Greg Smith on Goldman: An indictment of investment banking?

Greg Smith, the Goldman VP who resigned with a searing indictment of Goldman Sachs in the New York Times, has created quite a commotion. Predictably, the responses, which are understandably heated, have fallen into two extremes. On the one side are those who are predisposed to believe the worst about investment bankers and view this as vindication for their view that investment bankers are shallow, self serving and greedy. On the other are defenders of investment banking, who argue that this article states the obvious (that investment bankers are focused on making money) and that Greg Smith is a failed, middle level banker, having a midlife crisis.

I think I have the credentials to be on either side. On the one hand, many of my best and brightest students work at investment banks (including Goldman) and I teach training programs for both incoming analysts and associates at many of the investment banks. On the other hand, I have never been shy about critiquing investment banks for creating and marketing products that add little value or for providing self serving advice to some of their clients. In fact, I begin my corporate finance class with a clear statement that the class is not an "investment banking" corporate finance class but one that is structured around how businesses (who are the potential clients of investment banks) should make decisions. And I end the class, imploring students who do go into investment banking to preserve their options to abandon, if they find themselves unhappy with the grind or uncomfortable with the consequences of their actions.

Given that I have skin on both sides of the game, I want to look at the most troubling contention in Smith's piece, which is that Goldman Sachs bankers cared little about their clients and spoke about them with contempt. (To be honest, I am not sure what to make of "muppets" as an insult... I have always liked Kermit and have nothing but respect for Miss Piggy's self reliance...) After all, it is one thing to be cast as a ruthless money machine (a critique that has often been leveled at Goldman) and an entirely different one to be accused of ripping off your clients.

Do investment banks put their interests over the interests of their clients? I would not be surprised if they do, but before you are overcome by moral indignation, I would hasten to point out the following:

1. The typical client of an investment bank is more likely to be a corporation, hedge fund or institutional investor than an individual. So what? These entities are not exactly shy about promoting their self interests and I will wager that, given a chance, they would not only exploit mistakes made by investment banks but also mistakes made by their own clients.
2. The relationship between investment banks and their clients strikes me as mutually exploitative, and neither side can exist without the other's acquiescence. Let me use one example of the disfunction that is created as a consequence. There is strong evidence that many large M&A deals are value destructive for acquiring company's stockholders. While it is true the valuations from investment banks grease the wheels for these deals, it is also true that the managers of the acquiring firms are just as much to blame as investment bankers. Intent on spending stockholder money to gratify egos and build their corporate empires, these managers are less interested in honest advice from investment banks and more so in their deal-making prowess. In fact, I think that many corporations use investment banks as shields against having to take responsibility for bad decisions, with "It was not our fault, since the investment bank told us it was okay" becoming the post-failure refrain. 

Has this always been true? It was perhaps less so, four decades ago, when investment banks were almost all partnerships and catered to clients who did not shop around and stayed with their in-house banks. Before you become too nostalgic for the old times, remember that this was just as ruthless a world, where new competition was squashed quickly and becoming an investment banker was difficult to do, if you were not born into the right family, had the right connections or went to the right school.  The "old rich" were just as greedy as the "new rich" but they did do a better job of maintaining appearances. 

Rather than invoke the past or rail against the present, I would like to pinpoint at least three reasons why investment banks have become less client focused over time:

1. Deal shopping: As Goldman gets excoriated for not being client focused, it is worth remembering that loyalty is a two-way street. In a world where clients play investment bankers off against each other, hoping to get the best deal for themselves, these same clients cannot point fingers at investment banks for playing the same game with them.
2. Specialization: I do think that finance has become too specialized in both academia and practice, with experts and traders who know everything there is to know about narrower and narrower slices of finance or securitization. As a result, the people designing and trading new financial products/services have little sense of where these products fit into the larger scheme of things, and, as a consequence, when it makes sense to use them (or not use them).
3. Compensation: I do not begrudge investment bankers their income or wealth, but I do think that investment banks have tied compensation too closely to deal making and trading success. By doing so, they have encouraged their employees to get the deal or trade done, often at a cost not only to clients but also to the investment banks in the longer term.

So, in case investment banks are interested in my advice on how to be more client focused, here is what I would suggest:

a. Hiring: Investment banks have always focused on hiring the best and the brightest and they should continue to do so. Some people, though, are better at seeing the big picture than others (think Magic Johnson on the basketball court or Joe Montana on the football field) and investment banks need to find more of these generalists to balance the specialists.

b. Incentives/ Compensation: Tie incentives and compensation more closely to maintaining long term client relationships and getting good deals/trades done. I know that this will be more difficult to do than the existing system, but it will healthier.

c. Clients/Customers: This may perhaps be the hardest part of the process, but investment bankers may need to be more picky about their customers, saying no to some, even at the expense of substantial profits. 

Not practical, you say! Well, someone has to start the ball rolling and that someone has to profitable and powerful enough to set the trend. Wait! I do have a nominee! How about Goldman Sachs? This may be the perfect time for the firm to announce a revamp of hiring and compensation structures and see if others follow. 

Apple: Thoughts on bias, value, excess cash and dividends

Apple is hitting or is close to hitting two significant landmarks. Its market cap exceeded $ 500 billion yesterday (2/29) and its cash balance is at $ 100 billion. The twin news stories seem to have set investors, analysts and journalists on a feeding frenzy.  I think it is ironic that a company doing as well as Apple is right now, in terms of operations and stock price performance, is receiving this much unsolicited advice (split the stock, pay a dividend, buy back stock, do an acquisition, borrow money) on how it should fix itself. As we look at these prescriptions being offered to one of the healthiest companies in the market today, we should heed the Hippocratic oath, which is to do no harm.

