Investors should tread cautiously

Investors should tread cautiously
M Allirajan, TNN | Sep 23, 2011, 12.06AM IST

With the markets losing ground steadily, investors should buy equities at regular intervals. Safe havens such as fixed deposits and fixed maturity plans should be tapped only for the short-term. "People tend to be completely one-sided with asset allocation during such (turbulent) times," said Jayant Pai, vice president, Parag Parikh Financial Advisory Services. A one-sided approach, experts say, would spell trouble.

Take for instance gold as an asset class. Too many investors are chasing the metal because of economic uncertainty. The mad chase itself is pushing the prices up to record level, and a steep correction is imminent, said market watchers. "Investors should be cautious. They must not invest lump sum amounts in any asset class," says Anil Rego, CEO, Right Horizons, a wealth management firm.

In the case of bank FDs, investors should lock their money only for 3-6 months. "Choose short-term options and keep rolling them over. Don't lock your funds in three or five year instruments as equity markets would have turned for the better by that time," Pai said.

Fixed return products, such as non-convertible debentures issued by corporate houses, are more risky as in several cases they turn out to be mostly unsecured instruments. It is better to go for instruments issued by top-rated companies, said financial advisers.

While fixed maturity plans (FMPs) are attractive now, they would lose their sheen once the direct taxes code comes into effect, analysts said. Moreover, FMP returns, unlike bank FDs, are only indicative. The good old FDs may offer lower post-tax returns but offer an assured interest income besides ensuring safety of the principal amount.

Though investors would not lose money in debt mutual funds (MFs), they should also understand that products linked to NAV (net asset value) are not completely safe, say experts.

The biggest challenge is to make investors understand that they need to actually increase their overall exposure to equities during such turbulent market conditions, say advisers. "Investors should be buying more equity-related products as their proportion in the portfolio keeps coming down in a falling market," said Pai.

A systematic investment plan (SIP) in equity MFs spread over a year would work well, said Rego. Investors can also consider an SIP in income funds, he said. The bottom line is, don't go overboard on any asset class and follow the original asset allocation plan by making necessary adjustments.

http://timesofindia.indiatimes.com/business/india-business/Investors-should-tread-cautiously/articleshow/10083683.cms?prtpage=1

Selected Bursa counters 2 (COASTAL, DLady, GENM, Latexx, MBB, UMW)

Selected Bursa counters 1 (Guinness, Petdag, PBB, LPI, Nestle)

Hot stock: Crown (Australia): The odds are looking pretty good for Crown.

Hot stock: Crown
Greg Fraser
September 21, 2011


The odds are looking pretty good for Crown.

Crown is still the king of Australian casino businesses.

There is a high-stakes game being played out between Crown’s Melbourne and Perth casinos and Echo Entertainment Group’s newly renamed The Star Casino in Sydney.

Echo has spent $960 million on its upgrade but Crown will have spent almost $2.1 billion across its two casinos by the time everything is finished.


Crown has consistently upgraded its properties to avoid the dangerous ‘‘tired’’ tag that can easily sap patronage and earnings.

The company has always produced a nice mixture of gaming and non-gaming earnings that has become the norm for all casino resorts.

But the headlines usually focus on the glamour and mystique of the high rollers, who last year put about $40 billion on Crown’s gaming tables in Australia.

This lucrative business generated $486 million of revenue for Crown last financial year and should continue to contribute earnings growth following the latest incarnation of its private gaming suites.

Crown’s VIP customers come mostly from Asia, where there are an increasing number of fabulous gaming destinations to play, including Singapore and Macau. The latter is already the world’s largest gaming city, eclipsing Las Vegas in recent years.

Fortunately, Crown had the foresight to get an early seat at the Macau table, where it owns a one-third share in the listed Melco Crown Entertainment (MCE). MCE owns a casino licence and two large casinos, plus some options for growth. The Altira Macau is aimed at Asia’s junket players, while the much larger City of Dreams attracts both high rollers and the mostly Chinese mainland visitors now flocking to Macau for the chance to gamble legally.

Crown’s investments across all its properties will taper off after this year so its free cash-flow generation is about to take off. The timing is looking good, with the Macau business now full steam ahead and gaming activity in Australia steady despite the slow economy.

Price

At the current share price, just less than $8, investors are paying for the Australian casinos only and getting the Macau investments free when the whole package is really worth about $11. Crown’s major shareholder, James Packer, has been buying more stock recently and the company itself is conducting a $240 million share buyback.

The odds are looking good on this one.

Greg Fraser is an analyst at Fat Prophets.

Read more: http://www.watoday.com.au/money/investing/hot-stock-crown-20110920-1kj1z.html#ixzz1Yj7YfneJ

More clout for housing costs (CPI versus RPI)

Chris Zappone

September 23, 2011

The role of housing costs in inflation has been cemented in the latest Bureau of Statistics consumer price index assessment. Photo: Erin Jonasson

HOUSING costs will figure larger in official inflation figures to come, after a reweighting of the consumer price index by the Australian Bureau of Statistics.

The bureau yesterday released its latest weighting of average expenditures of households, with the share of housing rising 2.7 percentage points to 22.3 per cent from a 19.53 weighting in the June-quarter 2005 weightings.

