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Modeling and Valuation Mistakes

Integrated Financial Management

Nov 1, 2016

Introduction
The financial market volatility caused by the decline in value of housing
mortgages in the U.S. should create a different way to think about risk.
There has been something fundamentally wrong with the manner in
which financial professionals assess risk
Traditional financial theory taught in business schools (beta, option
pricing models and Monte Carlo Simulation) provided little or no guidance
in valuation
While the understanding of any discipline requires knowledge of
underlying technical principles, when it comes to valuation, learning
from past mistakes is also essential, if not even more important.

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Assumption Development is the Most Important Part of


Valuation Modelling

Assuming that prices and volumes can continue to increase in tandem when
there is surplus capacity.

Relying on experts who do not have a vested interest in investments and without
verifying analysis with back of the envelope analysis.

Using statistical analysis on historic data without realizing the manner in which
economic variables can suddenly change in non-linear ways.

Believing in innovative valuation techniques without understanding the ultimate


source of cash flow.

Not studying long-term marginal cost and fundamental economic principles


relative to prices in evaluating cash flows.

Simplistic assumptions with respect to downside and upside cases rather than
recognizing differences in upside potential and downside risk.

Assumption that contracts will protect investments without delving into the
potential for contracts to be broken or mismatched.

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Classification of Valuation Mistakes


Some Prominent valuation errors restatements of above include:
Failure to forecast potential price declines that occur when there is oversupply in a market;
Adoption of complicated analysis made by others without adequate
independent analysis;
Failure to check the underlying logic of the investment with simple tests or
back of the envelop analysis;
Belief in supposedly innovative new valuation techniques without fully testing
the underlying logic;
Assuming that historic trends and volatility will continue;
Failure to adequately contrast downside risks with upside opportunities.
Failure to account for the flexibility in investments

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Valuation Nightmares
All of these things factored into the mother of all valuation nightmares
the financial panic precipitated by declines in the U.S. housing loans
known as the sub-prime crisis.
A very general discussion of the explosive mixture of valuation errors that
contributed to the sub-prime mess is presented below before specific
valuation mistakes are discussed in more detail.
The problem is that none of these mistakes is very new they simply
occurred on a bigger scale and had wider implications for the overall
market.

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Other Valuation Nightmares


Telecommunication Meltdown loss of a trillion dollars in market value from
over-leverage, over-supply and belief in unrealistic growth.
Merchant Electricity caused and estimated decline in market value (debt and
equity) of more than $100 billion from ignoring fundamentals of supply and
demand.
Enron Bankruptcy Enron had very sophisticated salesmen, but there was little
underneath many of the products such as its power plant in Dabhol India began
the downfall of Enron.
LBO Crash of Early 1990s Over-optimism in assessment of cash flow
forecasts resulted in a very high default rate and brought buyouts to a close.
LTCM in 1998 belief in the complicated mathematical models and the reputation of
others led to a major collapse and intervention of the U.S. Federal Reserve.
Dot Com Bubble dramatic increase in valuations that ignored fundamental
valuation principles and was driven by easy access to investmet.
Eurodisney/Eurotunnel Cost over-runs and low volumes because of concept.

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Problem One
Ignoring the most basic of economic
principles in developing assumptions for
financial models

Integrated Financial Management

Nov 1, 2016

Most investors built their pricing models around


the sweet spot, the two-year adjustable
mortgage with a three-year prepayment penalty,
because it maximized revenue for everyone in
the food chain.

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Dont Assume Prices and Supply Can Increase over Long


Periods
Telecommunications Meltdown.
Investors and bankers did not account
for the obvious prospective oversupply
of homes in their analyses. This
surplus of residential homes could be
verified by a simple drive around
sprawling suburban areas of American
cities where it was apparent that supply
was increasing much faster than the
overall population.

Telecommunications companies
experienced higher bankruptcies than
any other industry in 2000-2002.
There was an overbuilding of fiber-optic
cable systems by a factor of at least 10.
Many New Economy companies were
built based on the idea that the telecom
sector would expand perpetually by 15
to 30% per annum.

.
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Debt to Income versus Debt to Capital


Part of the problem was relying on debt to
the value of assets rather than on debt to
income. The chart below shows that the
level of debt relative to aggregate income
was dramatically increasing.
Similar problems from relying on equity
buffer on balance sheet without
examining future cash flow exposure.
The second chart shows that the housing
as measured by cumulative starts has
increased by about 40% more than
population.

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Problem Two
Ignoring the Supply Side of Variables Driven
By Marginal Cost

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Nov 1, 2016

Ignoring Economics and Long-Run Marginal Cost when


Evaluating Prices
Loans were granted on the presumption that
housing prices would follow historic trends and
continue to increase. The most fundamental of
economic principles dictate that prices eventually
move to long-run marginal cost, or the cost of
building a new home. As a corollary, economics
suggests that prices can move to short-run
marginal when surplus capacity exists. The graph
of median housing prices in the U.S. shown below
illustrates how the basic economic principles were
ignored.

AES Drax and UK Merchants


Declines in prices were not predicted in merchant
electricity markets after increases in supply. Losses
were estimated to be $100 billion. In the U.K.
changes in the market structure and increased supply
pushed prices to marginal cost.

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Increasing credibility to stories new era stories that


appear to justify the belief that the boom will continue.
People think the world is led by independent minds who
invariability act with great intelligence.
Nov 1, 2016
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Standard and Poors and Housing Price Assumptions


According to one story an investor called the rating agency Standard &
Poors and asked what would happen to default rates if real estate prices
fell.
The man at S&P couldnt say; its model for home prices had no ability to
accept a negative number. They were just assuming home prices would
keep going up

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Other Examples of Believing Implausible Forecasts and


Herding Behavior Like Lemmings

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Problem Three
Forgetting the Fundamental Rule that Value
comes from Earning Returns above the Cost
of Capital and the Danger of Assuming High
Returns without Competitive Advantage
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Nov 1, 2016

Sub-prime lending jumped from an annual volume of


$145 million in 2001 to $625 million in 2005 more
than 20% of total issuances.

