Free Cash Flow to Firm and Net Change in [OPERATING] Working Capital

A few of my classmates have been asking me a very common question so I thought I would post the answer. Particularly because I think it is a fantastic question and is something I’ve wrestled with for sometime.

In Corporate Finance, Financial Management and Mergers & Acquisitions, one of the most important metrics of a company’s performance is it’s free cash flow. Or more specifically, it’s free cash flow to firm (aka. Unlevered free cash flow). This is the cash flow metric that is used to value the entire enterprise. It’s defined as:

FCFF = EBIT (1 – tax) + DA – NWC – Capex

Where:
EBIT is Earnings Before Interest and Tax (otherwise known as operating income)
DA is Depreciation and Amortization (which is actually a place holder for all non-cash expenses, but DA is the largest and most common one)
NWC – Change in net working capital (*NOTE* This is the tricky part that people are asking about)
Capex – Capital Expenditures

So while this formula is not new to most, what I want to focus on is NWC. If you have read my post on the difference between OPERATING working capital and working capital will know what I’m getting at.

First, before we even get to that, I want to emphasize a lesson taught in Anita McGahan’s first year strategy course relating to Dupont analysis (one of my favourite frameworks). Dupont analysis looks at Return on Equity and Anita made a fantastic point about how to look at the formula:

ROE = NI / Equity

ROE = (NI / A) * (A / E)

ROE = ROA * FLA

Where:
ROA is return on assets (Operational Strategy)
FLA is financial leverage (Financial Strategy)

In a discounted cash flow, a company’s value is calculated as it’s enterprise cash flows discounted at the appropriate enterprise cost of capital (it’s weighted average cost of capital).

In other words: In the summation formula, the numerator is operating (FCFF) and the denominator is financial (WACC).

This is another good way to think about the difference between OPERATING working capital (OWC) and working capital (WC) as I explained previously.

While the commonly accepted formula for FCFF is as explained above, anyone who has done a proper financial model is quick to learn that it isn’t change in net working capital which is important, but rather change in OPERATING net working capital (excluding financing items such as cash and short term debt).

FCFF = EBIT (1 – tax) + DA – NOWC - Capex

But the next logical question is what is the difference between something like short term debt (a quantifiable liability) and accounts payable (also a quantifiable liability which is equally a debt of sorts – a debt to a supplier). The answer? Interest.

The reason why something would be considered OPERATING working capital (or particularly an operating current liability) versus a normal working capital (or current liability) is that a financial current liability *bears interest* whereas an operating liability does not.

This raises the next interesting question: How do you treat pension liabilities? As you may recall, I mentioned previously how the CFA treat’s pensions as if they are interest bearing liabilities (or specifically, debts of the company owed to it’s workers which is expected to grow at the company’s cost of debt). This is a perfect example of a judgment call. Some of the top equity research analysts will consider pensions to be part of operating a business (not included in enterprise value as a financial consideration) whereas others will consider pensions to be a type of financing (don’t take my word for it, check out the research reports of companies with sizable pensions and see how different analysts treat different companies). Some will consider current pension obligations as debt (as it has to be financed to be paid out) whereas others will treat the entire long and short term obligation as debt.

Investment Banking and M&A - Scotia Capital

I returned from the Latin America Study Tour very early this morning. After filling up on Chinese food at lunch and running a few errands throughout the day, I'm finally settled at my new place.

Tomorrow, I'll be starting as a Summer Associate, Investment Banking and M&A at Scotia Capital. I anticipate being very busy and will also not be putting up any posts until I return to school in late August (probably with a post from MBA Orientation Camp).

So far, the CFA / MBA journey has been an exceptionally rewarding one and I am really looking forward to what challenges await in the summer and the opportunities of the coming year.

BATNA and Sharpe Ratios in M&A

While I missed the Negotiations class my classmates took for the Middle East Study tour, I was fortunate enough to have taken a Negotiations class at the Analyst Exchange in NYC where they explained concepts like BATNA (Best Alternative to a Negotiated Agreement) in a simulated negotiation environment.

Also, in ITP, we talked about the model for "rational experimentation", that is to say the formula which describes the logic between probability of successful outcomes versus the risk and initial investment required (looks suspiciously similar to an NPV calculation because it uses the same mathematical components with probability of success superimposed on the cash flow, similar to how the CFA teaches to account for risk).

With my last post on M&A and splitting synergies with the target's share holders, this got me thinking about what would be "rationally" fair in M&A negotiations. I thought about it and decided it might be a good idea to integrate the thoughts from the post below with the idea of a Sharpe Ratio (or more exactly, Roy’s Safety First Criterion – where we use a “minimum return” rather than risk free rate).

