The document discusses cash usage and corporate life cycles from an investor's perspective. It finds:
1) During growth stages, reinvesting cash into high return projects creates shareholder value, while mature companies may create equal value by returning cash to shareholders.
2) The market values cash based on a company's investment opportunities - cash is discounted for mature firms with low opportunities.
3) As cash surplus increases beyond investment needs, risks of overinvestment, known as "agency costs", also increase as managers may pursue lower return projects against shareholders' interests.
4) Distributing excess cash through dividends or buybacks can create value when agency costs are high due to large cash surpluses and few
Understanding the time value of money (annuity)DIANN MOORMAN
Here are the key points:
- Future value, present value, annuities, amortized loans are important time value of money concepts
- Formulas allow you to calculate unknown values (e.g. future value) given known amounts, interest rates, time periods
- Make sure time frames are consistent when annual vs monthly payments/interest are used
- Financial calculators make the calculations easy but understanding the concepts is important
This chapter discusses accounting issues related to foreign currency transactions and financial instruments for multinational companies. It covers how to record and report transactions involving foreign currencies, the different types of exchange rates used to translate balances, and how to account for imports/exports and hedging strategies using financial instruments. The key aspects are translating foreign currency transactions and balances to the reporting currency, managing foreign currency risk, and designating hedges as either fair value, cash flow, or net investment hedges for accounting purposes.
This document discusses various types of credit instruments such as checks, bank drafts, bills of exchange, promissory notes, government bonds, and treasury bills. It outlines their key characteristics and compares advantages like encouraging savings and capital formation to disadvantages like potential overspending. The role of credit in the economy is also examined, noting how it can facilitate large-scale production, shift capital to productive uses, and increase savings rates.
This document provides an overview of corporation accounting, including:
1) It discusses the process of forming a corporation through incorporation and securing equity financing through the issuance of stock. Some key advantages and disadvantages of the corporate form are outlined.
2) It covers different financing options like debt versus equity, and how stocks work on private and public corporations. The roles of common stock and preferred stock are defined.
3) Key terms related to stock like authorized shares, issued shares, outstanding shares, and treasury stock are explained.
This document discusses the time value of money and various time value of money concepts. It begins by explaining that money has time value because it can earn interest over time and because purchasing power changes with inflation over time. It then discusses the role of time value in finance decisions and provides examples comparing cash flows received at different points in time. The document reviews concepts of future value, present value, interest, compounding, discounting, and provides examples of calculations for these topics. It also covers annuities, the difference between ordinary and due annuities, and calculations for future and present value of annuities.
This document provides an overview of key finance concepts for managers in a course on finance. It defines cash flows, rates of return, interest rates, time value of money, and timelines. It also explains future value and present value calculations for ordinary annuities and annuities due using relevant formulas. Compounding and discounting are shown to be related concepts for dealing with time value of money.
This document discusses partnership accounting, including:
1. What a partnership is, with key features being two or more persons in business together to share profits and losses.
2. The different types of capital accounts including fluctuating, fixed, partners' current accounts, and profit and loss appropriation accounts.
3. How to record transactions in the capital accounts, including contributions of cash or assets and distributions.
4. Methods for valuing and allocating goodwill when new partners are admitted or profit sharing ratios change.
Understanding the time value of money (annuity)DIANN MOORMAN
Here are the key points:
- Future value, present value, annuities, amortized loans are important time value of money concepts
- Formulas allow you to calculate unknown values (e.g. future value) given known amounts, interest rates, time periods
- Make sure time frames are consistent when annual vs monthly payments/interest are used
- Financial calculators make the calculations easy but understanding the concepts is important
This chapter discusses accounting issues related to foreign currency transactions and financial instruments for multinational companies. It covers how to record and report transactions involving foreign currencies, the different types of exchange rates used to translate balances, and how to account for imports/exports and hedging strategies using financial instruments. The key aspects are translating foreign currency transactions and balances to the reporting currency, managing foreign currency risk, and designating hedges as either fair value, cash flow, or net investment hedges for accounting purposes.
This document discusses various types of credit instruments such as checks, bank drafts, bills of exchange, promissory notes, government bonds, and treasury bills. It outlines their key characteristics and compares advantages like encouraging savings and capital formation to disadvantages like potential overspending. The role of credit in the economy is also examined, noting how it can facilitate large-scale production, shift capital to productive uses, and increase savings rates.
This document provides an overview of corporation accounting, including:
1) It discusses the process of forming a corporation through incorporation and securing equity financing through the issuance of stock. Some key advantages and disadvantages of the corporate form are outlined.
2) It covers different financing options like debt versus equity, and how stocks work on private and public corporations. The roles of common stock and preferred stock are defined.
3) Key terms related to stock like authorized shares, issued shares, outstanding shares, and treasury stock are explained.
This document discusses the time value of money and various time value of money concepts. It begins by explaining that money has time value because it can earn interest over time and because purchasing power changes with inflation over time. It then discusses the role of time value in finance decisions and provides examples comparing cash flows received at different points in time. The document reviews concepts of future value, present value, interest, compounding, discounting, and provides examples of calculations for these topics. It also covers annuities, the difference between ordinary and due annuities, and calculations for future and present value of annuities.
This document provides an overview of key finance concepts for managers in a course on finance. It defines cash flows, rates of return, interest rates, time value of money, and timelines. It also explains future value and present value calculations for ordinary annuities and annuities due using relevant formulas. Compounding and discounting are shown to be related concepts for dealing with time value of money.
This document discusses partnership accounting, including:
1. What a partnership is, with key features being two or more persons in business together to share profits and losses.
2. The different types of capital accounts including fluctuating, fixed, partners' current accounts, and profit and loss appropriation accounts.
3. How to record transactions in the capital accounts, including contributions of cash or assets and distributions.
4. Methods for valuing and allocating goodwill when new partners are admitted or profit sharing ratios change.
The document summarizes revisions made to the Philippine CPA Licensure Examination, including:
- Reducing the number of exam subjects from seven to six by merging some topics and separating others.
- Distributing topics from Theory of Accounts, Practical Accounting Problems 1 and 2 to two new subjects.
- Separating the previous Business Law and Taxation subject into individual Taxation and Regulatory Framework subjects.
- Adding additional topics to the Taxation and Regulatory Framework subjects.
- Providing tables outlining the topics covered, weights, and number of items for each revised subject.
This document discusses sources of income and classification of income for tax purposes. It defines income as coming from sources within the Philippines, without, or partly within and partly without. It provides examples of how different types of income like dividends, income from services, rent, royalties, and gains from property sales are treated. The document also discusses what constitutes gross income, how income is distinguished from capital, receipts, and revenue, and provides examples of different types of compensation that are considered taxable income.
Settlement cash discounts provide a percentage discount to customers or suppliers for paying their accounts early. These discounts are recorded in discount allowed and discount received columns in a three column cash book. Discount allowed is given to customers and credited to their accounts, with the total recorded as an expense. Discount received is from suppliers and debited to their accounts, with the total recorded as revenue.
The document defines and discusses various aspects of annuities. It defines an annuity as a fixed sum paid at regular intervals under certain conditions. It discusses the amount of an annuity as the total of unpaid installments plus compound interest. It also defines the annuitator as the person obliged to make payments, and the annuitant as the person entitled to receive payments. The document then discusses different types of annuities based on continuity and timing of payments. It provides characteristics of annuities and formulas used to calculate future amounts, accumulated amounts, and present values of annuities.
The document defines taxable income and gross income for the purposes of taxation. It states that taxable income is gross income less any authorized deductions or exemptions. Gross income is defined broadly as all income from any source, including compensation, business income, property dealings, interest, rents, royalties, dividends, annuities, prizes, pensions, and partnership shares. The document goes on to list several exclusions from gross income for taxation, including life insurance proceeds, return of insurance premiums, gifts, damages from personal injury, income exempt by treaty, and certain retirement benefits.
This document discusses the time value of money concept. It defines key terms like present value, future value, interest rates, and annuities. It provides formulas to calculate future value, present value, and annuities. Examples are given to demonstrate calculating simple and compound interest, present and future value of cash flows over single and multiple periods, and ordinary and due annuities. The document also covers topics like finding interest rates, time periods, and loan amortization.
This document provides an overview of capital budgeting and investment decision making. It defines key terms like capital budgeting, investment decisions, cash flows, net present value, and discounted cash flow techniques. It also summarizes several approaches to evaluating investment projects, including payback period, accounting rate of return, net present value, and internal rate of return. The document emphasizes the importance of considering the time value of money when analyzing projects with cash flows occurring over multiple periods.
This document provides a history of money in the Philippines from pre-Hispanic times to modern day. It describes the evolution from barter systems to early gold and bead currencies. Spanish colonization introduced Mexican pesos and coins minted in Manila. The American period established the peso tied to the US dollar. The Japanese occupation saw war notes. Independence brought new designs celebrating Filipino culture and landmarks.
The document provides an overview of the international monetary system, including:
1) The evolution of international monetary systems from bimetallism to the classical gold standard to the Bretton Woods system to the current flexible exchange rate regime.
2) Current exchange rate arrangements including free float, managed float, and currencies pegged to other currencies.
3) Details on the euro and European monetary union.
4) Examples of currency crises like the Mexican peso crisis, Asian currency crisis, and Argentine peso crisis.
5) Differences between fixed and flexible exchange rate regimes and how imbalances are addressed under each system.
Baumol's cash management model seeks to determine the optimal cash balance by minimizing total costs, which include conversion costs incurred when converting securities to cash and opportunity costs of holding excess cash. The model assumes a firm can forecast cash needs, payments are uniform, and conversion and opportunity costs are known. The optimal cash balance is calculated by equating the marginal conversion and opportunity costs. However, the model has limitations as it does not account for uncertainty in cash flows or fluctuations in transaction costs and interest rates.
The document discusses methods for evaluating capital investment decisions in healthcare organizations. It introduces the payback period method, which calculates the number of years to recover an initial investment without considering the time value of money. The net present value (NPV) method is presented, which discounts future cash flows to account for the cost of capital and calculates the difference between the initial investment and discounted cash flows. The internal rate of return (IRR) method is also covered, which is the discount rate that makes the NPV equal to zero. Decision rules for accepting or rejecting projects using NPV and IRR are provided.
Analysis & interpretation of financial statementsry_moore
This document discusses various methods for analyzing financial statements, including ratios to evaluate profitability, liquidity, and returns. It defines key ratios like stock turnover, gross/net profit percentages, current ratio, acid test ratio, and return on investment. These ratios are used to analyze aspects of the business like profit results, financial status, working capital, and mark-up/margin. Calculating and interpreting these ratios provides meaningful insights about the business's performance and financial health.
The document discusses receivable management and changing credit standards. It covers topics like average collection period, effects of relaxing credit standards, key ratios used in receivables management, an example of analyzing changes to credit standards, factors considered in granting credit, finding the optimal level of accounts receivable, analyzing changes to credit policies, and methods of collecting on receivables.
This document discusses working capital and current asset management. It covers topics such as net working capital, the cash conversion cycle, funding requirements of the cash conversion cycle including permanent vs seasonal needs, strategies for managing the cash conversion cycle such as inventory and receivables management, changing credit standards and terms, and credit monitoring. The document uses examples and diagrams to illustrate key concepts in short-term financial management.
This document provides an introduction to financial statement analysis. It discusses the key types of financial statements, including the income statement, balance sheet, statement of changes in owner's equity, and statement of changes in financial position. It also outlines different classifications and techniques for analyzing financial statements, such as external vs internal analysis, horizontal vs vertical analysis, comparative statement analysis, trend analysis, common size analysis, funds flow analysis, cash flow analysis, and ratio analysis. The overall purpose is to introduce the reader to how financial statements are constructed and various methods for evaluating the financial and operational performance of a business based on its financial reporting.
