Mergers and Acquisitions: Which banks are next?

Saturday, 10 June 2017

BY YVONNE TANandGURMEET KAUR

After the RHB-AMMB proposed merger, talk of more M&As in the sector has resurfaced

WITH the ongoing merger talks between RHB Bank Bhd and AMMB Holdings Bhd, coupled with Bank Negara’s push for the institutionalisation of banks, the question of which banks will be the next merger and acquisitions (M&A) candidates has resurfaced.

Going by their size as the smallest banks in the country, could Alliance Bank Malaysia Bhd and Affin Bank Bhd be next?

This is the question that is making the rounds in banking circles.

According to banking analysts, there is a possibility of Alliance merging with Affin as they are very small banks.

“They will eventually feel the pressure to merge, given the market forces,” says one analyst.

Also, Affin is controlled by the Armed Forces Fund Board (LTAT), which is known to want to cast its net wider in the banking field.

“Additionally, Affin’s recent financial results demonstrate that its transformation plan is working out, while Alliance is a well-managed outfit and is doing well in its niche segment of small and medium enterprises. It makes sense for both entities to merge,” he adds.

However, recall, three years ago, Affin’s parent Affin Holdings Bhd had acquired Hwang-DBS Investment Bhd for RM1.36bil, edging out AMMB Holdings from the deal.

While the acquisition has given Affin a platform to carve its own niche with a stronger market presence in investment banking, some reckon that the return on the investment is still at the low end.

Then, there is the factor of Bank of East Asia Ltd (BEA), which is Affin’s second-largest shareholder with a 23.5% block.

image: http://www.thestar.com.my/business/business-news/2017/06/10/which-banks-are-next/~/media/26a0e83e176048c7b2fc9ddedab03cf2.ashx?h=305&w=500

 

Any M&A involving Affin would have to get the nod from the Hong Kong-listed BEA, where tycoon Tan Sri Quek Leng Chan has a strategic 14% stake.

In Alliance’s case, there were some changes in the shareholding structure of Alliance Financial Group Bhd (AFG)last year – the bank’s parent company – which suggested that there could be M&A-related developments for the bank.

Recall that last year, three individuals – financial corporate adviser Seow Lun Hoo, Singapore property tycoon Ong Beng Seng and one Ong Tiong Sin, who owns Singapore-based private equity firm RRJ Capital, had bought into Langkah Bahagia Sdn Bhd from Lutfiah Ismail, an associate of former finance minister Tun Daim Zainuddin.

The trio purchased the entire equity interest in Langkah Bahagia, which previously owned a 51% stake in Vertical Theme Sdn Bhd, the single largest shareholder in AFG with a 29.5% stake.

The remaining 49% stake in Vertical Theme is controlled by Duxton Investments Pte Ltd, which, in turn, is owned by Temasek Holdings Pte Ltd, Singapore’s sovereign wealth fund.

Via Vertical Theme, Temasek effectively has a 14.2% indirect stake in the financial group and thought to have management control of AFG.

It is to be noted that yesterday, Bank Negara approved AFG’s earlier proposed reorganisation, which included Alliance Bank taking over the listing status of AFG.

Meanwhile, industry observers reckon that the three individuals, who are well-known in corporate circles, are parties friendly to Temasek.

Beng Seng, who owns the Four Seasons and Hilton hotels in Singapore had previously joined hands with Temasek to buy up properties in London.

Nevertheless, owning stakes in banks has become all the more challenging, given that financial institutions are making frequent capital calls to boost their capital needs in order to meet international regulatory standards.

image: http://www.thestar.com.my/business/business-news/2017/06/10/which-banks-are-next/~/media/3227d904947e49678e6af34ad66a8a56.ashx?h=516&w=500

 

Capital-raising exercises are always an issue, especially for individuals. In this respect, the view is that because three individuals hold strategic stakes in AFG, it is ripe for a merger.

And a good fit could be Affin, which is small but has a strong institutional shareholder in LTAT.

“Whether this pans out is left to be seen. Because of the RHB-AMMB merger, all possible match-ups are coming up again,” says an investment banker.

There are eight local banking groups in Malaysia, namely, Malayan Banking Bhd (Maybank), CIMB Group Holdings Bhd, Public Bank Bhd, Hong Leong Bank Bhd (HLB), RHB Bank Bhd, AmBank Group, Affin Holdings and Alliance Bank Bhd.

Of the groups, Maybank, thanks to its strong capital levels due to its recent dividend reinvestment plan, has the financial war chest to initiate an M&A.

Public Bank and HLB remain the only two that have yet to court or be courted in recent times. In the case of Public Bank, its high valuations make it difficult for it to be swallowed up. Based on its last traded price of RM20.38 per share, Public Bank is trading at a massive 2.29 times price-to-book.

“It’s going to be difficult for any one bank to swallow Public Bank at its current valuations. One scenario could be to break down the units within the bank just like what happened between Affin and Hwang-DBS and sell these one by one.”

However, given its financial strength, Public Bank is likely to be the predator rather than the prey.

As for HLB, it last courted and bought EON Bank for RM5.1bil in 2010 after a long shareholder battle, valuing the deal at 1.4 times price-to-book.

Move to institutionalise

It is no secret that Bank Negara, especially in recent years, has sought to limit the ownership of individuals in local banks.

“As banks become bigger, there would be greater demand for capital that may not be met by individual owners... institutionalising the shareholdings of banks is seen as the right way to go, as is the case of mature markets like Singapore and Hong Kong,” says a banker.

Under Bank Negara’s Securities Industry (Reporting of Substantial Shareholding) Regulation 1998, individuals are not allowed to own more than a 10% stake each in a financial institution.In the case that happens, they are required to get approval from the central bank.

However, there is an exception or what is termed as the “grandfather rule” in the banking sector.

This is the unwritten rule that was first applied to the three seasoned bankers of Malaysia – Tan Sri Azman Hashim of AMMB Holdings, Quek of Hong Leong Financial Group Bhd and Public Bank’s Tan Sri Teh Hong Piow.

The individuals are allowed to hold more than a 10% stake in a bank, as their personal stakes in the respective banks were acquired before the Banking and Financial Institution Act 1989 or Bafia – the Financial Services Act 2013’s predecessor – was implemented in 1989.

In the case of the RHB-AMMB merger, if it materialises, analysts believe that Azman’s current 12.97% stake in AMMB will be diluted to about 6% in the enlarged entity, assuming he stays on as a shareholder.

Meanwhile, in terms of domestic institutions owning stakes in local banks, the Employees Provident Fund currently has a large stake of 40.7% in RHB Bank and is a substantial shareholder in all the other banks in Malaysia.

Permodalan Nasional Bhd, the country’s largest fund manager, is a controlling shareholder in Maybank with 48%, while LTAT owns a 35.4% direct stake in Affin Holdings.

Notably, Affin Holdings is working on a restructuring plan to transfer its listing status to Affin Bank.

In terms of the Islamic banks, pilgrim fund Lembaga Tabung Haji controls 52.5% of BIMB Holdings Bhd, which owns Bank Islam (M) Bhd.

Other government-linked investment funds, including the Retirement Fund Inc or KWAP, also have a presence in local banks.

Valuation issues

It is unlikely that banking mergers will take place at historical valuations of the past.

In a recent note to clients, CIMB Research says it believes that the price-to-book value for future banking M&As will be significantly lower than the historical average, given the decline in banks’ return on equity ratios arising from higher capital requirements under new financial regulations and thinning net interest margins.

Under the RHB-AMMB merger, RHB has proposed an all-share deal in order to acquire the assets and liabilities of AMMB at a potential pricing based on AMMB’s book value of one time. Gone are the days when banking transactions were done at a book value of more than three times.

The norm is probably closer to 1.4 times book value now. A year ago, most financial institutions here were trading at less than their book values.

Elsewhere in Europe, banks are still trading at less than book values, making Asean banks, which have seen their share prices rise this year, unattractive in terms of valuations.

As Europe’s economy is recovering, it is unlikely that foreigners would fork out hefty premiums for a stake in a bank that is based in the Asean region and which valuations are relatively higher when they can do the same for less in Europe.

