Financial Journalists Presentation

1
Financial Journalists Presentation

• The Following are highlight slides of a day long
  presentation given to the American Society of
  Business Publication Editors (ASBPE) at the City
  Club San Francisco on January 20, 2004 by Brian
  Berberet, CFA and Jim Keene, CFA, CFP.

2
A Primer on Risk, Valuations and Financing of
Assets and Companies and How Companies Use (and
Abuse) Financial Accounting

• Brian Berberet, CFA
• Principal, Carrick Bend Advisors LLC
• Public Relations Committee, Security Analysts of
  San Francisco
• Jim Keene, CFA, CFP
• Portfolio Manager, Bingham, Osborn Scarborough
• Faculty Practitioner, University of San Francisco
• Media Contact Liaison, Security Analysts of San
  Francisco

3
About Brian Berberet, CFA and Jim Keene, CFA, CFP

• Brian Berberet, CFA
• Principal, Carrick Bend Advisors LLC
• Co-managed a Morningstar 4 Star Small Cap Fund
• 8 years experience as securities analyst
  specializing in banking and telecommunication
  services
• Former Institutional Equities Trader
• Jim Keene, CFA, CFP
• Over 20 years experience in real estate
  financing, venture capital investing and private
  client advising
• Over 200mm financed in real estate, 100mm
  venture portfolio managed and 175mm private
  client assets managed
• Portfolio Manager at Bingham, Osborn
  Scarborough, a S.F.-based wealth manager
• Teaches Alternative Investments and Financial
  Markets for Security Analysts of San Francisco
  CFA prep classes Faculty Practitioner at
  University of San Francisco Masters of Science
  in Financial Analysis

4
About AIMR

• Association of Investment Management Research
• Mission Statement To advance the interests of
  the global investment community by establishing
  and maintaining the highest standards of
  professional excellence and integrity.
• 67,000 members (including 54,000 who hold
  Chartered Financial Analyst designation) in 112
  countries and territories
• 63 of members serve primarily institutional
  investors and 37 primarily serve individual
  investors
• Offices Virginia, London, Hong Kong
• Local CFA Societies Around the Country World
• Contacts Rich Wyler rgw_at_aimr.org
  434-951-5344
• Kathy Valentine kmv_at_aimr.org 434-951-5348

5
About SASF

• Security Analysts of San Francisco
• Mission Statement The SASF promotes high
  standards of competence and ethics for its
  members, encourages their continuing educational
  and professional development and sponsors
  programs to interchange investment ideas and
  corporate information.
• Approximately 2,200 members (79 are CFA
  Charterholders)
• Founded 1929 second oldest financial analyst
  society in U.S.
• SASF is dedicated to Promoting Financial Literacy
  with fund-raising through its Annual Wine
  Charity. Funds raised provide Bay Area high
  school students and teachers with programs that
  improve financial literacy. Now serving 60 high
  schools in the Bay Area.
• Contacts Jim Keene [phone] ext. 233
• jim.keene_at_bosinvest.com www.bosinvest.com
• Tina Myers [phone]
• sasf_at_vkam.com www.sasf.org

6
About the CFA designation

• No other designation within the profession of
  investment management carries as much integrity
  as the CFA charter.
• The CFA program sets the global standard for
  investment knowledge, standards and ethics.
• To be awarded the Chartered Financial Analyst
  designation, a candidate must meet the following
  qualifications, as specified by the Association
  of Investment Management and Research (AIMR).
• Examinations Three six-hour exams must be
  passed sequentially testing knowledge on a range
  of investment topics including portfolio
  management, accounting, statistics, economics,
  asset valuation and ethics.
• Experience Have at least three years acceptable
  work experience in the investment decision-making
  process.
• Compliance Once an individual becomes a CFA
  charterholder, he or she must comply with AIMRs
  conditions, requirements, policies and procedures
  of a CFA charterholder and AIMR member, including
  those set forth in the Code of Ethics and
  Standards of Professional Conduct.
• Education There is a voluntary professional
  development program that recommends 20 hours per
  year of qualifying education in investment and
  ethics programs at a level above the CFA exams.

