The 2007-08 Financial Crisis In Review

The 2007-08 Financial Crisis In Review
by Manoj Singh

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When the Wall Street evangelists started preaching "no bailout for you" before the collapse of British bank Northern Rock, they hardly knew that history would ultimately have the last laugh. With the onset of the global credit crunch and the fall of Northern Rock, August 2007 turned out to be just the starting point for big financial landslides. Since then, we have seen many big names rise, fall, and fall even more. In this article, we'll recap how the financial crisis of 2007-08 unfolded. (For further reading, see Who Is To Blame For The Subprime Crisis?, The Bright Side Of The Credit Crisis and How Will The Subprime Mess Impact You?)

Before the Beginning

Like all previous cycles of booms and busts, the seeds of the subprime meltdown were sown during unusual times. In 2001, the U.S. economy experienced a mild, short-lived recession. Although the economy nicely withstood terrorist attacks, the bust of the dotcom bubble, and accounting scandals, the fear of recession really preoccupied everybody's minds. (Keep learning about bubbles in Why Housing Market Bubbles Pop and Economic Meltdowns: Let Them Burn Or Stamp Them Out?)

To keep recession away, the Federal Reserve lowered the Federal funds rate 11 times - from 6.5% in May 2000 to 1.75% in December 2001 - creating a flood of liquidity in the economy. Cheap money, once out of the bottle, always looks to be taken for a ride. It found easy prey in restless bankers - and even more restless borrowers who had no income, no job and no assets. These subprime borrowers wanted to realize their life's dream of acquiring a home. For them, holding the hands of a willing banker was a new ray of hope. More home loans, more home buyers, more appreciation in home prices. It wasn't long before things started to move just as the cheap money wanted them to.

This environment of easy credit and the upward spiral of home prices made investments in higher yielding subprime mortgages look like a new rush for gold. The Fed continued slashing interest rates, emboldened, perhaps, by continued low inflation despite lower interest rates. In June 2003, the Fed lowered interest rates to 1%, the lowest rate in 45 years. The whole financial market started resembling a candy shop where everything was selling at a huge discount and without any down payment. "Lick your candy now and pay for it later" - the entire subprime mortgage market seemed to encourage those with a sweet tooth for have-it-now investments. Unfortunately, no one was there to warn about the tummy aches that would follow. (For more reading on the subprime mortgage market, see our Subprime Mortgages special feature.)

But the bankers thought that it just wasn't enough to lend the candies lying on their shelves. They decided to repackage candy loans into collateralized debt obligations (CDOs) and pass on the debt to another candy shop. Hurrah! Soon a big secondary market for originating and distributing subprime loans developed. To make things merrier, in October 2004, the Securities Exchange Commission (SEC) relaxed the net capital requirement for five investment banks - Goldman Sachs (NYSE:GS), Merrill Lynch (NYSE:MER), Lehman Brothers, Bear Stearns and Morgan Stanley (NYSE:MS) - which freed them to leverage up to 30-times or even 40-times their initial investment. Everybody was on a sugar high, feeling as if the cavities were never going to come.

The Beginning of the End

But, every good item has a bad side, and several of these factors started to emerge alongside one another. The trouble started when the interest rates started rising and home ownership reached a saturation point. From June 30, 2004, onward, the Fed started raising rates so much that by June 2006, the Federal funds rate had reached 5.25% (which remained unchanged until August 2007).

Declines Begin
There were early signs of distress: by 2004, U.S. homeownership had peaked at 70%; no one was interested in buying or eating more candy. Then, during the last quarter of 2005, home prices started to fall, which led to a 40% decline in the U.S. Home Construction Index during 2006. Not only were new homes being affected, but many subprime borrowers now could not withstand the higher interest rates and they started defaulting on their loans.

This caused 2007 to start with bad news from multiple sources. Every month, one subprime lender or another was filing for bankruptcy. During February and March 2007, more than 25 subprime lenders filed for bankruptcy, which was enough to start the tide. In April, well-known New Century Financial also filed for bankruptcy.

Investments and the Public
Problems in the subprime market began hitting the news, raising more people's curiosity. Horror stories started to leak out.

According to 2007 news reports, financial firms and hedge funds owned more than $1 trillion in securities backed by these now-failing subprime mortgages - enough to start a global financial tsunami if more subprime borrowers started defaulting. By June, Bear Stearns stopped redemptions in two of its hedge funds and Merrill Lynch seized $800 million in assets from two Bear Stearns hedge funds. But even this large move was only a small affair in comparison to what was to happen in the months ahead.

August 2007: The Landslide Begins

It became apparent in August 2007 that the financial market could not solve the subprime crisis on its own and the problems spread beyond the United State's borders. The interbank market froze completely, largely due to prevailing fear of the unknown amidst banks. Northern Rock, a British bank, had to approach the Bank of England for emergency funding due to a liquidity problem. By that time, central banks and governments around the world had started coming together to prevent further financial catastrophe.

