discounted cash flows

Valuation: Measuring and Managing the Value of Companies
by Tim Koller , McKinsey , Company Inc. , Marc Goedhart , David Wessels , Barbara Schwimmer and Franziska Manoury
Published 16 Aug 2015

This bias occurs because the method is only an approximation, not a formal mathematical relationship. Because of these inconsistencies, we recommend against discounting pretax cash flows at a pretax hurdle rate. ALTERNATIVES TO DISCOUNTED CASH FLOW To this point, the chapter has focused solely on discounted cash flow models. Two additional valuation techniques are using multiples of comparable companies and real options. ALTERNATIVES TO DISCOUNTED CASH FLOW 165 Multiples One simple way that investors and executives value companies is to value the company in relation to the value of other companies, similar to the way a real estate agent values a house by comparing it with similar houses that have recently sold.

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. + 1.11 (1.11)2 (1.11)3 (1.11)150 CV = $999 Next, use the growing-free-cash-flow (FCF) perpetuity formula: $50 0.11 − 0.06 CV = $1, 000 CV = 2 The sum of discounted cash flow will approach the perpetuity value as the forecast period is extended. In this example, a 75-year forecast period will capture 96.9 percent of the perpetuity value, whereas a 150-year forecast period will capture 99.9 percent. 262 ESTIMATING CONTINUING VALUE Finally, use the value driver formula: ( 0.06 $100 1 − 0.12 CV = 0.11 − 0.06 CV = $1, 000 ) All three approaches yield virtually the same result. (If we had carried out the discounted cash flow beyond 150 years, the result would have been the same.) Although the value driver formula and the growing-FCF perpetuity formula are technically equivalent, applying the FCF perpetuity formula is tricky, and it is easy to make a common conceptual error by ignoring the interdependence of free cash flow and growth.

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Since company values in emerging markets are often more volatile than values in developed markets, we recommend triangulating the scenario DCF results with two other valuations: one based on discounting cash flows developed in a business-as-usual projection but using a cost of capital that includes a country risk premium, and another valuation based on multiples. REVIEW QUESTIONS 729 REVIEW QUESTIONS 1. Define purchasing power parity. What is the importance of purchasing power parity when you are trying to establish value for a company located in an emerging market? 2. Identify four risks associated with emerging markets that affect enterprise discounted-cash-flow (DCF) valuation. How should these risks be treated within the enterprise DCF model?

Guide to business modelling
by John Tennent , Graham Friend and Economist Group
Published 15 Dec 2005

140–41 capital gains tax 258 cars 131 cash 198, 202 deficits 157 surpluses 154, 157 cash breakeven point 146 cash flow 13, 33, 60, 130, 130, 136, 141, 172, 189 adjusting 153 anticipated 151 cumulative project cash flow 152 and equity value 186 forecasts 70 free (FCF) 163, 173, 173, 180 net 146 operational 147, 152 projected 257 short time intervals 180 sign convention 176 statements 156, 157, 159, 161, 169 tax and 127, 174 timing 164, 176–7, 177 cash flow cycle 140, 140, 141, 141, 202, 202 causative techniques 85 cell comments 251–2 chart wizard button 53 check boxes 223–4 circular references 159, 211 COC see cost of capital coefficients 97, 100, 103 collinearity 105 colour scheme 67 column consistency 210 column widths 69 company acquisitions 146 company law 70 company valuation model 190–92 competition 4, 15, 257 compounding 182 computers crash 36, 39 purchase 131 CONCATENATE function 44–5, 50, 263–4 conceptual errors 206 conditional formatting 52–3 Consolidate box 37–8, 38 consumers credit 78 expenditure 14 spending patterns 88 consumption proportion 131 INDEX control toolbox 222 convertibles 149, 155 corporate decision-making 13 corporate planning pyramid 12–13, 12 corporation tax 163, 164, 167, 172, 174, 258 cost of capital (COC) 204, 205 costs 147, 172, 173, 257 capital 60, 117 drivers of 123–7 fixed 122–3, 122, 123 inflexible 125, 125 operating see operating costs COUNT IF function 47, 48, 48, 264 covenants 156 CPM see Critical Path Method credit agencies 151 credit controllers 123, 123 creditor days 145, 202 creditors 145, 145, 147 critical factors 15, 16, 17, 23, 29 Critical Path Method (CPM) 11 currency 14, 46, 46, 80, 168 current liabilities 147 customer segmentation 112–13, 113, 114 cyclical component 89 D data assumptions 6, 7 collection 6, 7, 8, 22–3, 24 labels 38, 54 scenarios 61 warehousing 8 data collection manager 9 data screens 240, 240, 241 DATA VALIDATION function 53 DCF analysis see discounted cash flow analysis de minimus rule 128 debentures 148 debt 147, 150, 151, 155, 157, 204 bad 160–63 doubtful 160–61 funders 155 funding 152 instruments 157, 157 net 155 debt to equity ratios 155–6, 156, 190 debtor days 142, 162, 202 debtors 142–3, 147, 160, 161 debugging see testing and debugging decision-making analysis 1 273 INDEX choice 2 corporate 13 implementation 2 defining the outputs 12–18 alignment with the business’s overall objectives 12–13 business model output checklist 18 creating an output template 16, 17 defining the outputs required to answer the question 13–14 establish the basics 14 model outputs and corporate decisionmaking 13 real versus nominal forecasts 14 specify the time frame and period length 13–14 identifying the critical factors that determine the outputs 15 running a workshop 17–18 demand 75, 107, 108 demand curve 87 downward-sloping 86, 87 demographic shifts 18 dependencies 258 dependency ranking 242–4 depreciation 33, 34, 46, 118, 128, 129, 187, 203 other depreciation methods 131 reducing balance 130, 130, 137, 137 straight line 129–30, 130, 132, 136, 136 development log 35, 38 dialog boxes 252 discount factor 191 discount rates 45, 180, 183 discounted cash flow analysis 172, 181, 185, 188 company valuation example 190–92 EBITDA exit multiples 189 growth rate models 188–9 terminal values 188 valuation range 190 discounted cash flow theory 179–82 discounted cash flows 34, 182–3 discounting 182 distribution 117, 133–4 divide by zero 51 dividend cover 204 dividends 147, 180 documenting the model documentation outside the model contents of a typical user’s guide 255 continuing user support 255 fit for the purpose 253 good document form design 253–4, 254 structure 254 training material 255 user’s documentation 254 documentation within the model 251–3 cell comments 251–2 dialog boxes 252 macro comments 252–3, 253 specific help software 252 text boxes 252 need for documentation 250 when to document 250 where to document 250–51 Du Pont 11, 199 dynamic effects 59 dynamic links the CONCATENATE function 44 multiple models 36–7 E earnings per share 204 EBITDA (earnings before interest, tax, depreciation and amortisation), multiples 187–8, 189, 190, 192, 203, 257 economic added value (EVA) 204 economy of scale 119, 120, 120, 175, 176, 200 Edit Links box 37, 37 endogenous variables 22 enterprise value (EV) 186, 188 environmental risk 249 equity 147, 150, 151, 155, 157, 204 equity value 186 Excel Scenario Manager 248 exchange rates 15, 53, 70, 150, 167, 168, 258 behaviour 80–81 definition and uses 80 modelling approach 81–3 seed 80 exit options 257 exit screens 239–40 exogenous variables 22 EXP function 264 extrapolation techniques 85 eyeball lines 55 F FIFO (first in first out) basis 139 file folder structure 36, 36 file-naming convention 35 finance calculations 34 financial performance 18 FIND 210–11 firm value 186 fixed asset turnover 201 274 fixed assets see under capital expenditure and working capital fixed costs see under operating costs fonts 67 for and next loops 234–6 FORECAST function 95, 95, 96 forecasting, revenue see revenue forecasting forecasts 13 nominal 14 real 14 foreign exchange calculations 167–70 generic approach to modelling foreign exchange gains and losses 168 modelling foreign exchange gains and losses on overseas financing 169–70, 170, 171 modelling foreign exchange gains and losses on overseas revenue and costs 169 principles of foreign exchange accounting 167–8 format painter 50–51 formatting 67–9 colours 67 column widths 69 fonts 67 lines 67, 68 macros 218–19 number styles 68 Forms toolbar 221–5 formula bar 41, 41 formulae, deconstructing complex 208–9, 209 free cash flow (FCF) 163, 173, 173, 180, 186, 191, 205 free-form development 32 FREEZE PANES command 229–30, 230 funding see modelling funding issues G Gantt chart 10, 11 GDP see gross domestic product gearing 155, 156, 190, 245 GO TO function 53 GOAL SEEK function 242–4 goal statement 18 Gordon Growth Model 189, 190, 192 graphs 53–8, 60, 261–2, 262 eyeball lines 55 fixed cost 122, 122 improving the appearance of 54 market value 129, 129 one graph suits all 55–8, 56 triangulation 126 variable costs 119, 119 INDEX gridlines 54 gross additions/connections 88, 93, 97, 97, 98, 98, 104 gross domestic product (GDP) 15, 76, 84, 189 behaviour 71–2 definition and uses 70–71 modelling approach 72–4 seed 71 group sheet function 39 growth 205, 258 GROWTH function 106 growth rate 45, 71, 72, 74, 74, 75 H hard coding 38, 60 hedging techniques 150 HELP function 51 hiding information 69 hyperlinks 226–7, 227 I IF function 45–6, 47, 51, 65, 73, 74, 77, 120, 145, 211, 223, 264 implementation 2, 6, 7, 9 income distribution 15 levels 15 INDEX function 46, 101, 103, 103, 104, 108, 264–5 inflation 14, 15, 53, 70, 75, 132, 258 inflation rate behaviour 75–6 definition and uses 75 modelling approach 76–7 seed 75 inflexible costs see under operating costs information, hiding 69 input sheets 59–65, 60, 61, 72, 72 input timelines 29, 29, 30, 31 inputs additional 29 alternative 22 analysis 23, 24 extreme 213 inflation 76, 76 seed 19 strategic 30 uncertainty/impact 23–4, 23, 25 validation 66 variables 6, 7 interest 147, 156, 180 interest calculations 157 interest costs 131 INDEX interest income and charges alternative approaches to modelling interest income 159–60, 159, 160 interest rate assumptions 158 issues in modelling interest income and charges 158 modelling interest income and circular references 158–9 interest rates 14, 15, 53 assumptions 158 base see base interest rates interface sheets 36 internal rate of return (IRR) 13, 172, 183–5, 183, 184, 245, 257 more than one 184–5, 185 investment commencement of 258 investment funding 203 net 157 overseas 150–51 reinvestment ratio 203 investment control 149 investor measures dividend cover 204 earnings per share 204 IRR see internal rate of return IRR function 265 ISDATE function 240 ISERROR function 46, 51, 211, 213, 265 ISSER function 265 J J curve 146, 146, 152, 154 joint ownership 149 judgmental techniques 85 L land residual value 132 leases 149 operating (rents) 147 LEN function 265 lending rates 152 leverage 155 lines, in formatting 67–8, 68 LINEST function 100–101, 101, 102, 103, 104, 108, 266 list box 224, 225 LN function 266 loans 149, 152, 156 losses 163, 165, 168 M macroeconomic factors 15, 70–84 275 base interest rates 78–80 exchange rates 80–83 gross domestic product 70–75 inflation rate 75–7 other macroeconomic variables 84 population 83–4 macroeconomic forecasts 8 macroeconomics 70 macros 216–21 calculation 233, 233 comments 252–3, 253 editing the macro code 218 macros for repeated tasks 218–21 creating a personalised toolbar 221 formatting macros 218–19 personal macros 218 protecting the model 219–21 Monte Carlo 245, 246 multiplication tables 234–6, 234, 235 print macro 231, 231 recording simple 216 running the macro 218 viewing macro code 216–17, 217 manual code review 208 market growth 15 market liberalisation 18 market size 15 market value 129, 129, 130, 132 mathematical operations 209–10 MAX function 45, 125, 135, 179, 196, 266 mean square error (MSE) 99 media 19 microeconomic variables 15 microeconomics 70 Microsoft Excel 2, 4, 37, 40, 50, 51, 53, 90, 106, 180, 183, 210, 216, 218, 227, 234, 235, 236, 237, 239 milestones 10, 258 MIN function 45, 139, 154, 196, 266–7 mission statement 18 mobile telecommunications industry bottom-down/top-up forecasting 88 critical factors 15, 16 decomposition of revenue 86 penetration 105, 106, 107, 109, 111, 111 product cycle life 106, 107 regression analysis 97, 106 segmentation 112 third-generation mobile data services 88 total revenue 115, 116 MOD function 50, 125, 134 model developer 9 model development process management 32–9 276 best practice in model development avoiding some common pitfalls 39 the basics of quality control 35–8 the model development process create workings pages for all main sections and develop calculations 33 develop the user interfaces and conduct user testing 34 set up output and input templates 33 test and debug 33 transfer results to output pages 33 a model development project plan 34 establishing a modelling charter 34 using material from the modeller’s library 34 populate input templates with base or test data 33 styles of development 32 free-form development 32 model layout 59–60, 59 model outputs 13, 17, 259–62 model ownership 35 modeller’s toolbox 40–58 naming sheets 40 range names 40–44 useful features conditional formatting 52–3 divide by zero 51 format painter 51–2 macros for repeated tasks 218–21 one graph suits all 55–8 shortcut keys 50–51 using graphs 53–5 useful functions AND and OR 46–7 AVERAGE 50 CONCATENATE 44–5 MIN, MAX or IF statements 45–6 MOD 50 OFFSET 49–50, 49 SUM IF and COUNT IF 47–9, 48 modelling funding issues 146–57 cost of funding 151–2 debt to equity ratios 155–6, 156 funding strips 152–4 identifying the cash flow to be funded 147 operating environment 150–51 project control 149–50 putting the funding cost back in the model 156–7 balance sheet 157 cash flow statement 157 profit and loss account 156–7, 157 INDEX time periods 154–5, 154 types of funding 147–9 weighted average cost of capital 152 modularisation 63 Monte Carlo analysis 245–8 moving average 90, 91, 92 MSE see mean square error multiplicative model 96 multiple models and dynamic links 36–7 multiple regression 85, 87, 101–4, 102, 103, 104, 105 N naming sheets 40 navigation see under spreadsheet applications NCF see net cash flow net book value 130, 138, 139, 140, 140 net cash flow (NCF) 182 net debt 155 net operating profit after tax 204 net present value (NPV) 13, 172, 179, 182, 183, 184, 184, 189, 190, 194, 242, 243, 245, 257 nominal forecasts 14 NPV see net present value NPV function 267 number styles 68–9 numbers for an output 4 negative 4 within a formula 4 O OFFSET function 49–50, 49, 57, 119, 125, 134, 135, 138, 224, 248, 267 operating costs 29, 31, 60, 117–27, 161 completeness of operating costs 117, 117–18 cost behaviour 118 drivers of costs 123–7 inflation 126–7 inflexible costs 125, 125 tax 127 triangulation 126, 126 fixed costs 122–3, 122, 123, 125, 126, 200 variable costs 118–22 operating environment 19, 149, 150–51 operating profit 186 operational risk 248, 249 options 148 OR function 46–7, 267–8 ordinary shares 148 output sheets 33, 60, 63, 63, 64, 248 output template 16, 17, 18 277 INDEX outputs 6, 7, 23, 29 presenting model 259–62 overdrafts 149 overheads, allocated 175 overseas investments 150–51 P P/E ratios 186–7, 188 packaging 117 payback 172, 177–9, 245, 257 payroll cost 126, 203 PBT see profit before tax PED see price elasticity of demand penetration 105, 106, 107–12, 109, 114, 115 total 114 period ends 14 period length 14 PERT (Performance Evaluation and Review Technique) 10–11 PEST analysis 21 plant residual value 131–2 utilisation 258 PLC see product life cycle population 70 behaviour 83 definition and uses 83 growth 15 modelling approach 83–4 seed 83 post-project review 6, 7 PPP see purchasing power parity preference shares 148 prepayments 141, 141, 142 present value 182 price elasticity of demand (PED) 86–7, 87, 115 prices constant 14 fall in 4 print ranges 231 probability models 19 product life cycle (PLC) 106, 107, 107, 189 product prices 53 profit and loss 33, 60, 164, 257 profit and loss account 129, 141, 143, 156–7, 157, 161, 162, 163, 167, 169, 173 profit before tax (PBT) 181 profit flow 172 profit margin 199–200 profits 14 operating 186 programming techniques with Visual Basic 232–6 project appraisal and company valuation 172–92 conventions for setting out the cash flows 176–7 sign convention 176 timing 176–7, 177 discounted cash flow theory 179–82 calculating the discount rate 180 calculating the WACC 181 dicounted cash flow decision rule 182 discount rate 180 risk premium 179 short time intervals 180 time value of money 179 discounting cash flows in practice 182–3 evaluating companies 185–92 techniques for valuing companies 186–8 using DCF analysis in practice to value companies 188–92 identifying the relevant project cash flows 172–6 the cash effect of change 174–5 dealing with allocated overheads 175 group versus project 176 relevant costs and capital expenditure 174 relevant revenues 174 relevant taxes 174, 174 internal rate of return 183–5, 183, 184 more than one IRR 184–5, 184 payback 177–9 project appraisal and valuation techniques 172 project control 149–50 project manager 8, 9, 10 Project Plan see under business modelling process property space requirement 123, 124, 124 utilisation of 258 protecting the model see under spreadsheet applications purchase, timing of 132 purchase cost 131 purchase tax 127 purchasing power parity (PPP) 80, 81 R R2 value 97, 98, 102 radio (option) buttons 222–3, 223 range names 4, 40–44, 158, 159, 164, 191 accessing the named inputs and rows 44 common range names 43–4 defining several individual names 42, 42 278 naming one cell 41 naming one cell where the cell name is displayed to the left of reference value 41, 41 naming several values at once 42–3, 42 naming whole rows 43 range test the model 212–13 RANK function 268 ratios 60 the Du Pont pyramid of ratios 199–203 balance sheet management 201–2 further analysis 202–3 percentage of sales measures 201 profit margin and asset turnover 199–201 external analysis 194 internal analysis 194–5 internal ratio analysis 195 interpreting 196–7 average 196 high and low values 196 rank 196 useful ratios to calculate return on average capital employed (ROACE) 198 return on equity (ROE) 199 return on net assets (RONA) 197–8, 198, 199, 200, 201, 204 real forecasts 14 recalculation 69 reducing balance 130, 130 regression equation 98, 98 regression techniques see under revenue forecasting regulatory environment 70 rents 147 replicating actual results 212 report style 259 research agencies 8, 70 residual (“disturbance”) component 89 residual value 132 retail price index 75 return on average capital employed (ROACE) 198 return on capital employed (ROCE) 242, 243, 245, 257 return on equity (ROE) 199 return on net assets (RONA) 197–8, 198, 199, 200, 201, 204 return on sales (ROS) 257 revenue 14, 30, 53, 60, 64, 117, 147, 172, 173 decomposition 86 derivation of 29 total 86, 115–16, 116 INDEX revenue forecasting 14, 85–116 approaches to bottom-up versus top-down forecasting 87–8 classification of forecasting methodologies 85 decomposition of revenue 86 price elasticity of demand 86–7, 87 time frame 88 long-term forecasting 105–11 fitting a product life cycle curve 107–11 the product life cycle 107, 107 regression techniques 96–105 estimating the coefficients 97–9, 97, 98 forecasting using the TREND function 100, 100 limitations of regression analysis 105 the LINEST function 100–101, 101 multiple regression 101–4, 102, 103, 104, 105 regression analysis 96–7 the TREND function 99, 100 segmentation 112–16 business segment 114–15, 114, 115 consumer segment 112–13, 113, 114 mix effects 116 total revenue 115–16, 116 time series analysis 85, 87, 88–96 additive and multiplicative models 89–90, 90 components of a time series 89 estimating the trend and seasonal factors manually 91–4, 92, 93, 94 estimating the trend using the built-in moving average function 90–91, 91 forecasting using the trend, seasonal factors and the additive model 94–5, 95 limitations of time series analysis 96 the multiplicative model 96 time series data 88, 89 revenue multiples 188 revenue tax 163 ripple effect 51 risk 149, 150, 151, 155 assumption 248, 249 commercial 257 environmental 249 operational 248, 249 premium 179 ROACE see return on average capital employed ROCE see return on capital employed ROE see return on equity RONA see return on net assets INDEX ROS see return on sales ROUND function 154, 268 rounding 65–6, 65, 66, 259 ROUNDOWN function 268 ROUNDUP function 123, 133, 268 row consistency 210 rows versus columns 261, 261 S sales forecast 55 tax 127, 163–4 saving the model regularly 36 scenario development 25–31 scenario planning benefits 20 the development of 20 stage 1: identifying high impact, highly uncertain inputs 20, 21–4 stage 2: identify alternative development paths for key inputs 20, 25–6, 25–6 stage 3: select the three or four most informative scenarios 20, 26–8, 27 stage 4: develop the scenario stories 20, 28–30 stage 5: develop the business strategy 20, 30 scenarios 20 scheduling 258 scroll bars 225, 225 seasonal component 89 seasonal factors 89–90, 90, 91, 93, 94, 94, 96 seed 19, 60, 62, 71, 75, 78, 80, 83 segmentation see under revenue forecasting sensitivity analysis 147, 241–2, 241 shareholder value 193–5, 194, 199 ratio analysis 194–5 short period rate 180 shortcut keys 50–51 sign convention 66, 176 simple modified exponential trend curve 108 SIN function 268–9 SINE curve 71, 76 SMART goals 9 social trends 70 socio-economic shifts 18 specific help software 252 spin buttons 225 splash screens 237–9, 238 spreadsheet applications appearance consistency 229 freezing the screens 229–30, 230 placement of macro buttons 230 279 removing the gridlines 230 simple layout 229 basic programming techniques with Visual Basic 232–6 Forms toolbar 221–5 navigation attaching a macro to a button 228–9, 229 basic navigation 226 creating a menu using Visual Basic 227–8, 227, 228 hyperlinks 226–7, 227 recording simple macros 216 viewing macro code 216–17, 217 printing 231 creating a print macro 231, 231 setting print ranges 231 protecting the model 219–21 spreadsheet functions 263–70 spreadsheets 2, 11 advantages and disadvantages of using 3 and model ownership 35 see also input sheets; output sheets; working sheets start of trade 133, 258 stock 143–4, 144, 202 stock days 143, 144, 202 strategic plan 12, 18, 31 style and outline 59–69 alternative model layout 63–4 formatting 67–9 colours 67 column width 69 fonts 67 lines 67–8, 68 number styles 68–9 making the model intelligible 64 making range names work 64–5, 64 model layout 59–60 recalculation 69 retaining consistent logic by having the same formulae every year 65 rounding to invisible 65–6, 65, 66 sheet layout: inputs 60–61, 60, 61 sheet layout: outputs 63, 63 sheet layout: working 61–2 sign convention 66 some things to avoid, recalculation 69 things to avoid, hiding information 69 sum of the digits 131 SUM function 269 SUM IF function 47–8, 48, 269 supply chain 176 280 SWOT (strengths, weaknesses, opportunities and threats) analysis 257 synergy 176 T tables of data 259–61, 260 tactical plans 18 tasks 10 tax shield on financing 181 taxation 33, 34, 127, 173, 258 the challenges of modelling taxation 163 forms of taxation 163–4, 163 generic approach to corporation taxation workings 164–5, 165, 166–7 technical errors 206 technical obsolescence 131 technological change 70 templates 11, 13, 16, 17, 33 terminal value 14, 189, 258 testing and debugging 33, 34, 206–15 the importance of 206 testing strategy 207–15 step 1: eliminate technical and conceptual flaws 208–12, 214 step 2: range test the model 212–13, 215 step 3: stress test the model 213, 215 step 4: user testing 214, 215 types of errors conceptual errors 206 technical errors 206 user errors 206 text boxes 252 third-party forecasts 70 tick box 43, 43 time frame 13–14, 88 time periods 154–5, 154 time series analysis see under revenue forecasting time value of money 179 top-down forecasting 87–8 total revenue 86, 115–16, 116 trace error button 51 transport trends 15 trend curves, exponential, Gompertz and Logistic 108 TREND function 99, 100, 101, 105, 269 trend see under revenue forecasting trendline 55 regression 98 triangulation 126, 126 U uncertainty, scenario planning and model inputs 19–24 INDEX business model input checklist 24 defining the inputs 19 examining different approaches to uncertainty 19 scenario-based forecasting approach 20 stages of a scenario-based forecasting approach 20, 20 stage 1: identifying high impact, highly uncertain inputs 21–4 analyse variables according to uncertainty and impact 23–4, 23 identify all the variables that influence the business 21–2, 21 identifying the relationships between variables 22 review the data collection requirements 22–3 understanding the nature of uncertainty 19 uncertainty/impact matrix 23–4, 23, 24, 25, 29 units 14 upper asymptote 107, 108, 108 urbanisation 15 useful economic life 131 users documentation 254 errors 206 interfaces 34 support, continuing 255 testing 214 using the model 241–9 dependency ranking 242–4 displaying the assumption dataset on the output sheet 248 Excel Scenario Manager 248 GOAL SEEK 242–4 Monte Carlo analysis 245–8 risk and its management 248–9 sensitivity analysis 241–2 V valuation 60 see also project appraisal and company valuation valuation approaches see project appraisal and company valuation valuation range 190 value-added tax 127 variable costs see under operating costs variables 21–2, 21 dependent 96 endogenous 22 exogenous 22 281 INDEX independent (explanatory) 96–7, 100 uncertainty/impact 23–4, 23 variance analyses 13 version control 35 versions of the model, retaining 35–6 vertical analysis 201 vision statement 18 Visual Basic 216, 232–6 Visual Basic Editor 216–17, 217, 218, 240 VLOOKUP function 121, 122, 269–70 W WACC see weighted average cost of capital warrants 148 warranty 118 weighted average cost of capital (WACC) 152, 167, 180, 181, 190 wind-farm operators critical factors for 15, 16 develop the scenario stories 28–30, 29 Gantt chart 10, 11 impact/uncertainty matrix 23–4, 23 input timelines 29, 29 output template 17 potential input development paths 25–6, 25–6 revenue model 29–30 strategic inputs 30 variables influencing 21, 22 withholding tax 258 working capital see under capital expenditure and working capital working capital turnover 201–2 working sheets 60–5 workshops 17–18 writing and presenting the business plan key issues to address in a business plan 256 presenting the model outputs 259–62 graphs 261, 262 rounding 259 rows versus columns 261 tables of data 259–60 report style 259 typical content of a business plan document assumptions 257–8 commercial risk 257 economic 258 executive summary 257 financial 257 manning 258 market 257 milestones 258 safety, health and environment 258 sensitivity 258 strategic importance 257 taxes 258 technical 258 Z zero, set all inputs to 211 zero book value 136 

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It fails to consider cash flows beyond the payback period (for example, the project could make $2,000,000 in year 6 and its payback would still be 2 years 4 months), and therefore says nothing about the scale of the project. It also ignores the time value of money, which is explained in the next section. However, it remains one of the most popular project appraisal techniques used by companies. DISCOUNTED CASH FLOW THEORY Typical projects normally involve a sequence of cash outflows followed by a sequence of cash inflows. Discounted cash flow or dcf analysis calculates the net cash flow as if all the future cash outflows and inflows occurred simultaneously at the same point in time, which is normally the first day of the project. The result is called the net present value or npv.

