What is "fair value"?

What is the fair value of an asset? Sounds like a simple question but the question has taken on a life of its own, given recent changes in both accounting and legal standards. In both contexts, the rule makers contend that their objective is to ensure that assets are recorded at fair value and have created rules to ensure that this happens.

Let us start with accounting. The push towards fair value accounting has now become an article of faith for accounting standards boards. In the United States, FAS 157 (the very fact that we are at rule number 157 tells you something about how accountants think - the more rules the better) provides a synopsis of what the accounting definition of fair value. I have expressed my skepticism about fair value accounting before on this blog and made my case for why this is not only a good idea. 

In legal circles, the hypocrisy about fair value is even greater. Appraisers are supposedly unbiased and fair in their estimates in value, no matter who they work for or which side of the legal divide pays them. The Internal Revenue Service has made this requirement explicit in its guidelines for appraisers. All of the valuation appraiser organizations - The National Association of Certified Valuation Analysts (NACVA), American Institute of Certified Public Accountants (AICPA), American Society of Appraisers (ASA), Institute of Business Appraisers (IBA)- argue that their members provide fair, unbiased estimates of the values of businesses.

I have a simple definition (and test) of fair value. If an asset is valued at fair value, the appraiser (or his client) should be indifferent to being either  a buyer or a seller at that value. If you are an appraiser valuing your business for tax purposes, would you really be willing to sell your business at the appraised value? If the answer is yes, you have stayed true the notion of fair value. If the answer is no, the talk about fair value is just talk... If you are the tax authority valuing the same business (for tax purposes), would you be willing to buy the business at the appraised value? If the answer is no, you too are guilty of hypocrisy.

Let's be honest. Asking "biased" appraisers to estimate fair value is a hopeless task; the bias comes from the way appraisers get compensated/ paid.  Either change the way that we hire/pay appraisers or accept that each side's appraisers are going to come up with valuations that reflect which side of the divide they are coming from.

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Parent versus Consolidated financial statements

My last post on valuing the Tata companies, all of which have significant holdings in other companies, has raised a natural follow up question. When valuing a company, is it better to use stand-alone parent company financial statements or should we use consolidated financial statements?  More generally, which of these two should you focus on as an investor/manager/regulator?

Accounting Background
The question of whether to use parent-company or consolidated statements becomes an issue only when a company has cross holdings in other companies. To illustrate the difference, consider a simple example, where company A owns 60% of company B. Company A can report its financial results in a parent company statement or in a consolidated statement.
a. If it chooses to report the financial results in a parent company statement, the operating income statement will center on just company A's operating results. The revenues and operating income will reflect only company A's operations. However, there will be a line item on the income statement, below the operating income line, which will include 60% of the net income of company B.
On the balance sheet, only the operating assets and liabilities of company A will be recorded. However, there will be a line item on the asset side of the balance sheet that reflects the accountant's estimate of the value of the 60% of company B; the rules on how to estimate this value and how often it has to be updated can vary from country to country.
b. If the financial results are in a consolidated statement, the operations of company A and B will be combined. As a result, the revenues, operating income and other operating numbers (depreciation, cost of goods sold) will reflect the sum of those numbers for companies A and B. In a similar vein, the assets and liabilities on the balance sheet will reflect the combined values of companies A &B, notwithstanding the fact that company A owns only 60% of company B. The accounting adjustment for the 40% of company B's equity that does not belong to company A takes the form of minority interest, shown on the liability side of the consolidated balance sheet. Again, the rules on how to estimate this value and how often it gets updated varies across countries.

A final note on consolidation. Consolidated statements exclude intra company transactions. Thus, if company A sells $ 100 million in products to company B, the parent company financials will show revenues of $100 million for company A and costs of $ 100 million for company B, but the consolidated statements will net them out and show nothing.

Why would a company choose to use one versus the other?
It is not always a choice. In the United States, companies are required to consolidate financial statements, if they own a controlling stake of a subsidiary (defined as >50% of the outstanding equity). They do not have to consolidate minority holdings in companies. In general, US companies are required to report only consolidated statements and do not have to provide parent company financials, but these consolidated statements represent a mix of consolidation (for majority stakes) and parent company rules (for minority stakes).

The rules for consolidation are similar in international accounting standards. In much of Europe and in many emerging markets, companies will report both parent company and consolidated statements in the same annual report, with wildly different results. What does add to the confusion is that the rules on consolidation still vary across markets.

