Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making - Rilegato

Hackel CFA, Kenneth S.

Rilegato

ISBN 10: 0071744355 ISBN 13: 9780071744355

Casa editrice: McGraw Hill, 2010

Riassunto

A superior new replacement to traditional discounted cash flow valuation models

Executives and corporate finance practitioners now have a more reliable discount rate to value companies and make important business and investment decisions. In today's market, it’s free cash flow, cost of capital and return on invested capital that really matters, and now there's a superior tool to help analyze these metrics—Security Valuation and Risk Analysis.

In this pioneering book, valuation authority Kenneth Hackel presents his next-generation methodology for placing a confident value on an enterprise and identifying discrepancies in value—a system that will provide even themost well-informed investor with an important competitive advantage.

At the core of Security Valuation and Risk Analysis is Hackel's successful credit model fordetermining an accurate fair value and reliable discount rate for a company. Using free cash flow as the basis for evaluating return on invested capital is the most effective method for determining value. Hackel takes you step by step through years of compelling evidence thatshows how his method has earned outsized returns and helped turn around companies that were heading toward failure.

Whether used for corporate portfolio strategy,acquisitions, or performance management, the tools presented in Security Valuation and Risk Analysis are unmatched in their accuracy and reliability. Reading through this informative book, you'll discover how to:

• Take advantage of early warning signs related to cash flow and credit metrics
• Estimate the cost of equity capital from which free cash flows are discounted
• Identify where management can free up resources by using a better definition of free cash flow

Security Valuation and Risk Analysis provides acomplete education on cash flow and credit, from how traditional analysts value a company and spot market mispricing (and why many of those traditional methods are obsolete) to working with the most recent financial innovations, including derivatives, special purposeentities, pensions, and more.

Security Valuation and Risk Analysis is youranswer to a credit market gone bad, from an expert who knows bad credit from good.

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SECURITY VALUATION AND RISK ANALYSIS

Assessing Value In Investment Decision Making

By KENNETH S. HACKEL

The McGraw-Hill Companies, Inc.

Copyright © 2011 The McGraw-Hill Companies, Inc.
All rights reserved.

ISBN: 978-0-07-174435-5

Contents

PREFACE
ACKNOWLEDGMENTS
Chapter 1 Overview
Chapter 2 Management
Chapter 3 Statement of Cash Flows
Chapter 4 Free Cash Flow
Chapter 5 Return on Invested Capital
Chapter 6 Financial Structure
Chapter 7 Cost of Equity Capital
Chapter 8 Cost-of-Equity-Capital Credit Model
Chapter 9 Portfolio Selection
Index

Excerpt

CHAPTER 1

Overview

Security Valuation and Risk Analysis is a book written to help investorsappraise the expected return from an investment in an equity security. Inundertaking this endeavor, half this book is allocated to risk, as measured bycost of capital, and half is allocated to to return, as measured by theinvestment's expected cash flows.

Many new lessons were taught and many old lessons were learned as a result ofthe financial system meltdown of 2008–2009, but none more important thanpossessing the deep skill set to practice the rigorous application of cash flowsand credit analysis. The investors having such a deep-seated knowledge were, inmany instances, able to earn outsized returns while avoiding the concerns thatwere forced into bankruptcy or forced to accept government aid. Many otherentities were severely weakened, with massive loss of market share. And when theeconomy stabilized, the firms that had strong cash flows and low cost of capitalquickly rebounded to their former levels, and over the course of a businesscycle, such enterprises normally outperform the general equity market by aconsiderable margin.

Investors who understand cash flow and credit have an important competitiveadvantage. They can place a confident value on the enterprise and spotdiscrepancies in value. To the extent that economic uncertainty is prevalent,investment opportunities are especially widespread. Those who succeed in thisenvironment are those who are best equipped with the new analytic skills to doso. Successful investors understand cash-flow adequacy is the most importantbenchmark in both security valuation and credit decisions; they also understandthere are risks associated with expected cash flows.