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This average is based on a weighted average cost of capital or wacc calculation. 181 Discounted cash flow theory Calculating the WACC In order to calculate the wacc a number of assumptions need to be made:      A is the proportion of the project financed by equity E is the cost of equity in nominal terms B is the proportion of the project financed by debt R is the cost of debt in nominal terms T is the tax rate If the cost of equity is the discount rate that would be used to discount the cash flows only to equity holders and the cost of debt is the discount rate used to discount cash flows only to debt holders, the wacc would be written as: WACC⫽(A*E)⫹(B*R*(1⫺T)) The important element of the equation to examine is the cost of debt.

What's Your Future Worth?: Using Present Value to Make Better Decisions
by Peter Neuwirth
Published 2 Mar 2015

In fact, managers at many companies—particularly if they have an MBA—would say that almost all important decisions a company makes utilize Present Value, only they call it the “discounted cash flow method.”39 It’s true that, superficially, the mechanics of the discounted cash flow method and Present Value thinking are quite similar, but in fact there are some subtle—but very important—differences. For one thing, the discounted cash flow method generally focuses on just the “high likelihood” scenarios, while in Present Value thinking we try to imagine all the possibilities, recognizing that low likelihood/high impact possibilities can be very important.

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Nassim Taleb calls these possibilities “Black Swan” events and suggests that such “impossible to predict” scenarios are the ones that ultimately change our lives in the most important ways.40 While I agree with Taleb that these scenarios are impossible to predict, I don’t think they are impossible to imagine. That is why step 2 is so critical to Present Value thinking, a step that is usually given little attention in discounted cash flow analysis. In addition to the above, discounted cash flow models typically only consider financial/measurable factors, while Present Value takes into account non-financial items. Furthermore, discounted cash flow models take a pure “foregone investment” or “cost of capital” approach to setting a discount rate. We have seen before that for individuals, non-financial factors can be extremely important, and setting a discount rate only based on “foregone investments” ignores the way we as individuals inherently value things today versus the value we place on future consequences.

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The shape of possible future scenarios stemming from the choice that an organization makes may be similar to that facing an individual, but since the effects are felt by more people to varying degrees, determining the “value” of each of those scenarios is more complex, and that value will vary considerably by virtue of the various stakeholders in the decision. To illustrate that complexity and the distinction between Present Value and “discounted cash flow” analysis for an organization, I want to look at a set of decisions that are being made across the country right now around an issue that is both vitally important to many people’s future and one that I believe is a textbook example of how the failure to utilize Present Value in the right way can lead to disaster.

Investment Banking: Valuation, Leveraged Buyouts, and Mergers and Acquisitions
by Joshua Rosenbaum , Joshua Pearl and Joseph R. Perella
Published 18 May 2009

BENCHMARK THE COMPARABLE ACQUISITIONS STEP V. DETERMINE VALUATION KEY PROS AND CONS ILLUSTRATIVE PRECEDENT TRANSACTION ANALYSIS FOR VALUECO CHAPTER 3 - Discounted Cash Flow Analysis STEP I. STUDY THE TARGET AND DETERMINE KEY PERFORMANCE DRIVERS STEP II. PROJECT FREE CASH FLOW STEP III. CALCULATE WEIGHTED AVERAGE COST OF CAPITAL STEP IV. DETERMINE TERMINAL VALUE STEP V. CALCULATE PRESENT VALUE AND DETERMINE VALUATION KEY PROS AND CONS ILLUSTRATIVE DISCOUNTED CASH FLOW ANALYSIS FOR VALUECO PART Two - Leveraged Buyouts CHAPTER 4 - Leveraged Buyouts KEY PARTICIPANTS CHARACTERISTICS OF A STRONG LBO CANDIDATE ECONOMICS OF LBOs PRIMARY EXIT/MONETIZATION STRATEGIES LBO FINANCING: STRUCTURE LBO FINANCING: PRIMARY SOURCES LBO FINANCING: SELECTED KEY TERMS CHAPTER 5 - LBO Analysis Financing Structure Valuation STEP I.

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As a general rule, the most recent transactions (i.e., those that have occurred within the previous two to three years) are the most relevant as they likely took place under similar market conditions to the contemplated transaction. Potential buyers and sellers look closely at the multiples that have been paid for comparable acquisitions. As a result, bankers and investment professionals are expected to know the transaction multiples for their sector focus areas. Chapter 3: Discounted Cash Flow Analysis Chapter 3 discusses discounted cash flow analysis (“DCF analysis” or the “DCF”), a fundamental valuation methodology broadly used by investment bankers, corporate officers, academics, investors, and other finance professionals. The DCF has a wide range of applications, including valuation for various M&A situations, IPOs, restructurings, and investment decisions.

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As shown in the football field in Exhibit 2.37, the valuation range derived from precedent transactions is relatively consistent with that derived from comparable companies. The slight premium to comparable companies can be attributed to the premiums paid in M&A transactions. EXHIBIT 2.37 ValueCo Football Field Displaying Comparable Companies and Precedent Transactions CHAPTER 3 Discounted Cash Flow Analysis Discounted cash flow analysis (“DCF analysis” or the “DCF”) is a fundamental valuation methodology broadly used by investment bankers, corporate officers, university professors, investors, and other finance professionals. It is premised on the principle that the value of a company, division, business, or collection of assets (“target”) can be derived from the present value of its projected free cash flow (FCF).

The Dhandho Investor: The Low-Risk Value Method to High Returns
by Mohnish Pabrai
Published 17 May 2009

We also have the formula to figure out what these businesses are worth. It is simple. Table 7.1 Discounted Cash Flow (DCF) Analysis of the Gas Station Year Free Cash Flow ($) Present Value ($) of Future Cash Flow (10%) 2007 100,000 90,909 2008 100,000 82,645 2009 100,000 75,131 2010 100,000 68,301 2011 100,000 62,092 2012 100,000 56,447 2013 100,000 51,315 2014 100,000 46,650 2015 100,000 42,410 2016 100,000 38,554 2017 Sale Price 400,000 154,217 Total 768,671 Table 7.2 Discounted Cash Flow (DCF) Analysis of the 10 Percent Yielding Low-Risk Alternative Year Free Cash Flow ($) Present Value ($) of Future Cash Flow 2007 50,000 45,454 2008 50,000 41,322 2009 50,000 37,566 2010 50,000 34,151 2011 50,000 31,046 2012 50,000 28,224 2013 50,000 25,658 2014 50,000 23,325 2015 50,000 21,205 2016 50,000 17,277 2017 Capital returned 500,000 192,772 Total 500,000 When we see a huge gap between the price and intrinsic value of a given business—and that gap is in our favor—we can act and buy that business.

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Let’s assume this continues for just 10 years and the business is sold for the same price as it was bought ($50,000). This is like a bond that pays 300 percent interest a year with a final interest payment in year 10 of 900 percent. This equates to a 21 bagger—an annualized return of well over 50 percent for 10 years. Assuming a 10 percent discount rate, the discounted cash flow (DCF) stream is shown in Table 1.1. Second, the economy goes into a severe recession and business plummets for several years. The bank works with Mr. Patel and renegotiates loan terms as described earlier. Mr. Patel has a zero return on his investment for five years and then starts making $10,000 a year in excess free cash flow when the economy recovers and booms (200 percent return every year after five years).

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The motel is sold in year 10 for the purchase price. Now we have a bond that pays zero interest for five years, then 200 percent for five years, and a final interest payment of 900 percent (see Table 1.2). This equates to a seven bagger—an annualized return of over 40 percent for 10 years. Table 1.1 Discounted Cash Flow (DCF) Analysis of the Best Case for Papa Patel Year Free Cash Flow ($) Present Value ($) of Future Cash Flow Excess cash 0 1 15,000 13,636 2 15,000 12,397 3 15,000 11,270 4 15,000 10,245 5 15,000 9,314 6 15,000 8,467 7 15,000 7,697 8 15,000 6,998 9 15,000 6,361 10 15,000 5,783 10 Sale price 50,000 19,277 Total 111,445 Third, the economy goes into a severe recession and business plummets.

The Investopedia Guide to Wall Speak: The Terms You Need to Know to Talk Like Cramer, Think Like Soros, and Buy Like Buffett
by Jack (edited By) Guinan
Published 27 Jul 2009

Assuming a discount rate of 10%, the The Investopedia Guide to Wall Speak 77 $1,000 in a year’s time would be the equivalent of $909.09 to you today (1,000/[1.00 + 0.10]). Related Terms: • Federal Funds Rate • Federal Open Market Committee • Monetary Policy • Interest Rate • Prime Rate Discounted Cash Flow (DCF) What Does Discounted Cash Flow (DCF) Mean? A valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them (most often by using the weighted average cost of capital method) to arrive at a present value, which is used to evaluate the investment’s potential.

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There are two main deficiencies with the payback period method: (1) It ignores any benefits that occur after the payback period and therefore does not measure profitability. (2) It ignores the time value of money. Because of these factors, other methods of capital budgeting, such as net present value, internal rate of return, and discounted cash flow, generally are preferred. Related Terms: • Cost of Capital • Internal Rate of Return—IRR • Return on Investment • Discounted Cash Flow—DCF • Opportunity Cost 222 The Investopedia Guide to Wall Speak Penny Stock What Does Penny Stock Mean? A stock that trades at a very low share price and market capitalization; usually it trades off a major market exchange.

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If a person or business does not have enough cash to support its operations, it is said to be insolvent and a likely candidate for bankruptcy if the insolvency continues. (2) The statement of a business’s cash flows often is used by analysts to gauge the business’s financial performance. Companies with ample cash flow are able to invest the cash back into the business to generate more cash and profit. Related Terms: • Cash Conversion Cycle—CCC • Discounted Cash Flow—DCF • Net Income—NI • Cash Flow Statement • Free Cash Flow—FCF Cash Flow Statement What Does Cash Flow Statement Mean? One of the quarterly financial reports a publicly traded company is required to disclose to the SEC and the public. It provides aggregate data regarding all cash inflows a company receives from both its ongoing operations and its external investment sources as well as all cash outflows that pay for business activities and investments during a specified quarter.

Warren Buffett Accounting Book: Reading Financial Statements for Value Investing (Warren Buffett's 3 Favorite Books)
by Stig Brodersen and Preston Pysh
Published 30 Apr 2014

The first calculation is called a discount cash flow calculation. The second calculation is a variant of the discount cash flow calculation and it values stocks similarly to fixed income bonds. Although both approaches might sound a little confusing, there’s no need to worry—we’ll go step by step and provide examples on the following pages. It is important to understand that every valuation technique can be boiled down to one thing: “How much money can I expect to get in return for my initial investment?” The Discount Cash Flow (DCF) Intrinsic Value Model Let’s start with the “discount cash flow” model. It consists of just six steps.

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For the next model, you’ll find that its core mathematics is based on a bond valuation formula that has been converted into a discount cash flow model for stocks. The specifics of the calculation can be found in the Appendix of this book. Since the math for this valuation technique can be a little cumbersome, I’ve tried to keep the description of the process simple in this portion of the book. Additionally, you can find this calculator on the BuffettsBooks.com website along with a video tutorial. Before using this calculator, I want to strongly emphasize the importance of finding stable and predictable companies (Principle 3). Like the discount cash flow model, without using a company that generally has predictable earnings and actions, you’ll find the calculator becomes less useful.

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Overview of steps Estimate the free cash flow Estimate the discount factor Calculate the discounted value of free cash flow for ten years Calculate the discounted perpetuity free cash flow (beyond ten years) Calculate the intrinsic value Calculate the intrinsic value per share Assumptions Current free cash flow: $1,000 The first ten years’ annual growth rate of the free cash flow: 6% Discount rate: 10% Long-term growth rate: 3% Shares outstanding: 1,000 Before we go through the first step, I want to highlight that a discount cash flow calculator is provided at BuffettsBooks.com. The calculator goes through the steps you’re about to learn. On the website, there is also an instructional video that you can watch to help complement the reading. If you would like to access the calculator and the video, the Web address is: http://www.buffettsbooks.com/security-analysis/intrinsic-value-calculator-dcf.html So let’s get started with the first step. 1.

Principles of Corporate Finance
by Richard A. Brealey , Stewart C. Myers and Franklin Allen
Published 15 Feb 2014

/Inflation and Nominal Interest Rates 3-6 The Risk of Default Corporate Bonds and Default Risk/Sovereign Bonds and Default Risk Summary Further Reading Problem Sets Finance on the Web 4 The Value of Common Stocks 4-1 How Common Stocks Are Traded Trading Results for GE 4-2 How Common Stocks Are Valued Valuation by Comparables/Stock Prices and Dividends 4-3 Estimating the Cost of Equity Capital Using the DCF Model to Set Gas and Electricity Prices/Dangers Lurk in Constant-Growth Formulas 4-4 The Link Between Stock Price and Earnings per Share Calculating the Present Value of Growth Opportunities for Fledgling Electronics 4-5 Valuing a Business by Discounted Cash Flow Valuing the Concatenator Business/Valuation Format/Estimating Horizon Value/ A Further Reality Check/Free Cash Flow, Dividends, and Repurchases Summary Problem Sets Finance on the Web Mini-Case: Bok Sports 5 Net Present Value and Other Investment Criteria 5-1 A Review of the Basics Net Present Value’s Competitors/Three Points to Remember about NPV/NPV Depends on Cash Flow, Not on Book Returns 5-2 Payback Discounted Payback 5-3 Internal (or Discounted-Cash-Flow) Rate of Return Calculating the IRR/The IRR Rule/Pitfall 1— Lending or Borrowing?

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In this case, instead of using the annually compounded rate of 10%, we must use the continuously compounded rate of r = 9.53% (e.0953 = 1.10). Therefore, to cover a steady stream of expenditure, you need to set aside the following sum:10 USEFUL SPREADSHEET FUNCTIONS ● ● ● ● ● Discounting Cash Flows Spreadsheet programs such as Excel provide built-in functions to solve discounted-cash-flow (DCF) problems. You can find these functions by pressing fx on the Excel toolbar. If you then click on the function that you wish to use, Excel asks you for the inputs that it needs. At the bottom left of the function box there is a Help facility with an example of how the function is used.

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Google is a growth stock because that large fraction of its market value comes from the expected NPV of its future investments. 4-5 Valuing a Business by Discounted Cash Flow Investors buy or sell shares of common stock. Companies often buy or sell entire businesses or major stakes in businesses. For example, we have noted Kinder Morgan’s plans to sell its El Paso exploration and production subsidiary. Both Kinder Morgan and potential bidders were doing their best to value that business by discounted cash flow. DCF models work just as well for entire businesses as for shares of common stock. It doesn’t matter whether you forecast dividends per share or the total free cash flow of a business.

How the City Really Works: The Definitive Guide to Money and Investing in London's Square Mile
by Alexander Davidson
Published 1 Apr 2008

Like the P/E ratio, the lower the enterprise value, the better the value of the company, although the ratio tends to be higher in high growth industries, and comparisons should be made against the sector. The most widely used tool of analysts, and arguably one of the most dangerous in the wrong hands, is discounted cash flow analysis. ________________________________________ HOW TO VALUE SHARES 39  Discounted cash flow analysis Discounted cash flow (DCF) analysis translates future cash flow into a present value. It starts with the net operating cash flow (NOCF). You find this by taking the company’s earnings before interest and tax, deducting corporation tax paid and capital expenditure, adding depreciation and amortisation, which do not represent movements in cash, and adding or subtracting the change in working capital, including movements in goods or services, in debtors and creditors, and in cash or cash equivalents.

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This book is for still for you, To celebrate a wonderful childhood and to look forward to what is to come, With love THIS PAGE INTENTIONALLY LEFT BLANK vi THIS PAGE INTENTIONALLY LEFT BLANK vii THIS PAGE INTENTIONALLY LEFT BLANK viii Contents Acknowledgements Introduction 1 The City of London Introduction The City defined Financial markets The City as a world leader No gain without pain Markets are people The future The next step xlvii 1 4 4 4 5 5 6 8 9 9 2 The Bank of England Introduction Origin Role today Monetary policy Lender of last resort International liaison 10 10 10 11 12 15 17 3 Commercial banking Introduction History Commercial banks today Building societies Raising finance 18 18 18 19 22 23 THIS PAGE INTENTIONALLY LEFT BLANK x THIS PAGE INTENTIONALLY LEFT BLANK xi THIS PAGE INTENTIONALLY LEFT BLANK xii THIS PAGE INTENTIONALLY LEFT BLANK xiii THIS PAGE INTENTIONALLY LEFT BLANK xiv THIS PAGE INTENTIONALLY LEFT BLANK xv THIS PAGE INTENTIONALLY LEFT BLANK xvi THIS PAGE INTENTIONALLY LEFT BLANK xvii THIS PAGE INTENTIONALLY LEFT BLANK xviii _________________________________________________ CONTENTS xix Credit collection Bad loans and capital adequacy  25 26 4 Introduction to equities Introduction Shares Market indices Stockbrokers The next step 29 29 29 32 33 34 5 How to value shares Introduction Analysts’ forecasts Ratios Discounted cash flow analysis Market influencers 35 35 35 36 39 40 6 New share issues Introduction Capital raising 42 42 42 7 Investment banking Introduction Overview The initial public offering Specialist types of share issue Bond issues Mergers and acquisitions Disclosure and regulation 47 47 47 47 54 56 56 58 8 Introduction to derivatives Introduction Cash and derivatives Four types of derivative transaction On-exchange versus OTC derivatives Clearing and settlement Hedging and speculation Problems and fraud 60 60 60 61 63 65 67 67 9 Derivatives for retail investors Introduction 69 69 THIS PAGE INTENTIONALLY LEFT BLANK xx THIS PAGE INTENTIONALLY LEFT BLANK xxi THIS PAGE INTENTIONALLY LEFT BLANK xxii THIS PAGE INTENTIONALLY LEFT BLANK xxiii THIS PAGE INTENTIONALLY LEFT BLANK xxiv ________________________________________________ CONTENTS xxv Options Futures Warrants Financial spread betting Contracts for difference  69 71 72 73 76 10 Wholesale market participants Introduction Banks Investors Inter-dealer brokers 78 78 78 79 79 11 Interest rate products Introduction Overview of money markets Debt securities Repos Interest rate derivatives Government bonds 81 81 81 82 84 85 86 12 Credit products Introduction Overview Bonds Credit derivatives The future 89 89 89 90 96 98 13 Commodities Introduction Overview Hard commodities Soft commodities The investment case for commodities Regulation 99 99 99 102 106 107 108 14 Foreign exchange Introduction Global overview In the City The participants Exchange rates 109 109 109 112 113 115 THIS PAGE INTENTIONALLY LEFT BLANK xxvi THIS PAGE INTENTIONALLY LEFT BLANK xxvii Visit Kogan Page online www.kogan-page.co.uk Comprehensive information on Kogan Page titles Features include: � complete catalogue listings, including book reviews and descriptions � sample chapters � monthly promotions � information on NEW and BEST-SELLING titles � a secure shopping basket facility for online ordering Sign up to receive regular e-mail updates on Kogan Page books at www.kogan-page.co.uk/signup.aspx and visit our website: www.kogan-page.co.uk THIS PAGE INTENTIONALLY LEFT BLANK xxix THIS PAGE INTENTIONALLY LEFT BLANK xxx ________________________________________________ CONTENTS Supply and demand Transaction types Electronic trading Default risk Further research XXXI  115 115 117 119 120 15 The London Stock Exchange and its trading systems Introduction Overview Trading facilities Users 121 121 121 122 127 16 Share trading venues and exchanges Introduction Overview Exchanges Multilateral trading facilities Systematic internalisers Dark liquidity pools Consolidation 130 130 130 131 134 137 138 138 17 Post-trade services Introduction Overview Clearing Settlement Safekeeping and custody Cross-border activity The future 140 140 140 141 142 143 144 150 18 Investors Introduction Retail investors Institutional investors 151 151 151 155 19 Pooled investments Introduction Investment funds Investment companies Exchange-traded funds Hedge funds 159 159 159 164 169 169 THIS PAGE INTENTIONALLY LEFT BLANK xxxii THIS PAGE INTENTIONALLY LEFT BLANK xxxiii THIS PAGE INTENTIONALLY LEFT BLANK xxxiv _______________________________________________ CONTENTS xxxv  20 Analysts and research Introduction The analyst Others 172 172 172 177 21 Financial communications Introduction Public relations Investor relations Corporate information flow Journalists 179 179 179 183 185 185 22 Financial services regulation Introduction Overview History of regulation The current regime 190 190 190 190 192 23 Financial fraud Introduction Overview Fraud busters The future 200 200 200 208 215 24 Money laundering Introduction Overview Know your client Action against money launderers The size of the problem 216 216 216 217 217 222 25 Overview of corporate governance Introduction The concept The Cadbury Code The Greenbury Committee The Combined Code The Turnbull Report OECD Principles of Corporate Governance Directors’ Remuneration Report Regulations Higgs and Smith 223 223 223 224 224 225 225 226 226 227 THIS PAGE INTENTIONALLY LEFT BLANK xxxvi THIS PAGE INTENTIONALLY LEFT BLANK xxxvii THIS PAGE INTENTIONALLY LEFT BLANK xxxviii _______________________________________________ CONTENTS The Revised Combined Code Listing Rules The Myners Report Developments across Europe The future XXXIX  227 228 229 230 230 26 Accounting and governance issues Introduction Accounting scandals The Sarbanes–Oxley Act European auditing and disclosure rules Business review International Financial Reporting Standards 232 232 232 233 234 235 237 27 Insurance: the London companies market Introduction Overview London Types of business The underwriting process Regulatory developments Market reform The future 239 239 239 240 240 241 243 245 245 28 Insurance: Lloyd’s of London Introduction Overview How Lloyd’s works Boom to bust More about Lloyd’s today The future 246 246 246 247 250 252 258 29 Reinsurance Introduction Overview Reinsurance contracts Retrocession Financial reinsurance Reinsurance reassessed Capital markets convergence The Reinsurance Directive 260 260 260 261 262 263 264 264 266 THIS PAGE INTENTIONALLY LEFT BLANK xl Visit Kogan Page online Comprehensive information on Kogan Page titles Features include: � complete catalogue listings, including book reviews � sample chapters � monthly promotions � information on NEW and BEST-SELLING titles � a secure shopping basket facility for online ordering Sign up to receive regular e-mail updates on Kogan Page books at www.kogan-page.co.uk/signup.aspx and visit our website: www.kogan-page.co.uk THIS PAGE INTENTIONALLY LEFT BLANK xli THIS PAGE INTENTIONALLY LEFT BLANK xlii _________________________________________________ CONTENTS xliii Offshore reinsurance collateral requirements in the United States Dispute resolution  267 268 30 Retail insurance, savings and domestic property Introduction Overview Products How the products are sold Complaints and compensation The future 269 269 269 273 277 279 280 31 Pensions in flux Introduction Overview The basic state pension Occupational and personal pensions Annuities and unsecured pensions 282 282 282 283 284 288 A word to investors 291 Appendix 1: Useful websites Appendix 2: Further reading 292 297 Index Index of advertisers 302 308 THIS PAGE INTENTIONALLY LEFT BLANK xliv THIS PAGE INTENTIONALLY LEFT BLANK xlv THIS PAGE INTENTIONALLY LEFT BLANK xlvi Acknowledgements This book owes everything to the City professionals who gave freely of their valuable time in providing interviews, source material and other help.

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A new chapter on new issues looks at the choice of markets in London. In another chapter, we focus on how investment banks bring companies to the market. Analysts are a link in the chain, but regulatory developments have placed restrictions on them, and we will see where they stand in a new chapter. We will cover valuation techniques such as discounted cash flow analysis and EBITDA, and I will explain the City’s dependence on earnings per share. The book provides an overview of technical analysis. We explore how the big institutional investors as well as private investors work. We cover hedge funds and how they move markets. We delve into some of the more esoteric areas of the City such as shipping and metals.