Multidimensional Problems

The subprime crisis's unique issues called for both conventional and unconventional methods, which were employed by governments worldwide. In a unanimous move, central banks of several countries resorted to coordinated action to provide liquidity support to financial institutions. The idea was to put the interbank market back on its feet.

The Fed started slashing the discount rate as well as the funds rate, but bad news continued to pour in from all sides. Lehman Brothers filed for bankruptcy, Indymac bank collapsed, Bear Stearns was acquired by JP Morgan Chase (NYSE:JPM), Merrill Lynch was sold to Bank of America, and Fannie Mae and Freddie Mac were put under the control of the U.S. federal government.

By October 2008, the Federal funds rate and the discount rate were reduced to 1% and 1.75%, respectively. Central banks in England, China, Canada, Sweden, Switzerland and the European Central Bank (ECB) also resorted to rate cuts to aid the world economy. But rate cuts and liquidity support in itself were not enough to stop such a widespread financial meltdown.

The U.S. government then came out with National Economic Stabilization Act of 2008, which created a corpus of $700 billion to purchase distressed assets, especially mortgage-backed securities. Different governments came out with their own versions of bailout packages, government guarantees and outright nationalization.

Crisis of Confidence After All

The financial crisis of 2007-08 has taught us that the confidence of the financial market, once shattered, can't be quickly restored. In an interconnected world, a seeming liquidity crisis can very quickly turn into a solvency crisis for financial institutions, a balance of payment crisis for sovereign countries and a full-blown crisis of confidence for the entire world. But the silver lining is that, after every crisis in the past, markets have come out strong to forge new beginnings.

To read more about other recessions and crises, see A Review Of Past Recessions.

by Manoj Singh, (Contact Author Biography)
Manoj Singh is a central banker and a freelance writer. Apart from writing for Investopedia, he and his spouse write a weekly column on economics and finance for a financial daily.http://www.investopedia.com/articles/economics/09/financial-crisis-review.asp

http://www.investopedia.com/articles/economics/09/financial-crisis-review.asp

How to Understand a Trillion-Dollar Deficit

How to Understand a Trillion-Dollar Deficit
By Barbara Kiviat Sunday, Jan. 11, 2009

"My favorite way to think of it is in terms of seconds," says David Schwartz, a children's book author whose How Much Is a Million? tries to wrap young minds around the concept. "One million seconds comes out to be about 11½ days. A billion seconds is 32 years. And a trillion seconds is 32,000 years. I like to say that I have a pretty good idea what I'll be doing a million seconds from now, no idea what I'll be doing a billion seconds from now, and an excellent idea of what I'll be doing a trillion seconds from now."


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$1.2 Trillion Deficit Expected for 2009

Actually, the deficit is on track to hit $1.2 trillion this year, but what's $200 billion among friends?

Seriously, what is it? To the average person, a number that big probably doesn't mean much. At some point long before the hundred-billion-dollar mark, large numbers simply become figures on the page, well beyond human scale and intuitive understanding. And yet as discussion about the economy and the impressive numbers that come along with it continue to dominate the news, it may be more important than ever to try to understand. Is a $700 billion financial-industry bailout a lot? Is a $775 billion economic-stimulus package enough? (See the worst business deals of 2008.)

Unfortunately, our puny human brains aren't particularly up to the task. Go back thousands of years and think about the simpler times of human existence. "We had a few friends; we had to be scared of a few animals. A trillion didn't come up very often," says Temple University mathematician John Allen Paulos, whose book Innumeracy addresses the topic. "There is a sense that when numbers are too big or too small, the brain just shuts off," says Colin Camerer, a professor of behavioral economics at the California Institute of Technology. "People either don't think about it at all or there is fear, an exaggerated reaction."

The genius of our numbering system is that we can signify massive quantities in short spaces. One billion takes no longer to write than one million does, points out Andrew Dilnot, an economist at Oxford University and author of The Numbers Game.

But that similarity trips us up when it comes time to imagine how those figures translate to the real world, where three more zeros make all the difference. "My favorite way to think of it is in terms of seconds," says David Schwartz, a children's book author whose How Much Is a Million? tries to wrap young minds around the concept. "One million seconds comes out to be about 11½ days. A billion seconds is 32 years. And a trillion seconds is 32,000 years. I like to say that I have a pretty good idea what I'll be doing a million seconds from now, no idea what I'll be doing a billion seconds from now, and an excellent idea of what I'll be doing a trillion seconds from now."
A common strategy for beginning to understand big numbers is to devise visual representations. One time, sitting at a baseball game in Philadelphia, Paulos started counting seats along the first-base line. Multiplying the number of seats in a row by the number of rows, Paulos came up with a section of the stadium that he figured contained about 10,000 seats — an image he can now think back to whenever a person starts talking about tens of thousands of a particular thing. When numbers get too large, though, that method breaks down. A stack of one trillion $1 bills would reach more than a quarter of the way to the moon — replacing one incomprehensible thought with another doesn't do much good.