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Assumption that Money Can Be Easily Made with No Work and


No Competitive Advantage
Lenders welcomed flippers people
buying houses solely for the purpose of
reselling in a year or so. By 2005, 40% of
all home purchases were either for
investment or for second homes. Experts
believe that a large share of the second
homes actually were speculations for
resale.
A surprising number of number of subprimes went to affluent people stretching
for second homes. If loan originators have
no stake in the borrowers continued
solvency, the competition for fees will
inevitably degrade the average quality of
loans.

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In the example below, an electricity plant


was assumed to be able to earn far more
than its cost of capital in a competitive
business where new entrants can easily
enter the market.

Rather than focusing on the model


mechanics or debt structure or even the
details of forward price forecasts, the
question of why the returns can exceed the
cost of capital must be answered

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Not evaluating the underlying logic of the investment with


simple tests
LBO Defaults

In the sub-prime crisis, loans that were


made that ignored fundamental lending
practices of evaluating whether cash flow
could cover debt service.
In the extreme, reckless loans named
NINJA loans (No Income, No Job, no
Assets) were dispersed on the
presumption that housing prices would
continue to increase. People bought
bigger and bigger houses.
U.S. census the floor area in one-family
houses rose from 1,525 square feet in
1973 to 2,248 square feet in 2006, an
almost 50% increase.

Financial projections that underpinned


several high-profile LBO bankruptcies in the
late 1980s. Many of these transactions
were based on assumptions that the
companies could achieve levels of
performance, revenue growth, operating
margins, and capital utilization never
before achieved in their industry. The
buyers of these companies typically had no
concrete plans for executing the financial
performance necessary to meet their
obligations. In many such transactions, the
buyers simply assumed that they could
resell pieces of the acquired companies for
a higher price to someone else.

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18

Rating Agencies and Examining Underlying Value


Moodys did not have access to the individual loan files, much less did it
communicate with the borrowers or try to verify the information they
provided in their loan applications.
We arent loan officers, Claire Robinson, a 20-year veteran who is in
charge of asset-backed finance for Moodys, told me. Our expertise is as
statisticians on an aggregate basis. We want to know, of 1,000
individuals, based on historical performance, what percent will pay their
loans?

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Problem Four
Believing that Innovative Financial Ideas can
Create New Sources of Value

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Nov 1, 2016

Mortgages were transferred to a trust and then sliced


or tranched horizontally into different segments, with
different bonds for each segment. The trick was that
the top-tier bonds, which represented say 70 percent of
the value sold had first claim on all cash flows. Since it
is inconceivable that 30 percent of a normal mortgage
portfolio can default, top-tier bonds go triple-A, super
safe ratings and paid commensurately low yields.
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Beware of analysis that supposedly is innovative Value


always comes from assessment of cash flow
The Dot Com Bubble
The structured finance products that
packaged loans together and distributed
different pieces of the cash flows different
investors.
These investments were somewhat complex
and opaque and investors did not perform
due diligence, but instead accepted the
expertise of rating agencies and marketing
professionals.

Some economists took to questioning


long-held tenets of competitive
advantage, and "new economy"
analysts asked, with the utmost
seriousness, why a three-year-oldmoney-losing Internet purveyor of pet
supplies shouldn't be worth more than
a billion dollars.

The securitized products often had strong


credit ratings which were not questioned by
many sophisticated investors.

These are not excuses!!!

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Rating Agencies and Complex Securities


The first mortgage-backed bonds were created in the late 1980s
structured finance was a process of pure alchemy: a way
of turning myriad messy mortgage loans into standardised, regimented
and easy-to-assess bonds.
"The problem is that these instruments have become so incredibly
complex that you need incredibly sophisticated computer models to work
out their value - and these are always liable to bugs. Moody's has
promised to overhaul its process to stop this happening again, but it may
be a case of shutting the gate after the horse has bolted: next time some
clever banker comes up with a tricky new financial instrument, who's
going to believe the ratings agencies now? Nobody with any sense.
The complexity of CDO.s undermined the process as well. Jamie Dimon:
There was a large failure of common sense by rating agencies and also
by banks like his. Very complex securities shouldnt have been rated as
if they were easy-to-value bonds.

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Statistical Analysis and Credit Rating Agencies


The real problem is that the agencies mathematical formulas look
backward while life is lived forward. That is unlikely to change.
Rating a new transaction, as an analyst, is a relatively simple procedure
but it can be time-consuming. From an ordinary desktop computer, you
start the Moodys rating software. A window opens in which you set the
basic assumptions: duration of bond, payment, collateral details ... and
then click the simulation is set running. Not once, but a million times,
each time with a different outcome. Its the average outcome from all
those simulations that gives you a rating.
A bug had a big impact on ratings. A single small error in the computer
coding that Moodys used to run its CPDO performance simulation had
thrown the results way off. When the error was corrected, the likelihood of
CPDO default increased significantly. CPDOs, it turned out, werent tripleA products at all. Preliminary results suggested the error could have
increased the rating by as many as four notches.

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Problem Five
Relying on Independent Experts and NonTransparent Analysis without Checking the
Logic and Using Simple Models

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As one former Moodys staffer recalls: The change was


just precipitous. There was suddenly a concentration on profits.
Management got stock options. Its true there was a big personality
shift in the company lots of cozying up to clients went on.
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Rating Agency Problems


Moodys Executive: Were in the service business, I dont apologise for
that.
The agencies were inundated with a huge volume of new structured
finance deals that they were being asked to rate. At Moodys, the flipside
to the huge revenue growth was a high-pressure work environment. One
analyst recalls rating a $1bn structured deal in 90 minutes. People at the
rating agencies used to say things like, I cant believe we got comfortable
with that deal,
There were stories of analysts going skydiving with clients; of
structured finance experts and bankers on weekend getaways together;
of golf outings and karaoke nights.

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Adoption of complicated analysis made by experts without


adequate independent analysis
Despite the clear oversupply of housing
and the bubble in housing prices,
economic forecasters projected
continued increases in housing prices
and housing starts. With hindsight,
given the oversupply and the high
prices, neither could have been
sustainable. The macro economic
forecasts along with the rating agencies
failed.