Getting a Job in Hedge Funds: An Inside Look at How Funds Hire
by Adam Zoia and Aaron Finkel
Published 8 Feb 2008

Quantitative funds have also been known to hire undergraduates, but would focus exclusively on individuals with exceptional mathematics and programming abilities. Some funds that may need execution-only traders could also be willing to bring on and train a raw person. The thinking is that traders don’t need the same skills as researchers—for example, how to build a discounted cash flow (DCF) model—and therefore wouldn’t necessarily have to go through an investment banking program. Notwithstanding the types of funds mentioned, when bringing on junior staff most firms focus on individuals with some investment banking and/or investing experience. Remember, most hedge funds are smaller organizations as compared to investment banks and don’t have the infrastructure to train graduates themselves.

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BEING IN THE RIGHT GROUP We have found that hedge funds target candidates from specific banking groups depending on their investment style. For example, there is a definite preference for analysts in groups such as M&A, leveraged finance, financial sponsors, and corporate finance, as they are typically the ones that involve detailed financial modeling, discounted cash flow (DCF) analysis, and accounting and balance sheet work. A fund that invests in CDOs, CLOs, or distressed debt is going to prefer someone from highyield or leveraged finance. Candidates from these groups usually have the skills to go into a value-oriented or stock-picking hedge fund—whether that is event-driven, long/short, or fundamental value.

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Credit Suisse/Tremont Fund Indexes www.hedgeindex.com Greenwich Alternative Investments www.greenwichai.com Provides hedge fund–related investment products and services, including research, indexing, investment management, and advisory services Hedge Fund Consistency Index www.hedgefund-index.com Profiles and ranks hedge funds, available to qualified investors Hedge Fund Research www.hedgefundresearch.com The Hennessee Group www.hennesseegroup.com MSCI Hedge Fund Indices www.mscibarra.com/products/indices/hf/press.jsp bapp01.indd 159 1/10/08 10:58:52 AM bapp01.indd 160 1/10/08 10:58:52 AM Appendix B SAMPLE RESUMES 161 bapp02.indd 161 1/10/08 10:59:49 AM bapp02.indd 162 1/10/08 10:59:50 AM Resume A Profile Pre-MBA: Bulge-Bracket Banker Lands at a Distressed Debt Fund (see CASE STUDY 1) Recruiter’ s Perspect ive • Top nam e school • Solid SA Ts/GPA • M&A ex perience • Worked on large d eals Pluses Interested in investin g EXPERIENCE BULGE-BRACKET INVESTMENT BANK New York, NY Financial Analyst, Mergers & Acquisitions, Investment Banking Division July 2005 – February 2006 • Performed detailed financial analyses on potential acquisitions, leveraged buyouts, and divestitures • Constructed valuation models, including discounted cash flow, comparable company, and precedent transaction analysis • Assessed the effects of multiple operational scenarios and capital structure alternatives on potential mergers • Created client presentations illustrating strategic alternatives • Worked closely with management to prepare offering materials, including management presentations • Evaluated companies’ defense profiles for vulnerabilities for both hostile buy-side and hostile defense transactions • Became familiar with multiple industries and subsectors SELECTED WORK EXPERIENCE • Advised a company on the acquisition of a supplier - Created a dynamic, bottom-up financial model for valuation based on public information and key metrics, incorporating sum-of-the-parts discounted cash flow, leveraged buyout, and pro forma merger analyses - Performed potential interloper analysis, analyzing the accretion/dilution and value impact on numerous possible bidders - Organized materials to prepare an indicative bid • Advised company on the sale of approximately $1.5 billion in assets - Created a full pro forma model capable of multiple operating scenarios, as well as LBO and DCF analyses - Performed due diligence on assets, and incorporated research and analysis into modeling effort • Advised company on the divestiture of approximately $3 billion in assets - Created a model to value the assets using both base-case metrics and bidders’ implied assumptions, particularly those revolving around the valuation of a major outstanding pension liability - Managed the flow of information between the company and interested parties • Advised company on hostile defense planning - Analyzed pro forma accretion/dilution impact to potential bidders based on internal company financials and public information - Prepared management presentation describing detailed financial and qualitative analysis of potential bidders and potential synergies as seen by bidding parties - Worked with the client to establish measures to defend against a hostile bid MAJOR AUTOMOTIVE COMPANY Summer Financial Analyst Summer 2004 • Built financial model to more accurately account for ocean freight shipments from overseas suppliers to Fortune 5 company • Worked closely with suppliers and company’s in-house technology department to create a new system to facilitate Sarbanes-Oxley compliance EDUCATION IVY LEAGUE UNIVERSITY B.S. with Honors; GPA: 3.91/4.00 Dean’s List Spring 2002 through Fall 2004 SAT: Math – 800, Verbal – 780; National Merit Finalist August 2001–May 2005 OTHER • Certified General Securities Registered Representative (Series 7) and Uniform Securities Agent (Series 63) • High level of skill with Microsoft Excel; background in C++, Stata, and Business Objects • Course work in Finance, Investments, Econometrics, Intermediate Accounting, Computer Science, Linear Algebra, Multivariable Calculus, and Group Theory • Ivy League recruiting team.

The Finance Book: Understand the Numbers Even if You're Not a Finance Professional
by Stuart Warner and Si Hussain
Published 20 Apr 2017

An extract from their ‘Financial Review’ included in their 2015 annual report is shown below: We manage return on capital against predetermined targets and monitor performance through our Investment Board, where all capital expenditure is subject to rigorous appraisal before and after it is made. For investments in new shops and refurbishments we target an average cash return on invested capital of 25%, with a hurdle rate of 22.5%, over an average investment cycle of seven years. Other investments are appraised using discounted cash flow analysis. The investment returns on our refurbishment expenditure in the year were good, with 2015 investments meeting our return hurdle and more mature refurbishments showing very strong returns, well above our target. The performance of new shops was excellent, with prior year openings maturing well and newer shops making a very strong start.

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For a private entity the P/E ratio quoted for its industry is typically discounted to reflect the fact that the business will be less marketable than a typically larger public listed company. BDO UK LLP publishes the quarterly PCPI (Private Company Price Index) which analyses the multiples typically used in valuing private companies. Historically, the larger the business, the larger the multiple. Discounted cash flows. Arguably the most sophisticated income-based valuation involves calculating the present value of future cash flows. This involves forecasting future cash flows based on various assumptions such as growth rate, margins, financing costs, tax rates and capital expenditure. Many companies use the concept of ‘free cash flows’, being operating cash flows less capital expenditure (see Chapter 7 Opex and capex).

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The non-financial benefits and costs of an investment as well as its risk are also relevant considerations. Ideally a range of financial appraisal methods should be used to assess an investment. Need to know There are several ways to appraise investments: Payback period Annual yield Measures which use discounted cash flows. Example ABC Ltd has two competing investments: A and B which both require £250,000 of initial investment and generate positive returns totalling £500,000 over the following five years. Investment A Investment B £’000 £’000 Initial investment (250) (250) Year 1 100 50 Year 2 100 75 Year 3 100 100 Year 4 100 125 Year 5 100 150 The only difference between the investments is the timing of the returns within the five years.

Corporate Finance: Theory and Practice
by Pierre Vernimmen , Pascal Quiry , Maurizio Dallocchio , Yann le Fur and Antonio Salvi
Published 16 Oct 2017

In addition, there are two approaches used in both the direct and indirect methods: The fundamental approach based on valuing either: a stream of dividends, which is the dividend discount model (DDM); or a stream of free cash flows, which is the discounted cash flow (DCF) method. This approach attempts to determine the company’s intrinsic value, in accordance with financial theory, by discounting cash flows to their present value using the required rate of return. The pragmatic approach of valuing the company by analogy with other assets or companies of the same type for which a value reference is available. This is the peer comparison method (often called the comparables method).

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If you remember the efficient market hypothesis, you are probably asking yourself why market value and discounted present value would ever differ. In this chapter we will take a look at the origin of the difference, and try to understand the reason for it and how long we think it will last. Ultimately, market values and discounted present values should converge. Section 31.2 Valuation by discounted cash flow The discounted cash flow method (DCF) consists of applying the investment decision techniques (see Chapter 16) to the firm value calculation. We will focus on the present value of the cash flows from the investment. This is the fundamental valuation method. Its aim is to value the company as a whole (i.e. to determine the value of the capital employed, what we call enterprise value).

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You might even be tempted to go a step further and apply a minority discount to the present value of future cash flows for valuing a minority holding. This is wrong. Applying a minority discount to the discounted cash flow method implies that you think the majority shareholder is not managing the company fairly. A discount is justified only if there are “losses in transmission” between free cash flow and dividends. This can be the case if the company’s strategy regarding dividends, borrowing and new investment is unsatisfactory or oriented towards increasing the value of some other assets owned by the majority shareholder. Minority discounts are inconsistent with the discounted cash flow method. Similarly, increasing the cash flow-based value can be justified only if the investor believes he can unlock synergies that will increase free cash flows.

Value Investing: From Graham to Buffett and Beyond
by Bruce C. N. Greenwald , Judd Kahn , Paul D. Sonkin and Michael van Biema
Published 26 Jan 2004

By assuming that it would grow steadily from then on, they could calculate its current value by discounting that cash flow back to the present, using only a hand calculator. Now, with spreadsheets, they can make their projections more detailed and carry them forward further in time. Discounted cash flow analysis, a method about which we expressed some reservations in the first part of this book, is Greenberg's valuation technique of choice for all the investments he makes. Greenberg's discounted cash flow approach is bounded by a set of restrictions that keep him securely within the value investing camp. He is only interested in companies with stable earnings and relatively predictable cash flows.

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Only the future will tell us with any certainty whether these multiples will be sustained. If they are not, then the index's status as a brilliant investment choice diminishes. Discounted Cash Flow in Practice: A Diversified Energy Company To perform better than the S&P 500 index, Greenberg and his partners have had to do a superior job in valuing a company. Though they may test other approaches, they only will invest if a discounted cash flow analysis indicates that the shares are available at an attractive price. They applied it to a diversified energy company operating largely in Canada in order to determine a price at which they would be willing to buy the shares.

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The real value of doing all the work required for a full discounted cash flow analysis is that it forces the investor to think long and hard about all the factors that will affect the future of the business, including the risks it may face that are currently unexpected and unforeseen. If Greenberg ran money with 200 names in his portfolios, he would not have the time-nor would it be worth the effort-to do all this work. But because of his concentrated approach and his determination not to lose his clients' money, he can't afford the luxury of a casual relationship with his companies. The discounted cash flow approach requires that all crucial assumptions about the future, such as rates of production or the price of energy, be made explicit.

The End of Accounting and the Path Forward for Investors and Managers (Wiley Finance)
by Feng Gu
Published 26 Jun 2016

Thus, Devon’s end-of-2014 proved reserves would last 11.37 years, under current production level and no new acquisitions. Changes in the discounted cash flows from the proved reserves are an important forward-looking indicator of company value and growth potential, unique to extractive industries. These changes are affected by varying estimates of future energy prices, in addition to acquisitions, production, and disposals. Interestingly, despite the decrease in the quantity of proved reserves during 2014, Devon reported a 31 percent increase in discounted cash flows. Obviously, this indicator is very sensitive to changes in underlying assumptions.

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Similarly, long-term efforts at cost containment, crucial for maintaining competitive advantage, are reflected in financial reports after a considerable delay, and important business relationships, such as joint ventures with other companies and contracts with governments—major value-creating assets in the industry—aren’t flagged on the balance sheet. The accounting system is simply unable to capture the intricacies of the oil business.2 True, specific oil and gas regulations by the FASB and the SEC, requiring disclosure (though not the audit) of proved (proven) reserves and their discounted cash flows, as well as data on productive wells, among other information items, are definitely helpful but insufficient for a comprehensive strategic assessment by investors of the operations of oil and gas companies and their growth potential. This became clear from our detailed examination of the earnings conference calls and investor day presentations of the 10 oil and gas companies, large and small, that we have studied.

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Mineral Acreage (000) Developed 2014 2013 2,317 4,328 % –46.5 Undeveloped 3,926 8,411 –53.3 Total 6,243 12,739 –51.0 By major geographical areas: U.S. 4,666 5,805 Canada 1,577 6,934 Energy type: Oil II. gas unconventional Proved Reserves (million Boe) 2,754; 2,963 (−7%) Discounted Cash Flows (billions) $20.5; III. $15.7 (31%) Total Productive Wells and Rigs (2014) Rigs Wells Oil Gas 7,165 X 11,124 X By geographical areas: X X (X) Refining Capacity and Usage Patents and Trademarks Key Governmental Agreements and Inter-Company Alliances FIGURE 15.2 Strategic Resources Strategic Resources & Consequences Report: Case No. 4 187 Devon’s footprint (acreage) at the end of 2014 decreased significantly (51 percent) from a year earlier, likely as part of the reorganization.

Mathematics of the Financial Markets: Financial Instruments and Derivatives Modelling, Valuation and Risk Issues
by Alain Ruttiens
Published 24 Apr 2013

These deterministic methods do not incorporate the volatility component of the growth rate, that is, the discounting is made in a deterministic environment. Here, the stock value is rather: S = a form of discounted cash flows + the PV of growing uncertainty, that is, a call option premium on the measurable potential Example: Tiscali The IPO was launched in November 1999, @ €4.60, as the result of the discounting cash flows method. Adding an option premium on the hypothesis that Tiscali foresees capturing 20% of the Italian e-com until 2003 (+ about 4 years), the calculation gives €6.70. On top of that, adding an option on cash flows brought by the third generation of cellular phones, the initial stock price goes to €30.90.

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collars collateralized debt obligations (CDOs) color sensitivity commodities commodity futures backwardation contango market price non-financial producers/users trading calculations conditional swaps Conditional VaR (C-VaR) confidence levels constant maturity swaps (CMSs) contango continuous interest compounding continuous interest rates continuous time continuous variables contracts contracts for difference (CFD) contribution, performance convenience yield conversion factors (CFs) convertible bonds (CBs) bond floor CB premium conversion ratio Hard Call protection outcome of operation pricing graph risk premium stock price parity convexity adjustments see also bond convexity copper prices copulas correlation basket options credit derivatives implied Portfolio Theory Spearman’s coefficient VaR calculations volatility counterparty risk futures see also credit risk counter-value currency (c/v) Courtadon model covered period, FRAs Cox, Ingersoll and Ross model Cox–Ross–Rubenstein (CRR) model credit default swaps (CDSs) on basket cash settlement with defined recovery rate market operations variants credit derivatives CDSs credit risk main features valuation application example basket derivatives binomial model CDO pricing correlation measures credit risk models useful measures Merton model “credit events” credit exposure credit risk behind the underlying components data use dangers default rates Merton model models in practice quantification recovery rates credit VaR crossing CRR see Cox–Ross–Rubenstein model CRSs see currency rate swaps crude oil market CTD see cheapest to deliver cubic splines method currencies futures options performance attribution spot instruments currency rate swaps (CRSs) c/v see counter-value currency C-VaR see Conditional VaR D see discount factors DCF see discounted cash flows method decision-making deep ITM (DITM) deep OTM (DOTM) default rates default risk see credit risk delta delta-gamma neutral management delta-normal method, VaR derivatives credit valuation problems volatility Derman see Black, Derman, Toy process deterministic phenomena diff swaps diffusion processes Dirac functions dirty prices discounted cash flows (DCF) method discount factors (D) duration D forward rates IRSs risk-free yield curve spot rates yield curve interpolations discrete interest compounding discrete time discrete variables DITM see deep ITM DOTM see deep OTM drift duration of bonds see bond duration duration D dVega/dTime dynamic replication see delta-Gamma neutral management dZ Black–Scholes formula fractional Brownian motion geometric Wiener process martingales properties of dZ(t) standard Wiener process economic capital ED see exposure at default effective duration, bonds efficient frontier efficient markets EGARCH see exponential GARCH process EONIA see Euro Over-Night Index Average swaps equities forwards futures Portfolio Theory stock indexes stocks valuation EUR see Euros EURIBOR rates CMSs EONIA/OIS swaps FRAs futures in-arrear swaps IRSs quanto/diff swaps short-term rates Euro Over-Night Index Average (EONIA) swaps European options basket options bond options caplets CRR pricing model exchange options exotic options floorlets Monte Carlo simulations option pricing rho Euros (EUR) CRSs forward foreign exchange futures spot market swap rate markets volatility Euro Stoxx EWMA see exponentially weighted moving average process Excel functions MA process Monte Carlo simulations excess return exchange options exotic options basket options Bermudan options binomial pricing model Black–Scholes formula currency options exchange options interest rates Monte Carlo simulations options on bonds options on non-financial underlyings PFCs pricing methods see also second generation options exotic swaps see also second generation swaps expected credit loss expected return exponential GARCH (EGARCH) process exponentially weighted moving average (EWMA) process exposure at default (ED) fair price/value “fat tails” problem financial models ARCH process ARIMA process ARMA process AR process GARCH process MA process MIDAS process finite difference pricing methods fixed leg of swap fixed rate, swaps floating rate notes/bonds (FRNs) floating rates floorlets floors forecasting ARIMA ARMA process AR process MA process foreign exchange (FX) see currencies; forex swaps; forward foreign exchange forex (FX) swaps forward foreign exchange 1 year calculations forex swaps forward forex swaps forward-forward transactions forward spreads NDF market operations forward rate agreements (FRAs) forwards Black–Scholes formula bonds CFDs CRSs equities foreign exchange FRAs futures vs forwards prices options PFCs rates swaps volatility forward zero-coupon rate 4-moments CAPM fractional Brownian motion FRAs see forward rate agreements FRNs see floating rate notes/bonds futures bonds commodities currencies equities forwards vs futures prices IRR margining system market price option pricing pricing settlement at maturity short-term interest rates stock indexes theoretical price future value (FV) bond duration short-term rates spot rates zero-coupon swaps FX see foreign exchange; forex swaps gain-loss ratio (Bernardo Ledoit) gamma gamma processes GARCH see generalized ARCH process Garman–Klass volatility Gaussian copulas Gaussian distribution Gaussian hypothesis generalized ARCH (GARCH) process EWMA process I/E/MGARCH processes non-linear models regime-switching models variants volatility general Wiener process application fractional Brownian motion gamma processes geometric Wiener process Itô Lemma Itô process jump processes volatility modeling see also standard Wiener process geometric average geometric Wiener process German Bund see Bund (German T-Bond) global VaR Gordon–Shapiro method government bonds Greece Greeks see sensitivities Hard Call protection Heath, Jarrow and Morton (HJM) model Heaviside function hedging bond futures delta-gamma neutral management futures 129–30 immunization vs hedging money market rate futures stock index futures heteroskedasticity hidden layers, NNs high frequency trading “high” prices historical method, VaR historical volatility HJM see Heath, Jarrow and Morton model Ho and Lee model Hull and White model Hurst coefficient IGARCH see integrated GARCH process immunization implied correlation implied repo rate (IRR) implied volatility definition historical volatility surface volatility curves volatility smiles in-arrear swaps indexes basket options capitalization-weighted price/value-weighted see also stock indexes inflation-linked bonds inflation swaps Information Ratio (IR) initial margin in the money (ITM) caps convertible bonds deep ITM options innovation term, AR instantaneous returns integrated GARCH (IGARCH) process interbank rates see EURIBOR rates; LIBOR rates interest rate options BDT process Black and Karasinski model caps collars floors forward rates HJM model LMM model single rate processes swaptions yield curve modeling interest rates day counting discount factors futures FV/PV interest compounding IRSs options short-term spot rates term structure see also yield interest rate swaps (IRSs) bond duration and CRSs fixed/floating rates pricing methods prior to swap pricing method revaluation vanilla swaps yield curve see also constant maturity swaps intermediate period, FRAs International Swaps and Derivatives Association (ISDA) intraday margining settlements intraday volatility investor decision-making IR see Information Ratio IRR see implied repo rate IRSs see interest rate swaps ISDA see International Swaps and Derivatives Association ITM see in the money Itô process Itô’s Lemma Japanese yen (JPY) Jarrow, Robert A.

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This should lead to an average that generalizes the above average life formula as follows, where ci is the coupons paid on year i: Another step further, we could take into account that a cash flow paid in year i should not be considered today as equivalent to a cash flow paid on another year j. To cope with this, the cash flows in (pi + ci), or ai, would better be actualized, at the YTM y: (3.6) This ratio is called the duration D, that is, the average of the discounted cash flows weighted by their maturities. The denominator of Eq. 3.6 is nothing other than the bond price B (cf. Eq. 3.3), so that D can be expressed as (3.7) Physical Approach of the Duration A “physical” approach of the duration facilitates the understanding of some of its properties. Let us take a kind of Roberval balance7 and align small containers on it.

Fred Schwed's Where Are the Customers' Yachts?: A Modern-Day Interpretation of an Investment Classic
by Leo Gough
Published 22 Aug 2010

Remember, also, that the results you get are only educated guesses – they are not absolute facts – and you should only use them to get a ‘feel’ for the nature of the firms. 43 DISCOUNTED CASH FLOW ‘The more financial predictions you make the more business you do and the more commissions you get.’ DEFINING IDEA… I don’t want a lot of good investments; I want a few outstanding ones. ~ PHILIP FISHER, GROWTH INVESTOR Discounted Cash Flow (DCF) is based on the idea that the value of anything, whether an asset or a company, is the sum total of the cash it can generate in the future, adjusted for the present value of that cash.

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THE TROUBLE WITH TRANSACTION COSTS 32. CROOKS 33. AVOIDING THE BIG COLLAPSES 34. COUNTER-CYCLICAL INVESTMENT 35. GLOBALISATION 36. NUMERACY REQUIRED 37. SHORT SELLING 38. THOSE CRAZY REGULATORS 39. COLLECTIVE INVESTMENTS 40. MERGERS AND ACQUISITIONS 41. MASSAGING THE FIGURES 42. LOOKING FOR BARGAINS 43. DISCOUNTED CASH FLOW 44. STOCK MARKET NEWSLETTERS 45. LIFE PLAN 46. HEDGE FUNDS 47. SOME IMPORTANT BASICS 48. BEHAVIOURAL FINANCE 49. BUSINESS IS HARD 50. LOSS 51. THE ‘FAT, STUPID PLEASANT’ APPROACH 52. BOOKS ON THE STOCK MARKET INDEX INTRODUCTION In 1940 Fred Schwed, a stockbroker whose father had lost everything as a short seller on Wall Street during the Roaring Twenties, published this timeless classic on how the stock market really works.

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A Abramovich, Roman 112 accounts, comparing 36–7 AIM (Alternative Investment Market) 70 analysis fundamental analysis 54–5 technical analysis (TA) 40–1 analysts 95, 96 annual reports 36–7 annuities 61 Aristotle 26 Arthur Andersen 53 assets, living off 22–3 astrology, use in predicting share prices 41 Austen, Jane 22 average performance 34–5 average returns 105 B bankers and financial crisis 28–9 banks, merger activity 89 bargains, finding 92–5 Barlow Clowes affair 74, 75 Baruch, Bernard 76 ‘bear raiders’ 82–3 behavioural finance 104–5 benchmarks 35, 87 Bernard, Claude 34 Black Scholes model 32–3 blue chip companies 51, 53 Bogle, John 110 ‘bond washing’ 75 bonds investing in 10–11, 50–2, 53 in the US 80 book value 92 books about the stock market 112–13 booms 18–19 dot.com 30 excessive borrowing in 29 mergers and acquisitions in 88–9 regulators in 85 selling in 76–7 borrowing and the financial crisis 29 British Rail 66–7 Brown, Gordon 18 Buffett, Warren 13, 32, 48, 50, 52, 54, 62, 64, 66, 68, 70, 83, 90, 96, 100, 105, 110 bull markets, new issues in 57 businesses, start-up 106–7 business failure 106 buying high 64–5 C capital raising 24–5 spending 22–3 car manufacturers 67 charting 40–1 China, government bonds 51 ‘churning’ 71– 2 Cisco Systems 90 ‘closed-end’ funds 86 collapses 74–5 collective investment 86–7 companies mergers 88–9 raising capital 24–5 under threat 66–7 compensation for collapses 74–5 compound interest 102 compounding 111 costs of transactions 70–1 counter-cyclical investments 76–7 crashes 28–9 reacting to 108 regulators in 85 credit card debts, during a boom 19 crooks 72–3 see also fraud cycles, economic 19 D debts, during a boom 19 deflationary periods 103 derivatives 32–3, 85 descendants entrusting with money 59 investing for 16–17 Discounted Cash Flow (DCF) 94–5 diversification 48–9 dividend discount model 95 dot.com boom 30 Dow Jones Industrial Average (DJIA) 35 Duttweiler, Rudolph 42 E earnings management 90 Ebbers, Bernard 73 economic cycles 19 economy, growth rate 42–3 Einhorn, David 83 Einstein, Albert 102 Enron 53 equity investment 80–1 estimating returns 80–1 execution-only brokers 71 executives, benefitting from mergers 89 F fact finds 98 false information 72–3, 90, 91 family, building 99 fees, transaction 70–1 Fibonacci numbers 40 figures, ‘managing’ 90–1 financial crisis, who to blame 28–9 financial professionals 96, 98 commissions 72 and investment skills 47, 54–5 risk aversion 58 see also fund managers financial statements 91 Fisher, Irving 56 Fisher, Philip 94, 113 fluctuations in share prices 38–9 Foreman, George 60 Franklin, Benjamin 10 fraud 73, 74–5 and blue chip companies 53 FSA (Financial Services Authority) 14, 74, 83, 84 FTSE 100 64–5 fund managers 35, 54–5, 101 and tracker funds 62 see also financial professionals fundamental analysis 54–5 fundamentals 110 G Garland, Judy 98 ‘gilts’ 50–1 globalisation 78–9 Goldstein, Phil 82 Goldwyn, Sam 40 good stories about companies 42–3 government bonds 10–11, 50–2 in the US 80 Graham, Benjamin 92, 104, 113 growth rate of economies 42–3 Grubman, Jack 73 ‘gurus’ 96–7 H ‘head and shoulders’ pattern 40 hedge funds 33, 82–3, 100–1 Hendrix, Jimi 16 I Icelandic banks 11 income from capital 22–3 index investing 34–5, 62–3, 110, 111 Indonesia 76–7 government bonds 10–11 Industrial Revolution 78 inflation 61 and rate of return 103 Initial Public Offerings (IPOs) 56–7 innovations, investing in 30–1 insurance for investments 74 insurance companies 72 annuities 61 interest calculating 103 on interest 102 rates 11 international diversification 49 international investment 79 internet, investing in 30–1 investment mergers before88–9 collective 86–7 income 10–11 and inflation 61 international 79 long term 16–17, 64–5, 98–9, 102, 111 popular 30–1 risks in 44–5 short term 63 skill in 20–1 trusts 35, 48–9, 58–9, 86 IPOs (Initial Public Offerings) 56–7 J Johnson, Ross 89 K Keynes, J.