7
Our Agenda Part I

• Return, Risk and Cost of Capital
• Cash Flow and Accounting Differences
• Revenue Recognition Channel Stuffing
• Minority Interests and Joint Ventures Impact on
  Debt Ratios
• Leasing Off Balance Sheet Debt Other Forms
  SPEs
• Stock Option Accounting Off-Balance Sheet
  Equity
• Pension Accounting Analyzing Pension Cost Today
  with regard to a Liability Tomorrow

8
Return and Risk

• In the financial world there is a relationship
  between return and risk.
• Everyone is familiar with returns
• S P 500 up 28.7 for 2003 (Capital gain and
  dividends)
• Lehman Brothers Aggregate Bond Index returned
  4.1 for 2003
• San Francisco Bay Area housing up 9.4for the
  twelve months ended November 2003

9
But What about Risk?

• In general, risk is uncertainty. However, there
  are certain types of
• risk
• Systematic Risk risks that affect a large
  number of assets, also known as market risk
• Uncertainties around inflation and interest
  rates tend to affect all investments and are
  systematic risk factors
• Unsystematic Risk risks that affect a single
  asset or small group of assets, also known as
  unique or asset-specific risks
• Loss of a government defense contract is an
  example of unsystematic risk it primarily
  affects that one company

10
And More Systematic Risk!!

• Operating Risk (of the firms equity) The risk
  associated with a firms operating activities
• High fixed cost, low margin firms tend to have
  more operating risk than low fixed cost, high
  margin businesses
• Financial Risk (of the firms equity) The risk
  associated with a firms use of debt financing
• As a firm begins to rely on debt financing, the
  risk to equity increases (and the required return
  on equity)
• While each firm has a specific business and
  financial risk profile, the risks are common to
  all businesses. As such, these are known as
  systematic risks.
• The total systematic risk of the firms equity
  is comprised of operating and financial risk.

11
How Do We Measure Risk?

• The risk of a project or investment can be
  evaluated in many ways. Some common quantitative
  methods include
• Standard deviation of returns
• Cash flow of projects and appreciation/(loss)
• Measures range of actual vs. average returns
• S P 500 has annual standard deviation of 14
  - based on average historical long-term return of
  11.5 this means that annual returns range from
  (2.5) to 25.5 (/- 14 from 11.5 average)
  two-thirds of the time
• Measure of volatility

12
Other Measures of Risk

• Downside Risk - How much can an investment
  decline in value?
• Often, the most important measure of risk for
  individual investors
• The 401K Plan statement risk the investor who
  didnt want to open his or her financial
  statements during the March 2000 October 2002
  bear market in equities
• Downside lower for investments such as
• Short-Intermediate term bonds (4.1 loss in
  1993-94)
• Un-leveraged residential real estate (14 down
  for LA in early 1990s)
• Small Company Value securities (31.8 loss in
  bear market compared to 48 decline for S P 500)

13
And More Types of Risk

• Businesses are subject to event risk, also. This
  is the risk of unexpected shocks to the economy
  including
• OPEC agreements that restrict the supply of oil
• Geopolitical events (war in Iraq)
• Strikes and labor unrest and severe weather
  conditions affecting crops
• Event risk tends to negatively impact the capital
  markets stocks and bonds
• There is a positive impact with commodity returns
• The nature of event risk is that surprises
  occurring in commodities markets tend to be those
  that unexpectedly reduce the supply of the
  commodity to market
• Event risk measured by skewness and kurtosis

14
Systematic Vs. Specific Risk

• Firm specific risk can be materially reduced by
  owning stocks in several different companies.
• Systematic risk can not be diversified away so
  easily.
• Since Firm specific risk can be easily
  diversified away, investors are not compensated
  for the amount of risk they take holding
  concentrated portfolios.

