Category Archives: Level III

CPG – Having an Adult Conversation about Crescent Point Energy – Reblog

Thought this blog that I wrote on Crescent Point back in April, 2013 was worth a re-blog. A lot of pain out there on this one, and from my weekend reading investors still hopeful Crescent Point can still meet its distribution obligations. Hope this blog answers some questions and gives everyone who was invested in CPG pause for thought. The proverbial writing was on-the-wall on this one and with the fall in oil prices since September only enhances the weak fundamentals that were clear, at least to us!

This blog has two objectives.  The first is to highlight the valuation divergence currently underway between our model price calculation and CPG’s stock price.  The second objective is to discuss why we use Net Income or earnings for our valuation analysis instead of cash flow per share.

Valuation divergences occur all the time in financial markets especially with individual equities.  Where the fundamentals and the market price of an individual stock price can go in opposite directions for whatever reason.  These divergences can correct themselves, with fundamentals changing positively or the stock price correcting to the appropriate valuation level without warning, so investors have to be vigilant.  Model Price is a service that calculates valuation, model price or fair market value, for over 2000 companies using the same company data for our algorithms.  No special treatment is necessary or special calculations for individual companies.  Also divergences can last for a prolonged period of time.  Timing when divergences can disappear is very hard to predict.

Sometimes a picture is worth a thousand words.  So let’s start with a picture.  Here is the long-term chart of Crescent Point Energy.

Crescent Point Energy with monthly price bars, EBV Lines (colored lines) and model price (dashed line)

Crescent Point Energy with monthly price bars, EBV Lines (colored lines) and model price (dashed line)

This model price chart displays our calculation of model price over the last 7 1/2 years.  After peaking in mid-2007, model price or our calculation of fair market value has steadily fallen over the last six years.

So what’s going on here?

Crescent Point Energy finally issued their 4th quarter and full year results on March 14, 2013.  I have downloaded the most recent financials, just as I have done with every annual report filed by CPG for the last few years.  This is fun reading for me.  Nothing like getting into the numbers, the balance sheet and don’t forget the all-important notes to the financial statements.

Three Reasons Crescent Point is notable!

First, the company clearly had a model price valuation either above its stock price – see chart above – or in the neighborhood of CPG’s trading value back in 2006 to 2009. Over time, since 2009, our model price calculation has eroded with no impact on the share price of CPG.  The gap in our calculated model price and CPG’s actual share price is getting wider as time goes on.  The market doesn’t seem to notice or doesn’t seem to care about this widening valuation gap.

One has to wonder why this is the case?  Doesn’t the market recognize the deteriorating fundamentals of the company’s earnings per share?  Certainly other Canadian oil companies have seen their share prices erode over the most recent past.  (Suncor and Imperial Oil are examples of this)  Are investors so enamored with the company and its annual distribution of $2.76 paid monthly that oil industry fundamentals are ignored?

Second, CPG has repeatedly paid investors distributions in excess of earnings for the last 4 years as I highlight in the table below.

2012 2011 2010 2009 2008
Cash Flow/Share 4.69 4.80 3.48 4.08 4.72
Net Income/Share 0.58 0.73 0.09 (0.19) 3.74
Distributions 2.76 2.76 2.76 2.76 2.61

The third item of note is the amount of shares Crescent Point has issued in the last two years.  The company has issued some 171 million shares!  At an average price of say $40 CDN, that’s a cool $6.8 billion of market value.  These shares were issued for company acquisitions and secondary offerings to investors.  CPG had a market capitalization at the end of 2009 of some $8.3 billion.  CPG’s market cap has grown to $14.8 billion as at mid March 2013, without a material change in the company’s share price!

Are you with me so far?

Let’s get into the current numbers and our model price chart.

Crescent Point Energy with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

Crescent Point Energy with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

For those interested, a daily updated chart of CPG subsequent to this post will be maintained on Facebook, here.

As you can see we have calculated model price or fair market value of CPG to be $21.25 as at the close on April 9, 2013.  This is a 43% discount to CPG’s stock price of $37.67.  We use expected earnings estimates to determine the fair market value for every stock included in our database comprising of some 2,000 securities including CPG.  At the time of our calculation CPG had a mean earnings estimate for 2013 of $0.56.

Positives on Crescent Point

Are you shocked!  Yes there are positives.

The first positive is the company’s solid execution of production, which was ahead of consensus.  For instance, in this latest quarter – 4th quarter – production was 108,007 boe/d ahead of consensus of 102,000 boe/d.  This increase in production drove funds flow, highlighting …

… The second positive, again in the 4TH quarter funds flow came in at $1.18 and ahead of consensus of $1.14.  The company beat on both metrics keeping investors and investment bankers happy for another quarter.  Several analysts revised upward Cash Flow per Share (CFPS) to recognize improved company performance.

The company seems to be a well run company, executing in a industry that seems to be struggling with commodity pricing, output cost inflation and decreased industry equity valuations.

One does have a sense, like any other growth stock, if CPG were to disappoint in the above noted metrics, oil production and cash flow, investors will be annoyed with possible consequences for CPG’s stock price.

Cash Flow versus Earnings

This is where the rubber hits the road for investors.  Crescent Point, as I stated earlier, is paying out an annual $2.76 a share in distributions on a monthly basis.  This payout offers investors a yield of 7.3% based on CPG current stock price.  This yield is “juicy” and certainly higher then anything else of quality in the fixed income area.

Highlighting my table (see above) the company seemingly does have the cash flow to pay such a generous distribution to its’ shareholders.  However earnings of the company over the last few years have been meager to say the least.  So which row of numbers, cash flow/share or net income/share, is more relevant to you the investor?

We use earnings per share in the calculation of model price.  Why?  Here is the distinction.

Ask yourself why the accounting profession, which I belong, has spent the last hundred years trying to define earnings of a company.  The reason for this pickiness is the earnings of a company belong to the common shareholders after all actual and potential stakeholders are accounted for.  An accumulation of these earnings is held in the retained earnings of the company.  The company builds equity, if you will, over time through compounding belonging to the owners of the company – the shareholders.

Cash Flow belongs to the enterprise.  Various stakeholders, debt holders, pension liabilities, banks, suppliers, employees all have claims against the cash flow of the company.  A company must continually invest in plant and equipment, people, R&D to maintain their competitive position.  Various managements, over time in the annals of financial history, can and have, restricted expenditures, boosting cash flow substantially in the short term only to the determent of the company longer term.  (I am NOT saying this is the case with CPG) In other words cash flow can be manipulated, volatile and of little use to the common shareholder as information regarding the financial net worth of their company.  Don’t get me wrong, cash flow is important to the company.  Without positive and sustainable cash flow the viability of the company can be impacted.  I am not arguing otherwise.  The issue becomes what number, cash flow or earnings, is more credible for valuation purposes – we favor net earnings of the company.

Lastly I found this quote from Graham and Dodd!

“No one questions the importance of cash flow– it is required to service debt and finance future growth, and it is the best predictor of the future stream of dividends.  However, we reject the notion that cash flows should be thought of as being the same as earnings.”  From Graham and Dodd’s Security Analysis – Fifth Edition. Page 262.