All of the Tata companies that I valued had both parent company and consolidated financial statements in their annual reports. Tata Steel, for instance, had a parent company statement, where its holding of equity in Corus Steel was shown as an asset on the balance sheet and a consolidated statement, which reflected the combined revenues and operating results of the companies, with a minority interest item reflecting the portion of Corus Steel that is not owned by Tata Steel.

Valuation fundamentals
 In theory, you can value a company using either parent company or consolidated statements, with the following key differences:
a. Parent company financials: If you value a firm, using parent company financials, you are using the operating income and cash flows (cap ex, depreciation, working capital) of just the parent company. Consequently, discounting the cash flows at the cost of capital yields a value for just the parent company. To value the equity in this company, you will have to subtract out net debt in the parent company and add the value of equity in cross holdings, using either the book value of these holdings as a base or through an intrinsic value of the subsidiaries.
b. Consolidated financials: If you value a firm, using consolidated financials, you have valued the parent firm and its consolidated subsidiaries together, since your earnings and cash flows reflect the combined earnings and cash flows of the companies. To get to the value of equity in the company, you will have to subtract out the net debt of the combined companies and the estimated value of the portion of the equity in the subsidiary that does not belong to the parent company. Again, this estimate can be based upon the book value of minority interest or on the intrinsic value of the subsidaries.

Which set of statements for valuation?
If I had access to full information on both the parent and the subsidiaries, I would value a company based upon its parent company financials and then value every one of its subsidiaries, using their individual financial statements. I have two reasons for this bias:
1. This would give me the maximum flexibility in terms of valuation inputs - the cash flows, growth and risk can be very different across parent companies and subsidiaries. The final value of equity in the company would then be the summation of the values of equity holdings in the parent company and all subsidiaries.
2. It allows me to avoid the two items in consolidated financial statements that give me headaches - goodwill (and whatever accountants choose to do with that cursed item) and minority interests (where I have trust an accountant to estimate the value of a holding)


In practice, though, this ideal is not easy to reach. In many cases, there will be incomplete or no financial statements available for subsidiaries. In this case, it becomes a choice between two imperfect estimates of value, the book value of the holdings in subsidiaries in parent company statements or the minority interests in consolidated statements.  The more homogeneity there is between the parent company (same business, same growth and profitability trends), the greater the argument for using consolidated financial statements, valuing the combined company and subtracting out the estimated value of the minority interests in the subsidiary. As

In the case of Tata Steel, for instance, I chose to value Tata Steel as a stand alone company in 2009 and added the book value of the Corus holding to arrive at the value of equity in Tata Steel overall. I could have valued the company using consolidated statements and subtracted out the value of minority interests. The choice ultimately was driven by the fact that Tata's Steel's consolidated statements were still in a state of flux in 2008-09, two years after the acquisition of Corus. As Corus is integrated in Tata Steel, the consolidated statements should become more informative. In fact, the 2009-10 consolidated statement looks far more settled and I may try to value the company based upon these numbers now.


More generally, which statements should you use to assess a company?
While the answer I have given is valuation focused, there are many constituent groups that use financial statements. Bankers and ratings agencies look at them, so that they can assess default risk. Portfolio managers and investors use the numbers from financial statements to compute ratios and multiples (PE, EV/EBITDA..) Since the rating is for a company, with its cross holdings, and the multiple is for the equity in the consolidated company, there is an argument to be made that we should be looking a consolidated statements. However. this makes sense if and only if the parent company has holdings in subsidiaries with very similar fundamentals - risk, growth and cash flows. If not, it would make more sense to judge the parent company and its subsidiaries separately and to make comparisons to different peer groups.

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Cash and Cross holdings

I am sorry about the long break between posts but I was on the road for much of the last two weeks and grading exams prior to that. I started my road trip with sessions in Slovenia and Croatia and continued on to India to make a presentation to the Tata Group, one of India's premier family groups, with a long history of operating in every aspect of Indian business. As part of the preparation, I did value a Slovenian pharmaceutical company (Krka), a Croatian tobacco company (Adris Grupa) and four Tata companies (Tata Chemicals, Tata Steel, Tata Motors and Tata Consulting Services). The presentations and the spreadsheets containing the valuations are online and can be accessed by going to:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/country.htm

Without belaboring the details, there were two key issues that came up when valuing Adris Grupa and the Tata Companies.