I am biased
I have to start with a confession. It is impossible for me to be objective in my analysis of Apple and it is not just because the stock has done so well for me over the last decade. My first computer was a Mac 128K that I bought in the early 1980s and I have bought every Apple model since (even the ill fated Lisa and the not-so-great Powerbook Duo). Why should you care? One reason that the debate on Apple is so heated is that people have strong preconceptions about the company and those preconceptions drive their suggestions about what the company should do. As you read the rest of this assessment, you should recognize that my substantial positive bias towards Apple does affect my analysis. To structure my thoughts about what Apple should do, here is how I see the choices for the company:

Is Apple's cash hurting its stockholders?
The first and most critical question is whether Apple's cash holdings are doing harm to the stockholders. Let's dispense with the reasons that don't hold up to scrutiny:
1. Cash earns a low rate of return: It is true that Apple's cash balance earns a very low rate of return. It is, after all, invested in treasury bills, commercial paper and other investments that are liquid and close to risk less. It earns less than 1% but that is all it should earn, given the nature of the investments made. Put differently, cash is a neutral investment that neither helps nor hurts investors.
2. If that cash were paid out, investors in Apple could generate higher returns elsewhere: Perhaps, but only by investing in higher risk investments. Investors in Apple, who were concerned that Apple was investing so much in low return, low risk cash could have eliminated the problem, by buying the stock on margin. Borrowing roughly 20% of the stock price to buy Apple stock would have neutralized the cash balance effect and would have been a vastly more profitable strategy over the last decade than taking the cash out of Apple and searching for alternative investments.

So, what could be defensible reasons for worrying about cash? Here are a few:
1. The "low leverage" discount: The tax laws are tilted towards debt and Apple by accumulating $ 100 billion in cash, with no debt, is not utilizing debt's tax benefits.  In fact, the gargantuan cash balance gets in the way of even talking about the use of debt at the company; after all, why would you even consider borrowing at 2 or 3% interest rates, when you have that cash balance on hand?
My assessment: By my computation, Apple's optimal debt ratio is about 40-50% (download the spreadsheet to check it out yourself) and its current net debt ratio is -20% (using the cash balance of $ 100 billion as negative net debt). Given the risk of the business that Apple operates in, I would not let the debt ratio go higher than 20-30%. Their cost of capital currently is about 9.5% and it could drop to about 9% with the use of debt. That would translate into a value increase of $20-25 billion for the company, not insignificant but that is about a 5% value increase.

2. The naiveté discount: It is undeniable that legions of investors still use the short hand of a PE ratio, often estimated by looking at an industry average, applied to current or forward earnings to get a measure of whether a stock is cheap or expensive. In the process, they can significantly under value companies that have disproportionate amounts of cash. To see why, assume that the average trailing PE ratio for electronics/computer companies is 14 and that the average company in the sector has no cash. If you apply that PE ratio to Apple's net income or earnings per share, you are in effect applying it not only to the earnings from its operating assets (where it is merited) but also to its earnings from its cash balance (where you should be using a much higher PE ratio). Thus, you will come up with too low a value for Apple.
My assessment: I would be more inclined to go along with this argument if Apple's stock price had dropped 50% over the last few years. I find it difficult to believe that after the run up that you have seen in Apple's stock price, stockholders are under valuing the company. The counter, of course, is that the PE ratio for Apple, at 16 times trailing earnings or 13-14 times forward earnings, seems low and may reflect a naiveté discount.

3. The stupidity discount: In a post on Apple more than a year ago, I referred to what I called the stupidity discount, where stockholders discount cash in the hands of some companies because they worry about what the company might do with the cash. If investors are worried that the managers of a company will find a way to waste the cash (by taking bad investments, i.e., investments that earn less than the risk adjusted rate of return they should make), they will discount the cash.
My assessment: My personal assessment in January 2011 was that, as an Apple stockholder (which I have been for more than a decade), the company had earned my trust and that I was okay with them holding my cash. I am open to a reassessment and I think any disagreement boil down to the answer to the following question: Do you believe that Apple's success and strategy over the last decade was attributable to Steve Jobs or Apple's management? If you believe it was Steve Jobs, you are now in uncharted territory, with Tim Cook, a capable man no doubt, but capable men (and women) have wasted cash at other high profile companies. If you believe that Apple's management team was responsible for its success over the period, your argument is that nothing has really changed and that you see no need to change your views on the cash.


What if there is no discount?
If the cash balance is not hurting Apple's stockholders right now, the pressure to return the cash immediately is relieved. However, you still have a follow up question to answer. Does Apple see a possibility that it could find productive uses for the cash? While Jobs never broached that question and preserved plausible deniability, I am afraid that Tim Cook has conceded on this issue, when he said last week that Apple had more "cash than we need to run the company".

Bottom line: I am inclined to believe that Apple is not being punished right now for holding on to $100 billion in cash. However, I am more concerned than I was a year ago. While I had the conviction that Steve Jobs could never be pressured (by investors, portfolio managers or investment banks) to do something he did not want to do, I am not as sure about Tim Cook. Having seen how quickly markets can turn on high flying companies (Microsoft and Intel in the early part of the last decade come to mind), in the face of disappointment or a misstep, I am worried that Apple may be one misstep away from a discount being attached to cash. Given that even Tim Cook does not think that Apple needs this big a cash balance, I think that it is time that we ask the follow up question: what should Apple do with all this cash?

What should Apple do with the cash?
In the broadest sense, Apple can either invest the cash or return it to stockholders and it seems that even Apple does not believe in the first option. Investing the cash internally in more products and projects sounds like a great idea, given Apple's track record over the last decade. In 2011, for instance, the company generated a return on equity of 42% on its investments; if you net the cash out of book equity, the return on equity exceeds 100%. If Apple could invest the $100 billion in cash at 42%, that cash would be worth $350 billion, but put those dreams on hold, because it is not going to happen. First, that high return on equity can be traced back to the blockbuster products that Apple introduced in the last decade, the iPod, the iPhone and the iPad, and those are not easily replicable. Second, there are other constraints (people, technology, marketing, distribution, production) that essentially limit the number of internal projects that Apple can take.