The Future of Money
by Bernard Lietaer
Published 28 Apr 2013

Understanding the relationship between interest rates and time perception will be accomplished in the three following steps: . comprehend how capital allocation decisions are generally made through the financial technique of 'Discounted Cash Flow'; · how such discounting of the future is one of the key underlying causes which create a direct conflict between financial criteria and ecological sustainability under our present money system; · and how the discount rate used in the Discounted Cash Flow technique is directly affected by the interest rate of the currency used in the cash flow analysis. 'Discounted Cash Flow' = ‘ Discounting the Future’ 'Discounted Cash Flow' is the financial technique generally used to decide on whether to invest in a given project, or to compare different projects.

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When a homeowner decides it is too expensive to install solar panels for heating the household water, she is implicitly saying that the cost of purchasing electricity or gas from the grid in the long run discounted to today is cheaper than the initial capital outlay required. When we build a house cheaply without appropriate insulation, we are really making the trade-off between the higher heating costs in the future discounted to today and the higher construction costs. Relationship with interest rates In the explanation of the Discounted Cash Flow technique, we made an assumption that the discount rate used is identical to the interest rate of the currency. In reality, the discount rate, which should be used, is the 'cost of capital of the project'. Without getting unduly technical, there is not one but three components to that cost of capital: · the interest rate of the currency involved; · the cost of equity; · and an adjustment reflecting the uncertainty about the cash how of the project itself.

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For reasons that will become clear soon, I will call this time-related charge a ‘sustainability fee'. Now, what would such a sustainability fee or demurrage charge do to the eyesight of our financial analyst? The project described in Figure 8.3 would suddenly appear to him as described in Figure 8.5. This is not just true because of a mechanical application of the equations of Discounted Cash Flow. Even if it looks strange at first sight, even if it contradicts what we are used to with our normal currencies, it still makes perfect financial sense. Let us assume that I give you a choice between 100 units of an inflation- proof currency charged by a sustainability fee, today or a year from now.

The Einstein of Money: The Life and Timeless Financial Wisdom of Benjamin Graham
by Joe Carlen
Published 14 Apr 2012

Let the reader not be misled into thinking that such projections have any high degree of reliability.”19 Graham's words regarding the growth-rate formula apply equally to the valuation formula presented above. However, it still has some value as a filter with which to determine whether a stock is worthy of further consideration. DISCOUNT CASH FLOW (DCF) METHOD A more common method for estimating intrinsic value is the discount cash flow (DCF) method, which Graham employed regularly, as does Buffett. Through this method, all future per-share earnings, discounted to their present value, are aggregated to arrive at a “net present value” that can serve as a defensible intrinsic value.

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As the acclaimed young value investor and author Pat Dorsey writes in his book The Five Rules for Successful Stock Investing, Unfortunately, there is no precise way to calculate the exact discount rate that you should use in a discounted cash flow (DCF) model, and academics have filled entire journal issues with nothing but discussions about the right way to estimate discount rates.20 For example, the discount rate applied to a small company with a history of uneven earnings should be somewhat higher than that applied to a large company with a history of stable and fairly predictable earnings. Indeed, there are a number of steps, of varying levels of nuance and complexity, involved with calculating intrinsic value through the discount cash flow method. Fortunately, there are now a number of free online resources (like Guru Focus's Fair Value Calculator, at http://www.gurufocus.com/fair_value_dcf.php) that have automated this process.

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diluted earnings: A stringent earnings metric, diluted earnings is calculated by dividing total earnings by a fully diluted base. This includes common stock, preferred stock, and unexercised convertible securities (unexercised stock options, warrants, and some forms of convertible bonds). discount cash flow method: A valuation method that discounts all future per-share earnings projections to their present value, the discount cash flow (DCF) method is widely used among value investors. The aggregate result is considered to be the intrinsic (present) value of the stock, which can then be compared with the current stock price to weigh its attractiveness as an investment.

The Automatic Customer: Creating a Subscription Business in Any Industry
by John Warrillow
Published 5 Feb 2015

Let’s take a closer look at how your company is valued without a subscription offering. In my experience, the most common methodology used to value a small to mid-size business is called discounted cash flow. This methodology forecasts your future stream of profits and then “discounts” it back to what your future profit is worth to an investor in today’s dollars given the time value of money. This investment theory may sound like MBA talk, but discounted cash flow valuation is something you have likely applied in your own personal life without knowing it. For example, what would you pay today for an investment that you hope will be worth $100 one year from now?

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For example, what would you pay today for an investment that you hope will be worth $100 one year from now? You would likely “discount” the $100 by your expectation for a return on investment. If you expect to earn a 7% return on your money each year, you’d pay $93.46 ($100 divided by 1.07) today for an investment you expect to be worth $100 in 12 months. Using the discounted cash flow valuation methodology, the more profit the acquirer expects your company to make in the future—and the more reliable your estimates—the more your company is worth. Therefore, to improve the value of a traditional business, the two most important levers you have are (1) how much profit you expect to make in the future and (2) the reliability of those estimates.

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Absolute Software, 116 access generation, 18–19, 22 accountants, 169 Acton, Brian, 2, 113 ADT, 116 Airbnb, 19 airplanes, 175 all-you-can-eat library model, 57–63 Amazon, 11–15, 84, 87, 89, 90 AmazonFresh, 14 Diapers.com acquired by, 15, 84–86 Mom, 85 Prime, 11–13, 14, 37, 84, 188 Subscribe & Save, 14–15, 25, 84 Web Services, 15 Ancestry.com, 30–31, 58–59, 135–36, 159, 163–64 Anderson, Chris, 16, 21 Any.do, 100 Apple, 22, 100 iPhone, 1, 19 iTunes, 57–58, 154 Joint Venture, 22–23, 79 One to One, 22, 23 Reseller network, 23 art education, 59–60 New Masters Academy, 59–62, 155, 166 Art Snacks, 187–88 Auger, Frank, 180–81 Avis Budget Group, 111 banking, 100, 177–78, 186–87 Bank of America, 126 BarkBox, 19, 92, 95, 165, 187 Barna, Haley, 39 Basecamp, 144, 145–46 Beauchamp, Katia, 39 Berkshire Hathaway, 118 Bessemer Venture Partners (BVP), 140–41 Bezos, Jeff, 14, 86, 145 Bharara, Vinit, 84–85 BirchBox, 38–39, 88, 172 Blackburn, Jeff, 85 Blacksocks, 83, 84, 88, 151 Blake, Kathy, 49–52, 197 Blake, Suzanne, 50–52, 197 Blockbuster, 59 Bloodhound Technologies, 147 Bloomberg Businessweek, 58, 85 Blue Dolphin, 179–80 Brand, Stewart, 47–48 brand, unique, 87, 89, 90 Branson, Richard, 67 Broughman, Brian, 147 Buffet, Warren, 118 Built to Sell: Creating a Business That Can Thrive Without You (Warrillow), 3 Burkhart, Bryan, 33, 197 burning platform strategy, 166–67 business-to-business (B2B) companies, 55, 69, 158 Buterin, Dmitry, 29, 184–85, 190 cancellations, see churn rate Capital Factory, 142, 173 Carsanaro, Joseph A., 147 car sharing, 109 Zipcar, 19, 109–11, 113, 153 car theft, 116 Case, Steve, 69 cash, 138, 139–43 cash sources, 143–51 charging up front, 148–51 outside money, 146–48 robbing Peter to pay Paul, 143–46 CA Technologies, 141–42 CBS MarketWatch, 88 Centore, Anthony, 76–77 charging up front, 148–51, 184–85 Chase, Robin, 109, 113 chocolate, 93–94 Standard Cocoa, 22, 93–94, 165 churn rate, 130–31, 142–43, 172–74 Ancestry.com and, 136 and charging up front, 184–85 communication and, 185–87 Constant Contact and, 137 evergreen subscriptions and, 193–94 happiness bombs and, 187–88 Hassle Free Home Services and, 173 HubSpot and, 133–34, 180 logo churn and, 191–93 lowering, 174–94 Mosquito Squad and, 138 net churn and, 189–91 90-day onboarding clock and, 176–82 rogue jet concept and, 175–76 Salesforce.com and, 176 and targeting larger businesses, 188–89 wow timetable and, 182–84 Cisco, 117 Coca-Cola, 89 Cohen, Jason, 177 Cohen, Ted, 58 cohorts, 182 Colony, George F., 150–51 communication, 185–87 Conscious Box, 35–36, 86, 95–96, 164 Constant Contact, 18, 136–37, 183–84 consumables model, 81–90 Consumer Intelligence Research Partners, 11 ContractorSelling.com, 35, 49 cost of goods sold (COGS), 132 counseling, 75–77 Cratejoy, 86, 96–97 Crisara, Joe, 35 cross-selling, 191–93 Cue, 100 customer acquisition cost (CAC), 128–30, 138, 139, 143, 146, 151, 189 Ancestry.com and, 136 cash up front and, 148–51 Constant Contact and, 137 HubSpot and, 133–34, 149–50 Mosquito Squad and, 138 payback period and, 140–43 Crystal Cruises, 50 DanceStudioOwner.com, 49–52, 197 Dance Teachers’ Club of Boston, 49 Danielson, Antje, 109, 113 data, 20–21, 22, 96–97 Daugherty, Gordon, 141–42, 173 demand, 33–34 De Nayer, Pierre, 158 Desk.com, 77 destination clubs, 68–70 Diapers.com, 15, 84–86 discounted cash flow, 28 distribution channels, 20 DocuSign, 140 Dollar Shave Club, 81–83, 84, 87–89, 157, 175–76, 192–93 Dorco, 88–89 Dream of Italy, 48–49 Driesman, Debbie, 101 Dropbox, 100 Dubin, Michael, 81–83, 87 e-commerce: consumables model, 81–90 surprise box model, 91–98 Economist Intelligence Unit, 25 Elaguizy, Amir, 86–87, 96 elevator business, 40–41 Entitle, 59 entrepreneurs, 129 eReatah, 59 evergreen subscriptions, 193–94 Everything Store, The: Jeff Bezos and the Age of Amazon (Stone), 85 Exclusive Resorts, 68–69 Facebook, 2, 19, 108, 146n New Masters Academy and, 61, 62 Family Circle, 179 Financial Times, 17, 48 first mover advantage, 146n float, 118–19 flower stores, 32–33, 34, 158–59, 195–96 H.Bloom, 33, 34, 39, 158–59, 197 Foot Cardigan, 165 For Entrepreneurs, 129 Forrester Research, 150–51, 192 Founders Investment Banking, 29–30 freemium model, 161–62, 164 free trials, 161–64 FreshBooks.com, 27, 144–48, 162–63, 164, 189 Fried, Jason, 144, 145–46 Fried, Jesse, 147 front-of-the-line model, 73–79 GameFly, 59, 155 Gartner and Forrester Research, 5, 24 Gates, Bill, 67 Generally Accepted Accounting Principles (GAAP), 127 Genius Network, 66–67, 155 Gerety, Suzanne Blake, 50–52, 197 Ghirardelli, 93 gifts: happiness bombs, 187–88 subscriptions as, 164–66 Gladwell, Malcolm, 71 Godiva, 93 Goodies Co., 20–21, 35 Goodman, Gail, 136, 183–84 Google, 55, 92 Apps, 24 Grano Speaker Series, 70–71, 159 Gray, Andrew, 168–70 Griffith, Scott, 109–10, 111, 113 Griffiths, Rudyard, 70 GrooveBook, 156–57 Hackers Conference, 47 Handler, Brad, 69 Handler, Brent, 69 Hansson, David Heinemeier, 144 happiness bombs, 187–88 Harland Clarke, 178 Hassle Free Home Services, 101–3, 173, 181, 194 H.Bloom, 33, 34, 39, 158–59, 197 Hearst, William Randolph, 16 Herbal Magic Weight Loss & Nutrition Centers, 24–25 Holland, Anne, 52–54 home ownership, 18 Hassle Free Home Services and, 101–3, 173, 181, 194 security businesses and, 4, 31, 116 Honda, 117 HubSpot.com, 131–36, 149–50, 180–81 Hunt, Sean, 37 Hunt, Stuart, 37 Hyssen, Alex, 24–25 Hyssen, James, 24–25 IBM, 126 inertia, 175, 180–81 information, 47–48 Infusionsoft, 176 Inspirato, 69–70 insurance companies, 117–19 International Air Transport Association, 175 Internet, 16, 137 reliability of, 19 Internet-based messaging services, 2 WhatsApp, 1–2, 108–9, 113, 157 iPhone, 1, 19 Islam, Frank, 101 iTunes, 57–58, 154 JackedPack, 91 Jacobo, Joshua, 59–62, 155 J.

More Than You Know: Finding Financial Wisdom in Unconventional Places (Updated and Expanded)
by Michael J. Mauboussin
Published 1 Jan 2006

I believe there has been a trade-off: higher economic returns for shorter periods are increasingly replacing lower economic returns for longer periods. Whether or not I am right, simplistic valuation assumptions invite danger. Another possible valuation pitfall comes with terminal valuations in discounted cash-flow models. Many discounted cash-flow models assume perpetual growth beyond an explicit forecast period, hence embedding an assumption of long-term value creation. In a world of shortening sustainable advantages, such an assumption appears particularly inappropriate.10 Clockspeed also has implications for portfolio turnover.

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Indeed, models show that this mix is the best search strategy for a correlated landscape.11 Tools of the Trade-Off Just as a different mix of short and long jumps is appropriate for different fitness landscapes, so too are different financial tools and organizational structures. Traditional discounted cash flow analysis is well suited for businesses that compete in stable fitness landscapes. A centralized management approach is effective, as industry activities are often clearly defined. A coarse fitness landscape requires a blend of traditional cash flow tools and strategic options. Strategic options are the right, but not the obligation, to pursue potentially value-creating business opportunities.12 Finally, companies that compete in roiling industries must lean more on strategic options to assess their current and potential fitness.

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Further, these companies are well served to adopt a “strategy by simple rules” approach. This decentralized approach has agreed-upon decision rules but lets individuals make decisions at the local level as they see fit.13 Fitness landscape Financial tool Organizational structure Stable Discounted cash flow Centralized Coarse DCF plus strategic options Loose centralization Roiling Strategic options Decentralized Tiger Woods showed that change, while sometimes painful in the short term, is necessary to improve fitness in the long term. Fitness landscapes can help you evaluate whether a company is pursuing the right potential strategies and has the appropriate organization.

The Doomsday Calculation: How an Equation That Predicts the Future Is Transforming Everything We Know About Life and the Universe
by William Poundstone
Published 3 Jun 2019

Lindy in the Stock Market John Burr Williams was a Harvard economist who sought to understand the 1929 stock market crash. Stocks had not been worth what investors of the Roaring Twenties thought they were. In The Theory of Investment Value (1938), Williams maintained that the value of any asset resides in its future income stream, discounted to present value. This is known as the discounted cash flow model. According to Williams, a dividend-paying stock is worth the sum of all its future dividend payments, suitably adjusted. Suppose Coca-Cola pays a dividend of $1.59 a share and will pay that same yearly dividend for the next hundred years. The total would be $159. These dividends must be adjusted to reflect the time value of money.

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Lindy’s law predicts that Coke is likely to pay dividends, and increase them, decades into the future. It is more likely to do this than a company with less of a track record of dividend payments. You may feel this is simply common sense. But it gets more interesting when you consider the long-standing puzzle of how to value stocks. Accept discounted cash flow, even as an inexact rule of thumb, and you discover something remarkable. The future lifespan of a company ought to matter in stock valuations, and it ought to matter a lot. Ben Reynolds, who has examined Warren Buffett’s investing in the context of the Lindy effect, gave this example. Suppose a stock pays a dividend of $1 a year now, and this dividend grows 6 percent a year until the company abruptly goes bust and its stock becomes worthless.

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Suppose a stock pays a dividend of $1 a year now, and this dividend grows 6 percent a year until the company abruptly goes bust and its stock becomes worthless. You have a discount rate of 7 percent, meaning, say, that you can get 7 percent as a risk-free return elsewhere. With discounted cash flow, here’s what the stock ought to be worth to you right now: • $9.47 if the stock survives another ten years before going bust • $18.03 if it survives another twenty years • $39.10 if it survives fifty years • $62.76 if it survives one hundred years • $100 if it survives forever In Reynolds’s example the dividend grows almost fast enough to make up for the time value of money.

The Joys of Compounding: The Passionate Pursuit of Lifelong Learning, Revised and Updated
by Gautam Baid
Published 1 Jun 2020

Second, personal fear is your enemy [emphasis added].”17 Markets oscillate between extreme optimism and pessimism, which is why it is so useful to have a “reverse discounted cash flow frame of mind.” Invert, always invert. Stock prices sometimes fall to such extremely low levels that the earnings of the next three to four years alone add up to the current market cap. Conversely, sometimes stock prices go to such extremely high levels that even a high earnings growth rate for a decade would not produce earnings sufficient to justify a future value large enough to make a commitment today. Thinking in terms of a reverse discounted cash flow analysis to evaluate stocks during such periods helps investors make better decisions.

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We should restrict ourselves only to those cases in which the investment decision looks like a no-brainer. As Charlie Munger says, “The goal of investment is to find situations where it is safe not to diversify.”5 Look for simple businesses that require fewer assumptions and fewer hypothetical scenarios to work out and that do not require discounting cash flows from way out into the future to justify the investment. As Thomas Carlyle aptly put it, “Our main business is not to see what lies dimly at a distance, but to do what lies clearly at hand.” In his 2004 letter, Buffett highlighted the importance of sticking to simple propositions: If only one variable is key to a decision, and the variable has a 90 percent chance of going your way, the chance for a successful outcome is obviously 90 percent.

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Rather than focusing just on the growth catalysts, think probabilistically, in terms of a range of possible outcomes, and contemplate the possible risks, especially those that have never occurred. 4. What is the growth rate being implied by the market in the current valuation of the stock? versus What is my future growth rate assumption? A reverse discounted cash flow fleshes out the current assumptions of the market for the stock. We can then compare the market’s assumptions with our own and make a decision accordingly. Good investors demonstrate the flexibility to completely change their opinions if necessitated by the facts. They don’t hope they will be right; they keep evaluating why they might be wrong.

Deep Value
by Tobias E. Carlisle
Published 19 Aug 2014

Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought. Williams’s discounted cash flow theory of intrinsic value is the foundation of modern finance, and forms the intellectual basis for a variety of valuation models. Buffett took William’s discounted cash flow theory and extended it to properly value growth in a business. According to Buffett, measures traditionally used in business valuation—book value, earnings, and growth—were flawed in their application. Intrinsic business value was “the measurement that really counts,” Buffett emphasized in his 1983 Chairman’s Letter: Book value’s virtue as a score-keeping measure is that it is easy to calculate and doesn’t involve the subjective (but important) judgments employed in calculation of intrinsic business value. 

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We might also have $700 $600 $500 $400 $300 $200 $100 FIGURE 6.1â•… Apple, Inc. 10-Year Stock Price Chart Source: Eyquem Investment Management LLC. 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 $– 112 DEEP VALUE observed that below $400 it was one of the most undervalued large capitalization stock in the United States, and, as we know, undervaluation is a condition for future market-beating returns. Shortly after Graham published Security Analysis in 1934, John Burr Williams published his 1938 masterpiece The Theory of Investment Value.44 Williams’s discounted cash flow theory of intrinsic value is the bedrock of modern valuation and forms the intellectual basis for a variety of valuation models, including, for example, Gordon’s growth model, which we saw earlier. The models all require an estimate for future cash flows, earnings, or dividends, making allowance for any growth, and out to perpetuity.

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Money has a time value—a dollar today is worth more than a dollar in a year—so we must then discount back to today those future cash flows at the appropriate discount rate. While the theory is sound, the slip ’twixt cup and lip is in its practical application. The three variables—future cash flows, the growth rate, and the discount rate—are all sources of potential forecast error. Discounted cash flow models are extremely sensitive to discount rates, which can lead to large errors, but the real problem is that the model assumes we have some way of forecasting future cash flows and the growth rates embedded in them. Time and again, we have been shown to be poor forecasters, preferring to extrapolate the current trend, rather than assume mean reversion.

Ethics in Investment Banking
by John N. Reynolds and Edmund Newell
Published 8 Nov 2011

Arranging finance would consist of preparing presentations to potential funders and securing financing (normally debt, but this can also include additional sources of equity finance) Bait and switch: investment banking practice of marketing a (senior) team of bankers to a client and then replacing them with more junior bankers once a mandate has been awarded Big cap: a quoted company with a large market capitalisation or share value Business ethics: an ethical understanding of business, applying moral philosophical principles to commerce Capital markets: collective term for debt and equity markets; reference to the businesses within an investment bank that manage activity in the capital markets Casino capitalism: term used to describe high-risk investment banking activities with an asymmetric risk profile Categorical imperative: the concept, developed by Immanuel Kant, of absolute moral rules CDS: credit default swap, a form of financial insurance against the risk of default of a named corporation CEO: chief executive officer, the most senior executive officer in a corporation viii Glossary ix Church Investors’ Group (CIG): a group of the investment arms of a number of church denominations, mainly from the UK and Ireland Code of Ethics: an investment bank’s statement of its requirements for ethical behaviour on the part of its employees Compensation: investment bankers’ remuneration or pay Compliance: structures within an investment bank to ensure adherence to applicable regulation and legislation Conflict of interest: situation where an investment bank has conflicting duties or incentives Corporate debt: loan made to a company Credit rating: an assessment of the creditworthiness of a corporation or legal entity given by a credit rating agency CSR: Corporate Social Responsibility DCF: discounted cash flow Debtor in Possession finance (DIP finance): secured loan facility made to a company protected from its creditors under chapter 11 of the US bankruptcy code Derivative: a security created out of an underlying security (such as an equity or a bond), which can then be traded separately Dharma: personal religious duty, in Hinduism and Buddhism Discounted cash flow valuation: the sum of: • the net present value (NPV) of the cash flows of a company over a defined timescale (normally 10 years); • the NPV of the terminal value of the company (which may be the price at which it could be sold after 10 years); and • the existing net debt of the company Distribution: the marketing of securities Dodd–Frank Act: the Dodd–Frank Wall Street Reform and Consumer Protection Act Downgrade: a reduction in the recommended action to take with regard to an equity; or a reduction in the credit rating of a corporation Duty-based ethics: ethical values based on deontological concepts EBITDA: Earnings Before Interest Tax Depreciation and Amortisation EIAG: the Ethical Investment Advisory Group of the Church of England Encyclical: official letter from the Pope to bishops, priests, lay people and people of goodwill x Glossary Enterprise value (EV): value of an enterprise derived from the sum of its financing, including equity, debt and any other invested capital, which should equate to its DCF value ERM: the European Exchange Rate Mechanism, an EU currency system predating the introduction of the euro ETR: effective tax rate EV:EBITDA: ratio used to value a company Exit: sale of an investment Free-ride: economic term for gaining a benefit from another’s actions Financial adviser: see Adviser Glass–Steagall: the 1933 Act that required a separation of investment and retail banking in the US Golden Rule: do to others as you would have them do to you Hedge fund: an investment fund with a specific investment mandate and an incentivised fee structure (see 2 and 20) High yield bond: debt sold to institutional investors that is not secured (on the company’s assets or cash-flows) HMRC: Her Majesty’s Revenue and Customs, the UK’s authority for collecting taxes Hold-out value: value derived from the contractual right to be able to agree or veto changes Ijara: Shariah finance structure for project finance Implicit Government guarantee: belief that a company or sector benefits from the likelihood of Government intervention in the event of crisis, despite the fact that no formal arrangements are in place Initial Public Offering (IPO): the initial sale of equity securities of a company to public market investors Insider dealing: trading in shares in order to profit from possessing confidential information Insider trading: see Insider dealing Integrated bank: a bank offering both commercial and investment banking services Integrated investment bank: an investment bank that is both active in capital markets and provides advisory services Internal rate of return (IRR): the annualised return on equity invested.

