Multi-Factor Models – Applying the Lessons Learned from the Numbers

In Finance 1 last year, we were introduced to the idea of multi-factor models (MFM) originally explained by Fama and French as an alternative to the traditional Capital Asset Pricing Model (CAPM) for assessing systematic risk. Additional factors include small versus big (SML) and value versus growth (HML).

In our Business Analysis and Valuation class, we discussed a merger case in which a large company acquired a smaller company. We talked about what would be the best way to approximate beta. The method I used (which was the best method I could conceive, I’d be happy to hear criticism or suggestions otherwise) was to weight the betas by market cap and take an average.

However, there was some discussion about the fact that one entity was much smaller than the other. While we were having a conversation of what that would actually mean, I would suggest a mathematical method for expressing the quantitative effect of size, using FF’s MFM.

1. 1. Express both company’s re as a three factor MFM
   Re1 – RFR = beta1 (Rm – RFR) + betas1 (SMB) + betav1 (HML)
   Re2 – RFR = beta2 (Rm – RFR) + betas2 (SMB) + betav2 (HML)
2. Take the larger company’s size beta and apply it to the smaller entity
   betasnew = betas2
3. Recalculate re for both entities
   Re1new – RFR = beta1 (Rm – RFR) + betasnew (SMB) + betav1 (HML)
   Re2new – RFR = beta2 (Rm – RFR) + betasnew (SMB) + betav2 (HML)
4. Take a weighted average (by market cap) as the expected return of the combined entity

By taking the larger company’s size beta for both, what you are saying is that you expect the smaller company to have the size “characteristics” of the larger entity. I might even be more appropriate to add the size factors (Would that be appropriate? As the MFM is a linear regression, is it appropriate to add these factors?) and use that for new return on equity for each entity as it relates to the combined entity.

betasnew = betas1 + betas2

While there are some significant assumptions which are required for this to work, it is the best solution I can conjure based on information given. I would really appreciate any additional ideas for creating a more robust model.

Abnormal Earnings Method – Not Entirely Useless

When we were introduced to the Abnormal Earnings method in Business Analysis and Valuation, I was decomposing the math formula which constructs the value of the equity. As far as I was concerned, it didn’t really tell us anything we didn’t already know through a equity based discounted cash flow (FCFE discounted at re).

However, there was an interesting scenario in which this method actually told us something unique. First the formula:

Market Value = Book Value + (NI1 – re*BV)/re + (NI2 – re*BV)/re^2 + …

Nix is Net Income in year x

BV is book value

While in theory, this formula should return a similar value to an equity based DCF, one unique value is that the valuation is relative to book value, rather than strictly looking at only cash flows. Essentially, what it is saying is, the company is worth it’s book value, PLUS it’s “abnormal earnings” where abnormal earnings are the earnings you get in excess of what you would expect (re).

So in looking at a company that is trading below book value, I used to think that it meant that the market did not believe in the company’s management to perform (the company was burning cash). But it doesn’t just have to be that the company is on a “crash” course. It could also just be that the company is not performing as “expected” that is to say there net income is not necessarily negative, but simply less than what is expected.

MBA Games - Rotman Team Kick off

Rotman is putting together a team for this year’s MBA games, hosted by Schulich from Jan 7th to 10th. I saw how much fun they had last year that I missed because I was on the study tour and wanted to make it a priority to participate if possible this year (postponing my flight out to London).

Last year’s team was the first time Rotman had competed in six years I’m told and was put together last minute. However, building on last year’s interest, the efforts and energy of our current organizing executive was quite obvious as they were eager to bring us all into the fold to compete and have fun at the games.

To our competitor colleagues at other MBA schools: “See you at the games!”

Write-Up of Intangible Assets

In M&A, acquiring a company requires you to pay a control premium above the current market price to capture a majority of the shares outstanding needed to own the company. Usually, a company’s equity trades at values above book value (the idea that the sum is greater than the parts) and that there is value creation.