The document discusses key concepts related to budgeting, budgetary accounting, and performance management in the public sector. It defines what a budget is, identifies the major components and principles of public budgets, and describes different budgetary approaches and the budget process, including preparation, legislative approval, execution, and accounting. The chapter also examines budgetary terminology, participation in budgeting, and alternative budgetary approaches like line-item, performance, and zero-based budgeting.
This document discusses key concepts related to financial statements, taxes, and cash flow. It covers the following key points in 3 sentences:
The balance sheet provides a snapshot of a firm's assets and liabilities at a point in time, showing book values which may differ from market values. The income statement measures financial performance over a period by reporting revenues and expenses to arrive at net income. Cash flow is also important as it shows the actual inflow and outflow of cash from operating, investing, and financing activities, which can differ from accounting profits.
The document provides an overview of completing the accounting cycle for a service business. It discusses using a worksheet to facilitate preparing financial statements and closing entries. The steps to prepare a worksheet are explained, including entering the trial balance, adjustments, adjusted trial balance amounts, and financial statement columns. Sample worksheet and financial statements are presented.
The document provides information about the statement of cash flows, including:
1) It defines cash equivalents and explains their inclusion with cash.
2) It outlines the three categories of cash flows - operating, investing, and financing activities - and gives examples of transactions in each.
3) It discusses how various transactions like interest, depreciation, and changes in accounts payable are classified and treated in the statement of cash flows.
Mercer Capital's Portfolio Valuation: Private Equity and Venture Capital Mark...Mercer Capital
Mercer Capital's Portfolio Valuation: Private Equity and Venture Capital Marks and Trends Newsletter provides a brief digest and commentary of some of the most relevant market trends influencing the fair value regarding private equity portfolio investments.
The first chapter introduces us to Corporate finance is essential .docxoreo10
The first chapter introduces us to Corporate finance is essential to all managers as it provides all the skills managers need to; Identify corporate strategies and individual projects that add value to the organization and come up with plans for acquiring the funds. The types of business forms are; sole proprietorship, corporation and partnerships. A sole proprietorship form of business possesses different advantages and disadvantages. A partnership maintains roughly similar pros and cons of a sole proprietorship. A corporation is a legal entity that is separate from its owners and managers. Advantages include a smooth transfer of ownership, limited liability, ease of raising capital. The disadvantages include; double taxation, and a high cost of set-up and report filing. The chapter then deals with Objective of the firm, which is to maximize wealth. The final topic is an in-depth look at Financial Securities, which are markets and institutions.
In the second chapter, we are introduced to financial statements, Cash flow and taxes. Financial statements include; the Income statement and the Balance sheet. An income statement is a financial statement that shows a company’s financial performance regarding revenues and expenses, over a particular period, mostly one year. A balance sheet, on the other hand, is a financial statement that states a company’s assets, liabilities and capital at a particular point in time. Under the cash flow, the chapter covers on the Statement of cash flows, indicates how various changes in balance sheet and income statement accounts affect cash and analyses financing, investing and operating activities. A free cash flow shows the cash that an organization is capable of generating after investment to either maintain or expand its database. Under taxes, Corporate and personal taxes are well explained and the scenarios under which they apply.
Chapter Three analyzes Financial Statements. This analysis is broken down into; Ratio Analysis, DuPont equation. The effects of improving ratios, the limitations of ratio analysis and the Qualitative factors. Ratios help in comparison of; one company over time and one company versus other companies. Ratios are used by; Stockholders to estimate future cash flows and risks, lenders to determine their creditworthiness and managers to identify areas of weaknesses and strengths. Liquidity ratios show whether a company can meet its short-term commitments using the resources it has at that particular time. Asset management ratios exemplify how well an organization utilize its assets. Debt management ratios, leverage ratios as well as profitability ratios are explained.
The DuPont equation focuses on several issues. These are; Debt Utilization, Asset utilization and the Expense Control. Consequently, Ratio analysis has various problems and limitations. These include; Distortion of ratios from seasonal factors, various operating and accounting practices can distort comparisons and also it i ...
The document summarizes revisions made to the Philippine CPA Licensure Examination, including:
- Reducing the number of exam subjects from seven to six by merging some topics and separating others.
- Distributing topics from Theory of Accounts, Practical Accounting Problems 1 and 2 to two new subjects.
- Separating the previous Business Law and Taxation subject into individual Taxation and Regulatory Framework subjects.
- Adding additional topics to the Taxation and Regulatory Framework subjects.
- Providing tables outlining the topics covered, weights, and number of items for each revised subject.
This document discusses sources of income and classification of income for tax purposes. It defines income as coming from sources within the Philippines, without, or partly within and partly without. It provides examples of how different types of income like dividends, income from services, rent, royalties, and gains from property sales are treated. The document also discusses what constitutes gross income, how income is distinguished from capital, receipts, and revenue, and provides examples of different types of compensation that are considered taxable income.
Settlement cash discounts provide a percentage discount to customers or suppliers for paying their accounts early. These discounts are recorded in discount allowed and discount received columns in a three column cash book. Discount allowed is given to customers and credited to their accounts, with the total recorded as an expense. Discount received is from suppliers and debited to their accounts, with the total recorded as revenue.
The document defines and discusses various aspects of annuities. It defines an annuity as a fixed sum paid at regular intervals under certain conditions. It discusses the amount of an annuity as the total of unpaid installments plus compound interest. It also defines the annuitator as the person obliged to make payments, and the annuitant as the person entitled to receive payments. The document then discusses different types of annuities based on continuity and timing of payments. It provides characteristics of annuities and formulas used to calculate future amounts, accumulated amounts, and present values of annuities.
The document defines taxable income and gross income for the purposes of taxation. It states that taxable income is gross income less any authorized deductions or exemptions. Gross income is defined broadly as all income from any source, including compensation, business income, property dealings, interest, rents, royalties, dividends, annuities, prizes, pensions, and partnership shares. The document goes on to list several exclusions from gross income for taxation, including life insurance proceeds, return of insurance premiums, gifts, damages from personal injury, income exempt by treaty, and certain retirement benefits.
This document discusses the time value of money concept. It defines key terms like present value, future value, interest rates, and annuities. It provides formulas to calculate future value, present value, and annuities. Examples are given to demonstrate calculating simple and compound interest, present and future value of cash flows over single and multiple periods, and ordinary and due annuities. The document also covers topics like finding interest rates, time periods, and loan amortization.
This document provides an overview of capital budgeting and investment decision making. It defines key terms like capital budgeting, investment decisions, cash flows, net present value, and discounted cash flow techniques. It also summarizes several approaches to evaluating investment projects, including payback period, accounting rate of return, net present value, and internal rate of return. The document emphasizes the importance of considering the time value of money when analyzing projects with cash flows occurring over multiple periods.
This document provides a history of money in the Philippines from pre-Hispanic times to modern day. It describes the evolution from barter systems to early gold and bead currencies. Spanish colonization introduced Mexican pesos and coins minted in Manila. The American period established the peso tied to the US dollar. The Japanese occupation saw war notes. Independence brought new designs celebrating Filipino culture and landmarks.
The document provides an overview of the international monetary system, including:
1) The evolution of international monetary systems from bimetallism to the classical gold standard to the Bretton Woods system to the current flexible exchange rate regime.
2) Current exchange rate arrangements including free float, managed float, and currencies pegged to other currencies.
3) Details on the euro and European monetary union.
4) Examples of currency crises like the Mexican peso crisis, Asian currency crisis, and Argentine peso crisis.
5) Differences between fixed and flexible exchange rate regimes and how imbalances are addressed under each system.
Baumol's cash management model seeks to determine the optimal cash balance by minimizing total costs, which include conversion costs incurred when converting securities to cash and opportunity costs of holding excess cash. The model assumes a firm can forecast cash needs, payments are uniform, and conversion and opportunity costs are known. The optimal cash balance is calculated by equating the marginal conversion and opportunity costs. However, the model has limitations as it does not account for uncertainty in cash flows or fluctuations in transaction costs and interest rates.
The document discusses methods for evaluating capital investment decisions in healthcare organizations. It introduces the payback period method, which calculates the number of years to recover an initial investment without considering the time value of money. The net present value (NPV) method is presented, which discounts future cash flows to account for the cost of capital and calculates the difference between the initial investment and discounted cash flows. The internal rate of return (IRR) method is also covered, which is the discount rate that makes the NPV equal to zero. Decision rules for accepting or rejecting projects using NPV and IRR are provided.
Analysis & interpretation of financial statementsry_moore
This document discusses various methods for analyzing financial statements, including ratios to evaluate profitability, liquidity, and returns. It defines key ratios like stock turnover, gross/net profit percentages, current ratio, acid test ratio, and return on investment. These ratios are used to analyze aspects of the business like profit results, financial status, working capital, and mark-up/margin. Calculating and interpreting these ratios provides meaningful insights about the business's performance and financial health.
The document discusses receivable management and changing credit standards. It covers topics like average collection period, effects of relaxing credit standards, key ratios used in receivables management, an example of analyzing changes to credit standards, factors considered in granting credit, finding the optimal level of accounts receivable, analyzing changes to credit policies, and methods of collecting on receivables.
This document discusses working capital and current asset management. It covers topics such as net working capital, the cash conversion cycle, funding requirements of the cash conversion cycle including permanent vs seasonal needs, strategies for managing the cash conversion cycle such as inventory and receivables management, changing credit standards and terms, and credit monitoring. The document uses examples and diagrams to illustrate key concepts in short-term financial management.
This document provides an introduction to financial statement analysis. It discusses the key types of financial statements, including the income statement, balance sheet, statement of changes in owner's equity, and statement of changes in financial position. It also outlines different classifications and techniques for analyzing financial statements, such as external vs internal analysis, horizontal vs vertical analysis, comparative statement analysis, trend analysis, common size analysis, funds flow analysis, cash flow analysis, and ratio analysis. The overall purpose is to introduce the reader to how financial statements are constructed and various methods for evaluating the financial and operational performance of a business based on its financial reporting.
The document discusses key concepts related to budgeting, budgetary accounting, and performance management in the public sector. It defines what a budget is, identifies the major components and principles of public budgets, and describes different budgetary approaches and the budget process, including preparation, legislative approval, execution, and accounting. The chapter also examines budgetary terminology, participation in budgeting, and alternative budgetary approaches like line-item, performance, and zero-based budgeting.
This document discusses key concepts related to financial statements, taxes, and cash flow. It covers the following key points in 3 sentences:
The balance sheet provides a snapshot of a firm's assets and liabilities at a point in time, showing book values which may differ from market values. The income statement measures financial performance over a period by reporting revenues and expenses to arrive at net income. Cash flow is also important as it shows the actual inflow and outflow of cash from operating, investing, and financing activities, which can differ from accounting profits.
The document provides an overview of completing the accounting cycle for a service business. It discusses using a worksheet to facilitate preparing financial statements and closing entries. The steps to prepare a worksheet are explained, including entering the trial balance, adjustments, adjusted trial balance amounts, and financial statement columns. Sample worksheet and financial statements are presented.
The document provides information about the statement of cash flows, including:
1) It defines cash equivalents and explains their inclusion with cash.
2) It outlines the three categories of cash flows - operating, investing, and financing activities - and gives examples of transactions in each.
3) It discusses how various transactions like interest, depreciation, and changes in accounts payable are classified and treated in the statement of cash flows.
Mercer Capital's Portfolio Valuation: Private Equity and Venture Capital Mark...Mercer Capital
Mercer Capital's Portfolio Valuation: Private Equity and Venture Capital Marks and Trends Newsletter provides a brief digest and commentary of some of the most relevant market trends influencing the fair value regarding private equity portfolio investments.
