哥伦比亚商学院：证券分析——学生课堂笔记

Columbia Business School

Security Analysis Student Lecture Notes

Michael J. Mauboussin

Round 1 Round 1

High __________ High __________

Estimate ___________ Estimate ___________

Low ___________ Low ___________

Round 2 Round 2

Estimate ___________ Estimate ___________

Round 3 Round 3

Estimate ___________ Estimate ___________

Listed below are ten requests for information that you are unlikely to know. For each write down your best estimate of the answer. Then put a lower and upper bound around your estimate such that you are 90% confident that the correct answer falls within the “confidence range”.

_____

1. Number of General Motors automobiles produced in 1990 _____ _____

_____

2. IBM’s assets in 1989 _____ _____

_____

3. Total number of $5 bills in circulation on March 31, 1990 _____ _____

_____

4. Total area in square miles of Lake Michigan _____ _____

_____

5. Total population of Barcelona, Spain, in 1990 _____ _____

_____

6. The amount of taxes collected by the IRS in 1970 _____ _____

_____

7. The average annual snowfall in Anchorage, Alaska _____ _____

_____

8. The number of bound volumes in all 26 branches of the _____ San Francisco Public Library _____

_____

9. The dollar value of outstanding consumer credit at the end of 1988 _____ _____

_____

10. The median price of existing single family homes in Honolulu, _____ Hawaii, in 1990 _____

VII. Groundwork

A. Two broad schools of thought regarding setting of stock prices

“Firm foundation” “Castle-in-the-air”

— intrinsic value — psychology

Ben Graham John Maynard Keynes John Burr Williams William O’Neill Warren Buffett George Soros

— value based on future — value based on “greater fool theory” earnings/dividend stream

— perception is reality

{ Need a model or thought process that can capture both

B. Risk/Reward Tradeoff Investor Corporate Return

WACC

Rf Prospective investments Risk

3 types of business projects

• first question to ask when looking at a business Stern Stewart Performance 1000

1) earn above WACC y r > WACC

2) earn WACC x r = WACC

3) earn below WACC x- r < WACC

C. Valuing a business

 course will focus on equities — but the explicit process we will use is relevant for all securities A

• value of assets = cash generated balance sheet ≠ value D

• value - liabilities = equity = + concept of residual claim for equities

• value independent of capital structure (M + M) E

• how does one measure returns?

D. Lemonade stand

• $100 needed to start

• bank loan - 10% - WACC

$15 - value created Outcomes: $10 - value neutral -$5 - value negative

• cash-in versus cash-out

• no question of short-term versus long-term

• understand how value is created

E. Equities as a “derivative” market

Business Capital Markets

Key elements Key elements

• Competitive advantage l Expectations (good business isn’t always a good stock)

• Limited information l Vast information

• Competitive dynamics l Macro drivers (interest rates, currencies)

• Strategy l Financials and psychological factors

• Financial performance

• Incentives

F. Mauboussin’s “Pyramid of Investing”

Understand Decision-Making Rational Shortcomings Decision Making

Understand Expectations Quantification Expectations Bottoms up Market signals

Understand Value Measurement Tools (VMT) Business “Good” business Valuation Capital Markets

Class II

I. Introduction

II. Subject: What makes stocks go up and down?

III. Open question: What factors affect stock prices? (draw up list)

IV. Market Myths - Market Realities

1. EPS drives value or EPS x P/E = value

A. When there is a deviation between earnings and cash flow, which does the market follow?

• Credit Suisse First Boston survey 4.1/3.5/3.4

Market follows cash flow!

B. Why EPS x P/E = value is banker’s dream

EPS x P/E = value 1. increase EPS

2. increase P/E

• Value is determined by risk-adjusted cash flows: unless cash flows, risk change → there is no change in value

• Buffett — Scott Fetzer example after acquisition — Earnings 30% lower identical economics talk more about P/E’s/valuation next week

2. The stock market is short-term oriented

A. Simple test → examine how much of a company’s current share price can be accounted for by expected dividends over next 5 years

e.g.

Value = NOPAT + I(r - WACC)CAP WACC WACC(1 + WACC)

Base year 1

C. KO out 2 years — someone will pay more

D. Why quarterly earnings matter

3. Investment R & D and accelerated capital spending is not rewarded

A. higher R & D spending as a % of sales leads to higher P/E

B. projects announced with long-term payoffs

C. Internet stocks

4. Dividends matter  accept classic finance theory that companies that earn high rates of return and grow rapidly should not pay dividends  employee stock options  but dividends are a valuable signaling mechanism

III. Summary of market mechanics

1. Given: (a) cash flow is more important than earnings

(b) there is a long-term relationship between risk/reward

(c) market is not short-term oriented

(d) being forward looking, market by definition based on expectations cash flow Driversrisk/reward forecast period (CAP)

2. What do top investors care about?

• in order to determine the direction of the herd, you need not interview each cow, just the lead steer

• lead steer = an influential investor that sets price on the margin

• generally, a lead steer is a buy side analyst, but it can include sell side

• lead steer roundtable

• Best example = Warren Buffett

3. Least Common Denominator Theory

• helps bridge gap between “reality” and rhetoric

• DCF * best model, leading investors

• Cash Flow (Cash Flow Multiple) * better, same flaws as EPS

• Earnings (P/E) * theoretically weak, easy to articulate

4. What about booms/busts?

• fear and greed play a role — when are they being evoked?

