In picking a company, keep the following
a. Pick a company which has been around at least a year (preferably two), since it is nice to have two annual reports to compare. If you want to pick a company that has been listed less than that, make sure that you can get at least one year of financial statements.
b. It can be listed anywhere in the world
c. Make sure that the companies in your group are tied together by a common thread – same sector or industry.
d. Avoid money losing companies, financial service firms and firms with capital arms like GE and GM). Once you have your group nailed down, let me know the names of the people in your group and, if possible, the companies you have picked. I will set up a Google Spreadsheet where you can enter your companies, once you have picked them. In picking a company, pick a theme that is fairly broad and pick companies that match this. Thus, if your theme is entertainment, you can analyze Sony, Time Warner, Netflix and even Apple. I would encourage getting diverse companies in your group - large and small, focused and diversified, and non-US companies. (In other words, you don't want five companies that are carbon copies of each other. There is little that you will interesting to say about differences across companies, if there are none).
e. Finally, some (unsolicited) advice:
Much of the data comes from Bloomberg and if you have never used a Bloomberg before, it can be daunting.... Let me know if you get stuck,. You can get much of it from the Bloomberg terminals (there is one on the second floor in the reading room and there should be one downstairs in the computer room) and if you have never used a Bloomberg before, it can be daunting.... Let me know if you get stuck (You can also get a manual on using Bloomberg data written by yours truly u on my web site.)If you have a foreign company: Analyzing a non-US company can be interesting but sometimes frustrating. Here are some suggestions on getting information (which is the most frustrating part):
If you have a US company, visit the SEC website
http://www.sec.gov and print off the latest 14-DEF for your firm. If you are wondering what an HDS page and how to get it, you need to get to a Bloomberg terminal, click the equity button and find your company. Once you have found the company, type in HDS and you will get a listing of the top holders of equity in your company.... print off just the first page.
Bloomberg: When you type in
your company's name into Bloomberg, the first thing that will strike you is the
number of listings that Bloomberg will pull up on your company. (Nokia has more
than a 100 listings under equity). To get the listing that will contain all the
information for your company, you need the primary listing in the local market.
(The ADRs (which are the listings traded in the US) will not provide you with
adequate information.) Look for the country code for the local market (In
Western Europe, for example, FP: France, IM: Italy, GR: Germany, GA: Greece;
UK; SW: Switzerland; Pl: Portugal: FH: Finland etc...You can get a more
complete list on Bloomberg). Once you have found the listings on the local market
(and there will often be more than one), it is a process of trial and error.
Check a listing and type in DES. If you get only 2 or 3 pages, you have the
wrong listing... Keep trying and you will hit the jackpot...) Once you have
found the listing, print off everything you would for a US company (HDS, Beta,
DES (first 10 pages), FA (item 25))
b. Financial Filings: You will be able to get annual reports for almost any non US company. I usually try the company's own web site first (companyname.com usually gets you there) and print off the annual report. You can also try the following web site that lets you print off annual reports once you have registered with them (a pain, but it is free).
The UK does have its own version of the SEC and you can get information on UK companies by going to
c. Company's website: Try going on to the company's own website and looking for investor relations. The last annual report is usually available to download
Once you have picked your company, start by assessing the board of directors (and making judgments on how effective or ineffective it is likely to be). To help in this process, I am attaching the original article in 1997 that covered the best and the worst boards as well as a more recent article detailing what Business Week looks at in assessing boards.
There are a number of interesting sites that keep track of directors and their workings. I have listed a few below:
http://corpgov.net/: This is a general site listing corporate governance issues and links
http://www.ecgi.org/ : Covers corporate governance in Europe
Yahoo! finance reports corporate governance scores for individual companies...
Type in the symbol for the company that you want to look up and check under profile.
Finally, if you have used Capital IQ (and you have access to it, you can download all kinds of stuff on your company's corporate governance structure).
You can find out more about your company by going to the SEC site (http://www.sec.gov) and looking up the 14-DEF for your company.. You may not be able to find a 14-DEF (or its equivalent) for a foreign company, but the difficulty of finding this information may be more revealing than any information that you may have unearthed.
Ultimately, there are to questions that you are trying to answer:
i. How much power do you as an individual stockholder have over the management of this company?
To make this assessment, you want to start by looking at the board of directors and examining it for independence and competence. I know that there are lots of unknowns here, but work with at least what you know - the size of the board, the appearance of independence, the (perceived) quality of these directors. With US companies, you can get more information about the directors from the DEF14 (a filing with the SEC that you can get from the SEC website). With non-US companies, you may sometimes find yourself lacking information about potential conflicts of interests, but what you cannot find is often more revealing than what you can find out; it points to how little power stockholders have in these companies. Also look at subtle ways in which power is shifted to managers at the expense of stockholders including anti-takeover amendments (poison pills, golden parachutes), if you can find reference to them.
ii. Are there other potential conflicts of interests between inside stockholders and outside stockholders?
In some companies, you will find that there are large stockholders in the company who also play a role in running the company. While this may make you feel a little more at ease about managers being held in check (by these large stockholders), consider who these large stockholders are and whether their interests may diverge from yours. In particular, the largest stockholder in your company can be a founder/CEO, a family holding, the government or even employees in the company. What they might want managers to do may be very different from what you would want managers to do... Look for ways in which these inside stockholders may leverage their holdings to get even more power (voting and non-voting shares for inside stockholders, veto powers for the government...)
