# discounted cash flows

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

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Finally, it can be shown that even when net investment equals depreciation, the final result will be downward biased—and the larger the cost of capital, the larger the bias. 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. To do this, first calculate how similar companies are valued as a multiple of a relevant metric, such as earnings, invested capital, or an operating metric like barrels of oil reserves.

To compare the methods of computing continuing value, first discount a long forecast—say, 150 years:2 CV = \$50(1.06)149 \$50 \$53 \$56 + + + ... + 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.

Although NOPLAT is consistently higher after adjustments for OPERATING LEASES 437 EXHIBIT 20.6 Leasing Example: Free Cash Flow and Equity Valuation \$ million Free cash flow (unadjusted for leases) Free cash flow (adjusted for leases) Year 1 Year 2 Year 3 NOPLAT (Increase) decrease in invested capital Free cash flow Reconciliation Interest expense Interest tax shield Cash flows to debt Cash flows to equity Reconciliation of free cash flow Discount factor Discounted cash flow Valuation Enterprise value Debt Equity value Year 1 Year 2 Year 3 96.8 114.8 130.7 70.2 86.0 101.1 (61.3) (46.4) 477.2 NOPLAT (Increase) decrease in invested capital 8.9 39.5 578.4 Free cash flow (23.2) 49.8 7.1 (1.8) (9.8) 13.3 8.9 7.7 (1.9) (3.1) 36.9 39.5 7.9 (2.0) 131.3 441.2 578.4 0.908 8.0 0.825 32.6 0.749 433.1 Reconciliation Interest expense Lease interest expense Interest tax shield Cash flows to debt Cash flows to lease debt Cash flows to equity Reconciliation of free cash flow 7.1 35.5 (10.7) (9.8) (58.7) 13.3 (23.2) 7.7 7.9 38.5 39.4 (11.5) (11.8) (3.1) 131.3 (18.6) 787.8 36.9 441.2 49.8 1,395.7 Discount factor Discounted cash flow 0.941 (21.8) 0.885 44.1 473.7 (118.4) 355.3 Valuation Enterprise value Debt Operating leases Equity value (120.0) (65.0) 1,265.0 1,395.7 0.833 1,162.0 1,184.3 (118.4) (710.6) 355.3 leases, free cash flow is not.

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Guide to business modelling by John Tennent, Graham Friend, Economist Group

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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. Future cash flows, however, must be adjusted to allow them to be compared on an equivalent basis with cash flows that take place at the start of the project.

The discount rate must therefore reflect the average required return for both types of financier. 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.

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

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SPREAD KEY STATISTICS, RATIOS, AND TRANSACTION MULTIPLES STEP IV. 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.

., 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. It is premised on the principle that a target’s value can be derived from the present value of its projected free cash flow (FCF).

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).

pages: 353 words: 88,376

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

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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. If the value arrived at through CF1 CF2 CFn DCF = + +...+ DCF analysis is higher than the (1 + r )1 (1 + r )2 (1 + r )n current cost of the investment, CF = Cash Flow the opportunity may be a good r = discount rate (WACC) one. It is calculated as follows: Investopedia explains Discounted Cash Flow (DCF) There are many variations in what can be used for cash flows and the discount rate in a DCF analysis.

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. These types of stocks generally are considered highly speculative and risky because they lack liquidity, have large bid-ask spreads, are small capitalization, and have limited analyst coverage and disclosure.

See Dollar cost averaging (DCA) DCF. See Discounted cash flow (DCF) DD. See Due diligence (DD) DDM. See Dividend discount model (DDM) Dead cat bounce, 65 Dealer. See Broker-dealer Debenture, 65-66 Debt, 66, 167-168 Debt financing, 66-67. See also Leverage; Liability; Mortgage Debt ratio, 67, 117-118 Debt/equity ratio, 67-68, 118, 168 Debt-to-capital ratio, 68-69 Default, 4, 58, 289 Default risk. See Counterparty risk Defined-benefit plan, 69-70, 153-154, 241 Defined-contribution plan, 70, 153-154, 241 Deflation, 70 Deleverage, 71 Delta, 71-72, 117 Delta hedging, 72 Demand, 73, 156 Depreciation, 73-74 Depression, 29, 120, 131-132 Derivative, 74, 319, 366. See also Option Diluted earnings per share (diluted EPS), 74-75 Dilution, 31, 75, 112, 262 Discount broker, 76 Discount rate, 76-77, 143, 227 Discounted cash flow (DCF), 77 Discounted value.

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

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The EV/EBITDA ratio takes debt and cash into account, which the P/E ratio does not, and it is used to ﬁnd attractive takeover candidates, helpfully showing how much debt the acquirer would have to take on. 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.

