Anna Valiullina

Dec 2019 · 10 min read

Merry Christmas and Happy New Year to all the subscribers of The Finance Association EPFL! In today’s article, we take the opportunity to wish you a productive year full of ambitious ideas and their great realizations! Having a holiday spirit we would love to introduce you the effect on the financial market which has a great relation to the Christmas and New Year! Yes, we meant it!

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Let’s start right over with the description of the January effect. Believers of January effect say that, overall, the stock rise in January is greater than in any other month of the year. The closely related effect is the Santa Claus Rally which is known for the rise of stock prices in the last 5 days of the year and first 2 days of the following one. While the January effect is a hypothesis, we see a persistent history of Santa Claus Rally (thought as this effect is becoming more known, the market is becoming more efficient).

                                                                                                                               Source:https://unsplash.com/photos/0O58LvoYdHk

There are several explanations for the Santa Claus Rally. The first one is that some traders believe in the January effect. So if one believes in the rise of the stock in January, no doubt the person would try to anticipate the effect and buy some shares before January to earn. When there are many people buying shares at the same time they would move the market and price would rise.

Another unproven assumption is that short-sellers investors tend to take vacations around the holidays. Giving that in general employees prefer to spend Christmas outside the office we have a situation where it might be easier to move the market in a positive direction due to a decrease in the number of players, trading volume and in a situation where there are fewer short-sellers.

Source:https://www.goodfon.ru

For the last decade, we saw the interest rate going down dramatically. In some countries, for example, Switzerland, the interest rate became even negative. Under such circumstances, some of the economists claim that Monetary Policy is not as effective as it used to be. Now, we don’t stop here (because as suspicious engineers we believe there must be something else). Let’s have a turn and talk about taxes! In a few words, whenever a company make some profit, it must report it as a capital gain and it will be taxed according to the amount it earned. However, we should not forget that any capital losses account for a tax deduction. Suppose I buy some shares at price X$, if the stock lost its value and now trades at (X-Y)$ and I sell it now I will get a capital loss of Y$. Having taxes I can recover some portion λ of the loss (λX$) through a tax deduction. Let’s get back to the Christmas time. As we just discovered, under certain regulations^[1] one can sell the shares of the underperforming position and gain a tax deduction. After counting all taxes for the last period a trader simply buys shares back (a reason for buying back is because often a person would hold the losing position due to belief in the future upward move). Confronting the time of tax reporting with regulations [1]  we find that buying back occurs exactly in January. This practice is known as a wash sale which we consider as one of the main reason for the January effect.

As a conclusion, we would like to thank you for this incredible 2019 and wish you Merry Christmas and Happy New Year! We hope that the following year will be even more fortunate than the current one!

With love,

Your TFA

For more information on this theme we would suggest the following reading:

[1] https://en.wikipedia.org/wiki/Wash_sale#Tax_Loss_Harvesting

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Written by Anna Valiullina

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Anna Valiullina

Dec 2019 · 10 min read

In today’s article, we are interested in describing the current affairs of Central Banks and by doing so we will briefly remind you about different ways which are used to affect the economy.

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To start with, there are mainly 2 ways how one can affect the current state of the economy: using Fiscal and Monetary Policy. The first one is controlled by the government and is associated with changes in taxes and government spending. The second approach, Monetary Policy, works through changes in money supply and changes in the interest rate on government bonds. Here we all remember the agiotage around FED’s meetings. (FED – Federal Reserve, the central bank of the United States). This mechanism of affecting the interest rate is exactly what we would like to cover today.

To give you a piece of intuition, in order for the economy not to be artificial improved before the president’s elections and thus give a false picture to the voters, the apparatus of Fiscal and Monetary Policies are strictly divided (i.e. the head country’s central bank doesn’t report to a president of the government). But let’s look at where the situation is now and whether the Central Banks still has the same power to affect the state of the economy as they used to?

For the last decade, we saw the interest rate going down dramatically. In some countries, for example, Switzerland, the interest rate became even negative. Under such circumstances, some of the economists claim that Monetary Policy is not as effective as it used to be. 

Source: Bloomberg

In practice, negative interest rates were introduced as a tool to mitigate the consequences of financial crises when no other policy would work. To this end, let us remind you that in 2009 Sweden, Denmark and since 2014 European Central Bank have introduced negative interest rates. Thinking of the recent crises, we saw a situation of great uncertainty which normally leads to stagnation of the economy, reduced output and increased rate of unemployment. The decision of cutting interest rates was done in the attempt to boost the economy since in this setting the investors are penalized for not spending money.