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Lord Goldsmith stated at the Lords Grand Committee on 6 February 2006 that “For a commercial company, success will normally mean long term increase in value.”7 Defining the long-term value of a company is not straightforward, especially for a large company with multiple businesses and assets. Value can be analysed using discounted cash flow analysis (DCF), although this has a number of subjective inputs, both in terms of methodology (e.g., discount rate) and in terms of business assumptions (e.g., market share), resulting in diverse outcomes. Value can also be assessed on the basis of comparisons with peers, where these are available, or on the basis of financial ratios, such as P:E (Price:Earnings) or multiples of enterprise value to EBITDA or cash flow (although multiple-based analysis tends to be cruder than DCF).

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Index ABACUS, 7, 16–17, 46, 63–4, 68, 73, 78 Abrahamic faiths Christianity, 52–4 Islam, 54–5 Judaism, 56 abuse market, 14, 70, 75, 84–8 personal, 159 of resources, 127–8 abusive management practices, 157 abusive trading, 93 adult entertainment, 56 advisers financial, 109 investment banking, 111 sell-side, 107, 111–13 trusted, 108–9, 125 advisory fees, 119, 124 advisory markets, 73 agents, 65 aggressive behaviours, 118–19 Alpha International, 9 American Bar Association, 19 Anderson, Geraint “CityBoy”, 8 Anglican Communion, 53 Anglicanism, 53 annual general meeting (AGM), 29, 54 Aquinas, Thomas, 34, 37 Aristotle, 34 Arjuna, 57 attrition rate, 132 authorisation, informal, 81, 98 BAE Systems, 48 bait and switch, 102–3, 158 bank debt, 82–3, 120 banking regulations, 16 Bank of America, 16 Bank of Credit and Commerce International (BCCI), 12 Bank of England, 25 Barclays Capital, 139 Bar Council, 19 Bayly, Daniel, 8 Bear Stearns, 5, 16, 76 beauty parade, 110 behaviours aggressive, 118–19 discriminatory, 129–31 of Hedge fund, 12 investment banking, 3 management, 131–2 market, 71 misleading, 86 unethical, 68 virtuous, 37 Benedict XVI, Pope, 6, 52 Bentham, Jeremy, 36 Bernanke, Ben S., 96 Besley, Tim, 42 Beyond the Crash (Brown), 4 Bhagavad Gita, 57 bid price, 64 big cap, 65, 85 black box approach, 114 Blackstone Group, 20 Blankfein, Lloyd, 47, 63–4, 68, 78 bluffing, 113 Boesky, Ivan, 12 bonds government, 23 investment grade, 118 junk, 118 bonus pools in public ownership, 136–9 Bootle, Roger, 4 Bribery Act 2010, 129 British Academy, 42 Brown, Gordon, 4, 135 Buddhism, 57 bullying, 159 170 Index business ethics of fiduciary duties, 27 of financial crisis, 12–32 within governments, 59 of market capitalism, 12–14 of regulation, regulatory changes and, 18–21 of religion, 51–62 of shareholders, 27–9 strategic issues with, 30–1 Business Ethics Center, 56 Business Judgment Rule, 20 Business Standards Report, 46 buy recommendation, 115 capitalism market, 12–14 modern, 54 see also casino capitalism capital markets, 155 advisory markets vs., 73 conflicts of interest in, 112–14 cardinal virtues, 37 Caritas in Veritate (Benedict), 6, 52 cash compensation, 132, 134 casino capitalism emergence of, 43 in investment banking, 3 speculative, 16, 93 categorical imperative, 34, 59, 69 Caterpillar, 48 Central Finance Board of the Methodist Church (CFB), 54, 59 chief executive officer (CEO), 116 Christianity, 52–4 Anglican Communion, 53 Methodist Church, 53 Roman Catholic Church, 53 Christian Old Testament, 34 Church Investors’ Group (CIG), 135 Church of England, 9, 53, 58 Citigroup, 19, 112 claiming credit, 134 clients confidential information, 120 conflicts of interest, 105–10 171 duty of care, 105 engagement letters, 122–3 fees, 115–18 financial restructuring, 119–20 hold-out value, 120–1 honesty, 101–5 margin-calls, 121 practical issues, 110–15 promises, 100–1 restructuring fees, 121–2 syndication, 118–22 truth, 101–5 Code of Ethics, 47–50, 147–51 for Goldman Sachs business principles, 46 in investment banking, 47–9 Revised, 47 collatoralised debt obligations (CDOs), 30, 42, 75 command economies, 13 commercial banking, 19–21, 25 communication within markets, 88 Companies Act 2006, 27 compensation cash, 132, 134 defined, 132 for employees, 135 internal issues on, 8 for junior bankers, 136 levels of, 132–3, 138 objectivity of, 144 political issues with, 6, 137 restrictions on, 10 competitors, 113 compliance corporate, 20 danger of, 20 frameworks for, 68, 146 regulatory, 18 requirements of, 6 confidential information, 120 conflicts of interest, 105–10, 158 with capital markets, 109–10 with corporate finance, 107–8 personal, 47 with pre-IPO financing, 110 with private equity, 110 172 Index conflicts of interest – continued reconciling, 68–70 of trusted advisers, 108–9 consequentialist ethics, 36–7, 42 corporate compliance, 20 Corporate/Compliance Social Responsibility (CSR), 7 corporate debt, 17 corporate entertainment, 128–9, 159 corporate finance, 107–8 Corporate Sustainability Committee, 152 Costa, Ken, 9 Cox, Christopher, 96–7 creative accounting, 12 credit crunch, 17 credit default swap (CDS), 71 credit downgrade, 17, 76 Credit Lyonnais, 12 creditors, restricted, 121 credit rating, 75–7 calculating, 76 inaccurate, 5 manipulating, 75, 156, 158 unreliability of, 17 credit rating agencies, 76 Crisis and Recovery (Williams), 53 culture, 46, 136, 151 customers, 69 Daily Telegraph, 84 Debtor in Possession finance (DIP finance), 80 debts bank, 82–3, 120 corporate, 17 junior, 118 rated, 77 senior, 118 sovereign, 17 deferred equity, 5 deferred shares, 133 Del Monte Foods Co., 107 deontological ethics, 34–6 stockholders, 41–2 trust, 40–1 derivative, 27, 30 dharma, 63–4 Dharma Indexes, 57 discounted cash flow (DCF), 27 discount rate, 27 discriminatory behaviour, 129–31 distribution, 15, 35, 66 Dodd–Frank Wall Street Reform and Consumer Protection Act, 25 dotcom crisis, 94 dotcom stocks, 17 Dow Jones, 55–6 downgrade credit, 17, 76 defined, 76 multi-notch, 17, 76 duties, see rights vs. duties duty-based ethics, 66–8 duty of care, 105 Dynegy, 8 Earnings Before Interest Tax Depreciation and Amortisation (EBITDA), 27 economic free-ride, 5, 21 economic reality, 137 effective tax rate (ETR), 140 emissions trading, 14 employees, compensation for, 135 Encyclical, 52 engagement letters, 122–3, 159 Enron, 8, 12, 17, 20, 76 enterprise value (EV), 27 entertainment adult, 56 corporate, 128–9, 159 sexist, 159 equity deferred, 5 private, 2–3, 12, 110 equity research, 88–9, 113–15 insider dealing and, 83–4 ethical behaviour, 38–9 Ethical Investment Advisory Group (EIAG), 53, 58 ethical investment banking, 145–7 ethical standards, 47 Index ethics consequentialist, 36–7, 42 deontological, 34–6 duty-based, 66–8 exceptions and, effects of, 89–90 financial crisis and, 4–8 in investment banking, 1 in moral philosophy, 1 performance and, 8–10 rights-based, 66–8 virtue, 37–8, 43–4 see also business ethics; Code of Ethics Ethics Helpline, 48 Ethics of Executive Remuneration: a Guide for Christian Investors, The, 135 European Commission, 89 European Exchange Rate Mechanism (ERM), 17 exceptions, 89 external regulations, 19, 31 fair dealing, 45 Fannie Mae, 43 Federal Home Loan Mortgage Corporation, 43 Federal National Mortgage Association, 43 fees, 115–18 advisory, 107, 116 restructuring of, 121–2 2 and 20, 13 fiduciary duties, 27–8 financial advisers, 109 Financial Conduct Authority (FCA), 26 financial crisis, business ethics during CDOs during, 90 CDSs during, 90 ethics during, 4–8, 12–34 investment banking and, necessity of, 14–15 market capitalism, 12–14 necessity of, 14–15 non-failure of, 21 positive impact of, 18 problems with, 15–17 reality of, 16 speculation in, 91 173 Financial Crisis Inquiry Commission, 76 Financial Policy Committee (FPC), 25 financial restructuring, 119–20 Financial Services Modernization Act, 19 Financial Stability Oversight Council, 25 firm price, 67 Four Noble Truths, 57 Freddie Mac, 43 free-ride defined, 26 economic, 5, 21 in investment banking, 24 FTSE, 55 Fuhs, William, 8 General Board of Pension and Health Benefits, 54, 59 German FlowTex, 12 Gift Aid, 141 Glass–Steagall Act, 19 Global Settlement, 113 golden parachute arrangements, 133 Golden Rule, 35, 150 Goldman Sachs, 7, 16, 45, 63 Business Principles, 45–6 charges against, 78 Code of Business Conduct and Ethics, 45, 68 Code of Ethics for, 47–8 Goldsmith, Lord, 27 government, 59 business ethics within, 60 guarantees of, 24 intervention by, 22–3 government bonds, 23 greed, 4–5 Green, Stephen, 8–9 gross revenues, 59 Hedge fund behaviour of, 12 failure of, 21 funds for, raising, 2 investment fund, as type of, 3 rules for, 133 174 Index Hennessy, Peter, 42 Her Majesty’s Revenue and Customs (HMRC), 140–1 high returns, 28, 110 Hinduism, 56–7 Hobbes, Thomas, 36 hold-out value, 120–1 honesty, see trust hospitality, 128–9 hot IPOs, 94 hot-stock IPOs, 94 HSBC, 9, 28, 152 Ijara, 55 implicit government guarantee, 22–3 Independent Commission on Banking, 25 inequitable rewards, 6 informal authorisation, 81, 98 Initial Public Offering (IPO), 7 of dotcom stocks, 17 hot, allocation of, 94 hot-stock, 94 insider dealings, 83–4, 155 equity research and, 83–4 ethics of, 66, 70 laws on, 84 legal prohibition on, 82 legal restrictions on, 10 legal status of, 82 legislation on, 74 restrictions on, 83 rules of, 82, 90 securities, 70 insider trading, 12 insolvency, 24–5 institutional greed, 4 integrated bank, 28 integrated investment banking, 2, 30, 67, 106, 108 interest payments, 59–60 interest rate, 60 internal ethical issues, 126–43 abuse of resources, 127–8 corporate entertainment, 128–9 discriminatory behaviour, 129–31 hospitality, 128–9 management behaviour, 131–2 remuneration, 132–9 tax, 139–41 internal review process, managing, 134 investment banking, 94 casino capitalism in, 3 Code of Ethics in, 47–9 commercial and, convergence of, 20–1 defined, 2 ethics in, 1 free-ride in, 24 integrated, 2, 30, 67, 108, 112 in market position, role of, 65–6 moral reasoning and, 38 necessity of, 14–15 non-failure of, 19–20 positive impact of, 18 recommendations in, 94–7 sector exclusions for, 58–9 investment banking adviser, 121 investment banking behaviours, 3 investment banking ethics committee, 151–3 investment bubbles, 95 investment fund, 3 investment grade bonds, 118 investment grade securities, 76 investment recommendations, 94 investments personal account, 128, 156 principal, 15, 28 proprietary, 29 IRS, 140 Islam, 54–5 Islamic banking, 6, 54–5 Jewish Scriptures, 34 Joint Advisory Committee on the Ethics of Investment (JACEI), 54 JP Morgan, 16 Judaism, 56 junior bankers, 139 junior debt, 118 junk bond, 118 “just war” approach, 38 Index Kant, Immanuel, 35, 69 karma, 57 Kerviel, Jérôme, 44, 80 Krishna, 57 Law Society, 19 Lazard International, 9 leading adviser, 41 Leeson, Nick, 12, 44, 81 legislative change, 25–6 Lehman Brothers, 5–6, 15, 21, 23, 31, 43, 76 lenders, 26, 131 lending, 59–60 leverage levels of, 25 over, 75, 80, 119 Levin, Carl, 17, 63–4, 68 light-touch regulations, 4 liquidity market, 95 orderly, 25 withdrawal of, 24 loan-to-own, 80 Locke, John, 34 London Inter-Bank Offered Rate (LIBOR), 23 London School of Economics, 43 London Stock Exchange, 65, 71, 84 long-term values, 147 Lords Grand Committee, 27 LTCM, 23 lying, 101 MacIntyre, Alasdair, 38 management behaviour, 131–2 margin-calls, 121 market abuse, 14, 70, 75, 86–8, 155 market announcements, 88 market behaviours, 74 market capitalism, 12–14 market communications, 88 market liquidity, 95 market maker defined, 65–7 investment bank as, 66 primary activities of, 65 175 market manipulation, 75 market position, role of, 104 market rate, 117 markets advisory, 73 capital, 73, 117–18, 158 communication within, 88 duties to support, 71–2 primary, 103 qualifying, 70, 82 secondary, 103 market trading, 41 Maxwell, Robert, 12 Meir, Asher, 56 mergers and acquisitions (M&As), 41, 79 Merkel, Angela, 93 Merrill Lynch, 8, 16 Methodism, 53 Methodist Central Finance Board, 59 Methodist Church, 54 Midrash, 56 Milken, Michael, 12 Mill, John Stuart, 36 Mirror Newspaper Group, 12 misleading behaviours, 86, 105 mis-selling of goods and services, 77–9, 155 modern capitalism, 54 moral-free zones, 31 moral hazard, 22, 70 moral philosophy, 1 moral reasoning, 38 moral relativism, 38–9, 49, 68 Morgan Stanley, 47 multi-notch downgrade, 17, 79 natural law, 34, 37 natural virtues, 37 necessity of investment banking, 14–15 New York Stock Exchange (NYSE), 65, 71 New York Times, 8 Noble Eightfold Path, 57 Nomura Group Code of Ethics, 47 normal market trading, 71 Northern Rock, 43 176 Index offer price, 64 off-market trading, 71–3, 90, 155 Olis, Jamie, 8 on-market trading, 70–1 oppressive regimes, 61 option value, 121 Orderly Liquidation Authority, 25 orderly liquidity, 25 out-of-pocket expenses, 127–8 over-leverage, 75, 80, 119, 158 overvalued securities, 155 patronage culture, 131, 142 Paulson, Henry M., 86 Paulson & Co., 78 “people-based” activity, 67 P:E ratio, 27 performance, 8–10 personal abuse, 159 personal account investments, 128, 156 personal account trading, 128 personal conflicts of interest, 45 pitching, 102, 159 Plato, 37 practical issues, 110–15 competitors, relationships with, 113 equity research, 113–15 pitching, 111 sell-side advisers, 111–13 pre-IPO financing, 110 prescriptive regulations, 31, 145 price tension, 79, 113 primary market, 103 prime-brokerage, 2 principal investment, 15, 28 private equity, 2–3, 12, 110 private trading, 94 Project Merlin, 133, 141 promises, 100–1 proprietary investment, 29 proprietary trading, 15, 25, 66, 150, 155 Prudential Regulation Authority (PRA), 26 public ownership, bonus pools in, 136–9 “pump and dump” strategy, 86 qualifying instruments, 70, 87 qualifying markets, 70, 82 quality-adjusted life year (QALY), 36 Quantitative Easing (QE), 23 Queen Elizabeth II, 42 Qu’ran, 54 rated debt, 77 rates attrition, 132 discount, 27 interest, 60 market, 117 tax, 140 rating agencies, 76 Rawls, John, 35, 136 recognised exchanges, 71 Regal Petroleum, 84 regulations banking, 16 compliance with, 28 external, 19, 31 light-touch, 4 prescriptive, 31, 145 regulatory changes and, 18–20 securities, 114 self, and impact on legislation, 19 regulatory compliance, 18 religion, business ethics in, 51–62 Buddhism, 56 Christianity, 52–4 Governments, 59 Hinduism, 56–7 interest payments, 59–60 Islam, 54–5 Judaism, 56 lending, 59–60 thresholds, 60 usury, 59–60 remuneration, 132–9 bonus pools in public ownership and, 136–9 claiming credit, 134 ethical issues with, 142–3 internal review process, managing, 134 1 Timothy 6:10, 135–6 Index research, 156 resources, abuse of, 127–8 restricted creditors, 120 restructuring of fees, 121–2 financial, 119–20 syndication and, 118–22 retail banks, 16 returns, 28, 156 Revised Code of Ethics, 47 right livelihood, 57 rights-based ethics, 66–8 rights vs. duties advisory vs. trading/capital markets, 73 conflict between, reconciling, 68–70 duty-based ethics, 66–8 off-market trading, ethical standards to, 71–2 on-market trading, ethical standards in, 70–1 opposing views of, 63–74 reconciling conflict between, 68–70 rights-based ethics, 66–8 Roman Catholic Church, 52 Royal Dutch Shell, 85 Sarbanes–Oxley Act, 20 Schwarzman, Stephen, 20 scope of ethical issues, 7–8 secondary market, 103 sector exclusions for investment banking, 58–9 securities investment grade, 76 issuing, 103–5 overvalued, 155 Securities and Exchange Commission (SEC), 7, 16 Goldman Sachs, charges against, 78 rating agencies, review by, 77 short-selling, review of, 96–7 securities insider dealing, 70 securities mis-selling, 77–9 securities regulations, 114 self-regulation, 19 sell recommendation, 115 177 sell-side advisers, 107, 111–13 Senate Permanent Subcommittee on Investigations, 46 senior debt, 118 sexist entertainment, 159 shareholders, 27–9 shares, deferred, 133 Shariah finance, 55 short-selling, 94–7, 154–5 Smith, Adam, 14, 35–6 social cohesion, 53 socially responsible investment (SRI), 56 Société Générale, 44, 80 solidarity, 53 Soros, George, 17 South Sea Bubble, 90 sovereign debt, 17 speculation, 91–4, 155 in financial crisis, 93 traditional views of, 91–3 speculative casino capitalism, 16, 91 spread, 21 stabilisation, 89 stock allocation, 94–7 stockholders, 41–2 stocks, dotcom, 17 Strange, Susan, 43 strategic issues with business ethics, 30–1 syndication, 119 and restructuring, 118–22 systemic risk, 24–5 Takeover Panel, 109 Talmud, 56 taxes, 139–41 tax optimisation, 158 tax rates, 140 tax structuring, 140 Terra Firma Capital Partners, 79, 112 Theory of Moral Sentiments, The (Smith), 14 3iG FCI Practitioners’ Report, 51 thresholds, 60 1 Timothy 6:10, 135–6 178 Index too big to fail concept, 21–7 ethical duties, and implicit Government guarantee, 22–3 ethical implications of, 26–7 in government, 22–3 insolvency, systemic risk and, 24–5 legislative change, 25–6 Lehman, failure of, 23 systemic risk, 24–5 toxic financial products, 5 trading abusive, 93 emissions, 14 insider, 12 market, 41 normal market, 71 off-market, 71–83, 90, 155 on-market, 70–1 personal account, 128 private, 94 proprietary, 15, 25, 66, 150, 155 unauthorised, 7 “trash and cash” strategy, 86 Travellers, 19 Treasury Select Committee, 26 Trinity Church, 53 Trouble with Markets, The (Bootle), 4 trust, 40, 53 trusted adviser, 108–9, 125 truth, 101–5 bait and switch, 102–3 misleading vs. lying, 101 securities, issuing, 103–5 2 and 20 fee, 13 UBS Investment Bank, 9 unauthorised trading, 7, 80–1, 155 unethical behaviour, 68 UK Alternative Investment Market, 89 UK Business Growth Fund, 133 UK Code of Practice, 141 UK Independent Banking Commission, 4, 22 United Methodist Church, 54, 59 United Methodist Investment Strategy Statement, 59 US Federal Reserve, 24, 25 US Financial Crisis Inquiry Commission, 4 US Open, 126 US Senate Permanent Subcommittee on Investigations, 64, 73 US Treasury Department, 132 universal banks, 2, 21, 28, 67 untoward movement, 85 usury, 59–60 utilitarian, 84 utilitarian ethics, 49, 84, 139 values, 9, 46, 119–21, 148 Vedanta, 57 victimless crime, 82 virtue ethics, 37–8, 43–4 virtues, 9, 34 virtuous behaviours, 37 Vishnu, 57 Volcker, Paul, 25 Volcker Rule, 2, 25 voting shareholders, 29 Wall Street, 12, 19, 53 Wall Street Journal, 20 Wealth of Nations, The (Smith), 14 Wesley, John, 53 Wharf, Canary, 18 Williams, Rowan, 53 Wimbledon, 127 WorldCom, 12, 17, 20, 76 write-off, 80 zakat, 55 zero-sum games, 118–22 

Investment: A History
by Norton Reamer and Jesse Downing
Published 19 Feb 2016

Let us restate this maximum value principle in an alternative form, thus: one option will be chosen over another if its income possesses comparative advantages outweighing (in present value) its disadvantages.”7 Fisher instructs the investor to discount future cash flow streams and be aware that while some investment opportunities 232 Investment: A History may have higher cash flows in particular years, it is essential to have a broader view and look at all of the discounted cash flows as the basis of comparison. Last, Fisher defines rate of return over cost as the discount rate that equalizes two possible investments in terms of present values.8 New investment can occur when this rate of return over cost is greater than the interest rate. The formula was simple, but powerful: one could assess the soundness of an investment project by finding the net present value of its future cash flows. Discounted Cash Flow Models Fisher helped devise the theory of discounted cash flow for any asset, but it was John Burr Williams who advanced this theory significantly.

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Williams also received the disapprobation of his thesis committee for sending the work to publishers before it was reviewed and accepted by the committee itself as degree worthy.11 Despite being met with this initial displeasure, Williams set the stage for the modern school of financial academics who think in terms of cash flows and a discount factor to value stocks. In some ways, what Williams did was take a known idea of valuing a traditional asset, such as real estate or a bond, as the sum of discounted cash flows and apply it to the stock market, where dividends represented the cash flows. A simple application in retrospect, perhaps, but it was the forward march of intellectual progress. The Effect of Capital Structure on Asset Pricing Franco Modigliani and Merton Miller analyzed a rather different question relating to asset pricing: how does the capital structure affect the value of a firm?

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The stockbroker seemed to suggest that Markowitz think about the portfolio selection problem in the context of linear optimization, and Marschak later agreed to his doing just that.27 Markowitz was the man for the job; he knew the linear optimization methods, having studied with George Dantzig at the RAND Corporation.28 Philosophically, Markowitz realized that the theory of asset pricing was incomplete without a corresponding theory of risk. Markowitz reasoned that one can indeed perform a calculation of dividends (in truth, proxies for discounted cash flows), but those future dividends themselves are uncertain. And yet, the risks are not captured by the concepts of net present value of Fisher or the dividend discount model of John Burr Williams.29 Markowitz offered a technical solution. To give a slightly more modern version of some of his ideas, his approach involves plotting all of the assets available on a graph where the left axis is the expected return and the horizontal axis is the excess volatility, as measured by the standard deviation of returns of the asset (see figure 7.1).

Secrets of Sand Hill Road: Venture Capital and How to Get It
by Scott Kupor
Published 3 Jun 2019

VCs often joke that “we can make the spreadsheet say whatever we want.” More significantly for startups—for those of you familiar with discounted cash flow models—because they tend to consume cash in the early years and (hopefully) generate cash in the mature years, most of the value in a discounted cash flow model will come from the far-out years, where the certainty of forecasts gets even more fuzzy. In addition to all these challenges, the comparable company and discounted cash flow analyses also suffer from the fact that they don’t account for dilution in the VCs’ equity holdings resulting from future financings.

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This analysis is doubly hard as applied to startups because (we hope) startups are by definition unique, and the ability to forecast revenue is inherently unpredictable. So even if we get the comparables right, who knows if we will get our revenue forecast right—garbage in, garbage out. Discounted Cash Flow Analysis Financial theory says—and who are we to argue with it—that over the long run, the value of a company equals the present value of its future cash flows. That is, whatever annual cash a company can generate in the future, if we discount that cash to present-day values, an investor should be willing to pay no more than the current value of that stream of future cash.