S = (E[R] - Rf) / sigma

Where:

• E[R] is the expected return of the project
• Rf is the risk free rate (or in Roy's SFC, minimum return)
• sigma is the standard deviation of the investment

Obviously, there are some of the same undertones that we have learned from CML or CAPM. While I was thinking about Synergies and Premiums analysis of an M&A deal, it struck me that while there is some "risk" in the total Synergies achievable, the Premium is paid in advance and essentially risk free. Immediately, some of the same terminology which was used in the previous post suddenly rung a bell with regards to the Sharpe Ratio (from CFA Level I).

I would propose that the Sharpe ratio calculation can be used in an analogous manner for an M&A deal with synergies. For example:

• Expected Returns --> Synergies
• Risk Free Rate --> Premium
• Sigma --> some sort of volatility related to success of M&A deals to achieve expected returns

In fact, you can take this a step further and get:

• Synergies / EV as a proxy for M&A incremental ROA
• Premium / EV as a proxy for M&A minimum return

S = (Synergies – Premium) / (EV * sigma)

The formula would then calculate something very similar to marginal excess ROA or value creation per unit risk by the deal. Besides helping you understand your BATNA, this metric might also help you select acquisition targets from a financial perspective.

PVs of M&A - Premiums and Synergies Analysis

There was an interesting perspective for Mergers and Acquisitions in the CFA course readings. Rather than look at accretion / dilution, there was the alternate perspective of looking at doing a sort of NPV analysis of M&A and seeing who benefits and what the implications are.

Example: Look at two companies A (Acquirer) and T (Target). The companies are all equity and have 100 shares each. However, A is valued at $1000 and T is valued at $400. Synergies (defined as the PV of all future cashflows) is valued at $200. The premium is $100 and the deal is all cash. What is the value of the combined entity, C?

C = A - Outflows + Inflows

Outflows = T + Premium
Inflows = T + Synergies

C = A - (T + Premium) + (T + Synergies) // T's cancel - makes sense, lose T in cash, but gain T in value by way of acquisition

Therefore,
C = A - Premium + Synergies
= $1000 - $100 + 200
= $1100

For the original share holders of A, the new stock price would be:
$1100 / 100 shares or $11, a $1 increase in value!

Note that T shareholders got $500 for their 100 shares or $5 each, also a $1 increase.

This is an interesting result, the actual value of T doesn't really affect the value of A. This alternative focuses more on two of the most important financial points of information on an M&A deal: Premium and Synergies. Because A and T split the synergies evenly through the premium, they both benefit the same. This result holds for any porportion of split between A and T shareholders based on the portion of the Synergies represented by the premium.

Another way of looking at it is this: Synergies are the value created in an M&A deal. The Premium represents what is picked up by the current owners of the target, T, where as what remains (Synergies - Premium) represents the value picked up by the original shareholders of A (the acquirer).

While this is a unique perspective, it also lends itself to another interesting result:

Continuing the example from above, the stock price for A is $10 ($1000 EV / 100 shares) and the acquisition price for T is $5 (($400 + $100) / 100 shares). A plans to acquire T by issuing T's current owners 1 Share of A for every share of T (giving away a "$10" dollar share for two "$5" dollar shares). We get an interesting result. Suddenly, the Value of A is different:

C = A + Outflows - Inflows

HOWEVER:

Outflows = 0
Inflows = T + Synergies = $400 + $200

Suddenly, value of C is $1600. Wow! Seems like we got something for nothing. But wait a second! We need to issue more shares to T's owners. How many? Well:

$500 EV / $10 per share = 50 shares.

So what is the new price per share of A? Well:

$1600 / 150 shares = $10.67 / share

Why is it lower? Where did the creation of value go? Well because A "gave away" some of their share of the synergies by paying T shareholders with PRE-merger valuations of their shares. Essentially, they gave T share holders some of their share of the synergies BEYOND the premium paid upfront in A's stock.

Note that T's former owners are now holding $10.67 for every two shares or $5.33 for each of their T shares or a $1.33 premium per share (@100 shares, thats $133). Notice anything interesting? The total synergies are the same ($67 for A shareholders + $133 for T shareholders = $200 total synergies), but T has taken a bigger slice. In the theoretical space, it is a zero sum game.

Why would A do this? A may not have enough cash on their balance sheet to entirely swallow T (they'd need T's full value in cash). Also, perhaps they are not entirely confident on being able to realize the synergies in the deal and are looking to share the risk with T's shareholders. Giving away stock might also incentivize some of T's current shareholders (aka current management) to stay, align their interests and realize the synergies.

