Characteristics of Commodity and Cyclical companies and their Value Drivers.

Characteristics of commodity and cyclical companies

            While commodity companies can range the spectrum from food grains to precious metals and cyclical firms can be in diverse business, they do share some common factors that can affect both how we view them and the values we assign to them.

1. The Economic/Commodity price cycle: Cyclical companies are at the mercy of the economic cycle. While it is true that good management and the right strategic and business choices can make some cyclical firms less exposed to movements in the economy, the odds are high that all cyclical companies will see revenues decrease in the face of a significant economic downturn. Unlike firms in many other businesses, commodity companies are, for the most part, price takers. In other words, even the largest oil companies have to sell their output at the prevailing market price. Not surprisingly, the revenues of commodity companies will be heavily impacted by the commodity price. In fact, as commodity companies mature and output levels off, almost all of the variance in revenues can be traced to where we are in the commodity price cycle. When commodity prices are on the upswing, all companies that produce that commodity benefit, whereas during a downturn, even the best companies in the business will see the effects on operations.
2. Volatile earnings and cash flows: The volatility in revenues at cyclical and commodity companies will be magnified at the operating income level because these companies tend to have high operating leverage (high fixed costs). Thus, commodity companies may have to keep mines (mining), reserves (oil) and fields (agricultural) operating even during low points in price cycles, because the costs of shutting down and reopening operations can be prohibitive.
3. Volatility in earnings flows into volatility in equity values and debt ratios: While this does not have to apply for all cyclical and commodity companies, the large infrastructure investments that are needed to get these firms started has led many of them to be significant users of debt financing. Thus, the volatility in operating income that we referenced earlier, manifests itself in even greater swing in net income.
4. Even the healthiest firms can be put at risk if macro move is very negative: Building on the theme that cyclical and commodity companies are exposed to cyclical risk over which they have little control and that this risk can be magnified as we move down the income statement, resulting in high volatility in net income, even for the healthiest and most mature firms in the sector, it is easy to see why we have to be more concerned about distress and survival with cyclical and commodity firms than with most others. An extended economic downturn or a lengthy phase of low commodity prices can put most of these companies at risk.
5. Finite resources: With commodity companies, there is one final shared characteristic. There is a finite quantity of natural resources on the planet; if oil prices increase, we can explore for more oil but we cannot create oil. When valuing commodity companies, this will not only play a role in what our forecasts of future commodity prices will be but may also operate as a constraint on our normal practice of assuming perpetual growth (in our terminal value computations).

In summary, then, when valuing commodity and cyclical companies, we have to grapple with the consequences of economic and commodity price cycles and how shifts in these cycles will affect revenues and earnings. We also have to come up with ways of dealing with the possibility of distress, induced not by bad management decisions or firm specific choices, but by macro economic forces.

Commodity and Cyclical companies: Value Drivers

Normalized Earnings

If we accept the proposition that normalized earnings and cash flows have a subjective component to them, we can begin to lay out procedures for estimating them for individual companies. With cyclical companies, there are usually three standard techniques that are employed for normalizing earnings and cash flows:

1.     Absolute average over time: The most common approach used to normalize numbers is to average them over time, though over what period remains in dispute. At least in theory, the averaging should occur over a period long enough to cover an entire cycle. In chapter 8, we noted that economic cycles, even in mature economies like the United States, can range from short periods (2-3 years) to very long ones (more than 10 years). The advantage of the approach is its simplicity. The disadvantage is that the use of absolute numbers over time can lead to normalized values being misestimated for any firm that changed its size over the normalization period.  In other words, using the average earnings over the last 5 years as the normalized earnings for a firm that doubled its revenues over that period will understate the true earnings.

2.     Relative average over time: A simple solution to the scaling problem is to compute averages for a scaled version of the variable over time. In effect, we can average profit margins over time, instead of net profits, and apply the average profit margin to revenues in the most recent period to estimate normalized earnings. We can employ the same tactics with capital expenditures and working capital, by looking at ratios of revenue or book capital over time, rather than the absolute values.