As a small note, let us give you an intuition on how exactly the Central Banks proceeds on their way to reduce the interest rates of government bonds. Central Banks use the tactic called Quantitative Easing (QE), they purchase the government bonds on the open market increasing the money supply and lowering the supply of the bonds. Having this, the rate of return on bonds is decreasing.

Talking about the current situation, it is clear that there is a boundary below which the interest rate is not expected to fall. The closer we approach the boundary the harder and harder it gets for the Central Banks to affect the state of the economy. While most of the countries are not willing to increase government spending (or actively employ Fiscal Policy), the Central Banks do not have any other option than searching for more complex tools to affect the economy or try to negotiate with government’s officials. 

For more information on this theme we would suggest the following reading:

• https://www.bloomberg.com/quicktake/negative-interest-rates
• https://www.bloomberg.com/news/articles/2019-07-17/the-only-way-is-down-for-central-bankers-already-at-peak-rates

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Stay tuned for other articles from The Finance Association of EPFL! Don’t hesitate to send us any suggestions to tfa@epfl.ch or write to us in our Facebook and Instagram pages

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Written by Anna Valiullina

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Stefano Ramella

Nov 2019 · 25 min read

Valuation Models are used to assess the worth of a given company : this is needed for IPO, Acquisition, Mergers. In this article, 3 methods are presented : Discounted Cash Flow Analysis, Comparable Companies Analysis and Precedent Transaction Analysis. Each of these methods can be thought as 5-steps process. 

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Overview

The three methods presented here are among the most commonly used among the finance professionals. They rest on different assumptions :

• • Discounted Cash Flow Analysis (DCF) : Discounted future free cash flow projections are a good estimate of the worth of the company
  • Comparable Companies Analysis (CCA) : Similar companies will have similar valuation multiples
  • Past Transaction Analysis (PTA) : Precedent transactions for similar companies are a good estimate of what the company would be worth in the case of an acquisition.

Discounted Cash Flow Analysis (DCF)

Presentation of DCF Analysis

The main assumption behind DCF is that the value of the company of interest is best approached through the present value of all future monetary benefits

Let’s go through each of the five steps.

Step 1 : Determine the Target and the Key Performance Drivers

To perform a DCF, it is key to study and learn as much as possible about the target and the sector in order to avoid misguided assumptions and valuation distortions. This is easily done for public companies (availability of data), but more challenging for private companies.

• • If the company is public, data can be get from SEC filing, earnings call transcripts and investor presentations. Equity research reports add additional information on the financial performance estimates
  • If the comapy is private, company management is the primary source of data to provide materials containing basic business and financial information

Once the data is acquired, one needs to determine the key performance drivers, as shown below :

Step 2 : Project Free Cash Flow

Free Cash Flow (FCF) is the cash generated by a company after paying all cash operating expenses and associated taxes, as well as the funding of capex and working capital, but prior to the payment of any interest expense. It can computed according to the following formula :

One should consider keep in mind the historical performance of the company as it provides valuable insight for developing defensible assumptions to project FCF : past growth, profit margins are usually a reliable indicator of future performance, especially for mature companies in noncyclical sectors. The Projection Period Length is often set to five years depending on its sector, stage of development, and the predictability of its financial performance.

Step 3 : Calculate the WACC

WACC (Weighted Average Cost of Capital) is the rate used to discount the target’s projected FCF and terminal value to the present : it represents the weighted average of the required return on the invested capital and can be thought of as an opportunity cost of capital or what an investor would expect to earn in an alternative investment with a similar risk profile.

The calculation of the WACC is performed by following these four steps :

1. Determine Target Capital Structure

• • Choose a target capital structure that is consistent with the firm long term strategy ( Debt and equity components have different risk profiles and tax ramifications, WACC is dependent on a company’s target capital structure).
  • Use comparables from public market to get a proxy of the optimal capital structure
  • The target capital structure is represented by debt-to-total capitalization

2. Estimate Cost of Debt

• • A company’s cost of debt reflects its credit profile at the target capital structure
  • Cost of debt is generally derived from the blended yield on its outstanding debt instruments

3. Estimate Cost of Equity

• • It is the required annual rate of return that a company’s equity investors expect to receive (including dividends)
  • CAPM ( Capital Asset Pricing Model ) : 
• 
  • The risk-free rate is often estimated with T-Bills and T-Notes
  • The Market Premium can range from approximately 5% to 8%
  • To calculate Beta from the public market one should neutralize the effects of different capital structures “Unlevering the Betas” : 
• 
  • Once the Unlevered Betas have been computed an average is computed
  • The beta is then relevered using the company’s target capital structure
  • CAPM is applied with the calculated Beta in order to obtain the cost of equity

4. Calculate WACC

Step 4 : Determine Terminal Value

Terminal Value quantifies the remaining value of the target after the projection period, and is typically calculated on the basis of the company’s FCF in the final year of the projection period. There two widely accepted methods: the exit multiple method (EMM) and the perpetuity growth method (PGM).