1. Cash holdings: Adris Grupa, as a tobacco company with significant operating cash flows, has accumulated a very large cash balance; it amounts to 20% or greater of the overall value of the firm. Adris is clearly not the only company that accumulates cash and it is not a phenomenon just restricted to emerging markets. Technology companies in the United States, such as Apple and Microsoft, have also been avid cash accumulators. While the conventional valuation practice with cash has been to add the cash balance to the value of operating assets, thus adopting the common sense rule that a dollar in cash has to be worth a dollar, there is substantial evidence that markets do not always treat cash as a neutral asset. In particular, markets seem to view companies that generate poor returns on their operating assets (less than the cost of capital) and accumulate cash with disfavor, while being much more sanguine about companies with good investment track records and substantial cash. Apple, for instance, is clearly not being penalized (and may be even be rewarded) for its large cash balance; after the most recent decade, investors trust the company to find good uses for the cash. In the Adris valuation, one of the concerns I raised was that the company's return on capital has lagged its cost of capital.It is therefore possible that the market may be discounting the cash holdings; a Croatian kuna in cash may be valued at less than a kuna.


2. Cross holdings: The Tata companies that I valued, with the exception of Tata Consulting Services, shared a common feature. A third to half the value that I estimated for each company came from  holdings in other Tata companies. In effect, investing in any Tata company is a joint investment in that company and a portfolio of 25-30 other Tata companies. While one reason for this cross holding structure is corporate control - it allows the family to preserve its control of the group companies - there are also more benign reasons, rooted in history. In the decades before the 1990s, Indian investors had little access to financial information from the company, let alone analyst reports or investment analysis. In that period, these investors had to essentially buy companies based on how much they trusted the promoters of the company, and a trusted family name became a proxy for research. In addition, when capital markets are undeveloped, having an internal family group capital market, where excess cash at some companies can be redirected to other companies that need the cash can be a competitive advantage.

The Indian equity markets today are different. While Indian companies have their own share of scandals and investment advice/ equity research can be tainted, the market is wider (thousands of publicly traded companies) and much deeper (more investors both from Indian and from outside). The cross holdings at family group companies can now become a valuation problem for two reasons:

1. To value one company, you have to value dozens:  Consider a firm with holdings in 25 other companies. Even if we could access information on these companies (because they are public), a thorough analysis of the firm would require a valuation of 26 companies. (Using the book value of these holdings, which are not marked to market, will yield skewed estimates. Using the market values of these holdings risks feeding any market mistakes into your valuation).
2. Some cross holdings cannot be valued: With many family group companies, some of the companies in the group are privately owned and never go public. As a consequence, there is little or no information that can be used to value companies. We have no choice but to use book value.

If you carry these concerns through to their logical conclusion, it is possible that investors either unconsciously (by using book value) or consciously (by discounting the market value of the cross holdings) will reduce the values of family group companies below what they would have been worth as independent companies. In effect, the sum of the parts will be greater than the whole. I have a paper on valuing cash and cross holdings that explores the technical details of this discount:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=841485

In my next post, I hope to examine the link between corporate governance and the phenomenon of cash and cross holdings.

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"We are not in Kansas anymore"

It looks like that they have found the culprit for the 1000-point intraday swing on the Dow 30 on May 6. It turns out that rather than the hedge funds that were initially suspected, it was a Kansas-based money management firm, Waddell & Reed Financial, that traded 75000 e-mini S&P 500 contracts between 2.32 and 2.51 pm on May 6. That amounted to 9% of the trading volume on e-mini contracts during that period and all of the trading was executed by one trader at the firm. Incidentally, the CME report that uncovered this news also found that neither the trader nor the firm were acting imprudently or were at fault. This news item may still leave you a little bemused. How does one trader at a small money management firm cause a drop in market value of billions? And how can they not be at fault if they caused a market collapse? So, here is my attempt at providing an explanation.

What are e-mini contracts?
E-mini contracts are future contracts on the S&P 500. The "mini" in the name refers to the fact that each contract is $50 times the level of the index. (If the S&P 500 is at 1200, each contract is for a notional value of $60,000) E-mini contracts were introduced in the late 1990s by the Chicago Mercantile Exchange to provide a "smaller size" alternative to the long-standing S&P 500 futures contracts which were set to $500 times the level of the index; they have since been dropped to $250 times the level of the index.

