Category: Management Notes

Debt investments and equity investments recorded using the cost method are classified as trading securities, available‐for‐sale securities, or, in the case of debt investments, held‐to‐maturity securities. The classification is based on the intent of the company as to the length of time it will hold each investment. A debt investment classified as held‐to‐maturity means the business has the intent and ability to hold the bond until it matures. The balance sheet classification of these investments as short‐term (current) or long‐term is based on their maturity dates.

Debt and equity investments classified as trading securities are those which were bought for the purpose of selling them within a short time of their purchase. These investments are considered short‐term assets and are revalued at each balance sheet date to their current fair market value. Any gains or losses due to changes in fair market value during the period are reported as gains or losses on the income statement because, by definition, a trading security will be sold in the near future at its market value. In recording the gains and losses on trading securities, a valuation account is used to hold the adjustment for the gains and losses so when each investment is sold, the actual gain or loss can be determined. The valuation account is used to adjust the value in the trading securities account reported on the balance sheet.

Debt and equity investments that are not classified as trading securities or held‐to‐maturity securities are called available‐for‐sale securities. Whereas trading securities are short‐term, available‐for‐sale securities may be classified as either short‐term or long‐term assets based on management’s intention of when to sell the securities. Available‐for‐sale securities are also valued at fair market value. Any resulting gain or loss is recorded to an unrealized gain and loss account that is reported as a separate line item in the stockholders’ equity section of the balance sheet. The gains and losses for available‐for‐sale securities are not reported on the income statement until the securities are sold. Unlike trading securities that will be sold in the near future, there is a longer time before available‐for‐sale securities will be sold, and therefore, greater potential exists for changes in the fair market value.

When valuing a company as a going concern, there are three main valuation methods used by industry practitioners:

(1) DCF analysis

(2) comparable company analysis,

(3) precedent transactions.

These are the most common methods of valuation used in investment banking, equity research, private equity, corporate development, mergers & acquisitions (M&A), leveraged buyouts (LBO), and most areas of finance.

As shown in the diagram above, when valuing a business or asset, there are three broad categories that each contain their own methods. The Cost Approach looks at what it costs to build something and this method is not frequently used by finance professionals to value a company as a going concern. Next is the Market Approach, this is a form of relative valuation and frequently used in the industry. It includes Comparable Analysis Precedent Transactions.  Finally, the discounted cash flow (DCF) approach is a form of intrinsic valuation and is the most detailed and thorough approach to valuation modeling.

Method 1: Comparable Analysis (“Comps”)

Comparable company analysis (also called “trading multiples” or “peer group analysis” or “equity comps” or “public market multiples”) is a relative valuation method in which you compare the current value of a business to other similar businesses by looking at trading multiples like P/E, EV/EBITDA, or other ratios. Multiples of EBITDA are the most common valuation method.

The “comps” valuation method provides an observable value for the business, based on what companies are currently worth. Comps are the most widely used approach, as they are easy to calculate and always current.

Method 2: Precedent Transactions

Precedent transactions analysis is another form of relative valuation where you compare the company in question to other businesses that have recently been sold or acquired in the same industry. These transaction values include the take-over premium included in the price for which they were acquired.

These values represent the en bloc value of a business. They are useful for M&A transactions, but can easily become stale-dated and no longer reflective of the current market as time passes. They are less commonly used than Comps or market trading multiples.

Method 3: DCF Analysis

Discounted Cash Flow (DCF) analysis is an intrinsic value approach where an analyst forecasts the business’ unlevered free cash flow into the future and discounts it back to today at the firm’s Weighted Average Cost of Captial (WACC).

A DCF analysis is performed by building a financial model in Excel and requires an extensive amount of detail and analysis.  It is the most detailed of the three approaches, requires the most assumptions, and often produces the highest value. However, the effort required for preparing a DCF model will also often result in the most accurate valuation. A DCF model allows the analyst to forecast value based on different scenarios, and even perform a sensitivity analysis.

For larger businesses, the DCF value is commonly a sum-of-the-parts analysis, where different business units are modeled individually and added together.

The inverse relationship between the interest rate and bond prices can be explained by opportunity risk. By purchasing bonds, an investor assumes that if the interest rate increases, he or she will give up the opportunity of purchasing the bonds with more attractive returns. Whenever the interest rate increases, the demand for existing bonds with lower returns declines as new investment opportunities arise (e.g., new bonds with higher return rates are issued).

