Stocks (Part 3)

Red Flag Phrases: "Material Adverse Effect"

There are some very important phrases that investors need to recognize as major red flags. Filings made to the Securities & Exchange Commission (SEC) and legal boilerplates often do more to obscure than disclose, but, by being able to recognize a few key phrases, the casual reader will be alert to some very important information that will help him or her avoid investment mistakes. One of these key phrases is "material adverse effect".
Material Adverse Effect Defined
A material adverse effect (MAE) statement is very important because it is a clear signal to investors that there is something very wrong. This phrase usually signals a severe decline in profitability and/or the possibility that the company may not be able to remain in business. In other words, the Grim Reaper is in the building and the FBI is probably not far behind.

For example, let's say Industrial Blowdart Inc. has a major customer that represents 75% of annual sales. If that client took its business elsewhere, the decision would have a material adverse impact on Blowdart's sales, profitability and ability to stay in business. The company's MAE might read as follows:

"One customer accounts for over 70% of our annual sales. If we lost this customer's business, the loss would have a material adverse effect on Blowdart's profits and ability to remain in business."

Another example would be if Blowdart has a critical line of credit that it uses to finance working capital (i.e. inventory or accounts receivable). If the bank refuses to renew the line of credit, the inability to find another lender would have a material adverse impact on Blowdart's ability to stay in business because the company would run out of money.

While most of this sounds like common sense, what is defined as "material" and what constitutes "adverse" are in the eye of the beholder. Generally accepted accounting principles allow flexibility in determining what must be defined and disclosed as a material adverse event. Despite SEC action in 1999 and the increased scrutiny that companies are currently under, many continue to use their own definitions in order to manage earnings.

Materiality: If It Matters, It's Material
A piece of information is material if it is reasonable to expect that disclosure of that information will impact the company's stock price. Or, if you prefer the legalistic definition, information is material if "it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item" (source: Financial Accounting Standards Board).
Despite the fact that common sense would determine materiality, companies and their accountants continue to find many ways to manage earnings by coming up with their own definitions of materiality. Generally, this involves establishing a numerical threshold, say 5%, and deciding that anything that has less than 5% impact on the bottom line is immaterial and thus does not require discussion. There are also cases where companies, in order to hide their mistakes, netted items against each other to keep below their numerical threshold. The reason for this subterfuge is, of course, earnings management.

For example, from 1991 to 1995, WR Grace used a $60 million "reserve" of supposedly immaterial items to smooth earnings, and the company's outside auditors knew about it (according to the SEC). They used the numerical threshold to stay within GAAP's gaps.

Many companies today continue to net so-called immaterial items in order to hit earnings targets. While we won't mention any names (AMZN), the netting takes place in the Other Income/Expense line of the income statement. Items that are used to net are gains/losses on investments and restructuring reserves.

In 1999, the SEC attempted to prevent companies from hiding material items by establishing the following rules:
• An intentional misstatement, even if it involves an immaterial amount, is material because of the intent to mislead.
• Numerical thresholds alone are unacceptable.
• Management must also weigh qualitative matters if the misstatement will hide a change in earnings or concerns a key business segment.
• The company cannot net items netting results in a misstatement of the company's financial statement.

Not Usually an Early Warning Signal
MAEs are not early warning signals, but rather signs that a situation has already deteriorated to a very bad stage. Usually they're the result of an accumulation of events over time that compound to a point where a critical limit is crossed. Closely following a company's operating results over time will alert investors to potential MAEs, but this kind of awareness requires a great deal of effort, time and experience.

Assume, for example, that as the result of the 2001-2002 recession, Blowdart's financial condition has deteriorated to the point where it is in default of its loan covenants. This is a typical material adverse event because it means that, if the company and the bank cannot agree on how to restructure the loan, Blowdart could go out of business.

If you followed Blowdart stock, you would know that it was having problems. But, you would have also had to dig through the SEC filings to find the loan agreements and then read those boring things in order to find the key operating ratios.

It is very possible that Blowdart and their bankers can restructure the loans and get the company through the difficult times. After all, that's what bankers are supposed to do, right? On the other hand, if the bank wants to exit the relationship, Blowdart needs to find another lender, which may not be easy to do because of the company's recent operating history and/or current economic conditions.

In this hypothetical situation, investors would need to review this stock in light of their own risk aversion profile (which determines the degree to which owning this stock keep you up at night). While the outcome might even be 60/40 in favor of a successful loan renegotiation, you may not want to deal with the added risk. If so, sell the stock. But you may have studied the company and industry closely and feel that there are some strong fundamental reasons for owning the stock for the long term.

Where to Look for MAE Statements
The MAE phrase can be found in several places because government regulations require companies to disclose material events:
• In the footnotes to SEC filings (10Qs and 10Ks) relating to the issue that could cause the MAE. This is the most likely place to look (and another reason to read the footnotes first). In the first example noted above, the MAE statement would appear in Blowdart's footnote that discusses accounts receivables or customer concentration. In the second example it would be found in the footnote related to financing and loans payable.
• Press releases sometimes also contain an MAE phrase if the release deals with financing issues or if the company is announcing a material event.
• Management's Discussion and Analysis (MD&A) should contain some reference to the MAE, but generally it does not. Companies put the MD&A upfront to highlight the good stuff and hide the bad stuff in the footnotes.
Conclusion
It is unreasonable to require companies to discuss every business detail in the financial statements. Heck, those things are too long and hard to read already. There is a need to find a balance between required disclosures and onerous reporting burdens. Perhaps the best advice that corporations should use is that more information is always better. Erring on the side of "over disclosure" - something that investors should value more than the illusion of steady earnings - will enhance corporate credibility

When Insiders Buy, Should Investors Join Them?

