Category: Finance

Valuation of Corporate Innovation and the Pricing of Risk in the Biopharmaceutical Industry: The Case of Gilead

Valuation of Corporate Innovation and the Pricing of Risk in the Biopharmaceutical Industry: The Case of Gilead

In the last article from the (JACF Spring/Summer issue) Richard Ebil Ottoo discusses how much of a firm’s market value derives from expected future growth value rather than from the value of current operations or assets in place. Pharmaceutical companies are good examples of firms where much market value comes from expectations about drugs still in the development “pipeline.”

Using a new osteoporosis drug being developed by Gilead Sciences, Inc., the author combines discounted cash flow methods values and real option models to value it. Alone, discounted cash flow (DCF) calculations are vulnerable to the assumptions of growth, cost of capital, and cash flows. But by integrating the real options approach with the DCF technique, one can value a new product in the highly regulated, risky and research-intensive Biopharmaceutical industry.

This article shows how to value a Biopharmaceutical product, tracked from discovery to market launch in a step-by-step manner. Improving over early real option models, this framework explicitly captures competition, speed of innovation, risk, financing need, the size of the market potential in valuing corporate innovation using a firm-specific measure of risk and the industry-wide value of growth operating cash flows.

This framework shows how the risk of corporate innovation, which is not fully captured by the standard valuation models, is priced into the value of a firm’s growth opportunity. The DCF approach permits top-down estimation of the size of the industry-wide growth opportunity that competing firms must race to capture, while the contingency-claims technique allows bottom-up incorporation of the firm’s successful R&D investment and the timing of introduction of the new product to market. It also specifically prices the risk of innovation by modeling its two components: the consumer validation of technology and the expert validation of technology. Overall, it estimates the value contribution per share of a new product for the firm.

Authored by Richard Ebil Ottoo, Global Association of Risk Professionals (GARP)

An Empirical Study of Insurance Performance Measure

An Empirical Study of Insurance Performance Measure

In the ninth article from the (JACF Spring/Summer issue) this author applies Insurance Performance Measure (IPM) to a set of Indian insurance companies over the period 2005-2016. This is the first article published that applies the IPM model on real industry data and studies its implications.

The IPM was introduced in a Winter 2002 JACF article by Joseph Calandro, Jr., then at General Star management, a subsidiary of Berkshire Hathaway and by Scott Lane, then an accounting professor at the University of New Haven. Those authors explained why financial reporting for insurance companies was so challenging and presented the IPM metric as a better way to assess industry and company performance. Evaluating P&C companies is difficult because the unique format of insurance company financials does not lend itself to traditional financial accounting analysis and because the industry’s preeminent performance measure, the Underwriting Ratio, captures underwriting and claims activity but says nothing about investment and risk distribution (reinsurance).

By contrast, the IPM represents the interrelation of underwriting, investment and reinsurance along with a hurdle rate and is quite consistent with Warren Buffett’s expressed desire for a balanced overview of industry performance. IPM uses financial data without modification thereby simplifying and fastening computation. Operationally, it could help in negotiations for reinsurance renewals and identify “Maximum Profitable capacity”—the threshold limit for overall profitability.

Authored by Sai Ranjani Bharathkumar, XLRI Jamshedpur, India

Processes and Accuracy of Cash Flow Forecasting: A Case Study of a Multinational Corporation

Processes and Accuracy of Cash Flow Forecasting: A Case Study of a Multinational Corporation

The eighth article from the (JACF Spring/Summer issue) discusses how, despite its pivotal importance in enterprise management, cash flow forecasting gets little attention from academics perhaps because few of them have access to internal processes and data. In this article, however, the authors explain how cash flow forecasting is organized at Bayer, a large multinational company headquartered in Germany, and which factors influence the accuracy of its forecasts. The research focuses on cash flow forecasts based on the direct method, prepared three times a yearat Bayer, involving about 62,000 individual forecasting items each time. These forecasts form the basis of the company’s liquidity and financial risk management, in particular, its foreign exchange risk hedging.

The authors explain how local managers in Bayer’s entities across the world derive the forecasts, i.e., what information they use as input, how they validate it, and how they deal with potential bias caused by managerial incentive systems. They also analyze whether forecasting processes are affected by characteristics such as business area, size, region, or specific local conditions, and ultimately whether forecasting practices and entity characteristics affect forecast accuracy.

