DSO Interpretation

While the textbook discusses a cross sectional comparison of the components of the operating and and cash cycles, a recent article discusses a method to examine accounts receivable (AR) and days' sales outstanding (DSO) in a time series. For example, if AR is growing more quickly than DSO, the company could be offering credit terms that are too generous, or is attempting to book sales at the end of the quarter to make its performance look better. The examination of health care education company Healthstream in the article indicates neither of those. Two things we would like to point out in the article: The author points out that he likes to use end-of-quarter numbers rather than average receivables in his calculations. Remember, ratios can be calculated a number of different ways, and each has its own interpretation. So, if you are using ratios calculated by someone else, make sure you know how the ratio was calculated. Second, the author cautions that an investor should look into the root causes of the changes in ratios, which is always an important step any time you are examining financial ratios.

Stock Yields

Stock returns include a dividend yield, but Chris Brightman, head of investment management at Research Affiliates, argues that the yield should include a buyback yield. His logic is that if a company maintains its profits and the price earnings ratio remains constant, if the company buys back 2 percent of its stock, the stock price should increase at 2 percent as well. This is similar to the dividend discount model in which the stock price grows at the dividend growth rate. Unfortunately, Brightman's math indicates that the stock market return going forward is only about 6 percent, significantly below the historical average. 

Financial Romance

Often, people outside finance view financial professionals as number crunchers, lacking emotion and feeling. We disagree with this idea, and further would argue that financial professionals are very romantic.

S&P 500 Dividends

A recent article geared toward investors yields some interesting dividend information. For example, over the past 10 years, the dividend payout ratio for the S&P 500 Index as a whole has been as low as 50.76 percent in 2002 and as high as 107.47 percent in 2008. Over this 10 year period, 18 S&P 500 companies have been able to reduce the payout ratio by more than five percent per year, but more impressively, eight of those companies have actually increased dividends by more than seven percent per year. These companies have been able to reduce the payout ratio but increase dividends, an indication of the fast earnings growth in these eight companies.

Spin-Off Value

The anti-merger, or spin-off, seems to be benefiting investors. The Bloomberg Spin-Off Index (BSOI) is up 41 percent in the past year compared to the 12 percent increase in the S&P 500. For the past 17 years, spin-offs have outperformed the S&P 500 by 13 percent in the year following the spin-off. There are structural reasons that this anomaly might exist including: the new management is forced to run the new business more efficiently, the new company lacks analyst coverage resulting in forced sales by index funds and investors who didn't buy the stock directly, and a soft landing set up by the by the parent, who might undervalue the spin-off to lower expectations on the new company.

Merger Valuation

A recent article in CFO outlines potential pitfalls in mergers. For example, the article advises avoiding over-optimism about the company, a flaw discussed in behavioral finance. The article also argues that the bidder should not pay for synergies unless they are well defined. For example, one CFO said that his company paid for synergies in one acquisition because the target would be rolled into a current division, which allowed for cost savings from eliminating part of the existing management, the board of directors, and other expenses that the target incurred. However, he would not include synergies if the target were in an entirely new business. The last pitfall we would like to mention here is to keep financial models honest. Logical errors are much more common than mathematical errors. For example, if margins are increasing, this cannot be infinite. After all, you can never get a 100 percent margin, and something a lot lower is more reasonable. 

1 + 1 = 3

Recently David Einhorn, the Greenlight Capital hedge fund manager, has suggested that Apple should issue preferred stock as a way of reducing the company's cash balance and increasing shareholder value. Einhorn argues that by giving the preferred stock to current shareholders, the market price of the preferred plus the new reduced price of the common stock (there would be a price drop since cash available to common shares would decrease) would be greater than the current stock price. In essence, Einhorn is arguing against M&M's pie model of the corporation. While we believe that excess cash does not create shareholder value, the idea that market participants can be fooled by adding preferred stock to a company's capital structure seems doubtful.