Archive for the ‘Profits’ category

Free Download of Valuation and Common Sense Book

December 19, 2013

RISKVIEWS recently got the material below in an email.  This material seems quite educational and also somewhat amusing.  The authors keep pointing out the extreme variety of actual detailed approach from any single theory in the academic literature.  

For example, the table following shows a plot of Required Equity Premium by publication date of book. 

Equity Premium

You get a strong impression from reading this book that all of the concepts of modern finance are extremely plastic and/or ill defined in practice. 

RISKVIEWS wonders if that is in any way related to the famous Friedman principle that economics models need not be at all realistic.  See post Friedman Model.

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Book “Valuation and Common Sense” (3rd edition).  May be downloaded for free

The book has been improved in its 3rd edition. Main changes are:

  1. Tables (with all calculations) and figures are available in excel format in: http://web.iese.edu/PabloFernandez/Book_VaCS/valuation%20CaCS.html
  2. We have added questions at the end of each chapter.
  3. 5 new chapters:

Chapters

Downloadable at:

32 Shareholder Value Creation: A Definition http://ssrn.com/abstract=268129
33 Shareholder value creators in the S&P 500: 1991 – 2010 http://ssrn.com/abstract=1759353
34 EVA and Cash value added do NOT measure shareholder value creation http://ssrn.com/abstract=270799
35 Several shareholder returns. All-period returns and all-shareholders return http://ssrn.com/abstract=2358444
36 339 questions on valuation and finance http://ssrn.com/abstract=2357432

The book explains the nuances of different valuation methods and provides the reader with the tools for analyzing and valuing any business, no matter how complex. The book has 326 tables, 190 diagrams and more than 180 examples to help the reader. It also has 480 readers’ comments of previous editions.

The book has 36 chapters. Each chapter may be downloaded for free at the following links:

Chapters

Downloadable at:

     Table of contents, acknowledgments, glossary http://ssrn.com/abstract=2209089
Company Valuation Methods http://ssrn.com/abstract=274973
Cash Flow is a Fact. Net Income is Just an Opinion http://ssrn.com/abstract=330540
Ten Badly Explained Topics in Most Corporate Finance Books http://ssrn.com/abstract=2044576
Cash Flow Valuation Methods: Perpetuities, Constant Growth and General Case http://ssrn.com/abstract=743229
5   Valuation Using Multiples: How Do Analysts Reach Their Conclusions? http://ssrn.com/abstract=274972
6   Valuing Companies by Cash Flow Discounting: Ten Methods and Nine Theories http://ssrn.com/abstract=256987
7   Three Residual Income Valuation Methods and Discounted Cash Flow Valuation http://ssrn.com/abstract=296945
8   WACC: Definition, Misconceptions and Errors http://ssrn.com/abstract=1620871
Cash Flow Discounting: Fundamental Relationships and Unnecessary Complications http://ssrn.com/abstract=2117765
10 How to Value a Seasonal Company Discounting Cash Flows http://ssrn.com/abstract=406220
11 Optimal Capital Structure: Problems with the Harvard and Damodaran Approaches http://ssrn.com/abstract=270833
12 Equity Premium: Historical, Expected, Required and Implied http://ssrn.com/abstract=933070
13 The Equity Premium in 150 Textbooks http://ssrn.com/abstract=1473225
14 Market Risk Premium Used in 82 Countries in 2012: A Survey with 7,192 Answers http://ssrn.com/abstract=2084213
15 Are Calculated Betas Good for Anything? http://ssrn.com/abstract=504565
16 Beta = 1 Does a Better Job than Calculated Betas http://ssrn.com/abstract=1406923
17 Betas Used by Professors: A Survey with 2,500 Answers http://ssrn.com/abstract=1407464
18 On the Instability of Betas: The Case of Spain http://ssrn.com/abstract=510146
19 Valuation of the Shares after an Expropriation: The Case of ElectraBul http://ssrn.com/abstract=2191044
20 A solution to Valuation of the Shares after an Expropriation: The Case of ElectraBul http://ssrn.com/abstract=2217604
21 Valuation of an Expropriated Company: The Case of YPF and Repsol in Argentina http://ssrn.com/abstract=2176728
22 1,959 valuations of the YPF shares expropriated to Repsol http://ssrn.com/abstract=2226321
23 Internet Valuations: The Case of Terra-Lycos http://ssrn.com/abstract=265608
24 Valuation of Internet-related companies http://ssrn.com/abstract=265609
25 Valuation of Brands and Intellectual Capital http://ssrn.com/abstract=270688
26 Interest rates and company valuation http://ssrn.com/abstract=2215926
27 Price to Earnings ratio, Value to Book ratio and Growth http://ssrn.com/abstract=2212373
28 Dividends and Share Repurchases http://ssrn.com/abstract=2215739
29 How Inflation destroys Value http://ssrn.com/abstract=2215796
30 Valuing Real Options: Frequently Made Errors http://ssrn.com/abstract=274855
31 119 Common Errors in Company Valuations http://ssrn.com/abstract=1025424
32 Shareholder Value Creation: A Definition http://ssrn.com/abstract=268129
33 Shareholder value creators in the S&P 500: 1991 – 2010 http://ssrn.com/abstract=1759353
34 EVA and Cash value added do NOT measure shareholder value creation http://ssrn.com/abstract=270799
35 Several shareholder returns. All-period returns and all-shareholders return http://ssrn.com/abstract=2358444
36 339 questions on valuation and finance http://ssrn.com/abstract=2357432

