by Amit Kumar
FREE FLOAT This approach to valuing insurance companies was popularized by Warren Buffett. Free float refers to the assets available from net claims liabilities under insurance contracts. Buffett makes the argument that these liabilities are available free of cost for insurance companies (with strong underwriting history) to invest in capital markets. The major components of float are unpaid losses, life, annuity and health benefit liabilities, unearned premiums and other liabilities to policyholders less premium and reinsurance receivables, deferred charges assumed under retroactive reinsurance contracts, and deferred policy acquisition costs.
INITIAL PUBLIC OFFERING (IPO) The initial public offering of shares in a private company that decides to sell its shares to the general public. IPO underwriters (investment banks) are responsible for allocation and pricing of the shares. IPO shares in the United States are allocated at the offering price, mostly to institutional investors.
LEVERAGE The magnitude of a company’s borrowings. Leverage or gearing (commonly used leverage ratios are D/C, D/E, Debt/EBITDA) measures a company’s indebtedness resulting from interest-bearing loans. Leverage can also result from large-scale operations or high fixed costs.
MARGIN Profitability expressed in percentage terms. For example, gross margin = gross profit/revenues, operating margin = operating profit/revenues. MARGIN STOCKS refer to stocks bought on loan from a stockbroker. Initial and maintenance margin (collateral deposit against portfolio) refer to the initial and maintenance deposits needed to buy or short stocks and derivatives.
OFF-BALANCE SHEET LIABILITIES Commitments and contingencies that are reported separately from the balance sheet, such as special notes and disclosures, and can result in additional borrowings.
PAY-IN-KIND (PIK) These stocks or bonds pay interest or dividends in the form of additional stocks or bonds, instead of cash payments.
Price/Book (P/B) The ratio of market capitalization to book value of equity. A P/B ratio of less than 1 indicates that the stock is cheap, and high P/B ratio indicates strong earnings growth or high return on equity (ROE). P/B is commonly used to value banks, insurance companies, and capital intensive or leveraged industries
Price/Earnings (P/E) or Price/Earnings per Share (EPS) The most commonly used valuation metric. A P/E multiple of 10 means that the investor is willing to pay $10 per share per $1 of EPS last year. In general, low P/E indicates that the market expects a lower earnings level, and high P/E indicates that the market expects growth in earnings. P/E for a company with growth expectations will be much higher than 10× and can reach ridiculous levels (100× to 500×) depending on hype and the market’s mood. Forward P/E is the ratio of stock price and forward EPS (or consensus).
P/FFO Similar to the FCF multiple for REITs. FFO (funds from operations) can also be adjusted for capital expenditures for a better picture.
Price to Sales (P/S) Can be a useful valuation metric for unprofitable companies. High growth companies and cyclical companies may sometimes produce low or negative earnings. In such a case, P/E, EV/EBIT, etc. may need to be normalized and P/S may be the right valuation multiple to use.
Price per Subscriber (P/Sub) or Enterprise Value per Subscriber (EV/Subscriber) A commonly used metric in telecommunications, media, and internet businesses.
P/E to Growth (PEG) This ratio is used for high growth companies. PEG adjusts P/E for earnings growth. A PEG ratio less than 1 could indicate that the growth stock is trading cheap.
PUT OPTIONS Similar to auto insurance. The insured pays a premium for auto collision and liability and gets the right to claim for damages in the event of an accident. Similarly, when you buy a put option on a stock, you pay a premium to protect (or hedge) your stock investment. A put option does not require you to own the stock and can be used as an alternative way to short stocks.
REAL ESTATE INVESTMENT TRUST (REIT) A trust that invests in real estate and mortgages and is required to distribute more than 90 percent of its taxable income to its investors.
REAL OPTION VALUATION The valuation of real options embedded in a stock. Real options are projects that a company can possibly undertake or discontinue; for example, launch of a new product or service, divestment of an unprofitable business segment, or expansion of production capacity. Valuation of hidden options and projects is especially important for short sellers because stocks can rocket up when companies exercise such options.
RETURN ON INVESTMENT (ROI) Profits expressed as a percentage of assets, equity, and invested capital. Returns help investors understand the impact of leverage and operating scale. Attractive businesses tend to have high overall returns. Returns of more than 10 percent over a 5-year period usually point to good business economics.
ROA = NET INCOME/TOTAL ASSETS
ROE = NET INCOME/TOTAL EQUITY
ROIC = NET INCOME/INVESTED CAPITAL
SEASONALITY The cyclical variation of revenues during a calendar year. For example, retail sales tend to peak in December due to Christmas sales. Natural gas demand tends to peak during winter, and oil demand peaks during summer, impacting the revenues and margins of refiners and oil companies.