• inherently difficult to gain from “psychological inefficiencies”

IV. Market Efficiency

How believe the market is inefficient?/efficient? why/why not?

1. Test of market efficiency

(1) uniform and costless information dissemination

(2) prices always fully reflect available information

(3) liquidity

(4) low/non-existent transaction costs

2. Three Forms of Efficiency

1900 French capital markets managers

• Maurice Kendall roughly 70% “outperformed” by market 1953 British stocks • Jensen 1955-64 78% “outperformed” by market

• Fortune (10/94) 2,700 equity managers 74% “outperformed” by market

Two Areas of Potential Exploitation:

• Information

• Analysis

3. Capital markets as a complex adaptive system B. Tension exists between academics and practitioners academics: rational agents, random walk, efficient markets practitioners: outperformance of some, irrational investors, inefficiency one model reconciles both: complex adaptive system B. Paradigm shifts — Thomas Kuhn

1) Theory laid out

2) Scientists test the theory and facts counter it

3) Original theory stretched

4) New theory superceeds the old

Example:

1) Aristotle proposes geocentric universe with orbits as circles

2) Astronomers observe that orbits are elliptical, not circular

3) Ptolemy introduces circles-upon-circles

4) Copernicus, Kepler, Galilieo introduce helocentric universe, elliptical orbits and celestial imperfection

Correspondence — Jeremy Bernstein (Cranks, Quarks and the Cosmos)

Two tests:

1) new idea must explain why the old theory worked

2) add some predictive value

C. Classical Capital Market Theory

Economics still largely based on equilibrium systems: supply and demand, risk and reward, price and quantity.

This stems from the view that economics is a science akin to Newtonian physics — cause and effect and implied predictability.

Many statistical tools only can be applied if equilibrium theory holds (Fama 1963)

Classical theory

1) Stock market efficiency — prices reflect all relevant information when that information is cheap and widely disseminated

• purchasing stocks is an NPV zero proposition

• prices not always “correct”, but not systematically wrong

• doesn’t require random walk, but often does

2) Random walk — security price changes are independent of one another

• lots of agents — current prices reflect info that is collectively known

• implies that probability distribution is normal

3) Rational agents — investors can assess and optimize risk/reward opportunities

• Markowitz — mean/variance efficiency

• Sharpe, Linter — CAPM

4) Assumptions/prediction

• stock returns treated as independent, identically distributed random variables

• rational agents

• modest trading activity, limited price fluctuations

D) Classical Theory Tested

1) Stock market turns are not normal

• high kurtosis — tails are fatter and mean higher than what is predicted

• punctuated equilibrium

2) Random walk not supported by data

• Campbell, Lo, Mackinley — show prices are predictable

• elements of persistence

3) Volume higher and changes greater than predicted

• volume is active

• large changes (crash ’87)

4) Risk and reward not linked via variance

• Fama

• firm size and price/book — maintained “rational” framework

5) Investors are not rational

• systematic judgment errors have been identified

• humans operate inductively, not deductively

E. Theory Stretch

1) Non-normal distributions

• fat tails observed — often explained away or data culled

• sticking with traditional probability calculus

2) Noise traders (Black 1986)

• “noise” fills the theory/practice gap

• should not trade

• “noise theories were all derived originally as part of a broad effort to apply the logic behind the capital asset pricing model to...behavior that does not fit conventional notions of optimization.”

3) Crashes

• Fama — “I think the crash in ’87 was a mistake”

• Miller — recommends reading Mandelbrot

4) Behavioral finance

• “as if” argument

• dilutes theory

F. Complex Adaptive Systems Complex adaptive systems can be described in three parts. First, there are lots of agents, each operating with their own decision rules. Next, the interactions between the agents become the basis of “emergence” – the aggregate becomes more complicated than the sum of the parts. Finally, a “meta-system” is created that has distinct characteristics. Each part is described briefly:

• Decision Rules. Agents within a complex adaptive system take information from the environment, combine it with their own interaction with the environment, and derive decision rules. Various decision rules compete with one another based on their utility, with the most effective rules surviving. This process allows for adaptation, which explains the “adaptive” in “complex adaptive system.”

Individual trading rules and investment rules of thumb are decision rules in the capital markets.

• Emergence. Emergence is the complex, large-scale behaviors that result from the aggregate interactions of many less complex agents. An ant colony is a good example of this phenomenon. If you were to interview any single ant about what it does, you would hear a narrowly defined task or set of tasks. However, because of the interaction of all ants, a functional and adaptive colony emerges. In capital markets language, the behavior of the market “emerges” from the interaction of investors. This is Adam Smith’s invisible hand.”

• Market as a “Meta-System”. We use the term meta-system to convey clearly the notion that the market has properties and characteristics distinct from the agents that comprise it. Two key characteristics of CAS include nonlinearity and critical points. Nonlinearity is the idea that the output of the system will not necessarily be proportionate with the input of the system. The familiar multiplier effect in economics is a good example. Critical points describe the fact the periodically, small-scale stimuli lead to large-scale effects – the proverbial straw that broke the camel’s back. In the realm of markets, this means booms and crashes.