Taking this into consideration, the only mergers in the local banking scene, going forward, are likely to be between domestic players. And that is what the central bank would like to see.

The question now is how long will the market have to wait before another merger comes into play. That could reignite an M&A theme in the banking industry – something that the local stock market can very well do with.

Read more at http://www.thestar.com.my/business/business-news/2017/06/10/which-banks-are-next/#RmmWIhuqLMxKcqoD.99

Analysing a company's future performance and estimating its value

Analysing a company's future performance and estimating its value 

• begin with examining historical and current data and 
• then making projections.

Several sets of forecasts or scenarios

Several sets of forecasts or scenarios should be made using different assumptions concerning

• the business environment and 
• the strategy of the firm.

A simple example is where only two or three scenarios are created, example,

• a business-as-usual scenario,
• an aggressive marketing or acquisition scenario, and 
• an operational improvement scenario.

Estimating Value

The value should be estimated using

1. various explicit forecast horizons and
2. different methods.

1.  Estimating Value using Various explicit forecast horizons

There are usually two periods to forecast:

• the explicit forecast period and 
• the period after that in which the challenge is to estimate the continuing value for that period.

2.  Estimating Value using Different methods

There is also the choice of using these methods for estimating value:

• the free cash flow (FCF) method and 
• the economic-profit method.

Both methods should be used and their results compared.

By estimating value using different explicit forecast horizons and methods,

• the robustness of the model and 
• the consistency of the assumptions can be verified.

Valuation Model should be tested for Validity and Sensitivity to Various Inputs and Economic Forecasts

Once the valuation model is complete, it should be tested for its

• validity, 
• sensitivity to various inputs and 
• sensitivity to various economic forecasts.

(a)  Validity

A model's validity can be questioned if there are mechanical errors or flaws in economic logic.


(b)  Sensitivity to Various Inputs and Economic Forecasts

Understanding how sensitive the valuations are to key input and economic conditions gives a more robust understanding of

• the long-term value drivers for a firm and 
• the potential for large swings in value.

Checks and Balances

Verifying valuation results involves checks and balances to see if the model is technically robust by addressing the following relationships:

• that the balance sheet balances and the correct relationships exist among income, retained earnings, and dividends;
• that the sum of invested capital plus nonoperational assets equals the cumulative sources of financing; and 
• that the change in excess cash and debt line up with the cash flow statement.

A good model will have automatic checks for these relationships.


Economic Consistency

Checking for economic consistency involves seeing if the results reflect appropriate value driver economics; for example, high growth and return should be reflected in value of operations higher than book value.

Check also to see if the patterns of key financial and operating ratios are consistent with economic logic and in general, check to see if the results are plausible.


Sensitivity Analysis

Sensitivity analysis aids in determining the impact of changes of key drivers, and scenario analysis allows for assessing results under a broad set of conditions.

Valuation can be very sensitive to small changes in assumptions, which is why market values fluctuate.

A good guide is to aim for a valuation range of +/- 15%, which is similar to the range used by investment bankers.

Flexibility: The inclusion of flexibility into the analysis is generally more relevant in the valuation of individual businesses and projects.

Net present values (NPVs) calculated from single cash flow projections may be inadequate because they do not take into account the ability to expand or scale back.



Here is a simple example.  

A firm can scale back by eliminating a negative cash flow project after the first period.

There is a 60% probability of $20 per year forever or 40% probability of -$6 per year forever.

The discount rate is 10%.


Without an option to cancel

If the initial cost today is $100, then without an option to cancel, the NPV would be:

-$100 + 0.6 x ($20/0.10) + 0.4 x (-$6/0.10) = -$4


With an option to cancel after the first year

With the option to abandon after the first year, the NPV would be:

-$100 + 0.6 x ($20/0.10) + 0.4 x (-$6/1.10) = $17.82


The value of the option to cancel the project is the difference, or $21.82



Conclusion:

The inclusion of flexibility into the analysis is generally more relevant in the valuation of individual businesses and projects.

The real-option valuation (ROV) and decision tree analysis (DTA) are the two primary methods of valuation.

• Both depend on forecasting based on contingent states of the world.
• Although ROV is often a better methodology to use than DTA, it is not the right approach in every case.

Three common approaches employed in the stock market: Value investing, Growth Investing and Technical Investing

There are essentially 3 types of investing employed in the stock market, namely:

1. value investing
2. growth investing
3. technical investing.

Value investing was taught by Benjamin Graham.

Growth investing was shared by Philip Fisher.

Warren Buffett started off as a strict value investor of Benjamin Graham type.  He has since incorporated a lot of Philip Fisher's teaching into his investing.

In effect, Warren Buffett teaches that value and growth investing are essentially different sides of a same coin.  What is investing if not value investing, that is, buying something for less than its intrinsic value?

Value investing and growth investing are most suited for those with a long term investing horizon.

Most successful long term investors are essentially value investors.

They hold long term portfolios that have compounded in values over a long period of investing.

Technical investing are employed mainly by those with short term focus in their investing.  

The majority of traders in the market are technical "investors".




Additional notes:

Fundamental analysis is both qualitative and quantitative.

In fact, in my practice, qualitative is the more important analysis.

The ability to understand the business ensures that you are investing in a great company within your circle of competence.

Some combine the fundamental with the technical, and feel that they have an edge when doing so.

Personally, technical analysis has played little role in my investing so far.

Corporate Portfolio Strategy. Constructing a portfolio of businesses.

Each firm should manage its portfolio of businesses by determining whether it is the best owner of each business in the portfolio.

• That is, whether it can create the most value from each business it owns.
• If so, then the firm should keep the business.
• If not, the firm should divest the business for a value that exceeds its value to the firm.

It should use the same basic philosophy when considering adding businesses to the portfolio.

Firms that can add the most value to a business usually have one of five advantages:

1. unique links with other businesses within the firm,
2. distinctive skills, 
3. better governance,
4. better insight and foresight, and 
5. an influence on critical stakeholders.

The firm that can offer one or more of these advantages can change over time as the firm, business, or economy changes.

• At the beginning of a business, for example, the founders are the best managers, but this will usually change.
• The needs of the business change as it expands and needs additional capital, a wider variety of management skills, and more connections to other businesses such as buyers and suppliers.
• A typical path of a business begins with the founders and end in a conglomerate corporation.

When constructing a portfolio of businesses, the firm should take five steps:

1. assess the gap between a firm's current value and its as-is-value,
2. identify internal opportunities to improve operations,
3. determine if some businesses in the firm should be divested,
4. identify potential acquisitions or the initiatives to create new growth, and 
5. assess if the company's value can increase from changes in capital structure.

Diversification considerations are not part of the list.

• The purported benefits of diversification are illusive, while the costs are real.
• For instance, diversification can hurt the value of the firm it it lowers the ability of the managers to focus on how to create value for each of the various businesses.

Cross-Border Valuation

U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) have been converging over time.

The valuation of companies and subsidiaries in foreign countries has become easier.

Four issues need to be considered when analyzing foreign companies:

1. making forecasts in foreign and domestic currencies,
2. estimating the cost of capital in a foreign currency
3. incorporating foreign-currency risk in valuations, and 
4. using translated foreign-currency financial statements

For a given company, forecast the cash flows in the most relevant currency.

Use either the spot-rate method or the forward-rate method to convert the value of the cash flows into that of the parent company.

It is important to use consistent monetary assumptions in the process (e.g., concerning inflation and interest rates).

When estimating the cost of capital, use the equity premium from a global portfolio without an adjustment for currency risk.

When translating statements into another currency, there are three choices:

1. the current method, 
2. the temporal method, and,
3. the inflation-adjusted current method.

Using, the current method is the most appropriate approach.

Valuing High Growth Companies

The recommended standard valuation principles apply to high-growth companies too.

There is a difference in the order of the steps of the valuation process and the emphasis on each step.

1.  The analyst should forecast the development of the company's markets and then work backward.

2.  The analyst should create scenarios concerning the market's possible paths of development.

3.  When looking into the future, the analyst should also estimate a point in time at which the company's performance is likely to stabilize and then work backward from that point.