We next move on to more formal manipulations. When trying to comprehend a trillion-dollar deficit, you might calculate how much money that represents per person in the U.S. One trillion dollars divided by 300 million Americans comes out to $3,333. Then you search for a useful comparison. A convenient — though perhaps unsettling — comparison is to the amount of credit-card debt carried by the average person in this country. That figure is $3,245. "So a good way of thinking about government debt financing is that it's similar to what the average person is doing," says Camerer.

In The Numbers Game, Dilnot and his co-author, journalist
 Michael Blastland, suggest dividing government spending by the number of citizens and the number of weeks in a year. A $700 billion bailout thereby translates into $45 per week for each American man, woman and child. Going one step further, it comes out to $6 a day. Are you willing to pay $6 a day to have a functioning financial system?

Just be careful once you start dividing and dividing again. It's often easy to come up with big denominators that make sense, though ultimately too much dividing reduces numbers to another sort of uselessness. Six dollars a day is also 25 cents an hour, or less than half a penny a minute. Would you be willing to pay less than half a penny a minute?

In a society where people routinely don't stop to pick up a penny off the ground, the better question might be: Is there anything you wouldn't be willing to pay half a penny for?
It's something to think about.

See pictures of the stock-market crash of 1929.
See pictures of the recession of 1958.

http://www.time.com/time/business/article/0,8599,1870699,00.html?xid=feed-yahoo-biztech

Pandit: Citi undergoing "long-term transformation"

Pandit: Citi undergoing "long-term transformation"
By MADLEN READ, AP Business Writer Madlen Read, Ap Business Writer

NEW YORK – Citigroup's CEO Vikram Pandit said Wednesday that the company is going through a "long-term transformation," a day after the embattled bank sold control of its Smith Barney brokerage to Morgan Stanley.
Speculation has been growing that Pandit, who for months supported the model of Citigroup as a "universal bank," will be taking further steps to dismantle the conglomerate.
"While we are embarked on a long-term transformation of Citi, our core mission is unchanged," Pandit wrote in a memo to employees obtained by The Associated Press.
"Our goal is to streamline our operations, strengthen our balance sheet, position ourselves to take advantage of historic global growth opportunities, and deliver to clients all the benefits of our strength, insight, and unique global reach."
Analysts are expecting more details about which businesses Citigroup plans to jettison when the company releases fourth-quarter results on Friday — nearly a week earlier than originally planned.
Citigroup shares fell $1.37, or 23 percent, to $4.53 on Wednesday.
On Tuesday, Morgan Stanley and Citigroup agreed to merge their retail brokerages. Morgan Stanley is paying Citigroup $2.7 billion for a 51 percent stake in the joint venture. Citigroup will have a 49 percent stake. The new unit — Morgan Stanley Smith Barney — will have more than 20,000 advisers, $1.7 trillion in client assets; and serve 6.8 million households around the world, the companies said.
Citigroup will recognize a pretax gain of about $9.5 billion because of the deal.

http://news.yahoo.com/s/ap/20090114/ap_on_bi_ge/citigroup_ceo;_ylt=AqZ31iUOTghy9MXvY3OOhYiyBhIF

Discount Rate Determinations: Summary

Discount Rate Determinations

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

VALUE INVESTING
Baseline: Long-term U.S. Treasuries
Additional: Risk assessment (conscious judgment)


PORTFOLIO INVESTING
Baseline: Long-term U.S. Treasuries
Additional: Market risk premium X beta (seemingly scientific)

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

Value investing and portfolio theory determine discount rates by adding an amount to the risk-free rate ascertained from long-term U.S. Treasury securities.

Portfolio theory uses the product of the market risk premium and the target’s beta.

Value investing questions the seemingly scientific quality of this exercise in favour of more judgment-laden but conscious assessments of associated risk.

Conceptually, discount rate is,
= cost of capital
= rate of return you require on your allocated capital.



Also read:

1. Understanding Discount Rates
2. Risk-free rate
3. Traditional Method: Discount rate or WACC (I)
4. Traditional Method: Discount rate or WACC (II)
5. Modern Portfolio Theory
6. Portfolio Theory: Market Risk Premiums
7. Portfolio Theory: Beta
8. Is the market efficient, always?
9. Discount Rate Determinations: Summary

Is the market efficient, always?

Is the market efficient, always?

But these conditions do not always exist. Market pricing and volatility of the late 1990s give reason to believe that these conditions did not exist. Some companies trade at prices bearing a discount from their intrinsic value – the key claim of value investing. Numerous other flaws infect beta, widely documented in a burgeoning literature over the past decade showing its declining utility.

General faith in beta requires general faith in efficient markets. But belief in efficient markets means the equity risk premium in the late 1990s was negative, zero, or very close to zero – that is the only way to make sense of the high stock prices prevalent in the late 1990s if markets are efficient. Under CAPM, a zero-market-risk premium implies a discount rate equal to the risk-free rate. But this is a strange result, defying common sense that common stocks are riskier than U.S. Treasuries.