Attachment: Business Week article on board of directors
Building on the theme of social good and stockholder wealth a little more, there are a number of fascinating moral and ethical issues that arise when you are the manager in a publicly traded firm. Is your first duty to society (to which we all belong) or to the stockholders (who are your ultimate employers)? If you have to pick between the two and you choose the former, do you have an obligation to be honest and let the latter know? What if you believed that the market was overvaluing your stock? Should you sit back and let it happen, since it is good for your stockholders, or should you try to talk the stock price down? On the question of socially responsibility, I mentioned that there were groups out there that ranked companies based upon social responsibility. I have listed a few below, but they are a few of many:
Calvert Social Index: http://www.calvert.com/sri-index.html
Dow Jones Sustainability Index:http://www.sustainability-index.com/
And this is just the tip of the iceberg. Environmental organizations, labor unions and other groups all have their own corporate rankings. In other words, whatever your key social issue is, there is a way to stay true (as a consumer and investor). I had also mentioned CRO magazine in class and their top hundred. In case you are interested, here is the link:
In general, assessing whether companies are socially responsible is difficult to do. You can get the outliers in both directions by looking at rankings in financial publications like the Wall Street Journal, Fortune and Business Week. For instance, you can get the “most admired companies” by going to
For how organized labor views companies,
If you interested in socially responsible investing, try this web site:
It has links not only to mutual funds that invest in socially conscious companies but also on resources that can be used to put pressure on companies that are not socially responsible.
To find your firm's marginal investor, start off by looking at the top 15 investors in your firm. You can get this by printing off the first page of the HDS function in Bloomberg by doing the following:
1. Press the EQUITY button
2. Choose FIND YOUR SECURITY
3. Type the name of your company
4. You might get multiple listings for your company, especially if it is a large company with multiple listings and securities. Try to find your local listing. For a US company, this will usually be the one with your stock symbol followed by US. For a non-US company, it will have the exchange symbol for your country (GR: Germany, FP: France, LN: UK etc...) It may take some trial and error to find the listing....
5. Type in HDS
6. Print off the first page of the HDS (it should have the top 17 investors in your company).
In addition, look up the percent of the stock held by institutions in your firm. In general, if most of the top investors in your firm are institutions and a high percent of the stock is held by institutions, your marginal investor is an institution as well. In doing this, note the following:
For an investor to be a marginal investor, you need both a large holding and trading. You can have firms like Oracle where the largest single investor is an individual (Larry Ellison) but that investor will not be the marginal investor.
If you are now ready to dip your
toes in the water, you can get started building towards a minimum acceptable
hurdle rate. If you are analyzing a company in US dollars (it could be a US or
non-US company), this will be easy. Go to
Get the 10-year bond rate.
If you are analyzing a company in
Europe, I mentioned in class that you would want to use the lowest 10-year Euro
bond rate that you can find:
If you are analysing an emerging market company,
things get really messy because the government bond rates will have default
risk embedded in them. If you are truly interested in delving
deeper on the topic (you must be sick), I have a paper (I know that I need
some psychological counseling) on risk free rates that you can read this
If you want to go from a sovereign rating for your country to a default spread, you may want to look at this handout from class.
Survey Risk Premiums:
I had mentioned survey premiums in class and two in particular - one
by Merrill of institutional investors and one of CFOs. I have attached
the links to both:
Merrill survey: http://newsroom.bankofamerica.com/index.php?s=43&item=8619
CFO survey: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1654026
Analyst survey: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1609563 (My revenge on Ibbotson is on page 7 of the downloaded paper... Petty, I know...)
Historical Risk Premium: If
you are analyzing a US company, you can get the historical premium out
of my notes (4.53% for 1928 - Current). To see the raw data on historical
premiums on my site (and save yourself the price you would pay for Ibbotson's
data...) go to updated data on my website:
If you have a non-US company, don't even bother estimating a historical premium. Instead, do the following.
Step 1: Get the sovereign rating for your country
Step 2: Get a default spread for a bond issued by your country. If you want to go from a sovereign rating for your country to a default spread, you may want to look at this handout from class. If you cannot find dollar or Euro denominated bonds, you can use the typical spreads for your rating by using the attached spreadsheet that I updated on my web site.
Step 3: Estimate the volatility of the equity market and the country bond. For this, you have to go to the nearest Bloomberg terminal. Find the equity index (start with WEI) and click on the index. Once you find it, type in HVT and change the default from daily (D) to weekly (W). Try the same with the bond. If you run into a dead end, use a relative volatility of 1.5
Step 4: Add
the premium you get in step 3 to the historical risk premium for the US.
I have the equity risk premiums for 90+ countries on my website at
Implied Equity Premium: You can download the implied premium spreadsheet from my web site (under spreadsheets) and play with it. In effect, we look at the level of equity prices today (S&P 500 Index) and expected cash flows from dividends & stock buybacks in the future to back out an internal rate of return on stocks. Subtracting out the riskfree rate gives you the implied equity risk premium. As you review your notes (and I hope you have been able to watch the webcast, in case you missed the class), here are some questions that may come up:
1. How do get the expected cash flows from stocks?
Unlike a bond, stocks do not come with promised cash flows. All you can do is look at the past and make your best estimates for the future. he best source for the cash flows on the S&P 500 is S&P. Every three months, they release an update on dividends and buybacks on the S&P 500 stocks, which you should be able to find on the S&P website.
I then looked up the growth rate that equity research analysts were estimating for earnings for the next 5 years (5%) and used it to get expected cash flows for the next 5 years. The best source for expected growth on the S&P 500 is zacks.com, a service that collects and reports on analyst estimates of growth for companies. While the premium edition requires a paid subscription, there is enough on the site which is free, for you to get this input. You can also get the growth rate from Yahoo! Finance, by looking up any company, and then clicking on estimates. The only problem with the Yahoo estimates is that they average out the expected growth rate from analysts following individual companies and are biased upwards.