I would very much appreciate any of your suggestions for improving the book.

Best regards,
Pablo Fernandez

Getting Paid for Risk Taking

April 15, 2013

Consideration for accepting a risk needs to be at a level that will sustain the business and produce a return that is satisfactory to investors.

Investors usually want additional return for extra risk.  This is one of the most misunderstood ideas in investing.

“In an efficient market, investors realize above-average returns only by taking above-average risks.  Risky stocks have high returns, on average, and safe stocks do not.”

Baker, M. Bradley, B. Wurgler, J.  Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly

But their study found that stocks in the top quintile of trailing volatility had real return of -90% vs. a real return of 1000% for the stocks in the bottom quintile.

But the thinking is wrong.  Excess risk does not produce excess return.  The cause and effect are wrong in the conventional wisdom.  The original statement of this principle may have been

“in all undertakings in which there are risks of great losses, there must also be hopes of great gains.”
Alfred Marshall 1890 Principles of Economics

Marshal has it right.  There are only “hopes” of great gains.  These is no invisible hand that forces higher risks to return higher gains.  Some of the higher risk investment choices are simply bad choices.

Insurers opportunity to make “great gains” out of “risks of great losses” is when they are determining what consideration, or price, that they will require to accept a risk.  Most insurers operate in competitive markets that are not completely efficient.  Individual insurers do not usually set the price in the market, but there is a range of prices at which insurance is purchased in any time period.  Certainly the process that an insurer uses to determine the price that makes a risk acceptable to accept is a primary determinant in the profits of the insurer.  If that price contains a sufficient load for the extreme risks that might threaten the existence of the insurer, then over time, the insurer has the ability to hold and maintain sufficient resources to survive some large loss situations.

One common goal conflict that leads to problems with pricing is the conflict between sales and profits.  In insurance as in many businesses, it is quite easy to increase sales by lowering prices.  In most businesses, it is very difficult to keep up that strategy for very long as the realization of lower profits or losses from inadequate prices is quickly realized.  In insurance, the the premiums are paid in advance, sometimes many years in advance of when the insurer must provide the promised insurance benefits.  If provisioning is tilted towards the point of view that supports the consideration, the pricing deficiencies will not be apparent for years.  So insurance is particularly susceptible to the tension between volume of business and margins for risk and profits,
and since sales is a more fundamental need than profits, the margins often suffer.
As just mentioned, insurers simply do not know for certain what the actual cost of providing an insurance benefit will be.  Not with the degree of certainty that businesses in other sectors can know their cost of goods sold.  The appropriateness of pricing will often be validated in the market.  Follow-the-leader pricing can lead a herd of insurers over the cliff.  The whole sector can get pricing wrong for a time.  Until, sometimes years later, the benefits are collected and their true cost is know.

“A decade of short sighted price slashing led to industry losses of nearly $3 billion last year.”  Wall Street Journal June 24, 2002

Pricing can also go wrong on an individual case level.  The “Winners Curse”  sends business to the insurer who most underimagines riskiness of a particular risk.

There are two steps to reflecting risk in pricing.  The first step is to capture the expected loss properly.  Most of the discussion above relates to this step and the major part of pricing risk comes from the possibility of missing that step as has already been discussed.  But the second step is to appropriately reflect all aspects of the risk that the actual losses will be different from expected.  There are many ways that such deviations can manifest.