Model Price is falling for CPG

CPG maybe meeting and exceeding expectations with regards to production and cash flow however actual net income along with other metrics we use in our model price algorithm has been less impressed yielding a downward sloping model price calculation over the last 5 years.

Looking at the published financial statements of Crescent Point Energy (CPG), December 31, 2012, we can review the retained earnings to see how much has been accumulated on behalf of shareholders.  The retained earnings balance has a deficit of $2.755 billion dollars.  In other words the company has paid common shareholders $2.755 billion more than what they are entitled to.  So there is an overdraft, if you will.  Who is covering this overdraft?  Strangely enough, the common shareholders themselves are covering this overdraft with dilution of their own shares.

Huh?

OK, the accountants – yes the guys and gals with the green eyeshades – have determined that common shareholders have been paid too much by way of distributions relative to accumulated of Net Income – retained earnings – of the company since inception.  So who made up or funded this $2.755 billion difference?  The common shareholders with additional shares issued!    As additional shares are issued the less fractional share of the company you own.  From the beginning of 2010 – assuming you purchased shares on this date – your share or ownership stake in CPG would have been diluted by some 45%.

So What?

“So what?” you say, and continue;  “My CPG shares are trading in the stock market at the same value that I purchased them back in January 2010 and I’ve been receiving my distribution to boot.  Certainly this makes CPG is one of the best performers investment wise considering both equity and fixed income alternatives.”

To which I say; “Yes, you are right!  However …”

One has to ask, “Without major corporate finance activity in the last two years would CPG have been able to pay their distributions?”

“What if CPG is too generous with the company’s distribution (yield), which is directly responsible for the elevated valuation of CPG’s current stock price?”

“What if CPG is relying on secondary share offerings to fund the company’s current high distributions instead of relying on its’ own business operations?”

“What if capital markets, which can be fickle, are not as generous to CPG in the future as they have in the past?”  The last secondary issue for CPG was back on November 1, 2012 the company issued 18.75 million shares at $40 per share.  With investors down 6 percent, will they readily accept more shares even though they have been collecting their distribution?

The second consideration is the law of large numbers.  With a market capitalization of $14.8 billion and distributions of over $1 billion dollars annually to shareholders Crescent Point is no longer a small-capitalized company.  As companies get larger, laws of compounding and acquisition size become problematic, as the numbers just get unrealistically large for the company to manage or to meet shareholder expectations.

I’m just saying there are limits both in terms of investor’s appetite for additional CPG shares and compounding law of large numbers.  Today there are “clear blue skies” and no sign of investor fatigue of corporate activity but in the future who knows.  I do have to ask the question with corporate activity possibly diminished can CPG sustain its distribution policy to its shareholders.  Leading to the ultimate question of this blog, without the generous distributions of CPG are investors and market participants more willing to see the clear divergence gap opening up between our model price calculation and the CPG’s share price.  Who knows!

Conclusion

So there you have it.  This will be an interesting situation in seeing how this divergence gap, between our model price calculation and CPG current stock price resolves itself, and I will be in the front row.  With all the corporate activity CPG has been doing over the last few years, both acquisitions and secondary offerings, coupled with large distributions relative to what is available in fixed income, investors can be challenged in deciphering what fair market value would be for Crescent Point Energy in the public markets.  The Model Price Service – our Facebook App – crunches the numbers and calculates model price consistently focusing on the relevant inputs that calculate our model price, including our focus on earnings instead of cash flow.  Pundits and experts may rely on cash flow and yield but unfortunately these attributes are NOT variables that make up fair market value of a public company in my estimation or variables used in our calculations.

Apple’s Stock Split – Why Stock Splits do Matter!

With the news of Apple Inc. announcing a 7-for-1 stock split, the subject of stock splits have been in the financial news often. The consensus from journalists and academics alike seems to be that stock splits don’t matter – a simple division exercise.

What if stock splits do matter? What if the very act of splitting a company’s stock price, in this case Apple, from the low $600’s to $90 a share substantially increases our calculation of fair market value or model price?

What if I disclosed here that Apple’s “innocuous” (I will explain this quote later in the blog) 7-for-1 stock split increased the company’s fair market value by 22% or a cool $120 billion dollars.

 

Heresy, you say!

 

Let’s examine or parse a couple of financial articles – one article and one video – discussing Apple’s stock split that I found interesting over the last week.

 

The first article that caught my eye on the subject of stock splits was written by Mr. David Milstead of the Globe and Mail’s Report on Business. (Thursday, May 29th)

 

Mr. David Milstead writes.

 

Apple’s split is scheduled for June 9, benefiting all who own the shares as of June 2. In the strictest sense, the split will “do nothing,” [referencing Tim Cook’s comments on stock splits some time ago], as one Apple share trading at $700 is no more valuable than seven Apple shares trading at $100. That’s the basic economics of a stock split, and the reason why market professionals say splits have little meaning.

 

David continues,

 

Academic research has suggested stocks that split tend to outperform the shares of similarly sized companies in the near term…

 

Yes, this above noted phenomena has been reported in academia for quite sometime (over performance usually after the announcement of the stock split) and David continues his thought by offering what some academics are thinking as to why these gains are seen.

 

… in part because they’re an underappreciated signal of confidence: A management team that recommends a split to its board is confident the shares won’t drift lower.

 

Huh?

The other article (video) of note on the subject of stock splits comes from the 67th CFA Institute Annual Conference held in Seattle this past May (2014) .  (OK, I can’t help myself poking fun at these guys!)

In this video (6:46 minutes) Mr. John Authers of the Financial Times interviews Mr. Aswath Damodaran, professor of finance at NYU Stern Business School about Apple.

 

https://www.youtube.com/watch?v=pc0eUW_ChSk&feature=youtu.be

 

In this interview, Mr. Damodaran correctly comments that in 2013 Apple announced a cash dividend (its first ever), corporate stock buybacks and significant borrowings (debt) and Apple’s stock did nothing to trend lower. He continues his observations by noting in April of this year Apple announces a dividend increase, more corporate buybacks, additional borrowings and an “innocuous” (7-for-1) stock split; further observing “seems to have triggered a move in the market [of the stock]”.

 

What’s going on here? Antidotal evidence seems to be piling up? Stock splits seem to have an unexplained positive impact on share values even though the simplistic theoretical textbook explanation seems to be wanting.

 

Enter Convexity

 

Model Price Theory (MPT) has many new concepts to offer the field of finance and investment management. Each of the new and original concepts – see Key Concepts tab – is grounded in a theoretical framework that is unique to MPT. Our convexity calculation variable is so important it’s one factor in our 3-factor algorithm that produces our model price value that you see on our model price charts.

 

Of course all public companies produce financial statements that include a balance sheet. All balance sheets have unique qualities that are specific to the company’s business, industry and choices made by the CEO and the Board of Directors on how they want to run the company. By analyzing each company’s balance sheet Model Price Theory (MPT) determines how the economic structure of the balance sheet is configured. More specifically a company’s economic structure can be viewed as a convex curve representing the specific nature of the balance sheet in question.

 

After a multitude of calculations we produce a convex curve that is unique to each company in our database. Some companies have very steep convex curves while others are relatively flat. The companies with steep convex curves may have little or relativity small amounts of recorded capital on their balance sheets’ for the simple reason they need little to no capital to run their businesses. Conversely companies that have very large balance sheets, relative to the size of the business, have convex curves that are relatively flat.