2. What happens after year 5?
Stocks, in theory, can generate cash flows forever. However, since we are looking at the largest companies in the market, the growth rate has to subside to the nominal growth rate of the economy. I used the riskfree rate as a proxy for this growth rate. Here is my reasoning:
Nominal growth rate in economy = Expected inflation + Expected real growth rate in economy
Riskfree rate= Expected inflation + Expected real interest rate
In the long term, expected real interest rate = expected real growth rate. To deliver a real interest rate of 2%, the economy has to generate 2% more in goods and services or it will operate at a deficit.
3. What next?
Once you have the expected cash flows and the current level of the index, it is trial and error to arrive at the internal rate of return. Alternatively, you can use the solver function in excel.
I know that the concept is complex but it is well worth understanding. If you are up to it, try computing today's implied equity risk premium in the attached spreadsheet (which has the implied premium from January 1, 2013). Remember that this is an implied premium for an entire market. It has nothing to do with your company. You need to input a dividend yield and growth rate for the entire market. Should you use this premium or the historical premium? Depends upon your point of view. If you want your valuation to be market neutral, use the current implied equity risk premium. If you believe that numbers revert back to historical averages, use the historical premium.
Betas are wondrous things, shifting and changing, as you change your index, your return period (two years, three years, five years etc...) and your return interval (daily, weekly, monthly). Just a quick review of the key issues on estimating betas:
1. All regression betas come with standard
errors. While you can get a point estimate for a beta, it is
more honest to consider the range for betas. (The standard
error itself is related to the R-squared of the regression;
high R-squared generally goes with low standard errors).
2. Because of the standard error (noise) in beta estimates, you should not be surprised to see different services report different betas for the same company. You can, for instance, compare your Bloomberg beta to the beta reported in Yahoo! Finance. The betas will be different for any number of reasons - different return periods, different return intervals, different indices - but if you consider the range on each beta (because of the standard errors of the estimates), you would be hard pressed to reject the hypothesis that the betas in the different services are the same
3. If you really want to see how betas change, capture a Bloomberg terminal (this may require hand-to-hand combat), find your stock, type BETA and play with the defaults. You can change the index (SPX to Dow to NYSE to NFT (MS Global Equity index), the return interval (D, W, M, Q) and the return period and see how the beta shifts as you do this. Note that the regression with the lowest standard error on the beta may not necessarily yield the best beta estimate.
To navigate your way through a Bloombeg beta page, you may want to try this link.
You can check the numbers from your risk analysis by going through the following steps:
a. Check out the obvious output:
a.1. The raw beta is your regression beta
a.2: The adjusted beta = 2/3 (Raw beta) + 1/3 (1). Thus, if your raw beta is 1.20, the adjusted beta will be (2/3) (1.20) + (1/3) (1.00) = 1.13
a.3. The R-squared should be listed in decimals. Thus a 0.30 R-squared tells you that have an R-squared of 30%.
b. Compute your Jensen's alpha
b.1: Start with the intercept on the beta page. It is already in percent. Thus, an intercept of 0.22 is 0.22% (Notice the inconsistency with how R-squared is reported)
b.2: You need the average riskfree rate for last 2 (5) years if you have a 2-year (5-year) regression. Since this a bit of a pain to look up,especially for non-US $ analyses, I have made the estimates for you for a few currencies:
b.3: Convert the riskfree rate (which is always reported in annualized terms) to a weekly or monthly riskfree rate by dividing by 52 or 12.
b.4: Jensen's alpha = Intercept - Riskfree rate (`1- Raw Beta). Keep your units straight.
One of the inputs that you require for Jensen's alpha is the average T.Bill rate from the last 5 years. If you want to do this precisely, you can visit the Federal Reserve site at St. Louis:
You can get approximate answers using the annual averages I have included in the attached spreadsheet. If you are wondering why you use current 10-year T.Bond rates for expected returns and T.Bill rates for the Jensen's alpha, it is a matter of perspective. When estimating expected returns, you are looking at a long term return for the future and hence you use the 10-year T.Bond rate today. When analyzing Jensen's alpha, you are looking at an investor who buys and sells each month for the last 5 years and hence you use the average T.Bill rate over the last 5 years....
Step 1: You have to get a breakdown of the businesses that your firm is in. You can get this by downloading your firm's 10K from the SEC web site or checking its annual report. Don't try to break the company down into too much detail, because you will have trouble finding comparable firms. Thus, if you have an oil company, breaking it down into drilling, refining and exploration is a recipe for frustration.
Once you have it, browse through it (I would say read it but that would be a painful exercise) to find the breakdown of your firm's business. Usually, the company will give you at least revenue and operating income by business. If you have a non-US company, you should be able to find this information in their annual report.
Step 2: Estimate bottom-up unlevered betas for each business. There are four routes you can follow, depending on how much time you are willing to spend on the process-
a. The Easy Route (5 minutes): You can use the unlevered betas that I have computed by business on my web site.
