Corporate Finance: Valuation for whom and for what
Corporate finance is the study of value over time and how this value grows within a company and what companies should do to budget their capital in the interest of increasing value. Generally, we look at net present value as a way of discounting cash flows in the future to a present aggregate that represents the value of the choice to undergo the project, where if this value is positive we undergo the project so long as there are no other projects that are mutually impossible to do at the same time and are better investments. Net present value is affected by capital budgeting when there is a scarcity of investment capital, perhaps because of inefficiencies in the lending process as otherwise we could lend or issue securities on capital markets to raise money to pursue projects with positive net present value after the costs of capital are taken into account. Capital budgeting means we pursue projects that give us payoffs in time to fund other projects with positive net present value to maximize value instead of possibly pursuing what looks good at the beginning only to find out we have no capital left to pursue even better projects or simply some good projects which would make us regret our choice. Diversification of different projects decreases individual risk across projects because projects net against each other in different stages of the world, good or bad, but does not remove systemic risk that affects all projects, the part of all projects that sink or swim together. Diversification is not rewarded in net present value: conglomerates are simply the sum of their parts, the diversity of their cash flows are neither rewarded or punished by the markets because opportunities exist for investors to build their own conglomerate-like cash flows from piecing together other investment opportunities so conglomerates can’t charge a premium nor can they be undervalued because diversification is a good thing. We do see companies spinning off departments the companies think are undervalued by the market so inefficiencies may exist but do not last for long as people remove them.
Internal rate of return and payback for investments are other tools that managers use but internal rate of return may be high on projects where little capital is deployed but the incremental internal rate of return remains higher than the cost of capital to invest even more on that project so long as net present value is positive so internal rate of return would come down once we complete the investment. We would realize we chose highest internal rate of return but invested until internal rate of return came down because net present value was still positive to further pursue value as opposed to doing nothing. Looking back at this project, we would see we maximized net present value and lowered the internal rate of return to pursue net present value. Net present value is always the cash flows in the future discounted at the opportunity cost of capital, as a cash flow tomorrow is worth a certain amount today depending on how much money today is required to exactly replicate the riskiness of the payoff of the cash flow tomorrow. For instance, General Electric has cash flows tomorrow of good quality and FlyByNight has cash flows tomorrow of poor quality and high risk. The cash flows of General Electric are worth more today because the discount rate is low, and that is because the opportunity cost is low to invest in General Electric, funds tied up in General Electric would only return a little bit of extra money if they were invested into another opportunity of similar risk to General Electric. Funds tied up in FlyByNight however are taking so much risk that the opportunity cost is quite high as these funds would just as well be invested in FlyByNight2 which pays amply for the risk you take when you invest in them. Payback is a convenient rule-of-thumb in assessing when you get your money back from an investment but because it doesn’t consider cash flows after the payback, we may be left with losses afterwards or at least our opportunity cost may be high locked into an investment that pays little after payback when we could have invested the same capital somewhere else that would more than return the investment over a number of years. We must also consider that some projects are not investing but rather borrowing if you get cash immediately and negative cash flows later and then we want projects with low internal rates of return since the discount rate that sets net present value to zero could be large to make the project fair but that large discount rate would be in effect what you are charged for borrowing money as the large discount rate makes a large negative cash flow in the future small enough to be palatable for a small initial borrowing but you still have to pay the negative cash flow and not just be satisfied that you are only paying that high of an interest because interest rates are high. The reason I take you into the language of corporate finance is because a lot of it is using language to talk about mathematical ideas that are just arithmetic if done in isolation but nontrivial if solved to solve real life problems. For example, in solving problems related to investment and capital budgeting, we maximize net present value by using linear programming to overcome all constraints on how we may use capital, for the example in the timing of projects and the scale and return of the projects.