How do investors use these contracts?
As with all futures contracts, there are speculators and hedgers in the e-mini market. The speculators buy or sell the e-mini to try to profit from overall market movements. Thus, a bullish (bearish) investor will buy (sell) e-mini contracts and make money if they are right on market direction. (If you buy 100 contracts and the S&P 500 moves up 80 points, you will make 100* 80 * 50 = $400,000; the 50 refers the fact that the futures contract is $50 times the index) The hedgers use the index to protect existing portfolio positions. Thus, a portfolio manager who wants to either protect profits already made or one who desires a floor on his or her losses will sell e-mini futures. (A portfolio manager who has $ 1 billion in equities can sell enough futures contracts to ensure that the value of the position does not drop below $ 900 million. Generally speaking, the more insurance you want, the more futures contracts you will have to sell. In more technical terms, you are creating a synthetic put on your portfolio, using options, and the number of futures contracts you will need to sell can be extracted using an option pricing model)

In many ways, the hedging position with futures is a lot more volatile than the speculative position, simply because the degree of selling is tailored to what the index does. As the index falls, the selling will often accelerate. partly because the point at which different portfolio managers hedge can vary. Thus, some portfolio managers may begin their hedging when the market drops 3%, others at 5% and still others at 10%.


How can futures affect the level of the index?
With financial futures, there is a third player that we have not mentioned in the section above, the arbitrageurs. Arbitrageurs have neither a market view nor do they have a portfolio to hedge. Instead, they are looking to make riskless profits, To prevent these profits, the futures price and the spot price are linked together in a rigid relationship:
Futures Price = Spot price (1 + riskfree rate - dividend yield)
To see why, assume that the S& P 500 is at 1000 right now, that the riskfree rate is 5% and that the dividend yield is 2%. Assume also that the one-year futures price on the index is 1045. Here is the arbitrage:
1. Borrow 1000 at the riskless rate and buy the index today at its spot price of 1000.
2. Sell the one-year futures contract at 1045.
3. During the next year collect dividends on the stocks in the index (2% of 1000 = 20). At the end of the year, deliver the stocks in the index in fulfillment of the futures contract and collect 1045. Pay the interest at the riskfree rate on the initial borrowing of 1000 (from step 1) and pocket the difference:
Profit = 1045 - 1000*.05 +20 = 15
To prevent this profit from occurring, the futures price has to be 1030. There are points at which you can quibble - being able to borrow at the riskfree rate and knowing the dividends for the next year - but they are minor ones, especially for the larger institutional players. The overall dividend yield on the S&P 500 index is very predictable and you can borrow at close to the riskfree rate, especially if you can back the borrowing up with marketable securities (as is the case here).

This futures-spot relationship creates the link. If one (spot or futures price) moves, the other has to follow. Thus, if there is an imbalance in the futures market, the futures price will change and the spot will follow. On May 6, here is how the script unfolded. The sell order placed by the trader at Waddell and Read was large enough to cause the e-mini futures price to drop significantly and the spot market had to follow. The fact that the trade was entirely driven by liquidity or hedging concerns (and not by information) resulted in a swift correction of both the spot and futures markets, with both reversing the losses by 3.30 pm.

What should be done about this?
I think that the May 6 collapse was an aberration. In what sense? The trade by the W&R trader occurred at a point in the day when the market was already skittish - it was down 250 points as worries about Greek default were rampant. When traders get antsy, they look for clues in trading by others. In other words, they assume that large trades, especially anonymous ones, must be coming from more informed traders (such as the Greek central banker) and they follow the trade.

While there is always the potential for this type of panic with or without futures markets, the existence of futures contracts has made it easier to create this type of panic. To the regulatory-minded, the solution seems simple. Ban futures trading or add more restrictions to the trading.  I disagree with the sentiment and think more harm than good will come out of it. As an investor who uses futures contracts very rarely and only to hedge, I still benefit from the liquidity created by these markets and bear little or no cost, simply because I choose not to trade frequently. In fact, as an intrinsic-value driven, long term investor, selling panics such as these can actually be opportunities to take positions in companies that I have always wanted to buy. For short term traders, though, futures markets may increase intraday volatility and thus their perception of risk in equities. I cannot speak for them but they are short term traders by choice!!