Exchange Rates - Currencies as Investment Instruments

Oddly, in my Global Managerial Perspective (an international economics course), we were discussing exchange rates and the professor brought up nominal and real exchange rates (nothing new really), but also introduced the idea of using a weighted average of currency exchange rates as a bench mark for appreciation. There are two neat ideas which I took away from this:

The first is that when currencies appreciate relative to one another (on a bi-lateral basis) it is often hard to tell what is happening. For example, the Canadian dollar flirting with parity to the US dollar in the last few years. Is this a result of the US recession and lack of confidence in their dollar? Or the fact that Canadian Exports are in high demand and driving up our dollar value? Or both? In putting together a weighted average of exchange rates against your currency, you can tell on a more clear individual basis if your currency is appreciating against your "basket", a proxy for global currencies and real Purchasing Power Parity growth.

The second idea is that this weighted average looks an awful lot like an index. Much of the language above encompasses the idea that it behaves like a portfolio of financial instruments. Having said that, I recognize that things like CAPM probably wouldn't work (considering that currencies are not return generating instrumentns) so a regression of gains over time from the currency to the "index" would probably be meaningless. In the same way that commodities (although they are assets - items that store value) are not investment assets in the same way other financial instruments are because they don't generate return.

As the CFA material mentions, the only real way to receive gains from non-income generating instruments (commodities and currencies) is to rebalance after a change in price of the underlying asset.

MBA or CFA? What's the Difference?

I've been asked repeatedly by various people about the difference in value between an MBA and a CFA. First there are some notable differences:

Pro-MBA

• If you decide to do an MBA, go to a top school. While the MBA teaches you very broad range of interesting topics, the value of the MBA program is heavily weighted towards the relationships and network you build.
• There is admissions in an MBA program with standards. You know the people getting in are motivated and ambitious and are probably very good at what they do and looking to take it to the next level. Also, with the Party Model of admissions, you have a diverse range of backgrounds and cultures.
• MBA programs have faculty, admissions, staff and alumni to provide support.
• Recruiters come to MBA programs looking for talent.
• You learn a broad base of business topics, not just those related to the Association of Investment Managment and Research (the old name of the CFA).

Pro-CFA

• There is no "admissions" into a CFA program. People here are motivated, but focused on finance. No need to write essays, cover letters, resumes etc. to apply. While you can just buy your way into writing the Level I exam, you can't advance without doing an enormous amount of work (mid-30%ish pass rate for Level I).
• If you don't go to a top MBA (and you are interested in finance), you might want to do a CFA instead. The CFA program has the benefit of being standardized and recognized around the world. It covers a lot of the same basic technical / quant materials as core courses in most MBA programs.
• If you are working in Toronto, it seems like everyone has one. Apparently, I'm told it also gives you the acumen to speak to buyside clients (or work on the buyside).
• There are local CFA societies where investment professionals meet. However, events are generally not free (sizable ticket costs for luncheons) but still good events.

Con-MBA

• An MBA will cost you about $70 to $80k at a top international school whereas the CFA is $400 for membership and $600 per exam (give or take) for a total of $2200ish (assuming you pass all exams in one go... A bit of a stretch).
• Admissions. Because it's not a light endeavour, you want to get into a top school. And top schools don't make it easy. Candidate profiles and application materials tend to skew higher for top schools.
• It consumes a LOT of time. Full time means you give up 2 years of work experience, pay, advancement, etc. If you do it part time, you give up a lot of "work life balance".

Con-CFA

• To get a proper CFA (the whole designation) it takes at least four years worth of experience [and] having completed the three tests (which will take you one year each assuming you pass each in one go).
• It also consumes a LOT of study time to prep for the exams. Almost like doing an MBA parttime I'm told for those who are doing it while working.
• HIGH failure rate. And most exams are yearly meaning a fail equates to a year delay and another $600 out of pocket.
• ALL self study. While you can take a course with Stalla or Schweser (or PASSMAX which I recommend), you don't really build your network. It's great for building your technical proficiency or signalling to the market (if you don't have any finance on your resume as I didn't when I started), but not as much for extending your contacts.

The Acumen

I've been exceptionally busy the last few weeks. Even though I've decided to place a moratorium on competitions, I’ve still found myself overwhelmed with the MBA and the CFA Level II material. One thing I’ve been trying to keep track of in my posts is the absolutely brilliant ideas I’m encountering, whether in the Rotman MBA or CFA Level II.

But lately, my ability to post and get work done has drastically dropped off. And I would like to think it’s not because I’ve gotten lazy, but rather because there is so much brilliant and interesting stuff going on that I can’t post it all.