You can get to it by going to updated data and looking for levered and unlevered betas by business- I have them as separate datasets for the US, Europe, Emerging Markets and Japan. The advantage is that it is easy to do... The disadvantage is that you will not get the wonderful experience of doing it yourself and the breakdown may not be detailed enough for you.
b. The Slightly more involved route (20-30 minutes): At the top of the updated data page, you will find the complete excel datasets of the 30000+ companies that I used to construct the industry average tables. You can download the datasets (Do it on a high-speed line because it is a very large dataset) and then create your own group of comparable firms. All of the raw data on the company is provided - betas, debt, equity and cash - and you have to construct your own unlevered beta. Try it if you have a chance.
c. The Bloomberg Way (30 minutes - 2 hours, depending): After all, real finance mavens use Bloomberg. You can get the information to estimate unlevered betas by getting on a Bloomberg terminal and typing ESRC. You can then screen across markets and industries to pick firms in particular markets. Once you have your sample ready, you can modify the output page to contain the information you need - betas, debt, equity, cash and tax rates, for example. The advantage is that you can do this for non-US stocks. The disadvantages is that Bloombergs are notoriously user unfriendly and you can get only a paper printout. (We don't pay enough for a download function)
d. Capital IQ: Capital IQ is an awesome database of global companies. You have free access to it, while you are at Stern and you should take full advantage. You do have to jump through a few procedural hoops to get your login and password, but once you do, you can screen in lots of different ways. I put together an absolutely spellbinding video of my screen as I used Cap IQ to show you how easy it is to use. Click on the link below (and be ready for a long wait. The file is big...)
Step 3: Compute the values of each of the businesses that your firm is in. I would recommend using revenues as the starting point. If you are not comfortable using pricing ratios, weight the businesses based on revenues. If you would like a more precise estimate, go back to the comparable firms you pulled up in step 2 and compute the value to sales ratio for the industry
Enterprise Value to Sales = (Market value of Equity + Debt - Cash) / Revenues
Multiply the revenues from each of the businesses by these value to sales ratios to get estimated values, and use them to compute weights.
Step 4: Compute a bottom-up unlevered beta for your company by taking a weighted average of the betas in step 2 with the weights in step 3..
Step 1: Peruse your company's balance sheet to see how much interest bearing debt it has outstanding. If you have the 10K, use it since it contains more information. (If there is conflict between your 10K and Bloomberg, go with the 10K). To find interest bearing debt, start with the current liabilities since short term debt and the short term portion of long term debt will be listed there. Then move on to long term liabilities to look for long term interest bearing debt. I have to warn you that there will be a bunch of other long term liabilities that are not interest bearing debt - ignore them.
If you are working with the 10K, look for two more pieces of information in
- Lease and rental commitments for the next 5 years and beyond (do not count capital leases). If you cannot find this information anywhere in your 10K, don't panic. About a third of all US companies have no operating lease commitments.
- A schedule of when the debt is owed. It will be listed by year. Take a weighted (by how much debt is due in each year) average of when the debt comes due. (You may find that the table just aggregates all debt due after year 5 into a lump sum. Just treat it as due in 10 years and move on)
Both pieces of information will be in the footnotes. European companies report this information in their annual reports.
Step 3: Obtain the interest expenses for the most recent financial year. If you cannot find any interest expenses, check to see if you have any debt. If you don't, there's your reason. If you do find debt but no interest expenses, if may be because your firm is netting interest expenses against the interest income from cash. (This will especially be the case when you have relatively little debt.) If you have a net interest expense instead of a gross expense, try this: multiply your cash balance by a riskless rate (say 3%) to get an estimate of interest income and add this to your net interest expenses.
Step 4: Obtain a rating for your company.
your company is rated: You can get the rating by going onto Bloomberg and
looking under corp bonds or into the bondsonline.com site:
Type your name under issuer and voila....
your company is not rated:
You can use the attached ratings.xls spreadsheet to get a synthetic rating for your firm (As a bonus, it will convert your operating leases into debt for you). You can use this spreadsheet for non-US companies as well. If your company has a market cap of $ 5 billion and higher use 1 (for type of firm). If less than $5 billion, use 2....
If you have negative operating income and no rating, talk to me...
Estimate a pre-tax cost of debt for your firm by first estimating the default
spread, based upon your rating, and then adding this default spread to
the 10-year riskless rate. (Stick with the same currency that you used
for your cost of equity). While I have default spreads at the start of the
year in the ratings spreadsheet, you can pay $39 and get updated numbers at
Use the industrial spreads over 10-yr bonds.
Estimate a marginal tax rate for your firm. Start with the effective tax
rate which should be reported in your 10K but remember that this rate may
be lower than the marginal. To get the marginal tax rate, you will usually
have to go to the tax code but let me save you the trouble. In the US,
you can safely assume that the marginal tax rate (if you have an operating
profit) is 35% +, maybe close to 40%. For the marginal tax rates in other
countries, try the following link:
Compute the market value of your interest bearing debt. To do this, set
the following parameters:
Coupon payment (PMT)= Annual interest expense from last year (gross)
Maturity (n) = Weighted average maturity of your debt from step 2
Face Value (FV) = Book value of interest bearing debt from step 1
Interest rate (r or i) = Pre-tax cost of debt from step 5
Estimate the present value of the debt. You will have the market value.
Compute the market value of equity (market price * Number of shares = Market
cap), taking into account all classes of shares outstanding (except for
preferred stock) and compute the weights of debt and equity:
Market value of debt = Market value of interest bearing debt (from step 8) + PV of operating leases (from step 6)
Market value of equity = Market capitalization
Compute a levered beta for your company. In making this estimate, you will be using an unlevered beta from the bottom-up estimate. Since the debt that you used for that unlevered beta calculation was only interest bearing debt (no operating leases were considered), use only the interest bearing debt and the market value of equity to compute a debt to equity ratio.(This is inconsistent with how you define debt in step 9 but the only way to preserve consistency is to convert the operating leases of all firms into debt and who has the patience for that?) Using the marginal tax rate, estimate a levered beta:Levered Beta = Unlevered Beta (1 + (1-t) (Debt/ Equity))
To compute a cost of capital for your firm, you need to use the levered beta from the last step to get a cost of equity and the after-tax cost of debt from the earlier step. You will weight each by the market value of equity and debt (including operating leases) to get a cost of capital.