 

An example of a Convex Curve calculated from a public company's balance sheet

An example of a Convex Curve calculated from a public company’s balance sheet

 

So why should anybody care about the steepness of some calculated convex curve?

 

There are a lot of influences that are brought to bear on a public company’s stock price. One of the influences, according to Model Price Theory (MPT), is the feedback between the actual stock price dollar value and the calculated convex curve. As the stock price value (the actual number) moves up or down and depending on where the dollar value and the steepness of the convex curve intersect, feedback between these two variables will impact the fundamental value or fair market value of the company.

 

Assuming a company has a highly convex economic structure and a very low stock price (say penny stock), the feedback between the two can cause the stock price to be volatile. As the stock price increases in price value, say from $0.80 to $0.85 cents, the fundamental market value of the company increases substantially more than the change in price value because the steepness of the company’s convex economic structure curve. With the fundamental market value of the company increasing exponentially relative to the price movement may provide a further warranted price move, say $0.85 to $0.90 cents, recognizing the positive change in fundamentals. This feedback loop, between the company’s stock price and the convex economic structure of the company’s balance sheet, can go back and forth creating visible stock price momentum – oversized capital gains.

Unfortunately before you get too excited about this phenomenon the same feedback loop can happen on the downside as well.

 

Anecdotally this explains why lower priced stocks have more actual price volatility, especially penny stocks, than higher price stocks. Also this feedback loop is prominent in what is known as momentum stocks.

 

We Reduced Convexity to a Single Variable

 

We realized that looking at convex curves and their steepness was going to be a lot of work and interpretation. So we computed a variable that would combine the steepness of a company’s convex curve with the stock price dollar value of the company. So a company that has a convexity value of say 1.5 has a lot less convexity or share price feedback loop than a company with convexity of say 5.0.

 

Make sense.

 

With this background let’s start talking about Apple, Inc.

 

First let’s look at this table comparing the convexity values of the undernoted companies.

Companies Convexity Score
Microsoft Corp. 1.58
Oracle Corp. 1.54
Intl. Business Machines Corp. 1.14
Intel Corp. 1.65
Cisco Systems Inc. 1.89
S&P 500 Index 1.27
Apple 0.12

 

 

As one can see Apple’s convexity score (value) is very low compared with other large capitalized technology companies and the S&P 500.

 

If Apple’s management increased it’s convexity value the calculation of our model price or fundamental value would also increase.

 

So how do you increase Apple’s convexity?

 

There are two ways of increasing Apple’s convexity. The first is to focus on the balance sheet. Reducing the overall size of Apple’s balance sheet would make Apple’s convex curve steeper. This steepness would enhance the feedback loop between the positive stock movement and its fundamental value. Apple’s management starting in 2013 started this process by initiating a cash dividend and corporate stock purchases. Both of these actions in effect reduce the size of Apple’s balance sheet. Unfortunately the dollar size of these above noted corporate actions with Apple’s ample ongoing cash flow has had a negligible impact in doing anything to our convexity calculation. Laughingly with Apple’s bond deal (replacing Apple’s depleted cash) Apple’s convexity has gone from 0.14 back in January 2012 to 0.12 as of last week. You can see why Apple’s share price has languished for much 2013.

 

The second way of increasing convexity is to lower the stock dollar value of Apple’s share price. Yes, by doing a stock split. The lower the stock price dollar amount the higher convexity value computed. (Note: the act of splitting a company’s stock and lowering the monetary value of the stock price will not change the shape of the company’s convex economic structure curve but will change the intersection or the steepness where the Apple share price intersects on our computed curve)

 

Apple’s management shocked everybody, including myself, by announcing a 7-for-1-share split in April. So the question is what would happen to our calculation of convexity value with this corporate action. Not surprisingly our convexity value will increase from the present value of 0.12 to 0.84. This is probably one of the largest jumps in convexity I have ever seen – granted there are only a handful of companies with convexity value as low as Apple’s to begin with.

 

So what does this mean?

 

Below I have reproduced our model price chart of Apple, Inc. for Wednesday, May 28th from our Facebook application.

 

Apple's Model Price chart on Facebook captured on Wednesday night

Apple’s Model Price chart on Facebook captured on Wednesday, May 28, 2014

 

I have annotated on the chart where Tim Cook announced the stock split and the market’s positive reaction. This announcement helped close the gap between Apple’s share price and our calculation of fair market value. This is the fundamental view of how Apple looks at present and note that our calculated model price value is $628.99.

 

For fun, (yes, it’s fun) I split Apple’s stock in our database on the announced 7-for-1 basis and allowed our algorithms to recompute a new model price value allowing for the recalculated change in the value of our convexity score because of Apple’s lower stock price value producing the model price chart below.

 

Apple's new Model Price chart showing the impact of the 7 for 1 share split as of the same Wednesday May 28, 2014

Apple’s new Model Price chart showing the impact of the 7 for 1 share split as of the same Wednesday May 28, 2014

 

 

No other data inputs have been changed from the original Apple model price chart produced above. The only change I made was the share split announced by company’s management. With a lower share dollar value producing a higher convexity value (0.12 to 0.84) Apple’s new model price value would be $109.50 post split. Multiplying Apple’s new model price of $109.50 times 7 is $766.50.

 

Yes, just by changing the dollar value of Apple’s share price through a share split Apple increased their model price from $628.99 to $766.50! That’s a 22% increase or $120 billion increased in Apple’s market capitalization. Not bad!

 

Conclusion

 

Share splits do have an impact on fair market values of publicly traded companies both in terms of intrinsic fundamental value and over performance contrary to ‘experts’ in the field of finance and investment management. Model Price Theory (MPT) through our mathematical variable called convexity can help explain why share splits can have positive impacts on share price performance. By doing an “innocuous” share split Apple’s management will benefit all stakeholders, especially common shareholders, in making Apple more valuable. Hopefully through management’s other corporate actions we’ll see a steady increase in our convexity value further increasing the fair market value of Apple in the future.

Yahoo’s Marissa Mayer – One of the Best CEO’s in the S&P 500!

Am I clueless!

The market and the haters seem to think so.

But according to the Model Price Theory (MPT) math she is doing all the right things.  Sure the market didn’t agree with my assessment – at least on Wednesday – sending the stock down over 8%.

And the haters, they are everywhere.  I guess that’s what Twitter is for …expressing one’s outrage!

What was the headline reaction from the mainstream business press on Yahoo’s 4th quarter?  “Marissa Mayer’s attempt to turn around Yahoo Inc. is struck in neutral.” reported the Wall Street Journal.  The other headlines and business stories were less favorable in their reaction to Yahoo’s closely watched slightly declining display-ad revenue.

Clearly she placed displayed-ad revenue in the hands of her Chief Operating Officer, Henrique de Castro, one of her first hires, who she summarily fired when the quarterly results became evident several weeks ago.  Mayer’s haters went into full chorus cries over the expense of such hire – fire decision over a 15-month period but you have to admit for the rest of the employees in the Yahoo organization this action probably got their attention.

So what does ModelPrice Guy see that’s so different then anybody else?