And I think that is exactly the case. Example? ITP, a course that had many of us scratching our heads in the beginning has suddenly burst forth with ‘light bulbs’. For example, not too long ago, I was complaining about how “past performance does [NOT] predict future behaviour” in some cases but not others. For example, individuals (as social science will tell you) are predictable (past performance DOES predict future behavior) but this is not so in finance and capital market instruments (good luck buying a stock based on it’s past behaviour hoping for gains).

And ITP has taken this exact point and, in our latest team assignment, asked us to investigate why this is. How “predictable” individuals (with their behaviour well defined) in a group produce slightly unexpected results. And the effect this has on our perception of what we learn in finance classes as it relates to theoretical concepts (CAPM comes to mind at the top of this list, but is closely accompanied by the idea of bubbles and crashes in the stock market, a very timely topic).

You can imagine that I am very excited. Suddenly, I am being given the vocabulary to describe in practical terms what we’ve been taught in textbooks. One of the reasons why I came to the MBA program was to help me structure my thoughts so that I could package them and deliver them to someone in a more digestible format.

While I was fortunate to have known many brilliant minds at McMaster Engineering, in my work life, I felt like I wanted to further develop my business skills to speak the same language as my colleagues and be able to use descriptors outside of the Engineering dictionary so we could understand each other, work together and accomplish amazing things. It was one of my goals coming into Rotman: I thought I was pretty clever. But I wanted to develop my business acumen.

Non-Leveraged Accretive Mezzanine Financing

I was looking over my CFA Level II materials for corporate finance this weekend when I looked at the CFA's definition of different types of risk. For instance:

Sales (Business / Industry risk)
- Operating Expenses (Operating Leverage)
- Interest Expense (Financial Leverage)
_____________
Cash flow

The definition of any type of leverage (operational or financial) is increasing your fixed cost component but reducing your variable component.

It got me thinking, is it possible to have an instrument which doesn't increase leverage and solvency ratios, but also provides accretion for common equity holders? For instance, if you want to deleverage, the general strategy is to purchase debt with equity (which results in dilution because cost of equity is higher than cost of debt due to risk concerns etc). I don't know if this is possible, but I asked myself about a preferred share with very particular characteristics.

Fixed income instruments (coupon paying bonds, dividend paying preferred shares) increase the fixed payments required which technically increase leverage.

Accretive
Is it possible to have a preferred share that, rather than paying a fixed predetermined dividend (similar to dividend yield based on price), that pays a percentage of net income (similar to a stated dividend payout ratio). Because it is more senior than common equity, the cost of this capital would be less than the cost of equity (accretive if used in a refinancing / capital restructuring).

No Leverage
But the payout would also be variable based on NI meaning that it isn't technically leverage according to the CFA definition (plus it would be classed as equity rather than debt on the books). If earnings are low, the payout is low. If the earnings are high, payout is high. It rises and falls as a variable component rather than a stated fixed component.

The problem with this model of an instrument is that I don't think you could get a "senior" level instrument to payout variable to net income with a cost of capital less than common equity because they technically face the same level of risk (percent of NI).

Also, because earnings can be manipulated, perhaps the payout would work if it was stated as a percentage of EBT or some other higher quality form of earnings? At first I thought EBITDA, but then I realized that doesn't make sense. It would have to be paidout after EBIT (because interest should be a more senior form of financing and paid first). However, EBT is often modeled with a fixed tax rate to go to NI (so a % of EBT is really a % of NI since tax rate is usually constant).

Perhaps it could be payed out as a % of EBITDA which is paid out after interest?

This would justify the instrument being more senior and paying a lower cost of capital.

Ian Schnoor - Financial Modeling 3, LBO's

Just arrived back from March Break and "warming up" to classes again in Ian Schnoor's third financial modeling module: LBO's. Before leaving for the break, he had come and done his second module: Valuations which talked about understanding the operations and finances of a company.

While module 1: Buiding a Financial Model, was a free lesson (I believe it's paid for by PACE at Rotman), Module's 2 and 3 cost $100 each, well worth the cost (again, I believe it's subsidized by PACE at Rotman).

The CFA charges quite a bit more if I'm not mistaken (but I'm lead to suspect that the CFA courses are also subsidized, though maybe not as much).

Having these financial modeling courses under your belt gives you a very good practical understanding of how to apply financial concepts learned in class beyond purely theoretical or academic textbook knowledge.

The 4 C's of Credit

I have some friends who are looking at trying to gain positions in Fixed Income so I thought I would have a quick review of the 4 C's of Credit. They are:

1. Character - The management team's record, strategy and internal controls
2. Capacity - Ability to meet debt obligations
3. Collateral - Assets pledged to back the loan
4. Covenants - Restrictions on activities as well as maintenance

Recall that in bankruptcy, there is a hierarchy to how remaining capital, collateral and other assets are distributed relative to tranches. However, in restructuring "everyone gets a haircut".