Eurotunnel Traffic Studies


Expert Traffic Studies were
dramatically wrong
Traffic study did not anticipate
response of ferries, surplus capacity,
stable growth, price elasticity

600 vs 1,600

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Difficulty in Making Forecasts of Economic Variables


The problem with making forecasts of economic variables versus
physical variables is illustrated by oil price forecasts made by the
famous Energy Information Agency of the U.S. which hires the
most respected consultants

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Problem Six
Using Statistical Models that Assume Stable
Systems for Economic Variables

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Nov 1, 2016

Statistical Analysis of Historic Data Ignoring Structural


Changes
Growth Estimates in Philippines
Analysts often used databases that computed
historic default statistics to value securities.
Statistical analysis of historic data can go
badly wrong when applied to economic
variables. Because of increasing leverage,
declining home prices and a slowing
economy, historic default rates turned out to
be irrelevant in predicting bad loans.

Forecasts of growth rate using historic


trends and statistical analysis have
created many problems. Forecasts of
growth rates caused major economic
problems in the Philippines because of
over-capacity and high capacity
charges.

Moodys estimated that this C.D.O. could potentially incur losses of 2


percent. It has since revised its estimate to 27 percent. The bonds it
rated have been decimated, their market value having plunged by half
or more. A triple-A layer of bonds has been downgraded 16 notches, all
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Default Rates Problems with History


Moodys used statistical models to assess C.D.O.s; it relied on historical
patterns of default. This assumed that the past would remain relevant in
an era in which the mortgage industry was morphing into a wildly
speculative business.
When the sub-prime CDO market first took off in 2005, sub-prime
mortgage defaults were only 3%. A 20% cushion of equity and
subordinated debt seemed like ample protection, so rating agencies
generally assigned triple A to the top 80 percent of bonds in the CDO.
Default rates then trended to 10 percent and rising.

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Problem Seven
Assuming that Variables Follow Smooth and
Linear Trends

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Nov 1, 2016

Moodys estimated that this C.D.O. could potentially incur losses of 2


percent. It has since revised its estimate to 27 percent. The bonds it
rated have been decimated, their market value having plunged by half
or more. A triple-A layer of bonds has been downgraded 16 notches, all
the way to B.

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Economic Variables are Non-Linear and Difficult to Evaluate


with Statistical Analysis of Historic Data
It is apparent that investors did not
appropriately consider changes in the
probability of default when different loans and
economic conditions occurred.
The problem is that investors focus on
expected returns without paying enough
attention to the skweness of the upside and
downside returns. The upside return on
underlying loans was a credit and a higher
margin when the loans were re-financed.

California Market Prices


Prices before the California
electricity crisis were relatively low. But
most of the forces that lead to the
extremely high prices such as high
electricity demand, no new capacity
and low levels of water in damns could
have been predicted.

.
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Statistical Problems and Rating Agencies


To add to the confusion, by the autumn of 2007 it seemed that events in some US
neighbourhoods were throwing the ratings agencies models off even further. As
house prices fell, defaults were rising to such a degree that they were blighting
entire areas. That was pushing house prices lower still, sparking yet more defaults.
This vicious circle had never been witnessed in the world of corporate loan
defaults; nor did it fit the traditional bell curve central to the statistical risk
assessment systems that were ubiquitous inside banks and ratings
agencies.
The class of 2005 and 2006 borrowers were defaulting much faster than
households which had taken out mortgages before those dates.
A particularly pernicious aspect of the defaults was that when this new breed of
subprime borrowers walked away from their homes, they often left them in such a
bad state that it was hard for lenders to realise any value from the repossessed
properties. Until the autumn of 2007, Moodys had assumed, on the basis of past
housing cycles, that lenders could recoup 70 per cent of their loans in case of
default. By October 2007, it had slashed that projection to just 40 per cent.

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Problem Eight
Ignoring Incentives

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Incentives of Rating Agencies and Bankers


Bankers, who are anxious to earn fees, convince themselves to believe
forecasts that are not sensible. Further, risk assessment mistakes are
compounded because after one major bank accepts the risk of a loan, if
analysts at a second bank question the efficacy of the analysis, they are
scoffed at.
Suppose you are a credit analyst at a relatively small bank ABC
bank and you believe there is too much risk for the suggested level
of debt. A typical conversation may be that if Citibank and HSBC
determined that a loan is an acceptable risk, who are you to say that
you do a better analysis than such a very sophisticated bank.

In structured finance, a handful of banks return again and again, paying


much bigger fees. A deal the size of XYZ can bring Moodys $200,000
and more for complicated deals. And the banks pay only if Moodys
delivers the desired rating.
You start with a rating and build a deal around a rating

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Belief in analysis of others when they do not have the same


incentives

Many of the problems from the sub-prime crisis


came from assuming that brokers, initial lenders,
financial institutions and rating agencies had
similar incentives.

Enron and the Dabhol Plant

The brokers, lenders and rating agencies did not


appropriately analyse the risk.

A World Bank analysis questioned the


project's economic viability and the contract
price allowed Enron to earn an equity IRR of
above 26%.

Within a few years of


the advent of the CMO,
however, the industry
decomposed into highly
focused sub-sectors.
Mortgage brokers
solicited and screened
applicants. Thinly
capitalized mortgage
banks bid for loans and
held them until they had
enough support of a
CMO. Investment
banks designed and
marketed CMO bonds.
Servicing specialists
managed collections
and defaults.

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Part of Enrons downfall began with problems


from the high cost Dabohl plant in India.

A New government was elected and the Plant


did not begin operations.

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Re-thinking Risk Assessment and Finance


The sub-prime crisis and other valuation mistakes should prompt re-thinking about
what finance theory has to say about a variety of issues including the manner in
which risk affects investment decisions and the cost of capital.
Established finance theory did very little to either explain the decision making
process or to assist professionals in making investment decisions.
Even if beta could be measured, the manner in which CAPM is applied does
not suggest that there is much of a difference in risk for alternative
investments. The typical risk premium used in investment analysis is about
4% and betas vary from about .5 to 1.5.
Using debt capacity along with sound thinking about the fundamental economics
of projects and mathematical simulation provides an alternative to risk assessment
that provides more guidance to decision makers. If lenders would rigorously
establish the debt capacity of an investment (as did not happen in the sub prime
experience), investors then would have a much more objective basis than the
CAPM to assess risk as part of investment decisions.