How about a few acquisitions? I am sure that there are willing and eager bankers who will find target companies for Apple. The sorry history of value destruction that has historically accompanied acquisitions of large publicly traded companies leads me to believe that this path of action will provide justification for those who attached a stupidity discount in the first place. So, to those who are counseling Apple to buy Yahoo!, Pandora, Linkedin or go bigger, please go away!

If Apple cannot find internal projects of this magnitude and the odds are against value creation from acquisitions, the company has to return the cash to investors and there are three ways it can do this: initiate a regular dividend and tweak it over time, pay a large special dividend or buy back stock. In my view, there are four factors that come into play in making this choice:

1. Urgency: A company with a large cash balance that has been targeted by an acquirer or activist investors has to return cash quickly, cutting out the regular dividend option. Apple's large market cap protects it from hostile takeovers and its stock price performance and profitability give it immunity from activist investors.
2. Stockholder composition: When a company that has never paid a regular dividend initiates dividend payments, it attracts new investors, i.e., investors who need or like dividends, into the company. While this "investor expansion" has been used as an argument for regular dividends, I think it should actually be an argument against regular dividends. While some of my best friends are "dividend investors", I think that they are temperamentally and financially a bad fit for Apple, a immensely profitable company that also operates in a shifting, risky landscape. If Apple initiates a dividend, the demands for increases in those dividends in future years will come and the company will find itself locked into a dividend policy that it may or may not be able to afford. 
3. Tax effects (for investors): The choice between dividends and stock buybacks is also affected by how investors in the company will be taxed as a result of the transaction. While both dividends and capital gains are still taxed at the same rate, that will change on January 1, 2013, when the tax rate on dividends reverts back to the ordinary tax rate (which could be 40% or higher). If Apple drags its feet into 2013, the choice becomes a simple one: buy back stock.
4. Valuation of stock: Finally, there is the question of whether the stock in the company is under or over valued. A company, whose stock is over valued, should pay a special dividend since buying back  shares at the inflated price hurts the stockholders who remain after the buyback. While I am normally skeptical of the capacity of management to make judgments about the "fair" value of the stock, I decided to take my best shot at valuing Apple using an intrinsic valuation model. Using what I thought were reasonable assumptions (8% revenue growth for 5 years and a 30% target margin, both significantly lower than the numbers from recent years), I estimated a value of $716 $710 per share for Apple. You can download the spreadsheet that I used to make your own judgment. Once you have made your own estimates, please enter them in this shared Google spreadsheet. A buyback at the current price would provide a double whammy: a reduction in a "too large" cash balance and a buyback at a price lower than value. (Update: As many of you have rightly pointed out, a significant portion of the cash is trapped overseas and Apple will have to pay the differential tax rate (between the US marginal tax rate and the foreign tax rate already paid) when the cash is repatriated. I have added the trapped cash input into the excel spreadsheet and factored in the additional taxes.)

Closing thoughts
Apple should announce a substantial buy back, but it should use it do so on its terms. First, the buyback should leave Apple with enough of a cash balance (my guess is about $15-$20 billion) to invest in new businesses of products, should they open up. For the moment, I would avoid the debt route, even though Apple has debt capacity. Second, Apple should follow the Berkshire Hathaway rule book and set a cap on the buyback price. While Berkshire Hathaway's cap is set in terms of book value (less than 110% of book value), Apple should set its maximum as a function of earnings or cash flows (say, 16 times earnings). Third, Tim Cook should stop talking about whether Apple has too much cash and get back to business. Make the iPad 3 a success and lets see an iTV, an iAirline, a iUniversity and an iAutomobile (think of any product you use now that is badly designed or a  business that is badly run and think of how much better Apple could do...). Apple did not get to be the largest market cap company in the world by finessing its capital structure or optimizing dividend policy. It did so by taking great investments.

Facebook: Playing the "IPO pop" game?

In my last post on Facebook, I provided my estimate of value (about $ 70 billion) and concluded that I would not be a buyer of Facebook shares even if the company was valued at close to $ 70 billion. A few of you have taken me to task for leaving what you see as easy profits on the table, noting that if I were able to get Facebook shares at the offering price, that I would be guaranteed (or close to guaranteed) a substantial profit. More generally, there is the perception that investing in IPOs at the offering price (and making money on the offering day pop) is a low-risk, high return strategy that can be used to augment your portfolio returns. Like most "sure" things in investing, this one comes with implicit assumptions and costs and is definitely not "sure". Here is my list of caveats for those considering the "Facebook IPO Pop" strategy.

1. You have to be able to get the shares at the offering price
Let's say that when the Facebook IPO does get "priced", you bid to buy shares at the offering price. One of two things will happen: you will either get your requested number of shares or you will not, and ironically, it is the former that should worry you. If you are right in your basic hypothesis, i.e., that IPOs are under priced, the demand for the shares at the offering price will exceed the supply and the investment bankers managing the IPO will have to ration the shares. If the process is fair, you should get only a proportion of the shares you asked for, with the proportion getting smaller as the shares get more under priced. If the process is fixed and the investment banks give first dibs to their preferred customers, the proportion you get, if you are not one of the preferred customers, will be even lower. Thus, the only scenario you should dread if you are not a preferred customer is one where you get your entire allotment filled, because that is an indication that the shares are over priced.

This allotment process has always been the achilles heel of strategies that try to invest across all IPO offerings. You may bid for $100,000 worth of shares of every IPO for the next year, but you will end up with a portfolio that has too little invested in the most under priced IPOs (since you will get far fewer shares than you requested in these) and too much in the most over priced IPOs (since you will get all of the shares you asked for with these).