We are back to where we started: Estimating appropriate discount rates for equity securities requires judgment about how much riskier a particular business is compared to risk-free benchmarks of U.S. Treasuries. Modern finance theory assumes return is correlated to risk (you get what you pay for); value investing understands return as correlated to effort (you get what you deserve).



Also read:

1. Understanding Discount Rates
2. Risk-free rate
3. Traditional Method: Discount rate or WACC (I)
4. Traditional Method: Discount rate or WACC (II)
5. Modern Portfolio Theory
6. Portfolio Theory: Market Risk Premiums
7. Portfolio Theory: Beta
8. Is the market efficient, always?
9. Discount Rate Determinations: Summary

Portfolio Theory: Beta

Beta

As for beta, it is intended to reveal what part of any “market risk premium” is borne by a particular company’s stock. Beta determines this component of the discount rate estimate for a company’s equity by using various assumptions to compare its stock price gyrations with those of the overall stock market or a market index such as the S&P 500.

A stock whose price is more volatile than the market’s is seen as “riskier” than one whose price gyrates less than the market as a whole. Multiplying this measure of price volatility by a “market risk premium” theoretically expresses the differential risk the particular stock poses. The result is added to the risk-free rate to give a discount rate.

Beta is only potentially useful if stock prices of the subject company and of all components of the market or market index result from investor behaviour that is, collectively, rational. Such conditions of “market efficiency” might substantially occur for some companies in some cases and for some markets or some market segments at some time.


Also read:

1. Understanding Discount Rates
2. Risk-free rate
3. Traditional Method: Discount rate or WACC (I)
4. Traditional Method: Discount rate or WACC (II)
5. Modern Portfolio Theory
6. Portfolio Theory: Market Risk Premiums
7. Portfolio Theory: Beta
8. Is the market efficient, always?
9. Discount Rate Determinations: Summary

Portfolio Theory: Market Risk Premiums

Market Risk Premiums

The variables also are integrated so that changes in one may indicate modification of another. For example, increases in the risk-free rate entail decreases in the market risk premium (the latter supposedly measures the difference between the risk-free rate and the expected return on common stocks). The need for estimation judgment, and the complex interrelationship among these variables, means that prudent analysis draws on multiple reasonable data points (by applying alternative methods and taking alternative measures of each variable).

The “market risk premium: is a guess based on history of what special inducements it takes to attract investors into stocks rather than buying U.S. Treasury securities or alternative investments. The idea is that investors must be given special compensation to bear the special risks of stocks or else they will not invest in them.

Data on Market Risk Premiums

Common practice is to consult data books published by leading economists, such as the one published by a firm run by Yale University professor Roger Ibbotson called the Ibbotson & Sinquefeld Yearbook. The harder way is doing it yourself, which is virtually impossible for non-professionals. But it is useful to understand why, so here goes.

Market risk premium data can be calculated up-to-the-minute at any time. Three crucial assumptions must be made to estimate the market risk premium.
1. First, the estimator must choose either historical data or some measure of future performance.
2. Second, one must define a “market” for the measure, such as the Standard & Poor’s 500, the New York Stock Exchange as a whole, or some other index.
3. Third, the estimate is based on a specified time period.

Alternatives include the period from the late 1800s (when market data were first recorded) to the time of valuation interest; from 1926 (when the University of Chicago began a database, thought to have the virtue of including a full business cycle before the 1929 market crash) to the time of valuation interest; for the 30-year period before the time of valuation interest (reflecting business cycles exhibiting more relevant business and financial risks and factors); or for specific environments being analysed, such as the early 2000s.

Challenges in using "market risk premium"

Seizing on a measure of the “market risk premium” became acutely tricky during the late 1990s because any such thing seemed to be evaporating. Any premium that once existed – e.g., in the period before 1990 – dwindled toward zero, as the most powerful bull market in world history produced investors who needed no inducements to join. Even staunch devotees of modern finance theory lamented the declining usefulness of “market risk premium” device during the 1990s.

Despite this well-known fact even among its fans, analysts sticking with this learning adhere to favourite benchmarks, such as 9 percent based on long-run historical returns on stocks dating back to the 1930s. Others respond to their gut sense that this is almost certainly wrong, and opt instead for rates of 7 percent, 5 percent, or less. Some believe it was moving towards zero in the late 1990s.

A group of the country’s leading financial economists assembled in mid-2000 to offer their measurements of the market risk premium. Eleven participated. Their estimates of the risk premium were: 0, 1-2, 3, 3-4, 4, 6, 6, and 8.1 percent, with three refusing to venture a guess giv en the concept’s indefiniteness and uncertain reliability.

Reasons for the decline or evaporation include powerful forces, such as U.S. investors became more long-term oriented, U.S. business efficiency heightened, fiscal policies and monetary management improved, capitalism spread globally, wealth increased, and business fundamentals exhibited less volatility.


