Friday, August 20, 2004

Wd (in WACC formula)

In viewing a recent valuation report, I noticed that the consultant didn't use the actual debt on the balance sheet in the WACC calculation. The percentage debt used was 33.3%, which appears to have been derived from an "ideal" debt to equity ratio of 1:2, although differentiation was not expressed anywhere in the report.

Was this an error, or is this a common practice among valuation consultants?

NPV valuation is unreliable

According to Henry Blodget, no investing advice seems more sound than that you should buy stocks when they are "cheap" and sell when they are "expensive." Wall Street, the financial press, and millions of investors devote countless hours and dollars to unearthing "undervalued" opportunities and panning "overvalued" ones. Business school professors forever develop and teach ever-more-refined valuation techniques. Fanatically precise analysts compute projected earnings to the penny and "intrinsic value" to the dollar.
But when are stocks cheap?
A share of stock is, in theory, worth the "present value of future cash flows" attributable to the share. Given the confidence with which some commentators cite the theory, a casual observer might assume that the "present value of future cash flows" is an indisputable number, akin to a price tag on a can of soup. In reality, however, it is not a number but an argument, and, in most cases, it is a surprisingly imprecise argument, with a wide range of reasonable conclusions.
An analysis of the "present value of future cash flows" requires, at minimum, two components:
1) an estimate of the future cash flows; and
2) an appropriate discount rate with which to determine their present value.
1. No one really knows what the future cash flows will be; and
2. Discount rates and terminal multiples are subjective assessments based on the trading prices and outlook for other securities (and, consequently, change as the prices of the securities change).
As a result, most valuation conclusions are extraordinarily subjective, and small tweaks in assumptions can yield big changes in estimated value. Rest of article

Friday, August 06, 2004

Does EVA beat Reported Earnings?

In an article in the latest issue (Winter 2004) of the Journal of Applied Corporate Finance, Glenn Feltham, Grant Isaac, Chima Mbagwu and Ganesh Vaidyanathan (all professors of Canadian University of Saskatchewan) report the results of their revisit of the famous study by Garry Biddle, Robert Bowen and James Wallace (Journal of Accounting and Economics, 1997) in which they found that market-adjusted stock returns were more closely associated with reported earnings than with EVA.Feltham ea report that they were unable to replicate the findings of Biddle ea. The results of the new analysis supports the claim that EVA has greater power than earnings in explaining market-adjusted stock returns. A significant conclusion I'd think.