2. The stock has to pop on the offering date
Once you have been allotted the shares at the offering price, you have to hope for a stock price pop on the offering date. You do have history on your side. Looking across all IPOs, there is evidence of an offering day increase in stock prices. The figure below graphs out the average "under pricing" across all IPOs, by year, for US stocks:

Note, though, that this return presupposes that you can invest an equal amount in each IPO, under priced or not, but it is still impressive. Over the entire 50 year time period, there have been only four years (1962, 1973-1975) where the average returns were negative, and there are periods, such as the late 1990s, where the average return is close to 100% (doubling of price on the offering date). That is good news for the "Facebook IPO Pop" strategy.

Before you get too excited, though, note that the under pricing is greatest with the smallest offerings, as evidenced in the graph below:

Given the size of the Facebook offering (even 5% of $100 billion makes this a big offering), this graph should lead you to lower your expectations of the price pop on the offering date.

There is also evidence that this under pricing is by design. The IPO pricing cookbook at most investment banks includes a "take 15% off the value" ingredient in every pricing recipe, since the positive news stories that accompany the pop are viewed as a sales pitch for future stock issues. The under pricing also is consistent with the incentives for investment banks, who generally guarantee the offering price to the issuers, and thus have fare more to lose by over pricing than from under pricing.

This IPO under pricing has been the source of angst for some, who feel that the under pricing is unfair to the founders/owners of the company going public, since they are leaving money on the table, by offering their shares at a discounted price. That argument, though, becomes less persuasive, when you recognize that only a small portion of the outstanding shares is generally offered on the offering date. The discounted price on these shares operates the same way a loss leader operates in a retail store: it is designed to whet your appetite and get you to buy more. You hope that those who buy these shares (and feel good about the profits they make) will be back in six months or a year to buy more shares in the company. So, if you are feeling sorry for poor Mark Zuckerberg on the offering date, don't worry! There are plenty more shares in Facebook that will be hitting the market in future years.

From an investor's perspective, what can go wrong? Note that the average is across all IPOs (and is skewed by the smallest IPOs) and that a subset of IPOs see a drop in price on the offering date. These are of course the IPOs where you got all of the shares you asked for. If you are not a preferred customer, your odds of making money on IPOs decrease. Even the preferred customers are offered a mixed bag. Not only does their preference stem from the large amounts that they pay the investment banks for other services rendered, but they are expected to be "good" investors. In other words, if they flip the stock soon after the offering, it may endanger their preferred status on future IPOs. More on that in the next section!

3. You have to time your exit well
Assume now that the first two pieces of the puzzle have fallen into place. You have been allotted shares in the Facebook IPO and the stock has popped 15% on the offering date. Should you sell now or should you wait? That eternal  question has particular resonance with IPOs, because the gains on the offering date can be fleeting. Remember that Groupon's 20% jump on the offering date is now all gone!

Studies that track the post-offering performance of IPOs suggest that they do are not good investments in the aftermath. In the figure below, we compare the returns in the first five years after an initial public offering, with the returns on non-IPO stocks.

The returns on IPOs lag the returns on other stocks in the market and do so much more in the first few years after the offering. Thus, if buying at the offering price requires you to hold the stock for a year or two (which may be required of you as a preferred customer), you may not be getting a great deal.

In fact, my valuation of Facebook is predicated on the assumption that you may want to hold Facebook for more than a day in your portfolio. If you do, once the buzz fades and the IPO paparazzi leave, the company will be judged increasingly by how it performs relative to expectations. If price and value are on a collision course, value always wins out.

4. You are playing a sector and momentum game, even if you don't want to...
If you bid for shares in the Facebook IPO offering, I do believe that the odds may be in your favor for winning the game, if you define winning as getting the shares at the offering price and flipping them very quickly after the IPO. Much as I am tempted to join you, I am afraid I will sit out that game and not because of any noble impulses (such as wanting to be a long term investor or not speculating).

The IPO game is a subset of the momentum game, on which I have posted before. It is a game that produces big winners but momentum always turns, and when it does, it creates big losers. To see the link, note that IPOs go through hot and cold phases, with years in which you have hundreds of IPOs and years in which you have a few dozen.

In addition, also note that IPOs in any given year tend to be concentrated in a few sectors and those sectors generally have momentum on their side (dot com stocks in the 1990s, social media companies today). Thus, the success of IPOs in a sector is closely tied to whether the sector maintains it "hot" status.

One worrisome aspect of IPOs is that they may operate as canaries in the coal mine in signaling momentum shifts; the loss of enthusiasm for dot com IPOs (and the withdrawals of some) coincided with the epic collapse of the sector that year. The momentum driving social media companies will end one day and it may very well be the day that Facebook goes public. "Unlikely", you say, and I agree, but the tough part of being a lemming is that you never know where the cliff is coming. Of course, you may be able to sense momentum change much better than I, in which case you should be able to play the game successfully.

Bottom line
A strategy of investing in IPOs at the offering price looks much better on paper than it works in practice. All of the academic studies that show the average underpricing are implicitly based upon the assumption that you can create an equally weighted portfolio of all IPOs, when in fact, a non-discriminating investor will end up  will be with too much invested in all of the worst IPOs.

The strategy can be made to work by an investor who uses analysis (valuation or information) to invest only in IPOs that are most likely to be under priced and follows through with timely selling to capture profits after the offering. Even for that investor, it is a supplementary strategy since there will extended periods where there are no or very few IPOs in the market.

So, if you are bidding for those Facebook shares, good luck. I hope you get only a fraction of the shares you ask for (see part 1 for why), that the stock price pops on the offering date, that you get out before the you-know-what hits the fan. and that you are not the unfortunate soul who helps ring in the end of the social media circus.

Finding Finance as a Solo Entrepreneur

Finding finance as a small business or a lone entrepreneur can be very challenging to say the least. Although most governments todayrealise that the success of theor economies can be greatly enhanced by supporting small businesses more and providing a good breeding ground for entrepreneurs with viable business plans to start up, few of them will be willing to take on the banks with regulation to force more small business finance and loans.