When we talk about risk of projects we are referring to a greater return demanded for more risk taken, and the risk we refer to is in the characteristics of a normal distribution of returns: the statistical return profile is fully determined by expected return and standard deviation. Projects with greater standard deviation are less desirable because we don’t know what will happen except when it does happen, the confidence bounds on what will happen will be weak in projects of higher standard deviation. It is important we understand a project with high standard deviation will not necessarily result in higher returns but only higher expected returns, we also don’t know what returns will be but we believe returns will be higher for projects where we have less confidence on what is going to happen because we are rewarded for seeking risk. If we look at investments in the USA, the risk free return of treasury bonds has been low and has barely beaten inflation but bills are slightly higher and equities are much higher with an average risk premium of about 7 percent which tells us stock market average returns are 7 percent above the returns of risk free treasury bills adding up to 11 percent for stocks. Owning stocks is well compensated by risk premia in average returns yet we do not know what will happen so stocks frequently fall ten or twenty percent in a year and we find people cannot stand the volatility implicitly in the standard deviation and cannot hold long enough to monetize the higher expected return in stocks which takes time to shine through, or we try to reduce idiosyncratic risk by owning a lot of different shares as it is unlikely anyone has a monopoly on the best ideas in the market, but systematic risk remains which can only go away in time provided we have invested in small enough size that we can hold on to our positions through a journey. This has nothing to do with gambling concepts like Kelly Betting or gambler’s ruin which delve in optimal bet sizes when you are betting your beliefs or betting on known edge against the ruin that comes from gambling as you run out of capital even with edge. However, my edge might not be in gambling and I may be good enough at poker for what I do but I choose to play straight as you can imagine going into a nightclub, you can gamble by asking a lot of questions to ascertain everyone’s positions behind your stack of reputation points backed by your credit card, or you can ask no questions and just try to increase your reputation points. In both cases, we can defend our stack against larger stacks bullying us or smaller stacks going wolverine on us, and in both cases we can take the offensive: I roll the dice and see the fear in my enemy’s eyes per Coldplay while the gambler reads you better than you read your own cards. The difference between investing and gambling though concerns the long-run as in the short-run it appears like a style difference but in the long-run, it is a major style difference where investors are not traders or bankers but are awash in prestige by their methods while gamblers are neither investor, trader or banker but are usually awash in money they have accumulated as their money is their ammunition. I’ve never gambled but I do recall it is faster to throw knives than load ammo, and that is why investors usually supplement themselves with consultant skills in power point slides, each slide being a card in the deck that you can supercharge and throw at someone like Gambit in the Xmen.
Regarding the question of whether it is in our interest to select securities or select the market basket as a whole, it is unlikely that anyone’s ideas are much better than anyone else’s so if we are seeking a better return we wouldn’t argue our ideas are better but that we are exposed to a better set of opportunities mostly because our information is better and we have the apparatus built intellectually and physically to monetize these opportunities in a real time ticking way. If we solely seek to reduce idiosyncratic risk, it is wise to hold some percentage of the market in your portfolio as a risk hedge in portfolio construction as we end up holding the market and moving it towards a tilted advantage rather than picking random names and exposing ourselves to fundamental based volatility like whether a railroad will be constructed in time to repair the whole system. A trader once said to me as he recognized me as primarily an investor: he said fundamental analysis would tell you there is no train on the tracks but if you saw a train coming you would get off the tracks not stand there staring. Once we make a trade we are open to revising it for this reason since monetary wounds are fatal to the wallet and we don’t hold a trade just so we can say we made a good decision at the time so we are taking losses now. That is how investors trade. But remember without execution, it is just thought.
In terms of portfolio theory, we draw an efficient frontier of assets using quadratic programming to plot expected return and standard deviation and we determine only combinations as represented by an efficient frontier efficiently balance risk and reward assuming we want the most reward for a given risk and least risk for a given return. We can go further and imagine possibilities where we can borrow at the risk free rate and invest the borrowed money to amplify returns. This tangent line in the mathematical representation uniquely identifies the efficient portfolio. We may also want to answer the question of how individual stocks vary with a portfolio including the market portfolio. This is known as the beta of the stock to a given portfolio though it usually refers to the beta to the market. We can infer that if the risk free portfolio demands a certain return and the market portfolio demands a certain return, there is a relationship between beta and expected return: high beta stocks demand a higher return. This is the Capital Asset Pricing Model. Individual volatility can be diversified away and that which is not reflected in beta is not rewarded with risk premium.
Now imagine if I were to just buy the most volatile high beta stocks to try to get a high return: what would happen? I put in a sufficiently small amount of my assets that I wouldn’t be prone to any questions about my ability to hang on to positions. Because we don’t know what will happen, I could just as well be poor as rich. I’d be a monkey as Warren Buffett called hedge fund managers, the ones he called out are the majority and are just good at buying junk to collect risk premia and amplifying the risk on themselves. They are risk amplifiers not risk takers. Someone who risk-takes improves his own outcomes by disembarking risk that other people can’t take perhaps because of risk appetite limits, and then managing this risk. A risk-taker constructs an efficient portfolio. He is a portfolio constructor. He isn’t a portfolio collector who just collects the most sordid collections of risk. We can see the difference in real life between someone who repairs vintage cars, a portfolio constructor, and somebody who collects medals and shows them off all the time. We must trust the markets are just as obnoxious as the men and women who make them, and just as interesting and just as real.
Net present value is reflective of a rate of return and if opportunities arise to invest at that rate of return, net present value won’t change. The excessive cash generated by the project may as well be held in the nearer term rather than invested if the investment doesn’t clear hurdle rates which remain the same as when the project first started since the nature of risk in the project hasn’t changed. Investing at a higher rate of return will increase net present value. Investing at a lower rate of return will destroy value compared to just holding on the capital in the nearer term, however many years out.