So in an acquisition scenario, there are a few considerations. Firstly, the market price is above the book value. Secondly, the purchase price is above the market value. The cumulative amount by which the purchase price is above the book value is referred to as “excess”. This excess is usually allocated in two ways: Good will and Write-up of Intangible Assets.

Purchase Price > Market Price > Book Value

Purchase Price = Book Value + Excess

Excess = Goodwill + Write-up of Intangible Assets

Intangible assets would normally be amortized, but in this scenario they do not provide a tax shield. This makes sense because if you could amortize them you would essentially be double counting your DA expense (or depending on what type of asset it is, such as Intellectual Property, your R&D expense). Also, if you could count this as an expense, this would provide a tax shield against your acquisition premium and promote higher premiums.

Another consideration is the effect on asset based leverage ratios depending on where you allocated the write-ups in value. One note was that in companies which depend heavily on leverage (and where asset based ratios can significantly affect ratings and therefore borrowing rates), there is a tendency to try to write up assets rather than allocate the excess to goodwill (also for “optics” reasons).

Aside: Any buyer that is offering an acquisition price below the current market price should seriously reconsider their position. Although we've seen this unique situation with the recent Potash deal, there are some obvious problems with offering a purchase price below the market price.

Financial Executives International – 5th Best in Class Competition

On Saturday, a Rotman team composed of myself, Shree, Fei and Matt Literovich competed in the Financial Executives International 5th annual Best in Class Competition. The case company was HudBay Minerals. Unfortunately, we placed second, behind Alberta School of Business.

The competition was intense, as many of the teams worked late into the night on Friday to put together our decks and get a few rehearsals in before scrambling to get a few hours of shut eye. The next morning, our names were drawn for presentation order and we found ourselves in the seventh spot.

Matt Literovich was phenomenal understanding potential legal issues related to mining and commanded the attention of the room when he spoke of precedent case law.

Fei gave a detailed account of all the organizational issues we could expect as HudBay Minerals grew and followed our acquisition strategy.

And Shree’s knowledge of mining and dissection of potential target companies gave us an exceptionally high level of credibility.

All three were exceptionally strong in both the presentation and the question and answer period and this short description does not do justice to the quality of our presentation.

While we were very disappointed that we didn’t take the top spot, the event itself was challenging and very entertaining. Judges from the competition included top executives from HudBay Minerals, USGold, OTPP, Mercator, a justice and many other top professionals. Definitely a great experience, I would recommend any MBA student to attend this competition.

Competitions Week – RMA Case Comp

Last week was very heavy for case competitions and presentations (hence the lack of posts).

On Wednesday, we had the Rotman Marketing Case competition. The case was based on the Pan America (Pan Am) games, where we were asked to create a strategy for how to engage university students to participate in the Toronto 2015 games.

One key insight from our team was that the university students of 2015 are currently high school students, so we took a two pronged approach:

1. Engage high school students now and use their 40 hours of volunteering to instill a culture associated with sport based mentorship.
2. Create the university infrastructure that would allow these students to be received into such post-secondary institutions.

We proposed that as the system developed, this program could follow PanAm games host cities and was modeled similar to "Right to Play" and eventually leverage the Olympics brand to become international and increase the sense of legacy of the games beyond just physical infrastructure.

While we didn’t place in the competition, it was interesting to see what other teams pitched as it was a fairly open ended question and there were plenty of unique solutions proposed by the other groups.

Islamic Finance - International Consulting Project

A new initative at Rotman (although you wouldn't know it as it has simply exploded this year) is the International Consulting Project. Laura Wood, Director of International Programs, has started a new research type project that engages students to work with professors on international topics. Some countries involved are the G20, Middle East, Israel, Africa and potentially others.

I myself am participating in the Islamic Finance ICP with Walid Hejazi, the professor who leads the Middle East study tour.

Yesterday, we were invited to attend the kick off event for the Islamic Finance EMBA course which will be offered in Jan 2011. The keynote speaker was David Dodge, Senior Advisor, Bennett Jones and former Governor of the Bank of Canada. He spoke about the growing interest in Islamic finance and how there it is common for people to see Shariah compliant instruments as simply "no interest" and how this superficial understanding does not encompass the fundamental rational for the structure of these products.