The first chapter introduces us to Corporate finance is essential .docxoreo10
The first chapter introduces us to Corporate finance is essential to all managers as it provides all the skills managers need to; Identify corporate strategies and individual projects that add value to the organization and come up with plans for acquiring the funds. The types of business forms are; sole proprietorship, corporation and partnerships. A sole proprietorship form of business possesses different advantages and disadvantages. A partnership maintains roughly similar pros and cons of a sole proprietorship. A corporation is a legal entity that is separate from its owners and managers. Advantages include a smooth transfer of ownership, limited liability, ease of raising capital. The disadvantages include; double taxation, and a high cost of set-up and report filing. The chapter then deals with Objective of the firm, which is to maximize wealth. The final topic is an in-depth look at Financial Securities, which are markets and institutions.
In the second chapter, we are introduced to financial statements, Cash flow and taxes. Financial statements include; the Income statement and the Balance sheet. An income statement is a financial statement that shows a company’s financial performance regarding revenues and expenses, over a particular period, mostly one year. A balance sheet, on the other hand, is a financial statement that states a company’s assets, liabilities and capital at a particular point in time. Under the cash flow, the chapter covers on the Statement of cash flows, indicates how various changes in balance sheet and income statement accounts affect cash and analyses financing, investing and operating activities. A free cash flow shows the cash that an organization is capable of generating after investment to either maintain or expand its database. Under taxes, Corporate and personal taxes are well explained and the scenarios under which they apply.
Chapter Three analyzes Financial Statements. This analysis is broken down into; Ratio Analysis, DuPont equation. The effects of improving ratios, the limitations of ratio analysis and the Qualitative factors. Ratios help in comparison of; one company over time and one company versus other companies. Ratios are used by; Stockholders to estimate future cash flows and risks, lenders to determine their creditworthiness and managers to identify areas of weaknesses and strengths. Liquidity ratios show whether a company can meet its short-term commitments using the resources it has at that particular time. Asset management ratios exemplify how well an organization utilize its assets. Debt management ratios, leverage ratios as well as profitability ratios are explained.
The DuPont equation focuses on several issues. These are; Debt Utilization, Asset utilization and the Expense Control. Consequently, Ratio analysis has various problems and limitations. These include; Distortion of ratios from seasonal factors, various operating and accounting practices can distort comparisons and also it i ...
Equity Research 16 December 2002AmericasUnited Stat.docxYASHU40
Equity Research
16 December 2002
Americas/United States
Strategy
Investment Strategy
Assessing the Magnitude and
Sustainability of Value Creation
Illustration by Sente Corporation.
• Sustainable value creation is of prime interest to investors who seek to
anticipate expectations revisions.
• This report develops a systematic way to explain the factors behind a
company’s economic moat.
• We cover industry analysis, firm-specific analysis, and firm interaction.
Investors should assume that CSFB is seeking or will seek investment banking or other business from the covered
companies.
For important disclosure information regarding the Firm's ratings system, valuation methods and potential conflicts of interest,
please visit the website at www.csfb.com/researchdisclosures or call +1 (877) 291-2683.
research team
Michael J. Mauboussin
212 325 3108
[email protected]
Kristen Bartholdson
212 325 2788
[email protected]
Measuring the Moat 16 December 2002
2
Executive Summary
• Sustainable value creation has two dimensions—how much economic profit a
company earns and how long it can earn excess returns. Both are of prime interest to
investors and corporate executives.
• Sustainable value creation is rare. Competitive forces—including innovation—drive
returns toward the cost of capital. Investors should be careful about how much they
pay for future value creation.
• Warren Buffett consistently emphasizes that he wants to buy businesses with
prospects for sustainable value creation. He suggests that buying a business is like
buying a castle surrounded by a moat—a moat that he wants to be deep and wide to
fend off all competition. According to Buffett, economic moats are almost never stable;
competitive forces assure that they’re either getting a little bit wider or a little bit
narrower every day. This report seeks to develop a systematic way to explain the
factors that determine a company’s moat.
• Companies and investors use competitive strategy analysis for two very different
purposes. Companies try to generate returns above the cost of capital, while investors
try to anticipate revisions in expectations for financial performance that enable them to
earn returns above their opportunity cost of capital. If a company’s share price already
captures its prospects for sustainable value creation, investors should expect to earn
a risk-adjusted market return.
• Studies suggest that industry factors dictate about 10-20% of the variation of a firm’s
economic profitability, and that firm-specific effects represent another 20-40%. So a
firm’s strategic positioning has a significant influence on the long-term level of its
economic profits.
• Industry analysis is the appropriate place to start an investigation into sustainable
value creation. We recommend getting a lay of the land—understanding the players, a
review of profit pools, and industry stability—followed ...
This chapter provides an overview of key concepts in financial management. It discusses the primary goal of maximizing shareholder value and agency relationships between shareholders, managers, and creditors. It also covers the importance of financial management skills for managers, factors that determine the value and cost of capital for firms, and types of financial securities and their typical rates of return.
WE BELIEVE that our Eighth Core Portfolio investment strategy provides the answers to the previously mentioned issues and offers a truly balanced approach to investing.
Equities, bonds, real estate and commodities are four asset classes that cover the core of any asset allocation process. The Eighth Core Portfolio is based on the idea that, during any given stage of a global investment cycle, money will flow across these assets, thereby affecting their performance. Rather than time the entry into the outperformer and the exit from the underperformer the Eighth Core Portfolio invests globally across all four in equal measure thereby ensuring that it participates in the best asset class in any environment. Over the investment period a constant exposure is maintained in order to avoid any outperforming asset class becoming a drag when the market turns.
This balanced approach is designed to produce medium to long term returns which exceed those of nominal cash returns. Historical evidence shows that this strategy has had proven outperformance in various timeframes and in all environments (see Tables 1 to 3) More importantly it minimizes volatility by taking advantage of the low correlations between the individual asset classes (see Table 4).
The document discusses cash flows for a company over three years (1991, 1990, 1989). In 1990, major sources of cash were from investing activities. In 1989, major sources of cash were from financing activities. In 1991, major sources of cash came from operating activities followed by investing activities. Major uses of cash in 1991 were less than operating activities. In 1990 and 1989, major uses of cash were financing activities. Cash flow from operations was greater than net income in all three years. Current assets were primarily sources of cash in 1991 and 1990, while current assets were uses of cash in 1989. Current liabilities were uses of cash in 1991.
Measure What Matters - New Perspectives on Portfolio SelectionUMT
The document discusses new frameworks for IT portfolio selection that consider both financial and strategic metrics. It summarizes that traditional portfolio selection focused solely on financial metrics, but recent research shows this led to underinvestment in strategic areas. The new framework evaluates investments from four perspectives: demand, supply, governance, and alternatives. This allows executives to consider financial returns, strategic alignment, risk exposure, architectural fit, options, costs, deadlines, and skills. Successful companies now use multiple financial and strategic metrics to optimize resource allocation and maximize investment value and benefits.
Mercer Capital's Value Focus: FinTech Industry | Third Quarter 2021 Mercer Capital
Mercer Capital’s quarterly newsletter, FinTech Watch, provides an overview of the FinTech industry, including public market performance, valuation multiples for public FinTech companies, and articles of interest from around the web. This newsletter focuses on FinTech segments, including payment processors, technology, and solutions companies, examining general economic and industry trends as well as a summary of M&A and venture capital activity.
This document provides information about capital budgeting. It begins with an introduction to capital budgeting, defining it as a firm's process for acquiring and investing capital in long-term projects. It then discusses the capital budgeting process, which includes project generation, evaluation, selection, and follow-up. Key factors that influence capital budgeting decisions are also outlined, such as business risk, tax exposure, financial flexibility, and growth rate. Finally, traditional capital budgeting methods like payback period, accounting rate of return, and discounted cash flow methods are explained.
Running head: Finance 1
Finance 2
Finance 5
Finance
Capital structure refers to how a company finances its general operations and expansion projection by utilizing various sources of funding. A company could normally have debt capital or equity as a composition of its capital structure (Bierman, H. 2003). Debt capital is usually composed of bonds issued or either, long term notes that are payable by the company whereas equity capital consists of shares (common stock) or retained earnings by the company. Furthermore, equity capital consists of common stock, preference stock and the retained earnings and these make up the total owners equity as recorded in the balance sheet. However, most analysts define the debt part in the capital structure as the long-term liability of the firm (Riahi-Belkaoui, A. 1999). The basic aim of optimizing capital structure is to select that proportion of various forms of debts and equities that maximizes the firm’s value while minimizing the average cost of capital. A firm should always yearn to optimize its capital structure because this will boost its effectiveness in the various operations in the market.
The balance sheet of a company is very key to any investor wishing to put an investment in a particular company and too to the managers in attempting to enhance shareholders wealth. In making this consideration, the health of the balance sheet is the front key to making this decision (Bierman, H. 2003). For instance, in making this evaluation, investors study keenly the working capital adequacy, the asset performance and lastly the capital structure. The fittest capital structure of a company is that which contains more of equity than the debt capital. A company having more of its capital derived from debts is not at all healthy in light of most investor’s analysis. This however is not consistent with the optimal view on capital structure. Ideally there is usually an optimum capital structure that is desirable for all companies. This optimal capital structure is that one that consists of a reasonable optimum amount of debt and also an optimum amount of equity. In practice though, there do not exist a magic ratio of particular leverage that the company can be able to have in its composition (Riahi-Belkaoui, A. 1999). This is also supported by the fact that the debt to equity ratio is different based on the type of industry in which a company is operating, its business type and also importantly the stage in the company’s life cycle.
The table below shows the capital structure of KONE’s business with a comparative analysis of ...
The document discusses factors influencing investment vehicle (SPV) decisions for structuring project funding. An SPV is a legal entity set up to manage risk, cost of capital, and control structure for a project. Investors in securitized instruments seek credit enhancements to reduce risk. Credit enhancements include internal mechanisms like credit tranching (senior/subordinate structures) and over-collateralization, as well as external guarantees or letters of credit. The document outlines various types of internal credit enhancements used in SPVs like credit tranching, over-collateralization, cash collateral accounts, spread accounts, and triggered amortization.
This document discusses portfolio analysis and cash flows. It provides examples of different types of investments and businesses someone could own, including franchises, mining companies, banks, and real estate. It then shows how someone could start investing small amounts regularly, such as emptying coins and low-denomination bills from their wallet each night. With regular small investments, it demonstrates how one could construct a diversified portfolio over time. The document also covers risk tolerance, strategies for passive versus active portfolio management, and techniques for analyzing stocks, bonds, and projects through valuation approaches and scenario analysis. It emphasizes cash flow analysis and stresses the importance of diversification and risk management.
Mercer Capital's Portfolio Valuation: Private Equity and Venture Capital Mark...Mercer Capital
This document provides a summary of private equity, venture capital, and portfolio valuation trends from Mercer Capital. It discusses several topics:
- Private equity deal activity and valuations remain robust, though pricing pressure is being felt as traditional PE investors look outside their typical sectors and geographies for opportunities. Technology deals accounted for 20% of PE buyouts in the first quarter of 2017, up from a historical average of 10-15%.
- Venture capital investments increased slightly in the first quarter of 2017 after two consecutive quarters of declines, reaching $16.5 billion. However, restrictions on visa programs and international trade could negatively impact venture-backed companies.
- Regulatory scrutiny of portfolio valuations continues, so
Leveraging Private Equity & Venture Capital for AccelerationEkoInnovationCentre
The document discusses leveraging private equity and venture capital to accelerate business growth. It defines private equity and venture capital, explaining how they work and their differences. Private equity involves larger deals with more established companies, while venture capital funds early-stage startups. The document outlines various sources of value creation that private equity and venture capital investors pursue, such as operational improvements, financial engineering, and governance changes. The overall message is that access to capital from these sources can be a major driver of business growth.