3.     Sector averages: In the first two approaches to normalization, we are dependent upon the company having a long history. For cyclical firms with limited history or a history of operating changes, it may make more sense to look at sector averages to normalize. Thus, we will compute operating margins for all steel companies across the cycle and use the average margin to estimate operating income for an individual steel company. The biggest advantage of the approach is that sector margins tend to be less volatile than individual company margins, but this approach will also fail to incorporate the characteristics (operating efficiencies or inefficiencies) that may lead a firm to be different from the rest of the sector.

Normalized commodity prices

            What is a normalized price for oil? Or gold? There are two ways of answering this question.

1.     One is to look at history. Commodities have a long trading history and we can use the historical price data to come up with an average, which we can then adjust for inflation. Implicitly, we are assuming that the average inflation-adjusted price over a long period of history is the best estimate of the normalized price.

2.     The other approach is more complicated. Since the price of a commodity is a function of demand and supply for that commodity, we can assess (or at least try to assess the determinants of that demand and supply) and try to come up with an intrinsic value for the commodity.

Once we have normalized the price of the commodity, we can then assess what the revenues, earnings and cashflows would have been for the company being valued at that normalized price. With revenues and earnings, this may just require multiplying the number of units sold at the normalized price and making reasonable assumptions about costs. With reinvestment and cost of financing, it will require some subjective judgments on how much (if any) the reinvestment and cost of funding numbers would have changed at the normalized price.

            Using a normalized commodity price to value a commodity company does expose us to the critique that the valuations we obtain will reflect our commodity price views as much as they do our views on the company. For instance, assume that the current oil price is $45 and that we use a normalized oil price of $100 to value an oil company. We are likely to find the company to be undervalued, simply because of our view about the normalized oil price. If we want to remove our views of commodity prices from valuations of commodity companies, the safest way to do this is to use market-based prices for the commodity in our forecasts. Since most commodities have forward and futures markets, we can use the prices for these markets to estimate cash flows in the next few years. For an oil company, then, we will use today's oil prices to estimate cash flows for the current year and the expected oil prices (from the forward and futures markets) to estimate expected cash flows in future periods. The advantage of this approach is that it comes with a built-in mechanism for hedging against commodity price risk. An investor who believes that a company is under valued but is shaky on what will happen to commodity prices in the future can buy stock in the company and sell oil price futures to protect herself against adverse price movements.

Little Book of Valuation

Aswath Damodaran

Characteristics of Declining Companies and their Value Drivers

Characteristics of Declining Companies

            In this section, we will look at characteristics that declining companies tend to share, with an eye towards the problems that they create for analysts trying to value these firms. Note again that not every declining company possesses all of these characteristics but they do share enough of them to make these generalizations.

1.     Stagnant or declining revenues: Perhaps the most telling sign of a company in decline is the inability to increase revenues over extended periods, even when times are good. Flat revenues or revenues that grow at less than the inflation rate is an indicator of operating weakness. It is even more telling if these patterns in revenues apply not only to the company being analyzed but to the overall sector, thus eliminating the explanation that the revenue weakness is due to poor management (and can thus be fixed by bringing in a new management team).

2.     Shrinking or negative margins:  The stagnant revenues at declining firms are often accompanied by shrinking operating margins, partly because firms are losing pricing power and partly because they are dropping prices to keep revenues from falling further. This combination results in deteriorating or negative operating income at these firms, with occasional spurts in profits generated by asset sales or one time profits.

3.     Asset divestitures: If one of the features of a declining firm is that existing assets are sometimes worth more to others, who intend to put them to different and better uses, it stands to reason that asset divestitures will be more frequent at declining firms than at firms earlier in the life cycle. If the declining firm has substantial debt obligations, the need to divest will become stronger, driven by the desire to avoid default or to pay down debt.

4.     Big payouts – dividends and stock buybacks: Declining firms have few or any growth investments that generate value, existing assets that may be generating positive cashflows and asset divestitures that result in cash inflows. If the firm does not have enough debt for distress to be a concern, it stands to reason that declining firms not only pay out large dividends, sometimes exceeding their earnings, but also buy back stock.