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Valuation and the Financial Crisis: The Case of Constellation Energy

Instead of making generalizations about financial crisis, study one


company
Was the company a victim or a villain in the financial crisis
What has happened to multiples in the financial crisis
How much real value really is created by trading and buying other
businesses
What does it really mean to not be transparent from the perspective of
valuation
What method should be used to compute the value of different segments
of the company

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Constellation Stock Price History

Constellation stated it was laser focused on increasing its stock price,


it ventured into businesses that could produce growth in earnings per
share.

Why was valuation


so bad

Compute cost
of capital and
arbitrage
pricing model
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Background and Problem


Increasing stock price was difficult for the Company because
Constellation purchased three nuclear plants at premium prices in New
York that came along with fixed price power contracts (named below
market hedges by the company).
Peers were earning high returns from the transition to deregulated rates
as shown in the table below.

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Increasing Earnings
The company was able to double
earnings which resulted in the
increased stock prices.
It also projected strong future growth
in earnings

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Business Components
The peer companies primarily in the business of selling electricity
from merchant generating plants and operating regulated
distribution companies.
As shown in the table (which was not published until 2009),
Constellation was earning almost fifty percent of its non-utility
earnings from businesses other than generation in 2006 and 2007.
bought ships that transported coal and named it freight
intermediation

Constellation Merchant Segments Reported in


2009

purchased oil and gas producing properties and named them


energy related assets

Gross margin:
Generation
Customer Supply
Global Commodities

1,490
764
656

1,700
889
654

1,956
765
260

Total

2,910

3,243

2,981

(the company purchased almost $1 billion of natural gas


producing properties as natural gas prices were increasing,
justifying the purchases by the bizarre logic that: As a
merchant supplier, we are able to identify opportunities to
serve customers, which provides the insight to acquire assets
and deploy risk capital at the right time.)

deploys risk capital in traded energy markets that investors


finally found out that meant taking speculative positions on
energy prices.

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2006

Generation Percent

51%

2007

52%

How would you


value the different
components

Nov 1, 2016

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2008

66%

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Solution Trading and Non-transparent Reporting

Mao Shattucks solution was to expand speculative trading, purchase


companies that could produce near term earnings and attempt to
minimize the risks of the new business ventures through no-transparent
reporting.
The lack of transparency was not limited to reporting financial results,
but also included use of confusing terms and distortions of investor
presentations involving what was the true nature of its business
activities.
Entry into the businesses along with increasing electricity prices did
produce increased cash flow.

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Meaning of Being Non-Transparent: Financial Reporting

One aspect of transparency involves presentation of financial statements.


The problem was not that assets were hidden in special purpose vehicles, but
that cash flows from different businesses were mixed together.
Before 2008, investors had no way to differentiate between the safe and
stable profits made from selling power from one of its nuclear plants under
fixed price purchased power contracts and the profits made by speculating on
the direction of energy prices.
The volatility of cash flows, cash flow drivers and trends in future cash flow
were different for each business segment and the historic data was useless in
making valuations.
Constellation was hoping that the aggregate cash flows would be valued at
the price to earnings and other multiples of peer companies that had safer
businesses.
We continue to hear from you regarding the transparency of our business and our
overall disclosure[In] improving transparency we will be working towards
discrete reporting on each business unit to provide more detailed information on
segments currently reported. As you are aware, in 2008, we refined our reporting
to show gross margin by activity

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Meaning of Being Transparent: Creating Confusion

Lack of transparency for Constellation was not limited to its financial presentation. The second aspect of
opaque presentation was the manner in which Constellation explained its businesses to investors.

Language used by Constellation is a good example of the way finance professionals attempt to create
confusion though showing how smart they are.

In earnings conference calls and other presentations, Constellation would use phrases such as
asymmetric collateral requirements,
deployment of risk capital,
leveraging business platforms,
as priced margins,
transitional liquidity,
right-sizing of strategic footprints

The general idea of the presentations seemed to be that investors should trust the superior qualities of the
company and not worry about risks in the business

Mao Schattuck: the realignment of all our merchant businesses allows us to leverage our world class
capabilities in risk management and portfolio management across our industry-leading platform.

When listening to Mao Schattuk and other Constellation managers, they seemed to want to leave an
impression of being very smart. It was easy to feel quite inferior to their superior intellect.

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Non-transparent Reporting: Distorting Business Activities

A third component of non-transparency was the way in which Constellation


minimized its exposure to potential losses from its trading activities by
emphasizing that most of its collateral requirements were for hedging activities
related to its merchant plants, hedging for customers and hedging its coal
business.
Constellation never directly admitted that the company had been engaging in
speculation until he discussed the transaction with EDF in December, 2008 when
he admitted taking positions.
Assertions that the company was not betting on energy price movements
were contrary to other statements made by Constellation. For example,
management stated that it was bullish on energy prices in its second quarter
conference call. One of the company executives reported: As Mayo stated,
we entered the second quarter bullish on energy commodities
In fact, Constellation was profiting from the long bubble in energy prices similar to
the way many companies and people were profiting from the housing price bubble.
While energy prices were increasing, it was easy to be confident in the trading
strategies that were producing profits. After all, when crude oil prices reached
$147 per barrel in the summer of 2008, almost everybody seemed to believe that
oil prices would soon reach $200 per barrel.

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51

Meaning of Being Transparent: Not Presenting Risk

A fourth way in which Constellation was non-transparent was in the way it


presented risk.
The company regularly reports value at risk,
a complicated statistic that supposedly measures the maximum loss
that could be realized in one day with a one percent probability.
In the third quarter of 2008, the value at risk number was about $30
million. This compares to the actual decline in earnings for the
commodities business of $634 million.
Dividing 634 by 30 implies there were as many as 21 days of one
percent likelihood events.
With hindsight, the value at risk statistic was meaningless for risk
assessment and it would have been for more useful to simply show what
happens to cash flow and earnings at different levels of commodity price.

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52

Suggested Valuation of Components by Constellation

Constellations valuation just before the price


collapse. Comment on the use of multiples and
the sample of comparable companies.

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53

Valuation of Generation Component

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54

Alternative Valuation (Two Months Later)

When MidAmerican proposed a merger, the investment bank made a


dramatically different valuation.