I was shocked when I saw the number.

When our computers finished calculating the numbers on Yahoo’s balance sheet the Theoretical Earnings (TE) came in at 93 cents.  Back in 2013 Yahoo’s TE was almost as high as $1.40.  That’s an incredible 33% reduction in TE.

I know what you are saying?

“I have no idea what Theoretical Earnings (TE) are (and nobody else does either) and why do I care whether TE goes up or down?”

The stock market cares!

Remember Theoretical Earnings (TE) is our calculation of what a balance sheet ‘in theory’ should produce in terms earnings.  Every balance sheet can produce this theoretical number irrespective of the company and what they produce.  This financial concept, Theoretical Earnings, is one of the foundations of Model Price Theory (MPT) and unique when thinking about financial analysis.  For more detail see ‘Key Concepts’ tab for more information.

So let’s have a look at the data.

image00111

My first chart shows our calculation of Theoretical Earnings (TE) of Yahoo since the company went public.  We compare our calculation of TE with the 12-month forecast of Yahoo’s earnings.  Generally over the span of the company’s history as the TE expanded, or move upward, so did the earnings of Yahoo.  This should make sense.  As the assets increase on the balance sheet of a company the earnings should as well.  Just like a bank account.  As the savings value increases so does interest earned on the account.

Another way of viewing the data is taking the two series in the above chart and combining them into a ratio.

image0035

Here you can see the ratio of Earnings per Share (EPS) over our calculation of Theoretical Earnings (TE).  More importantly look at this ratio since Ms. Mayer has become CEO of Yahoo, Inc.  In all of my work with large capitalized public companies I don’t think I have seen this ratio rise as fast as this.

What does this mean?

An increasing ratio of EPS/Theoretical Earnings means Ms. Mayer has not only significantly grown earnings since her arrival as CEO but also has shrunk the amount of capital in the business as our TE calculation shows.  In other words she is producing more earnings with less capital.  This is what CEO’s are supposed to do, but rarely seen.  Ms. Mayer is special in that she seems to get this fundamental mathematical aspect of leading a company and increasing the share price for investors/shareholders.

But why didn’t the market NOT like Yahoo’s 4th quarter earnings release?

This happens quite a bit in the equity markets.  Yes, so much for the Efficient Market Hypothesis.  Investors, analysts and traders tend to focus on the wrong metric.  In Yahoo’s case it’s the analysts’ focused display ad-revenue.

Yahoo has been a dog of a stock for quite sometime but there is a turnaround happening.  The same analysis that shows you a turnaround also shows why Yahoo has been underperforming.  In the chart above the ratio between EPS/Theoretical Earnings has been going down to flat since 2005.  One can see the change in the ratio since Ms. Mayer has taking the helm and it has been dramatic.

Conclusion

We have model price data and charts on every company in the S&P 500 in our database.  Is there one CEO in the whole population that is turning around a company as fast as Ms. Mayer?  Nope.  That’s why I have crowned her one of the best CEO’s in the S&P 500.  She seems to get the math, intuitively.  Nobody, and I do mean nobody is giving her any credit for this dynamic turnaround, except for me of course.  Everyone seems to think the stock price of Yahoo is going up because of Yahoo’s 24% ownership position in Alibaba.  Alibaba maybe the focus of investors/traders but they are missing an amazing story going on at Yahoo, the company itself.

As I admitted in my first blog about Ms. Mayer, I am a fan.  I had a feeling and anticipated that she would be a CEO to watch.  As time passes and the model price math becomes apparent I see my confidence has not been misplaced.  Hopefully we are in the early days of her tenure at Yahoo and shareholders in the company are in for a long and profitable run.

See our Model Price chart below;

Yahoo, Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

Yahoo, Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

For those interested, a daily updated chart of YHOO subsequent to this post will be maintained on Facebook, here.

In a Year of Multiple Transitions: This one is the most Important to your Financial Health!

While the world’s elite gathered in Davos drinking champagne and giving each other backslaps on saving the world from depression, the world equity markets roared back into the headlines on Friday (January 24th, 2014) by dropping suddenly with triple digit losses.

Is there any cause for concern?  What is going on?  Well, Model Price Theory (MPT) to the rescue.

Do you believe in leaps of faith?

Well this is where the US economy is right now.  And the world financial markets are preparing themselves.

What do I mean by leap of faith?

2013 will go down in the history books as a transition year for the US federal government.  From shutting down the government to budget sequestration the budget deficit forecast for this fiscal year (October 2014) will be 3% of GDP.  Roughly in line with projected US growth of say ±3%.  Down from a high of almost 13% in 2010.  This is a big accomplishment and the equity markets have rewarded this behavior with substantial gains.

The $64 million dollar question is whether the other economic actors in the US economy namely non-financial companies, financials, consumers and state/local governments get a sudden surge in confidence about the fiscal prospects to start spending/investing driving the US economy forward.

This is the leap of faith and it’s a biggie!

This is where the US equity markets are at present.  Fiscally, after tremendous amounts of stimulus to keep the US economy from entering depression, the US government is back on track of budget deficits in the $300 to $500 billion range for the foreseeable future.   In other words, the federal government has done all it can and wants to do to assist the private economy.  Monetarily, the Federal Reserve will start to ‘taper’ its bond purchases this month withdrawing its support of asset prices called ‘Quantitative Easing’ or QE.

Something like starting a car on a cold winter morning!  Will the engine ‘kick’ over or not?  After years of massive government support will the economy start to function normally again, pre 2008 financial crises?

This is how I interrupt recent global equity market and currency declines.  Investment dollars are leaving emerging market hot spots (including Canada) and migrating back to the US.

In terms of timing and future economic growth, it’s an interesting place to be, for investors.  Global equity markets are pricing in this lull between a government supported economy and a normal functioning economy without government support.  How do the global markets price this uncertainty?  Simple, they all go down – as we are currently seeing – and as fundamentals improve investors will drive stronger economies both equity and currency markets to new highs.  Leaving weaker global markets lower and investors with negative rates of return.

For those wanting more Model Price Theory (MPT) here is what I see.

Here is our ‘Solvency Curve’ that I introduced back in a blog on July 17th, 2012.

Solvency Curve - See Key Concepts for Description

Solvency Curve – See Key Concepts for Description

The US federal government – left hand side of the curve – has now stabilized its solvency at 0.135 or on the cusp of the 3RD Order of Insolvency.  As scary as this sounds – it’s OK.

The other economic actors – on the right hand of the curve – should start to move upward – becoming more balance sheet efficient – as consumers re-lever (start taking on debt after five years of deleveraging); nonfinancial companies with a record amount of cash – close to $2 trillion – start to make capital investments and grow top line sales and US global banks busting with excess reserves start to invest in a growing economy for higher rates of return on capital.

This virtual circle of economic activity should continue as investment spending and job creation will support future economic growth driving equity values higher.

What is my opinion?  Count me as a believer.  The US endured one of the largest financial and economic declines since the Great Depression.  Federal government policy actions both fiscally and monetarily were effective and innovative.  Sure Washington looked dysfunctional at times but the hard and necessary work got done.  The global equity markets are now realizing this reality and shifting investment dollars as a result. The US will recover as world’s economic leader where they have been noticeably absent over the last 5 years.