5.     Financial leverage – the downside: If debt is a double-edged sword, declining firms often are exposed to the wrong edge. With stagnant and declining earnings from existing assets and little potential for earnings growth, it is not surprising that many declining firms face debt burdens that are overwhelming. Note that much of this debt was probably acquired when the firm was in a healthier phase of the life cycle and at terms that cannot be matched today. In addition to difficulties these firms face in meeting the obligations that they have committed to meet, they will face additional trouble in refinancing the debt, since lenders will demand more stringent terms.

Declining companies: Value Drivers

Going concern value

To value a firm as a going concern, we consider only those scenarios where the firm survives. The expected cash flow is estimated only across these scenarios and thus should be higher than the expected cash flow estimated in the modified discounted cash flow model. When estimating discount rates, we make the assumption that debt ratios will, in fact, decrease over time, if the firm is over levered, and that the firm will derive tax benefits from debt as it turns the corner on profitability. This is consistent with the assumption that the firm will remain a going concern. Most discounted cash flow valuations that we observe in practice are going concern valuations, though they may not come with the tag attached.

            A less precise albeit easier alternative is to value the company as if it were a healthy company today. This would require estimating the cashflows that the firm would have generated if it were a healthy firm, a task most easily accomplished by replacing the firm's operating margin by the average operating margin of healthy firms in the business. The cost of capital for the distressed firm can be set to the average cost of capital for the industry and the value of the firm can be computed. The danger with this approach is that it will overstate firm value by assuming that the return to financial health is both painless and imminent.

Likelihood of Distress

A key input to this approach is the estimate of the cumulative probability of distress over the valuation period. In this section, we will consider three ways in which we can estimate this probability. The first is a statistical approach, where we relate the probability of distress to a firm's observable characteristics – firm size, leverage and profitability, for instance – by contrasting firms that have gone bankrupt in prior years with firms that did not. The second is a less data intensive approach, where we use the bond rating for a firm, and the empirical default rates of firms in that rating class to estimate the probability of distress. The third is to use the prices of corporate bonds issued by the firm to back out the probability of distress.

a. Statistical Approaches: The fact that hundreds of firms go bankrupt every year provides us with a rich database that can be examined to evaluate both why bankruptcy occurs and how to predict the likelihood of future bankruptcy. One of the earliest studies that used this approach was by Altman (1968), where he used linear discriminant analysis to arrive at a measure that he called the Z score. In this first paper, that he has since updated several times, the Z score was a function of five ratios:

Z = 0.012 (Working capital/ Total Assets) + 0.014 (Retained Earnings/ Total Assets) + 0.033 (EBIT/ Total Assets) + 0.006 (Market value of equity/ Book value of total liabilities) + 0.999 (Sales/ Total Assets)

Altman argued that we could compute the Z scores for firms and use them to forecast which firms would go bankrupt, and he provided evidence to back up his claim. Since his study, both academics and practitioners have developed their own versions of these credit scores.  Notwithstanding its usefulness in predicting bankruptcy, linear discriminant analysis does not provide a probability of bankruptcy.

b. Based upon Bond Rating: Many firms, especially in the United States, have bonds that are rated for default risk by the ratings agencies. These bond ratings not only convey information about default risk (or at least the ratings agency's perception of default risk) but they come with a rich history. Since bonds have been rated for decades, we can look at the default experience of bonds in each ratings class. Assuming that the ratings agencies have not significantly altered their ratings standards, we can use these default probabilities as inputs into discounted cash flow valuation models. What are the limitations of this approach? The first is that we are delegating the responsibility of estimating default probabilities to the ratings agencies and we assume that they do it well. The second is that we are assuming that the ratings standards do not shift over time. The third is that table measures the likelihood of default on a bond, but it does not indicate whether the defaulting firm goes out of business. Many firms continue to operate as going concerns after default. 

c. Based upon Bond Price: The conventional approach to valuing bonds discounts promised cash flows back at a cost of debt that incorporates a default spread to come up with a price. Consider an alternative approach. We could discount the expected cash flows on the bond, which would be lower than the promised cash flows because of the possibility of default, at the riskfree rate to price the bond. If we assume that a constant annual probability of default, we can write the bond price as follows for a bond with fixed coupon maturing in N years.