4.  By then, the company will have captured a stable market share; and one part of the forecasting process requires determining the size of the market and the company's share.

5.  Then, the firm must estimate the inputs for return:  operating margins, required capital investments, and ROIC.

6.  Finally, the analyst should develop scenarios and apply to the scenarios a set of probability weights consistent with long-term historical evidence on corporate growth.




########################

Time  ------->

Today ..... Rapid Growth ...... Growth Stabilizes .......

Today .....Growing Market Share .....Stable Market Share

Today..... How big is the market? .... How big is the market and the company's share?


Calculating the return:

1.  What is its total revenue?
2   What are its operating margins?
3.  What are its net operating profit after adjusting for tax?
4.  What are its capital investments?
5.  Calculate its ROIC

Valuing companies in Emerging Markets

Valuation is usually difficult in emerging markets.

There are unique risks and obstacles not present in developed markets.

Additional considerations include

• macroeconomic uncertainty, 
• illiquid capital markets, 
• controls on the flow of capital into and out of the country, 
• less rigorous standards of accounting and 
• disclosure, and high levels of political risk.

To estimate value, three different methods are used:

1. a discounted cash flow (DCF) approach with probability-weighted scenarios that model the risks the business faces,
2. a DCF valuation with a country risk premium built into the cost of capital, and 
3. a valuation based on comparable trading and transaction multiples.

For developed nations, the analyst must:

• develop consistent economic assumptions,
• forecast cash flows, and 
• compute a WACC.

Computing cash flows, however, may require extra work because of accounting differences.

If done correctly, the two DCF methods (1 and 2 above) should give the same estimate of value.

Valuing Banks

There are four complications in the valuation of banks:

1. the latitude managers have with respect to accounting decisions,
2. lack of transparency,
3. the level of leverage, and 
4. the fact that banks are multibusiness companies.

Those businesses include

1. borrowing and lending,
2. underwriting and placement of securities,
3. payment services, 
4. asset management, 
5. proprietary trading, and 
6. brokerage.

DCF on operations approach is not appropriate

In valuing a bank, a discounted cash flow (DCF) on operations approach is not appropriate because interest rates revenue, and costs, are part of operating income.



Equity DCF method is more appropriate

The equity DCF method is more appropriate, and the analyst should triangulate the results with a multiples-based valuation.

The equity approach uses a modified version of the value driver formula in which

• return on equity (ROE) and return on new equity (RONE) replace ROIC and RONIC, and 
• net income replaces NOPLAT:

Current Value at time t = Net Income at time t+1  *  [1 - (g/RONE)] / ke - g

ke = cost of equity


Problems and complications in bank valuations

Problems associated with applying the equity DCF valuation method include

• determining the source of value, 
• the effect of leverage, and 
• the cost of holding equity capital.

Economic spread analysis can help determine the sources of value creation.

Other complications in bank valuations are

• monitoring the yield curve and forward rates, 
• estimating loan loss provisions, 
• approximating the bank's equity risk capital needs, and 
• constructing separate statements for each of the bank's activities.

Valuing Cyclical Companies

A cyclical company is one whose earnings demonstrate a repeating pattern of increases and decreases.

The earnings of such companies fluctuate because of large

• changes in the prices of their products or 
• changes in volume.

Volatile earnings introduce additional complexity into the valuation process, as historical performance must be assessed in the context of the cycle.


The share prices of companies with cyclical earnings tend to be more volatile than those of less cyclical companies.

However their discounted cash flow (DCF) valuations are much more stable.



Why are the share prices of cyclical companies more volatile?

Earnings forecasts may be the reason that the former is more volatile than the latter.

Analysts' projections of the profits of cyclical companies are not very accurate, in that they tend not to forecast the downturns and generally have positive biases.

Analysts may produce biased forecasts for these cyclical firms from fear of retaliation from the managers of the firms they analyse.

The behaviour of the managers may play a role in the cyclicality.

They tend to increase and decrease investments at the same time (i.e., exhibit herd behaviour).

Three explanations for this behaviour are:

• cash is generally more available when prices are high,
• it is easier to get approval from boards of directors for investments when profits are high, and 
• executives get concerned about the possibilities of rivals growing faster than their firms.

An approach for evaluating a cyclical firm

The following steps outline one approach for evaluating a cyclical firm:

• construct and value the normal cycle scenario using information about past cycles;
• construct and value a new trend line scenario based on the recent performance of the company;
• develop the economic rationale for each of the two scenarios, considering factors such as demand growth, companies entering or exiting the industry, and technology changes that will affect the balance of supply and demand; and 
• assign probabilities to the scenarios and calculate their weighted values.

Capital Structure, Dividends and Share Repurchases

There is usually more to lose than to gain when making a decision in this area.

Managers should manage capital structure with the goal of not destroying value as opposed to trying to create value.

There are three components of a company's financial decisions:

1. how much to invest,
2. how much debt to have, and 
3. how much cash to return to shareholders.

Choices concerning capital structure

Managers have many choices concerning capital structure, for example,

1. using equity,
2. straight debt,
3. convertibles and
4. off-balance-sheet financing.

Managers can create value from using tools other than equity and straight debt under only a few conditions.

Even when using more exotic forms of financing like convertibles and preferred stock, fundamentally it is a choice between debt and equity.




Debt and Equity Financial Choices trade-offs

Managers must recognise the many trade-offs to both the firm and investors when choosing between debt and equity financing.

The firm increases risk but saves on taxes by using debt; however, investing in debt rather than equity probably increases the tax liability to investors.

Debt has been shown to impose a discipline on managers and discourage over investment, but it can also lead to business erosion and bankruptcy.

Higher debt increases the conflicts among the stakeholders.




Credit rating is a useful indicator of capital structure health

Most companies choose a capital structure that gives them a credit rating between BBB- and A+, which indicates these are effective ratings and capital structure does not have a large effect on value in most cases.

The capital structure can make a difference for companies at the far end of the coverage spectrum.

Credit ratings

• are a useful summary indicator of capital structure health and 
• are a means of communicating information to shareholders.

The two main determinants of credit ratings are

• size and 
• interest coverage.

Two important coverage ratios are

• the EBITA to interest ratio and 
• the debt to EBITA ratio.

The former is a short-term measure, and the latter is more useful for long-term planning.




Methods to manage capital structure

Managers must weight the benefits of managing capital structure against

• the costs of the choices and 
• the possible signals the choices send to investors.

Methods to manage capital structure include

• changing the dividends, 
• issuing and buying back equity, and
• issuing and paying off debt

When designing a long-term capital structure, the firm should

• project surpluses and deficits, 
• develop a target capital structure, and 
• decide on tactical measures.  

The tactical, short-term tools include

• changing the dividend,
• repurchasing shares, and 
• paying an extraordinary dividend.

Divestitures: Managers should devote as much time to divestitures as they do to acquisitions.

Managers should devote as much time to divestitures as they do to acquisitions.

However, managers tend to delay divesting, which leads to the loss of potential value creation.

Divestments can create value both

• around the time of the announcement and 
• in the long run.

A divestiture creates value because of the "best owner" principle whereby the old owner's culture or expertise is not well suited for the needs of the divested business.

A mature parent company divesting an innovative growth division is the typical example; however, companies ripe for divestiture could be at any stage in their life cycle.




Factors to Consider in Divesting

Considerations in divesting are

• possible losses from synergies and shared assets and systems;
• disentanglement costs, such as legal and advisory fees and fiscal changes;
• stranded costs;
• legal, contractual, and regulatory barriers; and 
• the pricing and liquidity of assets.

The costs from synergy losses, may be subtle, and existing contracts may have to be renegotiated.  

Evidence shows that the level of liquidity of the divested assets plays a role in the amount of value created.



Private or Public Transactions

Divestitures

• can be private transactions, such as trade sales and joint ventures, or 
• they can be public transactions.

Private transactions generally lead to more value creation for the seller.

Public transactions include

• IPOs, 
• carve-outs, 
• spin-offs (demergers), 
• split-offs, and 
• the issuance of a tracking stock.

Public transactions can be beneficial over the long term if the industry is consolidating.

