KCQ's Chapters 7 & 8

KCQ’s Chapter 7 - How to Predict the Future to Eternity

The basic principle of learning for me, fundamentally changed when I first decided to begin this tertiary academic journey. The idea that there was an alternative, more proficient way of learning than simply regurgitating what we are told and repetitively pounding that knowledge into our subconscious, was enlightening. Merely finding a personal connection, something we have already experienced and latching that new knowledge into where deep-seated erudition takes place, is a profound concept. Value is a very personal thing and it makes sense that we need to apply our own values to understand what is happening in our companies now and into the future. We use our subjective views to take risks every day, based on intelligent, educated and informative assessment and we can use the same techniques in our approach for our company’s forecast.

Putting the Guesswork into Eternity

I can see how studying Business Finance would have been a great advantage before tackling Financial Statement Analysis. Not only the familiarity with the current methods of analysing stocks and shares but also the theory behind the analysis. None the less, I can understand the concept of useful assumptions, since economic theory is based on the rational consumer, so it is not a stretch to understand finance theory assuming homogeneous expectation. My aspirations include becoming an investor…soon! I can be content earning a safe 9 to 5, provide my family with all the necessities and the occasional indulgence, however, I’m thinking my education, experience and ambition would give me an edge to achieve so much more. I don’t want to get caught up in the bull and bear of it all, but it would be nice to have financial windfall. In a nutshell, I want to be better than average and I’m starting to believe I can be. Using accumulated knowledge and experience to support a formidable margin of safety, I can also skew fortune to my favour!

Continuing Values

V_O^E = BV of Equity_O + Abnormal OI₁ + Abnormal OI₂ +…+ Abnormal OI_t + .   CV_t

                                            WACC                 WACC²                     WACC^t         WACC^t

This is a concept where I lack the confidence in my ability to make accurate guessimates in order to be convincing. How can I be sure that I’m making the right connections? What if I miss an important factor out? What do I know about real economic and business drivers? Well, the only way to get good at something, is to do a lot of it and this is my first go. I figure even if I get it wrong, it will still be a valuable learning experience. I have been gaining confidence in my discussions with others. Long discussions with my fellow college Chen from China gave so many valuable insights, online discussions with Iris, Hannah, Daniel and Kaidesha all exploring mutual ideas and making more sensible, intelligent associations with our company’s business and economic realities. All this increases my confidence to strengthen a convincing assessment. Speculations of economic drivers have translated as transactions in response to past, current and future issues which could be reflected in the accounting drivers.

CV_t = Economic profit_t+1 + OI_t+1 (g/RINOA)(RINOA-WACC)

                    WACC                            (WACC – g)

It follows logic that if we can predict the expected rate of return on new net operating assets and growth in operating income, we can predict the future value of the company. Taking all the factors involved into account can be time consuming. We have already used 11 weeks trying to gather and interpret a mere part of what would be considered an in-depth analysis. Time is money, but money can’t buy time. Somehow, we need to weed through the abundance of information and focus on those aspects which are clearly relevant. We can narrow down the extremes and analyse likelihood of scenarios and involve other people’s analysis for comparison and validation. Using these sensitivities to form intelligent judgements and assumptions.

Risk

Risk is something we face each morning. I’m often asked why I smile so much in the morning, it’s because I survived the night and happy to be alive! Some companies are lucky, some increase their luck with intelligent, informed analysis and good judgment. I err on the safe side but, I increase my confidence little by little and take risks that more often than not pay off. I have learnt you can stay in the safe zone but, then you really don’t go anywhere, you stagnate and that to me is not living efficiently. If I was running a company, I’d want to grow to full potential and beyond and that means taking risks. The same when I become an investor, I want my investment to reach full potential and more. I realise that studying business finance will give me a more positive balance of probabilities and I look forward to gaining that knowledge. For now, I can digest the nondiversifiable risk or the systematic risk of a firm from investor information to roughly calculate my company’s beta. This takes other people’s opinions into account. However, we make our own analysis, never rely on other people’s judgements.

Margin of Safety

‘A rational intelligent response to the reality of risk’. This makes the most sense to me. I have a statistical mind and can visualise the central tendency and dispersion graphically in a graph. This really helps form a clearer picture of all these calculations for the future. So, I can understand that the safety margin is the spread between our best estimate of the value of the company and the market value and the wider the spread, means the better response to business risk. I already have so many scenarios relating to my company’s business and economic realities and the possibilities for the future. I just worry about piecing them all together to make a useful, convincing analysis. I also worry that my personal bias and the perceived bias of other investors concerning the airline industry will somehow distort a rational analysis. There are so many things that need to be carefully considered.