Tips for beating the market tend to come and go quickly, but one has held up extremely well: if executives, directors or others with inside knowledge of a public company are buying or selling shares, investors should consider doing the same thing. Indeed, much research shows that insider trading activity is a valuable barometer of broad shifts in market and sector sentiment. But, before chasing each insider move, outsiders need to consider the factors that dictate the timing of trades and the factors that conceal the motivations.
Reasons to Follow
The argument for shadowing insiders makes a lot of sense. Executives and directors have the most up-to-date information on their company's prospects. Intimately acquainted with cyclical trends, order flow, supply and production bottlenecks, costs and other key ingredients of business success, these insiders are way ahead of analysts and portfolio managers, not to mention individual investors. Insiders' decisions - legal or not - to trade in their own company's stock are certainly worth examining.

Research supports the view that insider information works best in the aggregate. Independent research firm Market Profile Theorem (MPT) showed that insider trading trends signal an up-and-coming shift in market sentiment. To identify trends, MPT analysts employ the Brooks Ratio, which divides total insider sales of a company by total insider trades (purchases and sales) and then averages this ratio for 2,500 stocks. If the average Brooks Ratio is less than 40%, the market outlook is bullish; above 60% signals a bearish outlook.

University of Michigan finance professor Nejat Seyhun, author of "Investment Intelligence from Insider Trading", offers a similar story. Stock prices rise more after insiders' net purchases than after net sales. On the whole, insiders do earn profits from their legal trading activities, and their returns are greater than those of the overall market.

The Stories behind the Signals
Surges in insider trading appear to divine an upcoming switch in the market's direction. But outside investors have to be awfully careful about reading positive messages into every insider buy they see. Nor should investors treat individual sales as signals to unload their own holdings. Admittedly, one big insider buy or sell order might offer investors a hint of things to come, but it hardly translates into a sure-fire pointer for outperforming the market.

More companies require newly appointed executives and directors to own shares. As market indicators, these required purchases are irrelevant to outside investors. Other companies encourage ownership by providing stock loans to executives for half the purchase price. These are examples of the company taking steps to align the interests of management and shareholders. While certainly commendable, these transactions do not provide reason for outsiders to buy stock.

Sometimes an insider will announce a stock buy just to get Wall Street's attention, but announcing is not the same as doing. Healtheon founder Jim Clark once proclaimed that he intended to buy as much as $100 million worth of the company stock. Healtheon shares surged the day of the announcement, but Clark didn't buy anywhere near as much as he had suggested. The stock quickly declined, and those who followed his lead got burned.

Although they may buy their company's stock because they expect good things to come, insiders do not sell simply because they think their company shares are about to sink in value. Insiders sell for all kinds of reasons. They might want to diversity their holdings, distribute stock to investors, pay for a divorce or take a well-earned trip to Mustique.

Another big problem with using insider data on specific companies is that executives sometimes misread company prospects. Some insiders may buy even as share prices collapse. Far from being the first to jump ship, Nortel Network executives and directors bought Nortel stock several times since before the stock plunged by 90%. When insiders do correctly assess their companies' share, it can be a matter of luck as much as anything else.

Employee stock options, which compose an ever-larger portion of executives' compensation, can make analysis tricky. Remember this: if the insider is exercising stock options by buying the stock, it is not very meaningful if the options were granted at rock-bottom prices. At the same time, when buying through the exercise of their options, executives do not have to disclose this. Outsiders can really only guess how much "real" buying is taking place.

Tips for Using Insider Data
Investors should consider the following guidelines when analyzing specific insider trading situations:
• Some insiders are better than others - Directors know less about a company's outlook than executives. Key executives are the CEO and CFO. People running the company know the most about where it is heading.
• A lot of trading is better than a little - One or two insiders at a big corporation do not make a trend. Three or more provide a better indication that something is happening. Generally speaking, solitary trades are unreliable.
• People at small companies know more - At small and mid-sized companies, virtually all insiders are privy to company financials. At big corporations, information is more dispersed and typically only the core management team has the big picture.
• Stay the course - Evidence suggests that insiders tend to act far in advance of expected news. They do this in part to avoid the appearance of illegal insider trading. A study by academics at Pennsylvania State and Michigan State contends that insider activity precedes specific company news by as long as two years before the disclosure of the news.

Conclusion
Here is the upshot: insider tracking is not easy, and it is hardly a guarantee of big returns. A pattern of trades might offer a cue for upcoming market shifts, and it is certainly reassuring to buy or sell a stock knowing that an insider is doing the same thing. Following the lead of insiders, however, will never replace diligent research

"Widow And Orphan Stocks": Do They Still Exist?
In the past, the term "widows and orphans" was used to describe stocks with a relatively high degree of safety and dividend income. Because they had relatively minimal risk and provided income to feed the family, these kinds of stocks were literally thought to be the only investments suitable for widows and orphans. The term is noteworthy because it was generally used during market bottoms, but today it means something different.
A widow-and-orphan stock was the blue chip stock of its day: the stock of a large well-known firm that was thought to have an unassailable market leadership position and that paid a "good" dividend. This term was generally applied to utility stocks (electric, gas and telephones). Utilities are often referred to as widow-and-orphan stocks because of their monopoly (or, if you prefer, government-mandated market leadership) and dividend yield. Banks were excluded from this class as the result of their involvement in the bubble and crash of 1929. It was not until several years after the government-instituted regulations like the Glass-Steagall Act, which separated investment banking and "regular" commercial banking, that "widows and orphans" was again applied to commercial banks. Depending on the business cycle, the term was also applied to railroad and auto stocks.

While the need for safety and income of widows and orphans has not changed, the market and companies did. Stocks that were once viewed as a safe haven for very risk-averse investors changed either because the company's business strategy changed or the market changed. A good example is AT&T.

Despite many challenges, AT&T remained an archetypal widow-and-orphan stock for a long time. To use current terminology, it was the first to market and dominate its competitors until it became a de-facto monopoly. But times changed, and in the 1970s the government forced AT&T to break itself up into the Baby Bells. The breakup created competition, but AT&T continued to be viewed as a widow-and-orphan stock because, based upon its market position and dividend, it was perceived as a relatively safe investment.