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55

Alternative Valuation of Components

Issues:
What method should be used
How should valuation be presented
What adjustments should be made for fixed contract payments

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56

Constellations Demise

The specific reason for Constellations ultimate financial demise was panic in the financial
community that the company could not raise enough cash from lenders provide back-up
loans so that it could continue its trading activities. Management defined the finance
collapse as a liquidity crisis and attributed it to events that were beyond its control -- on
unprecedented turmoil in financial markets, volatile energy commodity prices and the
actions of rating agencies who were worried about trading partners losing confidence. The
table below illustrates that credit risk was even higher for Constellation than for Lehman
Brothers. The downfall began when rating agencies finally recognized that Constellation
had more risks than its peers the downgrade occurred after energy prices had began to
fall. The rating agency Fitch, noted Constellations exposure to energy prices, implying that
it was taking positions in its trading: Constellation is exposed to risks surrounding
market price, volumes, counterparty credit, and liquidity for collateral. When the company
places blame on volatile financial markets for its problems, it is like investors in sub-prime
mortgages blaming the fall in housing prices. It is not appropriate to term Constellation as
a victim of the financial crisis.

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57

Payments in Merger with Warren Buffets Energy Company

The accompanying table shows that


the cost of the failed MidAmerican
Merger was significant.

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58

Finance and Confusion


A medical doctor, an engineer and an investment banker are at a cocktail
party.
The medical doctor pompously asserts that the medical profession is
the oldest profession. He cites a passage from the Bible, in Genesis
where God creates man and woman. Surely, he says, this was the
first medical act.
The engineer jumps in and says, I remember a passage prior to
that, which says, out of the chaos and confusion, God created the
earth. Surely, this was the first act of engineering and predates the
first medical act.
Aha! says the investment banker, who created the confusion?!

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59

Forecast Error Examples


Example
Not considering the tendency for
humans to be over-optimistic in complex Airbus, Chrysler, Euro-disney
endeavors such as new technology,
mergers and war
Not checking highly complex, untransparent models with a back of the
envelope analysis

FPL purchase of CMP assets

Forgetting fundamental principles of


supply, demand and price elasticity in
establishing model assumptions

Argentina Electricity Market Overbuild, ENRON Dabhol

Assuming that things are really different,


LBO multiples
believing fast talking analysts and
assuming that history will not repeat
Believing that other large reputable
Iridum
institutions have some new kind of
analysis and/or that they have done their
homework

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60

Forecast Error Examples


Example
Applying historic trend lines in growth that
cannot be sustained
Accepting models that contain high returns
far above the cost of capital in competitive
industries

U.S. Electricity Industry

Internet Bubble

Pretending that real life is linear and


follows a normal distribution where the
upside and downside can be derived from
historic statistical analysis

Natural Gas Prices

Assuming that variables such as operating


expenses are variable when they are
partially fixed

Manufacturing Administrative
Expenses

Incorrectly accounting for the relationship


between capital expenditures and sales
without considering the cost of new capital
equipment

Freight Airline

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61

Forgetting To Look At Returns To See If They Make Sense

Models must reflect the economic reality of a company. If the


company has a sustainable competitive advantage, the return on
invested capital may be greater than the weighted average cost of
capital. Economic profit ROIC above WACC -- comes from things
like barriers to entry, pricing power and cost structure efficiency which
should be explicitly modeled.
If you model all of the details of the company and then the ROIC is not
at a plausible level given the competitive position of the company, go
back and re-visit the forecast.
If you plan to forecast large returns on capital and high growth, make
sure you can explicitly point to the source of the competitive
advantage

Look at the rate of return earned on investment in the terminal


period and evaluate if it is really sustainable instead of simply
assuming growth from the terminal period.

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62

Assuming That Your Investment Will Earn High Returns and


Nobody Else Will Figure it Out
In the example below, an electricity plant was assumed to be able to earn
far more than its cost of capital in a competitive business where new
entrants can easily enter the market.
100 becomes 1,000
in 10 years with 24%
return

Can we really
earn 24% when
anybody can build
a similar plant

Rather than focusing on the model mechanics or debt structure or even


the details of forward price forecasts, the question of why the returns can
exceed the cost of capital must be answered

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63

Beware of Investment Strategies That Depend on High Growth


That Cannot Be Sustained
Long-term growth rates are required
directly or indirectly in various parts of a
financial forecast. Long-term growth rates
that are high can imply that the company
becomes larger than the entire economy.
Growth rates should be sustainable and
reflect the earning power of the enterprise.

A better strategy would have been to


make flexible investments that could
respond to growth rather than locking
into long-term contracts with long lead
times.

Examples of errors in growth rate


estimation:
Use a long-period for growth
estimation rather than recent data.
Do not account for saturation in
demand and price elasticity of
demand as is often the case in
forecasts of growth in electricity
consumption.

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64

Overestimation of Growth Value of Flexibility to Adjust to


Growth Rate Changes
The electric power industry has provided
many examples of valuation mistakes
when extrapolating historic growth from
historic trends rather than accounting for
possible changes in future growth. In
the US, electric power demand grew at a
compound growth rate of 7.9% from
1949 to 1974 and then, in years since it
has grown at a compound growth rate of
2.5%. The change in growth rates
occurred because of increased energy
prices, saturation of appliance use,
improvements in energy efficiency and
other factors.
Growth rates of above 7% in the 1950s
and 1960s led managers to make
projections of similar growth rates for
subsequent periods. This demand
growth implied a need for requirements
to construct large amounts of new
capacity.

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Cost of Investment with and without Demand Volatility

4% Volatility

0% Volatility

Difference 4% vs 0%
Volatility

5 Year Construction

105,443.00

86,436.00

19,007.00

1 Year Construction

101,138.00

90,758.00

10,380.00

4,322.00

(8,627.00)

Difference in Cost
Percent Difference

(4,305.00)
-4.3%

4.8%

Assumptions: 6% Load Growth


Projected Growth from Exponential Smoothing

Nov 1, 2016

65

Evaluation of Alternative Growth Rates and Classic Risk


Analysis
Real world risk analysis that accounts for tradeoffs between cost and uncertainty
can range from relatively simple judgmental considerations to complex
mathematical approaches. Alternative risk analysis techniques include:
Adjusting the discount so that there is a greater risk premium on alternatives
with less flexibility with respect to growth rates.
Computing sensitivity cases to understand how the variation on demand
affects different scenarios.
Determining the break-even point in terms of changes in growth rates to
determine the year in which growth rate changes produce different investment
optimal investment strategies.
Computing alternative scenarios with different growth rates and assigning
probability to those alternative cases in order to gauge the expected value
and the distribution in value of different alternatives.
Using regression and other statistical techniques to compute the volatility of
sales growth and then using Monte Carlo simulation to compute alternative
probability distributions. In gauging the un