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Bloodhound Technologies, 236–239 Casado, Martin, 45, 131–132 cash as deflationary hedge, 59, 63 role of, 17–18 and Yale University endowment, 63 “cashless exercise option,” 184–185 C Corporations, 92–94 chief executive officers (CEOs) and board of directors, 171, 202–204, 207–209 compensation of, 205–206 and informal coaching by VCs, 207 and over-involvement of VCs, 203 of publicly traded companies, 268 role of, 199 strategic direction of, 203–204 Chinese wall strategy for managing conflicts, 214, 215 choosing a venture capital firm and ability to raise new funds, 67–68 and life cycles of funds, 66–67, 68 and state of fund, 84 Cisco, 11 clawbacks, 80–81 closing the company, 243–246 cloud computing, 20 cofounders, 94, 96–101 Columbus, Christopher, 53 commodities investments, 58 “common-controlled” boards, 172 common stock/shareholders about, 93, 141 and acquisitions, 252, 254–255 and Bloodhound case, 236–239 conversion of preferred shareholders to, 160–165, 177, 235, 280 and dilution of equity, 154, 167 and dividends, 155 and drag-along provisions in term sheets, 182 and fiduciary duty of board members, 211–215, 216, 231 and liquidation preference, 157, 158 representation of, on board, 171, 172 separate vote for, 230 and stock restrictions in term sheets, 181 “company-first company” concept, 44–45 comparable company analysis valuation method, 77–78, 79, 149–150 comparing finance deals, 189–198 and capitalization tables, 190–196 and governance terms, 196–198 compensation, 204, 244 competing companies, 212–215 competition for venture capital, 271–272 compliance, maintaining, 206–207 confidentiality addressed in term sheets, 285 duty of, 212–215 conflicts of interest anticipation/understanding of, 228, 230–231, 239 and Bloodhound case, 237 and duty of confidentiality, 213–214 managing, 214, 215, 230–231 resulting from a pivot, 213–214 and Trados case, 222–226, 228 “control” investments, 16–17 conversion/auto-conversion to common shares, 160–165, 177, 235, 280 convertible debt/notes, 142–147, 148, 233 corporate pension funds, 55 corporate structure for startups, 92–94 corporate veil, protecting against piercing, 206–207 co-sale agreements, 181 creditors, 245, 246 Credit Suisse First Boston, 12, 13 crowdfunding, 36, 273, 274 customer acquisition, 135–136 D&O (directors & officers) insurance, 183, 284 debt equity vs., 26–29 and winding down the company, 246 Decimalization and Regulation NMS (National Market System), 107 deflationary hedges, 59, 63 Delaware, 174 difficult financings, 232–246 and Bloodhound case, 236–239 and bridge financing, 233 and fiduciary duty questions, 232, 236, 237 reducing/eliminating liquidation preferences, 234–236 and reverse splits of stock holdings, 235–236 success following, 239–242 and winding down the company, 243–246 See also down-round financing; recapitalizations dilution of equity about, 120 and antidilution provisions in term sheet, 165–167, 193–196, 280–281 balancing incenting against, 146–147 and down rounds, 165–166, 167, 237 and employee option pools, 240 and pro rata investments, 178–180 and reverse splits of stock holdings, 235–236 Dimon, Jamie, 133 discounted cash flow analyses, 150–153 discount rates, 150–151 distribution of returns for venture capital, 30–32, 31, 35, 38, 40 diversification, 36 dividends, 154–155, 279 Dixon, Chris, 48 “DLOM” (discount for lack of marketability), 77–78 Doerr, John, 43, 112 domestic equities, 61–62 Dorsey, Jack, 133 dot.com boom/bust and buyout investors, 16–17 general outlook during, 9–11 initial public offerings during, 9–10, 15 and LoudCloud, 12–18 and Nasdaq index, 10–11, 15 pace of VC investment during, 10 and public markets, 10–11 and Yale University endowment, 64–65 double-trigger acceleration, 186–187, 250–251 down-round financing and Bloodhound case, 237 defined, 165 and dilution of equity, 165–166, 167, 237 and fiduciary duty questions, 232, 236, 237 and management incentive plans, 241–242 purpose of, 234 success following, 234, 239–242 and winding down the company, 234 drag-along provisions in term sheets, 182–183, 252, 284 dual-class stock, 160, 168–169 dual fiduciaries, 201–202, 212 duty of candor, 215 duty of care, 211–212, 215, 217 duty of confidentiality, 212–215 duty of loyalty, 212, 215, 218 early-stage financing/investors (angels or seed investors) and convertible notes, 28, 144 emergence of, 271 of Horowitz and Andreessen, 19 and Silicon Valley community (2007), 19 as source of referrals for VCs, 125 and valuation of startups, 153 economic impact of venture-backed companies, 3–4, 41 Edison, Thomas, 53–54 Edison General Electric, 53–54 egomania in founders, 47–48 Electronic Data Systems (EDS), 18 emerging growth companies (EGCs), 261–263 employee option pools, 103–106 board’s role in managing, 205 and capitalization tables, 190–191 following difficult financings, 240–241 size of, 154, 177, 205 employees cash-equity tradeoff of, 184, 185 and common stock, 93 compensation of, 244 and employment offers in acquisitions, 251, 256 and non-disclosure agreements, 187, 285 rights to technologies created by, 187, 285 and vacation policies, 244–245 and valuation, 121–122 and vesting, 183 and WARN statutes, 243–244 and winding down the company, 243–245 endorsement of a company, venture capital as, 43–44 endowments, 54–55 entire fairness rule, 218–220, 222, 226–229, 237 entrepreneurs and declining capital requirements for startups, 20, 270–271 equity held by, 145 goals/objectives of, 5 and information asymmetry, 5, 140, 275 power balance with VCs, 20–21 role of, in venture capital, 29 See also founders E.piphany, 12 equity financing, 26–29 equity partners agreement, 88–89 escrow accounts, 252–253 evaluation of early-stage companies, 42–52 and company vs. product-first companies, 44–45 and good ideas that look like bad ideas, 48 and idea maze of founders, 49, 135 and limited/imperfect data, 34, 42 and market size, 50–52 people/team considerations in, 43–48 and products, 48–50 evolution of venture capital industry, 270–273 exclusivity periods, 253 exiting options of venture-backed companies, 2.

The Personal MBA: A World-Class Business Education in a Single Volume
by Josh Kaufman
Published 2 Feb 2011

The Pricing Uncertainty Principle says the price could be anything—you have to set it yourself, since houses don’t come with built-in price tags. Let’s also assume you’d prefer to sell the house for as much as possible. How would you go about setting the largest price a customer will actually accept? There are four ways to support a price on something of value: (1) replacement cost, (2) market comparison, (3) discounted cash flow/net present value, and (4) value comparison. These Four Pricing Methods will help you estimate just how much something is potentially worth to your customers. The Replacement Cost method supports a price by answering the question “How much would it cost to replace?” In the case of the house, the question becomes “What would it cost to create or construct a house just like this one?”

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After you adjust for the differences, you can use the sale prices of those “comparable” houses to create a supportable estimate of how much your house is worth. Market Comparison is a very common way to price offers: find a similar offer and set your price relatively close to what they’re asking. The Discounted Cash Flow (DCF) / Net Present Value (NPV) method supports a price by answering the question “How much is it worth if it can bring in money over time?” In the case of your house, the question becomes “How much would this house bring in each month if you rented it for a period of time, and how much is that series of cash flows worth as a lump sum today?”

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For example, the Time Value of Money can help you figure out the maximum you should be willing to pay for a business that earns $200,000 in profit each year. Assuming an interest rate of 5 percent, no growth, and a foreseeable future of ten years, the “present value” of that series of future cash flows is $1,544,347. If you pay less than that amount, you’ll come out ahead as long as your assumptions are correct. (Note: this is the “discounted cash flow method” we discussed in the Four Pricing Methods.) The Time Value of Money is an extremely versatile concept, and a full exploration is beyond the scope of this book. For a more in-depth examination, I recommend picking up The McGraw-Hill 36-Hour Course in Finance for Nonfinancial Managers by Robert A.

Mastering Private Equity
by Zeisberger, Claudia,Prahl, Michael,White, Bowen , Michael Prahl and Bowen White
Published 15 Jun 2017

Assessing EV and equity value at entry and exit allows a PE investor to determine an expected return for the investment opportunity and assess whether it aligns with the riskiness of the opportunity and the mandate and target return of the fund. It should be noted that strategic investors employ different valuation methods, as they emphasize the long-term value of acquisitions as well as potential synergies with their existing business. As a result, strategic investors favor the discounted cash flow (DCF) valuation method, which uses future free cash flow projections and discounts them to arrive at an estimate of present value.3 PE investors mostly consider the output from a DCF valuation—and at times more exotic valuation techniques, such as real option pricing—only in a complementary manner or to assess how other parties may value the target.

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In addition to metrics from comparable businesses and recent transactions, fair value also takes current market conditions into account, yet rules out abnormally high or low valuations resulting from temporary market imbalances or distressed sales. Techniques used to determine fundamental value, including discounted cash flow or real option valuation, may also inform fair value and can balance market-based assessments. Various academic studies have highlighted the controversy and potential conflicts of interest between GPs and LPs when determining unrealized value in unlisted portfolio company investments. For example, a recent study2 suggested that at times the valuation of unrealized investments had been used to smooth out interim fund performance, particularly by overstating portfolio company valuations during bear markets.

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Prices are typically based on a fund’s NAV at a given point in time, and are quoted at a discount or premium to NAV. The two most common valuation methods are (1) the top-down valuation method, which applies comparable transaction multiples and/or trading multiples to arrive at the value of an LP interest, and (2) the bottom-up valuation method, which uses a discounted cash flow model to calculate the intrinsic value of the fund’s underlying assets. Top-down valuation employs information from comparable secondary market transactions to determine the pricing of an LP interest. A common multiple used in secondary market transactions is the ratio of the price paid and fund’s NAV in a given transaction (price/NAV).

Beyond Diversification: What Every Investor Needs to Know About Asset Allocation
by Sebastien Page
Published 4 Nov 2020

This change in methodology revealed an interesting pattern. The correlation profile was not as desirable as when we conditioned on stock returns. Although the correlations were generally low, when bonds sell off, stocks tend to sell off at the same time. Ultimately, investors should remember that stocks and bonds both represent discounted cash flows. Unexpected changes in the discount rate or inflation expectations can push the stock-bond correlation into positive territory—especially when other conditions remain constant. Despite consistent results across markets, there are caveats to our study. We showed that during crises, diversification across risk assets almost always fails, and even the stock-bond correlation may fail in certain market environments.

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See www.forbes.com/sites/simonconstable/2018/02/13/how-trillions-in-risk-parityvolatility-trades-could-sink-the-market/#3e6a7a362e2f. 10. Parts of this section are from this book review, with permission. http://www.tandfonline.com. 15 Private Assets and Something About Ostriches Any investment decision, and any decision made within an enterprise, must account for risk. Discounted cash flow valuations are completely invalid, have no significance whatsoever, and are useless for decision-making if they don’t properly account for risk. Market values derive from an estimation of risk. —JPP NO MATTER WHICH OPTIMIZATION METHODOLOGY WE use—multiperiod, full scale, mean variance, tail-risk-aware versions of mean variance, risk parity, and/or judgment and experience—a perennial challenge in portfolio construction has been to determine the optimal allocation to alternative asset classes.

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These two hypothetical companies have the same expected cash flows. The discount rate for both should vary as a function of the risk-free rate and a premium for risk. Over time, why would a stake in the private company appreciate much faster than a stake in its public twin if they are both valued based on discounted cash flows? And why would the private company’s business risk be lower than the public company’s? Perhaps there’s a premium for illiquidity. Shareholders in the private company may require a higher rate of return in exchange for the inability to buy or sell shares easily on the open market. The puzzle remains, however, whether this premium justifies a 270% increase in the Sharpe ratio, as reported in the Hamilton Lane study.

Buy Then Build: How Acquisition Entrepreneurs Outsmart the Startup Game
by Walker Deibel
Published 19 Oct 2018

LV is an important calculation for turn-around experts looking to acquire underutilized opportunities, but you won’t see any Offering Memorandums highlighting liquidation values. 151 CASH FLOW BASED VALUATION Cash flow based valuation has two common methods: Discounted Cash Flow (DCF) and Valuation Multiple. DISCOUNTED CASH FLOW Discounted Cash Flow is the most common valuation method for transactions at investment banks. The approach starts with projecting the future earnings of a company by looking at prior history, industry projections, and a dozen assumptions, then discounting those future earnings by applying a weighted average cost of capital to a value that it would be worth today.

The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments
by Pat Dorsey
Published 1 Mar 2008

Moats are a crucial element in Morningstar’s stock ratings. We have more than 100 stock analysts covering 2,000 publicly traded companies across 100 industries. Two main factors determine our ratings: (1) a stock’s discount from our estimated fair value, and (2) the size of a company’s moat. Each analyst builds a detailed discounted cash flow model to arrive at a company’s fair value. The analyst then assigns a moat rating—Wide, Narrow, or None—based on the techniques that you’ll learn about in this book. The larger the discount to fair value and the larger the moat, the higher the Morningstar stock rating. We’re seeking companies with moats, but we want to buy them at a significant discount to fair value.

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All three are valuable parts of the investing toolkit, and the wise investor will apply more than one to a prospective purchase. I’ll go over price multiples and yields in the next chapter. (Intrinsic values are a bit more complicated, and generally require a somewhat technical method called discounted cash flow, which is a bit beyond the scope of this book.6) However, understanding price multiples and yields will be easier if we first detour briefly into what drives stock returns. Over long stretches of time, there are just two things that push a stock up or down: The investment return, driven by earnings growth and dividends, and the speculative return, driven by changes in the price-earnings (P/E) ratio.

Rethinking Money: How New Currencies Turn Scarcity Into Prosperity
by Bernard Lietaer and Jacqui Dunne
Published 4 Feb 2013

In other words, every dollar, peso, or euro that exists today is someone’s debt, whether incurred by a state, corporation, or individual. This means that interest is a built-in feature of the monetary system. Furthermore, as known to anyone familiar with the discounted cash flow (DCF) technique used in financial decision making, the readiness to make long-term investments depends, to a significant extent, on the current and anticipated interest rates. Discounted cash flow analysts know that interest is one of the three factors in discounting any future cash flow. (The other two factors are the intrinsic risk of the investment project and the cost of equity capital.)

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See also Bankruptcy Defection, 196–197 Deflation, 167, 235n12 Democracy: in Bali, 187–188, 190–191; civic and, 147–148; concentration of wealth and, 21–22, 52– 53; in principled society, 193–194; regio and, 191; social capital and, 46 Demurrage: BONUS and, 171; on Chiemgauer, 88; concentration of wealth and, 67– 68; conceptual framework for, 176; saber and, 155; sustainability and, 67, 206; on Terra, 136, 138–139, 206; velocity and, 64, 68– 69; on wära, 179; on Wörgl, 176–177 Denver, 11–12 Development, 33 Disaster relief, 167, 169, 169–172 Discounted cash flow (DCF), 45– 46 Distance tax, 89 Diversity, 32– 33, 62– 63, 70 Divine right of kings, 24 Dixie Dollar, 113 Doctors without Borders, 17–18 Domestic care, 34 Drill and kill, 156, 220–221 Dual currency system, 65– 66, 99–102, 103–107, 162 Earthquake, 167, 169 Earthship model, 165 Ecological disaster, 34, 188 Eco-money, 235n12 Economic Literacy Program, 184 Economics, school of, 28, 35 Economic treadmill, 43, 52 Ecosystem, 32– 33 Ecosystem, monetary, 59– 60, 145, 199–202, 220 Education, 14, 16; for computers, 83; Creative Currencies Project and, 153–155; knowledge exchange network, 184; learning currency, 153–155, 201; in Mae Hong Son, 205; mentoring, 254 INDEX Education (continued) 153–154, 171–172; paradigms in, 220–221; in Paraná, 143–144; Patch Adams Free Clinic and, 165; in principled society, 193; Prussian model of, 216; standards, 43; Time dollars and, 82– 83; university, 153–154, 193, 226–227n13; wispos and, 156–157.

Stocks for the Long Run 5/E: the Definitive Guide to Financial Market Returns & Long-Term Investment Strategies
by Jeremy Siegel
Published 7 Jan 2014

Corporate History Sector Rotation in the S&P 500 Index Top-Performing Firms How Bad News for the Firm Becomes Good News for Investors Top-Performing Survivor Firms Other Firms That Turned Golden Outperformance of Original S&P 500 Firms Conclusion Chapter 9 The Impact of Taxes on Stock and Bond Returns Stocks Have the Edge Historical Taxes on Income and Capital Gains Before- and After-Tax Rates of Return The Benefits of Deferring Capital Gains Taxes Inflation and the Capital Gains Tax Increasingly Favorable Tax Factors for Equities Stocks or Bonds in Tax-Deferred Accounts? Conclusion Appendix: History of the Tax Code Chapter 10 Sources of Shareholder Value Earnings and Dividends Discounted Cash Flows Sources of Shareholder Value Historical Data on Dividends and Earnings Growth The Gordon Dividend Growth Model of Stock Valuation Discount Dividends, Not Earnings Earnings Concepts Earnings Reporting Methods Operating Earnings and NIPA Profits The Quarterly Earnings Report Conclusion Chapter 11 Yardsticks to Value the Stock Market An Evil Omen Returns Historical Yardsticks for Valuing the Market Price/Earnings Ratio and the Earnings Yield The Aggregation Bias The Earnings Yield The CAPE Ratio The Fed Model, Earnings Yields, and Bond Yields Corporate Profits and GDP Book Value, Market Value, and Tobin’s Q Profit Margins Factors That May Raise Future Valuation Ratios A Fall in Transaction Costs Lower Real Returns on Fixed-Income Assets The Equity Risk Premium Conclusion Chapter 12 Outperforming the Market The Importance of Size, Dividend Yields, and Price/Earnings Ratios Stocks That Outperform the Market What Determines a Stock’s Return?

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It ‘beat the Street’ by 20 cents, and its price has jumped $2 in after-hours trading.” Earnings drive stock prices, and their announcements are eagerly awaited by Wall Street. But exactly how should we calculate earnings, and how do firms turn these earnings into stockholder value? This chapter addresses those questions. DISCOUNTED CASH FLOWS The fundamental source of asset values derives from the expected cash flows that can be obtained from owning that asset. For stocks these cash flows come from dividends or from cash distributions resulting from earnings or the sale of the firm’s assets. Stock prices also depend on the rate at which these future cash flows are discounted.

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See Great Depression Developed economies age wave in, 63 distribution of world equity in, 195–196 emerging economies and, 68 GDP in, 197 real GDP in, 67 retiree-to-worker ratios in, 60–64 stock returns in, 199 Developing countries. See also Emerging economies distribution of world equity in, 195–196 GDP in, 197 stock returns in, 199 DIA ticker symbols, 273 Diamonds, 273 Difference between expectation/actuality, 258–261 Dimson, Elroy, 89–90 Discounted cash flows, 143–144 Discounts, 278 Distilling & Cattle Feeding, 116 Diversifiable risk, 176 Diversification, 198–205 The Dividend Investor , 182 Dividends of bonds vs. stocks, 157–159 discounting, 149 Gordon growth model for, 147–149 history of, 144–145 outperforming the market and, 179–183 payout ratios for, 147–149 per share, 145 DJIA (Dow Jones Industrial Average).

Financial Statement Analysis: A Practitioner's Guide
by Martin S. Fridson and Fernando Alvarez
Published 31 May 2011

In this circumstance, a dollar invested by a new shareholder purchases a larger percentage of the company than is represented by a dollar of net worth held by an old shareholder. discount rate. The interest rate used to equate future value (see) with present value (see). Also referred to as cost of capital (see). discounted cash flow. A technique for equating future cash flows to a present sum of money, based on an assumed interest rate. For example, $100 compounded annually at 8 percent over three years will cumulate to a sum of $125.97, ignoring the effect of taxes. This figure can be calculated via the equation where P = Principal value at beginning of period (Present value) r = Interest rate n = Number of periods F = Principal value at end of period (Future value) In this case, $100 × (1.08)3 = $125.97.

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This figure can be calculated via the formula where P = Principal at beginning of period r = Interest rate n = Number of periods In this case, $100 × (1.08)3 = $125.97. (This formula implicitly assumes that cash interest received will be reinvested at the original rate of interest throughout the period.) (See also discounted cash flow, net present value, and present value.) GAAP. Generally accepted accounting principles (see). GDP. Gross domestic product (see). generally accepted accounting principles. Rules that govern the preparation of financial statements, based on pronouncements of authoritative accounting organizations such as the Financial Accounting Standards Board, industry practice, and the accounting literature (including books and articles).

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The sum that, if compounded at a specified rate of interest, or discount rate (see), will accumulate to a particular value at a stated future date. For example: To calculate the present value of $500, five years hence at a discount rate of 7 percent, solve the equation: where F = Future value r = Interest rate n = Number of periods p = Present value In this case $500/(1.07)5 = $356.49. (See also discounted cash flow, future value, and net present value.) pro forma. Describes a financial statement constructed on the basis of specified assumptions. For example, if a company made an acquisition halfway through its fiscal year, it might present an income statement intended to show what the combined companies’ full-year sales, costs, and net income would have been, assuming that the acquisition had been in effect when the year began.

Competition Demystified
by Bruce C. Greenwald
Published 31 Aug 2016

The most common method for evaluating alternative courses of action in these areas is a business case analysis consisting of detailed projections of future distributable cash flows discounted back to the present. But discounted cash flow, as we have argued in chapter 16, is by itself a critically flawed tool for making decisions of this sort. The values calculated to justify initiatives depend on projections, into the distant future, of growth rates, profit margins, costs of capital, and other crucial yet highly uncertain variables. Also, a typical discounted cash flow analysis rests on a number of critical assumptions about the nature and intensity of future competition that are rarely explicit and generally untested.

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The strategic framework we have developed in this book, especially the view that the most important determinant of strategy is whether an incumbent firm benefits from competitive advantages, applies directly to issues of corporate development. In fact, the utility of this approach in clarifying decision making in this area is an important test of its worth. At a minimum, clarifying the competitive environment in which new initiatives will succeed or fail should provide an essential check on whether the conclusions of a discounted cash flow–based business case are reasonable. MERGERS AND ACQUISITIONS Decisions about mergers and acquisitions are essentially large-scale investment choices. They are based on an investment approach that has two main features. First, an acquisition is by definition a concentrated investment in a single enterprise or, in those cases where a conglomerate is being acquired, in a limited collection of enterprises.

Quantitative Value: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors
by Wesley R. Gray and Tobias E. Carlisle
Published 29 Nov 2012

THE CHAIRMAN'S SECRET RECIPE One of the bedrocks of modern corporate finance theory is that the value of any security is the present value of its future cash flows. This simple principle was first described in 1934 by John Burr Williams in his Theory of Investment Value.4 Williams's principle gives us the discounted cash flow (DCF) analysis, which allows us to calculate intrinsic value by taking a series of growing future cash flows and discounting them back to the present at a rate of return that takes into account the time value of money and the particular risk of the business analyzed. More recently, academics and practitioners alike have come to recognize the significance of Buffett's observation that the value of a business depends on its ability to generate returns on invested capital in excess of its cost of capital.5 Businesses expected to produce returns on invested capital in excess of market rates of return are worth more than the capital invested in them, and the market price of the stock should in time exceed its asset value.

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BEATING THE MARKET WITH QUANTITATIVE VALUE Value investing is a highly effective, well-studied method of investing. It is a broad church, encompassing investors who take positions in liquidations, special situations, undervalued assets, and undervalued businesses, using a variety of valuation methods, from simple price ratios, to detailed discounted cash flow analyses, and intricate sum-of-the-parts valuations that seek current market values for long-term and fixed assets. While the investment styles and valuation methods run the gamut, all are united by Benjamin Graham's simple notion that price and value are distinct quantities, and that, where the two are sufficiently far apart to provide a margin of safety, an opportunity exists to invest.

How I Became a Quant: Insights From 25 of Wall Street's Elite
by Richard R. Lindsey and Barry Schachter
Published 30 Jun 2007

While the dispute was ongoing, Exxon could either pay the disputed amount or wait until the final settlement to pay. If Exxon paid now and then won, the United States would pay back the disputed amount with interest; if Exxon didn’t pay, it would have to pay the disputed amount plus interest. Exxon had two methods of analyzing projects: If it was an investment, it discounted cash flows at their cost of capital; if it was a financing, Exxon discounted cash flows at their cost of debt. Exxon was evaluating the tax dispute as an investment. If it gave the money to the United States, it would only earn at the statutory interest rate, while its cost of capital was 16 percent. According to Exxon’s policies, since the outcome of the dispute was uncertain, it was an investment, not a financing.

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At the time, Exxon’s treasurer’s department was considered one of the spots in finance. Exxon managed much of its pension fund internally, including a large S&P500 index fund. It had also begun to issue its own debt, bypassing Wall Street bankers and fees. Exxon had global operations and had applied the latest thinking in project analysis using discounted cash flow methods and was analyzing and hedging the impact of currency changes on its operations. It should have been exciting. All in all, there couldn’t have been a more stifling place to work. JWPR007-Lindsey 180 April 30, 2007 18:1 h ow i b e cam e a quant Exxon had layers and layers of management.

Young Money: Inside the Hidden World of Wall Street's Post-Crash Recruits
by Kevin Roose
Published 18 Feb 2014

The result—which he estimated was something like $16 an hour, after taxes—was much more than minimum wage, but not nearly enough for Ricardo to be able to justify the punishment he’d been taking. Ricardo’s main task that spring had been making Excel model after Excel model. There were several kinds of models that banks used to value companies they were recommending as merger or acquisition candidates for their clients—including “discounted cash flows,” or DCF, a type of widely used model that used a company’s projected cash flows to estimate what it was worth on the open market. I’d learned how to make these models in my Training the Street seminar. It’s a fragile, delicate process that involves inputting long strings of numbers, linking cells to other cells, and cross-referencing each output so that when one input is updated, the rest of the model updates automatically.

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“He lived in Windsor Court, a massive apartment complex in Murray Hill”: The New York Times described Windsor Court as a place where “recent college graduates can find themselves among fellow alumni, meet up for familiar drinking rituals and flock to the frozen-yogurt shops and sushi bars that help them stay fit and find a mate for the next stage of life.” (Joseph Berger, “In Murray Hill, the College Life Need Never End,” January 18, 2011.) “abbreviations: DCF, CIM, LBO, VIX, and hundreds more”: If you’re curious: discounted cash flow, confidential information memorandum, leveraged buyout, and CBOE Volatility Index. “bars like Joshua Tree…and the Patriot Saloon are considered first-year watering holes”: For more establishments in the same vein, see Business Insider’s “The Most Obnoxious Bars on Wall Street” slideshow (Linette Lopez, August 3, 2012.)

