Facts and Fictions in The Securities Industry
Sam Vaknin, Ph.D.
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Created by: LIDIJA RANGELOVSKA REPUBLIC OF MACEDONIA
I. II. III. IV. V. VI. VII. VIII. IX. X. XI. XII. XIII. XIV. XV. XVI. XVII. XVIII. XIX. XX. XXI. XXII. XXIII. XXIV. XXV.
Introduction The Value of Stocks of a Company The Process of Due Diligence Financial Investor, Strategic Investor The Myth of the Earnings Yield Technical vs. Fundamental Analysis of Stocks Volatility and Risk The Bursting Asset Bubbles The Future of the SEC Privatizing with Golden Shares The Future of the Accounting Profession The Economics of Expectations Anarchy as an Organizing Principle The Pricing of Options The Fabric of Economic Trust The Distributive Justice of the Market Notes on the Economics of Game Theory The Spectrum of Auctions Distributions to Partners and Shareholders Moral Hazard and the Survival Value of Risk The Agent-Principal Conundrum Trading in Sovereign Promises Portfolio Management Theory Going Bankrupt in the World The Author
The securities industry worldwide is constructed upon the quicksand of self-delusion and socially-acceptable confabulations. These serve to hold together players and agents whose interests are both disparate and diametrically opposed. In the long run, the securities markets are zero-sum games and the only possible outcome is win-lose. The first "dirty secret" is that a firm's market capitalization often stands in inverse proportion to its value and valuation (as measured by an objective, neutral, disinterested party). This is true especially when agents (management) are not also principals (owners). Owing to its compensation structure, invariably tied to the firms' market capitalization, management strives to maximize the former by manipulating the latter. Very often, the only way to affect the firm's market capitalization in the short-term is to sacrifice the firm's interests and, therefore, its value in the medium to longterm (for instance, by doling out bonuses even as the firm is dying; by speculating on leverage; and by cooking the books). The second open secret is that all modern financial markets are Ponzi (pyramid) schemes. The only viable exit strategy is by dumping one's holdings on future entrants. Fresh cash flows are crucial to sustaining ever increasing prices. Once these dry up, markets collapse in a heap. Thus, the market prices of shares and, to a lesser extent
debt instruments (especially corporate ones) are determined by three cash flows: (i) The firm's future cash flows (incorporated into valuation models, such as the CAPM or FAR) (ii) Future cash flows in securities markets (i.e., the ebb and flow of new entrants) (iii) The present cash flows of current market participants The confluence of these three cash streams translates into what we call "volatility" and reflects the risks inherent in the security itself (the firm's idiosyncratic risk) and the hazards of the market (known as alpha and beta coefficients). In sum, stocks and share certificates do not represent ownership of the issuing enterprise at all. This is a myth, a convenient piece of fiction intended to pacify losers and lure "new blood" into the arena. Shareholders' claims on the firm's assets in cases of insolvency, bankruptcy, or liquidation are of inferior, or subordinate nature. Stocks are shares are merely options (gambles) on the three cash flows enumerated above. Their prices wax and wane in accordance with expectations regarding the future net present values of these flows. Once the music stops, they are worth little.
The Value of Stocks of a Company
The debate rages all over Eastern and Central Europe, in countries in transition as well as in Western Europe. It raged in Britain during the 80s. Is privatization really the robbery in disguise of state assets by a select few, cronies of the political regime? Margaret Thatcher was accused of it - and so were privatizers in developing countries. What price should state-owned companies have fetched? This question is not as simple and straightforward as it sounds. There is a stock pricing mechanism known as the Stock Exchange. Willing buyers and willing sellers meet there to freely negotiate deals of stock purchases and sales. New information, macro-economic and micro-economic, determines the value of companies. Greenspan testifies in the Senate, economic figures are released - and the rumour mill starts working: interest rates might go up. The stock market reacts with frenzily it crashes. Why? A top executive is asked how profitable will his firm be this quarter. He winks, he grins - this is interpreted by Wall Street to mean that profits will go up. The share price surges: no one wants to sell it, everyone want to buy it. The result: a sharp rise in its price. Why? Moreover: the share price of a company of an identical size, similar financial ratios (and in the same industry) barely budges. Why not?
