Why finance for A is not always finance for B

Finance like most things can be as simple or as complicated as one chooses to make it. With roots stretching back in history, finance began when things of value began to be equivocated with wealth. However, financial management does not have to be about wealth at all, it also pertains to debt management and the valuation of resources considered essential in day to day life.

How assets and debts are measured, utilized, exchanged and valued also differ considerably from individual to individual and society to society, in part because of an aspect of behavioral finance called behavioral heuristics, but also because of variances among individual and cultural values, and knowledge systems.

Money Transfer from person A to B: Each have different financial goals

Image attribution: Horatius License: Public Domain

Financial measurement is constructed

As with many modernizations, finance is a socially constructed reality that makes use of a selectively chosen deductive knowledge. For example, our numerical system is 'base 10' which according to Kenny Felder of North Carolina University really only means that all numbers larger than 9 are created using the original numbers 0-9. In a base 5 system, all numbers larger than 4 are derived from the numbers 0-4 and 5-9 are not used. Thus, numbers are only the result of meaning we as human allow them to have.

Different financial systems represent the same things

Multiple financial meanings can also be construed from exactly the same phenomenon. To illustrate, a commodity futures contract for the delivery of 5 tons of seal meat  may represent a present value of future cash flow to an investor, but absolutely nothing to a traditional Inuit who's currency consists of seal meat and not a derivative financial instrument. Both realities are the same, i.e. 5 tons of seal meat, but the former creates things based on other things whereas the latter simply deals with what is easily accounted for.

Financial management is linked to cultural values

In addition to the system used to measure things of value, and the extent to which that system derives meaning, finance also has cultural values associated with it. In a post-apocalyptic or purely agrarian culture, non-technological culture with limited products, currency may still exist, but may play a considerably smaller role in civilization. For example, a culture with no factories, automobiles, laboratories etc. is more likely to be indicative of one with less materialistic goals, and consequently, less products and services. Such being the case, finance and economics is less elaborate and are less likely to be a priority in that society.

The goals of finance are not always the same

Another inconsistency in finance is that financial goals are not always the same. Investing for one person may both be a completely different activity and may even serve antithetical purposes. To illustrate, suppose a farmer plants a seed that is intended to grow into an apple tree that will provide fruit for his family and livestock. That seed is an investment and has no affiliation with money because it was traded for a different kind of seed. Yet, another person may invest $100 which itself is a digital concept because it was transferred  through an Automated Clearinghouse, an electronic funds transfer service managed by the Department of the Treasury. Moreover, the goal of that investment is for it to appreciate in value alone.

Valuation Methods: Discounting Cash Flows vs. Using Multiples

Discounted cash flow (DCF) is the present value of an estimated future flow of money into a business, financial instrument or project. Multiples refer to ratio multipliers where the results of financial ratios are multiplied and then compared to the same multiplier for competing businesses. 

Both discounted cash flow and multiples are valuation tools, where the former technique weighs present value of future cash flow against an asking price, and the latter compares operational aspects of business performance. This article will discuss advantages and disadvantage to each valuation method in addition to illustrating how each is calculated.

Advantages and disadvantages of discounted cash flows 

The discounted cash flow equation allows one to estimate how much a future stream of payments are worth at present value. This can be useful in determining bond, and annuity values given an assumed future cash flow of specified amounts. In other words, the discounted cash flow is a mathematical method to determine actual rather than estimated present value of cash flow. In the case of large transactions or financial agreements involving considerable and predictable payment streams, this calculation can be invaluable.

A problem with the discounted cash flow equation is that the equation does not take into account several other factors such as 1) investment risk associated with opportunity cost. 2) unforeseen variations in future cash flow and 3) In other words, investments that could return greater cash flow yields would add an unrealized element of risk to the DCF. Additionally, economic factors such as interest rates and inflation are not incorporated into the equation.

Multiples: Advantages and disadvantages

Multiples can be a good way to get a general sense of business performance across a range of metrics such as asset and debt management, liquidity, profitability etc. If the ratios perform lower than industry averages or competitors, the company may not be a good strategic investment, acquisition or franchise opportunity depending on the circumstances surrounding the calculation.

With multiples, ratios are compared between similar companies. For example, company A produces serrated metal pipes for pluming and has a market capitalization of $250 million making it a small cap. Company B also manufacturers serrated metal pipes but is vertically integrated meaning it also distributes and installs the pipes. This element alone makes the ratio multiple somewhat invalid in the sense it is not an exact comparison.