But have you wondered why there are so many claims that the banks have shut up shop? Surely they can only make money by lending money. It simply makes no sense at all for them to stop lending completely.

The evidence is that they are still lending – at around R500 million each month in new term loans to businesses turning over less than R1 million. In total, the banks have about R37 billion of term loans outstanding to small businesses and around R7 billion of overdraft lending.

Of course figures can hide more than they tell you. Some numbers seem to say that, on average, small businesses are borrowing less and saving more, which could support the banks’ argument: that they cannot lend because small businesses do not want to borrow. But the answer must be more complicated than that or small firms would not be complaining.

To me, it seems that there are businesses that:
 • • Have enough cash to save some away and don’t need to borrow.
 • • Want to borrow and do get loans from the banks.
 • • Could borrow to invest, but choose not to just now.
 • • Might borrow but think they will be turned down.
 • • Want to borrow and don’t get a loan from their bank.
 It’s the last group that potentially causes the most concern. The most pressing cases are always when a business is on the brink. It may need to pay wages or a key supplier but a customer has not paid or, worse, has gone bust or gone elsewhere. So, even if the business is profitable, the cash isn’t there to pay the bills. The obvious first call is to the bank – can I have or extend an overdraft?
Well, while the bank will want to lend, it won’t want to lose money, so it needs to be satisfied that the business can repay the loan or pay down an overdraft.

It needs to be sure that there will be enough cash not only to repay, but also to provide a buffer in case other customers go down or disappear. And with the current state of the economy, the banks have probably been looking for bigger buffers.

Even if you show you can repay, the bank will often need some more comfort. It still needs to get its money back if the repayments aren’t made, so it asks for security as well.

That can make it very difficult to borrow. Even if you are profitable, think you can afford to repay, and have some assets, the bank might still say NO! Why? Well remember that the money being lent is often the savings of other people and other businesses: so it can’t afford to take risks with that.
But are the banks being too risk averse? The truth is that nobody knows the answer to that question because nobody can know with any certainty how quickly the economy will be back to sustainable growth and how rapid that growth will be. Only when confidence returns will banks feel able to relax their lending criteria. In other words, when the sun comes out!

So what can be done? If the banks don’t meet the targets government has set, growth will be slower and less certain, creating a vicious circle.

But it’s not just about targets; there is practical help for lending as well. Where a bank would lend but can’t because of a lack of security, it can call on the Government’s Enterprise Finance Guarantee (EFG). The scheme can substitute for a lack of, or even absence of security, and it can be used for new borrowing, restructuring existing borrowing, overdraft extensions or invoice finance facilities. It helps the bank to say Yes where otherwise it would say No.

There is plenty of capacity available for banks to use it and as much support as they need to help them do so. There is no reason for them not to. They’ve already used it to help over 15,000 businesses borrow more than R1.5 billion.

Not only does the EFG help businesses who would otherwise be turned down, it can also encourage those that think they may be turned down to make an approach to their bank. That can encourage investment and help to get the wheels turning again. Just what we need.

One final interesting statistic which questions the mood of gloom. Tucked away in the latest insolvency statistics is the news that the liquidation rate of companies in the year to end-June was 0.7 per cent.

That’s the proportion of active companies that went into liquidation in the year. That figure is much lower than the peak of 2.7 per cent in 1993 and lower than the 25 year average of 1.3 per cent. So perhaps things aren’t so bad in the real economy?

As a lone entrepreneur part of the challnge of starting up succesfully will surely t gain access to the business finance you need. In South Africa today companies like the IDC and SEDA is doing their bit to ensure that previously disadvantaged have the business finance support they need. Companies like Business Plan Whiz will provide you with direct access to investors when you are creating your business plan and Investors Network will introduce you to business investors at regular networking events for strart-ups. But the facs is that much more still needs to be done in order to esnure that this most crucial

Cash Flow and Solo Entrepreneurs

Cash is key for any solo-entrepreneur. Without the financial backing of a business partner or investor behind you, it will be crucial to you and your business that that the financial planning part of your business plan and the effective follow up and adjust process in relation to this is done effectively.

Without adequate cash, you can’t pay your bills and you can’t make plans for your business. what is cash flow planning? Cash flow planning is projecting your future cash inflows from sales, services, and loans, and comparing them to your future cash needs (suppliers, salaries/wages, loan payments, taxes, etc.). The difference between the two is your net cash flow.

Why is cash flow planning so important? Cash flow planning can help you identify problems down the road, and fix them before they occur. It can also help you make decisions such as should I attend that conference wanted to attend, should I buy the new computer I've been wanting, or do I need to work extra hard this month to avoid a cash deficiency next month?

The first step in planning your cash flow is knowing where you spend your money! Solo entrepreneurs need to have a good grip on both their personal and business spending, as most solo entrepreneurs rely on their business income to meet personal finance goals (i.e., pay the bills!). So, you should track both your personal and your business spending, although I recommend that you keep them separate (that’s a topic all by itself).

the best way to track your spending? You can use pen & paper, spreadsheets or a software program. The best method for you is the method that you will actually use on a regular basis.
You should project your spending for at least the next 12 months so that you include annual and other periodic expenses. If you are experiencing a cash flow crisis, you should track & project your cash flow on a weekly basis, instead of monthly.

If you are an existing business, you can project your cash flow for the next year by reviewing your expenses for last year. If you are a new business, you will need to estimate your start up costs in addition to regular operating expenses.

Start up costs include inventory, legal expenses, advertising, licenses & permits, supplies, and many more costs that you may not have thought of. To research startup costs you should contact your local Small Business Development Center, contact a SCORE counselor, join groups of similar business owners, and read as many books or articles you can find on the subject.
To improve your cash flow, you should:

1. Complete the first 3 steps. You have to understand cash flow planning, track your cash flow, and project your future spending needs before you can improve your cash flow.