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The Goldman indictment

I waited a couple of after the indictment of Goldman to post my thoughts on it, since I have mixed feelings on the topic. If you want to take a look at the indictment, you can go here:
www.sec.gov/litigation/complaints/2010/comp-pr2010-59.pdf
As most of you who have followed my work know, I have been been more negative on the products and practices of investment banks than most of my academic brethren. I think that investment bankers promise more than they can deliver and that there is far less value in most of the products that they sell than they claim in their sales pitch. On the Goldman indictment, my sympathies lies with Goldman because I feel that this it is selective prosecution, based upon 20/20 hindsight, designed to advance a larger agenda of "financial regulation and oversight" by the Federal government and Goldman happens to be (at the moment) every one's favorite bogeyman.

First, the background. The deal that has Goldman in hot water is titled Abacus and was a multi-billion dollar Collateralized Debt Obligation (CDO), a fancy terms for a bond backed up by assets, and in this case, the backing came from real estate mortgages. On the face of it, the deal looks unremarkable. In fact, Business Insider was able to get its hand on the pitchbook used by Goldman for the deal:
http://www.businessinsider.com/check-out-the-66-page-presentation-on-goldmans-abacus-cdo-deal-2010-4
The pitchbook has all the hallmarks of a standard sales presentation - the obligatory disclaimer that runs 3 pages, 63 more pages that reveal less than they should, uninformative (but colorful) graphs, and tables filled with enough numbers to numb the brain (which is the objective).

So, what made this deal stand out? Here are some of the factors for its being singled out:
1. A "big loser": The securities bundled in the Abacus deal were priced at the height of the housing bubble. Like other housing backed securities it did lose money. However, it was one of the "biggest losers", with losses exceeding in the billions.
2. The John Paulson connection: The seller of the securities in the Abacus deal was the hedge fund headed by John Paulson, one of the few winners in the housing bubble. His subsequent notoriety, chronicled in a book, has made him into a sage, at least in hindsight, about the housing bubble and its implosion.
3. Goldman was the intermediary: Among investment banks, Goldman Sachs was viewed as the only one that was able to cut its losses in the mortgage backed securities debacle and escape relatively unscathed. The fact that it was the broker in this transaction has evoked suspicion that is was partnering with Paulson to take advantage of the suckers on the other side.

The indictment of Goldman seems to rest of two claims:
1. According to the SEC, Goldman Sachs claimed wrongly that Paulson was buying the securities (packaged under Abacus), when it was the seller. I checked through the sales presentation that I linked to earlier to see if there was an explicit mention of Paulson but I did not find any. It is entirely possible that Goldman left the implicit understanding that it was a buyer (I assume that the SEC has something - emails, phone calls, phone video - to back up its claim).

2. Goldman had advance knowledge of the collapse of the housing market and took advantage of their clients: Even the SEC seems to recognize that this is a much weaker legal argument, but the Senate committee investigating Goldman Sachs had no qualms about making this the center piece of its accusations. Using emails from from Fabrice Tourre, who in addition to being an employee of Goldman seems to have forgotten that emails are not erased on the server when you delete them on your computer, senators accused Goldman of knowing that the housing market was going to collapse and actively exploiting investors by selling them securities that would be destroyed by this collapse.

I know that these are legal issues subject to the legal rules on what comprises reasonable. However, if this case were subject to what the rest of us (who are not lawyers and have the benefit of common sense) think as reasonable, it just does not stand up to scrutiny:

1. What if Paulson were the seller rather than the buyer and why should the buyer of these bonds (ACA) have cared? Implicit in the SEC's argument that holding back on the identity of the seller (Paulson) was somehow a deal breaker for the buyers of the securities involved in the Abacus deal. Notwithstanding the halo that Paulson might have acquired as a soothsayer in the housing bubble, he was a voice in the wilderness in 2007 on housing prices. I seriously doubt that ACA would have not bought these securities, even if they had known that Paulson was the seller. In addition, I don't think any intermediary in this market (securities) is required to reveal to the buyer the identity and motives of the seller.