Cost of capital = Cost of equity (E/ (D+E)) + After-tax cost of debt (D/(D+E))
Preferred stock is a pain in the neck. You cannot include it with debt since preferred dividends are not tax deductible. You cannot include it with equity, because it is not equity.
If you have preferred stock that is less than 5% of firm value, ignore it
If you have preferred stock that is greater than 5% of firm value, then create a third component in your cost of capital and weight it based on the market value of preferred stock. Attach the cost of preferred stock
Cost of preferred stock = Preferred dividend yield = Preferred dividend/ Preferred stock price.
To estimate the return on capital for your firm for the most recent year, you need two numbers - an after-tax operating income for the year and the book value of debt and equity at the start of the year. You should be able to get the pre-tax operating income from the most recent income statement and the book values of debt and equity from last year's balance sheet (For 2002 operating income, use 2001 book value of debt and equity). The debt will include all interest bearing debt and the shareholders equity should be the total (which will include paid-in capital and retained earnings)
Return on capital = Operating income from most recent year (1 - Marginal tax rate)/ (Book value of debt + Book value of equity from end of previous year- Cash from end of previous year)
b. Mechanical issues in computing
return on capital
* In computing return on capital, you should be using the book value of debt and equity from the end of the previous financial year. The book value of equity can be negative but the book value of capital should always be positive.
* If you have a lot of operating leases, you will get a cleaner estimate of return on capital if you adjust both the book value of capital and the operating income for the operating leases. Your adjusted return on capital will be
Adjusted return on capital =( EBIT (1-t) + Pre-tax cost of debt * PV of Operating leases (1-t))/ (Book value of equity + Book value of debt + PV of Operating leases- Cash)
Technically, you should be using the present value of operating leases from the end of the previous year (In other words, you will need the previous year's 10K. If you do not want to do this, go ahead and use this year's operating lease commitment PV
* If my book value of equity
is negative, how do I compute ROE?
You cannot. Just put in NA or NMF for the ROE. The book value of capital should not be negative... Use it to compute the ROC.
* I am getting a really low ROC for my firm. Is this possible?
Firms screw up and take bad investments. It is all too common.
c. From Return on capital to EVA
* To go from return on capital
to EVA, you will need your company's cost of capital. Some of you noted the
seeming inconsistency of using book value
for return on capital and market value for cost of capital. I think that
you can live with it if you recognize that you are trying to measure two
different things - the return on capital measures how well you are doing
on the projects you have already invested in (hence book value matters) whereas
the cost of capital measures what it costs you to raise money (where market
EVA = (ROC - Cost of capital) (BV of Debt + BV of Equtiy)
* You should stick with the previous year's book value of debt and equity in this calculation as well.
Comparing EVA across companies is problematic since it is a dollar value and will be larger for larger companies. One way you can compare your firm's EVA to the industry average is to compute what your company's EVA would have been if it had earned the same return spread (ROC - Cost of capital) as the rest of the industry
Industry average EVA = (Industry average ROC - Industry average Cost of capital) * (Your firm's book value of capital)
You can get the industry averages
by going to this
dataset that I have on EVA.
* As a final note, you are getting a snap shot of one year when you compute your firm's EVA and ROC. To get some sense of trends, you may want to compute the EVA and ROC over four or five years.
In this section, you will take
your firm through the five components that go into the trade off and see
where your firm will fall in terms of debt ratios based upon each:
a. Tax Rate: Take note of your company's effective tax rate and also check to see whether your company operates in any high tax rate entities (Germany is a good example). You can compare your company's tax rate with the average paid by other firms paid in the industry by going to my web site and checking the data set that summarizes debt fundamentals by industry.
b. Added Discipline: Generally, the power of debt to act as a disciplinary mechanism will be greater in larger firms with more dispersed stockholdings. You can look at both the size of the firm (in terms of market cap) but it may be more useful to look at insider holdings. Firms with less insider holdings should be more likely to use debt as a disciplinary mechanism than firms with high insider holdings.
a. Bankruptcy costs: You have to look at two things. One is the probability of bankruptcy. This should be a function of the volatility of earnings and cashflows in your business. A technology firm should have a higher probability of bankruptcy for any given level of earnings than a food processing firm. The other is the cost of bankruptcy - especially indirect costs. Firms that produce assets with long lives and a need for service should have higher indirect costs because the perception of default can be devastating for their sales.
b. Agency costs: Firms that have intangible assets should be faced with higher agency costs since lenders will have a tougher time monitoring how the money is used. They should therefore borrow less.
c. Future Financing Flexibility: If you are in an industry which is in transition or a business where future investment needs are uncertain, you will value financing flexibility more and borrow less.
When you do this part of the analysis, you have to recognize two things. One is that it is subjective. The second is that it will give you a sense of direction rather than a numerical answer. In other words, you may able to tell me that your firm should have a lot of debt but you won't be able to tell me whether that is 50% or 70%.
of Capital Approach to Optimal Capital Structure
1. Open the attached excel spreadsheet (you can also download the spreadsheet from my web site under spreadsheets).
2. Before you input any numbers, go into preferences in excel, open the calculation option and make sure that there is a check in the iteration box.
3. Read the Read me worksheet in the spreadsheet
4. Go to the input page and input the numbers for your firm. Each input box has a comment in it. Read the comment before you input the value. You can start off using the most recent year's numbers but may want to come back and normalize some of the numbers (EBITDA) later.