SECURITIZED PRODUCTS Securitization is the process of converting nontradable loans, such as mortgages and car loans, to tradable securities called securitized products.
SHAREHOLDER DILUTION Companies may issue employee stock options, warrants, convertible debt, and other derivatives that may result in issuance of additional shares. Consequently, company earnings must be shared with these new shareholders, resulting in dilution of existing shareholders.
SHORT INTEREST The total number of short-sold shares outstanding, often expressed as a percentage of shares outstanding or as a ratio of float. Exchanges update this information on a biweekly basis.
SHORT SQUEEZE Rapid driving up of the price of a (typically heavily shorted) stock when shorts are forced to cover their positions in response to positive news (mergers and acquisitions, analyst upgrades, positive company announcements, regulatory short sale bans, etc.), margin calls, and stop losses. Short squeezes are the biggest risk for short sellers.
SOVEREIGN CDS Equivalent to buying insurance on a government bond.
SPIN-OFF Separation of a parent stock corporation into two or more separately tradable stocks. Spin-offs are typically noncash, tax-efficient transactions where the parent company may distribute new shares in the resulting spin-off to existing shareholders.
SUM OF THE PARTS (SOTP) VALUATION Used to value conglomerates or companies with multiple business segments operating in different industries. For example, Berkshire Hathaway operates in various industries including insurance, reinsurance, utilities, and freight rail transportation segments. Each of the business segments can be valued separately using valuation methods relevant to its industry, and the right value of Berkshire Hathaway should be the sum of the value of each of these parts (or segments).
SWITCHING COST A tangible or intangible measure of the brand strength of a company. Switching cost may refer to the actual monetary cost for a consumer to switch from one brand to another, or to the inconvenience or wasted effort in switching brands.
TED SPREAD TED The difference between short term T-bills (short-term government borrowing) and LIBOR rates implied by short-term Eurodollar (ED) futures. LIBOR is the interbank borrowing rate and also serves to gauge the systemic banking risk. Any sharp increase in LIBOR reflects high credit risk in the banking system. During a crisis, investors tend to flock to Treasury securities and push down the Treasury yields, further widening the TED spread. Calculation: If a 3-month Eurodollar contract is trading at 97.5, the implied LIBOR = 100 minus 97.5 = 2.5 percent. If 3-month Treasury bills yield 0.5 percent, the TED spread is 2 percent or 200 basis points per share.
TERM STRUCTURE A graph showing the relationship among interest rates of Treasuries with different maturities. An upward slope usually indicates economic expansion while a downward slope indicates recession.
VALUE TRAP Like fallen angel stocks whose glory days m
ay not come back as a result of structural changes in their business or the industry. Value traps tend to trade at low valuation multiples (e.g., P/B, P/E) and their multiples can stay depressed for long periods.
VIX VIX (the Fear Index) A measure of implied volatility of 30-day options on the S&P 500. A VIX reading of 20 indicates an expected annualized move of 20 percent in S&P 500 over the next 30 days. VIX hit an all-time high of ~90 in October 2008, after the Lehman Brothers collapse. VIX tends to trade between 10 and 20 during periods of complacence and shoots up amid market worries.
ZONE OF INSOLVENCY Companies are said to be in the zone of insolvency when they begin to tread close to their credit covenants and show signs of distress. A company in the zone of insolvency may be pushed into bankruptcy by any additional distress, such as a sudden fall in operating profits or values of assets, or a steep increase in funding costs.