Bond Price = 

This equation can now be used, in conjunction with the price on a traded corporate bond to back out the probability of default. We are solving for an annualized probability of default over the life of the bond, and ignoring the reality that the annualized probability of default will be higher in the earlier years and decline in the later years. While this approach has the attraction of being a simple one, we would hasten to add the following caveats in using it. First, note that we not only need to find a straight bond issued by the company – special features such as convertibility will render the approach unusable – but the bond price has to be available. If the corporate bond issue is privately placed, this will not be feasible. Second, the probabilities that are estimated may be different for different bonds issued by the same firm. Some of these differences can be traced to the assumption we have made that the annual probability of default remains constant and others can be traced to the mispricing of bonds. Third, as with the previous approach, failure to make debt payments does not always result in the cessation of operations. Finally, we are assuming that the coupon is either fully paid or not at all; if there is a partial payment of either the coupon or the face value in default, we will over estimate the probabilities of default using this approach.

Consequences of Distress

Once we have estimated the probability that the firm will be unable to make its debt payments and cease to exist, we have to consider the logical follow-up question. What happens then? As noted earlier in the chapter, it is not distress per se that is the problem but the fact that firms in distress have to sell their assets for less than the present value of the expected future cash flows from existing assets and expected future investments. Often, they may be unable to claim even the present value of the cash flows generated even by existing investments. Consequently, a key input that we need to estimate is the expected proceeds in the event of a distress sale. We have three choices:

1.     Estimate the present value of the expected cash flows in a discounted cash flow model, and assume that the distress sale will generate only a percentage (less than 100%) of this value. Thus, if the discounted cash flow valuation yields $ 5 billion as the value of the assets, we may assume that the value will only be $ 3 billion in the event of a distress sale.

2.     Estimate the present value of expected cash flows only from existing investments as the distress sale value. Essentially, we are assuming that a buyer will not pay for future investments in a distress sale. In practical terms, we would estimate the distress sale value by considering the cash flows from assets in place as a perpetuity (with no growth).

3.     The most practical way of estimating distress sale proceeds is to consider the distress sale proceeds as a percent of book value of assets, based upon the experience of other distressed firms.

Note that many of the issues that come up when estimating distress sale proceeds – the need to sell at below fair value, the urgency of the need to sell – are issues that are relevant when estimating liquidation value.

Ref:

The Little Book of Valuation

Aswath Damodaran

Statement of Owners' Equity (Statement of Retained Earnings)

The equity statement explains the changes in retained earnings.

Retained earnings appear on the balance sheet and most commonly are influenced by income and dividends.  The Statement of Retained Earnings therefore uses information from the Income Statement and provides information to the Balance Sheet.

The following equation describes the equity statement for a sole proprietorship:

Beginning Equity
+ Investments
- Withdrawals
+ Income
----------------
= Ending Equity

For a corporation, substitute "Dividends Paid" for "Withdrawals".  The stockholders' equity in a corporation is  calculated as follows:

Common Stock (recorded at par value)
+ Premium on Common Stock (issue price minus par value)
+ Preferred Stock (recorded at par value)
+ Premium on Preferred Stock (issue price minus par value)
+ Retained Earnings
------------------------------------------------------------
= Stockholders' Equity


Note that the premium on the issuance of stock is based on the price at which the corporation actually sold the stock on the market.  Afterwards, market trading does not affect this part of the equity calculation.  Stockholders' equity does not change when the stock price changes!

Astonishing accident involving eight Ferraris 'world's most expensive car crash'

A fleet of high-performance cars, including eight Ferraris, has been involved in one of the most expensive accidents in history after an astonishing multi-car pile-up in Japan.

Image 1 of 2

Police officers investigate damaged Ferrari cars at the site of a traffic accident on the Chugoku Expressway in Shimonoseki, southwestern Japan

http://www.telegraph.co.uk/motoring/news/8934718/Astonishing-accident-involving-eight-Ferraris-worlds-most-expensive-car-crash.html

http://www.telegraph.co.uk/motoring/news/8934718/Astonishing-accident-involving-eight-Ferraris-worlds-most-expensive-car-crash.html

http://www.telegraph.co.uk/motoring/news/8934718/Astonishing-accident-involving-eight-Ferraris-worlds-most-expensive-car-crash.html

I don't understand why business schools don't teach the Warren Buffett model of investing.