I am looking forward to working with my four other colleagues on this research project to look at Islamic financial instruments.

Legacy REIT

In our corporate finance class today, we were responsible for presenting our valuation of the Legacy REIT IPO. We used a variety of different valuation methods and multiples to provide a range of potential valuations before recommending a price of $10.50.

My team was fantastic to work with. As we are also responsible for the RioCan valuation next week, we opted to split the group work down the middle and sort out our presentation. My team mates produced a robust DCF model which had it's assumptions firmly grounded in the economic realities of the industry. When it came to question and answers, my team mates were resilient in answering questions about reconciling the various valuation methods to resolve model tensions (the DCF says we should price higher, but yield analysis shows that we aren't generating a high enough yield to attract potential investors relative to other REITs).

In the end, it took all the strength I could muster to stop grinning like a Cheshire Cat as my team mates hammered back answers to questions by pulling up pre-emptive appendix slides and presenting a well founded case for our valuation.

As an interesting note, our professor had worked on this deal and mentioned that they had priced the deal at $10 (and that apparently, for mathematical simplicity, these units are generally priced at $10 and that the sources of funds are changed through the number of units issued - like bonds at $1000 or preferreds at $25).

Retail Experts Speaker Series - Jurgen Schreiber, President and CEO, Shoppers Drug Mart

Rotman hosted another speaker series session today from the Retail Experts Speaker Series @ Rotman and the guest was Jurgen Schreiber, President and CEO, Shoppers Drug Mart Corporation. And he spoke on "How and Why Shoppers Drug Mart is Transforming its Stores to One-Stop Shopping”.



After noting that this talk was organized before the change in pharma regulations, he began with a quick history of Shoppers and the development of its stores, noting that the first Shoppers store originally had a variety of products.

He offered a breakdown of Shoppers value proposition on five key elements:

1. Dominate on Convenience


2. Differentiate on Service


3. Differentiate on Products


4. Differentiate on Experiences


5. Compete on Price

Why? Simple answer: Because the customer is ready for it. Real answer: “Our gut told us to do so – to create something really unique and different” & “We have the capital resources and financial strength.”

Mr. Schreiber went on to discuss mega-trends that he perceived as being crucial to the long term success of Shopper’s including: Health, Convenience, Age Complexity, Gender Complexity, Individualism, Sensory, Comfort, Connectivity and how it was necessary to understand and embraces these factors, use them in combination to differentiate and innovate in a scalable way. He also reflected on the changes in demographics in the Canadian market place such as more singles, no or less children, smaller households, aging population and multiple income couples.

Jurgen defined a modern one-stop shopping experience as needed to focus on location and opening hours, store experience, clear assortment, in-store convenience, service, product, loyalty programs and loyalty specific products, to create a “Have it all drug store”. He emphasized how it was also necessary to avoid small and mega store formats, traditional assortments, all services, and all profit pricing. He spoke about how there is a concept of “My store”: my SDM (Shoppers Drug Mart), My SDM Associate and Team, My Optimum, as part of My Neighbourhood.

There was one odd little insight in Shoppers product mix. They don’t sell fresh food, but they make an exception for fresh bread, a noteworthy exception pointed out by Jurgen. He mentioned that, in testing, customers perceive this product has being an exception as to what types of products are expected at Shoppers.

He closed by speaking about the Optimum program. A classmate I was watching the presentation with on the third floor commented that Optimum was a program that was the first of its kind. Unlike popular third party programs, or other loyalty programs, Optimum induces customers to return to the shop to pick up additional items. As an example, this is in contrast to a gas station loyalty program which just causes you to return to the same gas station to purchase something in which you have a relatively inelastic demand – gasoline and convenience goods during travel – selecting between vendors versus marginal purchases though increasing basket size and return visits – two of the key value drivers of Dilip Soman’s customer value framework.