Step 5 : Present Value and Valuation

The final step consists in discounting FCF and Terminal Value to calculate the present enterprise value (EV). Present value centers on the notion of time value of money and it is performed by multiplying the FCF for each year in the projection period and the terminal value by its respective discount factor :

Implied equity value and share price can be derived from the EV :

Comparable Companies Analysis (CCA)

Overview of CCA

The logic behind CCA is different from DCF. The approach is comparative and is based on the assumption that similar companies will have similar valuation multiples. The criteria to judge the similarity between companies are mainly based on the size and sector.

Here are the five steps one could follow in order to conduct CCA :

Step 1 : Select the Universe of Comparable Companies

The process of learning the in-depth story of the target should be exhaustive. The knowledge of the company and the sector-specific material is essential : it can be simple and intuitive for certain sectors but challenging for others, especially when peers not readily apparent.

Note that the actual selection of the comparable companies should only begin once this research is completed.

It is important to consider the following points while screening for Comparable Companies : 

• • Various sources can be used to screen for potential comparable companies. Initially, the focus is on identifying companies with a similar business profile
  • Public companies typically discuss their primary competitors
  • Additional source for locating comparables is the proxy statement for a relatively recent M&A transaction in the sector as it contains excerpts from a fairness opinions
  • Sector knowledge and familiarity with the target from senior bankers could be the most valuable resource

Step 2 : Locate the Necessary Financial Information

The most common sources for public financial data are SEC filings, earnings announcement, investor presentations, equity research reports, consensus estimates and press releases available via Bloomberg. Here is a summary of financial data source that can be used :

Step 3 : Key Statistics, Ratios and Trading Multiples

 Several metrics and ratios are to be used here : 

• • Size
  • Profitability
    • Gross Profit Margin
    • EBITDA Margin
    • Ebit Margin
    • Net Income Margin
  • Growth Profile
    • Look at historical and estimated future growth rates as well as compound annual growth rates (CAGRs)

• • Return on Investment
    • ROIC
    • ROE
    • ROA
  • Credit Profile
    • Leverage
    • Interest Coverage Ratio

Step 4 : Benchmark the Comparable Companies

Benchmarking centers on analyzing and comparing each of the comparable companies with one another and the target. The objective is to determine the target’s relative ranking so as to frame valuation accordingly. Benchmarking is a two-fold process :

1. Benchmark the Financial Statistics and Ratios

• • It involves the comparison of the target and comparables universe on the basis of key financial performance metrics. Compute the mean, median, minimum and maximum for the universe’s selected financial statistics and ratios
  • Benchmarking goes beyond a quantitative comparison but examines the reason the a company’s high and low performance
    • Is the company market leader?
    • Is it gaining market share?
    • Effect of latest announcements?
    • What are the strategic initiatives?

2. Benchmark the Trading Multiples

• • Get a full range of multiples and assess relative valuation for each of the comparable companies
  • After an analysis of the trading multiples, one could operate a refinement of the comparable universe
  • Depending on the output it may become apparent that certain outliers need to be excluded from the analysis or that the comparables should be further tiered

Step 5 : Determine Valuation

The mean and medians of the most relevant multiple for the sector are used (typically EV/EBITDA or P/E), then the low and high multiples of the comparables universe are used as floor and ceiling to provide further guidance :

Precedent Transaction Analysis (PTA)

Overview of PTA

PTA logic holds the same logic as CCA, that is relative valuation of a company based on comparison with similar players. The main difference with CCA is that one estimates the value of the company based on previous transactions such as the price paid for similar players. As PTA and CCA are very similar, only an overview of PTA is presented below :

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Stay tuned for other articles from The Finance Association of EPFL! Don’t hesitate to send us any suggestions to tfa@epfl.ch or write to us in our Facebook and Instagram pages

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Written by Stefano Ramella

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This week’s article focuses on the Real Estate Market and innovation idea of combining it with Blockchain technology. Real Estate Market is considered to be one of many sources of investments, but it is still believed to be an inefficient and non-liquid market. In this article, we attempted to describe the main drawbacks of the Real Estate Market as a source for investments and show how modern technologies as Blockchain could dramatically affect the situation and investment decisions. 