''This simply implies that should the cost of compatible new houses fall, then this is more deflationary for headline CPI given the bigger weight,'' said Annette Beacher of TD Securities.

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Ms Beacher cautioned that CPI excludes existing house prices.

Interest rate uncertainty, along with worries about the health of the local and global economy, have cooled activity in the market.

In the ABS reweighting, new homes bought by owner-occupiers rose to a 8.67 per cent share of the basket of goods from 7.87 per cent in the last weighting using June-quarter 2005 prices. The change was due to ''both a price and volume increase'' in new home costs.

''The volume increase was driven by additional new residential construction driven by population growth in the capital cities and an increase in the average size and quality of new dwellings,'' the ABS said.

Rents will also figure larger in the CPI basket of goods, with their weights increasing to 6.71 per cent from 5.22 per cent in the last weighting in 2005.

While falls in the housing market could have a deflationary effect on CPI, said Moody's Economy.com analyst Katrina Ell, ''there could be a moderate upward bias given the greater weighting given to housing which is seeing rent and utility increases''. The share of utilities in the CPI weightings rose from 3.1 per cent in 2005 to 3.61 in the updated figures.

Insurance and financial services as a share of CPI dropped to 5.1 per cent, from 9.31 in June-quarter 2005 prices, as the ABS removed indirect charges related to deposits and loans.

The reweighting comes after the ABS revised the seasonally adjusted methodology on CPI last week, lowering its reading of core inflation to 0.6 per cent in the second quarter from the 0.9 per cent reported in July. The headline inflation figure was a reported 3.6 per cent in the June quarter.

Read more: http://www.smh.com.au/business/more-clout-for-housing-costs-20110922-1kn7k.html#ixzz1Yj3jffsB

What is the US-Europe turmoil's impact on Asia?

Thursday September 22, 2011

What is the US-Europe turmoil's impact on Asia?

Can Asia stand alone and be decoupled from the West?

WHY should Asian stock markets react negatively if America does not create any new jobs? This is the question on everybody's lips, especially those who have argued that Asia can stand alone and Asian growth has decoupled from American growth.

But the news on Sept 5 that most Asian stock market indices dropped appreciably because America did not create jobs in August, must in fact mean that Asia cannot stand alone and is not decoupled from the West. The West can still influence what happens in most Asian economies including Singapore, Malaysia, the Philippines and Thailand because these Asian economies are linked to America and Europe through the real and financial economy.

The real economy in many Asian economies are dependent on and in fact compete for greenfield investments in the form of foreign direct investments (FDI) from America and Europe. They are also dependent on America to absorb the manufactured exports from the multinational corporations (MNCs) operating from Asia. Asian stock markets and bond markets are also open to foreign portfolio investments that are managed by foreign hedge funds.

In fact, it has been said the peaks and troughs of Bursa Malaysia are determined by foreign portfolio investments and the floor of the Bursa Malaysia is maintained by government investments in government-linked companies (GLCs) listed on Bursa Malaysia.

A man looking at a stock quotation board outside a brokerage in Tokyo. The Nikkei 225 index added 0.23% to 8 ,741.16 points yesterday. — Reuters

The foreign ownership of stocks in Bursa Malaysia, for example, is quite high and amounts to about 22%. Recently the bond market in Malaysia got a boost because of the large inflow of foreign portfolio investments into the bond market, including the sukuk bond market.

The Asian banking system is also linked to the West as there are numerous branches of foreign banks in Asia and an increasing number of Asian banks are setting up branches in the West to participate in the financing of trade. The financial links are then kept alive by the banks and the capital markets.

If America does not create jobs then it means that the recovery from the recession is slow and this means that incomes will not grow and hence consumption will not grow in America.

Most of the exports of East Asian countries are destined to the USA and Europe although there has been some growth in exports to China. If American consumption does not grow then the demand for manufactured goods from countries like Malaysia will fall. If this happens investor confidence in the Malaysian economy might turn negative. If American jobs do not grow, then American GDP will not grow and may even fall if the recession gets worse.

It has been found that Asian economies are very sensitive to changes in the GDP of the USA. A study by, for instance, Bank of America (BoA) Merrill Lynch found that if the US GDP declines by 1%, it will have the impact of reducing GDP by 1.7% in Singapore; 0.8% in Malaysia; 0.4% in Thailand, 0.3% in the Philippines and Indonesia. It is clear then that the more an economy is dependent on trade as a percentage of its GDP, the more it is affected by an economic crisis in the USA. The sensitivity of GDP growth to changes in the GDP of the USA is then a function of the trade dependence of the Asian countries. Singapore, for example, is more trade dependent than Indonesia and hence its GDP is more sensitive to movements in the GDP of the USA.

If Asian countries are not able to keep up their export momentum, their incomes will drop and their companies may not generate more profits.

In fact profits might fall and this may lead investors to sell the stocks of the companies negatively affected by the fall in exports. If incomes go down as a result of the drop in external demand then savings will drop and the amount of funds available for margin financing of stocks might fall. Tighter loan conditions or credit conditions may persuade investors to move out of the market and this may cause stock prices and the market index to fall.