In the late 1990s, AT&T changed and was no longer a widow-and-orphan stock, although many did not realize this. The change was wrought by the combination of a significant market transformation and a modification in the company's strategy. In the dotcom market, "telephone" and "telecommunications" became "telcos" as the phone companies morphed into new-age Internet stocks. The combination of government deregulation and technological advances increased competition, and the number of LECs, CLECs and telcos increased as entrepreneurs entered the market to provide commodity communication services. All of this threatened AT&T's dominant position.

In response to the change in the marketplace, AT&T changed. Management decided that it had to modify its strategy for the company to survive. They made acquisitions that altered the basic nature of the company, most notably the acquisition of Telecommunications Inc. (TCI). The acquisition of TCI can be viewed as the beginning of the end because it signaled that AT&T was no longer "your father's phone company" but an Internet firm focusing on the convergence of telco and cable services.

This change, if noted, went largely unreported. After all, who wanted safety in the late 1990s? Investors wanted dotcoms, not widow-and-orphan stocks, because all stocks rose at 20% per year, and AT&T was no exception. Despite the change from a safe utility to a highly-risky dotcom, AT&T was still viewed as a safe stock by many long-time holders. But today, in the wake of the dotcom bust, few would call AT&T a widow-and-orphan stock.

Usage of the term "widows and orphans" seems to mirror the market. Ignored during bull markets and resurfacing in bear markets, the term regained usage during the 1970s, following the "Nifty 50" bull market of the 1960s. While these blue-chip stocks may have suffered from the economic downturn, their reliable dividend was enough to earn them the title of widow-and-orphan stock. Investors could, despite the business risk, find some degree of safety in the dividend income.
But this time may be different. Historically, widow-and-orphan stocks provided investors a safe harbor from business risk. Today investors seek refuge from an additional menace: credibility risk. This risk results from the frequent reported occurrences of corporate executives using creative accounting to cook the books, a technique these executives use to achieve profit goals and "earn" their big bonuses. Even if there are companies that seem to have credibility, can an investor ever be sure? Many of the respected big-cap stocks of the late 1990s are now discredited in retrospect, and their restated operating results almost make it seem like the economic boom was really a result of creative accounting. How can any stock be called safe enough for widows and orphans if there is the risk that the books are being cooked?

Perhaps it is time to redefine the terms "widows" and "orphans". Individual investors have been "widowed" by Wall Street, which, by following only big-cap, highly liquid stocks, has shifted its focus to serving the needs of institutional investors. "Orphan" stocks now are small-cap stocks (under $500 million in market capitalization) that have been abandoned by Wall Street, not because they are bad investments, but because they do not provide investment banking opportunities. Many of these orphan stocks are good investments because they have solid balance sheets, growing earnings, and sometimes a healthy dividend. But because Wall Street ignores them, investors remain unaware of these investment opportunities. A contemporary usage of widows and orphans may refer to small-cap stocks with solid fundamentals. These stocks pose relatively less credibility risk because management is more focused on the business rather than cooking the books.

We can reunite these widowed investors and orphaned stocks, but it will require new ways of thinking both on the part of investors and the companies of orphaned stocks. Investors must realize that they need to take more responsibility in doing their own research and looking at many sources of information (not just research reports) in order to make good investment decisions. In addition, the executives of orphaned stocks must take the initiative to get their information to the market of widows. These new channels of information distribution include webcasts and unbiased fee-based research.
The Hidden Value of Intangibles

What can explain the runaway success of an initial public offering from a company with no earnings history? On the other hand, why can a bit of bad news or an earnings report that just misses market expectations send a healthy company's share price into a nosedive?

When the market ignores a company's historical financial performance, the market is often responding to "information asymmetry". The asymmetry occurs because traditional financial reporting methods - audited financial reports, analyst reports, press releases and the like - disclose only a fraction of the information that is relevant to investors. The value of intangible assets - research and development (R&D), patents, copyrights, customer lists and brand equity - represents a large part of that information gap.
Any business professor will tell you that the value of companies has been shifting markedly from tangible assets, "bricks and mortar", to intangible assets like intellectual capital. These invisible assets are the key drivers of shareholder value in the knowledge economy, but accounting rules do not acknowledge this shift in the valuation of companies. Statements prepared under generally accepted accounting principles do not record these assets. Left in the dark, investors must rely largely on guesswork to judge the accuracy of a company's value.

A study comparing market value to the book value of 3,500 U.S. companies over a period of two decades shows the dramatic upward rise in intangible value. In 1978, market value and book value were pretty much matched: book value was 95% of market value. Twenty years on, book value was just 28% of market value. Lev Baruch, an accounting professor at New York University's Stern School of Business, reckons that in the late 1990s businesses invested a staggering $1 trillion per year in intangible assets.

Accounting rules have not kept pace. For instance, if the R&D efforts of a pharmaceuticals company create a new drug that passes clinical trials, the value of that development is not found in the financial statements. It doesn't show up until sales are actually made, which could be several years down the road. Or consider the value of an e-commerce retailer. Arguably, almost all of its value comes from software development and copyrights and its user base. While the market reacts immediately to clinical trial results or online retailers' customer churn, these assets slip through financial statements.

There is a serious disconnection between what happens in capital markets and what accounting systems reflect. Accounting value is based on the historical costs of equipment and inventory, whereas market value comes from expectations about a company's future cash flow, which comes in large part from intangibles such as R&D efforts, patents and good ol' workforce "know-how".

Investors' jumpiness about valuation hardly comes as a surprise. Imagine investing in a company with $2 billion market capitalization but with revenues to date of only $100 million. You would probably suspect that there is a big grey area in the valuation picture. Perhaps you would turn to analysts to supply missing information. But analysts' metrics help only so much. Rumor and innuendo, PR and the press, speculation and hype tend to fill the information space.

In order to better milk their patents and brands, many companies do measure their worth. But these numbers are rarely available for public consumption. Even when used internally, they can be troublesome. Miscalculating the future cash flows generated from a patent, say, could prompt a management team to build a factory that it cannot afford.