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66

Convincing Yourself That Unrealistic Optimistic Forecasts Will


Occur Firehouse Effect
It seems obvious that the base case should represent likely comments rather than
optimistic or best case estimates. However, models often represent optimistic
rather than likely outcomes. The Firehouse effect Fireman with too much time
agree on many things that an outside, impartial observer would find
ludicrous.
Examples:
LBOs: Some transactions were based on assumptions that companies could
achieve levels of performance revenue growth, operating margins, capital
utilization never before achieved. Buyers had no concrete plans.
Eurotunnel: The capital cost estimates of highly technical projects often are
over budget and do not reflect the history of cost estimates for similar
projects. In the case of US nuclear plants, estimates from statistical analysis
of other plants was far better than engineering estimates.
S&P
Financial projections are probably inherently skewed toward
successful results...hiding the true technical and operating risks
inherent in many projects..."

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67

Example of Buying into Unrealistic Assumptions: Euro tunnel


Case How Did All The Banks Buy Into This
31 Mile tunnel between England and France
Similar project in Japan had 100% cost over-run
Financed by 225 banks
Construction expected to be completed in May 1993; actual was in December 1994
Original construction budget was 4.9 billion; actual 12 billion
Bankers egos and ties got in the way, bankers were forced to take exposure in order to be in
other UK transactions
Problems with rail links, low cost airlines
Serious aspect of risk misjudged
Completion
Traffic (.6B vs 1.2B)
Infrastructure

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68

Eurotunnel Mistakes
Eurotunnel comments
"We were predicting that on Eurostar there would be 21 million
passengers (annually)," admits David Freud of Warburg, the
investment house which sold Eurotunnel shares to the public.
The actual figure was less than a third of that.
"So the traffic forecasts were not just out by a little bit. They were
completely potty; they were nowhere."
Those who drafted Eurotunnel's prospectus failed completely to foresee a
robust response from the ferries.
When the world's most successful investor, Warren Buffett, said, "if you
overpay for an asset, there ain't no cure", he might have had Eurotunnel
in mind.

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69

Eurotunnel Price and Traffic Estimates


Not only did P&O not fade away, as Eurotunnel had thought likely, it
fought back with better ships and lower prices, retaining the loyalty of
passengers who had been forecast to switch to the tunnel.
Another blow to Eurotunnel was the unexpected emergence of no-frills
airlines, offering rock-bottom prices on short-haul trips to a wide range of
European destinations.

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70

Relying on Complicated Models without Doing a Back of the


Envelope Check
Many models are highly complex these days. One example is traffic
studies that measure the number of trips on every single road in an area
and then attempt to project the number of people who will use a toll road.
Another example is electricity market studies that project the hourly
production of every plant in a country for twenty or thirty years. These
forecasts should be checked as illustrated by the errors made in traffic
forecasts:

Simple Checks:
-What is the total revenues people are
supposed to pay for the toll road in
one study, people were expected to pay
$7,000 per year.
-What is the market share of the toll
road. In one study, a road that was
unrealistically expected to capture 60%
of airport traffic.
-What is the price elasticity of toll road
users. In one study, traffic growth was
projected even though real toll rates
double.

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71

LBO Bubble Make Yourself Believe Crazy Assumptions So


You Can Earn The Fees
In 1981, 99 LBO deals took place in the US; by 1988, the number was
381.Early on, LBO players grounded their deal activity in solid analysis and
realistic economics.
Yet as the number of participants in the hot market increased, discipline
declined. The swelling ranks of LBO firms bid up prices for takeover prospects
encouraged by investment bankers, who stood to reap large advisory
fees, as well as with the help of commercial bankers, who were willing to
support aggressive financing plans.
Default Rate from unrealistic
financing of LBOs. This caused
LBO activity to dry up for decades

Private Equity
Transactions

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72

LBO Bubble Will History be Repeated


Financial projections that underpinned several high-profile LBO bankruptcies in the late
1980s. Many of these transactions were based on assumptions that the companies
could achieve levels of performance, revenue growth, operating margins, and capital
utilization never before achieved in their industry. The buyers of these companies typically
had no concrete plans for executing the financial performance necessary to meet their
obligations. In many such transactions, the buyers simply assumed that they could resell
pieces of the acquired companies for a higher price to someone else.
Why wouldn't investors see through such shoddy analyses?
In many of these transactions, bankers and loan committees felt great pressure to keep up
with their peers and generate high up-front fees, so they approved highly questionable loans.
In other cases, each participant assumed someone else had carefully done the homework.
Buyers assumed that if they could get financing, the deal must be good.
High-yield bond investors figured that the commercial bankers providing the senior debt
must surely have worked their numbers properly. After all, the bankers selling the bonds
had their reputations at stake, and the buyers had some capital in the game as well.
Whatever the assumption, however, the immutable laws of economics and value creation
prevailed. Many deals went under.

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73

Assuming That Upside Potential Equals Downside Exposure -Neglecting Skewed Distributions
Examples
Prices before the California
electricity crisis were relatively
low. But most of the forces that
lead to the extremely high prices
such as high electricity demand,
no new capacity and low levels
of water in damns could have
been predicted.

More potential for price increase


than potential for price decrease
should be accounted for in
forecasts

The real estate crash that


occurred in many cities in the
late 1980s related to the S&L
crisis could have been
anticipated by oversupply.

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74

Illustration of Considering the Skewness in Cash Flows with


Tornado Diagram

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75

Assuming That Growth Can Occur Without Making Capital


Expenditures
Forecasts often are computed from revenue growth, operating margins and turnover of
capital. While these may be reasonable forecasts, the capital expenditures can be
inconsistent with other aspects of the forecast.
Revenues

Revenue Growth

Operating Expense

Revenue x Margin

Total Assets

Revenue x (Assets/Revenue)

Capital Expenditure

Assetst Assetst-1

As with revenue forecasts from price and quantity, it is better to compute capital expenditures
from the quantity of production required (reserves, manufacturing capacity, electric capacity,
number of planes, number of subscribers etc.) and multiply the cost of new capacity by the
quantity. The capital expenditure forecast should include inflation in the cost of procuring
capacity and include sustaining capital expenditure.
Example
Revenue forecast for air freight company without consideration of maintenance capital
expenditures and without explicit modelling of the cost of new planes.