So American jobs mean an increase in aggregate demand for manufactured goods from Asia and this translates into increased incomes and increased demand for Asian stocks.

If Asian exports decline then the demand for Asian currencies will decline and this will trigger a depreciation of the local Asian currencies, which will mean that foreign portfolio managers will not be attracted by the prospects of an appreciating local currency.

If the money supply declines as a result of the drop in exports, then interest rates will rise and this will cause the price of stocks and bonds to tumble because there is an inverse relation between asset values and interest rates.

The rate of job creation in a crisis economy such as America, which is linked to the real and financial economies of Asia, has therefore a significant effect on the stock market performance of the dependent Asian economies.

In August, for example, foreign investors sold more than RM3.8bil worth of Malaysian stocks because of the fall in the S&P credit rating of America and the European debt crisis because of the expectation that the external demand for Malaysian exports will decline. As a result, the FTSE Bursa Malaysia KLCI Index fell 6.6% in August.

The writer is a visiting senior research fellow at the Institute of South-East Asian Studies (ISEAS) in Singapore.

Bailout blues: lessons learnt from the GFC

September 21, 2011

Clockwise, from top left ... Martin Conlon, Ian Silk, John Dani, Matthew Sherwood, Laura Menschik and Paul Taylor.

Annette Sampson asks a range of experts what they learnt from the global financial crisis and what their strategies are for coping with the latest volatility.

'If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience.'' - George Bernard Shaw

There's an old Hindu proverb that says, ''No physician is really good until he has killed one or two patients''. OK, so that's a bit extreme. But when it comes to investing, the best lessons are often learnt when things go wrong.

Any fool can look like a genius in a rising market but successful long-term investors are those who pick themselves up again after losing money and invest smarter.

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For most of us, the global financial crisis has provided the biggest investment learning experience of our lifetime. Australian shares fell 55 per cent from their peak, far in excess of the falls in 1987 and the early 2000s. And with widespread fear and markets still swinging from one extreme to another, its fallout continues to wreak havoc.

Money asked a range of experts three big questions:

What did they learn from the GFC?

How did it change their thinking?

How has it affected their approach to the current volatility?

MARTIN CONLON

Head of Australian Equities, Schroders

''[I learnt] that debt and leverage are not paths to prosperity. It doesn't matter whether the entity is a company, government or an individual, expenses cannot exceed income - this revelation is still proving too difficult for most governments to understand. We believe the extended period of easy credit and rising asset prices, largely the result of easy credit, removed focus from genuine productivity gain as being the only real way to create wealth. Bailout packages, expectations that government spending will create jobs and artificially cheap money the world over, are signs that this lesson has not been learnt.

''The other key lesson surrounds complexity. Almost everything about financial markets has become overcomplicated. The importance of simplicity should not be underestimated. We have always had a relatively conservative attitude to financial leverage [but] the GFC has served to reinforce this attitude.

''Financial engineering does not create real value and we are continuing to avoid companies that think otherwise. Our attitude to businesses and the financing of them is to reinforce the simplicity theme. The most important factor in running a business is to invest capital wisely and to generate a reasonable return on it, in cash!

''Volatility, in our eyes, has never had anything to do with risk. Volatility stems from changes in human behaviour, risk aversion and other factors, which have little to do with actual risk. Our objective is to do our best to avoid the noise and panic and try to focus on the underlying dynamics of the businesses we're buying, the sustainability of the cash flows coming from them and how much we're paying for them.''

IAN SILK

Chief executive officer, Australian Super

''The biggest thing [the GFC] taught me is that when there is a big shock in investment markets, it reverberates through all markets and diversification is not an absolute protection. Cash is really the only safe haven in dire markets, where there is a contagion effect in most investment markets. These shocks are rare and normally diversification does provide the intended benefits but when you have isolated dramatic events like the GFC, it provides limited benefits.

''[The GFC] hasn't changed our approach to diversification because you can't manage money thinking there will be a GFC all the time. You'd have all your money parked in cash all the time.

''What it has done, hopefully for everybody, is to provide a word of caution of how easy it is to lose money and for value destruction to occur. So there's a greater level of vigilance and concern for the downside. You could seek the security of cash all the time but that has its own longer-term costs in terms of returns.

''There is a greater awareness of how much money was lost during the GFC and how investment markets are fickle and volatile beasts but sometimes you have to overcome that caution to achieve the best long-term outcomes. There are people who predicted the GFC and some predicted it for years before it happened. They didn't perform in the preceding years and haven't generated the returns they could have.

''[The lessons from the GFC] aren't impacting terribly much on how we're handling the current environment. We're likely to experience volatile markets for some time and we're directing our cash flow into cash but holding on to the bulk of our other assets. We're not in the business of wholesale selling. Our caution is dictated more by the current environment than what happened in the GFC.

''Our reluctance to invest at the moment is more to do with the medium-term outlook for investment markets. But the GFC was only three years ago and if it's not still imprinted on people's minds, something is wrong.''

JOHN DANI

National manager advice development, ipac securities

''What I learnt is the extent to which our emotions are intimately linked to money. I had never witnessed such an emotional impact before. We've seen downturns but the GFC really revealed how much falls in wealth and large market swings can cause anxiety and feelings of utter helplessness. It leads to things like paralysis and anger, which in turn led to decisions being made based on fear and greed.