The findings show that cash flow forecasting procedures vary substantially across Bayer. While the central finance department gives general guidance on the required cash flow forecasting output and provides direction on the input to be used, there are no detailed instructions on how forecasts are to be prepared. Instead, local managers are free to determine their own forecasting practices. They use different forecasting inputs and validate forecasting inputs and output with different intensities, and they also differ in how they treat possible biases in input data. These findings document the limits of standardization and central control in large multinational corporations resulting from local managers’ need for flexibility to cope with the heterogeneity and dynamism of their environments. At the same time, however, local differentiation increases complexity and may increase errors.

Quantitative analysis of forecasting errors shows that forecasts of receipts from customers (cash inflows) are more accurate than forecasts of payments to suppliers (cash outflows). Moreover, forecasting practices affect forecast accuracy. Outflow forecasts are more accurate if managers intensively validate forecasting input; inflow forecasts, if they eliminate input biases that may result from internal target setting or from other managerial incentives, and if they carefully validate their forecasting output.

The study provides several insights.

1. Cash flow forecasting in a large multinational corporation is a complex system of interlaced processes, taking place in many organizational sub- units and located in different environments with different backgrounds.

2. Forecasting processes depend on entity characteristics. Managers at smaller, less complex entities tend to communicate closely with local counterparts and to verify forecasting output, while managers at entities whose liquidity is managed by the central finance department often use only rough assumptions about payment terms of cash inflows and outflows.

3. Quantitative analysis supports the contention that invoices issued to customers can be forecasted more accurately than invoices received from suppliers.

4. Forecasting practices affect forecast accuracy. Forecasts of invoices from suppliers are more accurate if managers intensively validate the forecasting input and prepare their own calculations rather than simply accept at face value input data provided by other departments.

Authored by Martin Glaum, WHU – Otto Beisheim School of Management, Peter Schmidt, Justus-Liebig Universität Giessen, and Kati Schnürer, Bayer AG & Justus-Liebig-Universität Giessen

Debt Crisis Looming? Yes, Corporate Debt Expanded but Don’t Panic Over the Prospect of Bbb Downgrades

Debt Crisis Looming? Yes, Corporate Debt Expanded but Don’t Panic Over the Prospect of Bbb Downgrades

In our sixth article from the (JACF Spring/Summer issue)Martin Fridson’s piece examines how the popular press often tends towards sensationalism and, unfortunately, the supposedly more sober financial press is not always better. It is true that many American companies have taken the opportunity to borrow large sums during recent years when interest rates were close to their all-time lows. This has also led some media commenters to predict a large number of marginally investment grade debt issues (e.g. BBB rated on the S&P rating scale) will be downgraded to less-than-investment-grade status–or to “junk”–as such bonds are commonly known.

Veteran fixed income analyst Martin Fridson takes stock of the situation in mid-2018. While emphasizing that a bear market is inevitable someday, he advises investors not to panic now. Despite the more apocalyptic scenarios offered by financial commentators making dubious connections between today’s corporate bond market and possible future high-yield events, the aggregate numbers do not add up to an end-of-civilization-as-we-know-it story. Some of the numbers mentioned in financial commentary are at least slightly misleading.

The present market lacks the sort of structural weaknesses likely to trigger a major bear cycle in fixed income securities, such as overleveraged buyouts and early-stage telecoms. While there are some questionable issuers in the market, these are isolated cases, rather than representatives of a vast segment of today’s high-yield universe.

Authored by Martin Fridson, Lehmann Livian Fridson Advisors.

“Big Data” Analysis: Putting the Data Cart before the Modeling Horse?

“Big Data” Analysis: Putting the Data Cart before the Modeling Horse?

In our fifth article from the (JACF Spring/Summer issue) the authors discuss the statistical analysis of very large data sets, so-called Big Data or Data Analytics, and how they have become enormously popular in Statistical Analysis and Operations Research. In some cases, such as research into the buying habits of online consumers, the results have come quickly and been very significant. Analysis of other data sets, however, is questionable. For example, time-series based statistical analysis, often under the descriptive envelope of “neural networks” and “data mining,” of stock market and futures prices, sometimes in combination with historical accounting figures such as earnings and cash flows.