15
Bringing it Together Risk and Return

• The Security Market Line describes the
  relationship between systematic risk and expected
  return in the financial markets. Systematic risk
  is simply risk associated with investing in
  financial markets, in general.

16
The Security Market LineExpected Returns

• Expected tong-term annual returns for
  increasingly risky investments
• Asset Class Exp. Ann. Return
• 3 Month Treasuries (risk-free) 0.9
• 5 Year Treasuries 3.2
• Lehman Brothers Aggregate Bonds 4.6
• Diversified Pool of BBB (High Yield) Bonds
  7.4
• Diversified Pool of Office/Ind. Real Estate
  8.2
• Large Company U.S. Stocks 10.0
• Small Company U.S. Stocks 12.0
• Emerging Market Stocks 13.0
• Leveraged Managed Futures 16.0
• Diversified Pool of Venture Capital 20.5

17

18
Capital Asset Pricing Model

• The capital asset pricing model shows the
  expected return for a particular asset depends on
  three things
• The pure time value of money (as measured by
  risk-free rate)
• The reward for bearing systematic risk (the
  premium for bearing an average amount of risk)
• The amount of systematic risk (relative to an
  average asset)
• The relationship is as follows
• Expected Return of Asset i Risk-free rate
  (Expected Return of Market Risk-free rate)
  Sensitivity of Asset Returns to Market Returns

19
CAPM and Equity Cost of Capital

• The Capital Asset Pricing Model can help estimate
  a firms equity cost of capital
• All you need is a firms estimated Beta (or
  measure of sensitivity to the market or
  average asset)
• Assume the following information for CAPM
• Risk-free rate 4.13 (10 Year Treasury)
• Average risky asset has an expected annual return
  of 10 (large company U.S. stocks)
• General Electric stock has an estimated beta of
  1.106
• What is General Electrics Cost of Equity
  Capital?

20
General Electric Cost of Equity Capital

• 4.13 (10 - 4.13) 1.106
• 10.62

21
Weighted Average Cost of Capital

• A firms overall cost of capital is a weighted
  average of the costs of the various components of
  capital structure
• The value of a firm is maximized when the
  weighted average cost of capital (WACC) is
  minimized
• The typical components of capital structure are
  debt and equity (there are hybrid instruments,
  also)
• Debt is unusual in the respect that it has a tax
  shield that is, the interest on debt is tax
  deductible

22
The WACC of a firm is
(Equity/Enterprise Value) Cost of Equity
(Debt/Enterprise Value) (1 Tax Rate) Cost
of Debt
23
General Electrics Estimated Cost of Capital

• GEs capital structure is
• Total Short-Term Debt (9/30/03) 165B 19.1
• Total Long-Term Debt (9/30/03) 389B 45.0
• Total Equity (12/19/03) 310B 35.9
• Total Market Cap. (Debt Equity) 864B
  100.0
• Note Debt should technically be marked to
  market
• GEs cost of Short-Term Debt (2 Yr.
  Maturity) 1.87
• GEs cost of Long-Term Debt (10 Yr.
  Maturity) 4.69
• Cost of Equity (based on CAPM)
  10.62
• GEs WACC Cost of Short-Term Debt Cost of
  Long-Term Debt Cost of Equity ((19.1
  1.87) (45.0 4.69)) (1 35) (35.9
  10.62)
• 5.42 after taxes (assumes 35 tax rate)

24
What Does the WACC mean?

• Companies should only invest in projects if they
  exceed the WACC
• This is true whether acquiring a delivery truck,
  building a new store or buying entire company
• WACC is very sensitive to changes in interest
  rates hence, the power of the Fed
• As stock prices increase, the WACC goes down
  stock becomes currency (end of 1990s)
• WACC is also known as the hurdle rate (minimum
  return required on project investments)

25
Major Differences Between Accounting and Cash Flow

• Revenue Recognition Channel Stuffing
• Minority Interests and Joint Ventures Impact on
  Debt Ratios
• Leasing Off Balance Sheet Debt Other Forms
  SPEs
• Stock Option Accounting Off-Balance Sheet
  Equity
• Pension Accounting Analyzing Pension Cost Today
  with regard to a Liability Tomorrow