G. Does the New Theory Conform to Reality?

1) Non-normal distribution’s explains high kurtosis

2) Random walk — although persistence exists — hard to detect

3) Homogeneous versus heterogeneous expectations

• deductive vs. inductive

• “El Farol” problem: errors independent OK; non-independent can lead to self-reinforcing trends

4) Portfolio manager performance

• not much predictability with complex adaptive system

• some investors “hard wired”

5) Artificial stock market

• Santa Fe Institute

• replicate market activity

H. What do we do?

1) Careful about risk and reward

• CAPM good first approximation

• more to come

2) Avoid cause and effect thinking

• human nature

• crash of ’87

3) DCF is valuable

• first principles

• sort out key issues

• crystallize expectations

4) Strategy/micro-economics

• Capital-based to information-based society

• increasing returns

4. Why does EMH still win out? ⇒ Thesis: still no way to game the system efficiency is effectively accurate

5. My opinion

6. An Interesting Analogy “Beat the Dealer” Stock market Focus 1 game define expertise not multiple games

Lots of “plays” 100 hands/hour examine lots of situations head on w/dealer get information

Limited opportunities 10% favorable small % favorable even when 90% unfavorable you know what you’re doing

Betting small when odds low none when odds low large when odds high huge when odds high

Thorp, Beat The Dealer, pp. 55-56.

⇒ reassuring to read Buffett Class III

I. Introduction

II. Valuation

• one of four course pillars

(1) how markets work

(2) what is a good business

(3) valuation

(4) decision making theory

• why is valuation important?

• 6 “myths” about valuation (Damodoran)

1. since valuation models are quantitative, valuation is objective

2. well researched and well done valuation is timeless

3. good valuation provides a precise estimate of value

4. the more quantitative the better

5. the market is generally wrong

6. the product of valuation matters, not the process

• approach is to review a number of different methods

• develop dynamic DCF

• P/E versus growth rate — “ buy at less than 1X growth rate”

• the EPS growth to P/E multiple link is fallacious − it should be EPS growth to ROIC to P/E multiple

equity vagaries

• indicator of value creation • does not capture key issues of value

D. Enterprise Value/Operating Cash Flow

• good for M & A versus multiple

• relates enterprise to cash flow

• industries that don’t money  P/E versus enterprise/EBITDA (Kellogg versus Nabisco)

E. Dividend Discount Model John Burr Williams Theory of Investment Value (1938)

capital needs yield stocks and

• mimics life cycle against growth stocks

• cumbersome to calculate

Ù typically 3 stages

(1) growth — high EPS growth, low payout

(2) transition — payout up, EPS growth stabilizes g = ROE x (1 - payout)

(3) mature — terminal value Dt Rf-ERP

Competitive Advantage

Intro Adoption Imitation Necessity

Time

• incorporates risk calculate

• incorporates capital intensity

• incorporates time value of $

IV. Full Development of DCF

• to value any business, security, you need to answer 3 questions

(1) What will cash flows be? (cash-in versus cash-out)

(2) When will they be received?

(3) How certain are they?

A. What is appropriate cash flow to project and discount?

• cash distributable to all claimholders  earnings after-tax

 after investment

 before financing costs Free Cash Flow = Net operating profit after tax (NOPAT) – Investment in future growth (I)

• Volume

• Pricing Sales

• Expenses

• R&D Operating Margin NOPAT

• Leases

• Tax Provision Cash

• Deferred Taxes Taxes

• Tax Shield Free Cash Flow

• A/R Working

• Inventories ∆ Capital Cash available

• A/P for distribution to all claimholders Capital Investment Expenditures

Acquisitions/ Divestitures

• NOPAT = net operating profit after taxes

= operating income

• cash taxes attributable to operating income

(1) income tax provision

(2) less: deferred taxes

(3) plus: tax savings from interest expense (tax rate * interest expense)

(4) less: taxes paid on interest income

• amortization of goodwill

• I = Investment in future growth

(1) change in working capital (operating: receivables and inventories less payables)

(2) capital expenditures (net of depreciation)

(3) acquisitions (net of divestitures)

• Buffett’s “owner earnings”= levered FCF

• Recommend think about FCF/DCF in terms of Al Rappaport’s “value drivers”

⇒ translates everyday items/ratios into Free Cash Flow

1. sales (growth)

2. operating margin (includes goodwill amortization)

3. incremental fixed capital ( capital expenditures - depreciation change in sales )

4. incremental working capital change in working capital change in sales

5. cash tax rate

6. cost of capital

7.competitive advantage period

• Financial Companies ⇒ debt is a “raw material” so interest expense is really “cost of goods sold”

⇒ rather than free cash flow, financials use modified earnings, cash flow available for equity investors and the cost of equity ⇒ model is slightly different but the concepts are the same

B. Appropriate Discount Rate

⇒ Weighted Average Cost of Capital (WACC)

4 steps:

1. Estimate cost of equity (Ke)

2. Estimate cost of debt (Kd)

3. Estimate weighted average based on target, market value debt/total capital ratio

4. Estimate WACC

• Arbitrage Pricing Theory = multifactor analog to CAPM

• Great book on risk: Against the Gods: The Remarkable Story of Risk by Peter Bernstein

D. Terminal Value — 3 Approaches

D. Growth in perpetuity

Value = FCF CAP +1 WACC – g

FCF CAP + 1 = normalized FCF one year after CAP

WACC = weighted average cost of capital

g = growth in FCF in perpetuity

2. Value driver formula — mathematically equivalent to growth in perpetuity

Value = NOPAT CAP+1 (1 –g/r)