We say that the stocks of the two companies have different elasticity (their prices move up and down differently), probably the result of different sensitivities to changes in interest rates and in earnings estimates. But this is just to rename the problem. The question remains: Why do the shares of similar companies react differently? Economy is a branch of psychology and wherever and whenever humans are involved, answers don't come easy. A few models have been developed and are in wide use but it is difficult to say that any of them has real predictive or even explanatory powers. Some of these models are "technical" in nature: they ignore the fundamentals of the company. Such models assume that all the relevant information is already incorporated in the price of the stock and that changes in expectations, hopes, fears and attitudes will be reflected in the prices immediately. Others are fundamental: these models rely on the company's performance and assets. The former models are applicable mostly to companies whose shares are traded publicly, in stock exchanges. They are not very useful in trying to attach a value to the stock of a private firm. The latter type (fundamental) models can be applied more broadly. The value of a stock (a bond, a firm, real estate, or any asset) is the sum of the income (cash flow) that a reasonable investor would expect to get in the future, discounted at the appropriate rate. The discounting reflects the fact that money received in the future has lower (discounted) purchasing power than money received now. Moreover, we can invest money received now and get interest on it (which should normally equal the discount). Put differently: the discount reflects the loss in purchasing power of money deferred or the interest lost by not being
able to invest the money right away. This is the time value of money. Another problem is the uncertainty of future payments, or the risk that we will never receive them. The longer the payment period, the higher the risk, of course. A model exists which links time, the value of the stock, the cash flows expected in the future and the discount (interest) rates. The rate that we use to discount future cash flows is the prevailing interest rate. This is partly true in stable, predictable and certain economies. But the discount rate depends on the inflation rate in the country where the firm is located (or, if a multinational, in all the countries where it operates), on the projected supply of and demand for its shares and on the aforementioned risk of non-payment. In certain places, additional factors must be taken into account (for example: country risk or foreign exchange risks). The supply of a stock and, to a lesser extent, the demand for it determine its distribution (how many shareowners are there) and, as a result, its liquidity. Liquidity means how freely can one buy and sell it and at which quantities sought or sold do prices become rigid. Example: if a controlling stake is sold - the buyer normally pays a "control premium". Another example: in thin markets it is easier to manipulate the price of a stock by artificially increasing the demand or decreasing the supply ("cornering" the market). In a liquid market (no problems to buy and to sell), the discount rate is comprised of two elements: one is the risk-free rate (normally, the interest payable on
government bonds), the other being the risk-related rate (the rate which reflects the risk related to the specific stock). But what is this risk-related rate? The most widely used model to evaluate specific risks is the Capital Asset Pricing Model (CAPM). According to it, the discount rate is the risk-free rate plus a coefficient (called beta) multiplied by a risk premium general to all stocks (in the USA it was calculated to be 5.5%). Beta is a measure of the volatility of the return of the stock relative to that of the return of the market. A stock's Beta can be obtained by calculating the coefficient of the regression line between the weekly returns of the stock and those of the stock market during a selected period of time. Unfortunately, different betas can be calculated by selecting different parameters (for instance, the length of the period on which the calculation is performed). Another problem is that betas change with every new datum. Professionals resort to sensitivity tests which neutralize the changes that betas undergo with time. Still, with all its shortcomings and disputed assumptions, the CAPM should be used to determine the discount rate. But to use the discount rate we must have future cash flows to discount. The only relatively certain cash flows are dividends paid to the shareholders. So, Dividend Discount Models (DDM) were developed. Other models relate to the projected growth of the company (which is supposed to increase the payable
dividends and to cause the stock to appreciate in value). Still, DDM’s require, as input, the ultimate value of the stock and growth models are only suitable for mature firms with a stable, low dividend growth. Two-stage models are more powerful because they combine both emphases, on dividends and on growth. This is because of the life-cycle of firms. At first, they tend to have a high and unstable dividend growth rate (the DDM tackles this adequately). As the firm matures, it is expected to have a lower and stable growth rate, suitable for the treatment of Growth Models. But how many years of future income (from dividends) should we use in our calculations? If a firm is profitable now, is there any guarantee that it will continue to be so in the next year, or the next decade? If it does continue to be profitable - who can guarantee that its dividend policy will not change and that the same rate of dividends will continue to be distributed? The number of periods (normally, years) selected for the calculation is called the "price to earnings (P/E) multiple". The multiple denotes by how much we multiply the (after tax) earnings of the firm to obtain its value. It depends on the industry (growth or dying), the country (stable or geopolitically perilous), on the ownership structure (family or public), on the management in place (committed or mobile), on the product (new or old technology) and a myriad of other factors. It is almost impossible to objectively quantify or formulate this process of analysis and decision making. In telecommunications, the range of numbers used for valuing stocks of a private firm is between 7 and 10, for instance. If the company is in the public domain, the number can shoot up to 20 times net earnings.
