A review and reminder of the fragility of financial markets (A Valuation Perspective)

A chilling reminder of the fragility of financial markets was served over the last few days following the earthquake hitting Japan and subsequent exposure of their nuclear facilities. Markets have receded and continue to do so (the Nikkei 225 is off ~20% over the last five days), driven by the magnitude of the disaster, the uncertainty of the conditions at hand, and by the instability caused by the repatriation of Japanese foreign holdings. Combine this with the strength of the yen, the monetary easing (designed to instill a certain degree of confidence), and what you have is a perilous situation affecting the global market.

The global external environment is generally viewed as the starting point for a valuation analysis. In constructing a pro-forma, which serves to enumerate a free cash flow analysis, we rely on estimates for the rate of growth of the macro economy to be able to forecast how revenues (sales) will change. The importance of these estimates (revenue/sales) is evident by the fact that the construction of the pro-forma requires us to make estimates of different accounts in relation to movements in sales growth. What this means is that if you make a mistake in your prediction of growth in the following period, then because COGS (the cost of goods sold) is derived from its relationship to sales (i.e. COGS/Sales) then our estimates will carry through the entire analysis. When I said this subject was an art not a science (not my words but wise ones none the less) you can see I wasn't kidding.

For this reason, you as valuation experts (at least in 10 weeks time) need to have an understanding of the accounting framework and the products of it; be able to understand the economics of our global environment; as well as be able to reason with the numbers that are produced by our pro-formas. Most of the time we can rely on accountants to do their job well (i.e. produce statements that provide a true reflection of the position and performance of a firm), and economists to supplant us with reliable consensus estimates. This means that we can stick with working hard on the third task. It however, doesn't hurt (especially when you have your own money on the line) to have an opinion or workable knowledge of all three areas! 

Returning to Lecture 3, this lecture sought to extend the understanding garnered from previous week’s coverage of accounting statements. Our review of simple accounting principles, like the definitions of assets, liabilities, revenues and expenses is required to help us understand how to use these classifications to construct a pro-forma analysis. A pro-forma statement is simple a statement of future projections modelled using the same accounting conventions used to create a P&L and Balance Sheet (and CFS). This does not mean that your pro-forma has to look exactly like these financial statements (i.e. line item by line item) but it needs to comply with accounting conventions like A = OE + L.

To construct one of these pro-formas we are going to rely on a sales driven approach (mentioned above). Though it may not appear so at first, this is driven by a theoretical presumption that in the long-run all items in the P&L and B/S are driven by sales. Let's think about this:

*COGS (or expenses) are a function of how much we sell. As sales increases so does COGS.

*Inventory - when we sell more, we need to have more on hand to be able to distribute in a timely fashion.

*PPE - in order to serve growing sales, you need a greater pool of assets/

*Debt - the more you sell, the faster you are going to need to grow and the larger debt will become

*Accounts Receivable/Payable - the bigger you become the more credit facilities will become important to you.

So one gets the jist. While not every item in the directly linked to sales, in the long-run we can establish a case for a high degree of correlation between sales and other aspects of these financial statements. I noted in lectures, however, that how we model these relationships does not have to be a fixed and rigid exercise. For example, three firms each produce 10, 100, and 1000 bottles respectively. To produce these bottles they require a piece of machinery which allows them to produce up to 10,000 bottles a day. Therefore, irrespective of whether a firm produces 0 bottles or 10,000 of them, each of these three firms will need 1 machine. The cost is fixed initially and as sales go beyond the 10,000 costs will begin to vary.

Pro-formas have many uses - allowing managers to evaluate the credit-worthiness of their firm, to allowing you and I to conduct a valuation exercise. Understanding cash flows is important for every stakeholder in a business. A simple principle learned in introductory corporate finance is to accept any project with a positive NPV. While intuitively this will result in value creation we must also be weary of the fact that most firms cannot afford to engage in value adding projects if the majority of cash flows come in later periods. Pro-formas can thus be a critical financial planning tool for firm management.