 2 HOW THE CITY REALLY WORKS ___________________________________ You will read about how capital markets work. 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. In the City today, derivatives are becoming increasingly sophisticated, and are used for both speculating and hedging.

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Getting a Job in Hedge Funds: An Inside Look at How Funds Hire by Adam Zoia, Aaron Finkel

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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.

We have also seen some global macro funds take people directly out of undergraduate school, as those types of funds do not use a bottom-up approach to picking stocks and can therefore bring on people without financial modeling experience. 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.

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

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In Devon’s case, our calculation shows that with proved (2014) reserves of 2,754 million Boe and reported 2014 production of 673,000 Boe per day, or 242.3 million Boe per year, the reserve life index is: 2,754 million Boe divided by 242.3 million Boe to give 11.37 years. 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. Yet another important indicator of the potential value-creation of the company’s properties is the extent of its productive (energy extraction) activities, measured by the number of wells and rigs operating on the properties, and classified by oil and gas, as well as by geographic areas.

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.

The top line—mineral acreage—presents the total area (in thousands of acres) controlled by the company through owning or leasing, and classified by developed (2,317) versus undeveloped (3,926) thousands of acres. Thus, 186 SO, WHAT’S TO BE DONE? Minerals I. 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.

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

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This growing rate is probabilistic, with some deterministic part and some volatility around it. 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.

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. Let us work with a 7-year bullet bond, with a 5% yearly coupon.

The Future of Money by Bernard Lietaer

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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. It is presented in full detail in any finance textbook.

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.

From a financial perspective, a demurrage charge on money is mathematically equivalent to a negative interest rate. 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. If you do not need the money for immediate consumption, and you have guarantees about my creditworthiness over the next year, you should logically prefer the money a year from now.

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The Automatic Customer: Creating a Subscription Business in Any Industry by John Warrillow

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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? 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.

., 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.

Investment: A History by Norton Reamer, Jesse Downing

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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. Williams spent his undergraduate years at Harvard studying mathematics and chemistry, and this mathematical frame of mind would serve him well in the years to come.

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? In other words, how does the breakdown of different forms of capital, like debt and equity, affect valuation?

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).

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Ethics in Investment Banking by John N. Reynolds, Edmund Newell

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The UK Government provided guidance as to the meaning of “promoting the success” of a company. 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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The Personal MBA: A World-Class Business Education in a Single Volume by Josh Kaufman

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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?” Assume a meteorite scored a direct hit on the house, and there’s nothing left—you have to rebuild the house from scratch.

They’re probably not exactly the same (maybe they have an extra bedroom or bathroom, a little less square footage, etc.) but they’re close enough. 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?” Rent payments come in every month, which is quite handy: you can use the DCF/NPV formulas2 to calculate what that series of payments over a certain period of time would be worth if you received it in one lump sum.

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. Cooke. Compounding Improve by 1% a day, and in just 70 days, you’re twice as good.

Rethinking Money: How New Currencies Turn Scarcity Into Prosperity by Bernard Lietaer, Jacqui Dunne

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Today’s money is created through bank debt, as explained in the last chapter, and it requires the payment of interest. 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.) With the issue of interest, however, an entrepreneur, for example, can put her capital in a bank instead of investing it.

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.

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

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In this chapter, we consider the academic research on sustainable high returns, and examine some simple metrics that help to identify firms with franchises. 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.

The strategy has tended to outperform over rolling 5- and 10-year periods, beating out the other investors around two out of every three rolling 5-year periods, and between six and nine out of every 10 rolling 10-year periods. Machine, it seems, beats man. 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, Barry Schachter

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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. I wrote one of those memos, explaining why Exxon should pay now and reduce its after-tax cost, since Exxon had a lower cost of debt than the federal rate for disputed tax amounts.

When I graduated from business school in 1983, I was offered a job in the treasurer’s department at Exxon. It was a dream come true. 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. All decisions were made through the editing of memos. As an analyst you would write a memo on a subject, making a recommendation.

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Expected Returns: An Investor's Guide to Harvesting Market Rewards by Antti Ilmanen

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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.

In the new thinking on expected returns, multiple systematic factors, time-varying risk premia, skewness and liquidity preferences, supply–demand effects, market frictions, and investor irrationalities can all play a role [4]. (No single model can capture all of these features. 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. But the great intuition is that SDF is an index of “bad times” and that the required risk premium for any asset (or a risk factor) reflects its covariation with bad times.

If most current holders bought the stock well above current market levels (so that they have large unrealized capital losses), disposition-biased investors will be slow to sell assets and any bad news will travel slowly (into the market price). 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. Five points are worth noting:• First, because we cannot directly observe expected returns, there has been considerable debate as to how much time series or cross-sectional predictability of returns really exists.