WACC - g

NOPAT = normalized NOPAT after CAP

g = growth in NOPAT

r = rate of return on new investment

• assumes I in FCF formula and I in value driver formula have same returns

3. Perpetuity assumption

Value = NOPAT CAP+1 WACC

• equal to value driver when r = WACC

NOPAT (1 – g/r)

WACC - g

= NOPAT (1 – g/WACC)

WACC - g

= NOPAT [WACC –g/WACC)]

WACC - g

= NOPAT WACC

E. Competitive Advantage Period

1. economic theory suggests that returns are driven down to the cost of capital

• CAP equals the period of time a company can generate excess returns on new investments

Excess Returns CAP

Time

• shaded area = aggregate value creation = P/E above “commodity” multiple = enterprise value/EBITDA above “commodity” multiple

• management should maximize shaded area — 2 dimensions height and width

• no one knows “real” number; helps quantify expectations

• CAP is defined by 3 factors ⇒ current ROIC ⇒ rate of industry change ⇒ barriers to entry

2. sources of value creation — change in expectations

(a) Better Financial Returns (b) Expanded CAP

Excess Excess Returns Returns

Time Time

• earnings surprise l change in industry structure

• balance sheet surprise l change in management

3. Goldman Sachs Study

4. How I think it looks

• threshold of pain

• concept of “Bid-a-Note” from “Name That Tune”

Excess Returns

Time

V. Debate about “growth” versus value

1. Buffett says debunking difference is considered intellectual cross dressing

• buy/sell securities that are under/overvalued to outperform

• in fact, most growth and value funds own the same stocks

Growth funds Value funds Philip Morris 1 1 FNMA 2 5 Merck 3 4 PepsiCo 8 16

2. EPS rising ≠ value creation

3. Growth defined

• buy value creating companies

⇒ hope that returns > expectation

⇒ hope that CAP remains static; expands

Excess Returns

Time Alan Shapiro USC:

Excess returns KO 73-83 2.9% 84-94 28.6%

*1974-183 ROE > 20% *13.6% S&P 500

4. “Value” defined *13.4% “super”

• buy value creator with transitory dip in returns or CAP

• buy value neutral/value destroyer with a catalyst

VI. Market Signals

 Essence of investing

 Recognize that stock prices convey very important information

 Stocks say something about businesses/business prospects

1. Bottoms up valuation

• take assumptions about business compare with current market value

• higher jumper, where the bar is set

2. Take stock price — reflect on implied corporate performance

(a) Hold constant value drivers most easily estimated

– capital intensity

– tax rate

– WACC

– Calculate IRR from stock price

Nopat Margins $53.00

Nopat Margins Assumes a Assumes a

VII. Understand Expectations

Class IV

I. Introduction

II. Rates of Return

• keep saying returns > WACC but have not clearly defined returns

• much easier said than done

• very important from corporate standpoint – you need to understand expectations

indicative — flawed denominator

— good proxy, — not an economic measure young companies — mix operating performance

— widely used with financing decisions returns > Kd ↑ ROE

Earnings Equity

— manipulated — manipulated

— time value $ — accounting convention

— risk — buybacks

— FASB 106

—all things equal, indicative —understates/overstates DCF returns —operating performance/ financing

• project that is NPV zero

useful over time than ROE, ROA

Operating Approach Financing Approach

Deferred taxes * Accumulated goodwill Net P, P&E Other liabilities amortization Goodwill Preferred stock * Restructuring charges Other Common equity * Phantom goodwill Invested Capital Invested Capital

D. Threshold/ Incremental Threshold Margin “economic break-even”

Incremental threshold margin = margin required on now investments to earn WACC

= (fixed capital + working capital rate) * WACC (1 + WACC) (1 - cash tax rate)

Threshold margin = margin required to earn WACC

Year0 EBIT + (Incremental threshold margin * incremental sales)

Year 0 sales + incremental sales

incorrectly — compensation EVA versus FCF

• mathematical equivalents

• allocation of value, value creation different

F. Rate of Return on Incremental Invested Capital

= return generated on capital added at the margin

Simple version

• has simplifying assumption that rate on “base” invested capital is stable

= NOPAT2 - NOPAT1 Invested capital1-Invested capital0

Complex version

The Market-Demanded Return on New Investment (MDROI)

A. Stock Price = expectations B. Expectations = “steady-state” value + PVGO C. PVGO = Investment, how long (MICAP), and return on investment D. You know: - stock price

• PVGO

• I

• WACC

• MICAP

Hence, you can solve the MDROI

1. First, take the current stock price as well as your forecast of future NOPATs and Investments and use them to calculate the Market-Implied Competitive Advantage Period (MI-CAP). For example, in Rappaport’s analysis on Chapter 6 of the revised Creating Shareholder Value, the share price is $130, and the MI-CAP is 5 years.

2. Next, look at your forecast of future Investments (the annual change in your company’s Invested Capital base). Calculate the present value of those investments using the weighted average cost of capital (WACC). Then calculate the sum of the PV’s of those Investments from Year 1 to the MI-CAP year (in this case, 5 years).