The appeal is understandable given the availability of share price data and cheap computer processing power. Nevertheless, the notion that historical data form some sort of repeatable pattern over time, and that complex time series or neural network techniques can be then be used to forecast future prices is hard to justify.

Economic modeling necessarily needs to factor in human behavior, unlike modeling in the pure sciences. The authors cite Lancaster University Professor Michael Pidd who summarizes six relevant principles:

    1. Model simple, think complicated
    2. Be parsimonious, start small and add
    3. Divide and conquer, avoid mega models
    4. Use metaphors, analogies and similarities
    5. Do not fall in love with data
    6. Model building may feel like muddling through.

Economic modeling must recognize three key components:

    (i) the incorporation of human cognitive understanding and experience of the underlying systems,
    (ii) the use of data to validate emerging models, and
    (iii) the role of mathematics to ensure internal coherence and logic.

Decision-makers ought to be very skeptical of models which skimp on any one of these three components. The authors emphasize that, rather than Big Data adding value, per se, people add value by creating models that use it.

Authored by Graham D Barr, Theodor J. Stewart & Brian S. Kantor, University of Cape Town

Building a Bridge between Marketing and Finance

How advances in behavioral science and financial analytics offer an effective way to bridge this gap between marketing and finance.

Our fourth article from the (JACF Spring/Summer issue) discusses how finance executives are often frustrated by spending proposals from their marketing colleagues but cannot seem to be able to quantify the putative benefits. Similarly, the marketing staff is frustrated by the finance team’s inability to convert soft marketing metrics, such as “awareness” and “customer satisfaction” into financial forecasts. The challenge is that neither marketers nor finance executives have been able to articulate a single analytical framework which both explains how and why brands come to flourish or flounder and how brand growth contributes to the business’s short and long term bottom line.

Lacking an effective way to do this now, most managers default to using the hard data they do have, namely how marketing investment is likely to impact sales this quarter and next. This reinforces the widespread focus on quarterly EPS and reduces the perceived value of the marketing department to their ability to hit three month sales targets. This degraded view of marketing’s contribution and the inability to link “soft” marketing metrics to longer term financial returns impedes building long-term brand value. This article focuses on how advances in behavioral science and financial analytics offer an effective way to bridge this gap between marketing and finance.

Building that bridge requires better measures of brand health and financial performance to allocate capital and marketing resources. Undoubtedly, brand building is both an art and a science. But, the finance people can develop an evidence-based framework explaining how some of the “softer” investments such as brand building, contribute to the value of the firm.

Authored by Ryan Barker, BERA Brand Management, and Greg Milano, Fortuna Advisors

The ESG Integration Paradox

The ESG Integration Paradox

Our third article from the JACF Spring/Summer issue is by Michael Cappucci.

Today, most investment managers have something to say about environmental, social and governance (ESG) issues, and written ESG policies are ubiquitous.

Today, most investment managers have something to say about environmental, social and governance (ESG) issues, and written ESG policies are ubiquitous.

Yet, a written policy is not a reliable indicator of a firm’s commitment. Actual ESG incorporation practices vary greatly, with most investment managers falling well short of full integration. Only a few firms seem to be using ESG factors to deliver alpha, hence, the paradox. If not implemented wholeheartedly, responsible investing can lead to lower financial returns. So, why have so few investment managers gone all the way?

The paradox involves a “valley” of lower returns where portfolios first absorb the costs of ESG integration before the promised benefits materialize. In the early days of ethical investing, the focus was on using negative screens to exclude certain companies for moral or ethical reasons but lower financial returns are inherent to exclusionary screening.

Hard exclusions force managers to tradeoff certain risks for others. So, for example, if the market discounts tobacco stock prices to account for changing consumer behavior, eventually tobacco stock prices become attractive again as, indeed, has been the case over the last two decades. Exclusionary screening alone is a self-limiting strategy.

By contrast, ESG strategies range from active ownership and engagement, to positive screening (selecting for certain attributes), to relative weighting (sometimes called “best-in-class selection”), to risk factor investing, to full integration.

Because the relationship between an asset manager’s ESG efforts and its risk-adjusted performance is not classically linear, asset owners should look for managers that are on the upward slope of the ESG intensity curve and are fully committed to advancing up it.