Although the prices of all bonds are affected by interest rate fluctuations, the magnitude of the change varies among bonds. Different bonds show different price sensitivities to interest rate fluctuations. Thus, it is imperative to evaluate a bond’s duration while assessing the interest rate risk.

Generally, bonds with a shorter time to maturity carry a smaller interest rate risk compared to bonds with longer maturities. Long-term bonds imply a higher probability of interest rate changes. Therefore, they carry a higher interest rate risk.

How to Mitigate Interest Rate Risk?

Similar to other types of risks, the interest rate risk can be mitigated. The most common tools for interest rate mitigation include:

1. Diversification

If a bondholder is afraid of interest rate risk that can negatively affect the value of his portfolio, he can diversify his existing portfolio by adding securities whose value is less prone to the interest rate fluctuations (e.g., equity). If the investor has a “bonds only” portfolio, he can diversify the portfolio by including a mix of short-term and long-term bonds.

2. Hedging

The interest rate risk can also be mitigated through various hedging strategies. These strategies generally include the purchase of different types of derivatives. The most common examples include interest rate swaps, options, futures, and forward rate agreements (FRAs).

Types of Interest Rate Risks

There are quite a few types of interest rate risks, which must be noted by every investor, be it an individual or a firm. These are explained below in detail.

• Price risk

The risk of change in the price of an investment bond or certificate is known as its price risk. This leads to unforeseen loss or gains while selling security in the future.

• Reinvestment risk

The risk of change in their interest rate might lead to the selling of the securities. In turn, this can lead to a loss of opportunity to re-invest in the current interest rate. Known as reinvestment risk, these types of interest rate risk can be further divided into 2 categories.

Factors Impacting Interest Rate Risks of a Firm

There are many factors, which directly impact the interest rate risk associated with a company. These factors are discussed below in detail.

• Credit risk associated with a company: A company’s debt to equity ratio is one of the primary determinants of credit risk. A rise in interest rates leads to more expense for a company since they have to pay more interest to its investors. As a result, the credit risk of an institution increases.

• Length of loan terms: Length of loan terms, both as a borrower as well as a lender, are major determinants of the interest rate risks of an institution. Companies and ventures charging a fixed interest on its receivable accounts might have baselines dropping down if they need to refinance themselves. This, in turn, increases the risk involved with the shift in interest rates.

• Market fluctuation: Market fluctuation and inflation can immensely impact the risk related to interest rates since refinancing, or other such necessities can become more difficult during such times. Such circumstances often lead to a situation where outgoing cash flow crosses the incoming cash flow, making it more difficult for the institution to function.

• Foreign exchange rates: Any company which has a foreign debt is also affected by a change in foreign exchange rates. The associated interest rate risks increase with fall in the price of the prevalent currency, while the inverse happens in case there is a rise in the price of the currency.

Manage Interest Rate Risks

It is important to learn how to manage interest rate risk since it can potentially make an institution dysfunctional and ultimately bankrupt. The few methods which can be employed to manage the interest rate and in turn associated risks are discussed below.

• Diversification: Among the different options that can be employed by an institution to manage the interest rate risk associated with them, one of the most effective options is to diversify their financial investments. For investors who invest in both equity and fixed investment options, this is the best method to manage the risks associated with interest rates.

• Safer investments: The safest option for investors who are trying to reduce the risks associated with interest rates is to invest in bonds and certificates, which have short maturity tenure. Securities with short maturity tenure are less susceptible to the fluctuations in interest rate. This method for interest rate management reduces the chance of being subjected to interest rate fluctuations since they have low maturity tenure.

• Hedging: Hedging is an option, which can be used successfully to reduce the risks related to interest rates. Generally referring to the purchase of various types of derivatives which are available, there are many ways of hedging. A few of the hedging strategies are illustrated in the table below.

• Selling long-term bonds: A common method which is often used is that of selling the long-term bonds. This effectively clears up the investment funds for re-investment in bonds with higher returns, thus allowing investors to manage the interest rate risk better. It is advisable to re-invest in securities which have shorter maturity tenure since these carry lesser risks related to interest rates.