The following is a partial listing of the risks that might be examined:

• Type A Risk—Short-Term Volatility of cash flows in 1 year

• Type B Risk—Short -Term Tail Risk of cash flows in 1 year
• Type C Risk—Uncertainty Risk (also known as parameter risk)
• Type D Risk—Inexperience Risk relative to full multiple market cycles
• Type E Risk—Correlation to a top 10
• Type F Risk—Market value volatility in 1 year
• Type G Risk—Execution Risk regarding difficulty of controlling operational
losses
• Type H Risk—Long-Term Volatility of cash flows over 5 or more years
• Type J Risk—Long-Term Tail Risk of cash flows over 5 years or more
• Type K Risk—Pricing Risk (cycle risk)
• Type L Risk—Market Liquidity Risk
• Type M Risk—Instability Risk regarding the degree that the risk parameters are
stable

See “Risk and Light” or “The Law of Risk and Light

There are also many different ways that risk loads are specifically applied to insurance pricing.  Three examples are:

  • Capital Allocation – Capital is allocated to a product (based upon the provisioning) and the pricing then needs to reflect the cost of holding the capital.  The cost of holding capital may be calculated as the difference between the risk free rate (after tax) and the hurdle rate for the insurer.  Some firms alternately use the difference between the investment return on the assets backing surplus (after tax) and the hurdle rate.  This process assures that the pricing will support achieving the hurdle rate on the capital that the insurer needs to hold for the risks of the business.  It does not reflect any margin for the volatility in earnings that the risks assumed might create, nor does it necessarily include any recognition of parameter risk or general uncertainty.
  • Provision for Adverse Deviation – Each assumption is adjusted to provide for worse experience than the mean or median loss.  The amount of stress may be at a predetermined confidence interval (Such as 65%, 80% or 90%).  Higher confidence intervals would be used for assumptions with higher degree of parameter risk.  Similarly, some companies use a multiple (or fraction) of the standard deviation of the loss distribution as the provision.  More commonly, the degree of adversity is set based upon historical provisions or upon judgement of the person setting the price.  Provision for Adverse Deviation usually does not reflect anything specific for extra risk of insolvency.
  • Risk Adjusted Profit Target – Using either or both of the above techniques, a profit target is determined and then that target is translated into a percentage of premium of assets to make for a simple risk charge when constructing a price indication.

The consequences of failing to recognize as aspect of risk in pricing will likely be that the firm will accumulate larger than expected concentrations of business with higher amounts of that risk aspect.  See “Risk and Light” or “The Law of Risk and Light“.

To get Consideration right you need to (1)regularly get a second opinion on price adequacy either from the market or from a reliable experienced person; (2) constantly update your view of your risks in the light of emerging experience and market feedback; and (3) recognize that high sales is a possible market signal of underpricing.

This is one of the seven ERM Principles for Insurers

Risk and Reward

May 19, 2012

Successful Businesses pay attention to risk.

– How much risk to take compared to their capacity to absorb risk via their level of average earnings and their capital position.  They have a basket.  Each basket is different.  It can easily hold so much.  Sometimes, you decide to put a little more in the basket, sometimes a little less.  They should know when they have stacked their risk far over the top of the basket.
– What kinds of risk to take.  They have a plan for how much of each major class of risk they they will pick up to use up the capacity of their basket.

– Then when the actually go to fill the basket, they need to carefully choose each and every risk that they put into the basket.

–  And as long as they have those risks in the basket, they need to pay attention and make sure that none of the risks are spoiling themselves and especially that they are not spoiling the entire basket of fruit or ruining the basket itself.

But that is not what a successful business is all about.  They are not in business to be careful with their basket of risks.  They are in business to make sure that their basket makes a profit.

+ So how much risk to take is informed by the level of profit to be had for risk in the marketplace.  Some business managers do it backwards.  If they are not being paid much for risk, they fill up the basket higher and higher.  That is what many did just prior to the financial crisis.  In insurance terms, they grew rapidly at the peak of the soft market.  Just prior to the cirsis, risk margins for most financial market risks were at cyclical lows.  What makes sense for a business that wants to get the best reward for the risk taken would be to take the most risk when the reward for risk is the highest.  Few do that.  However, the problem faced by firms whose primary business is risk taking is that taking less risk in times of low reward for risk creates even more pressure on their income because of decreased expense coverage.  This problem seems to indicate that businesses in such cyclical markets should be very careful to manage their level of fixed expenses.

