In the post-World War II years the majority of big companies used to depend on a classical form of annual financial planning: projections targeting medium range 5-year plans, and a detailed yearly budget. In many large organizations, however, the 5-year plans were a ‘me too’ exercise. They would largely sit on a shelf and collect dust. Only short-term financial instruments got the limelight.
● The budget
● Balance sheet, and
● Income statement.
Since the mid-1980s, however, this has started to change, at least among well- managed firms whose senior management is now taking a look 10 years into the future. As longer-range plans are being elaborated, top executives and inde- pendent analysts in the industry get together to give the board their opinion on the future state of the industry sector the company is in. During these roundtable sessions, senior management mainly looks at four factors:
● Economic
● Social
● Technological, and
● Customer demand.
This emphasis is well chosen and it rests on the appreciation that each one of these factors can affect the company’s strategy in a significant manner.
A case study helps in giving some muscle to what the previous paragraph stated. In 1985, a well-known copier company established the vision that, by 1995, the world would have gone digital and become networked. This prognostication, which proved to be accurate, enabled the entity to capitalize on new opportunities:
● Moving almost all of its R&D budget out of light lens and into digital, colour and networked products, and
● Ensuring that marketing, as well as all of its business units, were tasked with convincing customers to switch to digital machines.
The policy underlying this approach to an evangelical-type sales campaign was that the opinion of customers follows a longer-term trajectory; it does not change instantaneously. And a changing trend must be explained to customers ahead of time, in order for the company to be ahead of the curve. Moreover, the company has to refocus its activities and finance its changeover to the projected new line of technological evolution. This requires plenty of management guts, and also a great deal of financing. The faster the market and technology move, the greater become the financing needs. It is not surprising that, since the mid-1980s, a great deal of top management interest has concentrated on cash flows – almost on a par with the interest in profits. The term ‘cash cow’ has been coined to identify those product lines with good cash flow, which would provide the resources to finance other product lines
● With better ‘future prospects’, in the 10-year perspective
● But currently strained for liquid assets, both because theirmarket is not yet zooming, and theirR&D and marketing expenses are high.
As the balance sheet has a model, which we have seen in Box 13.1, well- managed companies develop and use a consolidated cash flow model. As Box 13.3 shows, this divides into five main chapters, summed up as an increase or decrease in cash and equivalent instruments.
There is evidence that cash flow estimates and realized profit figures tend to cor- relate. Theoretically, profits and cash flow are independent variables. Practically, as shown in Figure 13.2, behaviour of the cash flow variable has moved in tandem
with net profit. (The figure uses statistics from a major Swiss bank, from the early to mid-1990s.) This correlation does not necessarily hold true in connection to return on equity (ROE).
A basic reason why the tracking of cash flow by main source is so important is that money is needed to finance management’s plans. If internal resources don’t suf- fice, thenthe company has to take loans thereby leveraging itself – and there are limits beyond which leveraging becomes most unhealthy. (See also section 3.)8 Another fundamental reason for looking carefully into cash flow is that it consti- tutes the reference on which will be measured the intrinsicvalue of the company.
(As we have seen in Part 1, the intrinsic value is one of the methods helping in calculating fair value.) Generally speaking, there exist three metrics that can give an idea of what a company is worth, each with its own opportunities and challenges.
Box 13.3 Consolidated statements of cash flows
●
● Operations Net income
Cash provided by operations
Adjustments for non-cash and non-operating items:
Non-cash restructuring charges Loss on derivative instruments
Loss (gain) on sale of other investments Depreciation and amortization
Charge for acquired research and development Amortization of compensatory stock options Equity in losses of investees
Changes in operating assets and liabilities, net of acquisitions and dispositions:
Trade accounts receivable Other receivables
Prepaid expenses and other current assets Other assets
Investments including available-for-sale securities Accrued expenses and other current liabilities
Deferred revenue and other liabilities
(Continued)
● Market value, measured through the proxy of capitalization for the whole firm – or directly observed market value by inventoried position or busi- ness unit.