How to Be the Startup Hero: A Guide and Textbook for Entrepreneurs and Aspiring Entrepreneurs
by Tim Draper
Published 18 Dec 2017

After business school, I took a half venture capital, half investment banking job with Alex. Brown & Sons, a boutique investment bank in San Francisco (with regular trips to Baltimore). Under the tutelage of Steven Brooks and Don Dixon for banking and Bruns Grayson for venture capital, I got some good training, but I mostly calculated discounted cash flow projections on spreadsheets, and I lasted about one year. Origin Story In July of 1985, I was 27 years old, just a year out of Harvard Business School, when I informed Melissa that I was going to start my own venture capital firm. She was very concerned. We had a child then and one on the way, and taking this kind of a risk with their future was scary for her.

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Our government allows, even encourages, people to play the lottery while they carefully control, monitor and restrict those same people from investing in private companies that could become major engines of progress. It is time our regulations let private companies trade. The value of a company is determined by what the investors believe the discounted cash flows of a given company will be over time. Investors do tend to suffer groupthink in that they celebrate together and panic together. When investors are optimistic about the future, short-term cash flows and short-term profitability don't matter as much to them as future prospects. When investors become more pessimistic, they fly to 'quality.' which means that they focus purely on historic numbers to determine company value.

Green Swans: The Coming Boom in Regenerative Capitalism
by John Elkington
Published 6 Apr 2020

To shift from Black Swan to Green Swan trajectories, we must drop or evolve many such business and investment concepts, currently taken for granted but on the cusp of becoming absurd. In the early stages of the Tomorrow’s Capitalism Inquiry, for example, I had a profoundly helpful exchange with Steve Waygood, chief responsible investment officer at Aviva Investors, on “discounted cash flow,” known in the trade as DCF. Here is some of what he told me:31 I see DCF as a super wicked problem with profoundly negative real world consequences. Our financial services system should serve society and the real economy. But very few policy makers, politicians or civil society representatives understand how the many different financial services institutions work together to finance the world we live in today and will retire into tomorrow.

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See business leaders, working with D Dalio, Ray, 5 data, role in economy, 190, 192 Davies, Sally, 104–105 Davis, Chris, 227 debris, space, 111–116 democracy activism in, 227–228 Anthropocenic route, taking, 230–234 with Green Swan characteristics, 208–213 interplay with capitalism and sustainability, 4–5 unintended consequences of technology for, 168–170 Democracy and Prosperity (Soskice and Iversen), 212 Denmark, 3 destination, importance of clear, 159–161 diabetes, 101, 156–157 Diamandis, Peter, 37, 170 Diamond, Jared, 195 “Dieselgate” scandal, 130 diet, modern, 98–102 different thinking, need for, 23–27, 205–208 digital trade, 179 Dimon, Jamie, 14 disclosure system, CDP, 133 discounted cash flow (DCF), 205–206 discounting future, 85 Disillusionment, in Gartner Hype Cycle, 174 disruptive market forces, 150 disruptive technologies, 175–182 distributed ledger technology, 177–178 The Divine Right of Capital (Kelly), 205 Dorsey, Jack, 168–169 Doteveryone, 185–186 Doughnut Economics, 205 Dow Jones Sustainability Indexes, 31 Drawdown Project, 141, 232 drones, 178–179 Dumitriu, Anna, 107 E Eccles, Robert G., 207–208 e-commerce, 179 economic growth rate, 56 economics, 80, 85, 202–205, 224 The Economist (magazine), 30–31, 86–87, 88, 95, 97 economy.

Expected Returns: An Investor's Guide to Harvesting Market Rewards
by Antti Ilmanen
Published 4 Apr 2011

By reading both chapters, you may also find that the debate between the efficient market camp and the behavioralists remains healthy and has deepened our understanding of financial markets. Certainly, neither side has a monopoly on “the whole truth”. 5.1 THE OLD WORLD At the core of finance is always the present value relation that an asset’s market price should equal its expected discounted cash flows. Investors set prices so that the marginal cost of an asset (its price) equals its expected marginal benefit (its expected discounted future payoff):(5.1) There are different types of expected cash flows. The most common are promised coupons and principal payments of bonds, and dividends of equities:• Government bonds are typically assumed to be default free; thus their expected cash flows equal promised cash flows.

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Theoretical models need to be analytically tractable and they should be parsimonious. My survey will be neither.) Despite the diversity of new models, at least the rationally oriented academic literature retains one key idea in its core, albeit subtly different than in the old world. The asset price still equals expected discounted cash flows, but in a world of uncertainty and time-varying expected returns, equation (5.1) needs to be generalized. Using the new terminology:(5.3) where SDF is the stochastic discount factor; and x is the payoff (cash flow) for asset i [5]. The term “stochastic” in SDF emphasizes the uncertainty in time-varying discount rates.

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Conversely, if most current holders bought the stock well below current market levels (so that they have large unrealized capital gains), disposition-biased investors will be quick to sell assets and any good news will travel slowly. 6.4 CONCLUSION Behavioral finance implies that market prices do not only reflect the rationally expected discounted cash flows from an asset. Shifting asset demands from irrational investors influence market prices and expected returns. If there is some mispricing—overvaluation or undervaluation—then that should disappear over time. Active investors can exploit such mispricing and earn alpha through security selection across assets and maybe also through market timing over time.

The Big Secret for the Small Investor: A New Route to Long-Term Investment Success
by Joel Greenblatt
Published 11 Apr 2011

If our estimate of value can change dramatically with even small changes in our guesses about the proper earnings growth rate to use or the proper discount rate, how meaningful can the estimates of value made by “experts” really be? The answer to #4 above is—“not very.” As it turns out, there actually are 24-hour locksmiths in the Bronx—unfortunately, they are not available now. 1. These concepts involve a discussion of the time value of money and discounted cash flow. If you are already very familiar with these (and can’t possibly see how I can make them funny), feel free to look at the pretty pictures and then skip ahead to the chapter summary! 2. In reality, we should look for how much cash we receive from the business over its lifetime. For our purposes, we will assume that earnings are a good approximation for cash received.

Early Retirement Extreme
by Jacob Lund Fisker
Published 30 Sep 2010

While college means different things to different people--whether it's a place for higher learning, a two-to-four-year binge party, or simply a brand name admission ticket required by the job market--the increasing demand for education and resulting higher cost mean that many students take on debt. Student loans are often considered an investment in one's future. What most students forget is that the only way that they can sell this asset is by working off their debt. Also, except for possibly MBA students, few people do a discounted cash flow analysis to verify that their "investment" actually has a sufficient internal rate of return. It's perhaps surprising that many trade schools have higher rates of internal returns than college educations. They cost (much) less, have shorter times to graduation, and due to the overproduction of people with college degrees, the latter no longer bestows as much economic benefit compared to the trades as it used to.

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There's plenty of advice out there, the most important piece of which is, in my opinion, to pursue something you're good at rather than something you're passionate about--these are not necessarily the same thing--and consider the typical placement rates (unemployment levels), and in particular the cost of any kind of educational requirement, using either a discounted cash flow or internal rate of return analysis to see if it's worthwhile. Nonsalaried work Nonsalaried work though it may involve contracting with a single employer, technically a client, shouldn't be considered employment (see this figure), but it still qualifies as a job. Such a job involves either providing services or making products directly (see The working man) or involves running a business turning assets into income (see The businessman).

The Accidental Investment Banker: Inside the Decade That Transformed Wall Street
by Jonathan A. Knee
Published 31 Jul 2006

At bottom, traditional valuations are based on some assessment of current earnings or cash flow and future prospects. Current earnings are, by definition, more certain than future, so methods grounded in the former are less speculative than those grounded in the latter. For this reason, the least precise of traditional valuation methods is the “discounted cash flow” or DCF, which estimates the present value of cash flows projected five or even ten years out. DCF valuations can swing wildly based on relatively minor changes in assumptions on growth and interest rates. Typically, the majority of the DCF value is found in the “terminal value”—the value assigned the last, and thus most speculative, year of projections.

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See also specific firms Curry, Christian, 128–29, 192, 193 Curry, William, 128 Czinger, Kevin, 14–15, 16, 32, 33–34, 37–38, 55 “Dare to be Great” speech, 10 Davison, Todd, 162 Dean Witter Discover culture of, 189 merger with Morgan Stanley, 113, 188–92, 197 “The Death of the Banker” (Chernow), 226–27 De Baubigny, Andre, 141 Dell, 172 DePuy, Chris, 139 Deutsche Bank, 92, 169 Deutsche Morgan Grenfell (DMG), 148, 149 Deutsche Telecom, 25–26 DEVA (discounted equity valuation analysis), 124 “Digital Media Conference,” 142 Dillon, Clarence, 46 Dillon Reed, 92 discounted cash flow (DCF), 124 Discover and Co., ix Discover Card, 189, 200, 223 Dobkin, Eric, 36, 38–39 Donaldson, Lufkin and Jenrette (DLJ) and CSFB, 89–90, 92, 174, 190 IPO investments, 24 junk bond activities, 22, 24 Knee’s offer from, 86, 88, 89 Don Tech, 160, 170 Dow Jones, 192 downturn in the market, 157, 172–73, 178–83, 201, 203.

Toward Rational Exuberance: The Evolution of the Modern Stock Market
by B. Mark Smith
Published 1 Jan 2001

The most recent book published on the 1929 crash is The Causes of the 1929 Stock Market Crash, written by Harold Bierman, Jr., a professor at Cornell University. Bierman applies modern standards of market valuation to analyze 1929 stock prices. First, he calculates that the market P/E ratio in 1929 was 16.3 to 1. Then, using the discounted cash-flow model developed many years after the 1929 crash (which will be discussed in detail in later chapters; see definition on page 156), he finds that an annual rate of dividend increase of 3.6% would have been sufficient, by later standards, to support the 1929 market P/E. In fact, the rate of dividend increases throughout the 1920s was significantly higher than 3.6%, and even conservative estimates of future dividend growth were at least as great.

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consumer spending; and crash of 1929; on credit; during World War II Cooke, Jay, & Company Coolidge, Calvin Cornell University corners; of silver market, see silver crisis Cornfeld, Bernard Corn Products Corrigan, Gerald cost-push inflation Council of National Defense covariance Cowles, Alfred Cox, Albert Crane, Burton crashes; of 1837; of 1929, ; of 1962; of 1987; see also panics Cuban missile crisis customer stock purchase plans Cutten, Arthur Darvas, Nicholas Darwin, Charles Day and Night Bank DeAngelis, Anthony De Bondt, Werner Defense Department, U.S. defined-benefit pension plans defined-contribution pension plans Democratic party democratization of stock market depressions; fear of; of 1920–21; see also Great Depression Detroit Law School Dewey, Thomas Dillon, Douglas Dines, James discounted cash-flow model; see also Dividend Discount Model; present value, determination of Disney Dividend Discount Model Dodd, David Douglas, William O. Dow, Charles Dow Jones Industrial Average; and crash of 1962; and crash of 1987; and Eisenhower administration; graphs of ; during Great Depression; and Kennedy administration ; and Kennedy assassination; and “October Massacre,” ; effect of Federal Reserve policies on; launching of; mutual fund performance compared with; New Era advocates and; during World War I; during World War II Dow theory Drew, Daniel Drexel Burnham Lambert Duer, William Du Pont Corporation Eastman Kodak Eccles, Marriner Eckert-Mauchly Computer Corporation Eckstein, Otto efficient market theory; arbitrage and; behavioralist critique of; and crash of 1987 Eisenhower, Dwight D.

Super Thinking: The Big Book of Mental Models
by Gabriel Weinberg and Lauren McCann
Published 17 Jun 2019

Like any interest rate, it can compound, but instead of compounding positively as we discussed earlier, the discount rate compounds negatively. This negative compounding discounts payments out into the future more and more, since you won’t be able to access them until much later. The discount rate is the cornerstone of the discounted cash flow method of valuing assets, investments, and offers. This model can help you properly determine the worth of arrangements that involve future payments, such as investment properties, stocks, and bonds. For example, let’s say you win the lottery and are offered a choice between getting one million dollars each year, forever, or a lump-sum payment today.

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Department of, 267–68 delayed gratification, 87 deleveraging, 78–79 deliberate practice, 260–62, 264, 266 Democratic National Committee, 97 de-risking, 6–7, 10, 294 design debt, 56–57 design patterns, 92–93, 97, 226, 317 Detecting Lies and Deceit (Vrij), 13–14 deterrence, 231–32, 237, 238 Detroit, Mich., 41 Devil’s advocate position, 28–30, 202 diagrams, 192–93 dice, 170 Dick, Philip K., 201 diet, 1, 87, 102, 103, 130 Difficult Conversations (Stone, Patton, and Heen), 19 Diffusion of Innovation (Rogers), 116 diffusion of responsibility, 259 digital photography, 308–10 Dilbert, 140 diminishing returns, 81–83 diminishing utility, 81–82 dinosaurs, 103 diplomacy, 231 directly responsible individual (DRI), 258–59 disclosure law, 45 disconfirmation bias, 27 discounted cash flow, 85 discounting, hyperbolic, 87 discounting the future, 85–87 discount rate, 85–87, 180–82, 184, 185 discoveries, multiple, 291–92 Disney World, 96–97 dispersion, 147 disruptive innovations, 308, 310–11 distribution, see probability distributions distributive justice versus procedural justice, 224–25 divergent thinking, 203 diversity debt, 57 diversity of opinion, 205, 206, 255 divide and conquer, 96 divorce, 231, 305 Dollar Shave Club, 240 domino effect, 234–35, 237 done, calling something, 89–90 Donne, John, 209 don’t bring a knife to a gunfight, 241 drinking, 217, 218 drunk drivers, 157–58 drugs, 236 DuckDuckGo, 18, 32, 68, 258, 278 Dubner, Stephen, 44–45 Dunbar, Robin, 278 Dunbar’s number, 278 Dunning, David, 269 Dunning-Kruger effect, 268–70, 317 Dweck, Carol, 266, 267 early adopters, 116–17, 289, 290, 311–12 early majority, 116–17, 312 Eastman Kodak Company, 302–3, 308–10, 312 eBay, 119, 281, 282, 290 echo chambers, 18, 120 Ecker, Ullrich, 13 economies of scale, 95 Economist, 14–15 economy, 122, 125 inflation in, 179–80, 182–83 financial crisis of 2007/2008, 79, 120, 192, 271, 288 recessions in, 121–22 Edison, Thomas, 289, 292 education and schools, 224–25, 241, 296 expectations and, 267–68 mindsets and, 267 school ranking, 137 school start times, 110, 111, 130 selection bias and, 140 textbooks in, 262 see also college effective altruism, 80 egalitarian versus hierarchical, in organizational culture, 274 80/20 arrangements, 80–81, 83 Einstein, Albert, 8, 11 Eisenhower, Dwight, 72 Eisenhower Decision Matrix, 72–74, 89, 124, 125 elections, 206, 218, 233, 241, 271, 293, 299 Ellsberg, Michael, 220 email spam, 161, 192–93, 234 Emanuel, Rahm, 291 emotion, appeal to, 225, 226 emotional quotient (EQ), 250–52 empathy, 19, 21, 23 ruinous, 264 employee engagement survey, 140, 142 endgame, 242, 244 endorsements, 112, 220, 229 endpoints, 137 ends justify the means, 229 energy: activation, 112–13 potential, 111–12 engineering, 247 Enron, 228 entrepreneurs, 301 cargo cult, 316 entropy, 122–24 entry, barriers to, 305 environmental issues, 38 climate change, 42, 55, 56, 104, 105, 183, 192 EpiPen, 283 EQ (emotional quotient), 250–52 equilibrium, 193 Ericsson, K.

Zero to One: Notes on Startups, or How to Build the Future
by Peter Thiel and Blake Masters
Published 15 Sep 2014

Simply stated, the value of a business today is the sum of all the money it will make in the future. (To properly value a business, you also have to discount those future cash flows to their present worth, since a given amount of money today is worth more than the same amount in the future.) Comparing discounted cash flows shows the difference between low-growth businesses and high-growth startups at its starkest. Most of the value of low-growth businesses is in the near term. An Old Economy business (like a newspaper) might hold its value if it can maintain its current cash flows for five or six years. However, any firm with close substitutes will see its profits competed away.

The Monk and the Riddle: The Education of a Silicon Valley Entrepreneur
by Randy Komisar
Published 15 Mar 2000

"We have a good plan, and we know how to work a plan." I thumbed through the material. It was a fairly polished presentation: market description, customer need, product strategy, competitive positioning, launch schedule, sales projections, expense forecasts, IRR and other rates of return, investment required, discounted cash flow. All the numbers you'd want. Year one. Year two. Year three. Everything worked out with an inevitable logic. Lenny had outlined in some detail how he planned to run this business. But how would he react when reality swept over his PowerPoint slides? It was becoming clear that he believed his task was to raise money and then follow his plan.

Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined
by Lasse Heje Pedersen
Published 12 Apr 2015

However, rather than doing that, we use the valuation equation repeatedly to arrive at This equation shows mathematically what the Buffett quote above says in words, namely that the intrinsic value is the expected discounted value of all future dividends paid to shareholders. This equation is called the dividend discount model (and it is also called the discounted cash flow model and the present value model). Computing the intrinsic value is easier said than done, easier in principle than in practice.2 To compute the intrinsic value, one must estimate all future dividends, all future discount rates, and the co-movement of future dividends and discount rates.

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See hedge ratio (delta, Δ) demand pressure: bond yields and, 252; derivative prices and, 7t; need to identify source of, 266; option prices and, 46, 240; providing liquidity to, 45–46 demand shift, as catalyst of trend, 210 demand shocks, 5, 194–96, 195f, 195t derivatives: binomial model for value of, 236–38, 237f, 237n; Black–Scholes–Merton formula for value of, 7t, 238–40, 262, 263, 270, 272, 288; defined, 235; in efficiently inefficient markets, 7t; exchange-traded, 80; key markets for, 241; leverage achieved with, 74, 76, 80; in neoclassical finance, 7t; over-the-counter (OTC), 80; prime brokerage of, 80; volatility trades with, 262. See also futures; options; subprime credit crisis; swaps derivatives clearing merchants, 26 directional volatility trades, 262 discounted cash flow model. See dividend discount model discount rate, 89–90, 100, 102 discretionary equity investing, viii, 9, 10, 11, 87–88, 95–108; Asness on quantitative investing versus, 162–63. See also Ainslie, Lee S., III; dedicated short bias hedge funds; fundamental analysis; quality investing; value investing discretionary macro hedge funds, 185 Dish Network, 318 disposition effect, 106 distressed convertible bonds, 282f, 283 distressed investments, 14, 291, 311–12; Paulson on, 319–20 diversification: beta risk and, 28; of carry trades, 188, 188t; of convertible bond portfolio, 283; CTA investments as source of, 228; in event-driven investment, 292; as form of risk management, 59; hedge funds as source of, 26; by market neutral hedge fund, 21, 28; in merger arbitrage, 295, 303–4, 306, 317–18; portfolio optimization and, 55, 57; in quantitative equity investing, 133, 134, 144, 162; of time series momentum strategy, 209 dividend discount model, 89–92; fundamental analysis using, 97; margin of safety and, 98; quality and, 100; residual income model derived from, 92 dividend growth, 176, 177, 178 dividends: book value and, 92; early conversion of bond and, 276; in merger arbitrage, 296; recapitalization and, 314; on short equity position in convertible bond arbitrage, 277.

Investing Amid Low Expected Returns: Making the Most When Markets Offer the Least
by Antti Ilmanen
Published 24 Feb 2022

Empirical analysis can focus either on the historical realized premium (can still debate which equity index – the large-cap S&P500 or a broader US index or an even broader global index; over which period – how distant histories remain relevant; whether over cash or long-term bonds; whether arithmetic or geometric mean) or on a forward-looking premium (often estimated based on some valuation ratios or discounted cash flow models, again leaving room for debate). The historical average is a more relevant measure of future equity premium if we believe the required premium is constant over time and has not been impacted by any major structural changes. The forward-looking premium is more relevant if the required premium varies over time.

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The real price of gold rose sharply during the first decade after the Bretton Woods system (a quasi gold standard fixed at $35) ended in 1971, but for the 40 years since then there has been no net increase (see Figure 4.16). Mechanically, gold's low return reflects its lack of interest or dividend income (hard to use the discounted cash flow pricing when there are no future cash flows), and fundamentally, its safe-haven services against a variety of ills. I will later show that gold has performed well in many equity market drawdowns and in many inflationary episodes – but not all. Still, gold remains the ultimate thing to carry with you or hide underground when you worry about ambiguous catastrophes, including cyber-terrorism.

Obliquity: Why Our Goals Are Best Achieved Indirectly
by John Kay
Published 30 Apr 2010

In both cases, we don’t know enough about what they do for such emulation to succeed. ICI might have made calculations in the 1950s that estimated the market capitalization its pharmaceutical division could have achieved by the year 2000. The company could then have put that number into a discounted-cash-flow calculation to estimate a return on the company’s early investment in its pharmaceutical business. I would have been delighted to build that model for them. But no one would or should have taken such a calculation seriously. ICI could never have computed the likely effect of the company’s initiative, but that does not mean the activity was random or undirected.

Quality Investing: Owning the Best Companies for the Long Term
by Torkell T. Eide , Lawrence A. Cunningham and Patrick Hargreaves
Published 5 Jan 2016

Financial analysts’ models routinely underestimated the earnings growth driven by Novo’s attractive and stable financial and corporate characteristics. The Novo example, one of many, illustrates the rationality of prioritizing analysis of corporate quality over valuation. Typical valuation models, such as discounted cash flow (DCF), are riddled with limitations, even for companies with predictable cash flows. Most strikingly, DCF models are constrained by a powerful anchoring effect of prevailing market prices. If analysis indicates a valuation significantly different from market price – say 30% above or below – you can be sure the sell-side analyst will return to the drawing board and adjust some assumptions.

The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness
by Morgan Housel
Published 7 Sep 2020

It’s the notion that assets have one rational price in a world where investors have different goals and time horizons. Ask yourself: How much should you pay for Google stock today? The answer depends on who “you” are. Do you have a 30-year time horizon? Then the smart price to pay involves a sober analysis of Google’s discounted cash flows over the next 30 years. Are you looking to cash out within 10 years? Then the price to pay can be figured out by an analysis of the tech industry’s potential over the next decade and whether Google management can execute on its vision. Are you looking to sell within a year? Then pay attention to Google’s current product sales cycles and whether we’ll have a bear market.

The Golden Passport: Harvard Business School, the Limits of Capitalism, and the Moral Failure of the MBA Elite
by Duff McDonald
Published 24 Apr 2017

Students were taught to consider the administrative process as the unity of all six, with Control being “the use of figures in the choice of courses of action and in the appraisal of actual performance.”18 Robert Anthony, a former student of Walker who later became his research assistant and eventually a member of the faculty, took the mantle from his mentor and put the prevailing Control philosophy in textbook form with his 1956 book, Management Accounting: Text and Cases. In doing so, he also extended it to include the first HBS endorsement of the concept of discounted cash flow, or DCF, for use in management decision making as a superior approach to internal rate of return, or IRR. It was that addition, according to one commentator, that made the book influential, in that it prompted large multidivisional corporations around the country to adopt DCF in their budgeting and capital allocation decisions.19 As Rice University’s Stephen Zeff points out, the notion of attuning management to the fact that in accounting information could be found the seeds of future policy naturally led to increased interest by management in the choice of accounting policy itself, particularly when Generally Accepted Accounting Principles “did not give a definitive answer.”

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There was the takeover of top corporate positions by the financial types, who knew little about the fundamentals of the businesses they ran. And then there was this: “[Some] financial yardsticks that managers rely upon so much in deducing whether to make investments may yield results that are badly distorted in the current period of high inflation. The validity of some of these yardsticks, like ‘discounted cash flow’ or virtually indecipherable formulas for figuring ‘return on investment,’ is being called into question to some extent.” Meaning: Not only were business schools churning out too many numbers people; they were telling them to look at the wrong numbers to boot. “It may be that some of the basic tools we’ve been teaching in business schools for 20 years are inordinately biased toward the short term, the sure payoff,” Lee J.

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In 1986, BusinessWeek put McArthur on its cover, under the title “Remaking an Institution: The Harvard B-School.”10 The biggest change was the rise of the finance faculty, Michael Jensen foremost among them. The new science of managerial decision making was encapsulated in the capital asset pricing model and discounted cash flow, models that had no space for questions like customer loyalty and responsibility to one’s employees. It was no coincidence that the School finally dropped its Trade Union Program early in the decade. The rhetoric coming out of HBS about finance sounded as if it had been written by the financial services lobby itself.

The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success
by William Thorndike
Published 14 Sep 2012

Buffet was switching at midcareer from a proven, lucrative investment approach that focused on the balance sheet and tangible assets, to an entirely different one that looked to the future and emphasized the income statement and hard-to-quantify assets like brand names and market share. To determine margin of safety, Buffett relied now on discounted cash flows and private market values instead of Graham’s beloved net working capital calculation. It was not unlike Bob Dylan’s controversial and roughly contemporaneous switch from acoustic to electric guitar. This tectonic shift played itself out throughout the 1970s in Berkshire’s insurance portfolios, which saw an increasing proportion of media and branded consumer products companies.