+ What types of risk to take is also informed very much by the margins.  But it also needs to be informed by diversification principles.  Short term thinking suggests that risk taking shift all to the particular risk with the immediate best risk adjusted margin.  Long term thinking suggests something very different.  Long term thinking realizes that the business needs to have alternatives.  For most markets, the alternatives are only maintained if a presence in multiple risks is maintained in good times and bad.  Risk and reward needs to develop a balance between short term and long term.  To allow for exploiting particularly rich markets while maintaining discipline in other markets.

+ Which specific risks to select needs to incorporate a clear view of actual profitability.  It is very easy on a spreadsheet to take your sales projection and profit projections and multiply both numbers by two.  However, it is only through careful selection of individual risks that something even remotely like that simple minded projection can be achieved.  The profit opportunity from each risk for the additional sales may be at the same rate as the original margins, it may be higher (unlikely) and it may well be lower.  The risk reward system needs to be sensitive to all of these three possibilities and ready to react accordingly.

Do we always underprice tail risk?

April 23, 2011

What in the world might underpricing mean when referring to a true tail risk? Adequacy of pricing assumes that someone actually can know the correct price.

But imagine something that has a true likelihood of 5% in any one period.  Now imagine 100 periods of randomly generated results.

Then for each of three 100 period trials look at 20 year periods. The tables below show the frequency table for the 80 observation periods.


20 Year Observed Frequency Out of 80
0 45
5% 24
10% 12
15% 0
20% 0
20 Year Observed Frequency Out of 80
0 9
5% 28
10% 24
15% 8
20% 7
20 Year Observed Frequency Our of 80
0 50
5% 11
10% 20
15% 0
20% 0

if the “tail risks” are 1/20 events and you do not have any information other than observations of experience, then this is the sort of result you will get. The observed frequency will jump around.

If that is the situation, how would anyone get the price “correct”?

But suppose that you then set a price for this tail risk. Let’s just say you picked 15% because that is what your competitor is doing.

And you have a very patient set of investors. They will judge you by 5 year results. So then we plot the 5 year results.

And you see that my profits are quite a wild ride.

Now in the insurance sector, what seems to happen is that when there are runs of good results people tend to cut rates to pick up market share. And when the profits run to losses, people tend to raise rates to make up for losses.

So again we are stymied from knowing what is the correct rate since the market goes up and down with a lag to experience.

Is the result a tendency to underprice?  You be the judge.

Rents vs. Risk and Reward

April 16, 2011

Many people talk and write as if risk and reward were the true trade-offs in a capitalist system.  It certainly makes risk management important if that were true.

But unfortunately for us risk managers, and fortunately for business managers, choosing among risky alternatives is not the best choice for business success.

In fact, the natural tendency of capitalism is directly away from risk and towards Competitive Advantage.  If a business can find a competitive advantage, their first choice forever after is to strengthen that advantage and to reduce their risk.

A business with a total competitive advantage, also called a monopoly, is crazy to then take any risk.  Economists call their income a rent.  The income from risk taking is called a risk premium.  All businesses prefer rents to risk premiums under that definition.

So the risk managers who talk all of the time about the risk and reward continuum and about the efficient frontier of risk taking are talking nonsense to any business person who knows the story of any of the most successful businesses.  The most successful businesses all made fortunes for their founders by collecting rents.

What we should be talking about is the Rent / Risk continuum.  If you want to be really successful, you need to find a way to collect rents.  If you want to get mediocre returns, then you can go out and take risks.

Many years ago, Riskviews was producing risk reports for return on risk capital for an insurer.  The insurer had some fee for service business.  This business did not fit into the risk reward framework.

Investment Banks had at one time been mostly fee for services businesses.  Then for a time, they decided that they could make more money taking risks.  It turns out that they were largely wrong.  The “profits” that they were recording on their risk taking were risk premiums for taking very large risks that were “in the dark“.  According to Taleb, they were being massively underpaid for those large but infrequent risks.

Some reinsurers that make their business taking on large amounts of catastrophe risks can be shown to be taking a significant amount of their value from the “default put” that is created because they collect premiums for all expected claims under their reinsurance contracts, but they do not intend to pay off on the largest catastrophes because they will have defaulted.

Risk taking is a questionable way to make profits.

So risk managers need to work to identify rents and properly reflect the superior place that rents should have in business goals.  Risk managers should be slow to claim that any risk taking behavior will make a profit and not just mistaken accounting of risks that are waiting in the dark and growing stronger to take back all of the so called profits from risk taking.