This book will provide you with the tools designed to give you a real edgerelative to other security analysts by demonstrating how you can

• Enhance your forecasting skills by showing how to spot and take advantage ofearly-warning signals provided by cash-flow and credit metrics

• Have a better understanding of how financial statements are prepared

• Take advantage of a better definition of cost of equity capital from which todiscount free cash flow

• Capitalize on a better definition of free cash flow by understanding howmanagement could free up cash resources

• Earn superior investment returns through practical use of an advanceddefinition of cash flow from operating activities that is superior to thatreported under generally accepted accounting principles (GAAP)

• Spot and quantify important balancesheet and off-balancesheet items that mostoften are neglected or lightly scrutinized by securities analysts and investors

• Think like a corporate "insider" by showing how corporate executives view thevarious risks that confront them

• Take advantage of the many failings of earnings before interest, taxes,depreciation, and amortization (EBITDA)

• Take advantage of how rating agencies assign credit grades

To say that much has developed in the world of finance since I cowrote CashFlow and Security Analysis (2nd ed., McGraw-Hill, 1995) with distinguishedProfessor at the Stern School of Business, Dr. Joshua Livnat, would be a verygross understatement. Who knows how close the United States, and, for thatmatter, the industrialized world, came to financial collapse during the fall of2008?

What can be stated with complete and utter confidence is the study of cash flowand credit has become more important than ever. It is with this perspective thatI produced this book.

Investments—and their study—are a living, changing experience. Whatwe take for granted one day may not be so certain the next. And thus we mustadapt, even when our central rule makers, the Securities and Exchange Commission(SEC) and the Financial Accounting Standards Board (FASB), are slow to do thesame. The U.S. Congress also operates with a lag, normally reacting to events byswinging too hard and too late.

At other times, as we have seen, accounting rule makers are forced to refineaccounting standards that have stood for many years, reacting to events of themoment, in order to satisfy investors in problem sectors. We have witnessed thepublic weigh in, voicing support for modification of existing accountingstandards, supported by a Congress feeling the heat of the voters.

Let me state with authority what this book is not. It is not atext written for or designed to appeal to academic statisticians who practicemoney management. This book is for practitioners of security analysis. Ihave seen more than a couple of Nobel Prize–winning scholars run gigantichedge funds into the ground with their theories. I have been through too manyonce-in-a-hundred-years events.

The great investors throughout time started, built, or acquired companies whoseproducts enjoyed consistent and growing free cash flow. By relying onfinancially prudent business practices, their companies enjoyed a low cost ofcapital. They created a competitive advantage and did not deviate. And if theydid deviate, more often than not, they ran into trouble. I never hear successfulbuilders of businesses mention beta or other academic statistical risk tools.They talk about products, customers, risk, and cash. They talk about growthrates in free cash flow, taxes, and stability. This is how the reader will betaught to measure return and risk in this book.

This book is not centered on financial companies, although I willprovide many detailed examples and explanations of financial instruments,including why it is important to monitor creditors with whom the industrialentity relies on for financial backing.

While I am painfully aware of how problems in the financial sector spilled overto the rest of the economy, banks and insurers have investment accounts equal tomany times their shareholders' equity, and it is too often those assets thatdrive valuations and stock prices. If their investments are overstated, theirreserves understated, or their commitments, contingencies, or hedges in trouble,their valuations will see sharp declines. It doesn't seem so long ago that manyof the largest U.S. banks, quite a while before television commentators weretalking about derivatives, were in danger of failing from loan overexposure tothe energy sector. Readers will understand how risk to cash flows can bemitigated through the judicious use of financial instruments, but also how riskcan be amplified when those instruments are used improperly.

This book is designed to assist you in analyzing operating concerns. Largechanges in market value resulting from balancesheet assets deserve recognitionbut are not this book's focal point. For instance, when the price of gold runsup, EZCORP, Inc., a large pawn shop operator, often sees its stock rise owing tothe company's high inventory of gold pawned merchandise; as gold falls, so toodoes the price of its stock.

During the real estate boom preceding the outset of the 2008–2009recession, many stocks sensitive to the sector traded with little regard to cashflow or risk. Some shrewd managers of such entities recognized the discrepancyand placed their companies for sale to the greater fool, as did the board ofdirectors at Central Parking Corp., which was being valued as an asset play.

This book will not neglect a proper discussion, analysis, and treatment offinancial instruments because one would be foolish not to recognize theimportance of the financial sector to the consumer (final demand) and toindustrial companies, especially entities having financial subsidiaries. Indeed,industrial concerns do use hedging strategies, but in their case, such hedgesare not supposed to drive the train. For financials, they do.