To be sure, investors could benefit from financial reporting that includes improved disclosure. Already a dozen or so countries, including the U.K. and France, allow recognition of brand as a balance sheet asset. The Financial Accounting Standards Board is currently involved in a study to determine whether or not it should require intangibles on the balance sheet. However, because of the enormous difficulty of actually valuing intangibles and the big risk of inaccurate measurements or surprise write-downs, investors should not expect that decision to come any time soon.

It nevertheless pays for investors to try to get a grip on intangibles. Much accounting research is devoted to coming up with ways of valuing them, and, fortunately, techniques are improving. While opinions on suitable approaches still vary sharply, it is worthwhile for investors to take a look.

Here is a place to start: try calculating the total value of a company's intangible assets. One method is calculated intangible value (CIV). This method overcomes drawbacks of the market-to-book method of valuing intangibles, which simply subtracts a company's book value from its market value and labels the difference. Because it rises and falls with market sentiment, the market-to-book figure cannot give a fixed value of intellectual capital. CIV, on the other hand, examines earnings performance and identifies the assets that produced those earnings. In many cases, CIV also points to the enormity of the unrecorded value.

Using microprocessor giant Intel as an example, CIV goes something like this:
Step 1: Calculate average pre-tax earnings for the past three years. For Intel, that's $9.5 billion.

Step 2: Go to the balance sheet and get the average year-end tangible assets for the same three years, which, in this case, is $37.6 billion.

Step 3: Calculate Intel's return on assets (ROA), by dividing earnings by assets: 25% (nice business to be making chips).

Step 4: For the same three years, find the industry's average ROA. The average for the semiconductor industry is around 11%.

Step 5: Calculate the excess ROA by multiplying the industry average ROA (11%) by the company's tangible assets ($37.6 billion). Subtract that from the pre-tax earnings in step one ($9.5 billion). For Intel, the excess is $5.36 billion. This tells you how much more than the average chip maker Intel earns from its assets.

Step 6: Pay the taxman. Calculate the three-year average income tax rate and multiply this by the excess return. Subtract the result from the excess return to come up with an after-tax number, the premium attributable to intangible assets. For Intel (average tax rate 34%), that figure is $3.53 billion.

Step 7: Calculate the net present value of the premium. Do this by dividing the premium by an appropriate discount rate, such as the company's cost of capital. Using an arbitrary discount rate of 10% yields $35.3 billion.

That's it. The calculated intangible value of Intel's intellectual capital - what doesn't appear on the balance sheet - amounts to a whopping $35.3 billion! Assets that big deserve to see the light of day.
Fee-Based Research: The Good, The Bad And The Ugly

Because it refers to something that bridges the information gap created by Wall Street, fee-based research is a term that investors need to know about. This article will define the term and discuss how to decipher the good from the bad and the ugly.
Defined
Fee-based research is research compiled by an independent research firm that is compensated by the company that is the subject of the report (also referred to as the "subject company"). This research is different from subscription-based research, whereby the reader pays for research reports on a pay-per-view basis or with an annual subscription. And like investors using subscription-based research, investors using fee-based research need to know how to tell the difference between legitimate, objective research and reports written to manipulate stock prices.

The Good
Objective fee-based research plays an increasingly important role in today's market because it provides investors with information that would otherwise not be available. To fully appreciate how important this information service is, we need to review a bit of history.

In the beginning, the research departments of brokerage firms provided research on stocks of all market capitalizations. Wall Street firms tended to follow larger-cap stocks while regional firms followed smaller-cap stocks in their backyards. This allowed small brokerage companies to have access to capital, which allowed the small caps to grow to a point at which they were "discovered" by Wall Street. And investors saw that this was good.

But things changed when deregulation resulted in smaller commissions, shrunken trading spreads and industry consolidation. These events resulted in a smaller number of larger firms, which focused only on big-cap stocks because the big-cap stocks had enough profits to fund research departments. Consequently, thousands of small and micro-cap stocks were orphaned - dropped from research coverage - because they did not provide enough profit potential to the brokerage firm. If a stock did not generate a certain level of trading volume, or if the company did not have the potential for an investment banking deal of a specific amount, the stock was dropped from coverage. This left thousands of companies in the wilderness and unable to convey their story to investors. This was bad, but investors seemed unaware of the change because they were worshipping at the bull market of the late 1990s.

Onto the scene came fee-based research with a mission to bridge the information gap and guide orphaned stocks to the promised land of investor awareness. The independent analyst spends a lot of time and expense preparing fundamental research that is free to investors. In this way, the company's information is made available to the widest possible audience.

The increased need for fee-based research has been recognized by the investment community. In Jan 2002 the National Institute of Investor Relations (NIRI) issued guidelines for the use of fee-based research.

The Bad
The bad thing is that for most of its history, fee-based research has been used to manipulate stock prices. Unscrupulous firms used this "research" and boiler-room operations to pump and dump stocks while supposedly legitimate research was done by Wall Street firms. This resulted in a stereotype that all fee-based research is illegitimate, but while there are still many cases of market manipulation, investors are taking a closer look at fee-based research.

Investors read fee-based research because things changed in 2002. Wall Street research is no longer viewed as legitimate since it has been tainted by investment banking considerations. Realizing that the Street follows a limited number of companies, investors today are more educated and are looking for other sources of information.

The Ugly
The really ugly part of all this is that there are many small-cap companies with good investment potential that remain orphaned because they do not believe that investors give any credibility to fee-based research. They continue to wander in the wilderness, expecting the Street to eventually recognize their worth and start covering their stock.

As these orphaned companies wait for the Street, their competitors are discovering that the orphaned shares are undervalued and acquire the orphan. Based upon our research, the average take-out premium for an orphaned company is about 20%. Had orphaned companies taken the initiative to reach investors by using fee-based research, they probably would not have left so much money on the table.

The Bottom Line
In this brave new world investors are more educated and are looking beyond Wall Street for their information. Legitimate fee-based research is becoming more recognized because it fills the market's need for objective information. The challenge for both investors and small-cap companies is to differentiate between the good and bad independent firms.

