a company shipping more goods to distributors and retailers along the distribution channel than end-users are likely to buy in a reasonable time period. By channel stuffing, distributors temporarily increase sales figures and related profit measures for a particular period. Regulators frown on the practice and consider it deceptive. In some cases, legal action can be brought to the offending company.
Advantages of companies at the hub of social network
Chen (2015) finds that companies at the hub of social network have an informational and control advantage. As a result, they have higher operational and investment efficiency, and better future performance. Investments by BAT are bigger in number than those of independent VCs.
Issues reducing payment period for AP, solution is SCF Program
Commercial contract: P&G- supplier. Focus on product and payment terms Service contract: P&G-SCF bank. Focus on terms for P&G receivables from suppliers ie pay at face value Financing contract: Supplier-SCF bank. Focus is SCF bank has the right to buy P&G receivables on a discount if supplier requests advanced payment Nowadays, Logistic partners are also undertaking SCF programs in order to determine the quality of the vendor. The vendor can sell the AR to the bank at a discount, so that it can obtain the cash earlier. Later on, P&G will pay to the bank the AR at the face value. This scheme needs a Financial Institution willing to take these AR.
Dividend payout policy in China
In China, the capital market is dominated by retail investors 80% (global market is 80% institutional investor). Thus, in China the market is more demanding on liquidity and dividends, which makes it harder to have long term decisions (e.g. R&D). This is why CSC is making efforts to introduce new foreign institutional investors to make the market more sophisticated, by having those "anchor" investors to have more stability in the market. 2018 new regulation kills small VC. For individual investors to enter into VC it used to be 2 million RMB. In the new regulation, you need prior investment experience of 3-5 years. This is to have more patient capital in the VC space.
Encouraging China firms to give out dividends
In recent years, authorities have encouraged listed firms to offer more yields to investors in the stock market, where dividend payouts were previously infrequent. In 2013, the Shanghai Stock Exchange required companies offering dividends of less than 30 percent of net profit to submit a "please explain." It also gives priority in financing to firms offering dividends of 50 percent or more of net earnings. In August 2015, the CSRC and other government agencies jointly issued a notification, requiring capable listed companies to pay cash dividends. Season Equity Offering (SEO) is a follow-up emission of Equity after IPO. If a Chinese company does not pay dividend (provided they are able to do so), then the CSRC does NOT allow to go SEO.
Problems with OPM model
In this point, the regulation is acknowledging the exclusion of "pre-paid deposits" (advance proceeds from projects sold on contract). Real estate firms that have a lot of "prepaid deposits" have more regulation now with 70% ceiling on liabilities to assets excluding advance proceeds from projects sold on contract
Working Capital Management
Includes both establishing working capital policy and then the day-to-day control of cash, inventories, receivables, accruals, and accounts payable. Working capital policy: -The level of each current asset. -How current assets are financed.
Financial appearance is affected by
Industry, competitive strategy, asset composition (heavy like factory or light like app) and business models (Before looking to the financials, it is necessary to determine what is the business model, can mean differences in gross margin for example)
Ofo and Mobike followed the strategy that many other Chinese tech companies are following:
It consist on collecting enormous quantities of funds and use them to subsidies customers with the purpose of capture the market and raise the prices once they have no competitors. Lack of revenue model, high maintenance costs, VC back out, together with governance problems, drove Ofo and Mobike into problems. By 2018 Ofo started to experience financial problems, the company was forced to close offices, accumulate bikes in endless graveyards and face virtual queues of millions of customers who wanted their deposit back. Mobike was sold to company Meituan Dianping in 2018.
What can we learn from Mobike and OFO in terms of aggressive VC financing?
It used to be a norm to go through 3 VC rounds (A, B, C). However, nowadays it is increasingly common to go through many more rounds, for instance Elema went up to Series G! Companies tend to prolong pre-IPO financing, increasing dilution and actually putting off revenue & profit: priority is to increase the market share, the viability of the profitability model is put off.
Dividend payment type III uses
Just as debt is used as a signaling device by managers, payout policy can also be used to alleviate the asymmetric information between managers and investors since dividends tend to follow earnings Dividend Smoothing: -Firms adjust dividends relatively infrequently, and dividends are much less volatile than earnings. Dividends are stick with <10% companies decrease them. -This practice of maintaining relatively constant dividends is called dividend smoothing
Sustainable performance is difficult to achieve, we look at the example from LMZ
LMZ was a leader in dental care market in the 40s in China. Despite investments, foreign competition and aging have taken a toll on their core business. In the 2010s it made a substantial operating loss but had overall profit thanks to key investments. Has avoided being de-listed from the Shanhgai exchange by selling shares in a brokerage firm.