And that’s a good thing!

P.S. For a more detailed account of possible ‘Transitions’ for 2014 see our Acker Finley 4th Quarter (Year End) newsletter called “Transitions” here.

P.P.S. For a more in-depth review and ongoing discussion on our ‘Solvency Curve’ and the US economy over the last two years here are the applicable links.

What is going on with the world of finance, and how do you fix it!

What is going on with the world of finance, and how do you fix it! (Update 1)

What is going on with the world of finance, and how do you fix it! (Update 2)

NASDAQ 100 (NDX) – Positive Transit of EBV+5


Friday, October 18, 2013 was an historic day in the financial markets.  The NASDAQ 100 Index, a modified capitalization-weighted index, of the 100 largest traded companies on the NASDAQ had a positive transit of EBV+5.

Here is our short-term model price chart of the NASDAQ 100 Stock Index confirming the breakout.

NASDAQ 100 Index (NDX) with weekly price bars and EBV Lines (colored lines).

NASDAQ 100 Index (NDX) with weekly price bars and EBV Lines (colored lines).

As a reminder, I have republished our long-term model price chart of the same index using monthly bars and going back to 1995 – some 18 years.

NASDAQ 100 Index (NDX) with monthly price bars and EBV Lines (colored lines).

NASDAQ 100 Index (NDX) with monthly price bars and EBV Lines (colored lines).

Observables from our model price charts.

1.  Looking at the history of valuation of this index, especially in the late 1990’s and much of 2000, the NDX Index has always traded above EBV+5.  During the financial crisis of 2008, you can see the index had a negative transit of EBV+5 bottoming at EBV+3.

2.  Over the last 5 years the Index tried, without success, to transit above EBV+5.  (See arrows on our long-term model price chart)  EBV+5 was a barrier or resistance that collectively these companies could not transit.  Hopefully readers can see the significance of this transit and the struggles this particular Index has had to achieve this transit over the last 5 years.

3.  The other observable is where this index topped out in 2000.  Yes, this index topped out at EBV+9.  Just for fun EBV+9 in today’s terms for the NASDAQ 100 Index would be 17,369.  Four times what the index is trading today.  I not saying we are going there again anytime soon, but at least for reference purposes you can see what valuation level this market achieved in the past.

What is so important about EBV+5?

In Model Price Theory (MPT) every EBV level has a history and a story.  Some EBV levels are more significant than others.  EBV+5 is significant.  At this valuation level and above, companies are given a special valuation by the market.  These companies have, what we call ‘Economic Velocity’.  ‘Economic Velocity’ is a state an individual company is in, that the market recognizes, is operating or has the ability to operate at full potential.  The wind is at the company’s back, proverbially speaking.  Everything the company does in the interaction with its customers and suppliers – it business process – is easy and massively profitable.

Another way of looking at this valuation level is the equity markets are giving the company market value or an asset for management of the company, through its share price, to use to grow the enterprise.  Equity capital can be used by management, either issuance of shares or by way of acquisition, at relatively cheap cost to further their business process or strategy to promote even faster growth than what management is already getting.

EBV+5 Plus Convexity Equals Substantially Higher Equity Valuations

All market participants, at one time or another, have observed parabolic or positive dramatic momentum moves in stock prices.  Many market professionals simply observe these phenomena without a general understanding of why these stock moves exist.  Others like George Soros, have a better understanding of this phenomena and have given these market moves a name like ‘reflexivity’ but cannot give mathematical reasons why these moves exist.

Model Price Theory (MPT) has captured, mathematically, the preconditions, and adjustment process to capture this dynamic feedback mechanism that exists between the balance sheet of a public enterprise and the public market equity price of the company in question to determine the model price or our calculation of fair market value for the company.  We call this dynamic feedback mechanism and mathematical variable ‘Convexity’.  We believe ‘Convexity’ is an appropriate name in that the mathematical relationship is a convex one.  The greater the convexity, or bend, the greater the sensitivity the Economic Structure Value (ESV) has to changes in its stock price.  Or simply, the smaller the company’s balance sheet is relative to the public market value the higher the ‘Convexity’ variable of the company.  The higher the company’s ‘Convexity’, the higher the dynamic feedback mechanism as the company’s stock price goes higher.

It should be said ‘Convexity’ has a dark side as well.  As a company’s stock price falls this dynamic feedback mechanism can work in the opposite direction.  That’s why the ‘Technology Crash’ of 2000 was swift and just as fast as the ride up in share prices, making the boom – bust symmetrical in appearance on a log scale.  (See our long-term model price chart)

For those who are lost on this discussion, no problem!  Our Model Price calculation has ‘Convexity’ mathematics included in our algorithm.  ‘Convexity’ is one factor in our three-factor model that we use to calculate model price.

I only bring the ‘Convexity’ subject up, because of the importance of the positive transit of EBV+5.  ‘Convexity’ becomes more relevant factor and help boost share valuation significantly when ‘Convexity’ and share prices work in tandem elevating share prices ever higher.

Conclusion

The NASDAQ Index has been on a tear over these last few months culminating in a positive transit of EBV+5.  This is very positive for the US equity markets and adds another positive to the growing list of positives this equity market and the US economy has achieved over the last 5 years since the financial crisis of 2008.

Another aspect of this blog I wanted to review with my readers is the impact of ‘Convexity’ can have on valuation.  Like stored up energy, ‘Convexity’ has been a non-factor since 2008 and lays in wait to positively impact valuation like a turbo boost in a European sports car.  Having the NASDAQ 100 (NDX) Index transit positively over EBV+5 certainly is a pre condition of allowing ‘Convexity’ to play a larger role in valuation of a company.

Procter & Gamble – Front Page Story in the WSJ turns up the Heat on CEO

It was reported that Bill Ackman sat down with CEO, Robert McDonald, chairman and chief executive of Procter & Gamble on September 4, 2012.  The Wall Street Journal (WSJ), dated September 27, 2012 stated “William Ackman greeted him with a 75-page litany of complaints about his three years at the helm of the consumer-products giant – poor results, eroding investor confidence and sagging employee morale, according to several people familiar with the meeting”. The article further states Mr. Ackman wants to strip Mr. McDonald of his board-chairman role and search for a new CEO.

Luckily for my readers I didn’t need 75 pages of analysis to show that Mr. McDonald is not up to the task.  All I needed was 1300 words and 5 charts.  (here)

Even though P&G has been hitting new 52-week highs recently, P&G has underperformed its’ peers Colgate – Palmolive and Unilever. I have included our model price chart below.

Procter & Gamble with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

For those interested, a daily updated chart of PG subsequent to this post will be maintained on Facebook, here.

Major stories like this always leave me cold.  Ackman’s fingerprints are all over this article as McDonald is cast in an unfavorable light. Is McDonald a bad CEO that is need of replacement?  Stories, innuendo and personalities, are all very subjective when creating value for shareholders of Procter & Gamble however they make great reading and very prejudicial for a vulnerable subject such as Mr. McDonald.  Objective evaluation is certainly better than subjective, and theoretical earning math certainly evaluates management better than when Mr. McDonald gets up in the morning or how he runs his management meetings.