• Purchasing floating-rate bonds: Floating rate bonds, as suggested by its name, have a rate of interest, which is directly related to market fluctuations. It is advisable to invest in these securities since being related to the market fluctuations, the return on these investments go up and down too. These should also be bought in a healthy mix of long-term and short-term investments. While this cannot always be used to calculate the exact return, it is helpful in reducing the interest rate risk involved.

It is important for investors to note the above risk management options since risks related to interest rates can greatly affect a company or an investor. Evident from the interest rate risk example mentioned above in this article, managing the risk is necessary to prevent the devaluation of any investment security.

Interest rate risk is the potential for investment losses that result from a change in interest rates. If interest rates rise, for instance, the value of a bond or other fixed-income investment will decline. The change in a bond’s price given a change in interest rates is known as its duration.

Interest rate risk can be reduced by holding bonds of different durations, and investors may also allay interest rate risk by hedging fixed-income investments with interest rate swaps, options, or other interest rate derivatives.

• Interest rate risk is the potential that a change in overall interest rates will reduce the value of a bond or other fixed-rate investment:
• As interest rates rise bond prices fall, and vice versa. This means that the market price of existing bonds drops to offset the more attractive rates of new bond issues.
• Interest rate risk is measured by a fixed income security’s duration, with longer-term bonds having a greater price sensitivity to rate changes.
• Interest rate risk can be reduced through diversification of bond maturities or hedged using interest rate derivatives.

Interest rate changes can affect many investments, but it impacts the value of bonds and other fixed-income securities most directly. Bondholders, therefore, carefully monitor interest rates and make decisions based on how interest rates are perceived to change over time.

For fixed-income securities, as interest rates rise security prices fall (and vice versa). This is because when interest rates increase, the opportunity cost of holding those bonds increases that is, the cost of missing out on an even better investment is greater. The rates earned on bonds therefore have less appeal as rates rise, so if a bond paying a fixed rate of 5% is trading at its par value of $1,000 when prevailing interest rates are also at 5%, it becomes far less attractive to earn that same 5% when rates elsewhere start to rise to say 6% or 7%. In order to compensate for this economic disadvantage in the market, the value of these bonds must fall – because who will want to own a 5% interest rate when they can get 7% with some different bond.

Therefore, for bonds that have a fixed rate, when interest rates rise to a point above that fixed level, investors switch to investments that reflect the higher interest rate. Securities that were issued before the interest rate change can compete with new issues only by dropping their prices.

Interest rate risk can be managed through hedging or diversification strategies that reduce a portfolio’s effective duration or negate the effect of rate changes.

The Price Earnings Ratio (P/E Ratio) is the relationship between a company’s stock price and earnings per share (EPS). It is a popular ratio that gives investors a better sense of the value of the company. The P/E ratio shows the expectations of the market and is the price you must pay per unit of current earnings (or future earnings, as the case may be).

Earnings are important when valuing a company’s stock because investors want to know how profitable a company is and how profitable it will be in the future. Furthermore, if the company doesn’t grow and the current level of earnings remains constant, the P/E can be interpreted as the number of years it will take for the company to pay back the amount paid for each share.

P/E Ratio in Use

Looking at the P/E of a stock tells you very little about it if it’s not compared to the company’s historical P/E or the competitor’s P/E from the same industry. It’s not easy to conclude whether a stock with a P/E of 10x is a bargain, or a P/E of 50x is expensive without performing any comparisons.

The beauty of the P/E ratio is that it standardizes stocks of different prices and earnings levels.

The P/E is also called earnings multiple. There are two types of P/E: trailing and forward. The former is based on previous periods of earnings per share, while a leading or forward P/E ratio is when EPS calculations are based on future estimates, which predicted numbers (often provided by management or equity research analysts).

Price Earnings Ratio Formula

P/E = Stock Price Per Share / Earnings Per Share

or

P/E = Market Capitalization / Total Net Earnings

or

Justified P/E = Dividend Payout Ratio / R – G

where;

R = Required Rate of Return

G = Sustainable Growth Rate

Why Use the Price Earnings Ratio?

Investors want to buy financially sound companies that offer a good return on investment (ROI). Among the many ratios, the P/E is part of the research process for selecting stocks, because we can figure out whether we are paying a fair price. Similar companies within the same industry are grouped together for comparison, regardless of the varying stock prices.  Moreover, it’s quick and easy to use when we’re trying to value a company using earnings. When a high or a low P/E is found, we can quickly assess what kind of stock or company we are dealing with.