Several types of public transactions often generate negative returns, however, and the divestiture is usually temporary

In the case of carve-outs, for example,

• the market-adjusted long-term performance for carve-out parents and subsidiaries is usually negative, and 
• usually minority carve-outs are eventually fully sold or reacquired.

Alternative Measures of Return on Capital

The primary measure of return on capital is return on invested capital (ROIC).


ROIC = net operating profit less adjusted taxes (NOPLAT) divided by invested capital.

ROIC correctly reflects return on capital in most cases, but special circumstances require alternative measures.



Intangible assets

More specifically, investments in intangible assets are expensed, which can introduce a negative bias in ROIC and lead managers to make incorrect decisions concerning how to create value.




Three issues to focus on handling such complexities

1.   When does ROIC accurately reflect the true economic return on capital?

• When does a more complex measure, such as cash flow return on investment (CFROI) make sense?

2.  How should one deal with investments in R&D and marketing and sales that are expensed when they are incurred?

• Creating pro forma financial statements that capitalize these expenses can provide more insight into the underlying economics of a business.

3.  How should one analyze businesses with very low capital requirements?

• Here it is recommended to use economic profit, or economic profit scaled by revenues, to measure return on capital.

Investments in R&D and other intangibles should be capitalized

Investments in R&D and other intangibles should be capitalized for three reasons:

• to represent historical investment more accurately
• to prevent manipulation of short-term earnings, and 
• to improve performance assessments of long-term investments.

These change only the perceptions of performance, however, and will not change the value of the firm.
Since free cash flow (FCF) includes both operating expenses and investment expenditures, capitalizing an expense will not affect FCF.



The process for capitalizing R&D

The process for capitalizing R&D has three steps:

• build and amortize the R&D asset using an appropriate asset life,
• make the appropriate upward adjustment on invested capital, and,
• make the appropriate upward adjustment on NOPLAT.

These adjustments can be applied to other expenses, such as an expansion of distribution routes.



Drawbacks of such adjustments

A couple of drawbacks of making too many such adjustments are

• the increased ability to manipulate short-term performance and 
• the incentives for managers not to recognize when to write down an asset created from a capitalized expense.

Computing Operating Taxes

In estimating value, the followings need to be determined:

• the portion of taxes due from the operating activities,
• then determine the operating cash taxes, and 
• finally, estimate the value of the corporation recognizing that some taxes are deferred.

The available information on the analyzed firm will be incomplete, therefore, operating cash taxes can only be estimated and the estimates will have errors.

Using either the company's statutory tax rate or the company's effective rate with no adjustments is not appropriate for computing operating taxes.



Adjustments for Computing Operating Taxes

1.  One suitable approach is to compute taxes as if the company were financed entirely with equity.

• To accomplish this task, begin with reported taxes and undo financing and nonoperating items one by one.
• Make estimates based on the tax rates in the various jurisdictions in which the firm operates.  

2.  Estimates of operating taxes actually paid in cash provide a better input for valuation than those estimates that include accruals.

• As part of the estimation process, subtract the increase in net operating deferred tax liabilities from operating taxes.
• Information for this process should be in the tax footnote.
• The reorganized balance sheet needs to properly assign deferred tax assets and deferred tax liabilities.

For each deferred tax account, there are four valuation methodologies:

1. value the account as part of NOPLAT,
2. value the account as part of a corresponding nonoperating asset or liability,
3. value the account as a separate nonoperating asset, and
4. ignore the account as an accounting convention.

Leases, Retirement Obligations and Receivables Accounting

Leases, pension obligations and securitized receivables are like debt obligations.

Accounting rules can allow them to be off-balance-sheet items.

Such items can bias ROIC upward, which makes competitive benchmarking unreliable.

However, valuation may be unaffected.



Operating Leases Accounting

Adjust for operating leases:

• recognize the lease as both an obligation and asset on the balance sheet (which requires an increase in operating income by adding an implicit interest expense to the income statement and lowering operating expenses by the same amount),
• adjust WACC for the new leverage ratios, and 
• value the company based on the new free cash flow and WACC  

Assuming straight-line depreciation, an estimate of a leased asset's value for the balance sheet is:

Asset Value at time t-1 = Rental Expense at time t / [ kd + (1/Life of the Asset)]

kd = cost of debt




Receivables Accounting

(a) When company sells a portion of its receivables

Another source of distortion occurs when a company sells a portion of its receivables.

This reduces accounts receivable on the balance sheet and increases cash flow from operations on the cash flow statement.

Despite the favourable changes in accounting measures, the selling of receivables is very similar to increasing debt because

• the company pays fees for the arrangement,
• it reduces its borrowing capacity, and 
• the firm pays higher interest rates on unsecured debt.

(b) Securitized receivables

In the wake of the financial crisis of 2007, accounting policy has tightened.

Securitized receivables are now classified as secured borrowing.

In these situations, no adjustment is required

In the infrequent cases where securitized receivables are not capitalized on the balance sheet,

• add back the securitized receivables to the balance sheet and 
• make a corresponding increase to short-term debt.

These alterations will determine the necessary changes to return on capital, free cash flow, and leverage.

Interest expense should increase by the fees paid for securitizing receivables.



Pension Accounting

Companies must report excess pension assets and unfunded pension obligations on the balance sheet at their current values, but pension accounting can still greatly distort operating profitability.

Three steps should be taken to incorporate excess pension assets and unfunded pension liabilities into enterprise value and the income statement to eliminate accounting distortions.  

These three steps are:

1. identify excess pension assets and unfunded liabilities on the balance sheet,
2. add excess pension assets to and deduct unfunded pension liabilities from enterprise value, and
3. remove the accounting pension expense from cost of sales and replace it with the service cost and amortization of prior service costs reported in the notes.

Much of the necessary information for this process appears in the company's notes.

Non-operating items, Provisions and Reserves

Strict accounting rules exist for dealing with nonoperating expenses and one-time charges.

For determining value, however, these entries and the financial statements require adjustments.

These entries provide relevant information concerning past performance and future cash flows.



Assessing impact of nonoperating charges

A three-step process can aid in assessing the impact of nonoperating charges:

1. reorganize the income statement into operating and nonoperating items, 
2. search the notes for embedded one-time items, and 
3. analyze each extraordinary item for its impact on future operations.

Noncash expenses usually

• lower an asset or 
• increase a provision account in the liabilities.

In evaluating a business, there are four types of provisions:

1. ongoing operating provisions,
2. long-term operating provisions,
3. non-operating restructuring provisions, and
4. provisions created to smooth income.

Reorganizing the Financial Statements

A proper assessment of financial performance requires reorganizing financial statements to avoid traps like double counting, omitting cash flows, and hiding leverage.



ROIC = NOPLAT / (Invested Capital)

FCF = NOPLAT + Noncash operating expenses - Investments in invested capital.

Invested Capital (for a simplistic firm)
= Operating Assets - Operating Liabilities = Debt + Equity

Total Funds Invested (for a more realistic firm)
= Invested Capital + Nonoperating Assets
= (Operating Assets - Operating Liabilities) + Nonoperating Assets
= (Debt + Equity) + Nonoperating Assets
= (Debt and Debt Equivalents) + (Equity and Equity Equivalents)


(NOPLAT is.Net operating profit less adjusted taxes)



In practice, there are difficulties in categorizing assets as operating or nonoperating and right-hand balance sheet items as debt or equity, and this makes computing the values in these equations difficult.

--------------------------------

Excess Cash

Excess cash should not be included in invested capital because it is not necessary for core operations, and including it will depress ROIC.

Financial subsidiaries

The operations of those subsidiaries require a separate analysis from those of the manufacturing operations, because financial institutions have different capital and leverage norms.

Advanced analytical issues

Advanced analytical issues include 

• operating leases, 
• pensions and other retirement benefits, 
• capitalized research and development, and 
• nonoperating charges and restructuring reserves.

Operating leases:  The implied value of those leased assets that are not capitalized can be estimated.  A more appropriate measure of leverage can be obtained with the following equation:

Asset Value at time t-1 = Rental Expense at time t / [kd + (1/Asset Life)]

Pensions and other retirement benefits:  Like excess cash, excess pension assets and pension shortfalls should not be included in invested capital.