Also read:

1. Understanding Discount Rates
2. Risk-free rate
3. Traditional Method: Discount rate or WACC (I)
4. Traditional Method: Discount rate or WACC (II)
5. Modern Portfolio Theory
6. Portfolio Theory: Market Risk Premiums
7. Portfolio Theory: Beta
8. Is the market efficient, always?
9. Discount Rate Determinations: Summary

Modern Portfolio Theory

PORTFOLIO THEORY APPROACH: BETA AND PREMIUMS

Modern finance theory uses the “capital asset pricing model” (CAPM) to estimate discount rates for equities.

Using CAPM requires estimating two inputs in addition to a risk-free rate. These are a “market risk premium” and “beta,” a measure of stock price volatility seen by backers as a risk indicator.
The mistake some analysts make is to assume that there is a single accurate data point for each of these inputs. However, each of these variables is an estimate requiring judgment.



Also read:

1. Understanding Discount Rates
2. Risk-free rate
3. Traditional Method: Discount rate or WACC (I)
4. Traditional Method: Discount rate or WACC (II)
5. Modern Portfolio Theory
6. Portfolio Theory: Market Risk Premiums
7. Portfolio Theory: Beta
8. Is the market efficient, always?
9. Discount Rate Determinations: Summary

Traditional Discount rate or WACC (II)

Traditional Method: Discount rate or Weighted average cost of capital (WACC)

Most generally, the practice is to estimate the returns investors are insisting upon for companies bearing like qualities (in terms of industry, capital structure, maturation, size, competitive outlook, and so on).

• For companies with long records of sustained earnings, low rates are indicated, perhaps just a few points above the risk-free rate.
• For newer, more volatile operations, a larger premium is required.

The estimate requires exercising practical judgment based on learning what compensation is given to investors bearing comparable business and financial risks.

• What special business and financial risk do common stockholders face?
• What are the debt levels?
• What is the likelihood that debt investors would be paid before them or that high debt would throw the company into bankruptcy?
• What is the company’s financial strength and industry leadership?
• Is its market expanding or contracting?
• Is there room for growth that will add value?

In short, assessing risk relevant to the discount rate implicates the same questions value investors ask when defining circles of competence.

Value investors see risk as arising from either

• deterioration in an investment’s business value or
• overpaying for it in the first place.

Overpayment can result from inadequate or mistaken analysis of these questions. The possibility of misrelating price and value implies a commonsense point: High stock prices compared to earnings make for high-risk investments.

A value investor’s conception of risk differs from that of modern finance theory, today’s dominant model for defining risk. This theory measures risk using market price fluctuations as proxies for underlying business-value changes. While the exercise appears precisely scientific, in fact it is as judgment-laden as the traditional method. It also defies common sense: In this model, the fact that a stock price is high or low compared to earnings has no bearing on risk. Despite these weaknesses, the widespread use of this model warrants summarizing it as a contrast to value investing.

Also read:

1. Understanding Discount Rates
2. Risk-free rate
3. Traditional Method: Discount rate or WACC (I)
4. Traditional Method: Discount rate or WACC (II)
5. Modern Portfolio Theory
6. Portfolio Theory: Market Risk Premiums
7. Portfolio Theory: Beta
8. Is the market efficient, always?
9. Discount Rate Determinations: Summary

Traditional Discount rate or WACC (I)

Traditional Method: Discount rate or Weighted average cost of capital (WACC)

To the risk-free is added an amount reflecting risks associated with a particular investment. This produces the discount rate to apply to determine the present value of an asset.

For a business with debt and equity in its capital structure, this is commonly called the weighted average cost of capital (WACC). It is the proportional cost of a company’s debt, determined by the after-tax interest cost, and the cost of equity, determined by a more judgment –laden but conceptually identical inquiry.

The cost of equity is conceptually identical to the cost of debt because they involve the same question:

• What must the company pay to induce investment, whether from debt lenders or equity holders?

The cost-of-equity exercise is more judgment-laden than the cost-of-debt exercise because there are no maturity dates or set coupons on equity (dividends are payable solely in the corporate board’s discretion).

The key reference is what other capital market participants are paying investors to attract equity financing form enterprises of comparable risk.

• To estimate the cost of equity capital for high-risk venture capital projects, for example, one could consult the returns offered by venture capitalists in such enterprises.
• For low-risk enterprises, underwritten secondary public offerings of blue-chip companies can be examined.

Also read:

1. Understanding Discount Rates
2. Risk-free rate
3. Traditional Method: Discount rate or WACC (I)
4. Traditional Method: Discount rate or WACC (II)
5. Modern Portfolio Theory
6. Portfolio Theory: Market Risk Premiums
7. Portfolio Theory: Beta
8. Is the market efficient, always?
9. Discount Rate Determinations: Summary

Risk-free rate

VALUE INVESTING APPROACH TO RISK AND RATES

The “risk-free rate” can be estimated by reference to U.S. government securities, loans investors make to the U.S. Treasury.

The U.S. Treasury is seen as the purest credit risk in the world, committed to paying its debts when due without fail. Hence, yields on U.S. Treasury debt are considered the benchmark for valuing all other assets, including corporate debt and equities.