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Early Retirement Extreme by Jacob Lund Fisker

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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.

For these reasons, and because it tends to pay well due to the large number of hours worked, salaried work is the preferred method for accumulating a fund for financial independence (see Financial independence and investing). 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).

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

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.”

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.

The history reaffirmed HBS’s commitment to its case method—by 1980, the School’s \$15 million research budget exceeded the overall budget of any other graduate business school in the world,7 and in 1980–81, HBS shipped almost 100 million pages of materials from its case inventory of 18,000 to more than 6,000 customers.8 (By 1995, the research budget had topped \$44 million.9) But that commitment aside, by the end of the 1980s, A Delicate Experiment represented not much more than an historical artifact, a story of the way things used to be. 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. And it might as well have been. When the School launched its Global Financial System (GFS) project in 1992, its advisory board included executives from the likes of J.

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

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Lastly, to determine the intrinsic value at the current time t, it might seem that we need to estimate the intrinsic value next time period, t + 1. 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. To simplify this task, equity traders often assume a constant discount rate so that kt = k for all t.

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.

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Obliquity: Why Our Goals Are Best Achieved Indirectly by John Kay

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But that does not mean that these firms were any more capable of formally calculating the outcome of their activities than was Beckham, or that attempting to emulate them will be any more rewarding than emulating Beckham. 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. Far from it—it was an intelligent action in pursuit of the high-level objective of the responsible application of chemistry in industry.

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The Monk and the Riddle: The Education of a Silicon Valley Entrepreneur by Randy Komisar

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The accoutrements of established businessesthe company cafeteria, the clerical support, the illusory job security, the pension plans, and everything else a large organization can provideare inconsistent with Valley startup mentality. Page 36 "I'm not concerned about it," Lenny shot back. "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. As far as he was concerned, the answers were all there.

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

., 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.

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

(“You were able to raise money at a ten-million-dollar pre? Life isn’t fair. 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 Art of Scalability: Scalable Web Architecture, Processes, and Organizations for the Modern Enterprise by Martin L. Abbott, Michael T. Fisher

The company has had a number of scalability related incidents with its flagship HRM product and Christine determines that the current CTO (in AllScale’s case, the CTO is the highest technology management position in the company) simply isn’t capable of handling the development of new functionality and the stabilization of the existing platform. 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.

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. This bias most often shows up in an incorrect or F OCUSING ON S TRATEGY incomplete analysis showing that building a certain system is actually less expensive to a company than purchasing the same component.

Mathematics for Finance: An Introduction to Financial Engineering by Marek Capinski, Tomasz Zastawniak

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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.) Expectation with respect to the risk-neutral probability gives the initial bond price 100.05489, so the ﬂoor is worth 0.05489.

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The Misbehavior of Markets by Benoit Mandelbrot

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It “gave an early warning that the situation was very unstable,” they reported. 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. All this implies that value is somehow a single number that is a rational, solvable function of information.

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

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A company’s stock that is growing earnings and/or revenue faster than its industry or the overall market. hedge fund A fund, usually used by wealthy individuals and institutions, that is allowed to use aggressive strategies unavailable to mutual funds. 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.

pages: 292 words: 85,151

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

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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.

pages: 421 words: 110,406

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, Geoffrey G. Parker

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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.

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

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Shiller Redux Much of the thinking about the negative value of information on society in general was sparked by Robert Shiller. 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 volatility differential between prices and information meant that something about “rational expectation” did not work.

pages: 320 words: 33,385

Market Risk Analysis, Quantitative Methods in Finance by Carol Alexander

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Starting with basic definitions and notation, we provide a detailed understanding of matrix algebra and its important financial applications. 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. Without the use of matrices the analysis becomes extremely cumbersome.

pages: 504 words: 126,835

The Innovation Illusion: How So Little Is Created by So Many Working So Hard by Fredrik Erixon, Bjorn Weigel

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. However, the risk is that ignoring nonquantifiable objectives pushes companies to make the wrong investment choices: that overlooking becomes too mechanical, and that is a particularly acute problem when dealing with investments in innovation.

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

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pages: 819 words: 181,185

Derivatives Markets by David Goldenberg

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We will take the N=1 case of the BOPM using the example provided below. The question is, how do we determine the option OPTION PRICING IN DISCRETE TIME, PART 1 447 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.

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Den of Thieves by James B. Stewart

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Wilkis was still puzzled; he thought only gangsters had Swiss bank accounts. "So what?" he asked. But Levine refused to say more. "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."

pages: 701 words: 199,010

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

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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. There are still no standardized, reliable measures for liquidity risk. Banks need better liquidity risk measures, especially during times of crisis.