Research and development:  Research and development should be included in invested capital.

Nonoperating charges and restructuring reserves:  Provisions fall into four basic categories:

• ongoing operating provisions,
• long-term operating provisions,
• nonoperating provisions, and,
• income-smoothing provisions.

Each requires an adjustment to return or invested capital or both.

Using Multiples

The use of multiples can increase valuations based on DCF analysis.

There are five requirements for making useful analyses of comparable multiples:

1. value multibusiness companies as a sum of their parts,
2. use forward estimates of earnings,
3. use the right multiple,
4. adjust the multiple for nonoperating items, and,
5. use the right peer group.

1.  Value Multibusinesses companies as a sum of their parts

Multibusiness companies' various lines of business typically have very different growth and ROIC expectations.

These firms should be valued as a sum of their parts.



2,  All Multples should use forward estimates of earnings

All multiples should be forward-looking rather than based on historical data, as valuation of firms is based on expectations of future cash flow generation.


3.  Use the Right Multiples

(a) Value-to-EBITA & P/E Multiples

The right multiple is often the value-to-EBITA ratio.

This measure is superior to the price-to-earnings (P/E) ratio because:

• capital structure affects P/E and 
• nonoperating gains and losses affect earnings.

(b) Alternative Multiples

Alternatives to the value-to-EBITA and P/E multiples include

• the value-to-EBIT ratio, 
• the value-to-EBITDA ratio, 
• the value-to-revenue ratio, 
• the price-to-earnings-growth (PEG) ratio, 
• multiples of invested capital, and 
• multiples of operating metrics.

4.  Adjust the multiples for nonoperating items

All of these ratios should be adjusted for the effects of nonoperating items.



5.  Use the right Peer Group

The peer group is important.

The peer group should consist of companies whose underlying characteristics (such as production methodology, distribution channels, and R&D) lead to similar growth and ROIC characteristics.

From Enterprise Value to Value per Share

Enterprise Value is the value of the entire company.


1.   It equals the sum of value of core operations plus value of nonoperating assets.

Enterprise Value or EV = Value of Core Operations + Value of Nonoperating assets


2.  Subtracting debt, debt equivalents, and hybrid securities, and making other adjustments, provides an estimate of the value of equity.

Value of Equity 
= EV - debt - debt equivalents - hybrid securities - other adjustments
= EV - (debt + debt equivalents + hybrid securities + other adjustments)
= Value of core operations + Value of Nonoperating assets - (Debt + Debt equivalents + hybrid securities + other adjustments).


3.  The value of equity divided by undiluted shares outstanding gives value per share

Value per share = Value of equity / Undiluted shares outstanding




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Non-operating assets

The valuation must carefully evaluate the nonoperating assets, which consist of

• excess cash and marketable securities, 
• nonconsolidated subsidiaries and equity investments, 
• loans to other companies, 
• finance subsidiaries, 
• discontinued operations, 
• excess real estate, 
• tax loss carry forwards, and 
• excess pension assets.

Debts and debt equivalent

Debt and debt equivalents consist of

• debt of all kinds (for example, bonds, bank loans and commercial paper);
• operating leases; 
• securitized receivables; 
• unfunded pension liabilities; 
• contingent liabilities; and
• operating and nonoperating provisions.

Hybrid securities

Hybrid securities consist of

• convertible debt and 
• convertible preferred stock.  

ESOS and noncontrolling interest

Employee stock options and noncontrolling interests require additional adjustments.



############

Example:

A corporation has a 2 million shares outstanding.

Given the following information (all in millions), what is its value per share?

DCF of operations = $320m
Financial subsidiary value = $25m
Bonds = $185m
Discontinued operations = $2m
Securitized receivables = $4m
Operating leases = $6m


Value of Equity 
= EV - debt - debt equivalents - hybrid securities - other adjustments
= EV - (debt + debt equivalents + hybrid securities + other adjustments)
= Value of core operations + Value of Nonoperating assets - (Debt + Debt equivalents + hybrid securities + other adjustments).



Financial subsidiary value & Discontinued operations = Nonoperating assets
Bonds, Securitized receivables & Operating leases = Debt and debt equivalent


Value of Equity
= ($320 )+ ($25 + $2) - ($185 + $4 + $6)
= $150m

Value per Share
= $150 m / 2m shares 
= $75 per share.

Analysing Performance begins with an analysis of the Key Drivers of Value: ROIC and Revenue Growth.

The key drivers of value are:

• ROIC, and
• Revenue Growth.

The analysis of performance and competitive position begins with an analysis of these key drivers of value.

After having done that analysis, then do an assessment of the financial health of the firm to show whether it can make short-term and long-term investments



ROIC

It is useful to analyze ROIC with and without goodwill.


ROIC
= (1- Operating Cash Tax Rate) x (EBITA/Revenues) x (Revenues/Invested Capital)
= (1 - Operating Cash Tax Rate ) x EBITA / Invested Capital
= NOPLAT / Invested Capital



Revenue Growth

Revenue growth is one of the determinants of cash flows.

Organic revenue growth should be distinguished from growth derived from other factors such as currency effects, acquisitions, or divestitures.



-----------------------



Additional Notes:

Financial Ratios

A comprehensive model does a line item analysis, which converts every line in the financial statements into a ratio.

Ratios include common size entries computed in terms of assets or revenues for the balance sheet and income statement, respectively, and also days ratios found by the following general expression:

Days = 365 x (Balance Sheet Item / Revenues)



Efficiency Measures

Other measures provide insights into efficiency relative to other firms

One such expression is a breakdown of labour costs per unit:

Labour Expenses / Units of Output
= (Labour Expenses / Number of Employees) / (Units of Output/Number of Employees)



Power and danger of leverage

The following equation helps illustrate the power and danger of leverage

ROE = ROIC + [ROIC - (1 - T) x kd ] x D/E

T = tax rate
kd = cost of debt

It is important to note how the market debt-to-equity compares to peers in terms of the coverage and the level of risk the firm takes.

Forecasting Performance

Typically, forecasting involves making projections of cash flows to some point where the company has a steady state going forward  



The point when the Steady State going forward is reached

This steady state going forward is characterized by two properties

• the company grows at a constant rate with a constant reinvestment ratio, and 
• the company earns a constant rate of return on existing capital and new capital invested.

The Explicit Forecast Period

The horizon to the steady state, called the explicit forecast period, is usually 10 to 15 years.

This explicit forecast period should be divided into

• a first forecast period of five to seven years, where the statements will include many details,and,
• the remaining years' forecasts where the statements are simpler with less detail, which avoids the error of false precision.

Such forecasts require assumptions concerning a host of variables, including the return earned on invested capital and whether the company can stay competitive.



Steps in the Forecasting Process

There are six steps in the forecasting process.

1. Prepare and analyze historical financial statements and data.
2. Build the revenue forecast consistent with historical economy-wide evidence on growth.
3. Forecast the income statement using the appropriate economic drivers.
4. Forecast the balance sheet entries.
5. Forecast the investor funds into the balance sheet.
6. Calculate ROIC and FCF.

Additional issues include

• determining the effect of inflation,
• nonfinancial drivers, and 
• which costs are fixed and which are variable.

Estimating Continuing Value of a Company

There are two parts to the estimated value of a company based on future cash flows:

1. a portion of the value based on the initial, explicit forecast period, and,
2. a portion of the value based on continuing performance beginning at the end of the explicit forecast period.

Estimated value of a company
= Estimated Operating Value of the initial, explicit forecast period + Continuing Value beginning at the end of the explicit forecast period.


The continuing value (CV) 

• often exceeds half of the total estimated operating value, and 
• when early years have negative cash flows, the continuing value can exceed the total estimated operating value.

Two formulas for estimating continuing value

There are two formulas for estimating continuing value:

• the discounted cash flow (DCF) formula, and
• the economic-profit formula.

Other methods for estimating continuing value exist.

The convergence formula is related to the preceding formulas, for example, and it assumes that excess profits will eventually be competed away.