''Even though people may have had a rational understanding in the depths of the GFC that things had become crazy and there would eventually be a recovery of some description, the emotion was so great it totally overwhelmed that rational decision-making, resulting in total paralysis or just capitulating to what was happening.

''It doesn't so much change my attitude as to reinforce the importance of cash-based investments and reliable income-generating assets, particularly for people nearing or in retirement. There's a need for investors to be more proactive in how they prepare their portfolio so that it is more resilient as they near retirement. The days when you had your money in a growth portfolio and, six months before retirement, decided to review it or see a financial planner, are gone. You need to start building in protections at least five years before retirement.

''The big thing that has changed at ipac is that we're using technology much better to keep clients informed. What the GFC showed us was the need to cut through the noise and give people the information they're yearning for in times of volatility. For me, personally, there are things that stand out. One is that need to be proactive early on when looking to retirement. The other, given my age and the fact that I'm still in the accumulation phase, is that, if anything, the GFC has strengthened my own resilience. Despite all the doom and gloom, things did bounce back. It wasn't without some pain but, for me, it has provided a bit more courage to act and not be paralysed when things go wrong and to participate in the market a bit more. It's not about being flippant or super-aggressive but, even during the current volatility, the GFC experience can provide the strength to maintain a medium- to longer-term view.''

PAUL TAYLOR

Portfolio manager, Fidelity Australian Equities Fund

''The big lesson for me was the need to focus on balance sheets. Equity analysts tend to focus on the profit-and-loss statement while fixed-interest analysts focus on the balance sheet but during the GFC, the balance sheet was the only thing that mattered. The profit-and-loss means nothing if a company has too much debt, so you need to be on top of both. Companies that had low debt levels and were well structured benefited in two ways during the GFC. Trying to raise capital was very difficult during that period but they didn't have to worry about it and they were also in a position to invest.

''The other lesson was the importance of liquidity, as it can dry up very quickly and if you need to raise cash you can get caught, especially in mid- and smaller-cap stocks.

''[The GFC] hasn't overly changed my thinking, as Fidelity has always focused on these things anyway. But at times like the GFC you realise, 'OK, now I understand completely why we do this stuff'. It is when it pays off.

''There are a few things [I learnt] from the GFC that come back dealing with the current volatility. One, of getting advice from people who have been around for a very long time and making sure you're not looking at the screens continually. You can get caught up in market noise and psychology. When things are volatile, it's often better to get away from the screens and go out and talk to companies. You avoid getting caught up in the emotions of the market. You also need to have the discipline to follow your investment processes day in and day out, whether things are good or bad, and focus on investing long-term rather than trading in and out of stocks.''

LAURA MENSCHIK

Financial planner, WLM Financial Group

''One of the things I learnt is the value of going back to basics in terms of why people are investing, their time-frames, cash flow needs - all the preliminary stuff. Leading into the GFC, most people were comfortable with the strategies they had been following but when something like that happens the comfort levels are suddenly not there. What it taught everyone is what they thought they felt comfortable with could become uncomfortable in changing circumstances.

''You need to go back to the basics of your needs, aspirations, basic investment philosophies and strategies and work from that. Hindsight is a wonderful thing but, in general, income and liquidity are the main things you work with - especially in retirement. What do you need to live on? Do you have emergency money if you can't work? How quickly can you access it?

''There's a much more sober attitude generally now. People are paying down debt and being more responsible. They're more aware and paying more attention [to their finances]. They're probably holding a bit more in cash and fixed interest than before because things have been more volatile.

''We're looking closely at what people have and whether what they have is adding value. If they're in international funds, for example, have the managers been earning their fees? If they're in term deposits or cash, are they still getting a good return on their money? If they're holding shares that have fallen in value, would they be better to sell and put their money in other shares that have better earnings potential rather than hanging on hoping they'll come good? The GFC has emphasised the need for constant review. That doesn't mean you should be reacting to every share price movement but you can't set and forget. There are still opportunities out there but it comes back to discipline. People are much more inclined to stick to strategies like dollar-cost averaging in this market.''

MATTHEW SHERWOOD

Head of investment market research, Perpetual

''I think there were four key lessons to be learnt from the GFC. The first was the importance of balance sheets - never invest in a company without understanding its finances. That is probably the easiest and by far the best form of risk management. In every downturn, the companies with the highest debt and weakest balance sheets fall the farthest.

''The second lesson is the importance of income. In the 25 years to 2008, capital gains were dominant, providing about three-quarters of total returns. It got to the point where it almost seemed as if dividends didn't matter. People forgot that dividends are more reliable and an important risk-management tool. The third lesson was that the quality of an asset is important and that sometimes in bull markets the lowest quality rises the fastest. And the fourth is valuations. Investors never want to pay too much, regardless of how good an investment is. Quality companies don't always make quality investments because valuations can be too high.

''I think investors generally have become a lot less risk tolerant as a result of the GFC. They've probably gone to the other end of the spectrum, where all they want to hold is cash. Perpetual hasn't changed how it picks stocks and still looks at the fundamentals.