2. Create best and worst case scenarios and create appropriate responses to both scenarios. For example, if your best case scenario is to increase sales by 50%, how will you use the profits? Will you put the profits back into the company by investing in new equipment, training, etc.? If your worst case scenario is a drop in sales by 50%, how will you continue to cover your monthly expenses? By planning for the best and worst case scenarios, you ll be ready for any situation.

3. When estimating your future income, realize that some people will pay late, and account for that fact in your projection.

4. Charge what you are worth. Many businesses, especially service professionals, under-charge when they are first starting out. This is a great way to go out of business. Make sure you are charging what you are worth, and remember you are in business to make money, not to give your expertise away for free.

5. Watch your business spending. Focus on the value the item brings to your business, and avoid lavish spending (i.e., do you really need the fastest, newest computer available?).

6. Don?t hire until necessary. Consider using virtual assistants or temporary employees before hiring permanent employees. 7. Give incentives for early payment for products and services. On the flip side, chase down invoices the minute they?re late. Charge interest or late fees to encourage timely payments.

8. Update your projection regularly. Your cash flow plan will change frequently as your business grows. You may want to update it weekly when you first get started, then switch to monthly once you've got a good handle on your cash. Remember - whether you are a new or growing business, your cash flow projection can make the difference between success and failure.

Make sure you are being realistic about the cash flow of your venture in your business plan. Its easy to over estimate sales and under estimate costs and the time it may take for your business to start generating sales.

The IPO of the decade? My valuation of Facebook

The Facebook IPO gets closer and I don’t think I can put off this valuation much longer. While we don’t have an offering price yet, the preliminary estimates are that the company will be valued somewhere between $75 billion and $100 billion. As with my Skype, Linkedin and Groupon valuations, I will present my assumptions and valuation of Facebook, with the admission that I have no crystal ball and know that your estimates will be very different from mine. So, with that disclaimer out of the way, here are my valuation assumptions for Facebook.

1. Where Facebook stands right now: I started with the Facebook S-1 filing which contains their financials from last year. The pdf version is available here, with my highlights and annotations (just ignore my snarky comments... I cannot help them). Looking at the most recent year's numbers, here is what I see:
(a) Revenues in 2011 were $3,711 million, up  88% from revenues of $1,974 million in 2010, which, in turn, were up  150% from revenue of $777 million in 2009.
(b) The firm's pre-tax operating income increased from $1,032 million in 2010 to $1,756 million in 2011. The firm's net income increased from $ 606 million in 2010 to $ 1 billion in 2011, though a third of that net income was set aside for participating securities (convertible preferred and restricted stock units... More on that later...). Incidentally, Facebook paid 41% of its taxable income as taxes in 2011.
(c) The company is primarily equity funded and its book value of equity at the end of 2011 was $5,228 million; the only debt on the books was $398 million in capital leases. They did have operating lease commitments, which when capitalized yielded a value of $776 million. The total debt is therefor $1,174 million.

2. Future revenues: Facebook is on a "high growth" path, with revenues growing by 150% in 2010 and another 88% in 2011, but as even that sample of two observations suggests, the big question is how that growth rate will hold up as the firm becomes larger. I estimate a compounded revenue growth rate of 40% for the next five years and a scaling down of that growth rate to the nominal growth rate in the economy (set equal to the risk free rate of 2.01%)  by the end of ten years. While both assumptions may strike you as conservative, I am effectively assuming that Facebook will follow a revenue growth path close to Google's over the next 8 years, as evidenced in the chart below, where I compare Google's actual revenues in the 8 years since their IPO with Facebook's forecasted revenues for the next 8 years:

Since advertising revenues are the drivers of both firms' growth engines, and they may very well be competing for the same advertising dollars, I think a comparison of their competitive advantages is in order. Facebook's primary advantage is that they can use what they know about their users (which is a lot... scary thought!) to offer focused advertising. Google's advantage is that it has a more direct and easy business model, since its revenues come from user clicks. In contrast, Facebook has to be careful about making its focused advertising too obvious, since some users will find this creepy. Google has added other products to its mix, with the Android as the most prominent example, and Facebook also has potential avenues for expansion.

3. Operating margin: Facebook has a phenomenal pre-tax operating profit margin in excess of 45%. To provide a contrast, Google's operating margin is currently about 31% and has seldom exceeded 35%. However, Facebook's margins will come under pressure as they actively seek out more revenues and I am assuming that the pre-tax margin will decrease to 35% over the next decade. Even with this assumption, I am estimating operating income for Facebook will exceed Google's by a wide margin over the 8 years following the IPO:

4. Reinvestment: In one of a series of posts on growth, I argued that growth does not come free (or even cheap). That is true for even a company with the pedigree of Facebook. There is some information in the financial statements about reinvestment: the company had net capital expenditures of $ 283 million, an acquisition that cost $24 million and an increase in capital leases of about $ 480 million. To estimate reinvestment in future years, I assumed that the firm would be able to generate about $1.5 million in revenues for every million in additional capital investment. At this stage, it is impossible to tell what form the reinvestment may take, but looking at Google over the last few years should provide clues; the company has moved increasingly to using acquisitions to augment growth. Lest you feel that I am being too conservative, I am estimating that Facebook will generate a return on its capital of about 32% in year 10, up from just over 26% now.

5. Risk and cost of capital: Facebook is a company that is funded almost entirely with equity and while it is a young, growth company, it does have a business model that is working and delivering substantial profits. While we can start from the bottom and work up to a cost of capital, using parameters estimated for Facebook, I will employ a far simpler approach. Looking across the costs of capital of all US companies at the start of 2012 (you can find this on my website), I estimate a cost of capital of 11.42% for advertising companies. I will assume that Facebook will face a similar cost of capital to start. The median cost of capital for US companies is roughly 8% and as Facebook grows and matures, I do adjust the cost of capital down to 8%.