I rarely have a conversation these days where the topic of financing doesn’t arise as a serious concern for my clients. When the economy is robust, and the
capital markets are frothy, financing a commercial real estate transaction is a relatively simple matter. However during today’s recessionary times, the
commercial capital markets are severely constrained. Not only is the supply of capital tight, but the demand may be near all time highs as well. Depending on which industry source you quote there is between $150 and $200 billion dollars of CMBS debt maturing in...
- From October to December 2014, Crystal Cove Capital achieved an 11.3% return compared to 10.3% for the S&P 500. While pleased with the outperformance, the manager cautions that short-term results are difficult to predict.
- Institutional investors who focus on short-term gains face pressures that can hurt long-term performance, such as high taxes on short-term capital gains. Long-term investing provides tax and competitive advantages.
- One underappreciated opportunity is companies with leverage, such as cable companies, which have steadily increasing cash flows that naturally pay down debt over time with limited default risk.
Exchange Traded Funds allow investors to access international markets more easily through technological innovations, increasing globalization and expanded availability of securities. This has challenged the traditional view that solely investing in US securities provides the best risk-return tradeoff, as prudent investors now recognize the benefits of diversifying across industries and markets through international portfolio investments. The availability of global assets and ease of accessing international markets provides investors new opportunities to maximize returns while reducing risk through cross-country diversification.
Mercer Capital's Value Focus: FinTech Industry | Second Quarter 2016 Mercer Capital
Mercer Capital’s quarterly newsletter, FinTech Watch, provides an overview of the FinTech industry, including public market performance, valuation multiples for public FinTech companies, and articles of interest from around the web. This newsletter focuses on FinTech segments, including payment processors, technology, and solutions companies, examining general economic and industry trends as well as a summary of M&A and venture capital activity.
The buying back of shares increases the company’s gearing ratio, my point of ...Francesco Merone MBA
Shire Plc is a biopharmaceutical company that used cash flows to buy back shares, increasing its gearing ratio in percentage but not in real terms. The author analyzes Shire's 2012-2013 financial reports to examine the impact. In 2012, Shire had $3.1 billion in equity with a cost of capital of 12%. In 2013, Shire bought back $500 million worth of shares at $29.19 per share, reducing its equity by 3% to $3 billion. While buybacks increase gearing, some argue they maximize value when shares are undervalued and cash has no better use. The analysis focuses on how financial strategies like buybacks impact metrics like gearing and WACC.
Similar to HOLT Cash and the Corporate Life Cycle White Paper11.2010 (20)
The buying back of shares increases the company’s gearing ratio, my point of ...
HOLT Cash and the Corporate Life Cycle White Paper11.2010
1. Cash and the Corporate Life Cycle
A Framework for Understanding Cash and Optimal Cash Usage
September 24, 2010 Education and Training
CFROI
Discount Rate
(Investor's Required
Rate of Return)
RESTRUCTURESTARTUP
Discount
GROWTH
A
GROWTH FADE
B C
MATURE
Value to Cost Ratio
High Premium Premium to Par Par
D E
CFROI
Discount Rate
(Investor's Required
Rate of Return)
RESTRUCTURESTARTUP
Discount
GROWTH
A
GROWTH FADE
B C
MATURE
Value to Cost Ratio
High Premium Premium to Par Par
D E
Stage C,D,E? Grow
No
High Embedded
Agency Costs?
Yes
Return Capital
Keep Agency
Costs Low
Yes
No
Increase
commitment and
size in proportion to
magnitude of
agency costs
Source: HOLT Analysis
Note: Value to Cost Ratio = HOLT’s adjusted price to book ratio
Capital Deployment and Corporate Life Cycle From the Investor’s Perspective
In this paper, we examine the valuation implications of record surplus cash levels
in order to understand optimal cash usage from the investor’s perspective.
We find that:
• During the startup and growth stages of the corporate lifecycle, significant
shareholder value is created when management reinvests capital into
higher CFROI® projects;
• During the mature stage of the lifecycle, significant value is destroyed
when management reinvests capital into lower CFROI projects;
• Risks of overinvestment (defined as agency costs) increase as surplus
cash exceeds investment opportunities;
• Distributions of capital (in the form of dividends and share repurchases)
can create shareholder value when the perceived risk of misusing cash is
high.
Michael Oliveros, CFA
(212) 325-2292
michael.oliveros@credit-suisse.com
Ron Graziano, CPA
(312) 345-6169
ron.graziano@credit-suisse.com
Sergei Pliutsinski
(212) 325-3644
siarhei.pliutsinski@credit-suisse.com
Gautam Samarth
(212) 325-0688
gautam.samarth@credit-suisse.com
We would like to thank Jeff Ralto from Northeastern University for his valuable contributions to this report.
2. HOLT
2
Table of Contents
Table of Contents 2
Cash…Too Much of a Good Thing? 3
Cash and the Corporate Life Cycle 4
The Problem with Cash: Agency Costs 6
Can Cash Distribution Drive Shareholder Value? 8
The Practical Implications for Investors 10
Measuring the Market Implied Agency Risk Premium 11
Conclusion 13
Appendix A: Capital Decision Tree Backtests 15
Mergers and Acquisitions 15
Deleveraging 16
Dividends 17
Repurchase Shares 19
APPENDIX B: Case Study - SBUX 21
APPENDIX C: Why Repurchases Don’t Increase Share Prices 23
APPENDIX D: The Theory: Agency costs, Signals and Behavioral Biases 24
Agency Theory – Why surplus cash can be too much of a good thing 24
Assymetric Information/Signaling Hypothesis 25
Behavioral Corporate Finance – Why stock options may not prevent agency
problems 26
APPENDIX E: Agency Cost Derivation 28
The Math: Bridging Agency Theory to Valuation 28
3. HOLT
Cash…Too Much of a Good Thing?
Cash levels and corporate actions are at the top of investors’ minds. The chart below
shows cash surplus levels are currently at their 10yr peak, in absolute terms as well as
a percent of market capitalization.
Exhibit 1: HOLT Cash Surplus is at a 10 Year High
$-
$200,000
$400,000
$600,000
$800,000
$1,000,000
$1,200,000
$1,400,000
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
$CashSurplus
0%
2%
4%
6%
8%
10%
12%
14%
CashSurplus%ofMarketCapitalization
Cash Surplus
Cash Surplus % of Market Cap
10-year Average
A return to average,
correlates to a $420B
increase in share
buyback, dividends
and/or investment.
$-
$200,000
$400,000
$600,000
$800,000
$1,000,000
$1,200,000
$1,400,000
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
$CashSurplus
0%
2%
4%
6%
8%
10%
12%
14%
CashSurplus%ofMarketCapitalization
Cash Surplus
Cash Surplus % of Market Cap
10-year Average
A return to average,
correlates to a $420B
increase in share
buyback, dividends
and/or investment.
Source: HOLT ValueSearch®. Universe: S&P 1500 (ex financials, REITs, Insurance). Cash surplus = HOLT cash flows less fixed
charges + short term balance sheet liquidity. Short term balance sheet liquidity = sum of cash, working capital – short term debt. Cash
Flows = HOLT Gross Cash Flows. *Fixed Charges are dividends, interest, R&D, rent, and capital expenditures. Data date: April 2010.
HOLT’s Cash Surplus1
measures a firm’s investible/distributable cash flows adjusted
for recurring financing and operating costs, and short-term balance sheet liquidity. Post
the credit crisis, companies have built large cash balances by managing working capital
requirements, pushing out short-term debt obligations, and cutting cash outlays such as
capex, R&D, dividends and share buybacks. How should investors evaluate corporate
cash? What should companies be doing?
In this paper, we develop a framework for investors to evaluate corporate cash
balances and cash usages. Although it is difficult to draw a single conclusion on this
topic, we will show:
1
HOLT’s cash surplus measure is essentially a twist on free cash flow plus short term balance sheet liquidity. The
metric was extremely useful during the credit crisis to help identify companies that could survive the credit crunch and
can be used on a continuing basis to see who is best positioned to cover their operating and financing costs.
3
4. HOLT
•
• The market value of corporate cash is highly dependent on the stage of a
company’s life cycle. Cash is valued more highly in growing firms; and
discounted more heavily in mature firms.
Reinvestment of cash into higher operating returns creates the most value for
shareholders. However, maturing companies have equal opportunities to create
value by returning cash to shareholders, particularly if their actions are aligned
with investor expectations.
Cash and the Corporate Life Cycle
What’s the value of $1.00 sitting on a company’s balance sheet? According to
Pinkowitz and Williamson (2002), the market values $1.00 of corporate cash
somewhere between $1.19 and $1.25, which suggests, on average, the market values
the financial flexibility and growth potential afforded by cash. However, they also
observe significant variation across firms ranging from $0.26 to $2.38, attributing the
difference in valuation to the market’s assessment of each firm’s investment opportunity
set. Shareholders place a premium on cash for firms with high growth options; and a
discount on cash for firms with the potential to destroy shareholder value.
The market values
cash based on its
assessment of each
firm’s investment
opportunity set.
These findings make sense when considered in the context of HOLT’s Life Cycle
Framework (see Exhibit 2), represented below. During the Startup and Growth Phases,
successful innovators enjoy the virtuous cycle of increasing scale, increasing profits
(CFROI®) and seemingly endless investment opportunities. While firms innovate,
investors place a premium on liquidity since it allows firms to quickly gain scale,
outpace competitors and minimizes the risk of underinvestment, consistent with Myers
and Majluf (1984). Eventually, incremental project CFROI declines due to competition,
secular decline in end-markets and/or diminishing returns to scale, causing overall firm
CFROI to fade. As firms transition from Growth to Fade, investors fear the risk of
misusing cash, valuing capital discipline over growth.
4
5. HOLT
Exhibit 2: HOLT Corporate Life Cycle Framework
CFROI
Discount Rate
(Investor's Required
Rate of Return)
RESTRUCTURESTARTUP
Discount
GROWTH
A
GROWTH FADE
B C
MATURE
Value to Cost Ratio
High Premium Premium to Par Par
D E
CFROI
Discount Rate
(Investor's Required
Rate of Return)
RESTRUCTURESTARTUP
Discount
GROWTH
A
GROWTH FADE
B C
MATURE
Value to Cost Ratio
High Premium Premium to Par Par
D E
DiscountAverageDeclining Premium
High
Premium
High
Premium
Valuation
Typically highIncreasingRelatively LowLowLowLeverage
NegativeLowSlowingHighHighAsset Growth
Below cost
of capital
Around cost
of capital
HighImproving
Below cost
of capital
CFROI
DiscountAverageDeclining Premium
High
Premium
High
Premium
Valuation
Typically highIncreasingRelatively LowLowLowLeverage
NegativeLowSlowingHighHighAsset Growth
Below cost
of capital
Around cost
of capital
HighImproving
Below cost
of capital
CFROI
HOLT’s Corporate Life
Cycle Framework
provides an empirical
basis for considering
capital investment
Source: Credit Suisse HOLT
The discount or premium that investors place on cash reflects an expectation of
management’s success at investing cash; and by extension an underlying preference
for profitable reinvestment into high CFROI projects and aversion to overinvestment into
low CFROI projects, consistent with Pinkowitz and Williamson (2002).
Our analysis confirms this preference. We analyzed the share price returns of three
reinvestment categories: (1) Reinvestment leading to higher future CFROI; (2)
Divestment leading to higher future CFROI; and (3) Reinvestment leading to lower
future CFROI.
As you can see in Exhibit 3, shareholder returns are highest when firms invest in
projects that generate higher future CFROI; followed by divestment of lower CFROI
projects leading to higher overall future CFROI; and trailed significantly by reinvestment
into projects that lower future CFROI. The message is clear: the market rewards
reinvestment into higher CFROI projects and punishes investment into lower CFROI
projects.