''People all want to hold term deposits because they're backed by the government and provide a higher yield but over time, if you're interested in income, the sharemarket provides by far the greatest income growth. Since the oil crisis in 1974, when shares fell by 59 per cent and investors thought the world was going to end because energy prices had quadrupled in six months, Australian shares have produced income growth of 21 times your initial investment. Listed property trusts provided 14 times income growth, cash three times and gold, none. People are nervous about the European outlook and justifiably so but they're making the opposite mistake to the one they made before the GFC. Going into the GFC, the mentality was that share prices were rising and who cared about risk? Now people are highly risk averse. History will prove that one is right - but who knows which one?''

Read more: http://www.smh.com.au/money/investing/bailout-blues-lessons-learnt-from-the-gfc-20110920-1kivj.html#ixzz1YfkScHYI

Making Money On Line

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The Four Big Threats to Your Wealth in 2011 (MoneyWeek Magazine)

UK Housing threat
UK Stock market threat
Drop the Euro before it collapses
The "bond bubble" is about to burst


The fact is we're in unchartered territory ... and it's a very dangerous and unstable situation.

Does a 40% rise in the FTSE and a 9% rebound in property prices over the last 18 months seem right to you?

The way we see it, these aren't healthy markets at all ... they're not even recovering markets ...
...these are grossly inflated markets, pumped up by desperate government intervention.

Will the UK economyh sink into deflation if the Government follows through its pledge to rein in our national debt? ...

... Or, with the Bank of England's furious attempts to keep the ball rolling, is it inflation we have to fear?


So ... what should you do?
Survival Action #1 Buy defensives and "bear market protectors"

Defensive stocks: These kinds of companies don't need economic growth to make money, because people have to spend on their products out of necessity. In short, they're specifically suited to keep your portfolio ticking over in times of upheaval ... and GROW when the market truly recovers.


Survival Action #2 Get the right dividend players into your portfolio now

But since the bust up of 2008, investors have rediscovered the appeal of dividend cheques. This is for three reasons ...

1. Dividends outperform bond yields. According to Bloomberg, by the third quarter of 2010 more U.S. stocks were paying dividends that exceed bond yields than any time in the last 15 years.
2. Dividends can't be fudged - they have to be paid with real money.
3. Dividend-payers are excellent stocks to own in times of unprecedented uncertainty.
Dividends contribute to share price stability. If the share price of a dividend-paying firm falls, it is likely to fall less sharply than a pure growth stock. That's because as the price falls, the yield tends to pick up, encouraging investors to buy back in.


Survival Action #3 Ride gold all the way to $2,230 .. or even more!

... you're talking an eye-popping gold spike to $23,450 per ounce. And during times of confusion, gold often performs better than most other assets. Consider this ... adjusted for inflation, the 1980 gold peak of $850 gives you a price of $2,230 still on the horizon today.

How to Beat Inflation?

What is a dividend yield?

What is EV / EBITDA?

A beginner's guide to P/E ratio

Cash flow 3D

Working Capital Management Principal and Approaches

Valuing Stocks and Bonds

http://www.cosmolearning.com/video-lectures/valuing-stocks-and-bonds-7388/

Finance for Managers - How to value a company? Summary

This chapter has examined the important but difficult subject of business valuation.  It described three approaches:

1.  Asset based:  The first valuation approach is asset-based:  equity book value, adjusted book value, liquidation value, and replacement value.  In general, these methods are easy to calculate and understand, but have notable weaknesses.  Except for replacement and adjusted book methods, they fail to reflect the actual market values of assets; they also fail to recognize the intangible value of an ongoing enterprise, which derives much of its wealth-generating power form human knowledge, skill, and reputation.

2.  Earnings based.  The second valuation approach described is the earnings-based:  P/E method, the EBIT, and EBITDA methods.  The earnings-based approach is generally superior to asset-based methods, but depends on the availability of comparable businesses whose P/E multiples are known.

3.  Cash-flow based.  Finally, the discounted cash flow method, which is based on the concepts of the time value of money.  The DCF method has many advantages, the most important being its future-looking orientation.  This method estimates future cash flows in terms of what a new owner could achieve.  It also recognizes the buyer's cost of capital.  The major weakness of the method is the difficulty inherent in producing reliable estimates of future cash flows.


In the end, these different approaches to valuation are bound to produce different outcomes.  Even the same method applied by two experienced professionals can produce different results.  For this reason, most appraisers use more than one method in approximating the true value of an asset or a business.

Finance for Managers - Discounted Cash Flow Valuation Method

One big problem with the earnings-based methods just described is that they are based on historical performance - what happened last year.  And as the oft-heard saying goes, past performance is no assurance of future results.  If you were making an offer to buy a local small business, chances are that you'd base your offer on its ability to produce profits int he years ahead.   Likewise, if your company were hatching plans to acquire Amalgamated Hat Rack, it would be less interested in what Amalgamated earned int he past than in what it is likely to earn in the future under new management and as an integrated unit of your enterprise.