26
Partial and Controlling Acquisitions

• There is different accounting treatment for
  ownership in businesses depending on
• Degree of Ownership
• Level of Control or Influence
• Accounting Method Ownership Criterion
• Cost lt20 No significant influence
• Equity 20 50 Significant Influence
• Consolidation gt50 Control

27
Accounting Treatment

• Cost Method
• Investments in common, preferred shares and bonds
  of other companies held on books at cost as long
  as there is no significant influence
• Equity Method
• Ability to influence investee operations and
  strategic decisions. Investor recognizes
  proportionate share of income and net assets of
  investee
• Consolidation Method
• Ability to control the operations and strategic
  decisions of the firm. Account for all assets,
  liabilities, revenues and expenses on financial
  statements and back less than 100 in minority
  interest accounts

28
Major Differences Between Accounting and Cash Flow

• Revenue Recognition Channel Stuffing
• Minority Interests and Joint Ventures Impact on
  Debt Ratios
• Leasing Off Balance Sheet Debt Other Forms
  SPEs
• Stock Option Accounting Off-Balance Sheet
  Equity
• Pension Accounting Analyzing Pension Cost Today
  with regard to a Liability Tomorrow

29
Options Contract Preliminaries

• Intrinsic Value The difference between the
  exercise price of the option and the spot price
  of the underlying asset
• Time Value The value of the option as a result
  of remaining contract life and volatility of the
  underlying stock and interest rates

Option Value
Intrinsic Value
Time Value


30
Market Value of Call Option
Profit
ST
ST - E
Market Value
Time value
Intrinsic value
ST
E
Out-of-the-money
In-the-money
Loss
31
History of Stock Option Accounting

• APB 25 (enacted in 1972) and controversy of how
  to account for stock compensation has since
  continued
• Stock options were considered a cost only if the
  price of the stock was greater than the exercise
  price (or in the money)
• If not, then not reported, and hence, not an
  expense
• An effort was made in the mid-1990s to conform
  financial reporting to economic reality (now FASB
  123), but was refuted by the opposition ...
  mainly technology companies

32
History of Stock Option Accounting

• Technology companies argued that
• They could not attract top talent without sizable
  option awards to executives while disguising
  their true cost
• Stock options had no value and thus, had no cost
• The opposition forced FASB to compromise
• FASB 123 became optional
• Permitted use of APB 25 coupled with supplemental
  footnote disclosures
• Essentially no one was changing to FASB 123,
  until more recently

33
History of Stock Option Accounting

• FASB 123 designated as preferable GAAP for
  accounting for stock options (also mandatory by
  International Accounting Standards Board IASB)
• If an entity adopts FASB 123, it cannot revert to
  APB 25 for financial reporting purposes The
  entity must employ ONE set of rules for all stock
  compensation programs and plans in effect
• APB 25 Key Issue Stock Options are valued at
  Intrinsic Value
• Market Price less Cost (Strike) Price of the
  stock
• When difference gt 0, then expense recognized
• Time to Expiration Value not considered an
  expense

34
Stock Option Example MicrosoftThe New Economy

• From Footnote 15 Had compensation cost for
  the Companys stock option and employee stock
  purchase plans been determined as prescribed by
  FASB 123, pro forma income statements for 2000,
  2001, and 2002 would have been as follows

• Stock Option COMPENSATION impact growing on Net
  Income
• Difference in Net Income in 2000 1.3 billion
  (14 impact)
• Difference in Net Income in 2002 2.5 billion
  (32 impact)

35
Stock Option Example MicrosoftThe New Economy

• The weighted average Black-Scholes value of
  options granted under the stock options plans
  during 2000, 2001, and 2002 was 36.67, 29.31,
  and 31.57. Value was estimated using a weighted
  average expected life of 6.2 years in 2000, 6.4
  years in 2001, and 7.0 years in 2002, no
  dividends, volatility of .33 in 2000, .39 in
  2001, and .39 in 2002, and risk-free rate of
  6.2, 5.3 and 5.4 in 2000, 2001, and 2002.