5. For the moment, leave the answers to the last two questions on the input page at their default levels. (Yes and Yes)
6. Go to the output page. You should see the current and optimal debt ratio for the firm as well as the current cost of capital and the optimal cost of capital. You will also see the entire schedule of ratings and costs of equity for every debt ratio. I also calculate the change in value per share for your firm and do your laundry while I am it.... (Hey... What can I say? I am a full service operation)
Here is the good news for those of you who are lagging on the project. This spreadsheet will get you caught up with your hard working teammates.. One final point about the synthetic ratings worksheet embedded in this spreadsheet. It treats operating leases slightly differently from the stand alone synthetic rating sheet. This sheet makes the more reasonable assumption that only the imputed interest expense on the operating leases counts towards the interest coverage ratio.
c. Mechanics on computing optimal
I do not want the optimal capital structure spreadsheet to become a black box... So, let me try to explain some of the things that I am doing in the spreadsheet:
a. Refinancing old debt: As I mentioned in class yesterday, I assume that you have to refinance all of your old debt at whatever new interest rate you will have at the new debt ratio. Thus, if you have $ 1 billion in debt at 6% on your books and you increase your debt ratio (thus lowering your rating) and your interest rate to 8%, I assume that you will be forced to refinance the debt at 8%. This is not that unrealistic. A bank will probably have covenants that allow them to renegotiate the interest rate on old debt and many corporate bonds today have put clauses allowing bondholders to reset interest rates in the event of a recapitalization.
b. Firm value calculation: In computing the change in firm value, I calculate the change using both a perpetuity assumption and a growing perpetuity. In the latter case, I estimate the "implied growth rate" in your cashflows from your market value but I then cap this growth rate at the riskfree rate. (I am assuming that the riskfree rate is a good proxy for the long term nominal growth rate of the economy)
c. Per share value change: To compute the change in value per share, I divide the firm value change by the primary shares outstanding before the stock buyback. I am assuming that investors are rational and will demand their share of the spoils when they sell their shares back to the firm.
d. Checking for downside risk
To check for downside risk, there are two paths you can take. One is to reduce your operating income based upon either past standard deviation in operating income or what happened during the last recession. Don't do this if your operating income is already depressed. The other is to constrain your bond rating to be higher than investment grade and computing your optimal debt ratio with this constraint.
Your final recommendation on debt ratio for your firm should reflect this downside assessment and may very well be lower than the unconstrained optimal that you computed in the previous step.
You can also assess what
your optimal capital structure would be, if you allow the operating income
to change as the rating changes by using
e. Explaining your optimal
Once you have your optimal debt ratio, you may want to explain why it is what it is. To do this, compare your firm's optimal debt ratio to those of others in your group and compare them on three dimensions:
1. Tax rate: Other things remaining equal, the higher your marginal tax rate, the higher your optimal debt ratio. (In fact, experiment in your capital structure spreadsheet with a 0% tax rate and and a 70% tax rate for your firm and see what happens to the optimal debt ratio)
2. Cashflow generating capacity (EBITDA/ (Market value of equity + Market value of debt)): The higher this ratio, the higher your optimal debt ratio will be. Again, you can have firms that you categorize as very successful - Microsoft, for example - which have low optimal debt ratios because their market values are so high.
3. Volatility in Earnings/ Business: This will show up in a couple of places. One is in the cost of equity (higher unlevered beta) and the cost of debt (lower ratings). The other is when you do the what-if analysis on your operating income...
f. Other Capital Structure Approaches
If you just want to get a sense of how the APV approach works, you can download the apv.xls spreadsheet on my web site (I have also attached it to this email). I don't think it will add much to your analysis and you can skip it if you do not have the time. You can try to do a relative capital structure analysis of your company by looking at companies in your sector - in fact, use the same companies you used for your bottom-up levered beta calculation - and run a regression of debt ratios against fundamentals. This is similar to what I did for Disney with entertainment companies. You can get the raw data for this regression by going to my web site and downloading the compfirm.xls spreadsheet which is at the top of the updated data page. Finally, I have an updated market regression for debt ratio under updated data online (Cross sectional regression of debt ratio)... You can plug in the numbers for your company to see what its optimal debt ratio would be
g. Getting to the optimal debt
Once you have the optimal debt ratio, you need to go through the framework for getting to the optimal. Here are the steps:
Step 1: Evaluate whether you have the luxury of time. If you have an underlevered firm, you are looking at the likelihood of being taken over in a hostile acquisition. Make a judgment based upon
a. The market cap of the firm: The larger the market cap, the smaller the likelihood
b. Insider holdings: The greater the insider holdings, the lower the likelihood
c. Jensen's alpha: The more negative the alpha, the greater the likelihood
If you have an overlevered firm, you are looking at the likelihood of bankruptcy. Your best assessment will come from the bond rating of the firm. If it is below investment grade, the chance of bankruptcy is high.
Step 2: Examine whether your company has good investment opportunities. You can get a partial picture by computing the EVA and ROC for the firm. If they are positive and you believe that this will hold for future projects, you should invest in projects with your excess debt capacity (if you are underlevered) or with equity (if you are overlevered)
Step 3: Make your recommendation of the best path to the optimal debt ratio for your firm.
Calculation details: The cost of capital at my optimal is higher than the cost of capital at my current debt ratio. Why does that happen?
1. You are closer to your optimal at the existing debt ratio than at the optimal. Since the optimal is computed at 10% intervals, a 20% optimal debt ratio indicates that the true is optimal is between 15 and 25%. If you are at a 13% debt ratio, you may be closer to the optimal than any 10% increment.
Fix: Do nothing. You are already at your optimal.
2. If you use an actual rating (rather than a synthetic rating) to compute your current cost of capital, and your actual rating is much higher than your synthetic rating, you may find that your fhat the current cost of capital is lower than your optimal.