We can direct out earnings-based valuation toward the future by using a more sophisticated valuation method:  discounted cash flow (DCF).  The DCF valuation method is based on the same time-value-of-money concepts.  DCF determines value by calculating the present value of a business's future cash flows, including its terminal value.  Since those cash flows are available to both equity holders and debt holders, DCF can reflect the value of the enterprise as a whole or can be confined to the cash flows left available to shareholders.

For example, let's apply this method to your own company's valuation.of Amalgamated Hat Rack, using the following steps:

1.  The process should begin with Amalgamated's income statement, from which your company's financial experts would try to identify Amalgamated's current actual cash flow.  They would use EBITDA and make some adjustment for taxes and for changes in working capital.  Necessary capital expenditures, which are not visible on the income statement, reduce cash and must also be subtracted.

2.  Your analysts would then estimate future annual cash flows - a tricky business to be sure.

3.  Next, you would estimate the terminal value.  You can either continue your cash flow estimates for 20 to 30 years (a questionable endeavor), or you can arbitrarily pick a date at which you will sell the business, and then estimate what that sale would net ($4.3 million in year 4 of the analysis that follows).  That net figure after taxes will fall into the final year's cash flow.  Alternatively, you could use the following equation for determining the present value of a perpetual series of equal annual cash flows:

Present value = Cash Flow / Discount Rate

Using the figures in the illustration, we could assume that the final year's cash flow of $600 (thousand) will go on indefinitely (referred to as a perpetuity).  This amount, divided by the discount rate of 12 percent, would give you a present value of $5 million.

4.  Compute the present value of each year's cash flow.

5.  Total the present values to determine the value fo the enterprise as a whole.

We have illustrated these steps in a hypothetical valuation of Amalgamated Hat Rack, using a discount rate of 12 percent (table 10-2).  Our calculated value there is $4,380,100.  (Note that we've estimated that we'd sell the business to a new owner at the end of the fourth year, netting $4.3 million.)

In this illustration, we've conveniently ignored the many details that go into estimating future cash flows, determining the appropriate discount rate (in this case we've used the firm's cost of capital), and the terminal value of the business.  All are beyond the scope of this book - and all would be beyond your responsibility as a non-financial manager.  Such determinations are best left to the experts.  What's important for you is a general understanding of the discount cash flow method and its strength and weaknesses.

Table 10-2
Discounted Cash Flow Analysis of Amalgamated (12 Percent Discount Rate)

               Present Value                  Cash Flows
              (in $1,000, Rounded)       (in $1,000)

Year 1    446.5                               500
Year 2    418.5                               525
Year 3    398.7                               500
Year 4    381.6+2,734.8                 600+4,300

   Total    4,380.1



The strength of the method are numerous:

-  It recognises the time value of future cash flows.
-  It is future oriented, and estimates future cash flows in terms of what the new owner could achieve.
-  It accounts for the buyer's cost of capital.
-  It does not depend on comparisons with similar companies - which are bound to be different in various dimensions (e.g., earnings-based multiples).
-  It is based on real cash flows instead of accounting values.

The weakness of the method is that it assumes that future cash flows, including the terminal value, can be estimated with reasonable accuracy.

Finance for Managers - Earnings-Based Valuation - EBIT Multiple

The reliability of the multiple approach to valuation we have just described depends on the comparability of the firm and firms used as proxies for the company whose value we seek to estimate.  In the preceding Amalgamated example, we relied heavily on the observed earnings multiple of Acme Corporation, a publicly traded company whose business is similar to Amalgamated's.  Unfortunately, these two companies could produce equal operating results yet indicate much different bottom-line profits to their shareholders.  How is this possible?  The answer is twofold:  the manner in which they are financed, and taxes.  If a company is heavily financed with debt, its interest expenses will be large, and those expenses will reduce the total dollars available to the owners at the bottom line.  Likewise, one company's tax bill might be much higher than the other's for some reason that has little to do with its future wealth-producing capabilities.  And taxes reduce bottom-line earnings.

Consider the hypothetical scenario in table 10-a.  Notice that the two companies produce the same earnings before interest and taxes (EBIT).  But because Acme uses more debt and less equity in financing its assets, its interest expense is much higher ($350,000 versus $110,000).  This dramatically reduces its earnings before income taxes relative to Amalgamated.  Even after each pays out an equal percentage in income taxes, Acme ends up with substantially less bottom-line earnings.

This earnings variation between two otherwise comparable enterprises would produce different equity values for the two, and would have to be reconciled by adding in the liabilities for each company.  The problem can be circumvented, however, by using EBIT instead of bottom-line earnings in our valuation process.  Some practitioners go one step further and use the EBITDA multiple. EBITDA is EBIT plus depreciation and amortization.   Depreciation and amortization are noncash charges against bottom-line earnings - accounting allocations that tend to create differences between otherwise similar firms.  By using EBITDA in the valuation equation, this potential distortion is avoided.

Table 10-a

Hypothetical Income Statements of Amalgamated Hat Rack and Acme Corporation

                                                         Amalgamated     Acme
Earnings before Interest and Taxes      $757,500        $757,500
Less:  Interest Expenses                      $110,000        $350,000
  Earnings before Income Tax              $647,500        $407,500
Less:  Income Tax                               $300,000       $187,000
  Net Income                                       $347,500       $220,500

Finance for Managers - Earnings-Based Valuation - Earnings Multiple (2)

We calculate the multiple from comparable publicly traded companies as follows:

Multiple = Share Price / Current Earnings

Thus, if XYZ Corporation's shares are trading at $50 per share and its current earnings are $5 per share, then the multiple is 10.  In stock market parlance, we'd say that XYZ is trading at ten times earnings.

