Tuesday, July 28, 2009

Finally ,the third umpire has pressed the green light

I know it will happen..That was the amount of confidence I had in my own preparations...Finally CFA has announced it officially .I have cleared level 1 of CFA and I’m all set to think about the next level.
I understand that lot of my friends are going to take up CFA level 1 coming December...So I thought I could share some of my preparation strategies which might help them..
Start Early: There have been some exams during my engineering days which I will not be able to study completely even if I spend infinite number of hours...Because the subject would have been very difficult..But in CFA, there is no portion in the syllabus which you can classify as very difficult. The success or failure in CFA exam depends upon the amount of time you’ll be able to dedicate for this exam..Here is an approximate amount of time that you need to spend to prepare completely for the exam.

If you will complete term 4 and 5 at MBA/you are already a MBA degree holder and a major in fin before you take up the exam – 150-200 hours of preparation
If you have completed your year 1 of MBA – 250 hours of preparation is required
If you have not done the year 1 of MBA – At least 500 hours

Hence I would advise you to start early, so that you can adjust for unavoidable circumstances like the college exams or a critical deadline at office etc.
Every topic is important: You cant crack the exam by being a master in a particular area .. I have heard stories about people who had more than 5 years of experience in finance (say in corporate finance) and hence was overconfident that their scores in their area of strength can compensate for the other areas ..But that particular strategy has badly misfired.I would recommend you to concentrate on each and every topic.

Financial Statement and Analysis , Ethics : The two topics that could create the difference …FSA carries a lot of weightage(approximately 22%) and Ethics carries a weightage of 15% ..Now FSA is very important because it is difficult. If I can take the liberty to calling myself a veteran in this subject(my moment of stardom during my first year was because of this course) then even ‘I’ felt the area to be difficult and it needs immense amount of preparation..And regarding Ethics, you need to make sure you practice the situational questions a lot..Mere reading of the theory will not help..Make sure you have practiced at least 500 questions in ethics before you have reached the exam hall..The choices will be very close and differentiating them will be possible only if you have practiced.

Stick to Schewser : My personal take would be to stick completely to schewser notes . But make sure you understand every word of Schewser notes . Try to jot down your conceptual understanding/implications of concepts in your schewser material itself , so that it’ll help while revision . Some of my friends have completely read the 3000 page scary book sent by CFA institute . But you don’t have to read the books..But I would revoke my advise in case you think of doing a shallow reading of Schewser..I never touched the books but I would have been more thorough with the schewser material concepts than Schewser himself!!

Revision: The syllabus is heavy and it contains a lot of stuff. Hence you can tend to forget a lot of things..So keep at least a month for revision..And start practicing model papers which turned out to be very crucial for my preparation. Don’t skip derivatives, as the topic is very important for CFA Level 2...Also I would recommend you to maintain a formula sheet/concept sheet which you note down after you complete every study session. This will be very important before the day of the exam…

Wednesday, July 22, 2009

Devil's Advocate - An interview with Sam

This is a hypothetical situation wherein Sam , India’s best financial analyst and a firm believer in fundamental analysis(DCF valuation) is being interviewed in the Devil’s Advocate show by our own Karan Thapar..

After all the formal introduction about the guest is done , CNN IBN cameras now focus on the two persons in the closed room : Karan and Sam…

Karan : Sam …Do you think discounted cash flow valuations can work?

Sam : Why not?...(Usual stuff for about 15 seconds before Karan interrupts)

Karan : Then what is the reason you valued ‘Adani and Co’ at 2500 crore about an year ago and today you are valuing it at 600 crore..Are you factoring in the public sentiments..

Sam:(Like a typical guest who faces Karan thapar) : My valuation was not 2500 crore..Media had interpreted it wrongly.