Dividend payment type IV example
Lanzhou Huanghe recorded a loss of 25.09 million, but paid cash dividend of 12.26 million. Why: For dividend smoothing and fundraising since the China Securities Regulatory Commission (CSRC) issued a dividend policy in 2006 which set minimum payout levels for firms wishing to issue seasoned equity offerings. Also due to the controlling shareholder's own incentives: Younglight (ticker: 600795)'s controlling shareholder is Younglight Energy, which owns 51.25% of Younglight's share. In 2018, Younglight announced cash dividend of 0.364 billion RMB, which is 46.61% of net profit. More than half has gone to the controlling shareholder.
Risks of going asset light
Loose control of product quality - The case of Guangming Diary Co. Loose touch with market changes and flexibility.
Example of tunneling
MingLun Group: Subsidiary companies were prepared for tunneling Used company shares to get massive loans that were tunneled to the subsidiaries controlled by the Group's buyer Zhou Yiming
Free cash flow
NI+ depreciation/amortization - changes in working capital - capital expenditure
High Price/Book commanded by new economy firms suggests that many firm assets are off balance sheet compared to before ie
New:Apple P/B 14.66 Old:CIBC:0,78
OPM model
OPM = Other People's Money This type of money is a "zero-interest loan".Companies can use the Client's money or the Supplier's money Types: customer and supplier Largest Real Estate company in China, but with the highest leverage ratio among all publicly listed (high debt!). For any company, the average leverage in the US is 45-50%, in China 50-60%. Is there any reasonable explanation for this high leverage, or is it on the verge of bankruptcy?
R&D: recording an expense or capitalizing
Once the asset is recorded as an intangible, then amortization will start running. This will have implications in the future reports, compared to the one-time impact of Expensing Research. There will be some room for maneuver in deciding how much to consider Research (Expense) and Development (Capitalization). If a CFO wants to boost short-term earnings, more Capitalization will be done; if the short-term earnings look good and the CFO wants to preserve future earnings, then more Expense will be done. The key for external auditors nowadays is to understand the technology and research to be able to determine whether the Cap/Exp makes sense. Some tips: - Compare the Cap/Exp to other years in the same company - Compare to Cap/Exp ratio of peer companies in the same industry (horizontal comparison)
Long term financial consequences of over capitalization
Over-capitalization can have detrimental effect in future earnings by the effect of amortization.
What to do with free cash flow? Define FCF
Pay it out as dividends or share repurchase or retain it to invest in new projects or increase cash reserves. FCF = Cash Flow - Capital needed to be retained for investment (= disposable cash flow). FCF is not declared in the financial statements.
Two features of a capital investment project
Projects is relatively large Lasts a significant time period, usually more than 1 year, between investment and receipt of benefits
propping vs tunneling with controlling shareholders
Propping: in a difficult situation, having a big shareholder may be good to receive more funding... the truth is that "Tunneling" is more common: it will channel the wealth of the post-IPO company to the private company via dividends or preferential agreements. In this case, the minority shareholders are the ones who suffer the more.
Competitive strategy a Dupont analysis
ROE is composed of: Profit margin (business management status) Asset turnover ratio (asset management status) Equity multiplier (corporate debt management) Sales profit margin ×Asset turnover=Return on investment funds× Equity Multiplier=Pre-tax ROE× (1-tax rate) = ROE
Repurchasing shares as a signaling method
Repurchase Shares signals that the management believes that the company is undervalued in the capital market. Thus, if the market believes this signal, the price may probably increase again. Repurchase may also signal the intention of the founders or managers to privatize the company again (it happened a lot in China in 2011). Privatization has its hassles too, because a lot of money is needed: - In those cases, some banks may become the support to privatize the company. However, then banks become the main shareholder (PE) and may lose control. - Another problem is that the PE probably wants a lower price to the privatization, and most of the shareholders may be employees and managers. Thus, setting a fair price is a big concern to reconcile the PE and the employees views. - VIE = Variable Interest Entity -> (aka Sina Structure, the company that created the structure in preparation of US 2000 IPO). This structure is needed by Chinese companies to receive foreign capital (USD funds). In 2011 most companies had those structures. At that time, privatization required to dismantle the VIE structure, which was an additional complication of the process of privatization (nowadays this is easier, through CDR = China Depository Receipt, China allows companies to come back listing in China without having to dismantle VIE).