● Intrinsic value, computed as the discounted value of cash that can be taken out of the firm during its remaining life.
● Book value, an approach based on the classical accruals method whose results nowadays are not really meaningful.
While alert investors appreciate that book value does not mean much, this is still used as indicator when the equity price lags behind. Take Deutsche Bank book
Box 13.3 (Continued)
●
● Investing activities
Cash used in investing activities Purchase of property and equipment Product development costs
Proceeds from sale of investments Purchase of investments
(Purchase of) proceeds from short-term investments, net Purchase of minority interest
Net (payments) proceeds for acquisitions/dispositions Other investing activities
●
● Financing activities
Cash provided by financing activities
Proceeds from issuance of common stock, net Principal payments on debt
Payment of deferred finance costs Proceeds from issuance of debt
●
● Cash and equivalents at beginning of year Cash received during the year
Cash paid during the year
●
● Cash and equivalents at end of year
●
● Increase (decrease) in cash and equivalents
value as an example. Mid-2004, as Deutsche’s equity lost more than the stocks of its peers, analysts said the price-to-book multiple needed almost to double from its level of about 1 to 1.9 before large-scale deal-making would be feasible. (For
1993 1994 1995 1996 1997
CASH FLOW NET PROFIT
1993 1994 1995 1996 1997
CASH FLOW AND NET PROFIT
RETURN ON EQUITY (AS %)
JUST NOTE DIFFERENCEJUST NOTE DIFFERENCE
Figure 13.2 Cash flow, net profit and return on equity tend to correlate
starters, a price-to-book multiple below 1 means that the price of the company’s common shares is less than its break-up value.)
In this same case, other analysts expressed the opinion that, in a way, the mark- down in the credit institution’s share price was harsh. Josef Ackermann, Deutsche Bank’s CEO, did a restructuring which helped the bank enjoy a 20% pre-tax return on equity in the first half of 2004, up from 15% a year earlier. And the investment arm of the bank was doing rather well – but markets are hard critics.
Because book value may be way off the mark of what it intends to represent, tycoons use it to turn things to their advantage. In the late 19th century the clash between Andrew Carnegie, the majority owner of Carnegie Steel, and Henry Clay Frick, the president of his companies and third major partner, was one of per- sonalities. Eventually Carnegie evoked a partners’ agreement, known as the Iron Clad, to eject Frick and purchase his interest at book value.
● First, at a board meeting the move was seconded and approved.
● Then Carnegie strode into Frick’s office and delivered the news, along with a settlement.
The news was that the board had voted to enact the Iron Clad, and the transfer of Frick’s stock would be made at book value. The book value of Carnegie Steel was $25 million, giving Frick a mere $1.5 million for his 6% interest; whereas from Frick’s viewpoint, the company’s real value was at least $250 million, a selling price agreed a year earlier but never executed, which would make his interest worth $15 million in 1899 money. (Eventually Carnegie Steel was sold to Dr J.P. Morgan for $480 million – nearly double of what was offered by the failed takeover, and 20 times its book value.)
The problem often encountered with instrument-by-instrument market value is that quite often there is no direct observance of market value against which to mark portfolio positions. This has been explained in Part 1, and it is further doc- umented by 2005 Basel Committee research on ‘reference market’ for trading book positions. The research demonstrated that:
● Between 0.2% and 28% of total trading book positions have no reference market.
● But on net basis, this rises to between 80% and 85%.9
In the opinion of some of the experts, even what constitutes a ‘reference market’
is not well defined. Generally, it includes direct price comparison; comparison
to market inputs, according to market convention; and comparison to observable inputs, involving a range of models. But there are also other definitions.
Where no active market exists, the practice is that of marking to model.
Therefore, the Basel Committee examined the credit institutions’ valuation method, price verification procedures, and evaluation of reserves. The regulators also looked into challenges faced by banks in valuing their positions, and in gaining experience from the implementation of a fair value policy.