Fortunately, there are two good sources of information that will help investors and corporate management spot legitimate fee-based research. The first is an article entitled "Six Signs of an Objective Research Report", in which I detail how a reader can determine the objectivity of a research report.

The other source is the Research Objectivity Standards that have been proposed by the Association for Investment Management and Research (AIMR). These proposed standards detail the process required to issue an objective research report, and they provide the reader with a checklist to use in evaluating any research report. It also provides corporate management a list to use when evaluating the services of independent research firms.
Taking Stock of Discounted Cash Flow

At a time when financial statements are under close scrutiny, the choice of what metric to use for making company valuations has become increasingly important. Wall Street analysts are emphasizing cash flow-based analysis for making judgments about company performance.

A key valuation tool at analysts' disposal is discounted cash flow (DCF) analysis. Analysts use DCF to determine a company's current value according to its estimated future cash flows. Forecasted free cash flows (operating profit + depreciation + amortization of goodwill - capital expenditures - cash taxes - change in working capital) are discounted to a present value using the company's weighted average costs of capital. For investors keen on gaining insights on what drives share value, few tools can rival DCF analysis.

Recent accounting scandals and inappropriate calculation of revenues and capital expenses give DCF new importance. With heightened concerns over the quality of earnings and reliability of standard valuation metrics like P/E ratios, more investors are turning to free cash flow, which offers a more transparent metric for gauging performance than earnings. It is harder to fool the cash register. Developing a DCF model demands a lot more work than simply dividing the share price by earnings or sales. But in return for the effort, investors get a good picture of the key drivers of share value: expected growth in operating earnings, capital efficiency, balance sheet capital structure, cost of equity and debt, and expected duration of growth. An added bonus is that DCF is less likely to be manipulated by aggressive accounting practices.
DCF analysis shows that changes in long-term growth rates have the greatest impact on share valuation. Interest rate changes also make a big difference. Consider the numbers generated by a DCF model offered by Bloomberg Financial Markets. Sun Microsystems, which recently traded on the market at $3.25, is valued at almost $5.50, which makes its price of $3.25 a steal. The model assumes a long-term growth rate of 13.0%. If we cut the growth rate assumption by 25%, Sun's share valuation falls to $3.20. If we raise the growth rate variable by 25%, the shares go up to $7.50. Similarly, raising interest rates by one percentage point pushes the share value to $3.55; a one percent fall in interest rates boosts the value to about $7.70.

Investors can also use the DCF model as a reality check. Instead of trying to come up with a target share price, they can plug in the current share price and, working backwards, calculate how fast the company would need to grow to justify the valuation. The lower the implied growth rate, the better - less growth has therefore already been "priced into" the stock.

Best of all, unlike comparative metrics like P/Es and price-to-sales ratios, DCF produces a bona fide stock value. Because it does not weigh all the inputs included in a DCF model, ratio-based valuation acts more like a beauty contest: stocks are compared to each other rather than judged on intrinsic value. If the companies used as comparisons are all over-priced, the investor can end up holding a stock with a share price ready for a fall. A well-designed DCF model should, by contrast, keep investors out of stocks that look cheap only against expensive peers.

DCF models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out". Small changes in inputs can result in large changes in the value of a company. Investors must constantly second-guess valuations; the inputs that produce these valuations are always changing and susceptible to error.
Meaningful valuations depend on the user's ability to make solid cash flow projections. While forecasting cash flows more than a few years into the future is difficult, crafting results into eternity (which is a necessary input) is near impossible. A single, unexpected event can immediately make a DCF model obsolete. By guessing at what a decade of cash flow is worth today, most analysts limit their outlook to 10 years. Investors should watch out for DCF models that are taken to ridiculous lengths. Samantha Gleave, a London-based analyst with Credit Suisse First Boston, published a DCF model for Eurotunnel that runs through 2085!

These are not the only problems. With its focus on long-range investing, the DCF model isn't suited for short-term investments. A model that shows that Sun Microsystems is worth $5.50 does not mean that it will trade for that any time soon; furthermore, over-reliance on DCF can cause investors to overlook unusual opportunities. DCF can prevent investors from buying into a market bubble. DCF can also prompt investors to sell, which might mean they miss those big share price run-ups that can be so profitable (provided the shares are sold at the peak).

Don't base your decision to buy a stock solely on discounted cash flow analysis. It is a moving target, full of challenges. If the company fails to meet financial performance expectations, if one of its big customers jumps to a competitor, or if interest rates take an unexpected turn, the model's numbers have to be re-run. Any time expectations change, the DCF-generated value is going to change.

Here is a link that can't be missed: Aswarth Damadoran, professor of finance at New York University's Stern School of Business has created an excellent web site http://pages.stern.nyu.edu/~adamodar/ devoted to valuation techniques. He offers numerous DCF models set up in Excel spreadsheets, and he gives details on the intricacies of the models.

Stock Ratings: The Good, the Bad and the Ugly

Investors have a love-hate relationship with stock ratings. On the one hand, stock ratings are loved because they succinctly convey how an analyst feels about a stock. On the other hand, they are hated because they can often be a manipulative sales tool. This article will look at the good, the bad and the ugly sides of stock ratings.
The Good: Soundbites Wanted
Today's media, and investors, demand information in soundbites because our collective attention span is measured in nanoseconds (which also is apparently how the market measures a "long-term" investment). "Buy", "sell" and "hold" ratings are effective because they quickly convey the bottom line to investors.

But the main reason why ratings are good is that they are the result of the reasoned and objective analysis of experienced professionals. It takes a lot of time and effort to analyze a company and to develop and maintain an earnings forecast. And while different analysts may arrive at different conclusions, their ratings are efficient in summarizing their efforts. However, a rating is one person's perspective, and it will not apply to every investor.

The Bad: One Size Does Not Fit All
While each rating succinctly conveys a recommendation, this rating is really a point on an investment spectrum. It is like a rainbow, in which there are many shades between the primary colors.