Notes
1. Due Diligence in Short Selling
1. Chanos, J. (2003, May 15). Prepared statement for panel discussion on “Hedge Fund Strategies and Market Participation.” Retrieved from http://www.sec.gov/spotlight/hedgefunds/hedge-chanos.htm
2. U.S. Congressional Hearing (2008, November 13). Hedge funds and the financial markets. Retrieved from https://house.resource.org/110/gov.house.ogr.20081113_hrs15REF2154.1.pdf
3. Tilson, W. (April 2001). Notes from the 2001 Berkshire Hathaway Annual Meeting. Retrieved from http://www.tilsonfunds.com/motley_berkshire_brkmtg01notes.php
4. Cisco Systems (1998–2001). Form 10-Ks and 10-Qs. Retrieved from http://www.sec.gov/edgar.shtm
5. Questcor Pharmaceuticals (2010–2012). Form 10-Ks and 10-Qs. Retrieved from http://www.sec.gov/edgar.shtm
2. Leveraged Businesses: The Upside and Downside
1. Eastman Kodak (2011). Form 10-K. Retrieved from http://www.sec.gov/edgar.shtm
2. Office Depot (2009). Form 8-K. Retrieved from http://www.sec.gov/edgar.shtm
3. IATA (2008). Press release. Retrieved from http://www.iata.org/pressroom/pr/Pages/2008-29-05-02.aspx
3. Structural Issues in Industries
1. AIG (2006). Annual report. Retrieved from http://www.aig.com/Chartis/internet/US/en/2006-10k_tcm3171-440889.pdf
2. U.S. Department of Housing and Urban Development. Subprime lending. Retrieved from http://portal.hud.gov/hudportal/HUD?src=/program_offices/fair_housing_equal_opp/lending/subprime
3. Carpetright PLC (2006–2012). Annual reports, interim statements, and presentations. Retrieved from http://www.carpetright.plc.uk/investors
4. Boston Consulting Group (2010, March 2). Projecting U.S. Mail Volumes to 2020. Retrieved from http://about.usps.com/future-postal-service/gcg-narrative.pdf
5. Solar Energy Industries Association. Solar investment tax credit (ITC). Retrieved from http://www.seia.org/policy/finance-tax/solar-investment-tax-credit
4. Recipes for Cooked Books: Accounting Misstatements and Shenanigans
1. U.S. General Accounting Office (October 2002). Financial statement restatements: Trends, market impacts, regulatory responses, and remaining challenges. Retrieved from http://www.gao.gov/new.items/d03138.pdf
2. Incyte Corp. (2012, April 26). First quarter 2012 press release. Retrieved from http://investor.incyte.com/phoenix.zhtml?c=69764&p=irol-newsArticle_pf&id=1687652
3. Apple Inc. (2010). Form 10-K. Retrieved from http://www.sec.gov/edgar.shtm
4. Tesla Motors (2012). Form 10-K. Retrieved from http://ir.teslamotors.com
5. Financial Accounting Standards Board (2013, May 16). IASB and FASB propose changes to lease accounting. Retrieved from http://www.fasb.org/cs/ContentServer?pagename=FASB%2FFASBContent_C%2FNewsPage&cid=1176162614474
6. Skechers USA Inc. (2011, May 5). Form 10-Q. Retrieved from http://skx.com/investor.jsp?p=2
7. Garmin International Inc. (2008). Form 10-K. Retrieved from http://www.garmin.com/en-US/company/investors/sec/form-10-K
8. HP (2012, November 20). Press release. Retrieved from http://www8.hp.com/us/en/hp-news/press-release.html?id=1334263
9. The Walt Disney Company (2012). Form 10-K. Retrieved from http://thewaltdisneycompany.com/sites/default/files/reports/q4-fy12-form-10k.pdf
10. Marvell Technology (2012, December 27). Press release. Retrieved from http://www.marvell.com/company/news/pressDetail.do?releaseID=3296
5. The World Is Going to End
1. BBC News (1998, December 6). The man who broke the Bank of England. Retrieved from http://www.bbc.co.uk/search/news/?page=3&q=george%20soros%201992&dir=fd&news=41&news_av=1
2. Bernanke, B. (2003, May 31). Some thoughts on monetary policy in Japan, remarks by Governor Ben S. Bernanke. Retrieved from http://www.federalreserve.gov/boarddocs/speeches/2003/20030531/
3. Bernanke, B. (1994). The Macroeconomics of the Great Depression: A Comparative Approach. Working Paper No. 4814. Retrieved from http://www.nber.org/papers/w4814.pdf?new_window=1
4. Bernanke, Some thoughts on monetary policy.
5. Lattman, P. (2011, June 23). Regions settles S.E.C. action and puts a unit up for sale. Retrieved from http://query.nytimes.com/gst/fullpage.html?res=9E01EFDE103EF930A15755C0A9679D8B63&ref=regionsfinancialcorporation
6. Regions Finance (2009–2011). Annual reports, quarterly reports, presentations. Retrieved from http://ir.regions.com/
7. Matthews, D. (2013, October 9). Seventeen academic papers of Janet Yellen’s that you need to read. Retrieved from http://www.washingtonpost.com/blogs/wonkblog/wp/2013/10/09/seventeen-academic-papers-of-janet-yellens-that-you-need-to-read/
8. Yellen, J. and Akerlof, G. (2004). Stabilization policy: A reconsideration. Retrieved from http://www4.fe.uc.pt/jasa/m_i_2010_2011/stabilizationpolicyreconsideration.pdf