THE MACRO ENVIRONMENT

Although this book is principally about the analysis of free cash flow and riskto the equity holder, the latter measured by the cost of equity capital, it goeswithout saying that all companies are at the mercy of the macro environment. Aswe saw during 2010, the fiscal crises in Greece impacted the euro, and with itthe financial markets in Europe and the United States. The macro environmentaffects cost of capital in a multitude of ways—from top-line (revenue)growth to bottom-line free cash flow. For these reasons, as will become clearfrom my credit model, I evaluate consistency of revenues and interest-ratespreads, among other such metrics that are inextricably tied to the vagaries ofthe economic and business cycle.

All companies are affected by macroeconomic events, such as embargoes, wars,taxes, threats, consumer confidence, legislation, and general economicprosperity, and inflation. The latter, unless accompanied by substantialincrease in free cash flow, often forces the real return on invested capitalbelow the cost of capital, thereby depressing market values. Companies whosecustomers are regional in scope are more subject to local and state issues, inaddition to the unavoidable macroeconomic factors.

For instance, the primary factors affecting demand for power (revenues) forlocal utility companies are weather and the economic conditions in the regionsthey serve. In 2004, Consolidated Edison, the large New York City utility,estimated that cooler than average summer weather reduced their earnings by $5million. While it is difficult to forecast the weather, long-term normal demandfor electricity is easier to predict. Is the utility company located in a growtharea? Is the state in which the company is located successful in attracting newbusiness? Are taxes, environmental policy, and other regulatory mattersconducive to growth of both consumers and business?

While the operating environment for a company under review may be satisfactorycurrently, it is imperative that analysts understand the climate for potentialchange—economic, political, and social.

Over the long term, the real driver of the train is management. It is managementthat strives to add value by virtue of its investments in assets whose returnsare in excess of the firm's cost of capital. It is management that recruits,trains, and motivates. As such, we begin this book's journey, Chapter 2,with a discussion of management, showing how executives can create or destroyvalue. We show how the marketplace reacts to management changes in tacitrecognition of expected shifts in free cash flow and risk. Also presented is anexample of management leading a firm to bankruptcy by not calibrating the risksof leverage properly while both buying back shares and undergoing a largecapital spending budget.

In addition, Chapter 2 discusses productivity and shows that equityvalues are indeed enhanced when free-cash-flow increases resulting fromproductivity enhancements. For non-free-cash-flow producers, enhancements toproductivity have little value and generally are ignored.

MAKING EFFECTIVE USE OF FINANCIAL STATEMENTS

The role of financial statements is to provide users with relevant, reliable,comparable, and understandable information on which they can make rationaleconomic decisions about a reporting entity. However, as we will see, theanalyst can increase the predictive value of financial statements byincorporating adjustments to the balance sheet, income statement, and footnoteditems into their analyses. These adjustments will provide the analyst with morereliable information on which to base his or her investment decisions. Toooften, as we shall learn, the FASB, in its desire to present investors withgreater transparency, has been forced to reverse or partially reverse earlierpronouncements that at the time they were originally put into effect wereenacted with the intent of providing investors with greater insight andhoped-for comparability. Unless new accounting rules provide additional relevantinformation that the analyst could not gather easily on his or her own, theywould rarely affect the cash-flow and credit analyst.

There is no doubting financial statement rule makers, both in the United Statesand around the world, can have a remarkable effect on stock prices and the costof capital in the short run.

Chapter 3 begins our discussion on cash flows. I embark by providing adetailed understanding of the Statement of Financial Accounting StandardsNo. 95, Statement of Cash Flows (SFAS 95), including its intent andshortfalls and firms misapplications of the standard. Shown are various means bywhich cash flow from operations can be artificially bolstered or understatedthrough misclassification, expense timing, lease classification, or change infunding pattern. Managerial ploys are also discussed in relevant later chapters.

Illustrated in Chapter 3 is how to prepare a direct method statement ofcash flow from operations from balancesheet and income-statement information andthe importance of doing so. Taken is a critical view of the many firms currentlyreporting operating cash flows under the indirect method. Also illustrated are awide cross section of examples of firms' investing, financing, and operatingactivities, as well as examples of supplementary cash-flow information. Theexamples were chosen specifically for the information content in an attempt toprovide the reader with a very wide swath of presentations, lessons, andaccounting and cash-flow treatments. Although many examples are given, I wantthe reader to be prepared, in his or her own everyday analysis, for reportingrelated to anything from tax windfalls to hedge accounting, from voluntaryemployee benefits associations (VEBAs) to the effect of closing out of amultiemployer pension plan.