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76

Growth In Quantity Sold With Increasing Prices And Declining


Cost/Unit
In simple forecasts of revenue growth and margins, management would
like to grow both the level of sales and the margin on sales. There are
many cases when innovative products have been developed where this
can be the case. However, an increase in margin generally implies
higher prices which can cause volumes to decline because of price
elasticity.
Examples of not reflecting price elasticity in forecasts
Toll roads in developing countries the value of added time in using
roads.
Direct subway systems that connect airports there have been many
failures because traffic has not been realized.
Purchase of Distribution Companies in South America by US Firms
(AES, Aliant Energy, CMS). US firms assumed prices could be
increased without properly considering political pressures.

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77

Ignoring Economic Cycles


If possible, forecasts should have enough history so that economic cycles are
reflected. Cycles include economic recessions and the behavior of commodity
prices. The worst error is creating hockey stick forecasts from the top of the cycle.
Other errors involve assuming no economic downturns in forecasts.
Forecasts should account for the long-run marginal cost of the product being
produced --- prices that are always above or below marginal cost cannot be
sustained.
Examples of Valuation Mistakes and Economic Cycles
Florida power and light purchased assets from Central Maine Power for
much more than replacement cost. In the long-run prices converge to
marginal cost and the purchase price above replacement cost was not logical.
In addition to the logic error of assuming that prices would remain above
long-rum marginal cost, there was a mechanical error in the spreadsheet.
Oil price forecasts throughout the 1980s and into the 1990s assumed by
banks projected significant increases and did not account for mean reversion
in oil price.

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78

Merchant Plant Activity

in the US, private companies that own


merchant plants have lost of more than $100
billion in market capitalization.

Banks are now highly reluctant to take merchant


risk of any kind and they are skeptical about
long-term purchase or tolling contracts that in any
way are considered to be out of the money.

Merchants will have to redesign their business


models. Those players that have 80-90 percent of
their capital in the form of debt won't survive. The
ratings agencies have said that such debt-tocapital ratios must be in the 50-50 range to earn
investment grade status so that the cost of
borrowing is reasonable.

The merchant plant activity has been very high.

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79

Argentina Example of Merchant Problems


In Argentina, plant efficiency, over-capacity and increased hydro
generation caused financial problems with projects.

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80

Mistakes by Ignoring the Fundamentals


By the time the Internet frenzy peaked at the end of the 1990s, even
staunch traditionalists like Warren Buffett pondered whether the economy
had entered a new era of prosperity unbounded by traditional constraints.
Some economists took to questioning long-held tenets of competitive
advantage, and "new economy" analysts asked, with the utmost
seriousness, why a three-year-old-money-losing Internet purveyor of pet
supplies shouldn't be worth more than a billion dollars.

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81

Internet Notion Increasing Returns with Size and First Mover


The basic idea is this: In certain situations, as companies get bigger, they can earn
higher margins and return on capital because their product becomes more
valuable with each customer who purchases it. In most industries, competition
forces returns back to reasonable levels. But in so called increasing-return
industries, returns become high and stay there.
Take Microsoft's Office software, which provides word processing, spreadsheets,
and graphics. It is important for customers to be able to share their work with
others, so they are unwilling to purchase and use competing products. As the
installed base gets bigger and bigger, it becomes even more attractive for
customers to use Office for these tasks.
Because of this advantage, Microsoft earns 75 percent margins and operating
profits of $7 billion on this product, one of the most profitable products of all time.
As the Microsoft example illustrates, the concept of increasing returns to scale is
sound economics.
What was unsound during the Internet era was its application to almost every
product and service related to the Internet.

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82

Intellectual Short-cuts in the Internet Bubble


In the case of Microsoft Office, a key driver is the desire for compatibility to share documents.
But during the Internet bubble, the concept was misinterpreted to mean that merely getting big
faster than your competitors in a given market would result in enormous profits. Some
analysts applied the idea to mobile-phone service providers, even though customers can and
do easily switch from provider to provider, forcing these providers to compete largely on price.
The same logic seemed to apply to Internet grocery delivery services, even though the result
of attracting more customers is that these services need more drivers, trucks, warehouses,
and inventory.
The Internet bubble years were full of such intellectual shortcuts to justify absurd share prices
for technology companies. The history of innovation has shown how difficult it is to earn
monopolized sized rents except in very limited circumstances. But that was no matter to the
commentators who ignored those lessons. Those who questioned the new economics were
handed as people who simply "didn't get it."
When the laws of economics prevailed, as they always do, competition reined in returns in
most product areas. The Internet has revolutionized the economy, as have other innovations,
but it could not render obsolete the rules of economics and competition.
The Internet bubble shows what happens when managers, investors, and bankers ignore the
fundamental principles of economics and the underlying history of value creation. It was also
a classic example of herding behavior, as investors, managers, and commentators followed
the crowd instead of relying on their own independent analysis. For example, many equity
analysts could not justify the values of companies based on fundamentals, so they resorted to
commenting only on relative valueshow one company was valued relative to another
instead of dealing in absolute terms.

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83

Evaluate the ROIC and Market to Book Ratio in Forecasts


If a forecast includes a return on invested capital that is greater than the WACC, the question
should be asked as to what forces allow the firm to maintain a sustainable competitive
advantage and economic rents.
For example, in the late 1990s it was considered old fashioned to use traditional cash flow
and financial ratios in evaluating the value of new economy stocks. Why a three-year old
money losing Internet purveyor of pet supplies should not be worth more than $3 billion. Yet
the implicit assumption in valuations was that the companies could grow economic rents. For
some companies such as Microsoft and Cisco this may have been reasonable. For others
such as priceline.com this was unreasonable because there were no barriers to entry that
prevented other firms from entering the market.