6. Value Investing
1. Graham, B. and Dodd, D. (2009). Security Analysis. Sixth Edition (New York: McGraw-Hill).
2. Kahn, I. and Milne, R. (1977, May 4). Benjamin Graham: The Father of Financial Analysis, Occasion Paper Number 5. Retrieved from http://www.cfapubs.org/doi/pdf/10.2470/rf.v1977.n1.4731
3. Graham and Dodd, Security Analysis.
7. Activist Investing
1. George, B. and Lorsch, J.W. (2014, May). How to outsmart activist investors. Retrieved from http://hbr.org/2014/05/how-to-outsmart-activist-investors/ar/
8. Papa Bear: Coattailing Marquee Investors or Betting Against Them?
1. Einhorn, D. (2010, December 10). Fooling some of the people all of the time: A long short (and now complete) story. Retrieved from http://foolingsomepeople.com/main/
2. Richardson, K., Lucchetti A., and Pleven, M. (2008, February 1). “Bond insurer’s woes add to credit-market stress.” The Wall Street Journal. Retrieved from http://online.wsj.com/article/SB120175741480431553.html
3. Banco Popular (2006–2010). Form 10-Ks and 10-Qs. Retrieved from http://www.sec.gov/edgar.shtm
4. Kucera, D. (2012, May 16). “Einhorn Says Amazon’s future a ‘riddle’ as profit lags sales.” Bloomberg. Retrieved from http://www.bloomberg.com/news/2012–05–16/einhorn-says-amazon-s-future-a-riddle-after-profit-lags-sales.html
5. Bezos, J. (2012). Annual Letter to Amazon Shareholders. Retrieved from http://phx.corporate-ir.net/phoenix.zhtml?c=97664&p=irol-reportsannual
6. Apollo Group (2009–2011). Form 10-Ks and 10-Qs. Retrieved from http://www.sec.gov/edgar.shtm
9. Off Wall Street: Two Decades of Successful Shorting
Off Wall Street contributed its original research to be reproduced in this book.
1. Lieberman, J. (2002, Feb. 27). The watchdogs didn’t bark: Enron and the Wall Street analysts. Retrieved from http://www.gpo.gov/fdsys/pkg/CHRG-107shrg78622/pdf/CHRG-107shrg78622.pdf
10. When to Hold, When to Fold
1. Western Union (2012–2013). Annual Reports, Quarterly Reports, Presentations. Retrieved from http://ir.westernunion.com/
2. XOOM (2012–2013). Annual Reports, Quarterly Reports, Presentations. Retrieved from http://ir.xoom.com/
3. MoneyGram (2012–2013). Annual Reports, Quarterly Repor
ts, Presentations. Retrieved from http://ir.moneygram.com/
4. Nunez, C. (2014, July 23). As fiery accidents pile up, U.S. proposes new rules for oil trains. Retrieved from http://news.nationalgeographic.com/news/energy/2014/07/140723-united-states-oil-train-rules-proposed/
5. Lee, P. (2014, July 19). Trinity guardrail whistle-blower case results in mistrial. Retrieved from http://www.bloomberg.com/news/2014–07–19/trinity-guardrail-whistle-blower-case-results-in-mistrial.html
6. Ivory, D. and Kessler, A. (2014, October 20). Guardrail maker Trinity Industries liable for fraud in Texas. Retrieved from http://www.nytimes.com/2014/10/21/business/jury-says-trinity-industries-a-highway-guardrail-maker-defrauded-us.html?_r=0
7. Marsh, S. (2008, October 28). Short sellers make VW the world’s priciest firm. Retrieved from http://www.reuters.com/article/2008/10/28/us-volkswagen-idUSTRE49R3I920081028
8. eBay (2002, July 8). Press Release. Retrieved from http://investor.ebay.com/releasedetail.cfm?releaseid=84142
9. Rosmarin, R. (2006, July 12). The PayPal exodus. Retrieved from http://www.forbes.com/2006/07/12/paypal-ebay-YouTube_cx_rr_0712paypal.html
10. Friedman, J. (2003, April 27). Zip2 and PayPal pioneer prepares for latest launch. Retrieved from: http://articles.chicagotribune.com/2003–04–27/business/0304260304_1_space-exploration-technologies-corp-elon-musk-paypal
11. SpaceX About SpaceX. Retrieved from http://www.spacex.com/about