Important is the understanding of the role of the treasury manager, includingthe credit and collection process. Therefore, I discuss the cash conversioncycle, showing how it is calculated, as well as advances in Treasury Departmentsoftware that aids the cash balance and can have the same impact as growth insales.

It is here that I introduce the concept of power operating cash flow. Thisconcept begins with cash flow from operating activities, as reported, andadjusts important working-capital items to the same percentage of revenues asits 5-year average. This gives the analyst greater visibility into normalizedcash flow from operations, that is, exclusive of changes spurred on bymanagement or induced by temporary business conditions. For example, during2007, UPS reported a sharp decline in operating cash flows resulting from itswithdrawal from a pension fund necessitating a large payment, yet poweroperating cash flow was largely unaffected, reflecting the underlying strengthin the company's operations. For this reason, power operating cash flow is oftena superior tool for measuring the recurring cash flow than is operating cashflow.

I will show the relationship between the Standard and Poor's (S&P) 500 Index andpower operating cash flow going into and coming out of the 2007 recession. Youwill see that entering the recession, power operating cash flows were negative,reflective of weakness in business operations, and how this number providedgreater clarity than reported cash flow from operating activities, which wereholding up owing to balancesheet management. During the first quarter of 2009,power operating cash flow signaled an end to the recession, although growth wasweak. A chart on power operating cash flow underscores the reason that returnson the S&P 500 were negative for the decade ending December 2009, the firstsince data recording began in 1927.

FREE CASH FLOW

Chapter 4 expounds on one of the two focal points of the book—freecash flow. I focus on free cash flow because it is the purest form of return toshareholders. It is not influenced, over the course of the business cycle, byaccounting whims, such as accruals, and various other events, such as the timingof expense items intended to inflate cash flow from operations. It will takeinto account what a firm should have contributed to its pension fund versus whatit expensed, a large worker's compensation or other payout relative to itsnormal expense. Free cash flow is what equity investors generally can count onif the cost of capital for the firm is low.

While I have observed a greater percentage of companies talk about free cashflow over the past several decades, nowhere is the talk more heated than duringeconomic slowdowns. Regrettably, there is no standard definition of free cashflow, so I will provide one that has served me well over several decades, onethat makes business and economic sense. I also show how an analyst shouldaccount for discretionary expenditures and why part of such spending should beincluded as free cash flow.

Entities that cannot generate consistent free cash flow are more prone tofinancial irregularity. It is rare for a consistently positive generator of freecash flow to manipulate its results. There is no reason for such a company to doso. Once a financial irregularity is discovered for a net borrowing entity, itsrisk profile becomes extremely high as the door to outside financing slams shut.

Chapter 4 also shows how many firms devise a definition of free cashflow to suit their own needs and circumstances, not normally resulting in auseful measure of distributable cash to equity holders. Also explored inChapter 4 are taxes, a critical area of analysis to the cash-flow andcredit analyst. Tax rates often flash early-warning signs of trouble orimprovements to cash flow. Sudden changes in the rate, even for interimreporting, often result in unpleasant surprises affecting the value of asecurity, cost of debt capital, and estimated return on projects or investedcapital. Shown is the significance of using cash taxes paid (including a cashtax rate) versus the effective tax rate that is reported to shareholders. Tax-rate stability is shown to have the utmost value in setting cost of capital andin relation to owners of equity. Taxes other than income taxes also arediscussed for their often unrecognized importance in addition to its impact onfree cash flow.

I conclude Chapter 4 with a detailed example of how to construct aworksheet to estimate free cash flow, including the estimation of excessdiscretionary expenditures. Sources of liquidity aside from cash and cash flowfrom operations are presented. I compare the model with the most populardefinitions in use today, and the advantages of using the enhanced formulabecome apparent.

(Continues...)

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Excerpted from SECURITY VALUATION AND RISK ANALYSIS by KENNETH S. HACKEL. Copyright © 2011 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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Dettagli dell'edizione

• Editore: McGraw Hill
• Data di pubblicazione: 2010
• Lingua: Inglese
• ISBN 10: 0071744355
• ISBN 13: 9780071744355
• Rilegatura: Copertina rigida
• Numero di pagine: 614
• Contatto del produttore: non disponibile
• Persona responsabile: Ufficio Anagrafiche Messaggerie; 0039 0245774342; ufficio.anagrafiche@meli.it; ; Via Verdi, 8.; Assago Milano; 20090; Italia