A stock's investment risk and an investor's risk tolerance cause the blurring between the primary recommendations. A color may be a specific point on the spectrum, but the color's specific electromagnetic arrangement can be perceived differently by different people, either because of individual characteristics (like color blindness) or perspective (like looking at the rainbow from a different direction), or both.

A stock, unlike the fixed nature of the electromagnetic spectrum (a color's place along the spectrum is fixed by physics), can move along the investment spectrum and be viewed differently by different investors. This "morphing" is the result of the preferences of individuals (individual risk tolerance), the business risk of the company and the overall market risk, which all change over time.

For example, think of a line (or rainbow) and imagine "buy", "hold" and "sell" as points at the left end, middle and right end of the line/rainbow. I will demonstrate how things change by examining the history of the shares of AT&T (NYSE:T).

First, I will examine how perspectives at one point in time matter. In the beginning (say, in the 1930s), AT&T was considered a "widow-and-orphan" stock, meaning it was a suitable investment for very risk-averse investors: the company was perceived as having little business risk because it had a product everybody needed (it was a monopoly), and it paid a dividend (income that was needed by the "widows to feed the orphans"). Consequently, AT&T stock was perceived as a safe investment, even if the risk of the overall market changed (due to depressions, recessions or war).

At the same time, a more risk-tolerant investor would have viewed AT&T as a "hold" or "sell" because, compared to other more aggressive investments, it did not offer enough potential return. The more risk-tolerant investor wants rapid capital growth, not dividend income: risk-tolerant investors feel that the potential additional return justifies the added risk (of losing capital). An older investor may agree that the riskier investment may yield a better return, but he or she does not want to make the aggressive investment (is more risk-averse) because, as an older investor, he or she cannot afford the potential loss of capital (needs the dividend income to "feed the orphans").

Now let's look at how time changes everything. A company's risk profile ("specific risk" in Street talk) changes over time as the result of internal changes (e.g.. management turnover, changing product lines, etc.), external changes (e.g.. "market risk" caused by increased competition), or both. AT&T's specific risk changed while its break-up limited its product line to long-distance services, and while competition increased and regulations changed. And its specific risk changed even more dramatically during the dotcom boom in the 1990s: it became a "tech" stock and acquired a cable company. AT&T was no longer your "father's phone company," nor was it a "widows and orphans stock." In fact, at this point the tables turned. The conservative investor who would have bought AT&T in the 1940s probably considered it a "sell" in the late 1990s. And the more risk-tolerant investor who would not have bought AT&T in the 1940s most likely rated the stock a "buy" in the 1990s.

It is also important to understand how individuals' risk preference changes over time and how this change is reflected in their portfolios. As investors age, their risk tolerance changes. Young investors (in their 20s) can invest in riskier stocks because they have more time to make up for any losses in their portfolio and still have many years of future employment (and because the young tend to be more adventurous). This is called the "life cycle theory of investing". It also explains why the older investor, despite agreeing that the riskier investment may offer a better return, cannot afford to risk his or her savings.

In 1985, for example, yuppies in their mid-30s invested in startups like AOL because these companies were the "new" new thing. And if the bets failed, the yuppies still had many (about 30) years of employment ahead of them to generate income from salary and other investments. Now almost 20 years later, those same investors cannot afford to place the same "bets" they placed when they were younger. They are nearer to the end of their workable years (10 years from retirement) and thus have less time to make up for any bad investments.
The Ugly: Ratings Are Being Used as a Substitute for Thinking
While the dilemma surrounding Wall Street ratings has been around since the first trade under the buttonwood tree on Manhattan Island, things have recently turned ugly with the revelation that some ratings did not reflect the true feelings of analysts. Investors are responding like Captain Renault in Casablanca: they are "shocked, shocked to find that" such illicit happenings could be occurring in a fine establishment like Wall Street. But ratings, like stock prices, can be manipulated by unscrupulous people, and have been throughout time. The only difference is that this time it happened to us.

But just because a few analysts were dishonest, this does not mean that all analysts are liars. Their assumptions may turn out to be wrong, but this does not mean that they did not do their best to provide investors with thorough and independent analysis.

Investors must remember two things. First, most analysts do their best to find good investments, so ratings are, for the most part, useful. Second, legitimate ratings are valuable pieces of information that investors should consider, but ratings should not be the only tool in the investment decision-making process.

The Bottom Line
A rating is one person's view based upon his or her perspective, risk tolerance and current view of the market. This perspective may not be the same as yours. The bottom line is that ratings are valuable pieces of information for investors, but they must be used with care and in combination with other information and analysis in order to make good investment decisions.
Earnings Guidance: The Good, the Bad and Good Riddance?

"Earnings guidance" is a relatively new term that describes an old practice. But new regulations have changed how this information is given to the market. Some companies are now saying they will stop giving guidance to combat the market's focus on the short-term, but could it be because of the potential liabilities the companies face? This article will provide a perspective on this age-old tradition, discuss the good and bad points, and examine why some companies are saying "no more".
Defined
Earnings guidance is defined as the comments management gives about what it expects its company will do in the future. These comments are also known as "forward-looking statements" because they focus on sales or earnings expectations in light of industry and macroeconomic trends. These comments are given so that investors can use them to evaluate the company's earnings potential.

An Age-Old Tradition
Providing forecasts is one of the oldest professions. In previous incarnations, earnings guidance was called the "whisper number". The only difference is that whisper numbers were given to selected analysts so that they could warn their big clients. Fair disclosure laws (known as Reg FD) made this illegal and companies now have to broadcast their expectations to the world, giving all investors access to this information at the same time. This has been a good development.

The Good: More Information Is Always Better
Earnings guidance serves an important role in the investment decision-making process. Under current regulations, it is the only legal way a company can communicate its expectations to the market. This perspective is important because management knows its business better than anyone else and has more information on which to base its expectations than any number of analysts. Consequently, the most efficient way to communicate management's information to the market is via guidance. In an ideal world, analysts would use this information in combination with their own research to develop earnings forecasts.