Also, when building credit ratings, there are various ratios that are looked at, particularly:

• Profitiability Ratios
• Liquidity Ratios (Short Term Solvency)
• Capitalization (Leverage) Ratios (Solvency)

CFA Level II - Study Begins

I was studying for the CFA Level II on Sunday and I noticed that some of the topics covered in the Equity Analysis portion were items that I was pondering earlier including: alternate method of including the value of risk in DCF, inflation as a reasonable proxy for long term sustainable growth in a GGM or DDM, the constant relationship between ROE, k, PE, Dividend payout / retention, growth rate etc.

I'm very excited to be starting my study for the CFA Level II. Already, I'm learning a lot and getting confirmation and validations on some of the ideas I had pondered earlier as well as correction on some misconceptions.

So far, I'm particularly impressed with the integration of macro economic factors on valuations and approximating growth rates and factor variables in valuations via economic indicators (GDP growth, inflation, CPI etc). I am absolutely fascinated at the interplay and relationships for how different disciplines of study interact and how the mechanics of economics and strategy affect the mechanics of finance. Also, I think that the topics covered are pragmatic and absolutely brilliant in terms of applying theory in practice.

Mubadala

[MEIST - Dubai -Abu Dhabi 1, 2, 3, 4 - Jordan]

One company which was paritcularly impressive on this trip was Mubadala (arabic for "Exchange"). They are owned by (and intimately related to) the government of Abu Dhabi (the directors on the board are also the same ministers in government), yet operate seperately in many important respects which makes them a good proxy for what is happening the Emirate in general. While related to the Abu Dhabi Investment Authority (ADIA) and the Abu Dhabi Investment Council (ADIC) as a government owned entity, Mubadala has a different mandate to undertake long term, capital intensive projects with the intent of making competitive market level returns while diversifying Abu Dhabi's economy.

It was best explained on our trip as a "PE firm with a soul" where they have what they call a double bottom line: Financial returns and social / strategic improvement (will the project increase jobs, generate intellectual property etc). They try to balance their projects on "the curve" - a production possibility curve where the axes are financial return of the project and social and systematic improvements in the economy (shown above).

Another interesting characteristic is that Mubadalah recently (this year) released it's financial statements publically which is surprising considering it's size, the fact that it is essentially a sovereign entity. Our speakers made a point to emphasize Mubadala's focus on three guiding principles: Transparency, Accountability and Corporate Governance.



Some of their projects include Masdar city, an ambitious project attempting to build the first carbon neutral city in the world. They also have partnerships with the Ferarri Group which has a strong investment team and partners up in ownership of companies such as Piaggio Aero. We were told Mubadala has a particular investing style in bringing in partners. In order to ensure that they behave in a manner that is "best in class" (not being complacent with it's wealth - they have the funds to wholy own companies, but bring in partners anyways), they bring in parters for a variety of reasons:

• To "test" projects as if they were capital constrained and to get an affirmation that their project is financially sound by bringing in external institutions
• Gain additional expertise of partners who participate in principal co-investing on projects
• Lay off risk - balance risk and reward
• Find the sweet spot between 'optimal' versus 'maximum' leverage

Because of the nature of Abu Dhabi (in a similar nature as Dubai) a large proportion of the workers are Expats (we have constantly heard about the 80/20 split, 80% expats and 20% locals). This creates an interesting challenge. How can you create industries, business models, infrastructure and (eventually) jobs to benefit the local Emirates while attracting the international talent to help develop the human capital to support it? As a result, some of their projects have a high degree of automation since there is relatively low population numbers and the locals are actually in "minority".


These two sisters, Dubai and Abu Dhabi, have been exceptional at putting up the infrastructure and buildings required as shown by the Burg Dubai / Khalifa (above). However, developing human capital takes longer with training, experience and opportunity. As a result, Mubadala has emphasized what they called the "C's": CA, CFA etc as education beyond the MBA which are required to succeed. They believe in this philosophy so much that they have a special CFA training program for their local Emirates which acts as an accelerated training program as a fast track to management positions. The locals write the CFA level I exam and those that pass advance in the program.

Mechanics of Retirement Planning

A question I posed to some of my classmates who wanted to practice DCF or time value of money questions:

John is 20 years old and is making $100k annually. He plans on retiring at 65 and will require 70% of his current annual income every year thereafter. The general life expectancy is 'til 85. And he can earn 8% on any money he invests.

How much does John need to save per year in order to retire at 65 according to plan?

