Wednesday, April 16, 2014

Financial market conditions

Knowing how to interpret economics signals is sometimes more art than science. First, there is no magic or commonly known formula that takes so many variables in to account that it can determine the direction of markets or economies with 100 percent or even 95 percent accuracy. If there was, the Great Recession would have been far less likely to have occurred. Secondly, the relationship between economic and market variables is so complex and elaborate that it would not only require a perfect formula, but also access to a large amount of timely data and a lot of computing power. These are not things every or even the majority of investors has available to them.

Having recognized the shortcoming of financial analysis reports, market information releases and economic forecasting formulas, they are not without their uses as they do have some evaluative accuracy and predictive capacity. Efforts are constantly made to understand, report about and forecast the future direction of prices. The following Accuvest slide show is one such attempt and includes 64 slides covering recent market, industrial and economic data. It is divided in to several sections including financial conditions, fixed income and credit, global equity, the economy and currencies and commodities.
Chart Book and Financial Market Update (4/14/14) from advisorshares

To illustrate how economic signals conflict, consider slide numbers  19 through 30. They detail information about fixed income and credit. Of these the break even inflation rate on slide 24, investment grade bond prices on slide 25 and the investment grade vs 10 yr-Treasury spread on slide 26 seem to stand out. This is because the economy is supposed to be improving per the Federal Reserve Bank. Moreover, if economic growth is accelerating, why is inflation declining? Monetary policy is one explanation as it affords low-cost debt at the moment. This can be interpreted as meaning the Federal Reserve Bank is still trying to accelerate economic growth.

The reason why the investment grade bond prices on slide 25 are interesting is because their prices are rising. Rising bond prices typically means higher demand and lower yield. Moreover, bond demand rises along with economic or market uncertainty. This seems to suggest that equity holders  and/or bond purchasers are sensing market risk therefore demanding more bonds, thus driving the price up and the yield down. High yield bond prices have also risen per slide 27. 

Treasury yields also indicate a rising demand as prices have been rising for them. Yet, the source of demand is more likely to be at least partially attributable to monetary policy.  Furthermore, according to Zero Hedge, the Federal Reserve Bank was the largest holder of U.S. Treasuries toward the end of 2013 and held $2.16 trillion worth of them, up $517 billion from a year earlier. In addition, many countries excluding China have been investing a greater amount of U.S. Treasuries per the U.S. Treasury Department.

Just based on the information discussed in this post, and not the entirety of the information within the slides, it is difficult to say where the economy is actually heading. This is because the Federal Reserve Bank is supporting and/or stating growth is on the rise, yet investment bond prices indicate otherwise. Equity markets, especially Japan, have also slipped recently and gold prices have been rising. So, there is conflicting evidence, which can mean more due diligence and research would be needed to develop a more accurate evaluation or that economic recovery is not too steady as the Federal Reserve Board Chairwoman has already stated. 

Financial news: 04/16/2014

NYT: In 90 U.S. cities, median rent is ↑30% of gross pay
CNBC: Too many tech. IPOs is a problem per Cramer
Building Detroit: Opening bids on foreclosed properties start at $1,000
CNN: Several CEOs took large pay cuts in 2013
AP: Largest banks may be under-capitalized per Fed Chair
Fox: Margin requirements may stabilize wholesale funding during crisis
BLS: Consumer Prices up .2% in March
NAHB: Home builder confidence was flat in April per index of 47
Reuters: Italian PM wants to privatize .7% worth of GDP in assets per yr
BBC: The EU officially has a banking union after final approval
Bloomberg: Money supply growth in China has slowed per data

Tuesday, April 15, 2014

What matters in corporate finance

Corporate finance encompasses a wide range of approaches to financial management. It includes securities underwriting, asset management, financial reporting, strategic investing and more. The following presentation is essentially a textbook in a slide show since it has multiple chapters and is 816 slides long. This post attempts to summarize key points and navigate through the slides to highlight particularly useful concepts.

Present value

Of the thirty-five chapters in the slide show, six are devoted to the concepts of present value and net present value. That is a substantial weighting toward one particular way of thinking. So what is it about present value that is so important?  Present value measures the current value of future cash flows. In this sense, knowing what a project or investment is worth in advance of implementing it makes sense from a financial management perspective. According to Investopedia and the presentation, the formula for NPV is as follows:

Net Present Value (NPV) 

When expanded out, the net present value can also be expressed as the follows per Finance Formula:

Net Present Value Formula

So what do all these numbers mean? Basically, NPV is what a future cash flow would be worth if it were to be purchased in the present. For example, what is the value of a $100 face value bond that pays a periodic interest rate of 5% for 10 years? According to Money Chimp's PV calculator, it is worth $61.39. Since total interest includes the sum of all cash payments to be received in the future, the present value will be lower because the interest has not been applied yet. Without the present value calculations, a bond purchase or project management cost might be overestimated or underestimated leaving room for overpayment and underpayment.

Principles of-corporate-finance from Abdul Memon

Risk management

Another subject the slide show emphasizes is risk management. There are five chapters dedicated to this topic. Moreover, of those chapters, the issues of opportunity cost, international risk and capital budgeting risk are discussed. Opportunity cost is a type of investment risk that occurs when potential investments are forgone for other investments that may yield less return on investment. Since investment capital itself often has costs, knowing the price of risk is relevant to corporate financial planning so that risk can be priced in to expected ROI. To illustrate, Chapter 8 talks about how standard deviation around expected returns differs between corporations.

Debt management

How much debt and debt financing are also discussed in about five chapters worth of slides. This is because debt is important for businesses seeking to expand, grow and develop. Moreover, staying competitive is an ongoing endeavor for corporations and oftentimes, debt helps facilitate that. However, how well debt is managed also impacts the effectiveness of that debt. For example, Chapter 18 covers how much debt a firm should borrow and details tax benefits of interest payments when compared against capital investment.

The bottom line of corporate finance is profit maximization. How that profit is used is also relevant to financial management as distribution of profit via dividends lowers available cash for investing and operational activities. For a company with a strong growth trajectory and objective, too much dividend distribution negatively effects competitive positioning and market expansion. For larger, more established companies, dividends make more sense as they help ensure longer-term capital investment. Overall however, all facets of corporate financial management impact how monetarily efficient and optimal an organization is.