Karan:(Takes out the report prepared by Sam an year ago and reads it for him)..So what does the last statement mean? Why have you reduced the value by 75% today

Sam:(Some usual stuff..not very convincing though)

Karan: Ok , Sam ..the critics of DCF point out that it is not possible to find a reasonable estimate beyond three-four years..But you seemed to have predicted a high growth cash flows till 15 years before assuming a stable period(terminal value)..How on earth can you predict the absolute cash flow for 15th year from today

Sam:Karan..But we had sufficient assumptions which justify the growth and the cash flows(Very unsatisfactory answer indeed…But that’s the way it happens when you are caught offguard)…

Karan : What do you think about the market? Are they driven by sentiments or are they driven by fundamentals…

Sam(Like a batsman who has been long waiting long for that one loose delivery …pounces upon this)………..So I would say its completely driven by fundamentals…Markets are efficient Karan!!

Karan(He never asks a question without a follow up..and here it comes precisely)..So how on earth will you justify the 2000 point rise of the market when the election results were announced and UPA was elected back to power…Were they sentiments or did the cash flows of the Indian companies as a whole change all of a sudden…Are you not making a strong statement when you say that markets can’t be driven by sentiments…

Sam(tries to save his face…justifies for about 30 seconds before karan interrupts again)

Karan: I want to interrupt you here Sam…But if you can’t justify everything through fundamentals then relative valuation seems to be a better choice for investors..Compare two companies based on their multiple ratios…That seems to be efficient, time saving and also easily interpretable…

Sam: But it can’t justify the real value of a company…If a sector is completely overvalued then you can’t really identify it…

Karan throws a couple more questions before shaking hands with Sam towards the end of the show…

Monday, July 13, 2009

Sam, I Can’t take any more of it….One more word, you are fired!!

Caution: Read till the end…

Scene 1: @IIML
Wow…..I’m amazed, Thrilled ...” I have got the best corp. fin role on the campus”...Placements this year has been fantastic and it parallels…parallels…No , I can’t remember a year where IIML had such an amazing placement with 575 offers on slot 0!!....

Scene 2: @ my firm
Thomas: Hey Vivek, This is Jagadeesh Balu and he is the new management trainee under you , he is a IIML pass out
Vivek: Hey Balu!! Welcome to the firm (“God, The culture of calling with the last name has again started….I’m not Balu…I’m Jagadeesh :)”)

Scene 3: @ My desk
Vivek: Here’s the model which you are going to work on …Estimate all the values and come up with an NPV for the project
Me: (After working with the model diligently for about couple of days ) : But Vivek…This model seems to contain some basic flaw..This is not apt to value a technology firm…This has been created for manufacturing firms..Lot of tinkering work needs to be done in order to work on this!!
Vivek : We know our model ..This model has been working perfectly all this time…Do as directed
Me : ???

Scene 4: Five years latter: @IIML campus, as a recruiter for finals
Me: So why do you want to join our firm??
Ravi: (Blah blah blh…)
(Some Q and A does not change over years and this was one such standard ‘q’..I got a standard answer)
Me : Good!!

Scene 5: At the corporate headquarters(A grp level meeting abt an acquisition) : My first meeting with CFO of the firm
Pete Sampras (CFO): The competition has intensified and unless we diversify ,our bottom lines are going to be under serious threat…Hence this decision of acquisition...ML has given us a acquisition price of $25 billion (By this year, the value of M and A deals by Indian firms has become very much comparable to the developed world)………………………………………………(He keeps on speaking for about 2 hours , half of which goes above my head and remaining 25% through my ears and the rest 25 somehow reaches my brain!!)….Any views gentleman
Me (I rephrased whatever the CFO said , jargonized whatever the CFO told ,took in some numbers to my help)…….and hence we are in for a great run after we acquire this firm…
Pete : (He would have definitely understood that I was beating around the bush) : Excellent!!