We can use this multiple approach to pricing the equity of a non-public corporation if we can find one or more similar enterprises with known price-earnings multiples.  This is a challenge, since no two enterprises are exactly alike.  The uniqueness of every business is why valuation experts recognize their work as part science and part art.  To examine this method further, let's return to our example firm.

Since Amalgamated Hat Rack is a closely held firm, we have no readily available benchmark for valuing its shares.  But let's suppose that we were successful in identifying a publicly traded company (or, even better, several companies) similar to Amalgamated in most respects - both as to industry and as to size.  We'll call one of these firms Acme Corporation.  And let's suppose that Acme's P/E ratio is 8.  Let's also suppose that our crack researchers have discovered that another company, this one private, was recently acquired by a major office-furniture maker at roughly the same multiple 8.  This gives us confidence that our multiple of 8 is in the ballpark.  With this information, let's revisit Amalgamate's income statement presented in chapter 1 (table 1-2) to find its net income (earnings) of $347,000.

Plugging the relevant numbers into the following formula, we estimate Amalgamated's value:

Earnings x Appropriate Multiple = Equity Value

$347,500 x 8 = $2,780,000

Remember that this is the value of the company's equity.  To find the total "enterprise" value of Amalgamated, we must add int he total of its interest-bearing liabilities.  Table 1.1 shows that the company's interest-bearing liabilities (short term and long-term debt) for 2002 are $1,185,000.  Thus, the value of the entire enterprise is as follows:

Enterprise Value = Equity Value + Value of Interest-Bearing Debt

$3,965,000 = $2,780,000 + $1,185,000

The effectiveness of the multiple approach to valuation depends in part on the reliability of the earnings figure.  The most recent earnings might, for example, be unnaturally depressed by a onetime write-off of obsolete inventory, or pumped up by the sale of a subsidiary company.  for this reason, it is essential that you factor out random and nonrecurring items.  Likewise, you should review expenses to determine that they are normal - neither extraordinarily high nor extraordinarily low.  For example, inordinately low maintenance and repair charges over a period of time would pump up near-term earnings but result in extraordinary expenses int he future for deferred maintenance.  Similarly, nonrecurring, "windfall" sales can also distort the earnings picture.

In small, closely held companies, you need to pay particular attention to the salaries of the owner-managers and the members of their families.  If these salaries have been unreasonably high or low, an adjustment of earnings is required.  You should also assess the depreciation rates to determine their validity and, if necessary, to make appropriate adjustments to reported earnings.  And while you're at it, take a hard look at the taxes that have reduced bottom-line profits.  The amount of federal and state income taxes paid in the past may influence future earnings, because of carryover and carryback provisions in the tax laws.

Finance for Managers - Earnings-Based Valuation - Earnings Multiple

For a publicly traded company, the current share price multiplied by the number of outstanding shares indicates the market value of the company's equity.  Add in the value of the company's debt, and you have the total value of the enterprise.  Think of it this way:  The total value of a company is the equity of the owners plus any outstanding debt.  Why add in the debt?  Consider your own home.  When you go to sell your house, you don't set the price at the level of your equity in the property.  Its value is the total of the outstanding debt and your equity interest.  Likewise, the value of a company is shareholder's equity plus the liabilities.  This is often referred to as the enterprise value.

For a public company whose shares are priced by the market every business day, pricing the equity is straightforward.  But what about the closely held corporation, whose share price is generally unknown, since such a firm does not trade in a public market?  We can reach a value estimate by using the known price-earnings multiple (often called the P/E ratio) of similar enterprises that are publicly traded.  The price-earnings approach to share value begins with this formula:

Share Price = Current Earnings x Multiple

Finance for Managers - Earnings-Based Valuation

Another approach to valuing a company is to capitalize its earnings.  This involves multiplying one or another income statement earnings figure by some multiple.  Some earnings-based methods are more sophisticated than others.  There is also the question of which earnings figure and which multiple to use.  

Finance for Managers: Asset-Based Valuations - Replacement Value

Some people use replacement value to obtain a rough estimate of value.  This method simply estimates the cost of reproducing the business's assets.  Of course, a buyer may not want to replicate all the assets included in the sale price of a company.  In this case, the replacement value represents more than the value that the buyer would place on the company.

The various asset-based valuation approaches described here generally share some strengths and weaknesses.  On the up side, the approaches are easy and inexpensive to calculate.  They are also easy to understand.  On the down side, both equity book value and liquidation value fail to reflect the actual market value of assets.  And all  approaches fail to recognize the intangible value of an ongoing enterprise, which derives much of its wealth-generating power from human knowledge, skill, and reputation. 

Finance for Managers: Asset-Based Valuations - Liquidation Value

Liquidation value is similar to adjusted book value.  It attempts to restate balance-sheet values in terms of the net cash that would be realized if assets were disposed off in a quick sale and all liabilities of the company were paid off or otherwise settled.  This approach recognizes that many assets, especially inventory and fixed assets, usually do not fetch as much as they would if the sale were made more deliberately.  