How to calculate discounted cash flows and multiples

• Discounted cash flow: Financial calculator method

A simple way to calculate discounted cash flow is using a financial calculator. Using a financial calculator allows the step of incorporating mathematical steps to be bypassed and in the case of a present value of an annuity only three variable inputs are required 1) interest rate 2) time as expressed by a number integer and 3) cash flow as either a single or multiple set of payments at either the same or different amounts. 

To do this all one need do is input number of payments by pressing (N) on the calculator followed by the number, then interest, by pressing (I) then interest, then (PMT) for payments with a negative payment amount and (FV) with 0 then computer (PV). This will yield the present value of a future flow of cash payments and assist in determining value of that cash flow. For varying cash flows, the series of uneven cash flows will have to be entered into the calculator using the (CF) cash flow function.

• Discounted cash flow: Mathematical method

There are several different methods for calculating discounted cash flow, each making use of different variables such future capital investments, weighted average costs, and cash flow streams. Determining which method(s) are most suitable for a valuation may require an additional understanding into the entity in question and is in and of itself an appraisal method decision. Calculating discounted cash flow manually involves calculating net present value (NPV). The following is one such method and makes use of the weighted average cost of capital (WACC).

Step 1: Calculate WACC: For each percentage portion of 100% of capital invested calculate the percentage interest then average. Incorporating For example, 45% of 100% of capital invested costs 6% annually whereas the other 55% costs 5%. 45% of 6%=2.7 and 55% of 5%=2.75%. 2.7%+2.75%=5.45% =WACC This is a simple method for calculating WACC that does not incorporate taxation and does not differ between types of investment capital, but rather percentage costs of investment.

A equation for incorporating tax costs into weighted average cost is as follows: (Debt)*(1-Tax rate percent)*(Percent cost or Interest on debt)+(Equity Investment capital)*(percent cost of equity investment) (www.wikepdia.com)

Step 2:

NPV=Cash flow(s)/1+r to the exponent of the numerical order of the cash flow payment, where r=WACC (www.investopedia.com) For example, for 3 cash flows of $100.00 the equation using weighted average percentage cost of capital would be as follows. $100.00/(1+5.45%)exp 1+ $100.00/(1+5.45)exp 2 + $100.00/(1+5.45)exp 3=$64.73+$41.89+$27.11=$133.73

In addition to the above 2 methods of calculating discounted cash flow, are other methods such as via statistical programs and online calculators. Instructions for these calculations can be found using software tutorials and/or online financial calculators.

Calculating multiples

Calculating multiples simply involves determining the result of financial ratios such as the price earnings (P/E) ratio or Days sales outstanding (DSO) and comparing them across an industry average. For example, if company A has a price per share of $25.00 and annual earnings per share of $1.25, the P/E ratio is 20. If the industry average has a P/E of 30, it means competing companies have higher expected earnings as reflected through share prices making company A's ratio multiple below industry average.

How to incorporate discounted cash flow and multiples in investment decisions:

To make the best investment decisions will always be an art or at best a quasi-scientific estimate due to the elements of risk, probability, varied market conditions, inflation, leveraging etc. For this reason, making use of equations and tools such as the discounted cash flow and multiples can be of quantitative assistance in determine more accurate estimates of worth and/or valuation of a potential investment.

To illustrate the above, Mr. Jones wants to buy an annuity through Company I, the annuity agreement involves a monthly payment of $500.00 for 10 years at interest rate of 5%, with annuity payments beginning on the 11th year for $625.00/month. Using the financial calculator method above, this amounts to a present value of just $9701.89 when the actual payments amount to $60,000.00. What's more reversing the scenario and calculating future value for the same payments at 5% interest the value becomes $176,791.854 after compounding interest. In other words, the annuity would have to pay back approximately 22.66 payments or more to meet the 10 year future value level.

In summary, the discounted cash flow calculation can be useful in numerically determining actual value of a future cash flow stream as opposed to estimated value. The discounted cash flow equation is thus more useful in determining present value of future cash flows rather than business operational factors as measured by multiples. The former DCF, may be more beneficial in the valuation of financial instruments such as bonds, and annuities than in business acquisitions and equity positions. Nevertheless, both equations can be used in valuation in both scenarios however each is more suited to particular financial conditions.