What is the logic behind corporate valuation?
The NPV accounts for all future periodic cashflows and the terminal value of the firm. Firm value=short term value creation + long term sustainability
Example of OPM model
The highlighted items are "pre-paid deposit". This happens because when a client purchases a property in 2-3 years of advance before being given, they will make a down-payment. Those down-payments will be anotated as a liability. The key is that a liability is normally a "problem" if there is interest payment. In this case, this type of liability does NOT have a high risk. In fact, it is considered as "free borrowing": the company is actually having "free" cash borrowed by the clients for 2-3 years, that they can use for whatever purpose the company wants. This is what an "OPM: Other People's Money" business means, where the company uses the clients' money for financing. GOME Electronic Appliances group: This company used the Supplier's money to finance its country wide expansion, 12B RMB, by delaying payments to the suppliers by 2-3 months. This time gap is additional cash flow with free-interest.
Solving supply chain finance for small vendors
The key is to reduce "information asymmetry" between the bank and the vendor. -Third-party certification - The lead companies in the supply chain (i.e., these vendor's customers). They have incentives to do so to maintain a stable supply chain. The purpose is to help small companies in the supply chain resolve their financial needs. The core is to reduce information asymmetry between the bank and the small vendors. It is not a direct loan to the small vendor, but through the lead player in the supply chain (Walmart) that certifies those small vendors as a "trusted" partner. With this endorsement, the banks will be more eager to finance them. The big player has incentive to help its small suppliers in order to maintain a stable supply.
How does brand help sustainable growth?
The surface elements of a brand don't work unless they're married to substance. Apple combines economies of scale in purchasing materials, its own technology in software and custom hardware, network effects in its software development ecosystem, and more; all of these things reinforce the brand. Essentially it is the associations people make with the brand.
Financial strategy matrix: Value creation and cash surplus
There is cash surplus (post-IPO, mature), that should be used to grow faster (organic = slow / inorganic = fast, usually the case for post-IPO companies) or distribute it back to shareholders. The biggest danger in inorganic growth is integration of the acquired company in the holding (see Fuxin company in China)
What explains the phenomenon that company revenues increases, but OCF continues to be negative?
There must be a problem in the cash cycle. Maybe most of the sales are on credit and have a long recycle period. B2C businesses have less OCF problems than B2B In order to have better CFO you may incentivize discounts for earlier payment. Otherwise, financing (loan) may be the only alternative.
How does complex coordination help sustainable growth?
Think of Tesla's ecosystem business model. They have a battery factory, charging infrastructure, designers and builders of vehicles, electric utilities etc. All these work with and feed off each other in a complex way that is hard to replicate.
The issue with a financial data provider like Tonghuashun?
This company sells market data, so it is very light asset. Thus, if it was to be valued only using financial statements (e.g: DCF), it would give a much lower value than the real actual value of the company.
How do we prompt distributors to buy more inventory?
Through DISCOUNT or INCREASING PRICE IN THE END MARKET. In this case, the firm keeps increasing the product price in the end market (customer), so that distributors have incentives to buy more. From accounting perspective this means that the business model is no longer a B2C model, but more a B2B model of a speculative investments sold to distributors. The long-term sustainability is low, because increasing the price will at some point be impossible except for very scarce and luxurious products
Main goal of corporate governance in China
To mitigate the conflicts between controlling shareholders and minority shareholders. So not agency problem I (managers and shareholders) but II (minority and majority shareholders).
Financial strategy matrix: Value destruction and cash surplus
You are destroying value because there are not profitable business opportunities. If there is cash surplus then distribute it back and use rest in business. Review capital structure like D/E ratio, improve operating margin or asset management EVA < 0 may occur if the financing costs are very high (WACC very high).
Financial strategy matrix: Value destruction and cash deficit
attempt drastic restructuring or sell the business
Dividend payments are a function of? explain
capability and willingness. Type I: Match. Have no undistributed profit or FCF so don't pay dividends Type II: Alarming. Have undistributed profit or FCF but don't pay dividends Type III:Match. Have undistributed profit or FCF so pay dividends Type IV: Alarming. Have no undistributed profit or FCF but still pay dividends Undistributed Profit IS NOT Net income of this year, but it is the accumulated undistributed profit of all the previous years in operation. Thus, a company may have negative net income and still have positive undistributed profit and FCF.