To me, this represents the beginning of the end to Mr. McDonald.  As I stated in my blog, “…a company the size of P&G is like watching an oil tanker in the middle of the ocean turn around – in other words this will take time.  Will Ackman/shareholders give McDonald time?  I think not!”  With this WSJ article the ticking of the clock just got louder and without new tricks up Mr. McDonald’s sleeve to pacify both his board and Mr. Ackman, I don’t see Mr. McDonald given the time necessary for the turnaround however the board defines success.

By the way, I see this all the time in the business world, and through this blog I will point these situations out to you my readers.  First, a company does a big acquisition for strategic, scale or management ego reasons.  A substantial increase occurs in the acquiring company’s theoretical earnings.  Underperformance occurs, because of the original synergistic gobbledegook never really materializes, specially compared to the increase in TE.  Write-offs and reorganizations occur with new management.  Value is recognized in the market place, of the reorganized company, because of the lower TE or benchmark.  New management is heralded as geniuses to the business world.  I’m I jaded, you ask?  No, but when you see this cycle over and over again you have to begin to wonder what they are teaching in business schools.

Mr. A. G. Lafley, P&G’s previous CEO, did the big acquisition in Gillette back in 2005 and Mr. McDonald will have to pay the price, with his job as the cycle continues.

Maybe a more interesting question, even with a new CEO replacing Mr. McDonald, can he (she) change the relationship between theoretical earnings and estimated earnings in the future without breaking up the once mighty Procter & Gamble?  This will be interesting to watch.

Cage Match – Home Depot (HD) versus Lowe’s Companies (LOW)

(Intermittingly I’m going to write a series of future blogs comparing the internal Model Price math on S&P 500 type companies (Large Cap) for comparison purposes.  Usually this will highlight CEO’s who have done a good job in helping their company achieve a concept, which I define below as “economic velocity” and highlight CEO’s who haven’t performed well according to the numbers.  Along the way of having fun with model price math and what it discloses, I will highlight some philosophical questions incorporating larger economic issues.   I will call this series “Cage Match”)

What makes a “good” CEO?

How does one define a “good” CEO from a “bad” one?  One definition is what I call “economic velocity” of a company.  What is “economic velocity”, you ask? We can guess a company has “economic velocity” by the following attributes.  The company seems to do no wrong.  Earnings are increasing and the stock price is hitting new highs.  I’m sure employees are doing high fives as well.  Business magazines want pictures and interviews.  Television producers are on hold.  I guess if I say Apple Computer, you can picture my concept of “economic velocity” easily.  But the question I have “Is this just lighting in a bottle?”  In other words “Is this just luck, right time, right place for the man (sorry ladies) in the corner office?”  Or is it hard work, special knowledge that CEO’s possess?  Haven’t you always wondered?  I have.  These questions drove me crazy in the past.

Home Depot (HD) versus Lowe’s Companies (LOW)

Let’s compare two companies in the same industry.  Home Depot has been on fire, stock appreciation wise, returning 76% over the last year – textbook “economic velocity” if you will.  Lowe’s seems to be stuck in the mud.  Why does the market like HD over LOW’s?  Let’s have a look at the model price math to figure out what is going on here. First, let’s have a look at the long-term model price charts of each company.

Home Depot with monthly price bars, EBV Lines (colored lines) and model price (dashed line)

Note the EBV lines of Home Depot.  Remember EBV lines reflect the growth in net worth of the balance sheet.  See the decline in the lines in 2008, and the relative flatness since then.  This indicates the non-growth of theoretical earnings (TE) (see my discussion of TE below), even though the company was making net income.  As you can see our calculation of model price confirms the move in HD’s stock price.  Also theoretical earnings (TE) are used in our model price calculation.

Lowe’s Companies with monthly price bars, EBV Lines (colored lines) and model price (dashed line)

Note the upward sloping EBV lines, compared to Home Depot’s EBV lines.  Simplistically suggesting theoretical earnings (TE) are also trending upward.

As the reader can see back in 2008, both HD and LOW’s were trading roughly at the same valuation – EBV+3.  So let’s have a look at the background data to see what is going on to make an assessment of why Home Depot is doing better then Lowe’s in terms of valuation. In the charts below we can see, that earnings for each company are almost back to cyclical highs, which occurred back in 2007.

Readers will see that in Home Depot’s case the stock’s current valuation has exceeded valuation highs posted in 2007, even though cyclical earnings have yet to surpass 2007 highs.  Interestingly in the case of Lowe’s earnings even though close to cyclical highs however there is little growth in model price and current valuation is just over EBV+3.  Just looking at earnings may lead investors to think LOW’s maybe mispriced?  Or is HD overpriced?

One additional comment, if I may, if Lowe’s had the same valuation as Home Depot, Lowe’s would have an additional market value of some $40 billion dollars.  What is important to note here is the market is not a zero sum game.  In that Lowe’s could increase their market capitalization by $40 billion and not take $40 billion away from anybody else.  Public equity markets are truly wealth creators, if companies – CEO’s – can get their math correct.

Enter Theoretical Earnings (TE)

I talk about Theoretical Earnings under the “Key Concepts” tab of this blog.  We calculate theoretical earnings for every company in our database.  I have included our theoretical earnings on the above graphs highlighting earnings per share of each company.  To make it easier for everybody, including myself, we have made the two data series of each company into a ratio.  Below are the charts on both companies.

You can see the difference between each company.  The CEO of Home Depot is not only increasing earnings but also lowering theoretical earnings at the same time.  What does this mean?  Mr. Blake is increasing earnings with less or decreasing capital from the balance sheet of the company.  From my observation and years of experience using this math the market sends signals in terms of higher valuation from this combination.  However, look at Mr. Niblock at Lowe’s.  Yes, he is increasing earnings as one can see but his theoretical earnings of his company are going up faster then expected earnings gains.  The market, in my estimation, takes a dim view of this.

Knowing, Not Knowing the Math – The $40 billion dollar Question

So assuming the financial world doesn’t have theoretical earnings, my experience tells me that some CEO’s are better equipped then others for their jobs.  The “good” CEO’s are the ones who leach-out capital from their organizations balance sheet both financially and operationally.  Examples of financially reducing their theoretical earnings include share buybacks, paying dividends or extraordinary dividends when excess capital is residing in their companies and an acquisition policy that contributes to earnings more then the increase in the company’s balance sheet thereby increasing theoretical earnings (R+P).  Examples of operational efficiencies include increasing turns in inventories – six sigma stuff, better placement of store locations, and international expansion.

Answering the Question, Who is the “Good” CEO in this Cage Match Situation?

Well I think we both know the answer to this question.  Model Price math is an easy determinate in quickly assessing who is doing the better job, unfortunately the market is already ahead of us in terms of rewarding valuation.  Large cap stocks can be profitable for investors, when a “good” CEO takes over a large underperforming company, performs a turnaround (getting the math right) and everyone seems to be rewarded, the CEO, shareholders, and the economy in general with a higher stock valuation.

However which company is the better investment going forward?