Scene 6 : Ten more years later , A grp level meeting abt an acquisition : My first meeting with a group head….(didn’t I mention??…I’m the CFO)
Me (CFO): Sam..I would love this company and would be ready to pay any price for this…
Sam: But Sir…Paying a premium of $2billion for such a stock might not make too much of a sense..(He starts quoting a lot of facts , numbers and his argument was more than convincing I would say)
Me: But I love this firm…Acquiring this firm will make us the topmost in the industry..(As a CFO , obviously I had much more data and numbers to justify my stance….Another half an hour of elaborate discussion)
Sam: This is not fair Sir…This is going to erode shareholder value..This seems to be a decision purely driven by ego
(Partially he was right….But his last response was so blunt and it hurt me a lot!!)
Me: Sam, I Can’t take any more of it….One more word , you are fired!!
Sam: (Keeps on continuing)
Me:Sam..Sam (My tempo starts rising)

I was shouting at the top of my voice but I could hear somewhere somebody yelling my name and this voice also seems to be increasing all the time…
There was also some music playing around me…
God Gosh…..MY ALARM!! How long has it been ringing…What is the time….I opened my room door …

Arun: Dei, How long will I be banging at your door …Its already 9.30 in the morning and you have Prof Vipul’s class at 9.45…You were telling you might be having a surprise quiz

Me : Coming back to my senses ……..Realizing that I’m in my room , I started to rush to the class not to miss the lecture of one of the best professors in the campus!!
The sad story of classes, quizzes, exams continue!!

Thursday, July 9, 2009

Cash in hand –The double edged Sword

Fifteen years back
Me: Mummy, I need ten Rupees to buy Cadbury Diary Milk…
Mom :( After series of questions and negotiations): Ok, I’ll give you five Rupees dear…

Me: Mom, I need five hundred Rupees (I haven’t mentioned why do I need it)
Mom :( Without any further questioning brings the money from the safe): Is five hundred enough or do you need more??

This analogy can be interpreted in different ways from a market perspective. This can be seen in the light of a startup company asking for funds and even though the business idea may be genuine the funds may be rejected and in the case of a big matured company investors fear to question the management. But in this article I would wish to see this from the perspective of the market perception of ‘cash in hand’ with some of the companies.

Before that I would wish to give you some technical background on this front. A company, out of its earnings every year, retains some of the amount for its reinvestment needs and gives out some of them as dividend. But company need not use the entire undistributed dividend for its reinvestment purpose. It can have some free cash in the balance sheet. We have a terminology in Valuation called as FCFE – Free cash flows to equity. Free cash flows to equity is the free cash available with the company after meeting every conceivable reinvestment needs .This is the potential dividend which can be given to the shareholders .(If you are so technically inclined , the formula for FCFE is Net Income – (Capex-Dep) – (Change in Non cash working capital) )*..
But companies don’t distribute the potential dividends every time. They distribute only 50-60% of this amount as dividends...What happens to the remaining amount...They get into the balance sheet of the companies as (excess) cash...This cash gets on piling up year after year...If you go and ask the CFO of a firm which is piling up such huge cash his response would be “We have strategic growth plans…We are looking for potential acquisitions.In a couple of years we may be needing this cash for that acquisition” or “(Assuming a non recessionary environment) – You never know, when will the economy be hit by recession..So we are basically saving it for the rainy day!!” – To certain extent the arguments could be justified and they are reasonable.

Now let us come to the main point of contention.When some firms have such a huge cash balance in their balance sheet, how do you value them...”Hey wait.Whats the big deal in valuing cash – Ten Rupees in cash is going to be valued as ten Rupees..What big deal about it”...Nope…, Assume that your company was giving you a returns of 15% in the past (In technical parlance ROE=15%)..You were also happy that you are earning good returns. But the company was piling up huge cash on its balance sheet by not giving dividends to the investors...After a few years, analysts start questioning the reason for pile up of such huge cash...Now the company to save its ego, acquires a totally unrelated business and the Strategy head gives a justification in terms of diversification of the business…Five years later, the company finds itself In a difficult position..The return of 15% has now reduced to 13% as the new business has started to erode shareholder value. The company finally realizes its mistake and divests that particular business…
Now the same company, if it starts piling up cash in the balance sheet, how is it going to be viewed by the investor..?Is he going to value that cash in the balance sheet at par value? He will not do..Right??.His reason for worry would be that ‘What If the company gets into another stupid diversification activity and loses that cash”...So in that case the cash in the hand will be viewed with skepticism and will be assigned a lower value in the market than its actual value …
Similarly if an investor observes a CISCO or Microsoft building up cash then it is going to have a positive effect as they know the cash will be utilized effectively…

Like the analogy of the son and mother that I started with, whether the investors attach a par value or above par or below par value to your cash in the balance sheet depends on the companies past credentials…”Markets are efficient dear!!”

