It is often said the value of the share of a company is the present value of the cash flows the company is going to earn in the future. How does one know what these future cash flows are? Nobody knows. So, you can see, the assessment of the value of a company depends very much on the assumptions about the business and the operation of the company. But investors are into the shares to make money, not to physically run the business.
An investor gets into the shares by buying it at a price, which is affected by not only the assumptions about the company but also the supply and demand of the shares in the market at the point of transaction, news, rumors, and especially sentiment as we have been seeing recently due to the global health crisis. Notice that the shareholder does not actually collect the cash flows earned by the company; he or she must sell the shares at another price, higher than the buying price, in order to make a profit.
What about dividend?
“What about dividend?” you may ask. Well, let me give you a simplified example. Suppose you own a share worth 88. The company then pays a dividend of 8. ALL ELSE EQUAL, do you think the share price will stay at 88? While you have collected 8 from the company, the share price will have to go to 80 to reflect that 8 has flowed out of the share. In reality, the share will likely not trade exactly at 80 immediately ex-dividend because as we have mentioned, there are many factors affecting the price of the share. But you get the point, all that matters to an investor is the price.
What if you were a member of the company? Unless you also own shares of the company, the share price should not be your immediate concern. But that does not mean you do not need to understand the business of your company.
In fact, you should be even more informed than an investor because you are investing your time and effort in the company; and you physically benefit from the cash flow the company earns.
You will do well if the company does well; and you have all the interest to make that happen by knowing how your role fits into the entire business model and operation so that you know how you can best contribute to the success of the company.
When people know what the game is, they play better
A childhood experience really makes me realize the meaning of this phrase. I and a couple of my friends did not know much about basketball. But one afternoon the team coach came to us and got us to join the team for a match which was to start in 15 minutes. He did not have time to even explain to us the rules of the game, let alone training. I guessed he was shorthanded and just needed some bodies to buy some time for his main players to take some rest. But the three of us, not knowing how the game should be played, were giving up points and fouling so fast that we fouled out within minutes while the opposition built a big lead. The end result was obvious and there goes my dream to play in the NBA.
So, how do you go about understanding the business of your company?
While the process is somewhat similar to what an investor will go through, the motivation and the focus are definitely different; and you often want your understanding to lead to tangible actions related to the operation of the company, in particular, your role.
One key difference is that investors can be driven by headlines because they can buy or sell at the click of a button; you generally want to be in the company for the long haul.
Step 1 – Know the Numbers
The financial statements are an important source of information about what the company is about. But before you go to the numbers, you want to know the value proposition of the company, that goods and services the company sells that customers are willing to pay for. Since we have often worked with banks, let us use a bank as an example. Here, when we say a bank, we include the lending, trading and advisory businesses which most global banks have.
The key word in understanding the business of a bank is liquidity. Simply put, liquidity means the availability of the other side of the trade when needed. If you need to borrow money, you need a lender; if you need to sell your shares, you need a buyer; that is what the other side of the trade means. If there is no liquidity, you will have no access to cash, or you will be stuck with the shares which you do not want.
Traditionally, it is not so easy for a natural borrower such as a corporation and a natural lender such as a depositor to trade with each other; similarly, it is not easy for a natural buyer of securities such as an investor and a natural seller such as another investor or the issuer to trade with each other. So, the bank steps in the middle and acts as the other side of the trade for its customers and earn the spreads between where it borrows and where it lends, and where it buys and where it sells.
Since the bank operates in financial markets day in and day out, it has a lot of know how in relation to supply and demand, financial products, issuance and securities processes and other useful information and knowledge about financial markets. So, it provides advisory services as well.
Based on this understanding, it becomes easier to figure out what the numbers in the financial statements are telling you about the performance of the bank.
Interest income will be good if the loan book is big and healthy and interest margin is high.
Trading income will be good if there are a lot of trading activities by the customers.
Fee income from asset management business will be good if the bank is mandated to manage new money or if the stock market goes up because fee is usually charged as a percentage of the value of the portfolio being managed.
So how can you help in generating more revenue? The market forces are not under your control; but you can see there are many other things you can do.
Step 2 – Cutting Through the Jargon
It is important to know the key metrics and techniques in deciphering the financial statements so that you can identify the key value drivers of the company. A capital-intensive business will need to own large amount of assets to generate revenues; so, the so-called asset turnover is low.
In order to make up for that, it will have to mark up the selling price of its products over its cost and expenses, the so-called margin. So, pricing and capital expenditures are key components in driving return.
On the other hand, a retail business generally has low margin; so, it must make it up by having high turnover, what is commonly called volume.
Going back to a bank; a key asset is loans and the revenue is the interests on these loans. The turnover is generally small. Margin, at least on the product side, is generally small as well because banking products are fairly generic, plus the personnel cost is generally high.
So, how does a bank generate a reasonable return? Have you heard of the word leverage? Yes! Banks are some of the most highly leveraged entities around and it is a key value driver of their returns. Based on what we have discussed about the business of a bank, it should not be a surprise.
Quite often, for a typical company, the assets generated by its operation, such as trade receivables and inventories, can be partially funded by the liabilities generated by the operation, such as trade payables.
In other words, the operation is partially self-funded. A bank, being a middleman, generally has two sides of the trades. It borrows and lends, it takes on long and short positions, it pays and receives fixed on swaps etc. So, the operation of a bank is largely self-funded, and it can operate on a small amount of equity.
As the saying goes, leverage makes a good day better, but makes a bad day worse.
So, it is important to understand the metrics which measure whether the amount of leverage is appropriate, i.e. the capital strength of the bank, meaning whether it has enough capital to absorb potential losses from extreme events. There are also metrics which tells you how liquid the bank is, meaning whether it has enough or is able to access cash to meet payments under stress.
Step 3 – Joining the Dots
As a member of the company, understanding the business of the company does not lead to the decision to buy or sell the shares of the company but to tangible actions to drive revenue, manage cost, mitigate risk, and even transform businesses and processes to capture opportunities or face challenges. Such actions are organized through business planning and resource budgeting and may be related to tactical or strategic matters.
Due to the pandemic, the world economy has been hard hit; businesses and individuals alike have been weakened financially. In turn, banks may face larger amounts of defaults; and they are taking reserves against potential loan losses. Some investing blogs use the phrase “banks are ramping up the cash they put aside for potential losses”; is that right?
After having gone through step 1 and step 2, you would realize that there is a confusion between capital and liquidity in the statement; taking reserves actually reduces the capital of the bank. Whether the bank should hold more cash would be a separate tactical decision to make. Other tangible actions would be to work directly with the borrowers to see through the crisis.
Independent of the health crisis, banks are in some sense already facing an existential challenge. What if customers are able to find liquidity without going through a bank? Think crowd funding and electronic trading. What if investors are shifting to low fee passive portfolio constructed using ETFs tracking smart indices? Think robo-advisors.
Understanding the business of your company allows you to contribute to the strategic repositioning or reinvention of the company to tackle the challenges.
While we have used banks as an example, our program “Understanding Our Business”, designed as we have described above, can be customized to any type of businesses; it is meant for everyone in your company.
I wished my basketball coach had run this program before the game; I am sure our score would have been better.