When is a Risk Premium Earned?

April 7, 2011

This is a difficult question.  One that challenges our accounting systems.

Think of two insurance contracts.  One lasts for one minute, the other for an hour.  They are both sold for residents of Antartica.  They cover the risk of being hit with a snowball.  On the average, residents of Antarctica are hit with a snowball 3 times per day.  The contracts pay out $10 every time the insured is hit with a snowball.  Premiums are $5 for the one hour policy and $0.10 for the one minute policy. The policies are renewable.

On Antarctica it is the custom of insurers to publish quarterly financials, that is every quarter hour.

Right now, there are 4 people on Antarctica and two of them have policies.  One bought the one minute policy and the other bought the one hour policy.

After the first quarter hour, there have been no claims.  What are the profits from the two policies?

The answers are completely different depending upon whether you decide to look at earning risk premium over the maximum holding period for the policies or the minimum holding period.

Our accounting systems tend to take the minimum holding period approach.  However, the maximum holding period approach might give a more useful answer.

The maximum holding period approach would be to think of the risk over the effectively infinite maximum holding period.  To determine profits, look forward and consider the amount needed for future losses.  You expect to have lumpy losses that average to a certain level.  The maximum holding period approach would then tend to reflect the excess over the expected losses as the profits in a period as profits and allow a build up of reserves to take care of the lumpy losses.

The minimum holding period approach suggests that at the end of the minimum holding period, you are done and reflect any revenue not needed to pay losses as profits.

So if no snowballs were thrown that quarter hour, all premiums (less expenses, which are very high for insurers operating in Antarctica) as profits.  If during any quarter hour there are snowballs, then there will be losses.  Very lumpy results.

This is not just an insurance consideration, it applied to any risks, such as credit or any far out of the money derivatives where losses are not expected in every period.

The minimum holding period approach will tend to encourage risk taking.  The maximum holding period approach would tend to make risk takers realize that they do expect losses sometimes.

Then if someone wants to recognize all of their profits from exposure to an infrequent risk during no loss periods, they would need to totally exit that position.

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The following chart is referenced in the comment from Robert Arvanitis…

Eggs and Baskets

December 1, 2010

Andrew Carnegie once famously said

“put all your eggs in one basket. and then watch that basket”

It seems impossible on first thought to think of that as a view consistent with risk management.  But Carnegie was phenomenally successful.  Is it possible that he did that flaunting risk management?

Garry Kasparov – World Chess Champ (22 years) put it this way…

“You have to rely on your intuition.  My intuition was wrong very few times.”

George Soros has said that he actually gets an ache in his back when the market is about to turn, indicating that he needs to abruptly change his strategy.

Soros, Kasparov, Carnegie are not your run of the mill punters.  They each had successful runs for many years.

My theory of their success is that the intuition of Kasparov actually does take into account much more than the long hard careful consideration of a middling chess master.  Carnegie and Soros also knew much more about their markets than any other person alive in their time.

While they may not have consciously been following the rules, they were actually incorporating all of the drivers of those rules into their decisions.  Most of those rules are actually “heuristics” or shortcuts that work as long as things are what they have been but are not of much use when things are changing.  In fact, those rules may be what is getting one into trouble during shifts in the world.

Risk models embody an implicit set of rules about how the market work.  Those models fail when the market fails to conform to the rules embedded in the model.  That is when things change, when your thinking needs to transcend the heuristics.

So where does that leave the risk manager?

The insights of the ultra successful types that are cited above can be seen to refute the risk management approach, OR they can be seen as a goal for risk managers.

The basket that Carnegie was putting all of his eggs into was steel.  His insight about steel was correct, but his statement about eggs and baskets is not particularly applicable to situations less transformational than steel.  It is the logic that many applied during the dot com boom, much to their regret in 2001/2002.

The risk manager should look at statements and positions like those above as levels of understanding to strive for.  If the risk managers work starts and remains a gigantic mass of data and risk positions without ever reaching any insights about the underlying nature of the risks that are at play, then something is missing.

Perhaps the business that the risk manager works for is one that by choice and risk tolerance insists on plodding about the middle of the pack in risk.

But the way that the risk manager can add the most value is when they are able to provide the insights about the baskets that can handle more eggs.  And can start to have intuitions about risks that are reliable and perhaps are accompanied by unmistakable physical side effects.


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