Finance for Managers: Asset-Based Valuations - Adjusted Book Value

The weakness of the quick-and-dirty equity-book-value approach have led some to adopt adjusted book value, which attempts to restate the value of balance-sheet assets to realistic market levels.  Consider the influence of adjusted book value in a leveraged buyout of a major retail store chain in the 1990s.  At the time of the analysis, the store chain had an equity book value of $1.3 billion.  Once its inventory and property assets were adjusted to their appraised values, however, the enterprise's value leaped to $2.2 billion - an increase of 69 percent.

When adjusting asset values, it is particularly important to determine the real value of any listed intangibles, such as goodwill and patents.  In most cases, goodwill is an accounting fiction created when one company buys another at a premium to book value - that is, at a price higher than book value.  The premium must be put on the balance sheet as goodwill.  But to a potential buyer, the intangible asset may have no value.

Finance for Managers: Asset-Based Valuations - Equity Book Value

One way to value an enterprise is to determine the value of its assets.  Here are four approaches to asset-based valuations:

1.  Equity book value,
2.  Adjusted book value,
3.  Liquidation value, and,
4.  Replacement value.


Equity Book Value

Equity book value is the simplest valuation approach and uses the balance sheet as its primary source of information.  Here's the formula:

Equity Book Value = Total Assets - Total Liabilities

Example:  Amalgamated Hat Rack
Total assets $3,635,000
Total liabilities $1,750,000

Equity book value = Total Assets - Total Liabilities = $1,885,000

In other words, reduce the balance sheet (or book) value of the business's assets by the amount of its debts and other financial obligations, and you have its equity value.

This equity-book-value approach is easy and quick.  And it is not uncommon to hear executives in a particular industry roughly calculating their company's value in the context of equity book value.

For example, one owner might contend that his or her company is worth at least book value in a sale because that was the amount that he or she had invested in the business.   But equity book value is not a reliable guide for businesses in many industries.  The reason is that assets are placed on the balance sheet at their historical costs, which may not be their value today.  The value of balance0sheet assess may be unrealistic for other reasons as well.  Consider Amalgamated assets:

-  Accounts receivable could be suspect if many accounts are uncollectible.
-  Inventory reflects historic cost, but inventory may be worthless or less valuable than its stated balance-sheet value (or "book" value) because of spoilage or obsolescence.  Some inventory may be undervalued.
- Property, plant, and equipment net of depreciation should also be closely examined - particularly land.  If Amalgamated's property was put on the books in 1975 - and if it happens to be in the heart of Silicon Valley - then its real market value may be ten or twenty times the 1975 figure.

The preceding are just a few examples.  For many reasons, however, book value is not always true market value.

Finance for Managers: What is its value?

Whether you are buying or selling a global corporation, an operating division, a local restaurant, or a share of stock, the question, "What is its value?" outweighs most others, and for good reason.  The rate of return from a good company or a good stock is likely to be disappointing if purchased at too high of a price.  Likewise, underestimating the value of an entity in a sales transaction can leave plenty of the owners' money on the table.

Valuing an ongoing business - large or small - is neither easy nor exact.  The field of finance, however, has developed methods for getting close to the value.  This post will introduce you to several methods.

But before we get started, consider several cautions.  The true value of a business is never knowable with certainty.  We may seek it, but we can never be sure that we have found the true value of the business.  This lack of certainty is the result of two problems.

1.  Alternative valuation methods consistently fail to produce the same outcome, even when meticulously calculated.

2.  The product of valuation methods is only as good as the data and the estimates we bring to them, and these are often incomplete or unreliable.  For example, one method depends heavily on estimates of future cash flows.    In the very best cases, those estimates will only be close.  In the worst cases, they will be far from the mark.

Another consideration is that a company is worth different amounts to different parties.  Different prospective buyers are likely to assign different values to the same set of assets.

The acquisition of a small, high-tech company, for example, might provide an acquirer with the technology it needs to leverage its other operations.  This explains, in part, why so many firms are bought out for more than the market value of their existing share.

It is also important to keep in mind that valuation is the province of specialists.  Small and closely held businesses typically turn to professional appraisers when their value must be established for purpose of the entity's sale, to determine the value of its shares when an employee stock ownership trust is used, or for some other purpose.  When large, public firms or their business units are the subject of a valuation, executives generally turn to a variety of full-service accounting, investment banking, or consulting firms.  Many of these vendors have departments devoted entirely to mergers and acquisitions, in which valuation issues are a central focus.  Nevertheless, a well-rounded manager should understand the nature of different valuation methods - and their strengths and weaknesses.

Valuation problems often arise in the context of closely held businesses - that is, businesses with only a few owners - or in the sale of an operating unit of a public company.  In neither case are there publicly traded ownership shares.  Public markets for ownership, such as NASDAQ or the New York Stock Exchange, make value more transparent.  Everyday buying and selling in these markets establishes a company's per-share price.  And that price, multiplied by the number of outstanding shares, often provides a basis for a fair approximation of company value at a point in time.