Corporate debt bears greater risk than U.S. Treasury debt. In corporate bankruptcy, debt is paid before common stock, so the common stock of a company carrying debt bears a greater risk than that debt.

Selecting a risk-free rate requires judgment based on various factors. Such factors include:

• bond maturity,
• reference date or time frame, and
• reference source.

Possible sources include the rate disclose in the company’s own public filings. This is a non-arbitrary choice, reflecting the rate the company uses for its internal purposes and considered sufficiently material to disclose in its public filings.

Other customs include using 30-year bonds to reflect the long-term character of the investment in a corporation.

When valuing a business as a going concern, following the daily, weekly, or monthly movements in the U.S. Treasury market introduces distorting valuation volatility into the exercise. Business value does not move in tandem with daily or even monthly fluctuations in Treasury rates. Avoiding the sensitivity to short-term fluctuations in treasury rates can be done by averaging rates over the preceding year or so.

To the risk-free is added an amount reflecting risks associated with a particular investment. This produces the discount rate to apply to determine the present value of an asset. For a business with debt and equity in its capital structure, this is commonly called the weighted average cost of capital (WACC).


Also read:

1. Understanding Discount Rates
2. Risk-free rate
3. Traditional Method: Discount rate or WACC (I)
4. Traditional Method: Discount rate or WACC (II)
5. Modern Portfolio Theory
6. Portfolio Theory: Market Risk Premiums
7. Portfolio Theory: Beta
8. Is the market efficient, always?
9. Discount Rate Determinations: Summary

Understanding Discount Rates

Discount Rates

Choosing an appropriate discount rate (or cost of capital) is necessary to determine present value, whether measured by current earnings or a more elaborate discounted cash flow model.

The discount rate must reflect

• the time value of money and
• the specific risks associated with te individual company.

Equity is riskier than debt, so the discount rate for a given company will be some increment above the prevailing rates at which any debt it has outstanding are being discounted. The challenge is determining how much greater.

Conceptually, think of the discount rate as the rate of return a prudent investor would require for allocating capital to the subject company

A high-risk venture would warrant a proportionately high discount rate; a sure thing, a rate probably equal to the time value of money.

The surest investments in contemporary investing are U.S. government securities. These furnish the risk-free rate.

Appropriate discount rates for most corporate equity will take U.S. government securities as the starting point and add an additional element.

Considered below are two alternative conceptual approaches to thinking about and settling upon an appropriate discount rate,

• one traditional and
• one from modern finance theory.

Also read:

1. Understanding Discount Rates
2. Risk-free rate
3. Traditional Method: Discount rate or WACC (I)
4. Traditional Method: Discount rate or WACC (II)
5. Modern Portfolio Theory
6. Portfolio Theory: Market Risk Premiums
7. Portfolio Theory: Beta
8. Is the market efficient, always?
9. Discount Rate Determinations: Summary

Cash Flow Statement Value

Also read:

1. Cash Flow Statement Value
2. Discounted Cash Flow valuation method
3. Hazards of the Future and Limitations of DCF

Hazards of the Future and Limitations of DCF

Hazards of the future and limitations of DCF

The process of estimation and discounting is intended to recognize the hazards of the future by incorporating into the cash flow estimates the onslaughts of:

• competition,
• technology,
• patent expiration,
• deregulation,
• globalization, and
• other upheaval.

This entails close examination of factors such as sales, margins, and cap-ex.

Likewise, the discount rate is intended to capture the effects on capital costs of:

• long-term financing markets,
• lender appetites for the company’s securities, and all such underlying risks.

But all these variables are by definition unknown, uncertain, and difficult to quantify. In the math, moreover, tiny differences in the assumptions drive substantial differences in resulting valuations.

Among the largest component of resulting value in this model is the value assigned to the horizon (the perpetuity piece beyond the 5- or 10-year mark). Its derivation is a function of assumed growth rate and assumed cost of capital. At estimates of 5 percent and 10 percent, as noted, the multiple is 20; tweak these and enormous ranges emerge.

Even so, the discounted cash flow valuation model is the most widespread model in contemporary valuation.

• Some value investors use it, at least in part.
• Others eschew it entirely.

Both groups look instead to assets and earnings measures deemed more reliable than cash flows to come to grips with valuation.


Also read:

1. Cash Flow Statement Value
2. Discounted Cash Flow valuation method
3. Hazards of the Future and Limitations of DCF

Discounted Cash Flow valuation method

Discounted Cash Flow valuation method

Despite these points about cash flows, the most popular contemporary approach to valuation emphasizes cash flows pure and simple. Called discounted cash flow (DCF) analysis, the method also presents a number of choices an analyst must make.

EBIT and EBITDA: Cash flows can be measured in alternative ways. Chief examples are operating income (earnings before interest and taxes, called EBIT) and operating income plus the noncash expenses of depreciation and amortization (called EBITDA). Devotees of discounted cash flow valuation analysis rarely use accounting-driven metrics such as operating income.