Fix: Switch to a synthetic rating in the optimal capital structure spreadsheet.
3. If you use a synthetic rating, you may still have a mismatch between your actual interest expenses and the estimated interest expenses. If you have a lot of your debt at low rates on your books (either because you used short term debt or you were able to borrow at lower rates in earlier periods), your interest coverage ratio will be high when you use actual interest expenses. The spreadsheet computes the interest expenses at each debt ratio by taking the dollar debt and multiplying by the updated long-term interest rate (based upon the rating at each level of debt). For example, if you have $ 4 billion in debt and your firm value is $ 10 billion, your current debt ratio is 40%. If your current interest expense is $ 200 million, it is used to compute your synthetic rating. Assume that you compute a pre-tax cost of debt of 10% at at 40% debt ratio. The spreadsheet will compute your interest expenses to be $ 400 million and compute an interest coverage ratio and rating using this expense.
Fix: Say no to the default question of whether you want existing debt to be refinanced at the new rate. Be careful, though. This debt will eventually have to be refinanced at the higher rates and the spreadsheet is giving you some advance warning.
4. If you have only or primarily operating leases as debt, you may find that the interest rate at your existing debt ratio is higher than the interest rate that you compute at your optimal (even though the optimal interest rate is more debt). This comes about because the interest expense on operating leases is computed first with a conservative interest rate (estimated by treating operating leases as debt) and then used to compute a synthetic rating. The spreadsheet itself uses a more reasonable estimate of your rating.
Fix: You can go into your ratings worksheet in your capital structure spreadsheet and change the EBIT and interest expenses to include only imputed interest expenses on operating leaese PV rather than the entire expense. On second thought, send your capital structure spreadsheet to me and I will make the fix for you.
1. Keeping in mind the objective
of matching debt to assets, think about the typical investments that your
firm makes and try to design the right debt for the project. If your firm
has multiple businesses, design the right kind of debt for each business.
In making these judgments, you should try to think about
- whether you would use short term or long term debt
- what currency your debt should be in
- whether the debt should be fixed or floating rate debt
- whether you should use straight or convertible debt
- what special features you would add to your debt to insulate the company from default
Your objective is to get the tax advantages without exposing yourself to default risk.
2. You should also try to do a quantitative analysis of your debt. I have attached a spreadsheet that has built into it the macro-economic data that you need - interest rates, inflation, GDP growth and the weighted dollar. You can enter the data for your firm and the spreadsheet will compute the regression coefficients against each. You can use annual data (if your firm has been around 5 years or more). If it has been listed a shorter period, you may need to use quarterly data on your firm. The data you will need on your firm are:
- Operating income each period (this is the EBIT)
- Firm value each period (Market value of equity + Debt); you can use book value of debt because it will be difficult to estimate market value for each period.
I have to warn you in advance that these regressions are exceedingly noisy and the spreadsheet also includes bottom-up estimates by industry. The industries are listed by SIC code and you can find your company's SIC code by going to compfirm.xls, the spreadsheet with individual firms on my web site.
1. Qualitative Analysis of Dividend
Step 1: Examine how much your company pays in dividends and how much it bought back in stock over each of the last 5 years. The best place to get this information is the statement of cashflows.
Step 2: Examine the following qualitative factors to make a judgment on what you would expect your company to be paying in dividends:
a. Investment opportunities: Look at both your EVA calculation and how much your company invested in capital spending and acquisitions. The better your investment opportunities, the less you should return to stockholders.
b. Stability of Earnings: If your earnings are volatile, you should pay less in dividends (and perhaps shift to stock buybacks). To make an assessment of earnings stability, use both common sense (tech earnings are much more volatile than food processing earnings) and your firm's own earnings history. (try computing a standard deviation in earnings)
c. Signalling needs: If you are smaller firm with no or very few analysts following you, you may choose to use dividends as a signal and end up with more dividends.
d. Capital structure and bondholder constraints: If you are overlevered (from your capital structure) analysis, you should not be paying dividends. If you are underlevered, you may want to pay out more.
e. Stockholder characteristics: There will be an element of self-fulfilling prophecy here. If you have historically paid dividends, you have probably accumulated an investor clientele who likes dividends.
Based upon the qualitative factors, make a judgment on how much your company should be paying in dividends.
Step 3: Compare the actual dividend policy to your expected dividend policy. At this stage, remember that a policy of not paying dividends is also a dividend policy and has to be justified or rejected.
2. A Framework for analyzing Dividend Policy
Step 1: Collect the information to compute the FCFE every year for your company for the last 5 years. This information should be in the statement of cashflows each year. In making this assessment, consider the following:
a. Start with the net income each year and add back the non-cash charges (depreciation, amortization and other non-cash charges)
b. Subtract out capital expenditures. If there were cash acquisitions done during the period, add the value of these acquisitions to the cap ex. If you are using a statement of cashflows, the cap ex number will already be a negative cashflow. (Don't take a negative of a negative and make cap ex a positive cashflow)
c. Subtract out changes in non-cash working capital. You can get the individual items out of the 10K statement of cashflows or look at the Bloomberg summary of the statement of cashflows (in the description) where you consolidate the non-cash working capital. Here again, the sign on the cashflow should tell you whether non-cash working capital changes are creating positive or negative cashflows.
d. You should end up with the FCFE each year
You can use the spreadsheet on
my web site to do this.
Step 2: Compare the cash returned by your firm to its stockholders each year over the same period. The dividends and the stock buybacks should both be reported in the statement of cashflow. If your company has both stock buybacks and stock issues in the same year, it is probably best not to net them out and to focus on the stock buybacks alone.