The message is clear:
the market rewards
reinvestment into
higher CFROI projects
and punishes
investment into lower
CFROI projects.
5
6. HOLT
Exhibit 3: Shareholder Returns for CFROI and Growth Combinations
Universe: US > $1bn ex Financials (scaled through time)
+ CFROI: Increased CFROI levels 1 year forw ard
+ Growth: Real Asset Grow th > 0 (1 year forw ard)
- CFROI: Decreased CFROI levels 1 year forw ard
- Growth: Real Asset Grow th < 0 (1 year forw ard)
Cumulative Excess Returns (01/1985 - 08/2009)
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
'85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09
+ CFROI + Growth
+ CFROI
+ CFROI - Growth
- CFROI + Growth
The Problem with Cash: Agency Costs
Because investors prefer growth, one could reasonably expect that in a growth
constrained world, companies with a track record for profitable growth and the means
to grow should outperform. However, as we see in Exhibit 4, many large cap firms with
high cash surplus balances have underperformed over the last six months.
Exhibit 4: Top 15 US Companies with Cash…Shareholders Unimpressed
= + + + -
Company Ticker Sector
Market
Cap
Cash
Surplus
Cash
Flow less
Fixed
Charges
Working
Capital (ex
Cash)
Cash &
Invest
Debt in
Current
Liabilities
Share
Price (6
months
relative to
market)
GOOGLE INC GOOG Information Technology $156,080 $38,843 $3,383 $2,089 $33,371 $0 -10%
$11,077 -$10,648 $2,300 -13%
$8,324 -5%
$5,874 -$7,952 $3,184 -11
MICROSOFT CORP MSFT Information Technology $230,700 $38,694 $40,564
PFIZER INC PFE Health Care $124,860 $37,546 $11,460 $15,914 $18,496
CISCO SYSTEMS INC CSCO Information Technology $136,180 $34,561 $39,824 %
EXXON MOBIL CORP XOM Energy $291,000 $31,672 $6,832 $13,759 $13,827
JOHNSON & JOHNSO
$2,746 -5%
N JNJ Health Care $161,940 $29,603 $6,881 $7,532 $19,588
APPLE INC AAPL Information Technology $239,200 $27,617 $25,616 $0 21%
MERCK & CO MRK Health Care $109,010 $21,428 $5,871 $6,809 $10,478
ORACLE CORP ORCL Information Technology $122,080 $21,243 $22,670
$4,398 -5%
$7,156 -$5,155
$1,730 -2%
$6,605 -$4,172 $3,860 -5%
INTEL CORP INTC Information Technology $117,110 $20,225 $17,019
AMGEN INC AMGN Health Care $53,000 $18,193 $3,934 $1,623 $15,196
WELLPOINT INC WLP Health Care $22,440 $15,035 $20,532
$4,789 -$1,240 $344 -7%
$2,560 -5%
$2,524 -$7,249 $772 -14%
HEWLETT-PACKARD HPQ Information Technology $111,530 $13,161 $14,259
IBM IBM Information Technology $167,680 $11,485 $13,977 $0 1%
DU PONT DD Materials $37,710 $10,904 $770 $7,028 $4,630 $1,523 25%
$5,935 -$7,033 $0 -22%
$11,044 -$13,536
Source: HOLT ValueSearch®. Universe: US (ex financials, REITs, Insurance). Top 20 companies sorted by cash surplus in descending
order are shown. Cash surplus = HOLT cash flows less fixed charges + short term balance sheet liquidity. All data based on first forecast
year. Data date: Price returns are as of the six months ending August, 2010.
6
7. HOLT
Why are high cash surplus companies underperforming? Reconsider these companies
in light of macroeconomic concerns that investors struggle with on a daily basis: record
corporate margins; low economic growth prospects and significant global excess
capacity. If economic growth forecasts are correct, should companies be investing
cash? If they should not be reinvesting, what is the value of surplus cash in
management’s hands?
Agency Costs: The Potential for Value Destructive Investments
The theoretical explanation for the discount on cash observed by Pinkowitz and
Williamson (2002) can be found in agency theory, which states that the interests of
managers (the agents) and shareholders (the owners) are not always aligned (Jensen,
1986). Managers often prefer growth to increase their power, compensation and the
supply of jobs for up-and-coming middle managers (Murphy, 1985, Baker et.al., 1988);
while investors prefer increasing returns on growth in order to maximize the return on
their capital (see Exhibit 3). The problem for investors is that agency conflicts can lead
to overinvestment, lower CFROI, and lower share prices. Agency costs are the
expected economic losses due to management overinvestment.
Potential agency costs increase with the amount of surplus capital left to management’s
discretion. According to Jensen (1986), agency costs are most severe in companies
where cash flow exceeds investment opportunities. Referring back to our Life Cycle
Framework, we would then expect agency costs to be most acute in firms transitioning
from the Growth to Fade Stages (see Exhibit 2) when profits are high and the
investment opportunity set decreases – a common underlying characteristic of many of
the names we see in Exhibit 4.
The risk of
overinvestment
increases when cash
surplus is high and
reinvestment
opportunities are low.
7
8. HOLT
To help investors understand how agency costs impact valuation, we go into
mathematical detail in Appendix E. The main conclusions are:
1. Agency costs increase as cash builds and reinvestment opportunities fall. We
can represent this relationship as:
8
SurplusCashCostsAgency ∝
iesOpportunitntReinvestme
1
CostsAgency ∝
Source: HOLT Analysis
Agency costs are
directly proportional
to surplus cash and
inversely proportional
to reinvestment
opportunities
2. Agency costs increase firm’s cost of equity as follows:
∑
= ++
=
n
t
t
t
SuboptimalPV
1 )]PremiumRiskAgencyWACC(1[
FlowCash
Source: HOLT Analysis
Agency costs
increase a firm’s cost
of equity and
therefore decrease
the value of shares
Can Cash Distribution Drive Shareholder Value?
Cash distribution can
increase value when:
1. Agency risk
premium is greater
than 0 and
2. Repurchases come
with a commitment by
management to
reduce agency costs.
Traditional valuation theory would tell you no. Cash distributions represent a return of
capital as opposed to a value creating return on capital; as such should not impact
share prices (see Appendix D for why repurchases don’t increase share prices).
However, we would expect that a return of capital can drive share prices under two
conditions (1) shares already discount an embedded Agency Risk Premium; and (2) the
market views a return of capital as a credible sign that management intends to reduce
agency costs; and as such the firm’s discount rate declines and share price increases.
The data supports this view. Studies confirm the short-run positive impact of ~2-3% on
share price upon announcement of repurchases (Grullon and Michaely (2002), Chou
and Lin (2004)), consistent with Jensen’s hypothesis “except for firms with unfunded
projects, prices will rise with unexpected increases in payouts to shareholders and
prices will fall with reductions in payouts or new requests for funds” (1986).
9. HOLT
The persistence of post-announcement outperformance, however, will depend on
management’s commitment to reducing agency costs. The findings of Grullon and
Michaely (2002) support this view; they find that together with reductions in capital
expenditures and R&D, firms that repurchase shares experience a significant reduction
in their cost of capital over a number of years following an announcement.
To confirm this analysis, we look at relative price returns for US firms that we classify as
Fading (declining return on capital and growth) and Mature (below average return on
capital, low growth, increasing leverage), to understand the relative share impact of an
increase in share repurchases. The results of our analysis can be seen in Exhibit 5. It
is worth noting that similar results have been observed for companies increasing
dividends (Grullon and Michaely, 2002), consistent with Jensen’s view that the key is
constraining management’s ability to misuse cash.2
Grullon and Michaely
find that together with
reductions in capital
expenditures and
R&D, firms that
repurchase shares
experience a
significant reduction
in their cost of capital
over a number of
years following an
announcement.
Exhibit 5: Shareholder Returns for Mature Companies that Repurchase Shares
Universe: US ex fin > $1bn. scaled through time
Increase Share Repurchases: Companies that increased trailing 4Q Share repurchases by more than 5%
* Constituents in increased share repurchase universe held for 12 month forw ard period to control for under-reaction phenomenon
Cumulative Excess Returns vs. Universe (12/1984 = 1)
0.75
1.00
1.25
1.50
1.75
2.00
'85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11
All Fading (Stage C)
Fading (Stage C) + Increased Share Repurchases
All Mature (Stage D)
Mature (Stage D) + Increased Share Repurchases
Share repurchases
can drive
outperformance for
Fading and Mature
firms, particularly
when growth
prospects are low
Data Date: 01/1985 – 08/2010
2 Jensen, 1986. The use of repurchases in studies is more a practical consideration related to the robustness of data on
repurchasers. Our analysis of late stage dividend payers (see Appendix A) is consistent with the performance of late
stage repurchasers seen below.
9
10. HOLT
The Practical Implications for Investors
For investors, agency theory suggests that cash, free cash flow and free cash flow
yields should be considered in the context of the corporate life cycle. Depending on a
firm’s growth prospects, a high free cash flow yield can either signal a good investment
opportunity or high agency costs. Our findings suggest that the key considerations will
be: (1) a firm’s life cycle stage, (2) investor expectations, (3) management’s capital
plans and credibility.
For Fading and Mature Firms, the implications of agency theory are more subtle than a
simple discount to shares. Unlike company earnings that can be manipulated in the
short run, Discount Rates are more persistent because they are, in effect, measures of
market confidence (Chou, 1988). As such, the investor looking at companies with high
(and justified) market implied agency costs, should expect:
1. Changes in agency risk premiums to take time and
2. Assuming management has overtly committed to reducing agency costs, the
rate at which the agency risk premium declines (share rise) will be a function of
management’s credibility.
The implication for investors preceding the announcement of a capital distribution is that
alpha can be generated by encouraging/forcing management to credibly commit to
reducing agency costs. The implication for investors following the announcement of a
capital distribution is that alpha can still be generated by successfully analyzing the
disparity between the market implied agency risk premium and the strength of
management’s commitment to reducing agency costs.
Alpha can still be
generated following
an announcement, if
the market
underestimates
managements
commitment to
reduce agency costs.
For bondholders, the implications of agency theory are decidedly less positive.
Pinkowitz and Williamson (2002) identify stockholder/ bondholder conflicts as a
significant determinant of the discounts they observe on cash, particularly when
financial distress costs are high (as any benefits from holding cash accrue mainly to
bondholders). Jensen's control hypothesis specifically cites the effectiveness of debt in
minimizing agency costs as "debt creation, without retention of proceeds, enables
managers to effectively bond their promise to pay out future cash flows" (1986).
The implications of
agency theory are
bad for bondholders.
10
11. HOLT
Our findings seen in Exhibit 10 are consistent with these views. Aside from highly
distressed situations, we find that increasing levels of leverage generally do not lead to
relative share underperformance, which suggests that to stockholders, the control
benefits of debt significantly outweigh the risks up to the point of distress.
A Quick Note on Incentive Compensation Schemes
It is reasonable to question the relevance of agency theory given the increased use of
share based incentive plans. After all, managers of large cash flow generating
companies today have significant personal stakes that should align their interests with
investors. Malmendier and Tate (2005) suggest that management overconfidence can
counteract the benefits of alignment and find that management’s ownership
concentration is a significant measure of overconfidence. The agency problem in some
ways is complicated because management is potentially blind to it, in Malmendier and
Tate’s words, “Differently from traditional explanations, such as empire building, the
CEO truly believes that he is creating value with his (over-)investment” (Ibid). A more
recent study by Griffen and Zhu (2009) noted that corporate managers with
outstanding stock options exploit share buybacks to increase the value of their stock
compensation, which increases agency costs to outside shareholders.
Management
overconfidence can
counteract the
intention of incentive
compensation plans.