DCF valuation for a medium-term period, typically 5 to 10 years.

Once cash flows are defined using one of these metrics, the discounted cash flow valuation method estimates them for a medium-term period, typically 5 to 10 years.

The estimate entails examining a range of performance variables that drive cash flows, chiefly sales levels, profit margins, and required reinvestment in the business through capital expenditures (cap-ex).

With cash flows projected, the method discounts each year’s estimate by a discount rate intended to reflect the subject company’s cost of capital during the period.

Each year’s discounted result is added to all others to produce a preliminary valuation of the 5- or 10- year period.

DCF valuation for period beyond the medium term, to yield the perpetuity amount.

For cash flows beyond the medium term, an additional step estimates the further cash expected in perpetuity, at a constant growing rate. This is typically done by estimating the final year’s cash flows and multiplying it by some figure to yield the perpetuity amount.

The figure is determined by the relationship between the assumed growth rate and the relevant cost of capital at that horizon period.

It is equal to 1 divided by the difference between these rates – so with a cost of capital of 10 percent and a growth rate of 5 percent, the multiplier is 20 determined by 1/ (10 percent – 5 percent).

Overview

The requisite math is elegant, easy, superficially scientific and seemingly objective. The raw data is estimated, just as easily, but substantially artistic and actually subjective. Underscore the heroics:

• cash flows estimated for 5 or 10 years,
• cash flows in perpetuity,
• discount rates going out 10 years plus, and
• a growth rate on top of that in perpetuity.

Also read:

1. Cash Flow Statement Value
2. Discounted Cash Flow valuation method
3. Hazards of the Future and Limitations of DCF

Cash Flow Statement Value

Cash flow based valuation techniques (DCF analysis): High Subjectivity

The reason value investing emphasizes the balance sheet and income statement is that to resort solely to the cash flow statement can be deceptively simple.

Cash flows alone disguise important metrics. Cash is not exactly the bottom line. True, cash flows drive value, but some portion of cash flows will be needed to reinvest in capital resources necessary to sustain business production and results.

Thus to arrive at a cash flow figure by adjusting net income for noncash expenditures is only a partial step. Step two is to further adjust that figure by probable future cash commitments to capital expenditures.

Step 1: Adjust earnings for noncash charges
Suppose a company generates net income of $1 million. Part of the expenses recorded to generate the $1 million consisted of net noncash charges of $200,000. Cash flow is thus $1.2 million. That is step one.

Step 2: Free cash flows
Then this figure must be adjusted to reflect the amount the company will need to disburse in cash to maintain its property, plant and equipment at levels sufficient to sustain business productivity. Suppose this figure is either $0.1 million or $0.3 million. Adjusted, cash flows are now either $0.9 million or $1.1 million. This is the bottom line figure, and may be called free cash flows. (Buffett calls it owner earnings to designate that these are the free flows of results allocable to the common stock.)

Too often analysts fail to take this additional step of adjusting for the probable costs of required reinvestment. It would be more accurate for these analysts simply to stick with the net income figure. After all, the noncash charges to earnings that produce the net income figures are at least, in part, intended as a proxy to estimate such required reinvestment.

In this example, the bookkeeping allocation of noncash charges of $0.2 million may be as reasonable an estimate of required cash reinvestment as the separate estimates of either $0.1 million or $0.3 million. But zeroing in on this figure is a crucial value investing exercise.

Also read:

1. Cash Flow Statement Value
2. Discounted Cash Flow valuation method
3. Hazards of the Future and Limitations of DCF

Income Statement Value

Also read:

1. Income Statement Value: The Earnings Payoff
2. Adjustments in Current Earnings figure
3. Avoid Pro Forma financial figures
4. Avoid Extrapolated Future Earnings Growth figures
5. Estimating Growth in Value Investing
6. Franchise Value
7. GROWTH'S VALUE
8. GROWTH'S VALUE (illustrations)

GROWTH'S VALUE (illustrations)

Take an example drawn from Bruce Greenwald’s detailed book on value investing.
Suppose that earnings are $32. An analyst determines it would cost $20 to grow earnings by 10 percent forever. So you can have either:
· $32 forever with no growth, or,
· $12 ($32 - $20) growing at 10 percent forever.
Which is better, no growth or growth?
It depends on the cost of capital.

Use the following standard valuation formula:
V = D1 / (k-g)
This formula is a variation on the V = D/k when discussing current earnings, giving effect to same rate of growth designated by g.

Illustrations:
k=cost of capital=20%, 16% or 14%
g=growth=0% or 10%

Scenario 1: $32 forever with no growth
k=20%, 16% or 14% and g=0%
V=32/(0.20 – 0)= $160
V=32/(0.16 – 0)=$200
V=32/(0.14 – 0)= $229

Scenario 2: $12 ($32 - $20) growing at 10 percent forever.
k=20%, 16% or 14% and g=10%
V=12/(0.20 – 0.10)= $120
V=12/(0.16 – 0.10)=$200
V=12/(0.14 – 0.10)= $300

Note:

1. The higher the cost of capital, the lower is the return on capital (valuation) and vice versa.
   
2. With a 20-percent cost of capital, $32 forever with no growth ($160) is better than $12 growing at 10 percent forever ($120). Thus, growth subtracts value when the cost of capital exceeds the return on capital.
   