I don't understand why business schools don't teach the Warren Buffett model of investing.


Or the Ben Graham model. Or the Peter Lynch model. Or the Martin Whitman model. (I could go on.) In English, you study great writers; in physics and biology, you study great scientists; in philosophy and math, you study great thinkers; but in most business school investment classes, you study modern finance theory, which is grounded in one basic premise--that markets are efficient because investors are always rational. It's just one point of view. A good English professor couldn't get away with teaching Melville as the backbone of English literature. How is it that business schools get away with teaching modern finance theory as the backbone of investing? Especially given that it's only a theory that, as far as I know, hasn't made many investors particularly rich.

Meanwhile, Berkshire Hathaway, under the stewardship of Buffett and vice chairman Charlie Munger, has made thousands of people rich over the past 30-odd years. And it has done so with integrity and a system of principles that is every bit as rigorous, if not more so, as anything modern finance theory can dish up.

On Monday, 11,000 Berkshire shareholders showed up at Aksarben Stadium in Omaha to hear Buffett and Munger talk about this set of principles. Together these principles form a model for investing to which any well-informed business-school student should be exposed--if not for the sake of the principles themselves, then at least to generate the kind of healthy debate that's common in other academic fields.

Whereas modern finance theory is built around the price behavior of stocks, the Buffett model is centered around buying businesses as if one were going to operate them. It's like the process of buying a house. You wouldn't buy a house on a tip from a friend or sight unseen from a description in a newspaper. And you surely wouldn't consider the volatility of the house's price in your consideration of risk. Indeed, regularly updated price quotes aren't available in the real estate market, because property doesn't trade the way common stocks do. Instead, you'd study the fundamentals--the neighborhood, comparable home sales, the condition of the house, and how much you think you could rent it for--to get an idea of its intrinsic value.

The same basic idea applies to buying a business that you'd operate yourself or to being a passive investor in the common stock of a company. Who cares about the price history of the stock? What bearing does it have on how the company conducts business? What's important is whether you can purchase at a reasonable price a business that generates good returns on capital (Buffett likes returns on equity in the neighborhood of 15% or better) without a lot of debt (which makes returns on capital less dependable). In the best of all worlds, the company will have a competitive advantage that allows it to sustain its above-average ROE for years, so you can hang on to it for a long time--just as you would live in your house--and reap the power of compounding.

Buffett further advocates investing in businesses that are easy to understand--Munger calls it "clearing one-foot hurdles"--so you can come up with more reliable estimates of their long-term economics. Coca-Cola's basic business is pretty staid, for example. Unit case sales and ROE determine the company's future earnings. Companies like Microsoftand Intel--good as they are--require clearing much higher hurdles of understanding because their business models are so dependent on the rapidly evolving world of high tech. Today it's a matter of selling the most word-processing programs; tomorrow it's the Internet presence; after that, who knows. For Coke, the challenge is always to sell more cases of beverage.

Buying a business or a stock just because it's cheap is a surefire way to lose money, according to the Buffett model. You get what you pay for. But if you're evaluating investments as businesses to begin with, you probably wouldn't make this mistake, because you'd recognize that a good business is worth buying at a fair price.

Finally, if you follow the Buffett model, you don't trade your investments just because our liquid stock markets invite you to do so. Activity for the sake of activity begets high transaction costs, high tax bills, and poor investment decisions ("if I make a mistake I can sell it in a minute"). Less is more.

I'm not trying to pick a fight with modern finance theory enthusiasts. I just find it unsettling that basic business-school curricula don't even consider models other than modern finance theory, even though those models are in the marketplace proving themselves every day.

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/teachbuffet.htm

Understanding Bank Financial Statements

By Jerome Felix , eHow Contributor

Understanding bank financial statements is easy when you go through each statement slowly. The three main financial statements are the income statement, balance sheet and cash flow. A bank’s financial statement is similar to any other financial statement. These statements give you a snapshot of how the bank is doing financially.

 

Instructions

1  Understand financial statements by reviewing terms related to these statements. There are three       main types of bank financial statements: the income statement, the balance sheet and the cash flow statement. To get a thorough understanding of financial statements, do some research online to familiarize yourself.