High P/E

Companies with a high Price Earnings Ratio are often considered to be growth stocks. This indicates a positive future performance, and investors have higher expectations for future earnings growth and are willing to pay more for them. The downside to this is that growth stocks are often higher in volatility and this puts a lot of pressure on companies to do more to justify their higher valuation. For this reason, investing in growth stocks will more likely be seen as a risky investment. Stocks with high P/E ratios can also be considered overvalued.

Low P/E

Companies with a low Price Earnings Ratio are often considered to be value stocks. It means they are undervalued because their stock price trade lower relative to its fundamentals. This mispricing will be a great bargain and will prompt investors to buy the stock before the market corrects it. And when it does, investors make a profit as a result of a higher stock price. Examples of low P/E stocks can be found in mature industries that pay a steady rate of dividends.

Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. Yield to maturity is considered a long-term bond yield but it is expressed as an annual rate. In other words, it is the internal rate of return (IRR) of an investment in a bond if the investor holds the bond until maturity, with all payments made as scheduled and reinvested at the same rate.

Because yield to maturity is the interest rate an investor would earn by reinvesting every coupon payment from the bond at a constant interest rate until the bond’s maturity date, the present value of all the future cash flows equals the bond’s market price. An investor knows the current bond price, its coupon payments and its maturity value, but the discount rate cannot be calculated directly. However, there is a trial-and-error method for finding YTM with the following present value formula:

Alternative formula for finding YTM

Each one of the future cash flows of the bond is known and because the bond’s current price is also known, a trial-and-error process can be applied to the YTM variable in the equation until the present value of the stream of payments equals the bond’s price.

Solving the equation by hand requires an understanding of the relationship between a bond’s price and its yield, as well as of the different types of bond pricings. Bonds can be priced at a discount, at par or at a premium. When the bond is priced at par, the bond’s interest rate is equal to its coupon rate. A bond priced above par, called a premium bond, has a coupon rate higher than the realized interest rate and a bond priced below par, called a discount bond, has a coupon rate lower than the realized interest rate. If an investor were calculating YTM on a bond priced below par, he or she would solve the equation by plugging in various annual interest rates that were higher than the coupon rate until finding a bond price close to the price of the bond in question.

Calculations of yield to maturity (YTM) assume that all coupon payments are reinvested at the same rate as the bond’s current yield and take into account the bond’s current market price, par value, coupon interest rate and term to maturity. The YTM is merely a snapshot of the return on a bond because coupon payments cannot always be reinvested at the same interest rate. As interest rates rise, the YTM will increase; as interest rates fall, the YTM will decrease.

Risk retention is a company’s decision to take responsibility for a particular risk it faces, as opposed to transferring the risk over to an insurance company. Companies often retain risks when they believe that the cost of doing so is less then the cost of fully or partially insuring against it.

If a company retains a certain risk, it will have to pay for losses from that risk out of its own reserve funds. For this reason, it is important for companies to make sure that they can properly afford to pay for potential losses before they make the decision to retain particular risks. Companies may retain risks if the premiums for insuring against it are particularly high.

A risk retention group (RRG) is an alternative risk transfer entity created by the federal Liability Risk Retention Act (LRRA). RRGs must form as liability insurance companies under the laws of at least one state its charter state or domicile. The policyholders of the RRG are also its owners and membership must be limited to organizations or persons engaged in similar businesses or activities, thus being exposed to the same types of liability. Most RRGs are regulated as captive insurance companies. However, RRGs domiciled in states without captive law are regulated as traditional insurance companies.

A risk retention group is a corporation or limited liability association formed under the laws of any state for the primary purpose of assuming liability exposures on behalf of its members. Members of the group must be engaged in similar activities or related with respect to liability exposures by virtue of any related or common business exposure, trade, product, service, or premise. Members must have an ownership interest in the group and only members may benefit from the group. Risk retention groups only apply to liability loss exposures.