Measuring working capital efficiency
current ratio: current assets/ current liabilities Quick ratio: current assets-inventory / current liab Cash ratio: current assets-inventory-AR / curr liab Cash to debt: currency/current liab Most companies in China are very conservative, with 3x-4x Current Ratio The safety line for Cash Ratio is not 1, but 0.2 should be enough
What determines cash holdings?
firms with strong growth opportunities and riskier cash flows hold relatively high ratios of cash to total non-cash assets. Firms that have the greatest access to the capital markets, such as large firms and those with high credit ratings, tend to hold lower ratios of cash to total non-cash assets. family firms with excess control rights tend to have high cash holdings that are tunneled rather than being invested or paid to shareholders. We further show that the incentive for controlling families to hold cash and for tunneling is exacerbated by the agency conflict between controlling and minority shareholders
Value maximization relies upon
good investments, financing and risk control and government. Plus there needs to be good financial statement analysis.
Quality of a liquid asset
how easy it is for a (current) asset to be converted into cash. The quality of liquid assets may be different depending on the company or industries (e.g. AR are easier or harder to collect)
This is why a high leverage does not necessarily mean higher risk:
if a large part of the leverage does not have interest payment, then the risk is lower. This is why it is more wisely to compare the leverage ratio between companies by only focusing on the financial leverage, if you want to compare the risk. Operational leverage is low risk while financial leverage is high risk
Cashflow statement parts and what can affect the cashflow
operating, financing and investing activities Can be affected by the life cycle of a firm: Before making any judgement on a CF statement, it is necessary to know what is the life cycle time of a company: start-up? growing? mature? Companies can have negative operating CF before their IPO. This is contrary to traditional wisdom in finance, considering OCF < 0 to be very risky. In the last few years, in order to support technological companies there is no longer a requisite in China to have OCF > 0. On the other hand, the regulator may consider "Reasonable OCF", meaning that the OCF of the company matches the growth moment and business model of the company. The argument of "Reasonable OCF" will be disclosed in the IPO prospectus.
Objective of financial reporting
provide info useful to investors, lenders, and creditors when making decisions Should be relevant and faithfully represented. Quality is determined by timeliness, comparability, verifiability, and understandability. Although these can be costly to make.
Why split stocks?
to keep the share price in a range thought to be attractive to small investors(<100$), increasing the demand and the liquidity of the stock, which in turn may increase stock price. On average, announcements of stock splits are associated with 2% increase in stock price If the price of the stock split falls too low, a company can engage in a reverse split and reduce the number of shares outstanding
Porter's Five Forces
threat of entry, threat of substitute, supplier power, buyer power, and competitive rivalry
Capital budgeting process
1- estimate project expected cash flow 2- compute NPV 3-compute sensitivity of NPV 4-make investment decision Step 1 and Step 3 are the crucial step, because there will always be error in the forecast.
What does performance sustainability amongst Chinese companies look like?
48% achieved 1 year net income growth, 23 % achieved 3 year NI growth and 1.1% achieved 10 year NI growth of the 3,000 companies listed in 2000. In the US 10 year NI growth was 0.9%. This proves long-term sustainability is hard to achieve.
What is Capital Budgeting?
A capital budget lists the projects and investments that a company plans to undertake during the coming year. Capital budgeting is the process of analyzing investment opportunities and deciding which ones to accept. Each year the company will have to list the projects that may be financed. Since not all the projects can be financed, only increasing NPV>0 will be financed.
Share repurchase as a signal
Share repurchases, like dividends, may also signal managers' information to the market. However, there are several important differences: (1) managers are much less committed to share repurchase than to dividend payments; also it may take several years to complete the repurchase (2) firms do not smooth their repurchase activity (3) the cost of a share repurchase depends on the market price of the stock, so managers will be more likely to repurchase shares when they believe the stock is undervalued So share repurchases are a credible signal that firm shares are under-priced and investors will react favorably to share repurchase announcements
Creditor incentives vs shareholder incentives
Shareholders only have the residual claim on the company liquidation. Creditors thus care more about the bottom line (conservatives, risk averse) Shareholders care more about the long-term value creation. In financial distress situations, shareholders will have incentive for high risk bets (nothing to lose), whereas creditors will have the opposite.
Differing company objectives in China. SOE example
Some may be focused on amassing assets, employment, industrial output or the number of enterprises they own/ create. SOEs have negative EVA, but they have a higher social and political value: they compromise financial performance for better employment.