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84

Under or Over Use of History and Back of the Envelope Checks


History should be used in developing trends and relationships in
forecasts. You should calibrate items such and administrative expenses,
working capital ratios, depreciation rates and tax rates to historic data.
However, use of historic trends without an understanding of the
underlying economics can lead to problems.
Real-life business events can produce results that are anything but linear
and knowledge of supply and demand factors can predict market crashes
and price spikes.
Dismissing the past is as unwise as blindly projecting past performance
into the future.
If the firm has consistently met targets, it would be unwise to dismiss this
input

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85

Separation of Fixed and Variable Costs Is The CEOs Salary A


Variable Cost
One of the basic elements in a
financial model is operating leverage
and the sensitivity of financial position
to fixed costs. Assuming that costs
such as salaries can easily be varied
when they are in fact fixed can lead to
optimistic forecasts.
Examples
Cutting salaries and pension
costs in the Airline industry has
caused the failures of many large
airline companies. When
passenger volumes declined, the
cost per passenger increased
leading to the bankruptcy of
UAL.

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86

Too Complex and Non-Transparent Analysis Techniques


A medical doctor, an engineer, and a finance professor are at a cocktail
party. The medical doctor pompously asserts that the medical profession
is the oldest profession. He cites a passage from the Bible, in Genesis
where god creates man and woman. Surely, he says, this was the first
medical act.
The engineer jumps in and says, I remember a passage prior to that,
which says, out of the chaos and confusion, God created the earth.
Surely, this was the first act of engineering and predates the first medical
act.
Aha! says the finance professor, who created the confusion?!

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87

Cost Structure Understand Fixed Costs and Exposure to


Sales Declines

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88

The Iridium 'Team'

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89

Forgetting Fundamentals of Supply and Demand and Back of


the Envelope Analysis -- Telecommunications
At the end of the day you should evaluate whether
forecasts make sense in light of fundamental
economic principles.
In the 1990s telecoms seemingly limitless
upside potential
Venture capitalists and stock investors fell
over each other to invest insane amounts
of money in many companies
Success of internet companies premised
oh high growth continuing
When companies failed to generate cash
flow, defaulted companies skyrocketed

Barriers to telecommunications companies


came down
Telecommunications network became
overbuilt due to lack of demand

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90

Default Rates by Industry

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91

Telecommunications Meltdown
In 2001, 77 telecommunications companies sought bankruptcy
In 2000, 20 declared bankrupcy.
Two Trillion in Market Value Lost
Large bankruptcies included:
WorldComs -- the single largest bankruptcy in U.S. history.
The fiber optic network operator, Global Crossing, 4th largest
Other leaders -- Williams Communications Group and Network Plus
Reasons
Long distance price competition in pursuit of retaining market share.
Entry into local markets blocked.
It's fallout from a telecoms industry in which supply has dwarfed demand.

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92

Surplus Supply in Telecommunications


.

There was an overbuilding of telecom capacity based on


the fantasized vision of the objectives of the New Economy,
which will never be realized. For example, there was an
overbuilding of fiber-optic cable systems by a factor of at
least 10. Many New Economy companies were built based
on the idea that the telecom sector would expand
perpetually by 15 to 30% per annum.
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93

Demand versus Supply


The result is overcapacity: 39 million miles of cable were laid underneath
railroad beds, natural gas lines, corn fields, and roadsenough to
encircle the Earth more than 1,500 times. Today less than 5% of the
cable is "lit"; the rest remains dark, and most is not likely to be "lit."
But reality has further asserted itself, causing additional problems in the
physical economy and revenues of the telecom sector, and ripping apart
that sector's two fundamental assumptions. The sector's CEOs thought
that increased volumes of data traffic, as opposed to voice calls, would
be the savior of the telecom industry. But data users, mostly corporations,
instead of paying on the more expensive per-minute basis, are paying for
the data in bulk. On this basis, data transmission is not even as profitable
as old-fashioned voice calls.
Belief that voice-call traffic would rise. But alarmed industry executives
report that people are sending millions of e-mails per day, instead of
spending money for telephone calls. Some industry sources now predict
that, in the future, the volume of voice calls will fall each year.

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94

Financial and business problems


The telecom sector collapse is driven by two intertwined forces.
First, it is over-leveraged: Its companies borrowed enormous sums of
money during the 1990s, to finance a wave of mergers and some
expansion. Telecoms' total outstanding debtstill estimated at $650
billion or morerequires debt service far larger than that portion of
the sector's revenue stream available to service it; it is sucking the
telecom sector dry.
Every company that could get its hands on the stuff proclaimed that it
was going to build a national, or super-regional fiber-optic network. In
some cases, four to six companies built fiber-optic cable networks
between or within the same major cities, far beyond prospective
levels of voice or data transmission.

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95

The Iridium Concept


International Coverage
66-LEO Satellites
Launched 72; got 67; 5-year life each

12 Ground Stations
Handset Cost = US$3,000
A brick
Call Cost = US$3.00-US$7.50 per min.
US$800 million Loan
LIBOR + 4%; 2-year Bullet

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96

The Iridium Concept


Coverage
Does not work in your car
Does not work in a city
interference from buildings

Does not work as you exit an airport


Satellite crosses the sky in ca. 14 minutes
handover software aboard the satellites

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Nov 1, 2016

97

The Iridium Concept

Market Share Assumptions


Iridium
500,000 in 1st year of service
6,000,000 in 6th year

Existing Intelsat system


Laptop sized phone
140,000 subscribers
20-year history

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98

Failure to Account for Options and Distributions


Models often assume a more narrow band in variables than really exists
and assume that the upside case and the downside cases have an equal
magnitude and an equal probability.
In the case of Iridium, a satellite venture developed by Motorola, there
was a relatively narrow band around the market penetration assumption
even though the technology was very expensive and the product had
never been tried.
In another case, a company retired a nuclear plant when market prices
were very low. The decision would have been reasonable had prices
remained low, but the company did not account for the high upside
potential and limited downside risk that would have occurred from making
the decision to keep the plant operating.

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99

Resources and Contacts


My contacts
Ed Bodmer
Phone: +001-630-886-2754
E-mail: edbodmer@aol.com
Other Sources
www.sec.us.gov -- financial documents
www.finance.yahoo.com; www.googlefinance.com; www.valueline.com -- stock
prices and financial ratios
www.standardandpoors.com; www.moodys.com credit rating and other
information
www.bondsonline.com credit spreads
http://pages.stern.nyu.edu/~adamodar

www.edbodmer.com

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Nov 1, 2016

100

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