2. Goldman knew the housing market was going to collapse and took advantage of its clients: I find this argument to be beyond absurd, especially given the evidence to back it up. In fact, let's take this argument at face value. If Goldman were that prescient about the housing market in 2007, there was a dozen other ways (most of them more profitable and less work than Abacus) that they could have made money on this belief. So, why construct this convoluted way to make money? Furthermore, investment banks are not monolithic when it comes to views about markets. Having worked with investment banks for almost 30 years, I can guarantee you that at any point in time, views about whether a particular market is under or over priced (equity, bonds, real estate) diverge across an investment bank. For every strategist/analyst at the bank who is bullish, there is one who is just as strongly bearish. Thus, I find Tourre's emails (about what he thinks about the market) to be sensational but completely irrelevant to this discussion. (As an analogy, think of the following: If you were a real estate broker who believes that houses are over priced, should you stop selling houses to clients who want to buy houses?)

Did Goldman take advantage of "naive" clients"? Probably, but that is the nature of trading. All trading is predicated on exploiting the lack of information or good sense on the part of the the investor on the other side of the trade. I don't like what they did because it is bad business practice, in general, to take advantage of your customers. However, it is not illegal. If it were, home buyers should be suing brokers who sold them houses in 2007 and 2008 while secretly believing that these houses were overpriced, customers should be suing electronics salesmen who sold them video disc players, knowing that DVD players were the standard of the future, and voters should be suing politicians who told them that their pension and health care benefits were secure, while undercutting the basis for these benefits.

I know that a lot of people would like to see Goldman fall, and that some of them work at Goldman's competitors. While I understand the urge to bring the mighty back to earth, I think that failing to support Goldman at this time is a huge mistake. To me, this case reveals everything that is wrong with both politics and law - the use of ex-post evidence to back up a case (Paulson made money of the housing crash.. so, he must have known that the crash was coming), suspicious timing (just in time for the new law on regulating bank) and scapegoating.

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Currency Choices in Valuation

I am currently in Bogota, Colombia, doing a seminar in risk. One of the topics that came up yesterday was about the choice of currency to do a valuation in, and how it affects your inputs. In particular, the question that I was asked was whether an analyst should value a Colombian company in Colombian pesos or US dollars, and the implications of this choice. Here is how I responded:

Which currency should I do my valuation in?
If you do your valuation right, it should not matter. Your value for a company should be the same, no matter what currency you choose to value it in. Thus, a company that is under valued by 20%, when you do your valuation in pesos, should remain under valued by 20%, when you do your valuation in US dollars.
Given this proposition, you should pick the currency with which you are most comfortable with and where it is easiest to get the financial information. My instinct, given the latter requirement, is to do valuations in the local currency since most financial statements are richer and more detailed in the local currency. Your choice of currency should not be a function of the investor for whom you are doing the valuation. Thus, you should not try to value a Colombian company in US dollars, just because the investor for whom you are doing the valuation is dollar based.
 
How is my discount rate affected by my currency choice?
In the context of discount rates, the input that is most influenced by the currency choice is the riskfree rate. If you work with a higher inflation currency, the riskfree rate will be higher. In the Colombian context, the Colombian peso riskfree rate was 6.5% and the US dollar riskfree rate was 4% last week. The difference of 2.5% is entirely attributable to differences in expected inflation.

Just as a side note, while getting a US dollar riskfree rate is easy (I used the T.Bond rate), I had to work a little harder to get the riskfree rate in pesos, since the peso-denominated Colombian government bond does have some default risk embedded in it. In particular, I subtracted out the default spread for the Colombian government (about 2%) from the bond rate (8.5%) to get to the riskfree rate.

The other inputs remain pretty stable. Betas should measure the business risk of the company. I have never understood the rationale of a widely used practice of using betas against the S&P 500, when doing dollar based analysis, and switching to betas against local indices, for local currency analysis. Those of you who follow my work know that I am firm believer in using sector or bottom up betas. For Ecopetrol, the Colombian company, I estimated a beta of about 0.80, based on the fact that it was an oil company, and used that beta for both US dollar and Colombian peso analysis. Even more dangerous is the practice of using the US equity risk premium, for US dollar analysis, and the much larger Colombian equity risk premium, for peso analysis. The company is a Colombian company and you cannot make the country risk go away by switching currencies. Both the dollar and the peso analysis therefore should use the higher Colombian risk premium.

As a final note, the cost of debt should be in the same currency that you estimate the cost of equity in and this is true no matter what currency the company actually borrows in. Therefore, if the company borrows in US dollars but you are doing your analysis in pesos, you will have to restate the cost of debt in peso terms.