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Drawbacks of Real Estate Market

To begin with, we have started to analyse why exactly some investors have doubts about investing in the Real Estate Market.

 Firstly, let us draw your attention that the average price in Europe of residential property in EU-28 as of September 2019 is in the range from 1,633€ (Bulgaria) to 21,179€ (United Kingdom) per square meter. So, for example, if one wants to buy a 45 m2 apartment in Italy (where the average price is 6,589 €/m2)he should have 296,505 €. Giving these numbers, we can clearly state that this market is closed to the average investor.  Consequently, the average investor would rather invest in the equity market.

Another concern of investors would be the lack of data. Compared to the equity market where we can talk about high-frequency data, where there are many agencies/experts who provide their statics and opinion on any particular investments you consider, of course, the real estate market would seem insufficient and not-transparent. If we talk about the real estate market, there is no such word as an exchange and no global database with all available options to invest. 

As a matter of fact, investors are also concerned with timing. All of us have a smartphone in the hands can buy shares within seconds. Meanwhile, the real estate market is lacking transparency in this matter. Generally speaking, all involved actors (investor, owner, tenant and etc) need to perform several actions which are linked to each other and couldn’t be done automatically or at the same time.

 Here comes another issue, usually the actors encounter each other only once and therefore there must be no trust between them. Having this in mind we should also mention the great number of scums in the real estate market which again puts in not in favour of investors.

Tokenization of Real Estate Market

How does it work?

Tokenization is a process of splitting an asset into parts (tokens), while each token represents the value of the share of the asset. The owners of the property can create as many tokens as they want. Here, of course, knowing the real price of the property the price of each token will vary. It is as we say that cutting a cake in 10 or 50 pieces would create a different price for each piece. Now, let us walk you through the process of tokenization on the real estate market. Once the owner of the property has decided to tokenize it, the first thing would be to create tokens (security tokens in fact) and sell them to the investors. This process is called STO (Security Token Offering).

A security token is an investment contract written on the underlying asset. So in the case of STO, all the security tokens are linked to a real tangible asset. Advantage of STO over ICO (Initial Coin Offering) is that investing in STO the person also gets ownership on the share of the asset. Compared to ICO it reduces the risk of fraud and illegal activity (in case of STO each individual is obliged to be identified). After completing the STO, the tokens should be listed on the exchange so that the participants can trade it. For the particular exchange to be valid, it should compile with certain regulations. It is worth to mention that once the token is created, nothing prevents it from being traded on different exchanges.

Advantages of Tokenization

The tokens can be traded in secondary markets which will bring more liquidity to the real estate market. Everyone can buy or sell these tokens as a fraction of the ownership, this lowers the investment entry-level and will bring a larger number of investors into real estate. With the use of blockchain, the transactions are completed with digital contracts that are automatized so the transactions are cheaper and faster. Additionally, tokenizations allow investors to have a digital history of the transactions that allow them to prove ownership and makes impossible for someone to falsify transactions or try to sell the tokens more than once.

Room for improvement

Any token needs to be approved by the regulators. This is reducing the risk for the investors, but, on the other hand, it makes the procedure more complicated. In addition, all existing STOs are now registered under D exemption by a Securities and Exchange Commission (SEC) [1]. That means that if one wishes to invest in STO he should have a special authorization to do so, which creates a barrier for the pull of investors. Another important issue with tokenization of real estate is a lack of exchanges offering security token trading. This situation could be mainly explained by two factors. Firstly, it was estimated that 4/5 ICOs in 2017 were scams. Reasonably, investors are concerns about the security of STO and for now, are reluctant to make massive investments. Secondly, there is a number of countries where STO is banned (an example would be China). 

 As you can see, the tokenization of the Real Estate Market has a lot to offer. And though this method has a number of drawbacks, there is a chance that in the nearest future it will revolutionize the Real Estate Market and transform it beyond recognition

Stay tuned for other articles from The Finance Association of EPFL! Don’t hesitate to send us any suggestions at tfa@epfl.ch or on our Facebook and Instagram pages.

Anna Valiullina

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[1] Regulation D (Reg D) is a Securities and Exchange Commission (SEC) regulation governing private placement exemptions. Usually used by smaller companies, the regulation allows capital to be raised through the sale of equity or debt securities without the need to register those securities with the SEC. //Source: https://www.investopedia.com/terms/r/regulationd.asp