The fun of these Cage Match comparisons is what will happen in the future.  Will Lowe’s shareholders and directors put up with this underperformance for long?  Will Home Depot, and in particular Mr. Blake, continue earning gains with lower TE further expanding valuation of Home Depot or was Mr. Blake just lucky over the past few years?  Which investors will outperform going forward, Growth/momentum investors through holdings in HD or quasi value investors in hopes of a LOW’s turnaround to HD’s valuation?  This will be fun to revisit to see what happens.

Let’s hope Lowe’s can get their math right soon, or Mr. Niblock will be looking for work or giving up some of his titles.  From the proxy statement:

Mr. Robert A. Niblock from 2004 to present – Chairman, Chief Executive Officer, President and Chairman of Executive Committee.

Valeant (VRX) – Rollups, Math and How to become a Multimillionaire!

Last Monday – Labor Day, Valeant Pharmaceuticals International Inc. (VRX) announced that VRX agreed to buy Medicis Pharmaceutical Corp. for $2.6 billion.  The share price of VRX jumped 15%, Tuesday, September 4, 2012 when the markets opened.  This is very rare, that an acquiring company’s stock price gets this share price pop after an acquisition announcement.  Usually shares of an acquiring company fall dramatically after such an announcement.  Ever wonder why?  It’s all in the merger math and the markets seem to know it instantly even though the CEO’s and CFO’s don’t.

I like positive stories, and seeing VRX increase dramatically on this news signaled to me there had to be some sort of story here behind the numbers.  So I took some time to do my research.

Financial markets are about math. The current financial universe focuses on discounted cash flow, enterprise value and valuation tools, which don’t really explain a good acquisition (Good in terms of an acquiring company shares appreciating on a deal announcement) from a bad one, (Bad in terms the acquiring company shares trading down – sometimes dramatically – while the acquired company shareholders get a substantial premium) at least to me.

Have you wondered why the difference?

Remember Harvard MBA’s and CFA’s don’t have model price math.  So let’s see what is going on here and I will explain why Valeant had such a good day, through the math of model price.

Theoretical Earnings (TE)

As a review, our calculation of theoretical earnings represents a specific earnings number that a company needs in order for its’ balance sheet to maintain “state” or stay constant in the future.  Every balance sheet is different, just as a fingerprint, so every calculation of theoretical earnings is unique to the company’s balance sheet.  No finance book I have seen has this concept of TE.  However give this concept some thought and I believe TE makes sense on two levels.  The first level is comparing TE to the current level of earnings.  The company may have some patent or industrial process that produces additional earnings over the company’s benchmark.  We believe the differential between the two, earnings and TE, represents the market value the equity market is giving the company as a whole.  It is the “x” factor in the market value of the company.  We calculate TE on every balance sheet for every company, and keep a database of this number with the financial history of the company.

[Current financial industry practice use rather simplistic ratios like price/earnings, and compare ratios to similar companies in their own industry.  I have never found this particularly relevant compared to theoretical earnings concept.]

The second level is the dynamic between TE and actual earnings per share.  If the spread between TE and actual earnings is increasing the market will reward this company with market value – share price appreciates.  To us this is the most important driver of security prices going forward.  Tell me whether this dynamic is expanding, contracting and I can predict with certainty whether a company’s stock is increasing or decreasing.

So let’s have a look at Valeant and see what the market liked so much.

First let’s look at our long-term chart of Valeant (VRX) since 2005, using monthly price bars.

Valaent Pharma with monthly price bars, EBV Lines (colored lines) and model price (dashed line)

For those interested, a daily updated chart of VRX subsequent to this post will be maintained on Facebook, here.

Along with the above price chart, let’s review what was going on with theoretical earnings and estimated earnings since 2005.

Let’s also do a ratio chart of the above.

Discussion of the above charts

As observers can see before the selection of the current CEO, J. Michael Pearson, the spread between earnings per share and theoretical earnings was decreasing.  As the ratio was decreasing VRX was losing valuation or market value.  With Mr. Pearson as CEO, one can observe stability between this above noted ratio.  We highlight the merger with a Canadian Pharmaceutical Company  – Biovail – because the balance sheet increased in size dramatically thereby increasing theoretical earnings.  Since the Biovail merger VRX has been acquiring companies, WSJ notes 50 acquisitions since Pearson was rewarded the CEO position, with the above noted ratio of TE and estimated earnings expanding greatly, as one can observe

So let’s take this one step further.  Let’s look at the personality behind Valeant in one CEO named J. Michael Pearson.

Mr. Pearson earned his MBA from the University of Virginia, then went to work for McKinsey & Company.  Having worked at McKinsey for 23 years, rising to Director advising companies in the healthcare field including Valeant. Mr. Pearson left McKinsey for Valeant Pharmaceuticals (VRX) in February 2008.  In other words, he spent his 10,000 hours learning and advising individuals in the healthcare industry and found a vehicle in Valeant to try a business strategy that “went against the grain” of current industry practice, as, noted in publicly available articles.

As reported in the Wall Street Journal, Valeant directors began seeking a new CEO in December 2007. The Chair of the Board, at the time, told Mr. Pearson and two other finalists that he liked the private-equity model for executive pay “because it aligns management’s incentives with those of the investor,” he recalls.  The Directors required the winning candidate to buy at least $3 million in stock, and forgo routine annual equity grants and hold many shares for years before selling.  Mr. Pearson already was advising Valeant as head of the global pharmaceutical practice at McKinsey at the time and had the cash to meet the stock purchase requirement.  He ended up buying $5 million dollars worth of shares at the time.

Skipping to the present according to the latest proxy material Mr. Pearson has beneficial ownership of 5.6 million shares.  Plus with other restricted stock units and performance restricted stock units bring the total shares to 7.6 million shares.  So at the close on September 11, 2012 Mr. Pearson has $430 million in Valeant shares.  Mr. Pearson also will be getting $1,750,000 annual salary in 2012 for his efforts.

Remember this all happened since he joined the company in February 2008.  As we all know not exactly a friendly economic environment to garner this type of wealth.

Great story!

Valeant fits the definition of a “Rollup”

What Mr. Pearson is doing is not unique in finance.  Google the word “rollup”, and you will find in Wikipedia a “rollup” is a technique used by investors where multiple small companies in the same market are acquired and merged by a consolidator (VRX).  No mystery here.  As I mentioned earlier and reported by the Wall Street Journal, Mr. Pearson has overseen 50 transactions since becoming CEO in 2008, expanding the company’s annual revenue from $600 million to around $3.5 billion.  If the Medicis acquisition is completed, Mr. Pearson said, Valeant will have revenue of roughly $4.5 billion.

My takeaways from the above

1.  The model price math, in particular the management of theoretical earnings, from when J. Michael Pearson took over in 2008 to present has been masterful.  The market has recognized this by increasing the valuation for Valeant rewarding shareholders and in particular the CEO.

2.  When VRX announced the acquisition of Medicis Pharmaceutical on Labor Day, VRX jumped 15% because 1) the growth of VRX by acquisition is continuing after the company shares were consolidating over the last quarter or so. 2) Management has demonstrated it can manage TE and more importantly the spread between TE and estimated earnings – in other words I believe the market gave management and market participants the “thumbs up”.

