Professional Documents
Culture Documents
Nov 1, 2016
Introduction
The financial market volatility caused by the decline in value of housing
mortgages in the U.S. should create a different way to think about risk.
There has been something fundamentally wrong with the manner in
which financial professionals assess risk
Traditional financial theory taught in business schools (beta, option
pricing models and Monte Carlo Simulation) provided little or no guidance
in valuation
While the understanding of any discipline requires knowledge of
underlying technical principles, when it comes to valuation, learning
from past mistakes is also essential, if not even more important.
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Assuming that prices and volumes can continue to increase in tandem when
there is surplus capacity.
Relying on experts who do not have a vested interest in investments and without
verifying analysis with back of the envelope analysis.
Using statistical analysis on historic data without realizing the manner in which
economic variables can suddenly change in non-linear ways.
Simplistic assumptions with respect to downside and upside cases rather than
recognizing differences in upside potential and downside risk.
Assumption that contracts will protect investments without delving into the
potential for contracts to be broken or mismatched.
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Valuation Nightmares
All of these things factored into the mother of all valuation nightmares
the financial panic precipitated by declines in the U.S. housing loans
known as the sub-prime crisis.
A very general discussion of the explosive mixture of valuation errors that
contributed to the sub-prime mess is presented below before specific
valuation mistakes are discussed in more detail.
The problem is that none of these mistakes is very new they simply
occurred on a bigger scale and had wider implications for the overall
market.
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Problem One
Ignoring the most basic of economic
principles in developing assumptions for
financial models
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Telecommunications companies
experienced higher bankruptcies than
any other industry in 2000-2002.
There was an overbuilding of fiber-optic
cable systems by a factor of at least 10.
Many New Economy companies were
built based on the idea that the telecom
sector would expand perpetually by 15
to 30% per annum.
.
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Problem Two
Ignoring the Supply Side of Variables Driven
By Marginal Cost
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Problem Three
Forgetting the Fundamental Rule that Value
comes from Earning Returns above the Cost
of Capital and the Danger of Assuming High
Returns without Competitive Advantage
Integrated Financial Management
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Problem Four
Believing that Innovative Financial Ideas can
Create New Sources of Value
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Problem Five
Relying on Independent Experts and NonTransparent Analysis without Checking the
Logic and Using Simple Models
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600 vs 1,600
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Problem Six
Using Statistical Models that Assume Stable
Systems for Economic Variables
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Problem Seven
Assuming that Variables Follow Smooth and
Linear Trends
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Problem Eight
Ignoring Incentives
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Compute cost
of capital and
arbitrage
pricing model
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Increasing Earnings
The company was able to double
earnings which resulted in the
increased stock prices.
It also projected strong future growth
in earnings
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Business Components
The peer companies primarily in the business of selling electricity
from merchant generating plants and operating regulated
distribution companies.
As shown in the table (which was not published until 2009),
Constellation was earning almost fifty percent of its non-utility
earnings from businesses other than generation in 2006 and 2007.
bought ships that transported coal and named it freight
intermediation
Gross margin:
Generation
Customer Supply
Global Commodities
1,490
764
656
1,700
889
654
1,956
765
260
Total
2,910
3,243
2,981
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Generation Percent
51%
2007
52%
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2008
66%
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Lack of transparency for Constellation was not limited to its financial presentation. The second aspect of
opaque presentation was the manner in which Constellation explained its businesses to investors.
Language used by Constellation is a good example of the way finance professionals attempt to create
confusion though showing how smart they are.
In earnings conference calls and other presentations, Constellation would use phrases such as
asymmetric collateral requirements,
deployment of risk capital,
leveraging business platforms,
as priced margins,
transitional liquidity,
right-sizing of strategic footprints
The general idea of the presentations seemed to be that investors should trust the superior qualities of the
company and not worry about risks in the business
Mao Schattuck: the realignment of all our merchant businesses allows us to leverage our world class
capabilities in risk management and portfolio management across our industry-leading platform.
When listening to Mao Schattuk and other Constellation managers, they seemed to want to leave an
impression of being very smart. It was easy to feel quite inferior to their superior intellect.