*-Assuming completely equity funded company.

Friday, July 3, 2009

“This one is for you Prof”

Assume that you enter into a highly competitive environment, not sure of whether you belong to that place. Assume that there is a credible person, who takes pain to boost your morale in such a situation…Can you forget that person in life…My accounting professor ,the late Mr.Amanullah , is one such person who made me believe that i belong to that tough environment. He died a couple of days ago in a car accident, when he travelled from Delhi to Lucknow for a conference…

He managed to dedicate a majority of time for us in the first trimester..He handled quite a lot of additional sessions when students found accounting a hard nut to crack.And he was open to any doubts regarding the subject/personal counseling during any time…

This article is my humble dedication to you Prof…

When doing a Valuation, you need to do a lot of tinkering work in the Balance sheet before you can start using it. Here are some of them which are very crucial.Please bear in mind that Accounting was an area which was created for old age manufacturing companies. Though lot of accounting flexibility has been brought in for the new world companies, there are certainly some loopholes which can make the valuation totally different from the actual.Here are few of them.

R and D expense: When you deal with technology companies this is going to be a huge number.Technology companies classify Research and development activity as an expense. As per accounting norms expense should be matched with the benefit/revenue in the particular period. But the benefit of the R and D activity is going to accrue over a period through a breakthrough technology or a patent (in case of a pharma) or a new product in the market (FMCG).Hence this particular investment need not be expensed but has to be amortised over a period of time..The amortization period has to be in sync with the period over which the benefit is going to accrue. Same goes for advertising expense in the case of a marketing company whose spending is directed towards creating a brand.

Inventories /Depreciation policy: Be careful with the inventory/depreciation policy that the company follows..Companies could swing between different policies to make them look better under different situations .Basically a particular policy should economically justify the activity which they do. Delta Airlines extended its useful life in order to reduce its depreciation expense.As an analyst one should be sharp enough to observe this aberration (the industry was using a much lower useful life)..

Leases: Most of the FMCG/Airlines operate on leased assets .It makes a huge difference in terms of valuation whether you classify a lease as a financial lease or a operating lease..Most companies tend to classify their lease as a operating lease.This makes the impact of the lease item only to the income statement..But when we classify it as an financial lease then the there will be an asset/liability in the balance sheet and more often than not some of the crucial ratios like ROE, ROC are pulled down…

Underfunding of Pensions: Companies park a lot of their excess cash in pension accounts for the employees. Now the key thing to be noted is the interest rate earning assumption that the company has made for the Pensions. There could be an optimistic assumption regarding the interest rates .An analyst should observe the Pension interest rate assumption vis-à-vis other companies and need to adjust the balance sheet factor in a liability.

Onetime expenses/Divestures/restructuring expense: This item does not require any changes in the balance sheet/income statement as such.But while doing a valuation one needs to understand that this is not a recurring expense and need not be considered while valuation. Let me put in simple terms..Assume you bought a 10.Rs lottery and gained a crore out of it. Can you project this income over your life time.That is can you assume that you are going to invest 10.Rs year after year and you are going to earn 1 crore out of it.Distant possibility right…So in valuation we try to project only those items which are recurring in nature..Agreed that the above mentioned expense will be in tens of crores.But they are generally not considered because the value of a company will be in thousands of crores and one time activity of this magnitude will not affect the valuation of a company.

These are few of the accounting adjustments that need to be made before doing a valuation.If I could think of more, I’ll come up with another article on the same…

Me: Sir, I’m finding it hard to crack all other subjects except accounting
Mr.Amanullah: If you have cracked accounting, then certainly you have to be bright…You’ll definitely perform better in the other subjects as well.
True Prof, I was certainly bright…And you made me realize it!! I will not forget you in my life time…..