Step 3: Retrieve the EVA and Jensen's alpha you have already computed for your firm. There are four possibilities:
Scenario 1: Positive EVA, Positive Jensen's alpha: Firms with good projects delivering higher than expected returns
Scenario 2: Positive EVA, Negative Jensen's alpha: Firms with good projects but project returns were not as high as expected
Scenario 3: Negative EVA, Positive Jensen's alpha: Bad projects but returns may be improving and are better than expected
Scenario 4: Negative EVA. Negative Jensen's alpah: Bad projects delivering less than expected returns
1. Where can I get stock
returns and information on interest rates for earlier years?
The data can be obtained by going to updated data on my web site and clicking on historical returns. You need the stock returns and the T.Bill rates for each of the years for which you have data.
2. If my company has both stock issues and buybacks, should I net out stock issues against buybacks?
No. Stick with just the stock buybacks.
3. My FCFE jump around from year to year. Should I be worried?
This is normal. That is why you estimate the average FCFE over the period and compare it to the average dividends +stock buybacks over the same period.
4. Where can I get returns on my stock each year for the dividends spreadsheet?
The FA print out from Bloomberg has returns on your stock each year for the last 10 years.
3. Making a recommendation on dividend policy
If your firm is not paying out as much as it can afford to but returns scenario 1 (from step 3 of last part): let company accumulate cash and give it freedom to set dividend policy it wants
If your firm is not paying out as much as it can afford to but returns scenario 2 (from step 3 of last part): Give it freedom to set dividend policy but watch trend in returns; if returns continue to drop you may revisit the question
If your firm is not paying out as much as it can afford to but returns scenario 3 or 4 (from step 3 of last part): Company should return cash to stockholders
If your firm is paying more than it can afford to but returns scenario 1 (from step 3 of last part): Company should stop returning cash to stockholders and invest in projects
If your firm is paying out more than it can afford to but returns scenario 2 (from step 3 of last part): If downward trend in returns is long term, continue to pay out cash. It it can be reversed, invest in projects
If your firm is paying out more than it can afford to but returns scenario 3 or 4 (from step 3 of last part): Company should stock returning cash and fix its investment problem. Fixing the investment problem (investing less in bad projects) may make its dividend problem go away.
1. Which valuation spreadsheet should I use to value my company?
Use the fcffsimpleginzu.xls model, It is a malleable model, that should work for most firms. You can adapt it, if you want.
2. How do you deal with stable growth in each of the models?
In all of the spreadsheets
a. You can make the model a stable growth model by setting the high growth period to zero. You can also make any of these models a 3-stage growth model by saying yes to the question of whether you want your inputs to adjust gradually during the second half.
b. There is an industry average worksheet in each spreadsheet that provides industry average for relevant variables for your industry
c. Even though your valuation may use accounting data which is old, the value is a current value and should be compared to the market price today.
d. In stable growth, observe the limit on the stable growth rate. Set it less than or equal to the riskfree rate.
e. When you put your company into stable growth, try to adjust the inputs for the model to stable growth levels. In particular
- Move beta towards one. (The rule of thumb is that beta should be between 0.8 and 1.2)
- If your ROE (ROC) is higher than the industry average, move it towards the industry average in stable growth. If your ROE (ROC) is less than cost of equity (cost of capital), move it to the cost of equity (cost of capital) in stable growth
f. Make sure you input everything in the same units. If you enter your earnings in million, the number of shares also have to be entered in millions.
3. If you are
using the fcffsimpleginzu spreadsheet, what are the key inputs to the model?
If you are using the fcffginzu.xls spreadsheet:
* Make sure that you check the iteration box under calculation options before you start doing anything.
* You can get the information on options outstanding from your latest 10K. Just enter the total number of options outstanding, the average exercise price and the weighted average strike price from that table into the spreadsheet. (I use all options, not just the vested ones.)
* As with the equity valuation model, it is best to let the model compute the reinvestment rate in stable growth from your stable period ROC.
4. What do
I do if I have a money losing company?
If you have a money losing company, you have probably had an easy ride so far. Your optimal debt ratio was probably zero or close to zero and your firm certainly could not afford to pay dividends, but I am afraid the good times are over when you get to the valuation stage. As you have already probably realized, you cannot grow a money losing company out of trouble since the losses et only bigger. The use of reinvestment rates and returns on capital to get expected growth rates won't work because you have negative returns on capital and reinvestment rates. To value your firm, you will have to do the following:
1. Start with revenue growth: It is the only number on your income statement that is guaranteed to be positive. You can either forecast revenue growth based upon the company's history or you can look for a forecast of growth. Alternatively, you can look at growth rates for the industry.
2. Estimate future operating margins: The key to valuing these companies is to make the negative margin that they have now into a positive margin in the future. Rather than try to forecast what the margin is year by year, I would try to forecast a target margin 5 or 10 years out. I would adjust the margin from current levels to the target level. Again, industry average operating margins make sense.
3. Estimate reinvestment: You will need to still reinvest money to get the revenue growth. If current cap ex and depreciation numbers look strange or give weird results, you can use a sales to capital ratio to estimate reinvestment in future years. A sales to capital ratio of 3, for instance, would indicate that for every $3 in additional revenues, you will invest a $ 1 in new capital. The industry average sales to capital ratios may be worth looking at.
4. Adjust the cost of capital inputs: Troubled firms can have high betas and sometimes high debt ratios. You can adjust both to more reasonable levels over time.
The fcffsimpleginzu.xls spreadsheet allows you to do all of the above. You may still find your equity to be worth little or even a negative amount. (The latter can happen if the value that you get for the firm is less than the outstanding debt). Since a stock cannot trade for less than zero, your estimate of value would then be zero for the stock.