3.  Rollups as a financing technique usually have a lifespan. Either the acquirer (consolidator) runs out of company’s to buy, to fuel future growth or through ego and/or hubris the acquirer’s management acquires companies that are too big thereby substantially increasing theoretical earnings and crushing theoretical earnings versus the forward looking earnings per share spread or ratio. Financial history tells us shareholders at the end of the acquirer’s strategy or a large management “ego buy” bears the ultimate financial losses.

4.  Since Valeant’s management team doesn’t have model price math it is interesting to speculate, at least on my part, is Mr. Pearson doing this instinctively after his 23-year experience at McKinsey or do they some working financial model of their own.

5.  I have spent a lot of time and effort on this blog for a number of reasons.

a) Great real life example of model price cause and the effect on a company’s valuation.

b) There have been thousands of rollups in the history of finance and to me it’s fun to analyze one in action.

c) History tells me I will be writing about this company sometime in the future.  Call this piece a primer for future blog posts.  d) Mr. Pearson went from mere millionaire to multimillionaire status being at the right time and the right company – is he lucky?  Model price math currently says no, however does he know this?

e) Finance is an interesting spectator sport when you know what to look for, hopefully I’m telling you what to look for.

f) Every public company has the ability of managing this ratio, resulting in much higher valuations.  The market pays for efficiency in a company’s use of capital.  Unfortunately in the world of finance today, a Mr. Pearson is rare.

g) As I have stated previously this blog site is about illuminating new financial concepts, which are not in any textbook.  Hope you agree I am doing exactly this.

The Coming Social Media Bull (Bear) Market (Update 1)

With Groupon (GRPN) down 27% today, I thought I lampoon myself on a blog I wrote on February 12, 2012, where I announced with great fanfare “The Coming Social Media Bull Market”

To put this disaster in perspective I have borrowed a Chart from Zero Hedge and reproduced this chart below.  Yes, my friends in three IPO’s, Facebook, Groupon and Zynga, Zero Hedge have calculated a $60 billion dollar loss for investors.  (Notice they didn’t include LinkedIn (LNKD), which IPO proved successful – however why quibble?)

What Went Wrong?

1.  The endless growth that these companies were growing in the past few years seems to have come to a halt in the last 3 to 4 months.  Is this cyclical or secular?  Not sure, however the frothy valuations these companies were taken public, is disappearing as these companies share prices fall to earth.

2.  The macro business environment is most uncertain.  Investors want the certainty of dividend streams and businesses they understand.  New and unproven companies will be thrown aside for the time being.

3.  Groupon came public at over EBV+9, Facebook at EBV+7 and Zynga at EBV+6.  In hindsight these valuations were too rich for the given state of the market.   It will be interesting to see where valuations bottom out.  Zynga is already at EBV, but does it hold?

4.  Convexity added to these above companies’ problems.  Under our “Key Concepts” tab, we talk about convexity.  To some convexity is a hard concept to grasp, but one that shows itself in the market place nonetheless.  GRPN had convexity numerical value of 15 as of the March 30, 2012 balance sheet.  This is very high.  (Comparing this to Google at 0.07 or Apple at 0.15).  Convexity can work both ways; good while the stock is going up, however very bad when the stock is falling down.  Convexity can be thought as an accelerant not only for the stock price as a whole but also for daily price variability.

To me, GRPN and ZNGA should have taken in more cash on their balance sheets from the IPO process, like Facebook did.  This would have increased the size of their balance sheets (R+P) and reduced their convexity calculation and probably made them more stable companies longer term and on an intra day basis.  However, this is hindsight.

What Happens Now?

See where the dust settles out, in terms where each stock settles valuation-wise.  Each stock needs to go through a bottoming process, which could take months or quarters.  I have been writing blogs on Facebook, because to me, this is the gorilla of social media.   The key level for Facebook is EBV+5, if this level breaks than further downside is likely not only for Facebook but also for other social media stocks as well.

As these stocks are falling like a “hot knife from the kitchen table”, model price charts are here for those wishing to “hold out their hand” at the appropriate EBV level.  As for my blog, I should have named it “The Coming Social Media Bear Market”.

Facebook (FB) – What are Investors to do? How do you value FB shares? Where are FB shares going? Some Answers!

Reviewing the Twitter feed last night of people listening to the Facebook conference call was filled with frustration.  Analysts’ didn’t seem to know what to ask and management didn’t want to answer any questions to give nervous investors calm.  Facebook will not give any financial guidance and Zuckerberg himself giving listeners limited insight into his plans for the company’s future.

What are investors to do?  How do you value this company?  Where is this stock going?

ModelPrice Guy has some answers.  How? 

Facebook has a balance sheet!  Investors can use EBV levels to determine support and resistance price points.  How can we do this?  See our “Key Concepts” tab for information on our unique approach.

Here is our model price chart as of last night’s computer run, with Facebook’s latest financials.  Our pricing only includes last night’s close at $26.85 and not the after hours price.

Facebook with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

Erratum:  The above chart is in error.  See correction blog here.

For those interested, a daily updated chart of FB subsequent to this post will be maintained on Facebook, here.

On Thursday’s night close you can see FB resting at EBV+5 before the earnings were released.  Subsequent trading after the earnings release saw FB shares fall sharply, which we call a negative transit through EBV+5.  At the time of writing this blog, FB shares are trading down over 14% or $3.90 from last night close of $26.85.

With FB transiting down through EBV+5, the next area of support will be EBV+4 or $19.64.  Personal experience has taught me that EBV+4 is not very robust a level of support.  (Keep in mind I have been using these charts for well over a decade.)  So this leaves us with EBV+3 or $15.71 as a possible support level.  (Yes, EBV+3 is more robust a level than EBV+4.)

Trading Considerations I would have knowing Model Price and Facebook fundamentals.

1.  FB broke EBV+5.  This is big.  I quite frankly thought EBV+5 would hold.  Maybe after this spike down in price FB would recover back up to EBV+5.  This would be the only potential positive I would see in this situation.  If FB were to recover to EBV+5, then this will become support for FB for quite sometime until investors and management get use to each other.  So if you are currently holding FB shares this would be your upside – EBV+5 or $27.12.

2.  Capitulation trade has yet to happen.  You can see in our price chart, both private and public transactions that nobody has made any money on their FB positions since the beginning of the year.  This “over hang” of stock must be cleared out.  Investors must give up!  Selling positions at whatever price.  In my view this has yet to happen and is a worrying position for current holders of FB shares.

3.  FB needs to spend some time somewhere to consolidate its’ price action.  Strong hands need to take over the pricing action.  This will happen at one of our EBV levels.  At what level will this happen?  EBV+5, EBV+4, EBV+3 or EBV+2.  I don’t know, but I will know it when I see it.

Conclusion

So there you have it, my assessment on Facebook.  The way I look at this situation, the traditional fundamentalists’ are lost using P/E’s and price to book metrics, the technical guys have nothing other than their 5 minute tick charts but there is a third way.  The Model Price way, using a combination of balance sheet information (the only thing investors’ know is real) to derive EBV lines along with earnings and balance sheet metrics to determine model price (fair value) – less relevant in this situation.

So to be clear, I would be using our EBV lines for potential upside and downside metrics for my trading.  Transits, whether upside and downside will give traders important information on where FB shares will be trading in the future.  In other words by using our EBV lines there will be mathematical structure to the way you trade and invest.