Years 0 1 2 3 4 5

Total Inc. Investment 3.60 4.03 4.52 5.06 5.66 PV of Inv. (t) 3.27 3.33 3.39 3.45 3.52 Σ PV of Inv. (0 ... MI-CAP) 16.97

This gives you the present value of all the cash that the market expects managers to invest at a return different than the cost of capital.

3. Next, we want to calculate the Return on New Investments that shareholders demand the company must earn so that shareholders will at least earn their return on equity. How do we do this?

• Standard corporate finance tells us that Σ PV(FCF) = Σ PV(NOPAT)

• Σ PV(Investment).

• In an efficient market, a shareholder does not earn excess returns on his investment, i.e. buying the stock is an NPV-neutral proposition. Thus, the stock price − Σ PV(FCF) will equal 0.

• We’ve already calculated the Σ PV(Investment) in Step 2.

• So if we set the Σ PV(FCF) equal to 0, then we see that Σ PV(NOPAT) = Σ PV(Investment).

• We assume that the company will generate increased NOPATs due to its increased investment. Furthermore, we assume that investors will capitalize NOPAT improvements using the standard perpetuity formula of (Cash Flow)/(discount rate). Investors are assumed to capitalize the improvement in NOPAT using the minimum return on capital (R) that they expect the company to earn on these investments.

• The market will then calculate the present value of these perpetuities using this discount rate (R). (Remember that the perpetuity formula values a cash flow that starts NEXT year.

Thus, since these perpetuities start THIS year, we use the previous year (t-1) to calculate the discount factor.)

• We then sum the present value of these NOPAT improvements (capitalized at this minimum return on capital (R)).

Σ PV of ∆ NOPAT/R (0 ..CAP) 16.97

• Now all we need to do is to try different Market-Demanded Returns on New Investments (R) until the Σ PV(NOPAT) equals the Σ PV(Investment) that we calculated in Step 2. In this example, R = 27.17%.

Conclusion

• It highlights the fact that CAP, by itself, is incomplete. MI-CAP only tells you how long the market gives a company credit for investing above the cost of capital. This Return on New Investment number tells you what return the company will earn on its new investments, given that it can sustain the NOPAT from its old business.

• It’s forward looking.

• You can compare the R to several benchmarks. For example, you can compare R to historical returns, returns typical of the industry in which the company is investing, or annual Incremental Returns on Capital (IRC).

• It’s expressed as a percent. Most analysts and managers prefer percents (e.g. IRR, ROIC) over numbers (e.g. NPV dollar amounts, EVA dollars).

• You can use this tool to help pick a target price. You would repeat the 3 steps:

1) Calculate the CAP is implied by your target price.

2) Use your Investment forecast along with this CAP to calculate Σ PV(Investment)

3) Calculate the R needed to equate Σ PV(NOPAT) with Σ PV(Investment) Then, assess the reasonableness of the new R.

G. ROIC spread and Enterprise Value to Invested Capital

S&P Industrials 25.00

1997 Enterprise Value/Average Invested Capital 20.00

15.00

10.00

• ROIC - WACC spread better explains EV/IC than EPS or cash flow growth

• consistently true across industries and across time

• watch the y - intercepts and slope

III. Capital Structure Considerations

• market adjusted equity versus book equity

• maximize debt levels while maintaining financial flexibility

• analyze debt levels versus peer group

Theories of Capital Structure

A. Static Model

PV Interest Tax Shield PV Costs of Financial Distress

Market Value of Firm Firm Value wth Debt

Optimum Firm Value under All-Equity Financing

Debt

• -

• common sense—tax shield increases • so many companies don’t have optimal value capital structures

• correctly predicts that asset rich • within industry, most profitable companies borrow more than companies borrow less, least “growth” and asset poor companies profitable borrow most

• debt ↑ good, debt ↓ bad

E.G. Packaged Food

ROIC ROIC

Assumptions: 1. dividend policy is sticky

2. firms prefer internal to external financing; they seek external if necessary for NPV positive projects.

3. if they need external capital; they issue safest security first

4. as firm seeks more external financing; works down pecking order

• -

• intra-industry debt levels explained • why issue equity if could issue debt

• debt increases, equity increase explained

S = PV perks, overstaffing, above market wages

= “junior financial claim”

• managers with limited share holdings maximize W, not E

if you add debt, or repurchase shares as “ junior claim” S ↓

IV. Mergers and Acquisitions

1. Empirical facts/thoughts

• roughly 2/3 of all deals are value destroying for acquiring company

• main driver of “wealth transfer” is the premium paid

• value created = PV synergies — premium paid

• pooling versus purchase

2. Wall Street

• tends to focus on EPS accretion/dilution

• focus on strategic fit

• incorrect association between the project and funding source

• strategic fit at what cost?