6. Cash and Debt: The assumptions above are sufficient to estimate the value of the operating assets. Discounting the cash flows back at the cost of capital (with changes over time) results in a value of $71,240 million. To get to equity value, I subtract out the outstanding debt ($1,174 million) and add the current cash balance ($1,512 million). While I would normally augment the cash balance with any cash proceeds from the IPO, Facebook is open about the fact (See S1, page 7) that the proceeds will be going to Mark Zuckerberg to cover tax expenses from option exercise and will not be coming to the firm.

Value of equity = $71,240 + $1,512 - $1,174 = $71,578 million

Based on my estimates, the values being bandied around ($75 billion- $ 100 billion) are not unreasonable. As with my Groupon valuation, I ran a simulation,making assumptions about distributions for my key assumptions (revenue growth, operating margin, cost of capital and reinvestment). The results are summarized below:

Note that the median value of $ 70 billion is close to the base case estimate (as it should) but there is a 10% chance that the value could be greater than $ 117 billion and a 10% chance of a value of $ 43 billion or less.

7. Value per share: At some stage in this IPO process, Facebook's investment bankers will have to arrive at a value per share (offered) and you and I will have to decide on whether to buy or not. That could be messy because Facebook has multiple claims on equity, starting with:

a. Equity options: There are 138.54 million options outstanding, from earlier year compensation schemes, with an average maturity of about 2 years and an exercise price of $0.75. My estimate of the value of these options collectively, net of the tax benefits that I see Facebook getting from the exercise, is $3,782 million. I will net this value out against the equity value to get to a value in the shares:

Value in shares = $71,578 million - $3,782 million = $67,795 million

b. Restricted Stock Units: In the last few years, Facebook (like many other tech companies) has shifted to granting restricted stock units. These are regular shares but the holders who receive have to first stay long enough with the company (vest) to lay claim to them and often face restrictions on trading. The liquidity restrictions, in particular, should make these shares less valuable than regular shares. There are 380.719 millions class B shares, in restricted stock units, that will eventually become regular shares and I will add them to current shards outstanding.

c. Class A and Class B shares: After the IPO, there will be 117.097 million Class A shares (with one voting right per share) and 1758.902 million Class B shares (with ten voting rights per share). Other things remaining equal, the latter should trade at a premium on the former, though I don't think that the expected value of control in this company is significant.

If I take the equity value, net of the value of options, and divide by the total number of class A, class B and RSU shares outstanding, the value per share that I get is $29.05. Allowing for a slight discount (3-5%) on the non-voting shares, I would anticipate that the class A shares in the IPO will have a value of about $28 (assuming that my share count is right... I will wait to get a firmer update as we get closer to the offering, before I close in on a per share value). You can access the excel spreadsheet with the numbers by clicking here. If you don't like my inputs or assumptions, don't stew about them. Go in and change them and see what you get as the aggregate value of equity in Facebook. If you can post it in the Google spreadsheet that I have created for this purpose, even better... Let's see if we can get a consensus value for the company.

If you are investing in Facebook, give credit to the company for being upfront and honest about where the power rests in this company. On page 20 of the filing, you will find this "Mr. Zuckerberg has the ability to control the outcome of matters submitted to our stockholders for approval, including the election of directors and any merger, consolidation, or sale of all or substantially all of our assets. In addition,  Mr. Zuckerberg has the ability to control the management and affairs of our company as a result of his position as our CEO  and his ability to control the election of our directors. Additionally, in the event that Mr. Zuckerberg controls our company at  the time of his death, control may be transferred to a person or entity that he designates as his successor." A little later on page 31, you will find this "We have elected to take advantage of the “controlled company” exemption to the corporate governance rules for publicly listed companies. Because we qualify as a “controlled company” under the corporate governance rules for publicly-listed companies, we are not required to have a majority of our board of directors be independent, nor are we required to have a compensation committee or an independent nominating function." Let's be clear about this: this is Mark Zuckerberg's company and you and I are just providing him with capital.

For those of you who are familiar with my valuations of Linkedin and Groupon, you will note that I am more positive about Facebook than those companies. Part of that can be attributed to Facebook being further along in developing a business model that works and delivers profits. Another reason, though, is that Facebook has a real chance at being the next “winner take all” company. What am I talking about? In conventional businesses, a company that gets a large portion of the market is subject to competitive assaults that cap the market share and reduce profitability over time. In some parts of the technology business, controlling a large share of a market seems to give the winner the capacity to take over the whole market. Consider three big winners from the last 30 years. Microsoft started off in the “office suites’ competing with many players in the word processing, spreadsheet and presentation program businesses, but at some point, its dominance drove the competition out. To a lesser extent, Amazon’s dominance of online retailing and Google’s ownership of online advertising (so far) reflect similar “winner take all” phenomena. I am not suggesting that Facebook has a lock on social media advertising, but it has a chance to get a big chunk of it, and if it does, the value that I estimated will be too low. Note that the simulation does yield values of $120 billion or higher for the company, if the stars align.

Would I buy Facebook stock, if its equity were valued at $75 billion? No, and not because I believe that the price is outlandish, but for two other reasons.

• The first is that the price reflects the expectation that Facebook will become a phenomenal success. Anything less than superlative will be viewed as a failure.
• The second is that what Facebook is brazen about the fact that they don't see any need for input from stockholders. In effect, they want my money but don't want me to have any say in how the company is run. This does not jell with the notion that stockholders are part owners of the companies that they owned stock in. You may be comfortable with Zuckerberg as CEO for life but I am not. I am sure that I am in the minority on this one, but different strokes for different folks....