Mastering the VC Game: A Venture Capital Insider Reveals How to Get From Start-Up to IPO on Your Terms
by Jeffrey Bussgang
Published 31 Mar 2010

I had to struggle to get to a four-million pre and I have a prototype and real customers!”) Determining the pre-money valuation is an art, not a science, and many entrepreneurs get frustrated with what seems like an opaque process. Unlike what you learn in a finance class in business school, where you calculate discounted cash flows and apply a weighted average cost of capital, there is no magic formula. The valuation for entrepreneurial ventures is set in a back-and-forth negotiation based on three factors: (1) the amount of capital that the entrepreneur is trying to raise in order to prove out the first set of milestones; (2) the VC’s target ownership (often 20-30 percent); (3) how competitive the deal is (that is, if the entrepreneur has numerous VCs chasing them, they can drive up the price.

The Wisdom of Finance: Discovering Humanity in the World of Risk and Return
by Mihir Desai
Published 22 May 2017

P., 175–77 Socrates, 168 Stevens, Wallace, xi, 7, 32–34, 170 disorder and chaos, 33–34 insurance executive, 32–33 T talent, etymology of, 58–59, 74 “Tale of Beryn” (Chaucer), 74 Talmud, 52 Thales of Miletus, 7, 42–43, 162, 177 Tiger Moms, 95 Tolstoy, Leo, 9, 162–64 tontines, 28–30 Tontine Coffee House, 28 Tootsie Roll Industries, 78–80, 83–85 transaction cost approach to mergers, 115 Trilogy of Desire (Dreiser), 165 Trollope, Anthony, 7, 38, 175 Trump, Donald, 127, 152 Turner, Ted, 108 “Two Cultures” (Snow), 175 “Two Tramps in Mud Time” (Frost), xiii Tynan, Kenneth, 96 U Ulysses (Joyce), 91–92 V Vaillant, George, 138–39 value creation and valuation, 7, 59 accounting vs. finance, 64 alpha generation or getting paid for beta, 71–73 destruction of value, 63 discounted cash flows, 65 measuring value creation, 64–67 stewardship and, 61–63, 74 terminal values, 66–67 weighted average cost of capital, 65 value of education, 65–66 value of housing, 66 van Doetechum, Lucas, 58 (illus.), 59 van Eyck, Jan, 97 (illus.), 103 Vega, Joseph de la, 5–6, 43–44 venture capital, 73, 82 Vishny, Robert, 77 W Wall Street (film), 165, 166 Warhol, Andy, 129 Washington, George, 142–43, 145 Watson, Thomas, 138 Wealth of Nations, The (Smith), 121 Weaver, Sigourney, 97–98 Wells Fargo, 80 Wesley, John, 63 West, Kanye, 99 Wheel of Fortune (TV show), 17–18 White, Vanna, 18 Whitney Museum of Modern Art, 140 Wilder, Gene, 94 Wilson, E.

A Wealth of Common Sense: Why Simplicity Trumps Complexity in Any Investment Plan
by Ben Carlson
Published 14 May 2015

I got sucked into believing they could do no wrong. These opinions were slowly turned on their head, starting with the meeting that outlined the three sell ratings. While these analysts were all very smart people, many hailing from the top business schools and using the most sophisticated discounted cash flow models you can build, there were forces beyond their control that dictated their actions whether they were willing to admit it or not. I learned some important lessons from this experience. First and foremost, incentives are everything, both inside and outside of the world of finance. You can't always make decisions based on your intelligence or what you really think or feel if there are incentives or disincentives at play within the organization's culture.

Cogs and Monsters: What Economics Is, and What It Should Be
by Diane Coyle
Published 11 Oct 2021

The idea of discounting was introduced explicitly into political debate in the early eighteenth century in the context of calculating ‘the Equivalent’, the English payment to Scotland to bail out its economy at the time of the Act of Union. William Deringer writes: ‘It placed almost no value on anything that happened beyond one human lifetime. This peculiar claim clashed violently with many Britons’ intuition about what the future was worth to them’ (Deringer 2018). The debate about how to calculate discounted cash flows became highly polemical, one of the fronts in the political battle between Whigs and Tories. As the ever-sceptical David Hume put it: ‘Every man [sic] who has ever reasoned on this subject, has always proved his theory, whatever it was, by facts and calculations’ (Hume 1784, 328). A more recent manifestation of the politics of discounting followed the publication of the 2007 Stern Review on climate change.

Exponential Organizations: Why New Organizations Are Ten Times Better, Faster, and Cheaper Than Yours (And What to Do About It)
by Salim Ismail and Yuri van Geest
Published 17 Oct 2014

Micro-transactions will drive orders-of-magnitude increases in the sheer number of transactions needing to be processed, tracked and audited. Crowdfunding / crowdlending New ways of getting financed for products or services by leveraging the crowd (e.g., Gustin, Kickstarter, angels and Lending Club), especially to demonstrate market demand for a product or service. Cash flow measurement Discounted Cash Flows will be replaced by Options Theory as a preferred mechanism. We are seeing an overall unbundling of the financial arena, and the digital payments sector is particularly ripe for transformation. Quicken and Quickbooks have both had a major impact on traditional accounting firms. Now, similar to Mint for personal finance, Wave Accounting offers 100-percent-free small business accounting, although its real business model is to mine the data buried within those transactions.

Blitzscaling: The Lightning-Fast Path to Building Massively Valuable Companies
by Reid Hoffman and Chris Yeh
Published 14 Apr 2018

Unfortunately, this cautious and measured approach falls apart when new technologies enable a new market or scramble an existing one. Chris earned his MBA from Harvard Business School in the late 1990s, during the dawn of the Networked Age. Back then, his MBA training focused on traditional techniques, such as using discounted cash flow analysis to make financial decisions with greater certainty. Chris also learned about traditional manufacturing techniques, such as how to maximize the throughput of an assembly line. These methods focused on achieving efficiency and certainty, and the same emphasis was reflected in the broader business world.

Finding Alphas: A Quantitative Approach to Building Trading Strategies
by Igor Tulchinsky
Published 30 Sep 2019

Institutional Research 101: Analyst Reports189 6M 5M 4M 3M 2M 1M 0M –1M 2007 2008 Figure 24.9 2009 2010 2011 2012 2013 2014 2015 2016 Performance of alpha using earnings-call data6 their ratings and forecasts, and this effect is stronger for analysts with industry experience. Alpha researchers can learn a lot about methodology from analysts’ work. For instance: Valuation methodologies vary across industries. Constructing a discounted cash flow model may be very different for the manufacturing sector compared with consumer cyclical firms, noncyclicals, and other sectors. Analysts may focus on different valuation metrics, such as the price–earnings ratio for one industry and the price– book ratio for another. For the alpha researcher, it is important to understand the underlying reasons for these differences in order to normalize and compare data appropriately for the universe of tradable stocks.

Super Founders: What Data Reveals About Billion-Dollar Startups
by Ali Tamaseb
Published 14 Sep 2021

And for good reason. In the early stages, valuation is not a factor of revenue or much else. According to research done by Ilya Strebulaev, a professor of venture capital at Stanford Graduate School of Business, and his collaborators, most VCs, especially early-stage VCs, don’t use techniques such as discounted cash flow or net present value or other financial models to assess. Instead, in the early stages, valuation is often just a factor of how much money the company is raising in the round. In the first couple of rounds of investment in tech startups, each new round typically gives a total of 15 to 30 percent ownership to investors.

Nothing but Net: 10 Timeless Stock-Picking Lessons From One of Wall Street’s Top Tech Analysts
by Mark Mahaney
Published 9 Nov 2021

My advice for tech investors is to focus on three different financial metrics: revenue, revenue, and revenue. Now before The Wharton Business School at the University of Pennsylvania calls to revoke my MBA, I want to acknowledge that earnings matter. As does free cash flow. I don’t know of any sophisticated market investor who runs DR (discounted revenue) models. They all run DCF (discounted cash flow) models based on years of projections of revenue and cash flows discounted back to the present to determine reasonable current value. But you can’t generate earnings or cash flow if you don’t first generate revenue. Yes, there are many companies that generate revenue and don’t generate earnings or cash flow.

Infonomics: How to Monetize, Manage, and Measure Information as an Asset for Competitive Advantage
by Douglas B. Laney
Published 4 Sep 2017

Others worthy of consideration as well include: Douglas Hubbard’s “applied information economics” methodology strictly for measuring the decision value of information.15 Bill Schmarzo’s “data economic valuation” approach also strictly for measuring information’s contribution to decision making.16 Paul Strassman’s macroeconomic method of comparing the competitive gains of organizations with similar tangible assets, after accounting for all other valuation premium factors.17 Dilip Krishna’s methods for attributing business outcomes to specific information initiatives (Business Impact Model); an adapted discount cash flow model (a Monte Carlo simulation method); and a comparative analysis approach similar to Strassman’s but using a pure-play information company for comparison.18 Tonie Leatherberry’s and Rena Mears’s “net business value” method that considers information’s present and discounted future value to each department, various risks, and total cost of ownership.19 Robert Schmidt’s and Jennifer Fisher’s promising but loosely defined and abandoned patent application for an amalgam of information cost, accuracy, and other quality factors, along with information usage/access.20 Mark Albala’s conceptual valuation model, similar to that of Schmidt and Fischer, in which information value is based on information requests, usage (royalties), and outcomes.21 Dave McCrory’s concept and formula for what he calls “data gravity” that defines the proximal relationship among data sources and applications.22 As well, software and services companies such as Schedule1, Pimsoft, Everedge, ThreatModeler, Alex Solutions, Datum, Alation, and Real Social Dynamics (RSD) [in collaboration with the Geneva School of Business Administration] have developed exclusive approaches for measuring information value and/or risk in economic terms specific to their core offerings.

Concentrated Investing
by Allen C. Benello
Published 7 Dec 2016

“Over time,” says Simpson, “the nice thing about a good business is it becomes worth more and more so you have to constantly evaluate your targets.”144 On this point he agrees with Buffett that the most important thing is to figure out the future economics of the business. This allows an approximate discounted cash flow valuation. While a current valuation based on the past record is a simple matter, it’s not easy to figure out the future economics of the business. However, some businesses are easier than others. Coca‐Cola, for example, is easier to figure out than those businesses that have to deal with government regulation.

The Art of Scalability: Scalable Web Architecture, Processes, and Organizations for the Modern Enterprise
by Martin L. Abbott and Michael T. Fisher
Published 1 Dec 2009

Christine believes that one of the issues with the executive previously in charge of technology was that he really had no business acumen and could not properly explain the need for certain purchases or projects in business terms. The former CTO simply did not understand simple business concepts like returns on investment and discounted cash flow. Furthermore, he always expected the business folks to understand the need for any of what business peers believed were his pet projects and would simply say, “We either do this or we will die.” Although the technology team’s budget was nearly 20% of the company’s $200 million in revenue, systems still failed 35 36 C HAPTER 2 R OLES FOR THE S CALABLE TECHNOLOGY O RGANIZATION and the old CTO would blame unfunded projects for outages and then blame the business people for not understanding technology.

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As such, we are going to focus our build versus buy discussions along the paths of decreasing cost and increasing revenue through focusing on strategy and competitive differentiation. Focusing on Cost Cost focused approaches center on lowering the total cost to the company for any build versus buy analysis. These approaches range from a straight analysis of total capital employed over time to a discounted cash flow analysis that factors in the cost of capital over time. Your finance department likely has a preferred method for helping to decide how to determine the lowest cost approach of any number of approaches. Our experience in this area is that most technology organizations have a bias toward building components.

Understanding Asset Allocation: An Intuitive Approach to Maximizing Your Portfolio
by Victor A. Canto
Published 2 Jan 2005

Includes selling short, leverage, program trading, swaps, arbitrage, and derivatives. They are also exempt from many of the rules and regulations governing other mutual funds. high-yield bonds A debt instrument issued for a period of more than one year with high rates of return because there is a higher default risk. hurdle rate-of-return The required rate of return in a discounted cash flow analysis, above which an investment makes sense and below which it does not. index In economics and finance, an index (for example, a price or stockmarket index) is a benchmark of activity, performance, or evolution in general. Consumer price indexes (an inflation measurement), or a country’s gross domestic product (GDP) index (an economic growth measurement) can be used to adjust salaries, Treasury bond (T-bond) interest rates, and tax thresholds.

Mathematics for Finance: An Introduction to Financial Engineering
by Marek Capinski and Tomasz Zastawniak
Published 6 Jul 2003

At time 1 we evaluate the bond prices by adding the coupon to the discounted final payment of 101.00 at the appropriate (monthly) money market rate: 0.521% in the up state and 0.874% in the down state. The results are 101.4748 and 101.1213, respectively. The option can be exercised at that time in the up state, so the cash flow is 0.1748 and 0, respectively. Expectation with respect to the risk-neutral probabilities of the discounted cash flow gives the initial value 0.06598 of the option. 11.12 The coupons of the bond with the floor provision differ from the par bond at time 2 in the up state: 0.66889 instead of 0.52272. This results in the following bond prices at time 1: 101.14531 in the up state and 100.9999 in the down state. (The latter is the same as for the par bond.)

The Misbehavior of Markets: A Fractal View of Financial Turbulence
by Benoit Mandelbrot and Richard L. Hudson
Published 7 Mar 2006

You cannot beat the market, says the standard market doctrine. Granted. But you can sidestep its worst punches. 10. In Financial Markets, the Idea of “Value” Has Limited Value. Value is a touchstone to most people. Financial analysts try to estimate it, as they study a company’s books. They calculate a break-up value, a discounted cash-flow value, a market value. Economists try to model it, as they forecast growth. In classical currency models, they input the difference between U.S. and Euro zone inflation rates, growth rates, interest rates, and other variables to estimate an ideal “mean” value to which, over time, they believe the exchange rate will revert.

Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets
by Nassim Nicholas Taleb
Published 1 Jan 2001

Not just in financial markets; but overall his 1981 paper may be the first mathematically formulated introspection on the manner in which society in general handles information. Shiller made his mark with his 1981 paper on the volatility of markets, where he determined that if a stock price is the estimated value of “something” (say the discounted cash flows from a corporation), then market prices are way too volatile in relation to tangible manifestations of that “something” (he used dividends as proxy). Prices swing more than the fundamentals they are supposed to reflect, they visibly overreact by being too high at times (when their price overshoots the good news or when they go up without any marked reason) or too low at others.

The Reckoning: Financial Accountability and the Rise and Fall of Nations
by Jacob Soll
Published 28 Apr 2014

That way, there were three operations working to lower the debt, something that would prove crucial when the crash came. Hutcheson’s calculations went beyond accounting into the new realm of financial analysis. South Sea stock value was based on profit assumptions. Using present values (the value of past and future money at its calculated present value), discounted cash flow (discounting the value of future money, which loses its value) and annuity tables (how much a payment will be worth over time or at a given time), Hutcheson calculated the shortfall between necessary company profit and the stock’s value, on which now depended £43 million of government debt.

Boom and Bust: A Global History of Financial Bubbles
by William Quinn and John D. Turner
Published 5 Aug 2020

The South Sea Company, meanwhile, is characterised by Garber as ‘finance-first’: having accumulated a large fund of credit and the backing of Parliament, it was conceivable that the company would have found profitable investment outlets.65 The problem with this argument is that it is unfalsifiable: there is no theoretical price level for which it could not be made. A more conventional way of valuing an asset is to compare its price to its associated discounted cash flows, making allowances for uncertainty and liquidity. This was the method used by John Law himself, whose calculations showed that the peak share price of the Mississippi Company was only consistent with his estimates of future cash flows if he could reduce the discount rate to a wildly optimistic 2 per cent.

Platform Revolution: How Networked Markets Are Transforming the Economy--And How to Make Them Work for You
by Sangeet Paul Choudary , Marshall W. van Alstyne and Geoffrey G. Parker
Published 27 Mar 2016

All these terminological changes reflect the fact that marketing messages once disseminated by company employees and agents now spread via consumers themselves—a reflection of the inverted nature of communication in a world dominated by platforms.2 Similarly, information technology systems have evolved from back-office enterprise resource planning (ERP) systems to front-office consumer relationship management (CRM) systems and, most recently, to out-of-the-office experiments using social media and big data—another shift from inward focus to outward focus. Finance is shifting its focus from shareholder value and discounted cash flows of assets owned by the firm to stakeholder value and the role of interactions that take place outside the firm. Operations management has likewise shifted from optimizing the firm’s inventory and supply chain systems to managing external assets the firm doesn’t directly control. Tom Goodwin, senior vice president of strategy for Havas Media, describes this change succinctly: “Uber, the world’s largest taxi company, owns no vehicles.

The Global Money Markets
by Frank J. Fabozzi , Steven V. Mann and Moorad Choudhry
Published 14 Jul 2002

For the Enron floater we used in previous illustrations, the adjusted total margin is: Adjusted total margin 100 100 ( 100 – 99.90031 ) = -------------------------------------------------------- + 45 + 100 ( 100 – 99.90031 )0.05 ------------------------99.90031 0.9583 = 55.957 basis points In Exhibit 7.1, Bloomberg’s adjusted total margin is 55.957 which is obtained from the “MARGINS” box. Discount Margin One common method of measuring potential return that employs discounted cash flows is discount margin. This measure indicates the average spread or margin over the reference rate the investor can expect to earn over the security’s life given a particular assumption of the path the reference rate will take to maturity. The assumption that the future levels of the reference rate are equal to today’s level is the usual assumption.

Market Risk Analysis, Quantitative Methods in Finance
by Carol Alexander
Published 2 Jan 2007

An understanding of matrix algebra is necessary for modelling all types of portfolios. Matrices are used to represent the risk and return on a linear portfolio as a function of the portfolio weights and the returns and covariances of the risk factor returns. Examples include bond portfolios, whose value is expressed as a discounted cash flow with market interest rates as risk factors, and stock portfolios, where returns are represented by linear factor models. Matrices are used to represent the formulae for parameter estimates in any multiple linear regressions and to approximate the returns or changes in price of non-linear portfolios that have several risk factors.

The Innovation Illusion: How So Little Is Created by So Many Working So Hard
by Fredrik Erixon and Bjorn Weigel
Published 3 Oct 2016

Professionals get overburdened by performance measurements; and with a study showing that doctors in emergency rooms clicked the computer mouse up to 4,000 times in total during a busy ten-hour shift, spending 44 percent of their time entering data and only 28 percent with patients, it is hard to disagree.68 Consider how many companies, when investing, rely on quantitative valuation tools such as the net present value of an investment, calculated for instance by using discounted cash flow models. Qualitative approaches carry little weight, even if it is known that the qualitative aspects of an investment are at least equally as important as the quantitative ones. This is perhaps to be expected; at the least, it makes investment decisions easier, or rather less open to criticism.

How Money Became Dangerous
by Christopher Varelas
Published 15 Oct 2019

Mike’s first assignment was with Barbara Heffernan, a very smart managing director, tough, intimidating, yet known for being just and reasonable. The client was a young Mexican entrepreneur, Bernardo Dominguez. He was interested in buying Westin Hotels, but no one could tell how serious he was. Barbara told Mike to do the analysis and determine if it was a good deal. She asked Mike for a DCF (a discounted cash-flow analysis), but Mike didn’t know what that was. She wanted comps and an engagement letter, and Mike was likewise stumped. She presumed that he knew what he was doing. Despite Mike’s total ignorance, he did understand the importance of making a good impression this early in his time at Salomon, so he dove in hard, barely sleeping for three days.

Triumph of the Optimists: 101 Years of Global Investment Returns
by Elroy Dimson , Paul Marsh and Mike Staunton
Published 3 Feb 2002

At the same time, the equity risk premium has either fallen or is perceived to have fallen. With a decline in real interest rates, in the estimated equity premium, and in inflation, required returns are likely to be lower than many companies’ capital budgeting systems demand. Large corporations generally claim to base investment decisions on discounted cash flow analysis (Bruner, Eades, Harris, and Higgins, 1998). If the discount rates they use are excessive, they are likely to reject potentially worthwhile projects that should, in fact, be accepted. We have documented a fall in the expected equity risk premium that captures what we believe is really happening in financial markets.

The Asian Financial Crisis 1995–98: Birth of the Age of Debt
by Russell Napier
Published 19 Jul 2021

Still, just by being there to keep the price ‘honest’, the player in the global commodity business is ensuring their future profitability. In such a way, commodity-producing capacity is clearing at a dramatic pace across Asia, from cement companies in the Philippines, Malaysia and Indonesia, pulp and paper companies in Thailand and South Korea, and chemical companies in South Korea. So while we all ponder over the latest discounted cash-flow analysis or premium-to-book value analysis for Asian companies, we may be pursuing a form of analysis which is as useful a predictor of the future as a study of African tribal politics in the late 19th century. We are just beginning to see part of a great global game played out in Asia which may owe more to late 20th-century capitalist dialectics than the use of a pocket calculator with future value functions.

Radical Uncertainty: Decision-Making for an Unknowable Future
by Mervyn King and John Kay
Published 5 Mar 2020

Pension models In 1991 the ebullient fraudster Robert Maxwell disappeared from his yacht in the Canaries and was found to have looted the Daily Mirror pension funds to support his crumbling business empire. Far more extensive regulation of occupational pensions followed. ‘Defined benefit’ schemes promise pensions based on past earnings rather than on past contributions. The UK 2004 Pensions Act requires these schemes to compute a ‘technical valuation’ of their liabilities. This requires a discounted cash flow calculation using projections of prices, earnings and investment returns over the life of the scheme, which by its nature will exceed fifty years. The trustees of the scheme must compare this number with the current assets of the scheme, and take steps to eliminate any deficit. Of course, no one has any idea what prices, earnings and investment returns will be in fifty years’ time.

Order Without Design: How Markets Shape Cities
by Alain Bertaud
Published 9 Nov 2018

For instance, if the buses are too slow and result in very long trips, corrective action could be taken, for instance, by improving the design of road intersections and the traffic management along the route. Economic Rate of Return By combining the results of the input and impact indicators, it is possible to calculate the internal economic rate of return of the project. The economic rate of return will calculate the present value of a discounted cash flow of the expenditures and the benefits (the additional flow of income coming to the neighborhood because of newly employed workers). For instance, in the example depicted in figure 8.2, in addition to the economic rate of return, it will be possible to calculate what the capital and yearly recurring cost of the strategy is per new employed worker.

In the Plex: How Google Thinks, Works, and Shapes Our Lives
by Steven Levy
Published 12 Apr 2011

Schmidt provided an excellent summary of deal making in Internet time, embodying the Google principles of speed, scale, and minimizing opportunity cost. This is a company with very little revenue, growing quickly with user adoption, growing much faster than Google Video, which is the product that Google had…. In the deal dynamics, the price, remember, is not set by my judgment or financial model, or discounted cash flow. It’s set by what people are willing to pay. And we ultimately concluded that $1.65 billion included a premium for moving quickly and making sure we could participate in the user success in YouTube. If Google had been inclined toward remorse about the price, such worries were surely mitigated by a letter sent by Rupert Murdoch’s Twentieth Century Fox as the deal was closing.

Derivatives Markets
by David Goldenberg
Published 2 Mar 2016

The question is, how do we determine the option value C0 at time 0? A little option pricing history is useful here. Much of what we know as finance would respond that the solution is obtained by using standard discounting techniques. Let’s explore this potential avenue to pricing options. The standard discounted cash flow (DCF) approach has two steps, Step 1 Calculate the expected value of the option’s payoffs using the actual probabilities p and 1–p of up and down moves respectively in the Binomial process. Step 2 Discount the result of Step 1 by an appropriate risk-adjusted discount rate (RADR). Note that, in order to accomplish this, one needs the option’s risk premium, since an option is a risky asset.

The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal
by Ludwig B. Chincarini
Published 29 Jul 2012

That pushes the mark-to-market price to a very low value, even when the price would be much higher without the investor panic. As with VaR measurements, the market would be better off with marks that consider fundamental value. Some businesses go through predictable cycles. For these, a fair asset valuation might involve two sets of numbers: the mark-to-market value and the expected present discounted cash-flow value over a longer horizon. In 2008, bank capital wasn’t sufficient to withstand a major crisis, though most banks had the minimum Basel ratios. Different banks computed Basel ratios in different ways, so it was difficult to compare institutions. Banks also lacked sufficient liquidity cushions.

Den of Thieves
by James B. Stewart
Published 14 Oct 1991

"If you don't get it, I'm not going to spell it out." He seemed disappointed at Wilkis's lack of enthusiasm. Levine had a glaring weakness, however, that soon became apparent once he started work in the M&A department: his math skills were dismal. M&A work requires detailed calculations of discounted cash flow. Various kinds of valuations of business segments are necessary to arrive at the correct price for often huge transactions. Most of this work is done by junior M&A people. But Hill noticed that Levine invariably organized his team so that someone else had to do the math. Levine was a fast talker, and cut a swath through the fledgling department; but increasingly Hill sensed that Levine was, in his terms, a "bullshit artist."

The Power Law: Venture Capital and the Making of the New Future
by Sebastian Mallaby
Published 1 Feb 2022

There was one person, and one alone, who met their standards. “We like Steve Jobs!” Brin and Page reported.[49] Jobs not being available, Doerr hustled for an alternative. He sometimes described himself as a “glorified recruiter.” “We’re not investing in business plans, we’re not investing in discounted cash flows, it’s the people,” he insisted, revealing how the essence of the venture craft remained unchanged since the days of Arthur Rock and Tommy Davis.[50] Doerr duly worked his network to identify an executive with a computer science background, but his first choice refused to see a future in the umpteenth search engine.