• the market generally gets it

3. Proper Analysis of M&A A. value acquiring company

• overvalued/undervalued/fair value

• could affect funding options B. value target company without synergies

• understand expectations already embedded in the share price

• overvalued/undervalued/fair value C. identify synergies

• operating: sales, margins, capital needs

• financial: taxes, cost of capital

• human: management D. value synergies

• embed synergies into model from section B

• understand necessary performance to create value E. shareholder value at risk (SVAR)

• degree to which company is “betting the firm”

• very different for stock-for-stock versus cash deals

• cash = premium paid ($) / equity value of acquirer

• stock = premium paid ($) / combined equity value of acquirer and target F. the quick analysis

• calculate SVAR

• identify synergy (management credibility)

• value synergy (capitalize at WACC)

• estimate value changes G. pitfalls

• linking financing source with deal

• overvaluing synergies

• the “winner’s curse”

• management incentives

V. Employee Stock Options

1. Why they are relevant

• Agency costs

• Recruiting/retaining employees

• Liquidity

• New economy

2. Accounting versus Economics

• Diluted shares only count “in-the-money”

• No reckoning for “out-of-the-money” or time value

3. Valuation

• Already granted options as an economic liability

– Black Scholes adjusted for § Churn § Taxes § ESO’s are warrants

• Future grants as an “expense”

– Arbitrage between grant value and cash value

– FASB 123 offers guidelines on grant values

– Imbed in DCF

4. Signals

• Managers price ahead of good news

• Managers reprice at the bottom

• Disclosure prohibits exploitation

5. Indexed ESO

• Variable, not fixed

• 2x options can be granted

• accounting versus equity compensation

VI. Real options

1. Defined

• Application of financial options theory for real world investments

• Black-Scholes

• Drivers of the model are analagous

2. Advantages versus NPV

• Flexibility

• Contingency

• Volatility

3. When is options thinking applicable?

• Smart managers

• Market-leading businesses

• Uncertain markets

4. Valuation with real options

• Add base business and real options

• Impute real option value

Class V

I. Introduction

II. Summary of First 4 Sessions and Today

1. Markets are sophisticated and relatively well functioning

2 .Develop a model that translated performance of business into an economically correct set of expectations

3. Today most important facet of security analysis — strategy assessment

• This analysis will allow us to develop forecasts, or expectations, or value drivers

III. Two Additional Points on DCF

1. Applications under varied circumstances

A. straight forward (e.g., food, beverage, household) — no problem

B. cyclical • measure ROIC vs. WACC over cycle — watch swings

• consider returns on capital investment on margin

• still stock price versus expectations

• market compensates 1) higher discount rate

2) shorter CAP

C. startup/emerging • still valid

• options pricing more reflective

2. Sensitivity Analysis

• run alternative scenarios

• probability weight

IV. Strategy Assessment (The Mental Models)

• Porter framework

• New Economy

• Game Theory

Competitive Advantage Competitive advantage exists when a company’s sales are greater than costs, including the opportunity cost of capital. One measure of such returns is a positive ROIC-WACC spread. It should be stressed that competitive advantage is not qualitative judgement but rather a quantitative issue. By definition, a business with a competitive advantage either earns, or promises to earn, returns on capital in excess of the cost of capital.

Furthermore, competitive advantage must be viewed in absolute, not relative terms. A business that earns higher returns than its peers do, but does not earn its cost of capital, can be said to have a comparative advantage, not a competitive advantage.

Strategy A successful strategy is one that allows a company to capture a competitive advantage.

Porter defines strategy as “the creation of a unique and valuable position, involving a different set of activities.” He stresses that operational effectiveness represents excellence in individual activities while strategy is the appropriate combination of activities.

Strategic positions come in a number of forms. A variety-based position is when a company produces a subset of industry’s products or services. When a company serves the needs of a particular group of customers, it is pursuing a needs-based position. Finally, an access-based position relies on segmentation of customers by access channel.

Porter argues that strategic positions are not sustainable unless clear trade-offs are made with other positions. Trade-offs are necessary because of potential inconsistencies in image, the difficulty of executing within multiple positions, and limits on management resources.

V. Assessment Pages

O p e r a tin g A s s e s s m e n t

S u p p lier P o w e r C u s to m e r im a g e D iffe r e n t i a t i o n o f i n p u t s S u p p o r t activity S w i t c h i n g c o s t o f s u p p lie r s S u p p lie r c o n c e n t r a t i o n Im p o r t a n c e o f v o l u m e t o s u p p l i e r Buyer Power B u y e r c o n c e n t r a t i o n v s f irm c o n c e n t r a t i o n F irm I n f r a s t r u c t u r e

Buyer volum e Buyer switching costs H u m a n R e s o u rce M a n a g e m e n t M a rgin B u y e r i n f o r m a tio n S u b s titute products T e c h n o lo g y D e v e lo p m e n t B r a n d i d e n t ity S u b s titution T h r e a t P rocurem ent R e lative price perform a n c e o f substitutes S w itching costs Buyer propensity to substitute R ivalry In d u s t r y g r o w t h F ixed (or storage) costs Inbound O u tbound M a rketing In te r m itte n t o v e r c a p a c i t y O p e rations L o g istics & S a le s S e rvice M a rgin L o g istics P roduct differences C o n c e n tra t i o n a n d b a l a n c e Inform ational com p lexity E x it b a r r i e r s A b s o lute m a rket size M a rket growth P r i c e s e n s itivity G o v e r n m e n t r e g u la tio n s P rim a r y A c t i v i t i e s

E c o n o m i c c l i m a te G lo b a l S o c ie ta l t r e n d s

Financial Assessment

Capital Balance Intensity Sheet

Capital spending trends/outlook Optimal capital structure Impact on value Underleveraged Returns on incremental spending Overleveraged Capital needs versus industry Alternate financial strategies Government regulations Position versus industry Working capital management H idden assets/liabilities Off balance sheet alternatives Tax strategies Acquisitions/ Dividend Policy/ Divestitures Share Repurchases