In certain
circumstances,
ownership actually
reinforces
overconfidence.
Measuring the Market Implied Agency Risk Premium
Gauging investor expectations about returns and reinvestment rates is crucial when
considering uses of capital. HOLT’s Relative Wealth Chart provides insight into
management’s track record of historical investments, and more importantly for investors,
the market’s expectation of future investments.
11
12. HOLT
Exhibit 6: Quantifying Expected Agency Costs in HOLT: Microsoft (MSFT)
The market is pricing
MSFT’s CFROI to fade
from over 25% to
10% over the next 10
years.
The market is afraid
of either: competition,
secular decline in
PCs; agency costs; or
some combination
Market is pricing
in fade and less
growth
High growth
combined with
increasing CFROI
Source: HOLT ValueSearch. Data Date: September 2010. Microsoft is shown for illustration purposes only, The Relative Wealth Chart
displays a firm’s economic returns (define as CFROI in the top panel, blue bars) relative to its cost of capital (top panel, green line). The
middle panel shows real capital investment (asset growth) rates (purple bars) relative to a firm’s potential growth rate based on cash flows
and capital structure (green line). The bottom panel (line) represents the company’s total shareholder return relative to the S&P 500. The
green dots show the market’s expectations for CFROI (top panel) and asset growth (middle panel) over the next ten years. The market
implied level of fade is useful for shareholders and management because it allows us to quantify the magnitude of investor concerns – the
steeper the implied fade, the greater the fear of overinvestment.
Microsoft’s (MSFT) Relative Wealth Chart is an interesting example of potential agency
costs. Throughout the 1990s, MSFT was a Growth company - capital reinvestment
rates were high (exceeding 40% annually for 8 of 10 years – middle panel); CFROI
was consistently above 20% (top panel); and the company commanded a valuation
premium (Value-to-Cost Ratio averaged around 10x). During this period, shares
outperformed the market by over 1000% (bottom panel).
Since 2000, however, MSFT has struggled to grow profitably. Following the
technology bubble, CFROI steadily declined to a trough of 12% in 2002, mainly driven
by the accumulation of cash. The amount of sales generated per $1.00 of cash
declined from $1.15 in 1999 to $0.73 in 2002 (not seen in chart). By 2004, MSFT’s
cash balance reached $60B.
12
13. HOLT
13
Starting in 2005, MSFT’s CFROI began to rise. However, the middle panel Relative
Wealth Chart shows a significant change in the driver of MSFT’s CFROI. Note the
negative asset growth rates from 2005 through 2007; over that time period, MSFT’s
cash balance declined 61%. Coupling this shrinking asset base with recovering sales,
cash turns recovered from $0.61 in 2004 to $2.18 in 2007.
With CFROI back at peak levels and cash surplus once again accumulating (currently
~$40B), agency costs are a valid concern. And as we can see by the market implied
CFROI (the green dots), the market expects MSFT’s CFROI to decline to 10%.
Following the company’s recent share repurchase and dividend increase
announcements, investors should be asking, “Does the repurchase and accompanying
actions by management present a credible commitment to reduce agency costs?”
Conclusion
In this paper, we examine the implications of record surplus cash levels. We survey
financial literature to develop a framework for valuing the economic cost of cash, and
use HOLT’s life cycle framework to systematically test capital deployment strategies.
We find that during a firm’s growth stages, significant shareholder value is created
when management reinvests capital into higher CFROI projects; and that, when a firm
is maturing, significant value is destroyed when management reinvests capital into lower
CFROI projects (See Exhibit 3). We also find that distribution of capital (in the form of
dividends and share repurchases) can create shareholder value when the perceived
risk of misusing cash is high.
For investors agency, theory suggests that cash, free cash flow and free cash flow
yields should be considered in the context of the corporate life cycle. Depending on a
firm’s growth prospects, a high free cash flow yield can either signal a good investment
opportunity or high agency costs. Our findings suggest that the key considerations will
be: (1) a firm’s life cycle stage, (2) investor expectations, (3) management’s capital
plans and credibility.
14. HOLT
14
What is the optimal use of cash? The answer depends on a firm’s available
reinvestment opportunities. Startups and Growth firms should grow, either organically
or by acquisition. Fading and Mature firms should return capital. The amount and form
of the distribution should be in proportion to the size of the firm’s agency costs.
Restructuring firms should delever and divest low CFROI assets. Exhibit 7 below
shows a flowchart summarizing optimal capital usage strategies. Backtests of specific
capital deployment strategies can be found in Appendix A.
Exhibit 7: HOLT’s Cash Deployment Decision Tree
CFROI
Discount Rate
(Investor's Required
Rate of Return)
RESTRUCTURESTARTUP
Discount
GROWTH
A
GROWTH FADE
B C
MATURE
Value to Cost Ratio
High Premium Premium to Par Par
D E
CFROI
Discount Rate
(Investor's Required
Rate of Return)
RESTRUCTURESTARTUP
Discount
GROWTH
A
GROWTH FADE
B C
MATURE
Value to Cost Ratio
High Premium Premium to Par Par
D E
Stage C,D,E? Grow
No
High Embedded
Agency Costs?
Yes
Return Capital
Keep Agency
Costs Low
Yes
No
Source: HOLT Analysis
Note: Value to Cost Ratio = HOLT’s adjusted price to book ratio
Capital Deployment and Corporate Life Cycle From the Investor’s Perspective
15. HOLT
Appendix A: Capital Decision Tree Backtests
Mergers and Acquisitions
Our analysis suggests relatively few (less than 50%) acquisitions are wealth creating. We measured
price returns following 517 acquisitions occurring between 2000 and 2010 to understand how often
and under what conditions mergers and acquisitions create value. We find that high CFROI firms
generally make better acquirers, potentially suggesting that successful operating skill is to some
degree transferable to acquisitions and integration. Further tests should consider the impact of
previous experience by splitting high CFROI acquirers into acquisitive and organic cohorts to
understand the impact of general operating skill from specific acquisition and integration skill.
Exhibit 8: Acquisitive Growth Backtest Results
Acquirer Performance Post-Acquisition Announcement
Avg. 24 Month Relative Returns (%) Avg. 24 Month Absolute Returns (%)
Avg. 24 Month Relative Returns (%) Low High Low High
High 10.38 6.52 High 8.99 4.63
# of Obs. 146 106 # of Obs. 146 106
Low 4.49 1.50 Low 4.30 -3.27
# of Obs. 226 39 # of Obs. 226 39
Positive 24 Month Relative Returns Positive 24 Month Absolute Returns
(% of companies) (% of companies)
Low High Low High
High 51.37% 51.89% High 51.37% 50.00%
# of Obs. 75 55 # of Obs. 75 53
Low 42.92% 48.72% Low 45.13% 38.46%
# of Obs. 97 19 # of Obs. 102 15
Universe: US public companies, acquiring public companies from January 2000 - July 2010.
Deal size at least 10% of acquirers market capitalization. A portion of the deal w as paid w ith in cash.
Source: FactSet Mergers, HOLT
High CFROI defined as firms w here CFROI > sector w eighted average CFROI
Low CFROI defined as firms w here CFROI < sector w eighted average CFROI
Target's CFROI
Acquirer'sCFROI
Target's CFROI
Acquirer'sCFROI
Target's CFROI
Acquirer'sCFROI
Target's CFROI
Acquirer'sCFROI
15
16. HOLT
Exhibit 9: Companies Expected to Grow (Acquire?): Cash Surplus, High CFROI Levels,
and Priced to Grow
Company Ticker Industry
Market
Cap
5 Yr
Median
CFROI
Mkt
Implied
CFROI
Mkt
Implied
Growth
Cash
Surplus
DISCOVERY COMMUNICATIONS DISCA Media $16,630 12% 20% 13% $1,551
VISA INC V Software & Services $51,490 28% 18% 11% $8,746
PHILIP MORRIS INTERNATIONALPM Food, Beverage & Tobacco $97,220 35% 33% 10% $6,501
APPLE INC AAPL Technology Hardware & Equ$228,670 19% 14% 9% $27,617
GOOGLE INC GOOG Software & Services $146,670 21% 11% 9% $38,843
DR PEPPER SNAPPLE GROUP INDPS Food, Beverage & Tobacco $9,010 23% 28% 8% $1,100
MASTERCARD INC MA Software & Services $26,310 20% 21% 8% $4,100
CELGENE CORP CELG Pharmaceuticals, Biotechnol $24,250 11% 10% 7% $4,727
JUNIPER NETWORKS INC JNPR Technology Hardware & Equ$14,410 15% 17% 7% $1,849
EXPEDITORS INTL WASH INC EXPD Transportation $8,680 17% 17% 7% $1,377
FLOWSERVE CORP FLS Capital Goods $5,200 15% 13% 6% $1,402
CAMERON INTERNATIONAL CORCAM Energy $9,270 14% 11% 6% $3,049
THERMO FISHER SCIENTIFIC INCTMO Pharmaceuticals, Biotechnol $17,870 23% 16% 6% $4,245
EMC CORP/MA EMC Technology Hardware & Equ$39,320 14% 13% 6% $4,453
CF INDUSTRIES HOLDINGS INC CF Materials $6,580 11% 12% 6% $2,174
CUMMINS INC CMI Capital Goods $15,650 10% 11% 6% $3,534
UNITED PARCEL SERVICE INC UPS Transportation $65,590 10% 15% 6% $2,986
DANAHER CORP DHR Capital Goods $24,800 23% 12% 5% $2,800
AMPHENOL CORP APH Technology Hardware & Equ$7,640 23% 15% 5% $1,446
AMERISOURCEBERGEN CORP ABC Health Care Equipment & Se$7,860 27% 30% 5% $1,231
Source: HOLT ValueSearch ®. Universe: USA market cap > $5B (ex financials, REITs, Insurance). Cash Surplus > $1B. Market
implied growth > 3.5%, 5 Yr median CFROI > 10%. Cash surplus = HOLT cash flows less fixed charges + short term balance sheet
liquidity. Top 20 companies showed ranked by market implied growth in descending order. Data Date: August, 2010.
Deleveraging
Are shareholders rewarded when firms pay down debt? To answer this question, we looked at
performance of US firms by decile of HOLT’s probability of default. Probability of default measures
the potential for a firm to default on its debt based on its debt to capital ratio (distance to default)
and the volatility of its capital (likelihood the firm hits its default boundary). As you can see below,
over the past 25 years the highest decile of US firms based on probability of default generally
underperforms the market. The 90th percentile of firms based on probability of default has only
underperformed during the past three recessions. This suggests that, generally speaking,
deleveraging is most beneficial for very highly leveraged firms (when financial distress costs are
high) or during economic contractions.
16
17. HOLT
Exhibit 10: Default Risk Backtest Results
Universe: US > $1bn ex Financials (scaled through time)
Cumulative Excess Returns (1/1985 - 7/2010)
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
'85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11
Median
Second Highest Decile of High Default Risk Stocks
Top Decile of High Default Risk Stocks
Given wide-open credit markets and record low yields, we question the strategic relevance of
paying down debt in the current environment. Debt becomes even more attractive when you
consider the recent increase in the cost of equity (risk premium) post the credit crisis.
Dividends
Dividends, like share repurchases, are a return of cash to shareholders. Paying a dividend is a
wealth distribution event, not a wealth creation event, except when it occurs in lieu of wealth
destroying (below cost-of-capital) reinvestment.
Unlike, share repurchases, which pay out current cash surpluses while leaving future cash flows at
the discretion of management, dividends tend to be viewed as a more permanent commitment to
pay out both current and future cash surpluses. This distinction is important for companies that
wish to signal their commitment to slower growth and capital discipline.
Consistent with our findings on late life cycle share repurchasers, we find Fading and Mature firms
(collectively defined as Late Stage) benefit most from high dividend yields.