KCQ’s Chapter 8 - Going Forward

‘I write the songs’ sung by Barry Manilow was not actually written by him or for him, it was written by Bruce Johnston for David Cassidy. The point is, although it sounds good, the contents and intentions are not what they seem. I find this is similar with financial statements and annual reports. I am learning that accounting isn’t so much about the numbers but, as much about the stories they tell that matter most. The average person would find bookkeeping and financial statements quite boring but, the stories they can tell are quite fascinating.

Two Frameworks

The DCF and Economic profit frameworks have shown me the strength of a firm’s ability to respond to past, current and future economic and business events. It’s my understanding that they are useful tools in determining the business performance now and into the future, which entices the equity investor to invest. It’s all about the value add. How does investing in this particular firm add value not only to my investment, but to my soul as well? It is possible to get more than expected returns on an investment, more than just dividends, for an extended period of time. We can express the material value in the economic profit model:

V_E = BV₀ + PV of AE

If the firm does not materially add value from their financial activities, it can be restated as:

V_E = BV₀ + PV of Abnormal OI

Therefore, the two models can show the expected future dividends and expected future cash flows using the book value, present value and economic profit. This changes our thinking about value, involving the cost of capital and utilizing assets to generate return on investment. It is that bit extra that we are most interested in, the returns above and beyond the expected, there in lies the real value add. We need to be able to assess this in a timely fashion. Much like my decision to pursue a tertiary qualification, I had to weigh up factors of time and earning. Would it be worthwhile gaining the skills to earn the money and how much time do I have before the pay off before I die? I will always pick yes, because the education adds more value to me than just the financial reward and there is the possibility of earning much greater rewards above and beyond my initial endowment. This journey reaches beyond financial rewards and into my soul and the soul all that care about me, the stakeholders in my life. That is the added value of my decision to study.

Price Multiples

“Price is what you pay, value is what you get”. I like this analogy; the logic resonates with me. I don’t like to part with money lightly and when I perceive the value expected, it is comforting, but it’s when I receive value above my expectations, such as the extra fries in the bottom of a McDonalds paper bag, that I experience real joy. That is of course the instant gratification, over time you realise others receiving the extra fries and the joy wanes, you compare the fries with the chips from the chip shop and suddenly it does not seem valuable anymore. Value can be smoke and mirrors. We need to rely less on other people’s opinions of value to experience the joy. Basing decisions on grounded theory and  incorporating our own judgements and assumptions will clear the smoke and reflect a truer image. We could give up; crystal ball theory has no real answers about the future. Though, I am not a quitter and I want to make informed, intelligent decisions for the future now. Each step into the future doesn’t have to be so random, we know where we now and where we want to be in the future.

V_E = BV₀ + PV of Abnormal OI

     = BV₀ + Abnormal OI₀

                      (WACC -1)

Allowing for drift:

V_E = BV₀ + PV of Abnormal OI

     = BV₀ + Abnormal OI₀

                  (WACC -1) – g

The crystal ball theory can become even more clearer with real engagement of our company’s business and economic realities. We will never be spot on perfect, but we can be in the range of useful expectation. The real connection of facing our fears, intelligently with courage and conviction and take the leap of faith.

Forecasting

We know that company’s do not last for eternity. The likelihood of air travel being replaced with superior technology is still a long way off…or so we expect. The likelihood of new entries of competition is more likely, rising fuel prices are inevitable and the increasing population means more passengers are likely to be buying airfares. There are limitations to  forecasting but, we can apply degrees of probability and include them in our calculations. The beta β of a firm is the expected erosion of abnormal earnings over time, because nothing lasts forever.

V_E = BV₀ + β Abnormal OI₀

                     (WACC – β)

Things are beginning to fall in place. Why do we need to restate the financial statements? To save time and redirect our focus on the business realities. Why do we need to know the accounting drivers of a firm’s performance? Because this is where the firm is currently deriving value and the ability derive value in the future. Why do we need to link the accounting drivers with the actual economic and business drivers?  Because this is the firm’s real value. This is where the prospect of a firm’s future value is revealed.  The real value is in the forecasting. The real value lies in our ability to convert forecasts into a practical assessment with an acceptable margin of safety.

It is Now Up to You

I know this is just the beginning, but I am excited to use these skills to practice into the future and possibly ‘get really good at it’! I am concerned that being my first time, I won’t get it right. I am concerned that my forecasts will be way off to be considered useful. But I will never give up. I want to grow and develop, and I want my children to have those skills too. There are so many more dreams and possibilities that are closer to be a reality. This has been an incredible journey. I feel more equipped than ever to handle the future. My mind is open, and the future is a blank canvas but, I have the paint and equipment to paint a beautiful, stimulating picture and share it with the world.

∞