In addition to the Capital Asset Pricing Model, there is the Arbitrage Pricing Theory which predicts that the return of an asset will be the result of its exposures to factors, proxied for by portfolios of assets, and the risk premium of each of these factors. In the case that the factor risk premiums are the same as what would be predicted from the underlying betas of the assets within the proxy portfolios, the Arbitrage Pricing Theory predicts the same risk premium per factor and then the same risk premium for the asset compared to the capital asset pricing model. Many of these factors are macroeconomic. We can also say that the Fama French extension to the Capital Asset Pricing Model gives a higher predicted return to value stocks and small stocks based on factors built on the differing exposure to book-to-market ratio which proxies for value and to just small stock returns minus big stock returns. Fama French is trying to account for factor exposures in a way equivalent to the Arbitrage Pricing Theory. It is a real historical phenomenon that value stocks and small stocks outperform what is expected by the Capital Asset Pricing Model. High beta stocks as determined by the Capital Asset Pricing Model have recently failed to produce returns expected of them in the last few decades. The conclusion of all of this pricing model discussion is that real phenomenon affects returns demanded. For example, companies with high book-to-market ratios are great value stocks if looked at on the basis of a ratio only but may be close to going out of business and investors would demand a higher return. Investing in small stocks or value stocks in an attempt to get the risk premium from those categories also requires an ability to manage the risks in those sectors as even if we buy a Russell ETF of highly diversified small stocks, we would be merely selecting a hidden risk factor that gives us higher returns, and one that may not be giving us disproportionately higher returns: we don’t know if the higher return in small stocks or value stocks compensates us for the risk in those stocks but we presume what investors demanded is what the market decided is fair. For example, we know buying a home to rent in a bad neighborhood at the borderline of gentrification will give us higher returns based on the value factor and the small factor since it probably is a small out of the way neighborhood. However, unless we know how to gentrify the neighborhood and how to tell if the neighborhood is on a track to gentrification, buying a home like that just makes you a future slumlord as you will have to raise rents on people and be a landlord just trying to make ends meet if you lose control of your rental business in the sense that volatility moves against you in the real risks of a neighborhood going downhill like with crimes on people and property. We don’t put garbage in our bodies and we don’t put things into our portfolios just because they are calories but also because they are good for us. Looking at return in the long-run is one way to differentiate good investors from bad but we also know academia is oriented towards the long-run and academia has trouble competing with salaries and prestige compared to the business world. I recommend looking at competence. The lesson of Long-Run Capital Management is genius will fail. Nonetheless, I think the key is: does this investor take his own medicine? We are reminded of a Canadian song when the boy sings from Newfoundland that he’s the boy who builds the boat, he’s the boy who sails her, he’s the boy who catches the fish and brings it home to Liza. Don’t let geniuses make decisions for you that you should be doing on your own, and don’t let people with self-confirming ideas persuade you that you should give up on the principles that uphold civilization, one of which is “no guts, no glory,” you must be willing to bleed red to attain glory like Curt Schilling pitching with the Boston Red Sox, or at least understand, the only way to make money is to be willing to lose it. The lesson of “City Lights” the film is that a gentleman makes the lady more blind when he gives her an operation to restore her sight as she can’t tell he is a gentleman anymore. But an essence of a gentleman is he is willing to be a tramp for a lady to see. An essence of investing is willing to be a loser and be seen as a stupid one for that in order for your lady to see the world of investing, that you’ve participated. We don’t talk about skin in the game which just makes you a gambler, but about making you watch what you need to watch, as watching stock prices just makes you learn how to watch a ticker.
High beta stocks tend to be cyclical stocks and ones with high operating leverage which refers to the ratio between fixed costs and variable costs. A company with high debt has a weighted average cost of capital which leans towards the rate demanded by debt investors. When I interned in private equity, one of the colleagues said to me he had a greater understanding of the world than any trading gambler and he made enough money and had a nice office to boot. He said the people who make the most money are in hedge funds but you have to find something you like instead of chasing salaries. He also said some jobs pay decently compared to what private equity partners got paid considering private equity partners have been bustling around and taking supplements for decades. I decided what he meant was private equity were the kings of capitalism and they were raising money from debt markets to buy into the corporate world. However, I wanted to fly so I went into into trading at an investment bank instead of banking as a route to go into corporate finance. One of the private equity guys basically asked me years later if I forgot my parachute. No I gave mine to someone else and I aimed right for the trees in my skydive where I broke most of my ribs but survived. There is more to capitalism than being a king. There is modernity for example and that is when you walk into something that looks like NASA’s mission room at the trading floor at UBS. Ultimately we must understand a rate of return on an investment is a tool to make investments. If one is trading, it is a different game altogether. But if you are the best clown in the world you are rewarded, and you want to be the best investor in the world in your own way before you move on from corporate finance. Private equity are value investors for the most part. Some use fancy metrics but they do the same thing which is they fling money around in creative ways to make the most stuff happen in capitalism. They discount it all to the present and take home the check. Greed is good so long as you are not afraid. Our president has said we have to keep getting smarter. There is no retreat in the other direction but to clean up the financial system so we can engage political actors on topics like fair trade and living wage and employer stakeholders. Andrew Jackson is one of my role models and he is the founder of the Democratic Party but a party is a small number of people, and I am with the people who serve this country party regardless of politics. Corporate finance is at its heart rational as we can agree quantitatively on what value is being added so long as we aren’t concerned about the accuracy of forecasts but as a methodology, corporate finance is quite objective.