[Solution]
You would break this question into two parts.

Part I: Nest Egg - Understanding the PV of the money he needs in retirement (aka how much he needs to have saved by 65)
Using a financial calculator:
PV = ?

FV = 0 (Doesn't plan on giving any inheritance when he dies)
PMT = 70,000 (70% of 100k)
P/Y = 1 (1 period per year, NOT semi-annual)
I/Y = 8
N = 20 (Retires and lives for 20 years, 85 - 65)
PV = 687,270.32 (How much his nest egg should be at 65)

Part II: How much he needs to invest every year
PMT = ?

FV = PV @ 65 = 687,270.32 (How much his nest egg should be at 65)
P/Y = 1
I/Y = 8
N = 45 (Works for 45 years, 65 - 20)
PV = 0 (Starts with nothing)
PMT = 1,778.16

John needs to save 1,778.16 per year. Now most people will say: "That seems really low"

That's true, but look at the scenario: John is saving for 45 years and spending for 20 years. For all of those 65 years, John is earning 8% on every dollar he's invested (aka he's not using). This returns to our original point when it comes to personal finance: "You can buy stocks. You can buy bonds. You can even buy good advice. But the one thing you can't buy is time."

ICUP

I know it's the eve of the finance exam and most people are expecting me to do finance posts. I'm sure I'll oblige later. But first, I need to make a comment regarding exams and people going to the washroom. What is it about exams where people suddenly have weak bladders? During exams, whether they be MBA or CFA, there are always people getting up to go the washroom.

During today's MCV exam, at the 45 minute mark when people were officially allowed to use the rest room facilities, a few hands immediately went up to use the facilities. I have to admit I do find it mildly hilarious. I don't think I've ever used the facilities during an exam. I think it's a bit creepy and childish to have to be escorted by an exam proctor.

Rotman Finance Association - Building My Prep Team

It seems the most popular clubs feel like they can have their kick off meetings late on Friday afternoon and still get pack rooms. Which they did. The two undisputed heavy weight champions in terms of clubs interest are the Management Consulting Association (MCA) and the Rotman Finance Association (RFA), both of which held their kick off meetings on consecutive Friday afternoons. Last week was MCA, this week was RFA (today).

The info session was a good primer for those with little or no background in finance as well as an introduction to the upcoming events. They emphasized some key points (which I've been talking to some of the Club Executives about) in terms of how to prepare for what amount to the most competitive and desired jobs available to MBAs. The RFA Exec made a good point, essentially: "All the skills you need to interview for summer jobs, you won't learn until it's too late. You're on your own." There's just too much going on too fast. It's really up to you to take the initiative. Keep in mind that if you went to Ivey (One year program), you'd be facing the same challenges except you'd be worried about full time rather than internships.

I'm currently in the process of putting together a team of people who are interested in investment banking and high finance. I offering to teach them what I know (learned over the summer and through CFA) in exchange for having serious partners for preparation in the same way we're building a case interview / competition team for consulting. The Analyst Exchange was very good in prepping me to discuss and build valuation, consolidated financial statement modeling, leveraged buy outs, mergers and acquisitions.

My goal is two fold. In terms of what I'm offering to give, I hope my Rotman counterparts and I can improve our odds to boost our recruitment and offer batting average (the other side of the hiring batting average) which I promised as my speech for Rotman 1st Year rep.

More selfishly, I want to find a group of dedicated people who I can potentially draw upon as teammates for investment challenges and (in the future) network contacts.

"10 years from now when we've all reached our potential, I want you to tell your executive assistant to take my call when I'm looking to find partners interested in doing a deal." ~ Josh Wong, 2009

Negative LIFO reserve?

I had previously posted about LIFO reserve and how to approach questions on the CFA exam, but I had a a great question about if it was possible to get negative LIFO reserve. While it is mathematically possible, I suggested that there might be some sort of accounting rule that prevents it (I thought it would look really awkward on financial statements).

When I asked my professor if it was possible, however, he was quick to point out that it was (both in theory and practice). When asked what real world scenario would this actually happen, he brought up the example of computer companies such as Dell and Cisco, whose technology products depreciate in cost (rapidly). It becomes apparent that they would:

1. Prefer FIFO accounting over LIFO
2. Probably have small, just-in-time (JIT) inventory management

Revenue Recognition for Large Projects

I apologize for not really discussing Financial Accounting. At the risk of sounding a bit arrogant, a lot of this material (but certainly not all of it - liability recognition percentages for GAAP (80%) versus IFRS (50%) ) has been covered in the CFA level I (for the question that most people ask, should I do an MBA or CFA, this is part of the answer... I should post more on this sometime and why I decided to do both). Plus, as my colleague Megan so eloquently puts it:

"... it is an important and necessary subject, so I may as well learn to love it
because I can't escape it."