The Bad: Management Can Manipulate Expectations
The cynical view is that, because this is not an ideal world, managements use guidance to sway investors. In bull markets some companies have given optimistic forecasts when the market wants momentum stocks with fast-growing EPS. In bear markets companies have tried to lower expectations so that they can "beat the number" during earnings season. It is one of the analyst's jobs to evaluate management expectations and determine if these expectations are too optimistic or too low, which may be an attempt at setting an easier target. Unfortunately, this is something that many analysts forgot to do during the dotcom bubble.
Why Some Companies Stopped Giving Guidance
Claiming that guidance promotes the market's focus on the short term, some companies have said they will stop providing guidance in order to try to combat this obsession with the short term. While this may sound noble, they can't seriously think this will be effective.

Eliminating guidance will not change the market's fixation on the short term because the market's incentive policies cannot be dictated. Coke could stop talking to everybody, but there would still be a score of quarterly estimates on First Call. Why? Because that is what institutional investors want. The Street will remain focused on the short term because that is how it is compensated. Everyone on Wall Street is paid annually and gets paid more if he or she outperforms in that year. This focus will not change if companies don't talk to the Street.

The real reason why some companies have stopped giving guidance is probably a legal one. In this post-bubble, litigation-happy environment, eliminating guidance will avoid potential liability expenses. It will also allow management to spend more time on running the company because it won't have to answer guidance questions anymore.

The Ugly: Eliminating Guidance Will Increase Volatility
Eliminating guidance will result in more diverse estimates and missed numbers. Analysts often use guidance as a reference point from which to build their forecasts. Without this anchor, the range of analysts' estimates will be wider, producing larger variances from actual results. Misses of more than a penny may become commonplace.

An interesting question is what will the Street do if misses become bigger and more frequent? Today, if a company misses the consensus estimate by a penny, its stock could suffer or soar, depending on whether the miss was negative or positive. Bigger misses could result in bigger swings in stock prices, producing a more volatile market. On the other hand, if the market is aware that the misses are caused by the lack of guidance, it may become more forgiving. If there is an argument for stopping guidance, it is that the Street would be more forgiving of companies that miss the consensus estimate.

The Bottom Line
Guidance has a role in the market because it provides information that can be used by investors to analyze the company, evaluate management and create forecasts. Companies are foolish if they think they can alter the market's short-term focus. The Street will still do what it wants, and it will stay focused on quarterly timelines. If, however, more companies opt for no guidance, the Street may inadvertently become more rational and therefore stop whipsawing stock prices for miniscule variances that are really just SWAGs (Systematic, but We're All Guessing).
Reg AC: What Does It Mean To Investors?

The Securities & Exchange Commission (SEC) recently released a new regulation that is meant to increase the level of honesty in research reports. Many think the law will have little impact because it does not go far enough. This article will define Reg AC and discuss its potential impact on the market and investors.
Reg AC Defined
On Feb 6, 2003, the SEC issued Reg AC (the "AC" stands for analyst certification) which requires analysts to "certify the truthfulness of the views they express in research reports and public appearances, and disclose whether they have received any compensation related to the specific recommendations or views expressed in those reports and appearances." The goal is similar to the regulation that requires CEOs and CFOs to certify the truthfulness of the financial statements they publish.

What Does It Accomplish?
At the very least, Reg AC will increase disclosure and hold analysts more accountable, much like CEOs and CFOs are now more accountable for the financial statements they issue. How much of an impact Reg AC will have is open to debate. Some claim the law does not go far enough. Others feel that existing laws already provide enough protection.

I originally thought this would be a non-event because there are already regulations and policies that require disclosures. Pre-existing SEC regulations require disclosures of the nature of the relationship between the brokerage firm and the subject company. For example, the brokerage firm must disclose if it has been involved in an investment banking deal or if it has acted as an underwriter within the last three years. Independent fee-based research firms must also disclose if and how much the subject company has paid them. And if an analyst is a CFA charter holder, CFA Institute's Code of Ethics and Standards of Professional Conduct currently require the analyst to state his or her true opinions in the research report.

The new twist that Reg AC will introduce is that it requires the disclosure of whether the analyst received any compensation "related to the specific recommendation or views expressed". I interpret this to mean that analysts must report whether or not the subject company has paid for a "buy" rating ("specific recommendation") or a favorable report ("views expressed").

The Potential Impact
I think the main contribution of Reg AC will be that it requires analysts to disclose whether the subject company paid for an objective research report or a rating. In order to discuss how this will impact the market, we need to review how Wall Street has changed.

At one time, brokerage firms researched most publicly-traded companies; however, the number of companies that receive research coverage declined significantly over the last 10 years due to industry consolidation and, more recently, due to staff reductions at Wall Street firms. Today, the remaining brokerage firms cover a relatively small number of stocks. This minority consists of stocks with the largest market capitalization and highest liquidity.

The majority of publicly traded firms (about 65%, based upon our research) has been "orphaned" by Wall Street and has little or no research coverage. We have found that most of these orphaned companies have good fundamentals and represent long-term value investments. The challenge facing these companies is reaching investors who are looking for good long-term investments.

Independent research firms are attempting to bridge this information gap. As with any industry, some are more legitimate than others, and a good way to differentiate the good from the bad is to read disclosure statements. And this is where Reg AC may have its greatest impact.

Contracting for objective research coverage is very different from paying for a rating. In my opinion, legitimate fee-based research involves both parties committing to objective research coverage for at least one year. This provides investors with the ability to read about and evaluate a company's progress for four quarters. One-time reports do not help investors track a company's progress, nor do they indicate a company's commitment to providing investors with necessary information.
To provide the market with objective research for a period spanning several quarters, companies who want to maintain their credibility will contract only with legitimate independent research firms. These research firms will provide Reg AC disclosures because they want to abide by the laws and have nothing to hide.