36
If all companies used FASB 123

• If the nations 500 largest companies expensed
  the cost of the options, their annual profit
  growth from 1995-2000 (during the Tech Boom)
  would have been 6 instead of the 9 reported

37
Major Differences Between Accounting and Cash Flow

• Revenue Recognition Channel Stuffing
• Minority Interests and Joint Ventures Impact on
  Debt Ratios
• Leasing Off Balance Sheet Debt Other Forms
  SPEs
• Stock Option Accounting Off-Balance Sheet
  Equity
• Pension Accounting Analyzing Pension Cost Today
  with regard to a Liability Tomorrow

38
Components of Annual Pension Expense

• Service Cost increase in pension obligation due
  to employee services performed in the current
  year
• Interest Cost increase in pension obligation
  due to time value of money (uses an assumed
  discount rate)
• Expected Return on Plan Assets what the plan
  sponsors assume the long-term rate of return is
  for the plan portfolio

39
Standard Poors Core Earnings

• Standard Poors has attempted to set standards
  for earnings calculations that more accurately
  reflect the earnings generated by the ongoing and
  sustainable operations of a company. Certain
  items that are included and excluded from Core
  Earnings are
• Items included and excluded from Core Earnings
• Included
• Employee Stock Option Grant Expenses
• Restructuring Charges from Ongoing Operations
• Write-down of dep./amort. Operating assets
• Pension Costs
• Purchased R D Expenses
• Excluded
• Goodwill Impairment Charges
• Gains/(Losses) from Asset Sales
• Pensions Gains
• Unrealized Gains/(Losses) from hedging activities
• M A related expenses
• Litigation of ins. Settlements and proceeds

40
Our Agenda Part II

• Asset Valuation, Cash Flows and Discount Rates
• Asset/Entity Financing
• Merger Acquisition Waves
• Success of Mergers Acquisitions and Motivations
  Behind Them
• Review of CFO Magazine Articles

41
Asset Valuation, Cash Flows and Discount Rates

• The most important concept in finance is present
  value (and net present value)
• Present value is used to calculate the value of
  an asset or interest (in a company)
• Present value depends on expected cash flows
  discounted at the appropriate risk rate
  (remember cost of capital)
• The present value is calculated as follows
• The last cash flow includes proceeds from the
  terminal value of the asset. Cash flows are
  discounted for n periods representing the total
  time periods for the cash flows. Modifications
  to model can be made for infinite life constant
  growth of cash flows (often used in equity
  valuations)

42
Free Cash Flows To Firm

• Free cash flow to the firm (FCFF) are the sum of
  the cash flows to all claimholders in the firm
  including stockholders, bondholders, and
  preferred stockholders
• Two methods to calculate FCFF
• Free Cash Flows to Equity Interest Expense (1
  tax rate) Principal Repayments New Debt
  Issues Preferred Dividends
• Earnings Before Interest and Taxes (1 Tax Rate)
  Depreciation Capital Expenditures ?Working
  Capital
• The primary difference between Free Cash Flow to
  Equity and Free Cash Flow to the Firm are cash
  flows from debt and other non-equity claims
  (preferred dividends)

43
Free Cash Flows to Equity

• Free Cash Flows to Equity (FCFE) are used to
  value company equity (equity shareholder value)
  vs. the entire firm value under FCFF
• FCFE are the residual cash flows left over after
  meeting interest and principal payments and
  providing for capital expenditures to both
  maintain existing assets and create new assets
  for future growth
• FCFE Net Income Depreciation Capital
  Spending ?Working Capital Principal
  Repayments New Debt Issues
• The FCFE is a measure of what the firm can afford
  to pay out as dividends.