17
18. HOLT
Exhibit 11: Dividend Backtest Results
Universe: US > $1bn. (Scaled through time to maintain proportional size)
High Dividend Yield: Top Tercile of Dividend Yield
High Growth Spread: Top Tercile of Grow th Spread
Cumulative Excess Returns vs. Universe (12/1984 = 1)
0.5
1.0
1.5
2.0
2.5
3.0
'85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11
Late Stage, High Dividend Yield, High Growth Spread
High Dividend Yield
Late Stage
Dividend Payers
ate Stage: Low realized grow th relative to peers over the past three years; low grow th expectations relative to peersL
Data Date: 01/1985 – 07/2010
Exhibit 12: Companies With More Dividend Potential?
>$200 Yes >40%
Company Ticker Sector Country
Market
Cap
Cash
Surplus
Sector
Dividend
Yield
Company
Dividend
Yield
Dividend <
Sector
Average
% of
Institutional
Shareholders
= Value and
Yield
CISCO SYSTEMS INC CSCO Information Techno USA $132,330 $37,558 0.4% 0.0% Yes 40%
AMGEN INC AMGN Health Care USA $55,310 $18,678 0.5% 0.0% Yes 46%
WELLPOINT INC WLP Health Care USA $23,070 $13,852 0.5% 0.0% Yes 55%
NEWS CORPORATION INC NWSA Consumer DiscretioUSA $38,160 $11,671 1.0% 0.9% Yes 56%
ARCHER-DANIELS-MIDLAND CO ADM Consumer Staples USA $21,360 $10,488 1.9% 1.7% Yes 58%
MOTOROLA INC MOT Information Techno USA $18,580 $8,432 0.4% 0.0% Yes 66%
CVS CAREMARK CORP CVS Consumer Staples USA $42,080 $7,869 1.9% 1.1% Yes 53%
FREEPORT-MCMORAN COP&GOLDFCX Materials USA $44,810 $7,364 1.4% 0.6% Yes 43%
EBAY INC EBAY Information Techno USA $33,660 $6,947 0.4% 0.0% Yes 41%
WALGREEN CO WAG Consumer Staples USA $33,120 $6,615 1.9% 1.6% Yes 47%
HUMANA INC HUM Health Care USA $9,470 $6,033 0.5% 0.0% Yes 57%
DELL INC DELL Information Techno USA $28,570 $5,566 0.4% 0.0% Yes 54%
FOREST LABORATORIES -CL A FRX Health Care USA $9,540 $4,948 0.5% 0.0% Yes 55%
NEWMONT MINING CORP NEM Materials USA $29,710 $4,948 1.4% 0.7% Yes 43%
THERMO FISHER SCIENTIFIC INC TMO Health Care USA $19,910 $4,052 0.5% 0.0% Yes 41%
EMC CORP/MA EMC Information Techno USA $43,510 $4,048 0.4% 0.0% Yes 41%
AVNET INC AVT Information Techno USA $4,210 $3,973 0.4% 0.0% Yes 45%
NRG ENERGY INC NRG Utilities USA $5,200 $3,760 3.8% 0.0% Yes 57%
GOODYEAR TIRE & RUBBER CO GT Consumer DiscretioUSA $2,890 $3,674 1.0% 0.0% Yes 53%
WESTERN DIGITAL CORP WDC Information Techno USA $7,050 $3,606 0.4% 0.0% Yes 56%
YAHOO INC YHOO Information Techno USA $21,510 $3,506 0.4% 0.0% Yes 41%
ZIMMER HOLDINGS INC ZMH Health Care USA $10,210 $3,235 0.5% 0.0% Yes 49%
INGRAM MICRO INC IM Information Techno USA $2,770 $3,145 0.4% 0.0% Yes 57%
ST JUDE MEDICAL INC STJ Health Care USA $12,610 $3,117 0.5% 0.0% Yes 41%
MACY'S INC M Consumer DiscretioUSA $9,470 $2,912 1.0% 0.9% Yes 47%
< Sector Yield
Source: HOLT ValueSearch ®, Factset, LionShares data. Universe: USA (ex financials, REITs, Insurance). Cash Surplus > $200M.
Companies with dividend yield < sector average and total known shareholder mix is greater than 40% value and yield. Cash surplus =
HOLT cash flows less fixed charges + short term balance sheet liquidity. Top 25 companies shown ranked by cash surplus in descending
order. Data Date: August, 2010.
18
19. HOLT
19
A conclusion of this paper is that share repurchases and dividends have just as much opportunity to
create value as growth, as long as a firm’s actions are properly aligned with shareholder
expectations. As shown in exhibit 12, an important data point related to investor expectations is
shareholder type (i.e. Value vs Growth).
Repurchase Shares
Similar to many of the academic studies we reviewed, it is difficult to attribute long-term
outperformance specifically to share repurchases. Grullon and Michaely (2002), Chou and Lin
(2004)) confirm significant short-run excess stock returns upon announcement of a repurchase
(~2% for open-market repurchase programs). However, the long-run persistence of this
outperformance is disputed. An oft-cited study by Ikenberry, Lakonishok, Vermaelen (1995) shows
long-term persistent abnormal returns post-announcement on the order of 12% over the four years
following the initial announcement of open market share repurchases, which is consistent with the
reduction in risk premium proposed by Grullon and Michaely (2002).
Comment and Jarrell (1995) show that the form of repurchase can impact performance. Fixed price
self tenders result in an average excess return of ~11% compared with less than 8% for Dutch
auctions and ~2-3% for open-market repurchases, consistent with Jensen’s view that “the
magnitudes of value changes are positively related to the change in the tightness of the commitment
bonding the payment of future cash flows” (1986).
We find that outside of the tech bubble, the cumulative excess return for all repurchasers is almost
zero. The wide variation in cash valuations observed by Pinkowitz and Williamson (2002), however,
predicts that the impact of repurchases should vary with firm-specific growth prospects. Our
results shown in Exhibit 5 support this prediction; Late Stage repurchasers do outperform.
Wealth redistribution is a commonly cited reason for repurchases. The basic reasoning is that firms
can purchase undervalued shares from selling shareholders, accreting value to long-term
shareholders. So to test the impact of valuation, we looked at the cumulative performance of large
repurchases of cheap shares and found significant excess returns. However, when we compare
those shareholder returns to those of cheap stocks overall, we see little difference with the
exception of the late 80s and late 90s, which warrant further analysis.
20. HOLT
20
Exhibit 13: Share Repurchase Backtest Results
Universe: US > $1bn. scaled through time
Repurchasers: Companies that repurchased shares over the trailing 4 quarters
High Repurchase Yield: Companies w ith a repurchase yield ( market value of share repurchases
over the trailing 4 quarters divided by Market Cap.) greater than the median of all repurchasers
Cheap: Top quintile of HOLT Valuation
Cumulative Excess Returns (01/1985 - 07/2010)
0.5
1.0
1.5
2.0
2.5
3.0
3.5
'85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11
Cheap Stocks
High Repurchase Yield + Cheap
Net Repurchasers
High Repurchase Yield
Exhibit 14: Companies Positioned to Buy Back Shares
>$200 >0% >0 >40%
Company Ticker Sector
Market
Cap
Cash
Surplus
HOLT
Price % to
Best
Up(down)
Side
HOLT's
Economic
P/E
(Sector
Average)
Company
Econ omic
P/E
% of
Institutional
Sharehol ders =
Value and
Yield
MICROSOFT CORP MSFT Information Techno$219,390 $45,624 116.76 20 12 46%
PFIZER INC PFE Health Care $141,960 $39,961 38.97 17 13 53%
CISCO SYSTEMS INC CSCO Information Techno$132,330 $37,558 34.35 20 15 40%
EXXON MOBIL CORP XOM Energy $336,110 $37,145 30.16 20 19 43%
JOHNSON & JOHNSON JNJ Health Care $175,160 $28,314 21.95 17 15 48%
INTEL CORP INTC Information Techno$109,340 $24,128 70.50 20 11 46%
AMGEN INC AMGN Health Care $55,310 $18,678 30.67 17 13 46%
MERCK & CO MRK Health Care $113,980 $15,827 47.95 17 13 49%
WELLPOI NT INC WLP Health Care $23,070 $13,852 34.39 17 11 55%
NEWS CORPORATION INC NWSA Cons umer Discret io$38,160 $11,671 29.87 19 14 56%
HEWLETT -PACKARD CO HPQ Information Techno$98,310 $11,076 34.62 20 11 47%
ARCHER-DANIELS-MIDLAND CADM Cons umer Staples $21,360 $10,488 44.56 19 15 58%
INTL BUSINESS MACHINES C IBM Information Techno$175,410 $10,241 15.45 20 15 44%
ABBOTT LABORATORIES ABT Health Care $80,940 $9,429 67.63 17 15 46%
LILLY (ELI) & CO LLY Health Care $39,580 $9,171 139.96 17 9 55%
CVS CAREMARK CORP CVS Cons umer Staples $42,080 $7,869 45.24 19 13 53%
BRISTOL-MYERS SQUIBB CO BMY Health Care $46,090 $7,598 53.08 17 13 49%
FREEPORT-MCMORAN COP&FCX Materials $44,810 $7,364 48.32 24 15 43%
MEDTRONIC INC MDT Health Care $37,480 $7,337 31.66 17 14 44%
TEXAS INSTRUMENTS INC TXN Information Techno$33,570 $7,064 13.98 20 12 50%
EBAY INC EBAY Information Techno$33,660 $6,947 42.73 20 17 41%
WALGREEN CO WAG Cons umer Staples $33,120 $6,615 17.67 19 17 47%
HUMANA INC HUM Health Care $9,470 $6,033 37.00 17 13 57%
COMPUTER SCI ENCES CORPCSC Information Techno$7,620 $5,659 38.19 20 13 60%
GENERAL DYNAMICS CORP GD Industrials $24,280 $5,582 89.72 20 13 52%
< sector
Source: HOLT ValueSearch ®, Factset, Lion Shares data. Universe: USA (ex financials, REITs, Insurance). Cash Surplus > $200M.
Companies with positive % to best, Economic P/E below sector average and total known shareholder mix is greater than 40% value, and
yield index. Cash surplus = HOLT cash flows less fixed charges + short term balance sheet liquidity. Top 25 companies shown ranked by
cash surplus in descending order.
Data Date: August, 2010.
21. HOLT
APPENDIX B: Case Study - SBUX
SBUX is a classic example in HOLT of the corporate life cycle - profitable growth, eventual over-
expansion, and fiscal retrenchment in the face of diminishing growth opportunities. Since the
company’s IPO in 1992, Starbucks grew retail store base from under 200 to around 6,400 stores
globally by 2004. As the company improved its scale, profitability increased (measured by CFROI
levels) in excess of market expectations, and shares went on a tear through the ‘90s and early
2000s.
Exhibit 16: Starbucks (SBUX) in HOLT
Overinvesting in less
profitable ventures
High growth
combined with
increasing CFROI Capital
Discipline
Source: HOLT ValueSearch. Data Date: September, 2010. Starbucks is shown for illustration purposes only.
However, Starbucks reached a growth inflection point by mid 2006. Embedded in its share price
were expectations of unprecedented profitability and high growth rates. When SBUX started
growing internationally (incrementally less profitable) and diversifying away from its core business
(SBUX developed a slew of consumer products including its own record label launched in 2007),
the market realized it was only a matter of time before profitability was affected. This combined with
21
22. HOLT
22
continued expansion of stores in an already saturated domestic retail market signaled a real increase
in agency costs and resulted in underperformance of SBUX shares over the next two years.
It was only after founder and Chairman Howard Schultz was reinstated as CEO and set about
refocusing on the company’s core competency, that Starbucks’ share price started rebounding.