Some methods do not depend on the time value of money.  Those methods include

• using multiples such as P/E, 
• estimates of liquidation value and 
• estimates of replacement costs.

Valuing by Parts provides greater insights into where and how the company is generating value

Many large companies have multiple business units, each competing in segments with different economic characteristics.

Even pure-play companies often have a wide variety of underlying geographical and category segments.

If the economics of a company's segments are different, you will generate more insights by valuing each segment and adding them up to estimate the value of the entire company.

Trying to value the entire company as a single enterprise will not provide much insight, and the final valuation will likely be noisier than valuing by parts.



Valuing by parts generate better valuation estimates and deeper insights

Consider a single case where a faster-growing segment has lower returns on capital than a slower-growing segment.

If both segments maintain their ROIC, the corporate ROIC would decline as the weights of the different segments change.

Valuing by parts generate better valuation estimates and deeper insights into where and how the company is generating value.

That is why it is standard practice in industry-leading companies and among sophisticated investors.



Steps for valuing a company by its parts

Four critical steps for valuing a company by its parts are:

1. understanding the mechanics of and insights from valuing a company by the sum of its parts,
2. building financial statements by business unit - based on incomplete information, if necessary,
3. estimating the weighted average cost of capital by business unit, and 
4. testing the value based on multiples of peers.

To value a company's individual business units, you need income statements, balance sheets, and cash flow statements.

Ideally, these financial statements should approximate what the business units would look like if they were stand-alone companies.

Creating financial statements for business units requires consideration of several issues, including

1. allocating corporate overhead costs,
2. dealing with inter-company transactions,
3. understanding financial subsidiaries, and 
4. navigating incomplete public information.

Inflation

Inflation makes analyzing performance and making comparisons difficult.

Inflation usually impedes the creation of value.

Inflation lowers the value of monetary assets and the firm can rarely pass along the full effects of inflation to customers.

Typically, ROIC does not increase enough to compensate the firm for inflation.

The increase in inflation from the 1960s to the 1970s was accompanied by a decline in P/E ratios.



Periods of High Inflation

During periods of high inflation, the problem becomes much worse.

During periods of high inflation, the following distortions can occur and need to be corrected:

1. overstated growth,
2. overestimated capital turnover,
3. overstated operating margins, and 
4. distorted credit ratios.

When making forecasts in periods of high inflation, adjustments can be make in either nominal or real terms.but consistent financial projections require elements of both nominal and real forecasts.

Five steps for making forecasts in periods of high inflation are:

1. forecast operating performance in real terms,
2. build financial statements in nominal terms,
3. build financial statements in real terms,
4. forecast free cash flow in real and nominal terms, and 
5. estimate discounted cash flow (DCF) value in real and nominal terms.

Estimating the cost of capital

The weighted average cost of capital, WACC is the opportunity cost of choosing to invest in the assets generating the free cash flow (FCF) of that business as opposed to another business of similar risk.

For consistency, the estimate of the WACC should have the following properties:

1. it includes the opportunity cost of all investors,
2. it uses the appropriate market-based weights,
3. it includes related costs/benefits such as the interest tax shield,
4. it is computed after corporate taxes, 
5. it is based on the same expectations of inflation as used in the FCF forecasts, and 
6. the duration of the securities used in estimating the WACC equals the duration of the FCFs.

Given:
D/V = target weight in debt
E/V = target weight in equity
kd = required return of debt as source of capital
ke = required return of equity as source of capital
Tm = marginal tax rate

WACC = D/V * kd (1 - Tm) + E/V * ke



Cost of equity

The capital asset pricing model (CAPM) is a popular way to estimate the cost of equity.

It includes an estimate of

• the risk free rate, 
• beta, and 
• the market risk premium.

Estimated equity risk premium
= risk free rate + Beta x (market risk premium)
= risk free rate + Beta x (market risk - risk free rate)


Note:  there are alternatives to the CAPM such as the Fama-French three factor model and the arbitrage pricing theory.


Cost of debt

The after tax cost of debt requires

• an estimate of the required return on debt capital and 
• an estimate of the tax rate.

Other estimates include the weights in the target capital structure and, when relevant, the effects of debt equivalent and the effects of a complex capital structure

The Alchemy of Stock Market Performance - Total Returns to Shareholders

Total Returns to Shareholders

Decomposing total returns to shareholders (TSR) can give better insights into a company's true performance and in setting new targets.

The traditional method decomposes TRS into three parts:

1. percent change in earnings
2. percent change in P/E, and, 
3. dividend yield.

A clearer picture can be found from breaking TRS into four parts:

1. the value generated from revenue growth net of the capital required to grow
2. the growth in TRS that would have taken place without the measure in (1),
3. changes in shareholder's expectations about the company's performance as reflected in a measure such as P/E, and
4. the effect of leverage.

A good company and a good investment may not be the same.

Example:

Comparing the company and stock performance of Reckitt Benckiser Group (RB) and Henkel from 2008 to 2013

Revenue growth and ROIC:   RB outperformed Henkel in both

Annualised TRS:  RB 19% and Henkel 932%)

Explaination:  Henkel's low starting multiple in 2008 reflected difficulties with its adhesives business, which experienced significant declines in sales volume in 2008 and 2009.




Expectation treadmill

This is the name for a problem faced by high-performing managers who try to meet market expectations that result from the high level of performance in recent periods.

RB above, illustrates the reason that, in the short term, extraordinary managers may deliver only mediocre total returns to shareholders.

Lesson derived (for investors and managers):  A small decline in TRS in the short run to adjust expectations (P/E) may be preferable to desperately trying to maintain TRS through acquisitions and ill-advised ventures.



Summary:

For periods of 10 - 15 years or more, it is true that if managers focus on improving TRS to win performance bonuses, then their interests and the interests of shareholders should be aligned.

The detrimental result of the expectations treadmill is that, for firms that have had superior operating and TRS performance, the managers who try to continually meet the higher expectations may engage in detrimental activities such as ill-advised acquisitions or new ventures.

A company should measure management performance in terms of the company's performance, not its share price.

Three areas of focus should be its performance relative to its peers in its::

• growth,
• ROIC, and 
• TRS,

Conservation of Value and the Role of Risk. Increasing value through reducing the company's risk and its cost of capital.

Cash flow drives a firm's value creation.

Growth and ROIC generate cash flow.



Value creation

Companies create value:

• when they grow at returns on capital greater than their cost of capital or 
• when they increase their returns on capital.

Actions that don't increase cash flows over the long term will NOT create value, regardless of whether they improve earnings or otherwise make financial statements look stronger.

One Exception:  reducing the company's risks or its cost of capital can create firm's value

Actions the company takes to reduce a company's risk and therefore, its cost of capital.

There are different types of risk and it is important to explore how they enter into a company's valuation.

Only risk reductions that reduce a company's nondiversifiable risk will reduce its cost of capital.

How good is the company in creating value for its shareholders? How much value can it create?

The chief measures for judging a company are

• its ability to create value for its shareholders and 
• the amount of total value it creates.

Corporations that create value in the long term tend to increase

• the welfare of shareholders and employees 
• as well as customer satisfaction.

 They tend to behave more responsibly as corporate entities.


Value Creation

Value creation occurs when a company GENERATES CASH FLOWS AT RATES OF RETURN THAT EXCEED THE COST OF CAPITAL.

Accomplishing this goal usually requires that the company have a COMPETITIVE ADVANTAGE.

Strengthening its competitive advantage also creates value in the long run.



Activities that do not create value

Activities such as leverage and accounting changes do not create value.

Frequently, managers shortsightedly emphasise earnings per share (EPS).

• A poll of managers found that most managers would reduce discretionary value-creating activities such as research and development (R&D) in order to meet short-term earnings targets.
• One method to meet earnings targets is to cut costs, which may have short-term benefits but can have long-run detrimental effects.

Fundamental Principles of Firm's Value Creation

Value creation is determined by cash flows.

Cash flows are driven by 

• revenue growth and 
• return on invested capital (ROIC).

For any given level of revenue growth, increasing ROIC increases value.

However, increasing revenue growth does not always increases the firm's value.