Track record Signalling mechanism "Growth" for growth's sake Willingness to return cash to shareholders Willingness to divest value destroyers Alternate strategies Focus D ividend versus repurchase decisions Integration skills

Management Assessment

Capital A llocation S trategic Focus

Focus Formulation of plans Ability to build value-creating businesses Ability to execute W illingness to sell value destroyers/nonstrategic Management resources Astute balance sheet management G lobal capabilities W illingness to return cash to shareholders Past record Understanding of capital markets Human Resources/ E thics Compensation

S traight shooters Ability to develop managers Disclosure Management turnover Accounting principles Equal opportunity Treatment of stakeholders Share ownership e m p lo y e e s Compensation package retirees Financial management system customers Performance measurement suppliers C o m m u n ity interaction

Time Allocation

Slow-cycle

Characteristics Relative stable value chains Competitive advantage not directly related to economies

Examples Telephone Utilities

Value driver characteristics Long competitive advantage periods Predictable cash flows Valuation key Medium-cycle Fast-cycle

Characteristics Characteristics Evolving value chains High value chain instability of scale Productivity key to competitive advantage

Examples Examples Food Biotechnology Beverage Computers Chemicals Entertainment Cosmetics/Household products Semiconducters Autos Airlines Packaging Entertainment

Value driver characteristics Value driver characteristics Varied and dynamic CAPs Short competitive advantage periods Varied and dynamic cash flows Fundamentals critical Valuation important Valuation not important

Valuation Slow-cycle

Medium-cycle

Fast-cycle

Fundamentals

V. New Economy Strategy

1. What’s “New” about the New Economy?

• Networks more prominent

• Trumping tradeoffs

• Economics of physical capital versus intellectual capital

2. Network economics

Old Economy

• Old economy has economics of scale

• Supply-side driven

• Positive feedback dissipates as dominance is approached

New Economy

• Network effects

• Demand-side driven

• Positive feedback strengthen with dominance

Radial Interactive

"Of networks there shall be few." — Arthur's Law

3. Trumping trade-offs

et ’t g the s n on in as io M izat “D ck dle” m sto Richness stu mid cu Richness

Reach Reach

4. Economics: atoms versus bits

Atoms Bits

Lock-in (standard)

6. Topology of the internet

100

10- 2 % sites % visits

Top 150 Internet Stocks (12/99)

Market Capitalization ($)

107

10 0 Alexa Infoseek 106

7. What to look for

• Heavily discount – or give away – new products

• Link and leverage

• Understand the power of the web

• Think adaptation, not optimization

VII. Game theory

A. can’t make decisions in a void

• always weigh competitive response

B. aim for “cooperation”

• tit-for-tat wins an iterated prisoner’s dilemma

• be aware of the risk of sparking defection

C. competitors are sometimes hard to define

• a challenger may reinforce your business

• “co-opetition”

VIII. Strategic issues

Distinguish between delivering value to consumer/customer and delivering value to shareholders

Shareholder value

Customer satisfaction

IX. Resource Allocation

If you do not understand where capital has gone and at what return it has been greeted, you do not understand the company.

Four key ideas:

1. Zero-based resource allocation

% of value created

% of capital invested in the business

2. Fund strategies, not projects

3. Capital rationing

4. Zero tolerance for bad growth

XI. Buffett Tenets

A. Business Tenets

• consistent operating history

• favorable long-term prospects

• rationality in industry

• candor in management

• avoidance of the “institutional imperative”

B. Financial Tenets

• high return on equity that is sustainable (with low debt, ROE nearly equals ROIC)

• owner earnings (with low debt nearly equals free cash flow)

• attractive margins (learned from Phil Fisher)

• one dollar premise (basically market value added)

C. Market Tenets

• determine value (John Burr Williams)

• buy only with a margin of safety

XII. Due Diligence

Very important to securities analysis, but value varies significantly among industries

Due diligence is more intensive with:

• Businesses that have changing models

• Smaller companies

• Less visible companies

• One product companies

What do you do?

• Act as a detective

• Who uses the product or service?

• Who supplies raw materials?

• Who distributes the product/service?

• Verify claims — the vast majority of what you hear is true; what’s not true is what’s important

Class VI

I. Introduction

• questions from class 5

• current events

• review presentation skills

II. Role of decision making theory/psychology in investing Course Pillars

1. capital markets — independence/non-independence of errors

2. valuation — optimism/pessimism

3. strategy — company decisions/capital allocation

4. decision making theory permeates all areas

• not a “soft” issue — as important to understand as finance and strategy

A. Group level

• non-independence of errors

• cumulative impact of information

B. Individual level

1. Humans are not “hard wired” to invest

• “In terms of biological design for the basic neural circuitry of emotion, what we are born with is what worked best for the last 50,000 human generations, not the last 500 generations — and certainly not the last five. The slow, deliberate forces of evolution that have shaped our emotions have done their work over the course of a million years; the last 10,000 years — despite having witnessed the rapid rise of human civilization and the explosion of the human population from five million to five billion — have left little imprint on our biological templates for emotional life.”

