Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making
COMING THIS OCTOBER FROM McGRAW-HILL
Kenneth S. Hackel, C.F.A.
Reason Book was Written: To introduce a successful and innovative approach to the valuation of equity securities.
(a) Cost of capital, a principal component of valuation, should not be determined by stock volatility, as is widely practiced by enterprises, investors, consultants and security analysts, but by the entity’s cash flows and credit health.
(b) Return on Invested Capital (ROIC), a principal component of valuation, should be measured as a function of the assets production of free cash flows, as it should benchmark the expected cash return for cash expended; and
(c) Free cash flow should include cash the entity could easily free up, and this can be captured thru analysis of various discretionary spending areas. EBITDA, an income statement based accounting concept, is not a measure of the true economic return.
Security Valuation and Risk Analysis is a book written to help investors appraise the expected return from an investment in an equity security.
To accomplish the endeavor, half the book is allocated to risk, as measured by cost of capital; half to return, as measured by the investment’s expected cash flows.
Because security analysts are not confronted with the daily barrage of problems and exposures that managers and executives directly working for the entity confront, and rarely are many mentioned during investor presentations, this wide swath of risks tend to be ignored or not properly calibrated. Investors need to think and identify with the chief financial officer to truly appreciate the multitude of exposures the firm faces to accurately determinate a cost of capital that properly takes into account these uncertainties, of which any one could damper cash flows or even threaten the entity’s survival. On the other hand, if investors were to overweight such risks, the entity’s valuation multiple would depress, leading to out-sized investment performance for investors who properly weighed them.
The determination of the proper discount rate is a function of these risk factors, as defined by the cost of equity capital. Only thru an accurate and reliable cost of equity capital can fair value be established, as well as the determination if management is creating value for shareholders, as measured by the free cash flow-based ROIC capital compared to its cost.
The book’s comprehensive credit model replaces and improves upon the Capital Asset Pricing Model, by providing rating criteria of financial health resulting in a superior discount rate which is applied to the firm’s free cash flows. From this, fair value is established.
The text explains why entities having a low ROIC resulting in small amounts of distributable cash flows deserve low valuation metrics despite having higher rates of growth in revenues and/or earnings.
Tax effects are discussed in detail throughout the text as it relates to those affected areas, both from a cash flow effect and its associated financial reporting.
This book explains relevant current accounting requirements and how they are applied by reporting entities, especially to the Statement of Cash Flows. The text is replete with examples to illuminate each topic.
Prominent discussions, analysis and topics relate to:
- Free Cash Flow
* How to compute the maximum distributable cash available to equity holders without impairing growth
* Are cash flows and income telling the same story?
* The many failings of EBITDA and why it is inappropriate for use by practitioners and business analysts, including its use as a measure of unlevered cash flow
* Adjustment procedures for normalizing reported cash flow from operating activities to both improve comparability and eliminate management influence.
* The adjustment of various other expenses which could free cash, such as cost of sales, SG&A, and capital spending.
* The analysis of taxes, including cash rate stability and cash versus effective rates.
* Shows how improved balance sheet management has the same impact as an increase in revenues or free cash flow
* Analysis of cash flow volatility
- Cost of Capital
* Why a 1 percentage point change in the cost of capital often results in a 25% change to fair value
* Why analysts often ignore the Capital Asset Pricing Model
* A discussion of the prominent cost of capital models and how IBM could not accurately estimate its cost of capital using them
* Importance of yield spreads to the cost of capital
* Sensitivity analysis for components of cost of capital
- Return on Invested Capital
* How it should be defined using free cash flow (not EBITDA, net income or operating cash flow) and a realistic capital base
* Why it is management’s chief responsibility to continue to improve the firm’s ROIC and reduce cost of capital.
* Why share buybacks only rarely add value and do not improve ROIC
* How a new large capital investment would be analyzed and discussed from the point of view of the firm.
* How economic profit, using free cash flow, should be implemented, when ROIC is not appropriate.
- Financial Structure
* A thorough analysis of the roles debt, equity and hybrid securities play in the capital structure including possible calls on capital such as commitments, contingencies, guarantees, convertible securities, exposure to lawsuits and other cash requirements, such as sinking funds. Also explored are contingent capital, debt covenants, adjusted debt, goodwill, special purpose entities, contingent liabilities, and the importance of sensitivity analysis in evaluating financial structure.
* Detailed explanation, with examples of the accounting for pension and other post-retirement benefits, including healthcare. Importance of studying non-US plans, whose liabilities are often growing much more quickly than a firm’s US plans.
* Detailed explanation with examples, of derivatives and hedges, used for risk reduction as well as a speculation.
* Thorough explanation of lease accounting, including why current accounting rules almost always result in an understated liability. Clarification of tax accounting and reporting under the Statement of Cash Flows.
* Analysis of the roles played by of credit rating agencies, including how they evaluate ratings as well as their importance and influence