• When ROIC is greater than the cost of capital, increasing growth increases the value of the firm.
• When the ROIC is less than the cost of capital, increasing growth decreases the firm's value.
• When ROIC equals the cost of capital, growth does not affect a firm's value.

The Stock Market is Smarter than We Think

The only 2 drivers of value creation are:

1. Return on Invested Capital (ROIC) 
2. Growth

Return on invested capital (ROIC) and growth are the only drivers of value creation.



Activities that do not drive value creation

Managers often spend time and resources attempting to:

• smooth earnings, 
• meet earnings targets,
• stay listed in a stock index,  
• become cross-listed,
• change the accounting rules, and 
• do stock splits.

The evidence shows that the stock market does not reward these efforts.  

Changes in accounting rules and stock splits do not have lasting effects.

ALL the above issues do not have an effect on stock returns unless they reflect a change in fundamental value.

Listing and delisting from an index and cross-listing

Listing and delisting from an index do not seem to have long-term effects for any given firm.

Although there can be a negative effect initially from delisting, the effect usually reverses in a few months.

Furthermore, cross-listing within developed markets does not have an effect; however firms in emerging markets may benefit from cross-listing in a developed market.



Accounting Changes

Investors apparently see through accounting changes.

If investors focused on earnings, for example, a move from FIFO to LIFO would lower the share price, but it generally does the opposite because of the increase in cash flows.

Another example, mere changes in goodwill do not affect share price; however, a change in goodwill that is associated with a real change in the firm produces a reaction from sophisticated investors.




Mispricing in the Market

Two possible sources of mispricings are:

1. the combinations of overreaction, underreaction, reversal and momentum, and
2. bubbles and bursts.

Unrealistic expectations of continued growth, which led to excessively high P/E ratios, caused the tech bubble in the late 1990s.

High earnings that were not sustainable caused the credit bubble a decade later.  In this case, it was not that the P/E ratios were too high, but that the earnings in the ratio eventually had to fall.

The basic source of value creation is competitive advantage. A High ROIC is the result of a Competitive Advantage.

A High ROIC is the result of a Competitive Advantage


The basic source of value creation is competitive advantage.

A high ROIC is the result of a competitive advantage from

• being able to charge a higher price or 
• being able to produce at a lower cost.

A strategy model for competitive advantage (Porter's framework)

A structure-conduct-performance framework provides a strategy model for competitive advantage.

One of the most widely used approaches in analyzing strategy is Porter's framework, which focuses on

• threat of entry,
• pressure from substitute products,
• bargaining power of buyers,
• bargaining power of suppliers, and,
• the degree of rivalry among existing competitors.

These forces differ widely by industry.



Five pricing advantages and Four cost advantages

Five pricing advantages and four cost advantages determine overall competitive advantage.

The five pricing advantages are:

• innovative products,
• quality,
• brand,
• customer lock-in, and,
• rational price discipline.

The four cost advantages are

• innovative business methods, 
• unique resources,
• economies of scale, and,
• scalable products/processes.

Pricing and cost advantages can erode through competition

In a competitive economy, the pricing and cost advantages can erode through competition.

The sustainability of the high ROIC from a competitive advantage depends on issues such as

• the length of the life cycle of the business and 
• the potential for renewing products.

Relative ROIC of a firm is fairly sustainable for periods of 10 years or more.

The evidence shows that the relative ROIC of a firm to the average of all other firms and to the firms in the industry remains fairly sustainable for periods of 10 years or more; however, there will be some reversion to the median and/or mean.




Additional Notes:


ROIC

=   NOPLAT / Invested Capital

= {(1- Tax Rate) * [Price per Unit - Cost per Unit]}/Invested Capital per Unit


NOPLAT = Net Operating Profit less Adjusted Tax

This formula explains how a higher ROIC is the result of a competitive advantage from being able to charge a higher price or being able to produce at a lower cost.

Growth

The two sources of organic growth are:

1. increase in the size of the market, and 
2. increasing market share.

The drivers of growth of business, in order of size, from largest to smallest, are:

1. Market growth
2. Mergers and acquisitions
3. Market share growth

Incremental Innovation and Growth

Incremental innovation will rarely create lasting value, because competitors can easily retaliate.

Competitors can either

• lower the prices on their existing products, or,
• if the innovator raises the price of the improved product, keep their prices the same.

Also, the rivals can also come up with their own incremental innovations, which is easier than coming up with a new product or service.



Product Development and Growth

With respect to product development, growth is difficult to maintain because for each product that is maturing and reaching its peak in revenue, the company must develop a new product that will grow faster to replace it.

This is called the portfolio treadmill effect.




Why have publicly traded firms grown at a higher rate than GDP?

The two reasons for this are:

1. Publicly traded firms can grow faster because of their ease in raising capital, so their growth can be higher than the overall economy at the expense of nonpublic firms.
2. Public firms have experienced higher growth from expanding sales to overseas markets, and expanding markets and bringing in new consumers are the most effective means of growing and creating value.

Better Investor Communications

Managers should communicate with investors to help align the value of the stock with the intrinsic value of the company.

Negative consequences of an underpriced stocks

If the stock is underpriced, a few of the negative consequence are that:

• employees may be demoralized, 
• the stock is less useful in stock acquisitions, and 
• the firm may become a takeover target.

Negative consequences of an overpriced stocks

If the stock is overpriced, the price will eventually fall, which will lead to:

• a fall in employee morale and 
• increased tension between the board of directors and the managers.
• Also, once the stock is overpriced, managers may engage in value-destroying activities in an attempt to prop up the stock price.

How can companies improve investor communications?

Three ways many companies can improve investor communications are to:

1. monitor the gap between price and intrinsic value,
2. understand the investor base, and 
3. tailor communications to the investors who matter most.

In general, the managers should try to communicate with sophisticated intrinsic investors because the activities of these investors have the most impact on the price of the stock.

Managers should be honest and not use gimmicks such as changing the metrics reported each period to give the most favourable numbers.

How useful is earnings guidance?

Earnings guidance does not provide any discernible benefits.

Mergers and Acquisitions (2)

Acquisitions rarely create value unless they do one or more of the following:

1. improve performance of the target company,
2. remove excess capacity,
3. create market access for the acquirer's or target's products,
4. acquire skills or technologies at a lower cost and/or more quickly than could be done without the acquisition,
5. exploit a business's industry-specific scalability, and
6. pick winners early.

Most of the value of an acquisition goes to the target's shareholders unless one or more of the following hold for the acquirer:

1. it had strong performance before the acquisition,
2. it can pay a low premium,
3. it had fewer competitors in the bidding process, and 
4. the acquired assets were from a private firm or a subsidiary of a large company.

Value Created for Acquirer

The value created for the acquirer is:

Value Created for Acquirer
= (Stand-Alone Value of Target + Value of Performance Improvements) - (Market Value of Target + Acquisition Premium).

Mergers and Acquisitions (1)

Empirical research has shown that acquisitions have come in waves and generally rose when

• stock prices were high, 
• interest rates were low and 
• one or more large deals had already taken place.

Of the mergers and acquisitions:

• 1/3rd of the deals created value for the acquirer,
• 1/3rd destroyed value, and 
• 1/3rd had unclear results.

Cost analysis

Cost savings can create value, but estimating those savings requires a framework.

As an example for a generic drug firm, the analyst might allocate the savings into six categories:

• R&D,
• procurement,
• manufacturing,
• sales and marketing,
• distribution, and 
• administration.

Assumed cost savings should be estimated and categorized in detail to avoid double counting.

It is recommended that those directly involved in the cost-savings process be involved in the estimations of cost savings.



Revenue analysis

Revenue analysis has both explicit and implicit considerations.

Revenue improvements generally have four sources:

• increasing sales to a higher peak level,
• reaching a peak level faster,
• extending the life of products, and 
• adding new products.

Revenue could increase from higher prices, but antitrust regulation can prevent higher prices unless the quality of the products increases.




Stock offer or cash offer

Generally, an acquiring firm's stockholders benefit more if the firm uses stock instead of cash for the acquisition.