Other times, companies will hire a firm to write a one-time favorable report with a "buy" recommendation. These types of reports will not contain the Reg AC disclosure. The absence of the disclosure should serve as a red flag to investors, who should then ignore the report.

Time Will Tell
It may take some time to determine the real impact of Reg AC, but I think the end result may be surprising. Today, not much is expected to change with the implementation of Reg AC. People had the same opinion when CEOs and CFOs were first required to certify their financial statements, but these regulations did bring about many changes. CEOs and CFOs implemented new reporting procedures and made their subordinates more accountable, which appears to have eliminated some of the abuses that were made famous by Enron and others.

What is certain is that this reiterates the importance of reading disclosure statements and gives investors another indicator of the legitimacy of a report. Investors must read disclosure statements so that they understand the nature of the relationship between the research firm and the subject company. Investors should not put much faith in reports that do not contain the Reg AC disclosure.
All about EVA
The goal of all companies is to create value for the shareholder. But how is value measured? Wouldn't it be nice if there were a simple formula to figure out whether a company is creating wealth?

A growing number of analysts and consultants think there is an answer. Like many economic formulas, the measure - Economic Value Add (EVA) - is both intriguingly clever and maddeningly deceptive. Does EVA simplify the task of finding value-generating companies or does it just muddy the waters?
What Is EVA?
It is a performance metric that calculates the creation of shareholder value. It distinguishes itself from traditional financial performance metrics such as net profit and EPS: EVA is the calculation of what profits remain after the costs of a company's capital - both debt and equity - are deducted from operating profit. The idea is simple but rigorous: true profit should account for the cost of capital.

To understand the difference between EVA and its older cousin, net income, let's use an example based on a hypothetical company, Ray's House of Crockery. Ray's earned $100,000 on a capital base of $1,000,000 thanks to big sales of stew pots. Traditional accounting metrics suggest that Ray is doing a good job. His company offers a return on capital of 10%. However, Ray's has only been operating for a year, and the market for stew pots still carries significant uncertainty and risk. Debt obligations plus the required return that investors demand for having their money locked up in an early-stage venture add up to an investment cost of capital of 13%. That means that, although Ray's is enjoying accounting profits, the company lost 3% last year for its shareholders.

Conversely , if Ray's capital is $100 million - including debt and shareholder equity - and the cost of using that capital (interest on debt and the cost of underwriting the equity) is $13 million a year, Ray will add economic value for his shareholders only when profits are more than $13 million a year. If Ray's earns $20 million, the company's EVA will be $7 million.

In other words, EVA charges the company rent for tying up investors' cash to support operations. There is a hidden opportunity cost that goes to investors to compensate them for forfeiting the use of their own cash. EVA captures this hidden cost of capital that conventional measures ignore.

Developed by the management consulting firm Stern Stewart, EVA really caught fire in the 1990s. Big corporations, including Coca-Cola, GE and AT&T, employ EVA internally to measure wealth creation performance. In turn, investors and analysts are now scrutinizing company EVA just as in the past they observed EPS and P/E ratios. Stern Stewart has gone so far as to trademark the concept.

The Calculation
There are four steps in the calculation of EVA:
1. Calculate Net Operating Profit After Tax (NOPAT)
2. Calculate Total Invested Capital (TC)
3. Determine a Cost of Capital (WACC)
4. Calculate EVA = NOPAT – WACC% * (TC)
The steps appear straightforward and simple. But looks can be deceiving. For starters, NOPAT hardly represents a reliable indicator of shareholder wealth. A firm NOPAT might show profitability according to the GAAP (generally accepted accounting principles), but standard accounting profits rarely reflect the amount of cash left at year end for shareholders. According to Stern Stewart, literally dozens of adjustments to earnings and balance sheets - in areas like R&D, inventory, costing, depreciation and amortization of goodwill - must be made before the calculation of standard accounting profit can be used to calculate EVA. To protect its trademark, Stern Stewart doesn't fully disclose the adjustments - making the job of using the metric even more difficult.

Figuring out the cost of capital (WACC) is even more thorny. WACC is a complex function of the capital structure (proportion of debt and equity on the balance sheet), the stock's volatility measured by its beta, and the market risk premium. Small changes in these inputs can result in big changes in the final WACC calculation.


That said, if carried out consistently, EVA should help us identify the best investments, that is, the companies that generate more wealth than their rivals. All other things being equal, firms with high EVAs should over time outperform others with lower or negative EVAs.

But the actual EVA level matters less than the change in the level. According to research conducted by Stern Stewart, EVA is a critical driver of a company's stock performance. If EVA is positive but is expected to become less positive, it is not giving a very good signal. Conversely, if a company suffers negative EVA but is expected to rise into a positive territory, a good buying signal is given.

Of course, Stern Stewart is hardly unbiased in its assessment. New research challenges the close relationship between rising EVA and stock price performance. Still, the growing popularity of the concept reflects the importance of EVA's basic principle: the cost of capital should not be ignored but kept at the forefront of investors' minds. Best of all, EVA gives analysts and anyone else the chance to look skeptically at EPS reports and forecasts.
The Changing Role Of Equity Research

In this interactive discussion of equity research, we will review the role of this research and how it is impacted by bull and bear markets. We will also discuss fee-based research and its growing importance. Your responses to the questions at the end of this article will be the basis for the last part of this article, where you can observe what investors think is the role of equity research in today's market.

*Editor's note: The follow-up to this article is posted here.
Research and the Stock Market
Actually, the title of this article is a bit misleading because the role of research has not changed since the first trade occurred under the Buttonwood Tree on Manhattan Island. What has changed is the environments (bull and bear markets) that influence research.

The role of research is to provide information to the market. An efficient market relies on information: a lack of information creates inefficiencies that result in stocks being misrepresented (over or under valued). Analysts use their expertise and spend a lot of time analyzing a stock, its industry and peer group to provide earnings and valuation estimates. Research is valuable because it fills information gaps so that each individual investor does not need to analyze every stock. This division of labor makes the market more efficient.

Research in Bull and Bea