44
Valuation Examples

• Calculate the present value of a bond
• Assume a 30-Year U.S. Government bond has a
  coupon rate of 7.5 and the market rate is 7.75.
  The value of the bond at issue is
• Real estate is valued using the same methodology
• Assume an income-generating piece of real estate
  generates the following three years of cash flows
  (see following slide)
• Year 1 - 63,000 The sales price of the real
• Year 2 - 66,450 estate at the end of 3 years
• Year 3 - 70,085 is 778,717
• At an 11 discount rate, what is the value of
  the property?

45
Unleveraged Income Real Estate Value
46
Private Equity FCFE Valuation
47
Discounting FCFE

• In order to arrive at an estimated value of firm
  equity, we need to assume a discount rate
• Some factors to consider
• Relatively low margins
• Volatility of income stream
• Concentrated customer base (two customers account
  for 58 of revenues)
• Private firm (no immediate prospects of IPO)
• Modest financial leverage (5,000,000)
• The risk in firm equity is estimated at 17/year
  given these risk factors (See Security Market
  Line for comparisons)

48
Private Equity Valuation

• Under the FCFE valuation we estimate the
  sustainable cash flow to equities, discount it
  at the appropriate risk level and adjust for the
  long-term growth rate of the cash flows
• In this example, we have a 17 discount rate and
  approximately 8.5 annual increase in net income
• The value of the equity of the firm is
• (in thousands)
• Note Private equity firms differ from public
  firms in the lack of liquidity the lower
  liquidity either needs to be factored into the
  discount rate or the value of equity needs to be
  discounted for the illiquidity

49
Our Agenda Part II

• Asset Valuation, Cash Flows and Discount Rates
• Asset/Entity Financing
• Merger Acquisition Waves
• Success of Mergers Acquisitions and Motivations
  Behind Them
• Review of CFO Magazine Articles

50
Venture Capital Investments

• Main category of private equity investing
• Intent is to grow firm and go public or sell as
  exit strategy
• Institutional and wealthy investors access VC
  through limited partnerships
• Capital is committed and called in stages
• High percentage technology, biotechnology and
  health/life sciences applications

51
Venture Capital Stages of Investing

• Seed stage capital provided for a business idea
  product dev./market research
• Early stage companies moving into operations
  prior to manufacturing
• First stage capital to initiate commercial
  manufacturing and sales
• Second stage capital used for initial expansion
  of company already producing and selling a
  product
• Third stage capital provided for major
  expansion (physical plant, marketing, etc.)
• Mezzanine (bridge) financing capital provided
  to prepare for going public

52
Venture Capital Investing Continued

• Seed stage historically is least profitable
  (contradicts general risk/return tradeoff)
• Most venture capital investing done post-seed
  stage
• Return hurdle rates are 40 100/year on capital
  actually invested in companies
• Long-term venture returns to limited partners
  approximately 20.5/year (last 20 years)
• Difference between individual company targets and
  actual net return to investors accounts for
  failures and general partner operating expenses
  and incentive compensation

53
Venture Capital Raised by Year
54
Venture Capital Finance Basics

• Professionally managed venture capital primarily
  financed using participating preferred
  convertible stock (PPCS)
• PPCS is convertible stock where, under certain
  conditions, the holder receives both the return
  of the original investment and a share of
  companys equity
• Has liquidation and dividend priority over
  owners equity so owners maintain incentive to
  effectively add value to business
• Often has certain level of operational and
  strategic control (Board representation, ability
  to block mergers, set minimum prices for IPOs,
  have first rights on additional financing, etc.)

55
A well researched article does a good job showing
the important role that valuation can play in
bankruptcy proceedings.
56
(No Transcript)
57
(No Transcript)
58
(No Transcript)
59
(No Transcript)
60
Final Notes

• Theres no free lunch in investments returns
  are matched with risks
• Cash flow much more important than accounting net
  income challenge is to translate accounting to
  cash flow
• Maintain a healthy skepticism when evaluating
  financial transactions whether in real estate,
  venture capital, distressed debt or corporate
  mergers and acquisitions
• Dont be afraid to ask management what seems like
  a dumb question