Although the stock offering can lead to dilution, it lowers the risk to the acquirer and allocates more risk to the target firm's shareholders.

Research has shown that stock prices react to creation of intrinsic value in an acquisition and that dilution and other accounting issues do not matter.

Performance management systems.

These systems align decisions with short- and long-term objectives and the overall strategy.

Such systems typically include:

• long-term strategic plans,
• short-term budgets,
• capital budgeting systems,
• performance reporting and reviews, and 
• compensation frameworks.

The rigor and honesty of implementing the system is at least as important as the system itself.

Implementing the system includes

• choosing the metrics, 
• composing the scorecard, and 
• setting the meeting calendars.

1.  Choosing the right metrics

Choosing the right metrics means identifying the value drivers.

Typically the ultimate drivers are

• long-term growth,
• ROIC, and
• the cost of capital.

Short- , medium-, and long-term value drivers determine growth, ROIC and the cost of capital.


Short-term value drivers

Short-term value drivers are usually the easiest to quantify, and examples include

• sales productivity,
• operating cost productivity, and 
• capital productivity.

Medium-term value drivers

Medium-term value drivers consist of

• measures of commercial health, 
• cost structure health, and 
• asset health.

Long-term value drivers

Long-term value drivers address strategic issues such as

• ways to exploit new growth areas and 
• the existence of potential market threats.

Understanding the value drivers allows the managers to have a common language for their goals and to make better choices of trade-offs between critical and less critical drivers.


2.  Composing the Scorecard


Balanced scorecard approach

This was introduced by Robert S. Kaplan and David P. Norton in "The Balanced Scorecard:  Measures That Drive Performance" (Harvard Business Review, February 1992).

This approach can reflect many aspects of the firm and its goals.

The choice of critical drivers should be tailored to the firm's businesses.



A tree based on profit-and-loss structure approach

This is often the most natural and easiest to complete.

The targets need to be challenging and realistic, however, and should not consist of only a single point.

One recommendation is the use of base and stretch targets, where achieving the latter reaps a reward for the manager and not a penalty.



3.  Organizational Health

In addition to determining the drivers and targets, managers should assess organizational health, which is determined by

• the people, 
• skills and 
• culture of the company.

Managers should help set the targets to better understand these issues.

Fact-based reviews with appropriate rewards should depend on:

• stock performance where macroeconomic and industry trends have been removed,
• long-term assessments that might mean deferring rewards, and 
• measures of performance against both quantitative and qualitative drivers.

The firm should harness the power of nonfinancial incentives, such as creating a culture that attracts and motivates quality employees.

What future return can you get for investing into Public Bank Berhad?

We should keep our investing very simple and readily understandable.

Public Bank Berhad is a strong bank in Malaysia. Banking sector is highly regulated. Public Bank Berhad has done very well for decades building its banking business in Malaysia and increasingly in our neighbouring emerging countries. The challenge going forward is how well it adopts to new financial environment, in particular, that of fintech.

Its revenues, profits before tax and earnings per share have grown consistently over the last decade. It is this consistency and growth that confer to this company its high investment qualities.

It has also been distributing dividends regularly. Dividends have grown over the years (dividend growth investing). In the previous decade, it paid a higher dividend paid out relative to its earnings. It is presently paying out about 44% of earnings as dividends. It retained about 56% of its earnings in recent years. Its return on equity for the last 5 years averaged around 16.7%, which is remarkable. As an investor, I am happy that Public Bank Berhad is able to generate this high level of return on its equity. Its dividend payout ratio has declined in recent years due to its need to retain and build up its equity base in keeping with new Basel capital adequacy ratio guidelines.

It is a very well managed bank. It has been growing its net interest income and non-interest income satisfactorily without taking undue or too high risk.

At its present price of $19.98 per share, how attractive is Public Bank Berhad as an investment for the long term? Long term is taken to mean a period of at least 5 or 10 years.

Here are some facts and my opinion on Public Bank Berhad below.

1. At 19.98, it is trading at a PE ratio of 14.90.

2. It is trading at its fair price (neither undervalued or overvalued).

3. Its reward:risk ratio (based on my own method) is 6.84:1 (the probability risk of losing money is low and the reward: risk ratio is in your favour).

4. At the present price, assuming its future consistent growth in earnings per share of 6% per year (very conservative), this company can be expected to give about 13.07% simple average annual total return (= Annual capital appreciation of 9.62% and Average annual dividend yield of 3.45%) or 10% compound annual total return over the next 5 years.

5. At the present price of $19.98 and last FY dividend of 58 sen, its present Dividend Yield is 2.89%. Assuming its earnings and dividends grow consistently at 6% annually the next 5 years, we can expect a back of the envelop calculation return of approximately 2.89% + 6% = 9% annually (simple average). At such a conservative assumption in our calculation, this company may well surprise on the upside, making its investors happier.

I sought a higher return of 15% per year. This illustration shows that to get a return of 8% to 10% in the stock market or a stock, is actually quite achievable. To get a higher return, is more challenging than most realise.


Good luck in your investing.



Additional Notes:

Intrinsic value or Price
= Dividend / (required rate of return - growth)
= D / (r-g)

P = D / (r-g)
r-g = D / P
r = (D/P) + g
r = (Dividend Yield) + g

If you invest into a company that grows dividends at a constant rate of g, your expected return can be easily worked out as:

r = (Dividend Yield) + g

The present DY of Public Bank Berhad is 2.89%.

Our assumption is its dividend will grow at 6% per year.

Therefore, we can hope for a return of 2.89% + 6% = 8.89% or 9% per year.

Public Bank Berhad's last financial year dividend of 58 sen can support a share price of $16.25.


[Disclaimer:  Please do your own diligent analysis before investing.  Your investing should be based on your own analysis and informed decision.  This is not a recommendation.  You invest at your own risk.]

Howard Marks: "The Most Important Thing - Origins and Inspirations"

Talk at Google



https://www.oaktreecapital.com/insights/howard-marks-memos

OCBC Q1 profit rises 14pc, driven by wealth management business

Tue, 9 May 2017 SINGAPORE: Singapore's Oversea-Chinese Banking Corp Ltd reported a nearly 14 per cent rise in quarterly profit, largely led by sustained growth in its wealth management business and robust results from insurance operations. The city-state's second-biggest lender said net profit came in at S$973 million (US$692 million) in the three months ended March 31 versus S$856 million a year ago. Net interest margin however contracted 13 basis points to 1.62 per cent. "We achieved broad-based loan growth, grew our private banking assets under management (AUM), and reported significantly higher fee income," chief executive officer Samuel Tsien said in a statement on Tuesday. The bank said the overall quality of its loan portfolio remained stable and although the stress in the oil & gas support services sector continued, sufficient provisions had been made. OCBC is the last Singapore bank to report results after DBS beat market estimates and United Overseas Bank posted an increase in quarterly profit. -- REUTERS

JJPTR, lasted barely 2 years before it collapsed in April 2017

Johnson Lee, 29 year old, started this "investment product" promising return of 20% per month on the money invested.

How did he invest these money to get such high returns?

Did the investors ask this simple question before parting with their hard earned money?

I believe many wondered how he was able to promise such high returns and probably knew that this was too good to be true.

However, they threw caution to the wind when their colleagues or friends who entered the scheme earlier started receiving their monthly 20% return of their investment.

The early birds benefited for the period and this attracted the new comers.

Some put a small amount of money initially as a gamble on the scheme, but soon lost control of their emotions, adding more money into the scheme, when they started to receive their 20% returns monthly.

Now that the whole scheme is broken, those who are in it should be prepared to lose a large percentage, if not all, of their invested money.

Sadly, Johnson Lee has announced another scheme, somewhat similar, but now promising 35% return on capital monthly.

Of course, the question that has to be asked is:  If Johnson Lee cannot sustain the previous scheme that promised 20% per month return from investment, how can he hope to sustain this new scheme that promises an even higher return per month?

Those who usually make such proposals are either very confident in their abilities, or are very dishonest, or suffer from delusions on a grandiose scale.

Similar schemes had surfaced and collapsed in the past, leaving many of those who invested in them impoverished.

Why are such schemes so common in Malaysia?