3. With a 16-percent cost of capital, $32 forever with no growth ($200) is the same as that of $12 growing at 10 percent forever ($200). Growth is neutral to value when the cost of capital equals the return on capital.
   
4. With a 14-percent cost of capital, $12 growing at 10 percent forever ($300) is better than $32 forever with no growth ($229). Thus, growth adds value when the return on capital exceeds the cost of capital.
   

This illustration proves the powerful insight:

When capital costs equal capital returns, growth neither adds nor subtracts value, no matter how much or how little growth there is. The reason is intuitive: If an investor putting in new capital charges the same rate that capital generates, then there is no additional return available to prior investors.

To come full circle, growth is not free.

1. If a company can attract capital at a cost lower than returns it generates, growth adds value.
2. If it attracts capital at a cost higher than what it generates, growth subtracts value.
3. If the cost of capital is the same as the return on capital, growth is neutral to value.

The only businesses in the first category are those possessing franchise characteristics. The only way to capture returns on capital greater than the cost of capital is to keep competitors out. If competitors can get in, capital costs and returns will soon converge upon each other (or worse, capital costs will exceed capital returns).

Before turning to examining cash-flow based valuation techniques, note two crucial points:
(1) Assets drive earnings and cash flows, and
(2) Assets are analytically more important than either.

As to point (1):

• for most businesses, asset value exceeds earnings value;
• businesses whose earnings value exceeds asset value possess franchise characteristics. This implies the ability to sustain high returns on equity (high earnings relatives to net assets).
  

As to point (2),

• data reliability varies.
• Balance sheet data tend to be most reliable for valuation exercises, then income statement data concerning current earnings.
• Properly estimated cash flows are probably less than earnings, though many contemporary analysts draw the opposite conclusion by ignoring important noncash charges to income such as depreciation.

Also read:

1. Income Statement Value: The Earnings Payoff
2. Adjustments in Current Earnings figure
3. Avoid Pro Forma financial figures
4. Avoid Extrapolated Future Earnings Growth figures
5. Estimating Growth in Value Investing
6. Franchise Value
7. GROWTH'S VALUE
8. GROWTH'S VALUE (illustrations)

GROWTH'S VALUE

GROWTH’S VALUE

Growth is not free.

Its price is the cost of capital necessary to support it.

Growth adds value only when the return on capital exceeds the cost of capital.

When capital costs equal capital returns, growth neither adds nor subtracts value, no matter how much or how little growth there is. The reason is intuitive: If an investor putting in new capital charges the same rate that capital generates, then there is no additional return available to prior investors.

Therefore:

1. If a company can attract capital at a cost lower than returns it generates, growth adds value.
   
2. If it attracts capital at a cost higher than what it generates, growth subtracts value.
   
3. If the cost of capital is the same as the return on capital, growth is neutral to value.

The only businesses in the first category are those possessing franchise characteristics. The only way to capture returns on capital greater than the cost of capital is to keep competitors out.

If competitors can get in, capital costs and returns will soon converge upon each other (or worse, capital costs will exceed capital returns).

To come full circle, growth is not free.


Also read:

1. Income Statement Value: The Earnings Payoff
2. Adjustments in Current Earnings figure
3. Avoid Pro Forma financial figures
4. Avoid Extrapolated Future Earnings Growth figures
5. Estimating Growth in Value Investing
6. Franchise Value
7. GROWTH'S VALUE
8. GROWTH'S VALUE (illustrations)

Franchise Value

FRANCHISE VALUE

Franchise businesses are those boasting
· barriers to entry and
· other competitive advantages
that make it too costly for new entrants to join.

1. Strong brands can help, so long as competitors cannot match them.
Examples include at least for some period of time those products bearing names synonymous with the goods, such as Coke, Kleenex, Hoover (in its days), Harley-Davidson (to some extent), and others.

2. Techniques producing franchise value include
· patents,
· exclusive licenses,
· know-how, and
· secret formulae.
· Generally high fixed-costs of entry also help.

3. Common elements of franchise businesses include
· high costs to consumers of switching away from the target’s own product in favor of products sold by competitors,
· high costs to consumers of seeking out such alternatives, and
· habits commanding consumer loyalty.

4. Foes of the franchise power are constraints competitors can evade. Examples are
· a unionized labor force,
· burden-some distribution arrangements, or
· limitations on an entity’s adaptability in the face of change.


Also read:

1. Income Statement Value: The Earnings Payoff
2. Adjustments in Current Earnings figure
3. Avoid Pro Forma financial figures
4. Avoid Extrapolated Future Earnings Growth figures
5. Estimating Growth in Value Investing
6. Franchise Value
7. GROWTH'S VALUE
8. GROWTH'S VALUE (illustrations)