What is the ultimate goal of a company?
Some might say to maximize profit, maximize market capitalization or to minimize costs. Maximizing shareholder value?
Drivers of sustainable growth
Sources of sustainability and monopoly power: Technology (most value in the long-term) Network effects (like ebay supply/demand) Scale (lower costs, EOS, price competition) Distribution (deals to be more available in shops) Brand Complex coordination Government
Who shouldn't engage in price competition?
Startups.
Stock dividend in conjunction with stock pledge
Stock Pledge = when controlling shareholders need to raise cash but are not willing to sell the equity (very common in China). Upon pledging the shares, the promoters cannot trade their shares unless they repay the loan amount. Main benefit - Access to cash without giving away control Challenges with selling shares: (1) Loose control (2) Timing is important (market condition) (3) Compliance and disclosure Most of stock pledges are done by controlling shareholders: (1) Minority shareholders do not have enough stocks to pledge. (2) Minority shareholders do not have control power over the firm When majority shareholders engage in Stock Pledge, they assume a risk: if stock starts plummeting, the bank has the capacity to force selling the stock that is collateral. Thus, the majority shareholders will push up the stock value by the means they have. One of this means is actually paying out stock dividend.
Share repurchase
Stock repurchase or buyback presents another way to pay cash to investors Three ways to do it: (1) Open market repurchase This is the most common way Firm can buy back its shares in the stock market just like any other investors Firm must not buy its shares in a way that might appear to manipulate the price SEC recommend that the firm not purchase more than 25% of the average daily trading volume in a single, nor make purchases at the market open or within 30 minutes of the close of trade 2)Tender offer Firm offers to buy shares at a pre-specified price during a short time period - usually within 20 days The price is usually set at a substantial premium (10% - 20%) to the current market price However, if shareholders do not tender enough share, firm may cancel the offer and no buyback occurs 3) Targeted Repurchase Firm buy back shares from a major shareholder Purchase price is negotiated directly with the seller This type of transaction may occur if a major shareholder desires to sell a large number of shares but the market for the share is not sufficiently liquid to sustain such a large sale without severely affecting the price. Under these circumstances, the shareholder may be willing to sell shares back to the firm at a discount to the current market price
Income statement from stockholder perspective vs stakeholder perspective
Stockholder: revenue-cost-salary-interest-tax=NI Stakeholder: Revenue -Cost is wealth creation and is equal to salary+ interest+tax+NI which is wealth distribution
Where are most unicorn companies from?
US 42% and China 39%
Agency problem II in China vs US
US firms very rarely have a controlling shareholder and often it is disclosed if you own more than 5%. In China however the average ownership of controlling shareholders among non-SEOs is 33.4% in 2018
Alibaba example of intangible assets value
Value in partners, credit records, consumption preferences, transaction data, active buyers not assets. All these intangible assets are extremely valuable, but they cannot be reported in the BS because there is not an standard way in accounting to valuate them. Another conundrum relates to depreciation: in accounting, the more frequent an asset is used, the faster it is depreciated; in the new digital economy, the more an asset is used the more value it brings!
Maintain ROE when sales decline
When sales are on decline, to maintain ROE, the company has to change operating model to reduce costs ie Coca-Cola spun off bottling to partners. The "Smile Curve": for a manufacturing company to gain higher profitability, you actually have to move out from fabrication, which has high cost low margin, and go to R&D or to Marketing. This is how theoretically "manufacturing" companies can turn to light-asset companies, such as Coca-Cola did by spunning out all the bottling.
Leverage Change vs. Dividend Change
While both are used to signal managers' view about firm's future earnings prospects, the strength of their effects differs While cutting the dividend is costly for managers in terms of their reputation and the reaction of investors, it is by no means as costly as failing to make debt payments. As a consequence, we would expect dividend changes to be a weaker signal than leverage changes When you increase leverage there will be more interest expense, which is a good signal for not wasting cash. Because of dividend smoothing, if dividend decreases the market will react badly
working capital
Working capital is the capital available for conducting the day-to-day operations of the business and consists of current assets and current liabilities. Net working capital = Current assets - Current liabilities Net operating working capital (NOWC): Current Operating Assets - Current Operating Liabilities = (Cash + Inventory + A/R) - (A/P + Accrued Expenses)
Company Life Cycle stages
startup, rapid expansion, high growth, mature growth, decline
3 most common employment for urban workers in China
state owned unit 29%, private enterprise 25% and self-employed at 19%