Under Schultz, management has shown greater prudence in its capital deployment strategy by
slowing down growth and shutting down underperforming stores. Furthermore, an increased focus
on marketing and branding to capitalize on its core coffee retailing business while growing its more
profitable licensing business both domestically and internationally have effectively reduced agency
costs, causing its share price to outperform since the beginning of 2009.
The initiation of a dividend in 2010 may serve as an important signal from management that it is
committed to its strategy of capital discipline, and is willing to redistribute capital in the absence of
credible growth opportunities.
23. HOLT
APPENDIX C: Why Repurchases Don’t Increase Share Prices
A common question we hear with respect to share repurchases is, “If you reduce the number of
shares outstanding how do share prices not go up?”
Theoretically, EV = PV of Operating Asset + PV of Non-operating Assets. We value the Operating
asset by discounting cash flows; the non-operating asset equals the market value in the case of a
hard asset or the present value in the case of an intangible like an acquired Net Operating Loss
(NOL).
With this in mind, let’s look at 2 simple examples. The first assumes that a firm uses excess cash to
repurchase share; the second assumes an increase in debt to repurchase shares.
Scenario 1: Scenario 2:
Current
Repurchase $100 of
Shares with Cash
Repurchase $100 of
Shares with Debt
PV of Operating Business 1,000$ 1,000$ 1,000$
Plus: PV of Surplus Cash 100 -100
-500 -500 -100 -600
0 -10 -10
0 100
Enterprise Value 1,100 1,000 1,100
Less: Debt
Market Cap 600 500 500
Divided by: Shares 6 50 50
Share Price 10.00$ 10.00$ 10.00$
Source: HOLT Analysis
Assuming the market has valued the operating asset and the non-operating asset correctly, there is
no change in the share price.
The only conditions where repurchases could add value in these examples are:
1. When an asset is mispriced, or
2. When distributing cash or increasing debt reduces agency costs, i.e., is better than an
alternative use that destroys value.
23
24. HOLT
24
APPENDIX D: The Theory: Agency costs, Signals and Behavioral
Biases
The subjects of cash, capital structure and cash usage have been well researched by academia
over the past 30 years on topics ranging from generalized theory on management motivations to
empirical studies on why managers repurchase shares. In this section, we present a brief survey of
the theories we find most relevant for investors to consider today.
Agency Theory – Why surplus cash can be too much of a good thing
The Theory: The basic idea behind agency theory is that the interests of managers (the agents)
and shareholders (the owners) are not always aligned. For example, managers are often incented
to grow their companies to increase their power, increase compensation and increase the supply of
jobs for up-and-coming middle managers, despite the best interests of shareholders. This conflict,
or agency cost, can lead to overinvestment and declining profitability. According to Jensen (1986),
agency costs are most severe in companies where cash flow exceeds investment opportunities. To
constrain management and reduce agency costs, Jensen proposed the control hypothesis of debt,
which states that “debt creation, without retention of proceeds of the issues, enables managers to
effectively bond their promise to pay out future cash flows” (Ibid).
The Evidence: Jensen found that most leverage-increasing transactions resulted in significant
share appreciation (2-day performance of 2.2% up to 21.9% for leveraged repurchases); while
most leverage-reducing transactions resulted in share declines (-0.4% to -9.9% for common for
debt). More specifically, Jensen found that “the magnitudes of value changes [in shares] are
positively related to the change in the tightness of the commitment bonding the payment of future
cash flows,” or more simply, the stronger and more explicit management’s commitment to reducing
agency costs, the bigger and more persistent the impact on shares (Ibid).
Key Implications:
1. Agency costs are highest when:
i. Firms have lots of cash to burn,
ii. Reinvestment opportunities are low, or
iii. Management / investor alignment is low.
25. HOLT
25
2. Announcements of cash distributions will have the biggest impact when there is an
unexpected change in cash policy.
3. Aside from distressed situations, debt repayment is a bad thing when agency costs are high.
4. If we define agency costs as the difference between the potential reinvestment rate of
surplus cash and the actual reinvestment rate of profitable projects, then (in the absence of
competition and secular decline) the market’s implied fade rate will equal the “perceived”
agency cost.
Assymetric Information/Signaling Hypothesis
The Theory: The information/signaling hypothesis is based on the idea that firms have asymmetric
information about their businesses and prospects that is unknown / unrecognized by the market.
According to the theory, management will use cash in different ways to convey to the market
information about future business prospects. Per signaling theory, surplus cash has strategic value
because it allows firms to invest in positive NPV projects that managers might otherwise forego;
share repurchases signal impending earnings improvement not yet reflected in shares; and dividend
programs signal slowing growth prospects.
The Evidence: Studies on share repurchases do not support asymmetric information/signaling
theory in the conventional sense. Numerous studies (Chou and Lin (2004), Grullon and Michaely
(2002)) confirm a short-run impact of about 2%-3% upon announcement of open-market share
repurchases. However, Grullon and Michaely (2002) found that the long-run abnormal stock
returns observed by Ikenberry, et.al (1995) following open-market share repurchase
announcements (12.1% average abnormal returns over the four years following a repurchase
announcement) do not come from impending improvement in earnings and profits, but rather from a
demonstrated commitment to reducing agency costs. They found that together with reductions in
capital expenditures and R&D, repurchasing firms experience a significant reduction in their cost of
capital over a number of years following an announcement; and attribute the underreaction
phenomenon observed by Ikenberry, et.al. (Ibid) to the slow process of reducing perceived agency
risks.
26. HOLT
26
Key Implications:
Assuming shares are fairly valued, cash distributions will have the most positive impact on shares
when:
1. The market believes agency costs are high,
2. Management’s commitment to reducing agency costs is understood and trusted by the
market,
3. Otherwise, cash distributions are simply a return of capital (see Appendix D for why
repurchases do not create value),
4. Communication and management / investor alignment are key. Huang and Thakor (2010)
note the potential use of repurchases to force alignment by buying out dissident
shareholders,
5. Cash distributions are not a valuation catalyst per se, but one step towards reducing
perceived agency costs.
Behavioral Corporate Finance – Why stock options may not prevent
agency problems
The Theory: Behavioral corporate finance considers corporate actions in light of potential investor
and manager biases. As pointed out by Baker, Ruback and Wurgler (2004) the literature on
behavioral corporate finance breaks into two general approaches. The first approach considers the
effect of irrational investor behavior on corporate actions; the second approach considers corporate
actions in light of irrational managerial behavior.
Under the irrational investors approach, market mispricing can persist and managers must balance
three conflicting goals: (1) maximizing long-term fundamental value; (2) while “catering” to short-
term investor demands in order to keep their jobs; and (3) exploiting current stock mispricing for the
benefit of existing, long-run investors.
Under the irrational managers approach, markets are rational while managers suffer from “positive
illusions of optimism and overconfidence” about their firm’s assets and investment opportunities.
The irrational manager approach is consistent with agency theory as overconfident managers will
tend to overinvest surplus cash.
27. HOLT
27
The Evidence:
Ample studies support both of the approaches above. There are too many interesting findings to list,
however, Baker, et.al. (2004) provides a very good review of relevant papers. For the purposes of
this report, we list a few key findings below:
• Exploiting mispricing: CFOs cite undervaluation as a key motivation for share repurchases,
and overvaluation as a key motivation for share issuances.
• Catering: Several studies support the catering view that companies adjust dividend policy to
suit current market tastes, i.e., firms initiate dividends when shares of dividend payers trade
at a premium, and cut dividends when payers trade at a discount (Baker and Wurgler 2004).
• Overconfidence: In a survey conducted by John Graham of Duke University, two-thirds of
CFOs surveyed stated their stock is undervalued, while only three percent state that their
stock is overvalued.
• Overconfidence: Optimistic CEOs complete more mergers, especially diversifying mergers
(Malmendier and Tate, 2005).
Why do agency costs exist when managers are compensated with stock and options? Because of
overconfidence according to the findings of Malmendier and Tate (2005). Consistent with agency
theory, they find that managers with significant financial exposure to company-specific risk tend to
overinvest when internal funds are abundant, but refrain from investing when external funds are
required.
28. HOLT
APPENDIX E: Agency Cost Derivation
The Math: Bridging Agency Theory to Valuation
We define agency costs as the value destroyed by suboptimal investments, which we can express
as follows:
[Eq 1] ( ) ( )SuboptimalOptimal VEVECostsAgency −=
( )
( ) investmentcapitalsuboptimalofvalueexpectedtheisand
investmentcapitaloptimalofvalueexpectedtheisWhere
Suboptimal
Optimal
VE
VE
Transforming this equation (see below), we see that agency costs equal the probability of
suboptimal investment multiplied by the value destroyed.
[Eq 2] ( )SuboptimalOptimalSuboptimal PVPVp −∗=CostsAgency
The risk of suboptimal investment increases as cash exceeds investment opportunities:
[Eq 3] ⎟⎟
⎠
⎞
⎜⎜
⎝
⎛
=
iesOpportunit
InvestmentOptimal
-
Surplus
Cash
fpSuboptimal
Where: SurplusCashCostsAgency ∝
iesOpportunitntReinvestme
1
CostsAgency ∝
From a discounted cash flow perspective, we express agency costs as an increase in the cost of
equity through an agency risk premium.
[Eq 4] ∑
= ++
=
n
t
t
t
SuboptimalPV
1 )]PremiumRiskAgencyWACC(1[
FlowCash
28
30. HOLT
30
APPENDIX F: Bibliography
Baker, Malcolm, Richard Ruback and Jeffrey Wurgler. 2004. “Behavioral Corporate Finance: A
Survey.” (October).
Baker, George P., Michael Jensen and Kevin Murphy. 1988. “Compensation and Incentives:
Practice vs. Theory.” The Journal of Finance, vol. 43, no.3 (July): 593-616.
Comment, Robert and Gregg A. Jarrell. 1991. “The Relative Signaling Power of Dutch-Auction and
Fixed-Price Self-Tender Offers and Open-Market Share Repurchases.” The Journal of Finance, vol.
46, no. 4 (September): 1243-1272.
Chou Ray Yeutien. 1988. “Volatility Persistence and Stock Valuations: Some Empirical Evidence
Using Garch.” Journal of Applied Econometrics, vol. 3, issue 4 (Oct.-Dec): 279-294.
Chou, De-Wai, and J.R. Lin. 2004. “False Signals from Open-Market Stock Repurchase
Announcements: Evidence from Earnings Management and Analyst’ Forecast Revisions.” (January).
Griffen and Ning Zhu. 2009. “Accounting Rules? Stock Buybacks and Stock Options: Addiotnal
Evidcne. (March)
Grullon, Gustavo, and Roni Michaely. 2002. “The Information Content of Share Repurchase
Programs.” (November).
Huang, Sheng, and Anjan Thakor. 2010. “Investor Heterogeneity, Investor-Management Agreement
and Open-Market Share Repurchases.” (February).
Ikenberry, David, Josef Lakonishok and Theo Vermaelen. 1995. “Market Underreaction to Open
Market Share Repurchases.” Journal of Financial Economics 39 (October, November): 181-208.
Jensen, Michael. 1986. “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers.”
American Economic Review, vol. 76, no. 2 (May): 323-329.
Malmendier, Ulrike, and Geoffrey Tate. 2005. “Does Overconfidence Affect Corporate Investment?
CEO Overconfidence Measures Reivisited.” European Financial Management, vol. 11, no. 5: 649-
659.
Myers, Stewart, and Nicholas Majluf. 1983. “Corporate Financing and Investment Decisions When
Firms have Information That Investors Do Not Have.” (December).
Pinkowitz, Lee, and Rohan Williamson. 2002. “What is a Dollar Worth? The Market Value of Cash
Holdings.” (October).