Online sources:

1. http://www.investopedia.com/terms/d/dcf.asp
2. http://www.investopedia.com/terms/m/multiplesapproach.asp
3. http://en.wikipedia.org/wiki/Weighted_average_cost_of_capital
4. http://en.wikipedia.org/wiki/Discounted_cash_flow

Text references:

1.Howard Bryan Bonham CPA, The complete Investment and Finance Dictionary. Avon Media Corporation, 2001.p.62
2.Eugene F. Brigham, and Joel F. Houston. Fundamentals of Financial Management 9th Ed. South-Western, 1999.p.107.
3.Howard Bryan Bonham CPA, The complete Investment and Finance Dictionary. Avon Media Corporation, 2001.p.62
4.Zvi Bodei, Alex Kane and Alan J.Marcus. 'Investments' Mcraw-Hill Irwin. New York, 2002. P. 265-271

Using Capital Turnover Ratio to Analyze a Company's Financial Statements

The capital turnover ratio, also defined as the working capital turnover ratio, measures how effective a company's use of debt is. The ratio is calculated by dividing sales revenue for a specific period of time by the difference between short-term assets and short-term liabilities for the same time period. (www.investopedia.com) The reason why liquid assets and liabilities are used is they are more reflective of capital cash flow for operations than long-term assets. The capital return ratio can be utilized in appraisal of a number of financial scenarios.

• Business valuation and profitability measurement
• Assessment of business performance
• Determination of variation in profitability over time
• Profitability in relation to market and/or operational returns
• Evaluation of acquisition risk

Using the capital turnover ratio to analyze a company's financial statement will assist in discovering return on debt. The higher the ratio, the greater the revenue return per dollar of debt is as measured by the ratio. Since time is a factor, the capital turnover ratio can change on a quarterly and annual basis.

For this reason, it may be more effective to measure the capital turnover ratio for different periods. If the differences in the ratio value are volatile, it indicates either fluctuating sales and/or variable debt. That is to say, if the ratio changes significantly over different time periods of measurement, sales and/or debt use may be unsteady and therefore the company may be a greater investment risk.

To illustrate how the capital turnover ratio is used, the following example can be used. Company X has a first quarter revenue of $500,000.00, its liquid assets for that same quarter are valued at $400,000.00 and liquid liabilities are $200,000.00. The difference between the assets and the liabilities are $200,000.00 making the ratio calculation $500,000.00/$200,000.00= 2.5. For the second fiscal quarter, sales decrease to $400,000.00, short-term assets increase to $450,000.00 and short-term liabilities increase to $250,000.00. The second quarter capital turnover ratio will consequently change to $450,000.00/$200.000=2.25.

The capital turnover ratio can be calculated over time to arrive at multiple indicators of return on capital including 1) an average capital turnover ratio 2) variable capital turnover ratios and 3) Correlated capital turnover ratio. The average capital turnover ratio will yield a ratio value that represents the capital return over a larger period of time whereas the variable capital turnover ratios can assist in determining seasonal, cyclical and environmental shifts in capital returns.

Furthermore, if the individual capital return ratios are correlated against a market index such as the Nasdaq, several other numerical relationships can be discovered. For example, quarterly percentage differences in the capital return ratio can be divided by quarterly percentage differences in the Nasdaq to determine if fluctuations in the ratio are statistically linked to variations in market returns over the same time period.

Additionally, the variable capital turnover ratio can be measured against internal performance benchmarks rather than against market returns as in the company to market beta relationship. That is to say, rather than relating the variable capital return ratios to a market index they can be related to other internal ratios such as profit margin on sales, return on equity (ROA) or return on assets (ROA).

To do this calculate the percentage change or average percentage change in the capital turnover ratio by dividing each periods capital turnover ratio by the previous periods ratio and then continuing on and averaging those percentage returns for an average variable capital return ratio percentage. Then, divide that value by the average percentage change of any one of several profitability ratios such as profit margin on sales, which is net income available to shareholders divided by sales. (Brigham and Houston p.107)

The result will be a numerical value reflecting the average variable capital return ratio as a function of profitability rather than market returns. In this case, the closer the value is to 1, the greater the connection between corporate operations and profitability to debt management.

In summary, the capital return ratio is a measure of profitability. The ratio can be expanded through multiple calculations over time to determine variation in profitability and average profitability. Additionally, the capital return ratio can be used in risk calculations by measuring it against market returns and operational performance by inserting the percentage change of the ratio in to a beta slope calculation where the numerator value is the capital turnover ratio percent change and the denominator is the operational percent change as measured by profit margin on sales.

A company that makes good use of debt leveraging is more likely to have a higher capital return ratio than a highly leveraged company with the same sales. For this reason, the capital return ratio us useful for business valuation purposes, assessment of business performance, and calculation of relationship(s) between profitability and market and/or operational performance.

Sources:
1. http://www.investopedia.com/terms/w/workingcapitalturnover.asp
2. http://www.investopedia.com/terms/a/alpha.asp
3. Eugene F. Brigham, and Joel F. Houston. Fundamentals of Financial Management 9th Ed. South-Western, 1999.p.107.