Authored by Michael Cappucci, Harvard Management Company

‘The Big Four’ Review: Titans of the Books

‘The Big Four’ Review: Titans of the Books

Wall Street Journal, Book Review, September 24, 2018

The mightiest accounting firms now scorn their traditional core business of auditing and have taken to “consulting” like ducks to water. Jane Gleeson-White reviews “The Big Four” by Ian D. Gow and Stuart Kells.

By Jane Gleeson-White
Sept. 23, 2018 1:32 p.m. ET

Deloitte, EY, KPMG and PwC are among the best-known brands in the world. These “Big Four” accountancy firms are international organizations which together generate revenues of more than $130 billion annually and employ almost 1 million staff. Despite their modish names with hip abbreviations and the stylish typography of their logos, each firm can trace its origins to 19th-century Britain. Take PricewaterhouseCoopers: Samuel Price started practicing in 1848, and William Cooper in 1854. William Deloitte began in 1845. The earliest ancestor organizations of Ernst & Young and KPMG were also founded in England.

In “The Big Four,” Ian Gow and Stuart Kells, with a characteristically light touch, observe that the 19th century was the accounting profession’s “ ‘wild west’ era, even more so than the 1980s.” Samuel “Sammy” Price was a “rule-breaking, lumbago-suffering oddball.” From a family of potters, he could work his hands in more than one respect: As a “fan of prize fights, streetfights and indeed any kind of fight, he was not averse to joining in himself.” Edwin Waterhouse was a member of the Religious Society of Friends—that is, a Quaker. His Quakerism shaped his view of himself as “a ‘Christian gentleman’ responsible for delivering an important social service.” His son Nicholas, however, threw “very un-Quaker-like” parties in his Chelsea home that featured “drugs as well as sex.”

The boom in British railways fueled the need for financial rigor, and as the law increasingly required accounting for the conduct of commerce, the small firms flourished and merged to meet the demand for auditing, annual reporting, and liquidation. In the century and a half since, their descendant firms have expanded globally and survived fraud, lawsuits and scandals. Yet unusually in these times of transparency, the inner workings of the accounting giants remain shrouded from view.

“The Big Four” is not so much the history of these institutions as a brief tour of accounting’s past, from its origins in Renaissance Italy to the current era of mega-firm dominance. The authors are well-placed to examine this history. Mr. Gow has worked for Morgan Stanley and other multinationals, has taught at Harvard Business School and is now a professor at the University of Melbourne. Mr. Kells has been a director of KPMG, as well as an assistant auditor-general of the state of Victoria in Australia.

Their pacy prelude opens with the 1880 founding of the world’s first national accounting association, the Institute of Chartered Accountants in England and Wales, and then canvasses the origins of modern accounting via three formative books acquired by the organization for its library. One is Luca Pacioli’s 1494 “Summa de Arithmetica,” which includes the first printed treatise on double-entry bookkeeping. The other two, published in 16th-century Antwerp and London, reflect double entry’s movement west across Europe.

The authors argue that the institute’s collection of such books is a monument to the principle “that sound bookkeeping is the foundation of success in statecraft and in commerce.” The Big Four reached the pinnacle of their profession by trading on a widespread belief in this idea; the authors then explore how well-founded the public’s faith in these institutions is today.

The book is divided into four parts whose titles convey its argument: “Infancy’” “Maturity,” “The Difficulties of Adulthood” and “The Twilight Years.” The first two sections take us from the Medici Bank through the rise of the Big Four. But the authors hit their stride in part three, which covers the postwar years, when the firms made auditing the books of major corporations into the basis of their brands. Recently, the authors note, auditing has become undervalued and scorned within the four fiefdoms. Instead, they have taken to “consulting” like ducks to water.

Messrs. Gow and Kells believe the Big Four are endangering their futures by neglecting their one-time core business. They point out that the corporate collapses and scandals of the early 21st century—most spectacularly Enron, which brought down its adviser and auditor Arthur Andersen—led to a regulatory response “focused largely on the role of the auditor.” In the United States, the Sarbanes-Oxley Act of 2002 didn’t prevent “a string of similar-sized calamities” during the 2008 financial crisis.

As the authors observe, each of the Big Four was linked to “some of the most spectacular failures. Deloitte had audited Bear Stearns and Fannie Mae. KPMG had audited Citigroup. PwC had audited American International Group and Goldman Sachs. EY had audited Lehman Brothers.” These examples challenge the mistaken view of outsiders that audited accounts are trustworthy.