Currently, we are discussing different revenue (and cost and profit) recognition techniques for larger projects who span more than one reporting period. The question is how should we recognize these items in financial statements? There are two methods we are looking at: the percentage of completion method and the completed contract method.

The completed contract method is quite simple, where (intuitively) all the revenues are accounted for once the contract is completed. It is more appropriate in scenarios where the contract involves extremely high risks (and may not be completed).

Another method not yet mentioned is the cost recovery method, where revenues match costs until the last period where gross profits are recognized all at once.

[Case] Same as the case in the percentage of completion post:

Assume a construction project with the following construction cost structure:

Year 1: $5M
Year 2: $15M
Year 3: $10M

The overall contract price is $46M.How much profit should be recognized in each of the given years under different methods?

[Solution]
Case 1 - Completed contract method revenue:
Year 1: $0
Year 2: $0
Year 3: $46M

Profit:
Year 1: $0
Year 2: $0
Year 3: $46M - $30M = $16M

Case 2 - Cost recovery method PROFIT:
Year 1: $0M
Year 2: $0M
Year 3: $16M

(Although I don't know what the cost schedule looks like, the revenue recognition will be such that revenues will match and equal costs, until the last year). Note that while the profit schedules are identical in both methods, the revenue and cost recognition schedules are different in these two methods.

Continuing the class after the break, we discussed COGS and Inventory as an extention of the above concepts. Our professor is starting to do a primer (and enter into) the topic of LIFO versus FIFO, one of my top (most popular) posts. And as mentioned before, there are interesting concerns when it comes to accurately measuring performance versus position. Another major issue we are discussing is accounting for inventory costs when they haven't yet been sold, but their value moves with what happens in the market and LOCOM, the lower of cost or market as an accounting standard for both US GAAP and IFRS.

Population Distributions

In our statistics class, we have begun to move into the realm of distribution parameters and describing data for management purposes. We were discussing how standard deviations could be used to approximate distributions and probabilities of occurrences with appropriate assumptions. CFA candidates will immediately perk up and remember concepts like Chebyshev's inequality, which describes the percentage of a population which lies within k standard deviations regardless of the underlying population by the formula:

(1 - k^-2) * 100%

k = 2 --> 75%
k = 3 --> 89%

Or more common normal distributions where:
1 σ = 68%
2 σ = 95%
3 σ = 99%
(values shown above are 'expected knowledge' for MBAs and slightly oversimplified)

However, like the CFA exam, I anticipate that the trick in demonstrating an understanding of this concept will be more related to picking appropriate bounds rather than the pure memorization of the percentages for different values of sigma. For instance, in our stats class, we had a problem where we needed to know the probability that our value would not fall below 1 σ. As a clue, that indicates that we need to do a 'one-tailed' test. It is important not to fall into the trap of saying "I see 1 σ, therefore the answer is 68%". In this case, the answer is:
100% - ((100% - 68%) / 2)
100% - (32% / 2)
100% - 16%
= 84%
because it is only a one tailed test.

I have always loved stats. Not just for the pure math value, but more importantly, when trying to prove when math (or anything else for that matter) works or doesn't work, stats is the first place people should go to to determine correlations as a precursor to causality.

Toronto CFA Sociey - The Geopolitics of Investing

At lunch today, I went to my first Toronto CFA event (where I am an Associate Member). The speech was given by Pierre Fournier, Geopolitical Analyst, National Bank Financial at the National Club.

His talk covered a broad range of topics as they related to investing in foreign and emerging markets (such as the BRIC countries: Brazil, Russia, India and China). When asked at the end of his presentation which country he liked best, he responded with 'Brazil', for it's long term outlook, resource base and demographically young population.

In his team's specific role, he described this small foray into geopolitical analysis as a comprehensive peek at research and analysis relating to current geopolitical challenges facing investors in major foreign and emerging markets. He framed geopolitical analysis as focusing on the political structure of governments as well as their relationship with super powers. He described systematic risk in this arena as event risk based on or affecting the international investment system versus country specific risk and characterized the new challenges facing emerging countries as based on economic power struggles rather that the outmoded ideological struggles (ie. as a resource race rather than communism versus democracy). He described the decline of the US as a super power to resulting in multipolar rather than unipolar and the move away from unilateral as moving away from a "nice to have" towards a necessity.

There are other notable changes as well when investing on foreign soil. Rather than nationalization and outright appropriation being a challenge, hostile countries will now rather increase taxation and regulation in order to 'show you the door'. These more subtle tactics may make investors feel safer on the surface, but are a much more subtle way to indicate that you've outstayed your welcome.