While some companies pay dividends (some even borrow to do so), others do not. So in stock valuation, dividends are not the only future incomes you would expect to get. Capital gains (profits which are the result of the appreciation in the value of the stock) also count. This is the result of expectations regarding the firm's free cash flow, in particular the free cash flow that goes to the shareholders. There is no agreement as to what constitutes free cash flow. In general, it is the cash which a firm has after sufficiently investing in its development, research and (predetermined) growth. Cash Flow Statements have become a standard accounting requirement in the 80s (starting with the USA). Because "free" cash flow can be easily extracted from these reports, stock valuation based on free cash flow became increasingly popular and feasible. Cash flow statements are considered independent of the idiosyncratic parameters of different international environments and therefore applicable to multinationals or to national, export-orientated firms. The free cash flow of a firm that is debt-financed solely by its shareholders belongs solely to them. Free cash flow to equity (FCFE) is: FCFE = Operating Cash Flow MINUS Cash needed for meeting growth targets Where: Operating Cash Flow = Net Income (NI) PLUS Depreciation and Amortization Cash needed for meeting growth targets = Capital Expenditures + Change in Working Capital
Working Capital = Total Current Assets - Total Current Liabilities Change in Working Capital = One Year's Working Capital MINUS Previous Year's Working Capital The complete formula is: FCFE = Net Income PLUS Depreciation and Amortization MINUS Capital Expenditures PLUS Change in Working Capital A leveraged firm that borrowed money from other sources (even from preferred stock holders) exhibits a different free cash flow to equity. Its CFCE must be adjusted to reflect the preferred dividends and principal repayments of debt (MINUS sign) and the proceeds from new debt and preferred stocks (PLUS sign). If its borrowings are sufficient to pay the dividends to the holders of preference shares and to service its debt - its debt to capital ratio is sound. The FCFE of a leveraged firm is: FCFE = Net Income PLUS Depreciation and Amortization MINUS Principal Repayment of Debt MINUS Preferred Dividends PLUS Proceeds from New Debt and Preferred MINUS Capital Expenditures MINUS Changes in Working Capital A sound debt ratio means: FCFE = Net Income MINUS (1 - Debt Ratio)*(Capital Expenditures MINUS Depreciation and Amortization PLUS Change in Working Capital)
Also Read: The Myth of the Earnings Yield The Friendly Trend - Technical vs. Fundamental Analysis The Roller Coaster Market - On Volatility and Risk
The Process of Due Diligence
A business which wants to attract foreign investments must present a business plan. But a business plan is the equivalent of a visit card. The introduction is very important - but, once the foreign investor has expressed interest, a second, more serious, more onerous and more tedious process commences: Due Diligence. "Due Diligence" is a legal term (borrowed from the securities industry). It means, essentially, to make sure that all the facts regarding the firm are available and have been independently verified. In some respects, it is very similar to an audit. All the documents of the firm are assembled and reviewed, the management is interviewed and a team of financial experts, lawyers and accountants descends on the firm to analyze it. First Rule: The firm must appoint ONE due diligence coordinator. This person interfaces with all outside due diligence teams. He collects all the materials requested and oversees all the activities which make up the due diligence process. The firm must have ONE VOICE. Only one person represents the company, answers questions, makes presentations and serves as a coordinator when the DD teams wish to interview people connected to the firm.
Second Rule: Brief your workers. Give them the big picture. Why is the company raising funds, who are the investors, how will the future of the firm (and their personal future) look if the investor comes in. Both employees and management must realize that this is a top priority. They must be instructed not to lie. They must know the DD coordinator and the company's spokesman in the DD process. The DD is a process which is more structured than the preparation of a Business Plan. It is confined both in time and in subjects: Legal, Financial, Technical, Marketing, Controls. The Marketing Plan Must include the following elements:
• • • • • • • •
A brief history of the business (to show its track performance and growth). Points regarding the political, legal (licences) and competitive environment. A vision of the business in the future. Products and services and their uses. Comparison of the firm's products and services to those of the competitors. Warranties, guarantees and after-sales service. Development of new products or services. A general overview of the market and market segmentation.