Pro-formas capture our view of the firm's efficiency in the production and marketing of its products. What this means is that in constructing these statements we need to make decisions in three main areas: the degree of investment, the level and source of financing, and decisions regarding the dividend payout or retention rate. From here everything else will follow. Why is this the case? Well, one cannot expect supernormal growth rates if it cannot find the necessary finance to fund the necessary projects. Therefore, if the financing is unavailable, so are the necessary assets and subsequent growth. It is at this point of the analysis where we need to roll up the sleeves and make some bold, yet well thought out assumptions in our modelling.

We should also remember that pro-forma's in describing the current and future state of a firm should realistically track a firm's life cycle. If a firm is both mature, and in an industry that has reached maturity, we cannot hope to increase growth to 10-20% through simple re-investment (in theory we could, but we would be taking money away from more productive uses).

Unfortunately, pro-formas are reliant on the provision of accurate data which we know not always to be the case. Therefore, if ever stuck with bad accounting numbers, don’t despair because there are alternatives. Remember, the cash flows you are projecting can be proxied by the dividends that a firm pays out. Why? Because dividends are payed out of cash we can use the DDM model to usually give us a rough idea of where valuations should be at.

In constructing a pro-forma we often discover that the balance sheet, after inserting our projections does not in fact balance. This is a function of the fact that you are forecasting both the long term investment and financing cash flows independently of one another. Luckily, all we need to do to reconcile this problem is introduce something called the plug. The plug serves two practical purposes. Firstly, it ensures that we are consistent with accounting conventions which rule that A = OE + L. More importantly however, the OE/L sections of the balance sheet provide a cumulative record of the source of funds used to purchase assets. If these funds are less than projected assets then a company can't purchase the assets and implement operating plans. The plug is simply calculated to be the difference between a firm's trial assets and its trial liabilities/equity.

Therefore when confronted with situations where Assets > Funding then we can solve for this in a number of ways:

1. Sell some short term assets (like marketable securities) to decrease the level of assets.

2. Issue ST debt increasing funds to balance the equation.

If the converse situation prevails (where liabilities (funding) > Assets) then the following can be done to address this issue:

1. Reduce (pay-off) ST debt.

2. Increase short-term investments.

These are simple methods by which we can "plug" the difference between total liabilities, shareholder's equity and total assets.

The lecture also addressed the issue of circularity. The concept of circularity recognises that the interdependencies that exist between financial statements. For example, net income depends on interest expense, interest expense depends on short-term debt which depends on the level of financing, financing depends on retained earnings (dividend payout ratio) which also depends on net income which depends on interest expense. We've gone full-circle and when putting together pro-forma's we need to understand that changing one of the accounts will change the numbers across both these sets of statements. This is why we need to ensure that we have the iterations function working in excel and that everything is soft-coded (as opposed to being hard-coded (having numbers typed in instead of excel references)).

The final part of this lecture discussed how pro-forma's allow us to conduct sensitivity analyses. Sensitivity analysis is about varying the inputs of a pro-forma statement to examine how outputs are affected. Scenario analysis is a type of sensitivity analysis, although practitioners generally differentiate the two by the degree of sophistication. The latter usually allows multiple inputs to vary at once in order to examine how output is affected.

While it is unclear how valuations will be affected over the medium term from this Japanese crises, the short-term effects are a little clearer. Any company was foreign links to Japan (take Renault for example, with its association with Nissan), the sellers of luxury ticket items (Japan is a big consumer of high-end luxury goods), and producers of commodities are in the firing line. Should we therefore be selling? At least someone doesn't think so - Glenn Mumford in today's AFR writes an article titled "Time is ripe to buy Australian Shares" where he concludes that the "rewards offered by stocks once more exceed the risks". While the title indicates a personal conviction that the time is right to buy the writer of the article offers not much in the area of substance to convince me. But as always, its not my opinion or Glenn's that matters.

Let's just hope in the meantime that Japan is able to stave itself from any further catastrophe.