In part four, “The Twilight Years,” the authors assess the threats to the supremacy of these giants from “smaller players with low overheads and high agility.” But they also take us back to a story begun earlier in the book, that of the unraveling of the Medici Bank, which is offered as a sort of precursor to the Big Four. What the two stories share, the authors suggest, is the dilution of an original purpose: “Focus had been at the heart of the Medicis’ success,” they write. “Gradually, though, they had forgotten their core business.” The book’s analysis of the causes of the Medici Bank’s collapse—defaults by profligate borrowers, increased appetite for risk, failure to oversee the bank’s distant franchises and a departure from the organization’s core business—offers a salutary lesson for the Big Four today.

While there is still a larger, more detailed history of these firms to be written, Messrs. Gow and Kells have made an invaluable contribution, writing in an amused tone that nevertheless acknowledges the firms’ immense power and the seriousness of their neglect of traditional responsibilities. “The Big Four” will appeal to all those interested in the future of the profession—and of capitalism itself.

Ms. Gleeson-White is the author of “Double Entry: How the Merchants of Venice Created Modern Finance.”

Rethinking the Purpose of the Corporation

Rethinking the Purpose of the Corporation

Our second article from the (JACF Spring/Summer issue), written by Edward Waitzer, reviews how over the last forty years, corporate governance and corporate law have focused on minimizing “agency costs” by aligning the interests of shareholders and managers through a series of techniques, including regulatory standards, independent directors, take-overs and activist shareholders.

These means, combined with implicit acceptance of the “Efficient Market Hypothesis” (EMH) reinforced belief that share prices reflected objective corporate performance and that maximizing shareholder wealth was the purpose of the corporation.

This author, however, argues that proper corporate governance requires more than just faith in efficient equity markets and strong managerial incentives. Despite the desire for simplicity, there is no one “right” governance model. Governance is highly contextual and, ironically, the existing corporate law and regulation have tended to frustrate dynamic adaption and have led to governance systems that underperform.

The author offers Systems Theory as a better way to think about corporate purpose and governance. Systems are more than the sum of their parts, they are comprised of subsystems which in turn are comprised of other subsystems on so on, and the overall health of the system depends on the continued health of each of its essential subsystems, as well as of the larger system.

Systems theory counsels against focusing on any single metric (and in favor of the need for new ones – the relevance of metrics inevitably run down over time). Metrics such as profits, employee turnover, and customer satisfaction are not ends in themselves. Rather, they are a source of information about whether the corporation is relevant, resilient and sustainable. The systems challenge is to bring about a paradigm shift that restores connectivity between investors, employees, management, other corporate stakeholders and governments. This will require thinking differently about how the constituent elements interact and produce results.

Authored by Edward J. Waitzer, Stikeman Elliott LLP

Investors as Stewards of the Commons?

Investors as Stewards of the Commons?

In our first article from the (JACF Spring/Summer issue) George Serafeim makes the case that business generally, not just government, should assume responsibility for social and environmental problems. The Sustainable Development Goals (SDGs) formally recognize the role of the private sector in addressing some of the world’s most pressing environmental and social challenges. What started as a corporate social responsibility movement now a focuses on integrating positive social impact into the core mission of the organization.

Encouragingly, studies document that improving firm performance on business-relevant ESG issues has a positive association with future financial performance. Investors can enable better societal outcomes by exercising ‘voice’ and voting rights in corporate governance.

He acknowledges that competitive businesses face a “commons” or “free-rider” problem where a defector avoids the full cost of his actions. Overcoming this problem requires legally sanctioned collaboration between business enterprises and large institutional shareholders, particularly pension funds. He also acknowledges that the corporate level free-rider problem has a counterpart that at the investor level. Investor engagement with companies involves resources, money and time. It is no simple matter to justify increased costs in the context of asset managers that compete on the basis of low management fees, such as index funds.

Collaboration between companies can mitigate some of these free riding problems. Large institutional investors with long time horizons and significant common ownership across different companies may have the best opportunities for collaboration. But, smaller activist funds and retail investors also have an important role in pushing large institutional investors to engage. While it is unlikely that investors will be able to solve all of the pressing societal problems, progress can be made.

Authored by George Serafeim, Harvard Business School