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Issues:
What method should be used
How should valuation be presented
What adjustments should be made for fixed contract payments
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Constellations Demise
The specific reason for Constellations ultimate financial demise was panic in the financial
community that the company could not raise enough cash from lenders provide back-up
loans so that it could continue its trading activities. Management defined the finance
collapse as a liquidity crisis and attributed it to events that were beyond its control -- on
unprecedented turmoil in financial markets, volatile energy commodity prices and the
actions of rating agencies who were worried about trading partners losing confidence. The
table below illustrates that credit risk was even higher for Constellation than for Lehman
Brothers. The downfall began when rating agencies finally recognized that Constellation
had more risks than its peers the downgrade occurred after energy prices had began to
fall. The rating agency Fitch, noted Constellations exposure to energy prices, implying that
it was taking positions in its trading: Constellation is exposed to risks surrounding
market price, volumes, counterparty credit, and liquidity for collateral. When the company
places blame on volatile financial markets for its problems, it is like investors in sub-prime
mortgages blaming the fall in housing prices. It is not appropriate to term Constellation as
a victim of the financial crisis.
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Internet Bubble
Manufacturing Administrative
Expenses
Freight Airline
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Can we really
earn 24% when
anybody can build
a similar plant
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4% Volatility
0% Volatility
Difference 4% vs 0%
Volatility
5 Year Construction
105,443.00
86,436.00
19,007.00
1 Year Construction
101,138.00
90,758.00
10,380.00
4,322.00
(8,627.00)
Difference in Cost
Percent Difference
(4,305.00)
-4.3%
4.8%
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Eurotunnel Mistakes
Eurotunnel comments
"We were predicting that on Eurostar there would be 21 million
passengers (annually)," admits David Freud of Warburg, the
investment house which sold Eurotunnel shares to the public.
The actual figure was less than a third of that.
"So the traffic forecasts were not just out by a little bit. They were
completely potty; they were nowhere."
Those who drafted Eurotunnel's prospectus failed completely to foresee a
robust response from the ferries.
When the world's most successful investor, Warren Buffett, said, "if you
overpay for an asset, there ain't no cure", he might have had Eurotunnel
in mind.
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Simple Checks:
-What is the total revenues people are
supposed to pay for the toll road in
one study, people were expected to pay
$7,000 per year.
-What is the market share of the toll
road. In one study, a road that was
unrealistically expected to capture 60%
of airport traffic.
-What is the price elasticity of toll road
users. In one study, traffic growth was
projected even though real toll rates
double.
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Private Equity
Transactions
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Assuming That Upside Potential Equals Downside Exposure -Neglecting Skewed Distributions
Examples
Prices before the California
electricity crisis were relatively
low. But most of the forces that
lead to the extremely high prices
such as high electricity demand,
no new capacity and low levels
of water in damns could have
been predicted.
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Revenue Growth
Operating Expense
Revenue x Margin
Total Assets
Revenue x (Assets/Revenue)
Capital Expenditure
Assetst Assetst-1
As with revenue forecasts from price and quantity, it is better to compute capital expenditures
from the quantity of production required (reserves, manufacturing capacity, electric capacity,
number of planes, number of subscribers etc.) and multiply the cost of new capacity by the
quantity. The capital expenditure forecast should include inflation in the cost of procuring
capacity and include sustaining capital expenditure.
Example
Revenue forecast for air freight company without consideration of maintenance capital
expenditures and without explicit modelling of the cost of new planes.
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Telecommunications Meltdown
In 2001, 77 telecommunications companies sought bankruptcy
In 2000, 20 declared bankrupcy.
Two Trillion in Market Value Lost
Large bankruptcies included:
WorldComs -- the single largest bankruptcy in U.S. history.
The fiber optic network operator, Global Crossing, 4th largest
Other leaders -- Williams Communications Group and Network Plus
Reasons
Long distance price competition in pursuit of retaining market share.
Entry into local markets blocked.
It's fallout from a telecoms industry in which supply has dwarfed demand.
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12 Ground Stations
Handset Cost = US$3,000
A brick
Call Cost = US$3.00-US$7.50 per min.
US$800 million Loan
LIBOR + 4%; 2-year Bullet
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