Daniel Goleman, Emotional Intelligence

“Mitochondrial Eve”

3. There are 4 types of “intuitive knowledge”

• Language

• Psychology

– Understanding other people’s mental state

• Biology

– Living versus inanimate objects

– Horse in striped pajamas ≠ zebra

• Physics

– Physical objects have different set of rules than mental concepts

– Solidity, gravity, inertia are hard wired

4. Emotional baggage/foibles

• humans love to be part of the group — its comforting, safe and offers confirmation

• we love a story — the brain will actually make up causes for a given affect (LeDoux)

• escalation of commitment — “once committed to a course of action, executives often allocate resources in ways that justify their previous choice, whether or not they now appear valid.”

• humans are influenced by how information is presented

• Robert Cialdini — Influence: The Power of Persuasion ⇒ commitment and consistency ⇒ social proof ⇒ scarcity ⇒ reciprocity ⇒ authority ⇒ liking

5. Heuristics and associated biases

• humans operate inductively, not deductively

• it’s a complicated world — we need short-hands, rules of thumb, to determine behavior

• these rules of thumb, formally called heuristics, lead to biases that can undermine the quality of decisions

Three general heuristics:

1. Availability Individuals assess the frequency, probability or likely causes of an event by the degree to which its instances or occurrences are readily available in memory.

2. Representativeness Individuals assess the likelihood of an event’s occurrence by the similarity of the occurrence to their stereotypes of similar occurrences.

3. Anchoring and Adjustment Individuals make assessments by starting from an initial value and adjusting it to yield a final decision.

Biases from Heuristics

1. Availability ease of recall — individuals judge events that are more easily recalled from memory, based on vividness or recency, to be more numerous than events of equal frequency whose instances are less easily recalled.

retrievability — individuals are biased in their assessments of the frequency of events based on how their memory structures affect the search process

2. Representativeness regression to the mean — individuals tend to ignore the fact that extreme events tend to regress to the mean in subsequent trials insensitivity to sample size — individuals frequently fail to appreciate the role of the sample size in assessing the reliability of sample information

3. Anchoring and Adjustment insufficient anchor adjustment — individuals make estimates for values based upon the initial value and typically make insufficient adjustments from this “anchor”

when establishing a final value overconfidence — individuals tend to be over confident of the infallibility of their judgments when answering moderately to extremely difficult questions “need based illusions”

• superiority

• optimism — underestimate probability of a bad outcome

• control — believe they control outcomes Other Biases the confirmation trap — individuals tend to seek confirming information for what they think is true and neglect the search for disconformatory evidence

hindsight and the curse of knowledge — after finding out whether or not an event occurred, individuals tend to overestimate the degree to which they would have predicted the correct outcome endowment effect — people value what they possess higher than an object of equal value that they don’t possess

winner’s course — demonstration

• anchor/consistency

• winner “wins” prize, gets a bad deal

• plot distribution

Class VII

I. Introduction

II. Final Thoughts/Course Wrap-up (What I hope you gained from the course)

A. Readings and lecture notes with an extended shelf life

• review the reading and notes periodically, they will make more sense each time

B. Course Framework

1. Capital Markets

• acknowledge the role of luck in the money management/stock picking process

• understand the role of independent errors (jelly bean, academy awards)

• understand the established record of money managers ⇒ 75% underperform after costs and fees

• focus on the right drivers, emphasizing clarity of thought ⇒ don’t get fooled by the business press and faulty causality

• understand that the final chapter has not been written in finance theory ⇒ what you have learned at CBS regarding efficiency, risk may be superseded by complex adaptive system ⇒ complex adaptive system framework is already a better descriptive model ⇒ complex adaptive system charge has not been led by economists

2. Valuation

• valuation in and of itself cannot be a competitive advantage ⇒ you can’t “out value” the world ⇒ valuation is a key part of the process, but the journey is more important than the destination ⇒ its important to get valuation right, but its not as important as developing a “variant perception”

• we reviewed different valuation techniques and found that the DCF best sorted out the sources of value creation ⇒ P/E’s and cash flow multiples are not valuation methods, they are shorthands for valuation ⇒ investors that use P/E’s aren’t dummies, investors that use DCF aren’t geniuses; recognize that people use P/E as a heuristic, based on (useful or arbitrary) accumulated experience

• valuation is a great tool for understanding expectations ⇒ understand the consensus view ⇒ understand your view ⇒ determine, with independent thinking, whether or not these views differ

• “margin of safety” means you have a different view and that the probability of you being right is high ⇒ there is always the risk you are wrong ⇒ you want the odds in your favor (think of a gambling analogy)

3. Strategy Assessment

• the most critical element of security analysis, period

• understand the business proposition (what does this one company do?) ⇒ understand ROIC of operations ⇒ understand opportunities to grow

• industry structure/competitive position/competitive advantage ⇒ flesh out each element of the process

• critically evaluate management ⇒ do they have a strategy?

⇒ can they execute the strategy?

⇒ how are their capital allocation skills?

4. Decision making theory/psychology

• our cognitive makeup is not geared toward investing - this is a truism

• understand the shortcomings we all share to some degree ⇒ irrationally escalating commitments ⇒ consistency versus correctness ⇒ overconfidence in attaining outcomes ⇒ relying too much on readily available information ⇒ anchoring your judgments

• focus on minimizing your errors

C. Professionals

D. Presentations

E. Thank you!

Jar Auction

1. Guess how much money is contained in the jar.

_______________________

2. Make a bid for the amount in the jar.

________________________