1. • 2
     The bank income statement shows total revenues, total expenses and total tax. Notice that this statement starts with revenues, subtracts total expenses and then subtracts taxes. Go through the revenues, expenses and tax; you’ll notice many items within those groups.
   • 3
     The balance sheet lists the bank’s total assets, total liabilities and owner’s equity. The formula for the bank’s balance sheet is “assets” minus “liabilities” is equal to “owner’s equity.” The owner’s equity means the value of the bank owner's ownership of the bank.
   • 4
     The bank’s cash flow statement is a snapshot of its cash operations. This is a summary of operation activity cash, investing activity cash, finance activity cash and net cash change. This summary traces cash in-flow and cash out-flow.
   • 5
     Review the bank’s statement of owner’s equity. This statement records the prior equity, and then adjusts it with investments, withdrawals and income to get the final equity.

Read more: Understanding Bank Financial Statements | eHow.com http://www.ehow.com/how_4557967_understanding-bank-financial-statements.html#ixzz1fY6FKAwv
http://www.ehow.com/how_4557967_understanding-bank-financial-statements.html

How to Analyze a Banks Financial Statement

By an eHow Contributor

Related Searches:A bank's financial statements are composed of three sections: the balance sheet, income statement and cash flow statement. The financial statements of a bank are complex because banks sell diverse financial products and services, and, they undertake their own financing and investment activities. However, once you learn the basics of reading financial statements---whether for a bank or another type of business---you'll understand what all the numbers mean.

Difficulty:

 

Challenging

Instructions

1. • 1
     Start with the balance sheet which shows the value of what the bank owns or money that is owed to the bank (assets), the amount of money that the bank itself owes (liabilities), and the amount of money invested by shareholders into the bank (shareholder's equity) at a specific point in time. An easy way to remember the data on the balance sheet is: assets = liabilities + shareholder's equity.

     The assets for a large commercial bank, for example, can be extensive. The biggest line item is typically its loans and leases which are made to consumers, businesses and institutions. Be sure to read the summary notes that follow the financial statements to find more details about each of the bank's assets.

     Review the liabilities section which includes the bank's deposits made by its customers as well as the bank's short- and long-term debt which are loans, lines of credits and notes that the bank has less than one year (short-term) or more than one year (long-term) to pay back.

     The final section of the balance sheet to review is the shareholder's equity composed of capital stock plus retained earnings. Capital stock is the total amount of money shareholders have invested in the bank's stock. Retained earnings are the earnings that the bank has not paid out yet as dividends to its shareholders.
   • 2
     Refer to the income statement which provides information on the bank's profitability. It covers a specific period of time and details income from the bank's loans, lease financing, securities available for sale and other items. Like consumers and businesses, banks themselves borrow money to cover their own expenses and maximize profits. The last line of the income statement---the net income---shows the bank's total profits after all expenses and taxes have been paid.
   • 3
     Review the cash flows statement which tracks a bank's cash inflows and outflows over a specific period of time. Cash comes in and goes out of a bank from its operating, investing and financing activities. The cash flow statement will show the beginning cash balance and the ending cash balance after reporting all the bank's deposits (cash inflows) and payments (cash outflows).
   • 4
     Calculate key profitability, liquidity, activity and solvency ratios to assess a bank's overall performance. You can download a free template of these ratios from Microsoft Office Online (http://office.microsoft.com/en-us/templates/). Use data from the bank's current and past financial statements to calculate and compare these ratios.

     Try comparing the bank's ratios to composite ratios for other banks from Standard & Poor's Indices listings (http://www.standardandpoors.com/indices/main/en/us/). When you calculate and compare ratios, you'll get a summary of the bank's financial health and its performance relative to the competition.

Read more: How to Analyze a Banks Financial Statement | eHow.com http://www.ehow.com/how_5973660_analyze-banks-financial-statement.html#ixzz1fY7IWIBu

The 4 Financial Statements

http://www.quickmba.com/accounting/fin/statements/

Balance Sheet
Income Statement
Statement of Owner's Equity
Statement of Cash Flows

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