How are my cash flows affected by my choice of currency?
The key rule here is that your cash flows have to be in the same currency as your discount rate. Thus, if you decide to do your analysis in pesos, you cash flows have to be in nominal pesos. If you decide to do your analysis in dollars, your cash flows have to be in nominal dollars. If it is a company with Colombian operations, this will often mean that you have estimate the cash flows in pesos and convert them into dollars. You have to use forward or expected exchange rates (and not the current spot rate) to make the conversion. In fact, if you want to preserve consistency, your expected exchange rate has to be computed from either interest rate or purchasing power parity. In the context of Colombia, for instance, the 2.5% higher inflation in Colombia that I have built into the riskfree rate will translate into an expected devaluation in the peso of about 2.5% a year.


Can I avoid this currency choice altogether?
You could, if you do your analysis in real terms. Thus, your discount rate has to be a real discount rate; the real riskfree rate is about 2% (I used the inflation-indexed US treasury to get this) and you can build the rest of the inputs on top of this rate. Your expected cash flows should be real cash flows; thus, you cannot count the inflation component of growth. Again, if you do it right, you should get the same value.

The bottom line: Make your choice of currencies at the start of the process and stay consistent with that choice all the way through. If you are wrong about expected inflation, it will cancel out - both your discount rates and cash flows will change. If you are inconsistent about inflation, applying one rate to cash flows and another to discount rates, your valuation cannot be salvaged.

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Stock versus Flow: My thoughts

When analyzing companies, the three financial statements that we primarily use are the income statement, the balance sheet and the statement of cash flows. We obtain the inputs for earnings and cash flows from the income and cash flow statements and the numbers for debt, cash and working capital from the balance sheet.

While all three statements are governed by accounting standards and are audited, there is a key difference between them. Income and cash flow statements represent flow statements: they measure how much the company earned and spent over the period. Balance sheets capture the values of assets and liabilities at a point in time and thus represent "stock" statements.

So what? Stock statements are inherently less trustworthy than flow statements, because the numbers may not be representative of what the company did over the course of the year. This can be manifested in almost every number extracted from a balance sheet:

a. Debt: The debt that is reported on December 31 of a fiscal year will reflect what was owed on that day. A company can therefore pay down debt on December 30 and borrow again early the next year, manipulating its debt figures. In fact, there is a story in the Wall Street Journal about banks doing exactly this to make themselves look less indebted and thus safer.
http://online.wsj.com/article/SB10001424052702304830104575172280848939898.html 
Another common way in which debt can be kept off the books is by using lines of credit or seasonal financing during the course of the year but to pay them down by the end of the year.

There a couple of clues that we can use to detect this practice. One is to look at quarterly balance sheets, in additional to the year-end balance sheet, with the intent of finding big changes in debt from quarter to quarter. While enterprising companies may still be able to hide debt, it is much more difficult to do so on a quarterly basis. The other is to look at interest expenses as a percentage of the year-end debt. If a firm has debt for the bulk of the year, it has to pay interest expenses on that debt, even if it retires the debt towards the end of the year. As a result, the book interest rate (interest expense/ book debt) will be disproportionately high (relative to what you would expect the company to pay.

b. Cash: The cash on a balance enters intrinsic valuations as an add-on to the estimated value of the operating assets and relative valuations when we use enterprise value multiples (where cash is netted out of debt). However, the cash balance on the balance sheet may bear little or no resemblance to the actual cash balance today (which is really the number we should be using in intrinsic and relative valuation). This is one reason why some firms actually trade at negative enterprise values, where market equity is updated to reflected today's value but debt and cash remain frozen at year-end values.

c. Working capital: Net working capital is the difference between non-cash current assets (inventory and receivables) and non-debt current liabilities (payables and other accrued liabilities). Any of these numbers can be altered over short periods. For instance, receivable collections can be stepped up and inventory cleared (how about those year end clearance sales) just before balance sheet dates to make working capital look smaller.

In closing, I am not suggesting dynamic balance sheets. That would be too expensive and not quite practical. However, I am suggesting that we be more careful about balance sheet based analysis. Never trust a single balance sheet; if you can get quarterly balance sheets, do so; if you have access to the current numbers (on cash, debt and working capital), even better. The last may seem unrealistic but if you are the acquirer in a friendly merger, you should be able to demand and get this information from the target company.

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