RRGs provide their members with the following benefits:

• Program control
• Long-term rate stability
• Customized Loss control and risk management practices
• Dividends for good loss experience
• Access to reinsurance markets
• Stable source of liability coverage at affordable rates
• Multi-state operations

Advantage of Risk Retention

• Avoidance of multiple state filing and licensing requirements
• Member control over risk and litigation management issues
• Establishment of stable market for coverage and rates
• Elimination of market residuals
• Exemption from countersignature laws for agents and brokers
• No expense for fronting fees
• Unbundling of services

Disadvantage Risk Retention

• Risks are limited to liability insurance
• Not permitted to write risks outside its homogenous group
• No guaranty fund coverage for members
• May not be able to comply with proof of financial responsibility laws
• Can be without a financial rating from a rating agency

A transfer of risk is a business agreement in which one party pays another to take responsibility for mitigating specific losses that may or may not occur. This is the underlying tenet of the insurance industry.

Risks may be transferred between individuals, from individuals to insurance companies, or from insurers to reinsurers. When homeowners purchase property insurance, they are paying an insurance company to assume various specific risks associated with homeownership.

When purchasing insurance, the insurer agrees to indemnify, or compensate, the policyholder up to a certain amount for a specified loss or losses in exchange for payment.

Insurance companies collect premiums from thousands or millions of customers every year. That provides a pool of cash that is available to cover the costs of damage or destruction to the properties of some small percentage of its customers. The premiums also cover administrative and operating expenses, and provide the company’s profits.

Life insurance works the same way. Insurers rely on actuarial statistics and other information to project the number of death claims it can expect to pay out per year. Because this number is relatively small, the company sets its premiums at a level that will exceed those death benefits.

Working

Risk transfer is a common risk management technique where the potential of an adverse outcome faced by an individual or entity is shifted to a third party. To compensate the third party for bearing the risk, the individual or entity will generally provide the third party with periodic payments.

The most common example of risk transfer is insurance. When an individual or entity purchases insurance, they are insuring against financial risks. For example, an individual who purchases car insurance is acquiring financial protection against physical damage or bodily harm that can result from traffic incidents.

As such, the individual is shifting the risk of having to incur significant financial losses in a traffic incident to an insurance company. In exchange for bearing such risks, the insurance company will typically require periodic payments from the individual.

Reinsurance companies accept transfers of risk from insurance companies.

The insurance industry exists because few individuals or companies have the financial resources necessary to bear the risks of the loss on their own. So, they transfer the risks.

Risk Transfer to Reinsurance Companies

Some risks are too big for insurance companies to bear alone. That’s where reinsurance comes in.

When insurance companies don’t want to assume too much risk, they transfer the excess risk to reinsurance companies. For example, an insurance company may routinely write policies that limit its maximum liability to $10 million. But it may take on policies that require higher maximum amounts and then transfer the remainder of the risk in excess of $10 million to a reinsurer. This subcontract comes into play only if a major loss occurs.

Property Insurance Risk Transfer

Purchasing a home is the most significant expense most individuals make. To protect their investment, most homeowners buy homeowners insurance. With homeowners insurance, some of the risks associated with homeownership are transferred from the homeowner to the insurer.

Insurance companies typically assess their own business risks in order to determine whether a customer is acceptable, and at what premium. Underwriting insurance for a customer with a poor credit profile and several dogs is riskier than insuring someone with a perfect credit profile and no pets. The policy for the first applicant will command a higher premium because of the higher risk being transferred from the applicant to the insurer.

• A transfer of risk shifts responsibility for losses from one party to another in return for payment.
• The basic business model of the insurance industry is the acceptance and management of risk.
• This system works because some risks are beyond the resources of most individuals and businesses.

Methods of Risk Transfer

There are two common methods of transferring risk:

1. Insurance policy

As outlined above, purchasing insurance is a common method of transferring risk. When an individual or entity is purchasing insurance, they are shifting financial risks to the insurance company. Insurance companies typically charge a fee an insurance premium for accepting such risks.

2. Indemnification clause in contracts

Contracts can also be used to help an individual or entity transfer risk. Contracts can include an indemnification clause  a clause that ensures potential losses will be compensated by the opposing party. In simplest terms, an indemnification clause is a clause in which the parties involved in the contract commit to compensating each other for any harm, liability, or loss arising out of the contract.

For example, consider a client that signs a contract with an indemnification clause. The indemnification clause states that the contract writer will indemnify the client against copyright claims. As such, if the client receives a copyright claim, the contract writer would

• Be obliged to cover the costs related to defending against the copyright claim.
• Be responsible for copyright claim damages if the client is found liable for copyright infringement.