In terms of Obama's plans for the US, there comes an interesting challenge as it relates specifically to oil. On one hand, the country aims to have more energy security, however on the other side getting at oil poses significant environmental challenges, a seemingly disparate and irreconcilable challenge (perhaps a good integrative thinking question). Pierre went on to predict that China's move into the Calgary oil sands project would probably move forward after approval from the Investment Canada Board and result in increase M&A activity, China continuing to search for more resources resulting in a squeeze for the US.

Diversification and Correlation - Understanding Risk and Reward

Often you'll hear people quoting investment cliches: "Don't put all your eggs in one basket" "Diversify, diversify, diversify" but not really understand what they mean. Most will understand that if they only invest in one stock and it tanks that they can lose everything straight away (or hit it big). However, few understand the risk and benefits of diversification.

The CFA Level II material begins to go into the idea of correlation, one of my favourite topics in math. While I am often criticized for loving math a little too much (one colleague went so far as to say that I think math can "solve all the world's problems" whereas I would prefer to think of it as "math can describe most of the world's patterns"). I even said that "there is math to describe when math fails" and that in my opinion is statistics.

A Quick Primer on Correlation
Correlation is the idea of how closely to items move together (in finance, the most notable example is stock prices) and the strength of their linear relationship. Relationships measured in correlation can have a value between 1 (perfectly linearly correlated) and -1 (perfectly negatively linearly correlated). What does this mean in layman's terms?

With a correlation of 1, two stocks will move in perfect harmony. If one stock rises, the other stock will rise proportionally. With a correlation of -1, if one stock rises, the other stock will fall proportionally. A correlation of 0 implies no linear relationship (strictly speaking not independent, but independent variables will have a correlation of 0).

Correlations of less than 1 mean that they move in the same direction, but do not have a perfectly linear relationship (most stocks in the stock market) and do not move proportionally (sometimes one will move faster or slower than the other). I would propose that the only way to find a perfect correlation is to buy more of the stock (or short it for a -1 correlation). Obviously, correlation is a bit more complicated that this but this will do for now.

Risk and Return of a Portfolio
Now that we have a basic understanding of correlation, how can that help us understand diversification, risk and reward? Let's look at two stocks A and B with expected returns 15% and 10% and a correlation of .5. Let's say the stocks have std dev of 9% and 6% respectively and the risk free rate is 4% (therefore the Sharpe ratio is 1.22 and 1 respectively). A is riskier, but offers more marginal return per unit of investment risk.

There are four possible actions:

1. Long (buy) A - Correlation to Long A: +1
   
2. Short (sell) A- Correlation to Long A: -1
   
3. Long (buy) B - Correlation to Long A: +0.5
   
4. Short (sell) B- Correlation to Long A: -0.5
   

Note that if you only care about maximum returns you will allocate all your capital to action 1: Long (buy) A. It has an expected return of 15% so it has the highest growth potential. But note that it also has the highest risk profile (largest standard deviation). If you were more moderate, you would Long (buy) a combination of A and B (with an expected return of between 10 to 15% depending on allocation and a standard deviation between 6 to 9%).

The lower risk portfolio construction would be from some combination of stocks with negative correlation (example Long A, Short B or Short A, Long B) because if one ever went down, the negative correlation will imply that the other will go up (possibly by more, possibly by less). However, also note that if their movements are counter each other as is usually the case in a negative correlation, your profit potential becomes much less.

Diversified Portfolio
In this over simplified scenario, assume that a portfolio, evenly weighted between a Long A position and a Long A and Long B. If the both hit their growth targets their combined return is 12.5% (equally weighted average between 10 and 15% and std dev between 6 and 9%). This is less reward than just buying A, but also less risk.

Assume another evenly weighted portfolio between a Long A and Short B position has it's Long A hit +15% and it's counterpart, the Short B hits -10%. The portfolio only gains 5%. Conversely, if the Long A drops to -15% and the Short B rises to 10%, the portfolio only loses 5%. Whereas the movement in the individual stocks is much more pronounced, the portfolio is dampened from extreme gains and losses.

Implication
There are times to over diversify and there are times to cherry pick. Arguably, in this recovering economy, it's easy to pick "sprouts in scorched earth". That is to say, most stocks are undervalued so it's not hard to pick "winners". This is a decent time to over diversify, because the general trend is to go up in value.

The worst time to over diversify is at the peak of the market, when most stocks are over valued. In this case, it is better to be very specific about your investments and be extra diligent in your homework (or find another asset class like fixed income - deleverage).