In closing, Facebook has immense promise as a company and it is being priced on the premise that the promise will be delivered. Could it be worth $ 100 billion? Sure, but you are fighting the odds as an investor. Social media companies today collectively and Facebook in particular resemble stores with tremendous foot traffic (850 million users in the case of Facebook) but with nothing on the shelves. You are buying access to the foot traffic and hoping that you can get something on the shelves that they will stop and look at and buy. Given that social media is still in its infancy, we really don't know whether this promise will pan out, and that remains the basis for the uncertainty, and why short cuts that are based on value per member (a metric that I see with social media companies all the time) are fraught with danger.

Options and Taxes: Is a "Facebook" tax next?

Facebook is in the news and I will do my usual pre-IPO valuation and posting in a few days on the company but I want to focus in on an interesting story in this morning's New York Times about option exercise and taxation (at both the individual and corporate levels).

The story itself focuses on two tax issues. The first is that Mark Zuckerberg is planning to exercise about $ 5 billion of options ahead of the offering, resulting in a tax bill of roughly $ 2 billion for him, about $1.5 billion in federal taxes and $ 500 million in California taxes.  The second is that Facebook will be claiming a tax deduction of roughly the same value, which will shelter them from taxes this year and allow them to claim tax refunds of about $ 500 million from prior years. All of this has some in Congress in full "indignation" mode, with Senator Carl Levin saying "“When profitable corporations can use the stock option tax deduction to pay zero corporate income taxes for years on end, average taxpayers are forced to pick up the tax burden,” he said. “It isn’t right, and we can’t afford it.” Before we embark on another tax policy change predicated on a sample of one (Facebook), it is worth examining the broader question of how employee options get taxed, especially at the corporate level.

At the moment, if you are a company that grants options to its employees, the accounting laws require you to value those options as options (rather than at exercise value) and expense them when you grant them (though you can amortize these expenses over a period of time). Thus, what you see reported as operating or net income for a company today is after employee options have been expensed. This, of course, is a sharp reversal of accounting policy prior to 2006, when firms had to show only the exercise value of the options at the time of the grant. Since at the time of the grant, employee options were usually at the money (strike price = stock price), this effectively meant that option grants had no effect on earnings when they were granted. However, if and when the options were exercised, companies were required to show the difference between the stock price and the strike price as an expense. 

To illustrate the difference, assume that you grant 100 million options with a strike price of $10, when the stock price is also $ 10, in 2008. Let's also assume that the options get exercised 2 years later when the stock price is $ 40. With pre-2006 accounting, you would not have shown an option expense in 2008 but you would have shown an expense of $ 3 billion [$40 - $10) (100)] in 2010. In the post-2006 time period, the company would have had to show an option expense in 2008, with the expense computed by valuing the options at the time. (For instance, an at-the-money option with five years to expiration on a stock with a price of $ 10 and a standard deviation of 40% would have a value of $3.36. Carrying this through, the company would have to record an expense of $336 million in 2008 and revisit this expense in subsequent years, as stock prices go up or down.  If you want to, you can try your hand at valuing options with the attached spreadsheet).
[Update: I have been taken to task by the accountants among my readers for being simplistic (and wrong) on the accounting rules, since they are far more complex than what I have described in this example. I confess to the crime but I feel no remorse. I think that I am being truer to the underlying accounting principle of matching expenses up to revenues than the current accounting rules claim to be. My point is that accounting has moved grudgingly to accept the fact that options have to be expensed when they are granted and not when they are exercised, though the accounting obsessions with smoothing and back filling finds their way into the rules. In fact, more on that in my next post]

So, what does this have to do with today's story? While the accounting treatment of options changed in 2006, the tax treatment did not. In effect, the tax authorities still use the pre-2006 convention, not allowing companies to expense options when they are granted but only when they are exercised. This creates a disconnect between accounting earnings and tax earnings, which can make valuation more difficult. But is it a loophole? Seems like it, if you only consider Facebook, which will save a billion dollars in taxes because its options will be exercised at a time when its stock price is sky high. But let's add to this sample of one. Take a company like Cisco, which has granted hundreds of millions of options over the last decade. Since the stock has stagnated over the period, many of these options are now under water and will either end up un-exercised or exercised for far less than the value at the time of the grant. If Cisco had been able to deduct these options at the time they were granted (at option value), they would have saved hundreds of millions of dollars, which they may now will lose forever, if these options remain under water. In the aggregate, with the current tax treatment of options, the government collects less in taxes from Facebook and more in taxes from Cisco.  

Do I think that the tax rules on options should be changed? Perhaps, but it is not because the tax law is unfair or because I think it creates a loophole. As I see it, here are the three choices:

1. Continue with the existing policy of taxing options when they are exercised. The net effect is that the most successful companies (at least in terms of creating market value) will get bigger tax deductions from option expensing than the least successful companies.
2. Change tax law to match accounting law and allow companies to expense options in the year that they grant them. It will smooth out tax collections, level the playing field across companies and create more consistency. But here is the follow up question that gives me a little pause:  Should employees who receive the options then have to show them as income in the year that they receive them? If you are being consistent, the answer is yes, but where will they come up with the cash to pay the taxes? After all, employee options are not liquid and the employee while wealthy (in terms of options) may be cash poor.
3. If you follow Senator Levin's logic that this is a loophole, and you try to craft legislation, I am not sure where it leads you. Should we ban the expensing of options by companies? I would accept that, if you stop taxing employees who receive these options. (If that had been in place this year, Facebook would have to pay about a billion more in taxes but the government would be collecting two billions less in taxes from Zuckerberg...)

As someone interested in valuation, I have wrestled with options and their effect on value for a while. I think that options are mishandled in many valuations, with flawed arguments (Options are non cash expenses...) and perilous short cuts (treasury stock and fully diluted value approaches) overwhelming common sense. In fact, I wrote a paper on the topic that you can download by clicking here.