Beta

Anyone who has ever dealt with valuation or modern corporate finance has probably encountered the use of beta. In modern finance beta is the key relative risk measure used in the Capital Asset Pricing Model (CAPM) to determine the risk premium demanded by equity investors. I’d like to take a minute to talk about what exactly beta is measuring along with methods by which to determine the beta used in CAPM.

Let’s begin with what exactly beta is meant to measure. Beta is a measure of systemic risk of a security versus the market as a whole. It is generally viewed as the covariance between the returns of the security and the returns of the aggregate market divided by the variance of returns of the aggregate market. Or rewritten as the correlation between the returns of the stock and the aggregate market multiplied by the standard deviation of the stock returns dividend by the standard deviation of aggregate market returns. 

Most commonly these calculations are done using a simple regression with the returns of the aggregate market being the independent variable and the returns of the stock being the dependent variable. The regression result will provide the coefficient of the x variable which will represent beta. In essence, if we apply the simple linear equation (Y = mX + B) the “m” is beta which show how much of a movement can be expected in the given stock based on the movement of the aggregate market. It is common to use the returns of the S&P 500 to represent the market and between a 3-5 year time horizons for return data.

While much more could be said regarding the technical side of regressing to find beta, I would like to look at one simple fact. In any regression the coefficient of determination (R²) indicates how much of the data can be explained by the regression model. Put simply, it is a measure of accuracy within the regression model. In almost any regression model to find beta, the R² will be very low (0.30 or less), this leads us to question the accuracy of using this method to calculate such an important variable when calculating the cost of equity capital.

Before I get into an alternative method for beta, I would like to shift our focus back to what beta measures for a moment. Beta is the measure of systemic risk of a firm, and part of this risk is both operating risk and financial risk. Operating risk can be defined as the risk inherent in a firm that is fully financed with equity, essentially the risk of the business if it had not required debt payments. The firm’s operating risk is impacted by the amount of fixed versus variable costs. The other part of this risk is financial risk, which is the risk as firm’s equity holder bear due to the use of leverage and thus required debt payments. Now in calculating a regression beta we will have a result of levered beta, which is the beta that includes both operating risk and financial risk. Let’s now jump to an alternative method for calculating beta. 

An alternative that is commonly used is to first identify the firm’s industry and collected data on a group of comparable companies. Then take these firms and run a simple regression to calculate beta. The betas collected, as described above, are levered betas. Since our firm, and each firm in the group of comparable companies will most likely have different uses of leverage, we must “unlever” these betas. The process of unlevering beta is essentially factoring in both the amount of debt capital used as compared to equity capital along with the benefits provided by the tax shield offered from interest payments. Levered beta can also be calculated from unlevered beta. The calculations for both are described below.

To continue with the alternative beta calculation, you first must take the levered betas found through regression and unlevered each of these based on each firms respective debt to equity capital structure and corporate marginal tax rate. Then a mean or median of these unlevered betas can be used to determine and estimate for the industry beta; the choice of mean of median will be a judgment based on variance of these betas. Once the industry’s unlevered beta is found, the beta can be relevered using our given firm’s debt to equity structure and marginal tax rate to determine the beta used within the CAPM.

Now you may ask “what is the benefit of completing this process versus using a simple regression?” Well as discussed above, simple regressions have very low predictability value and can lead to misleading betas. By using this alternative, you are collecting date on multiple firms within the industry which can eliminate some of the risk of having an outlier. Is it perfect? No, but I do believe that it can provide a better estimate of the true systemic risk of a firm. 

Hope you found this interesting. 

My CPA Exam Journey

I have been asked by the student accounting group at my graduate program to talk to both undergrad and graduate accounting students about my journey throughout the CPA exam. As almost all of these students are in the process of, or planning on soon sitting for the exams, I hope sharing my experience will be helpful in better preparing them to pass. While I am in no way a “CPA Guru,” I have taken the exam very recently and can share the tips and tricks I learned along the way. Hope you enjoy.

Let us begin by talking about the structure of the Uniform CPA exam. As of 2013, the exam consisted of four individual sections. These sections are Auditing & Attestation (AUD), Business Environment & Concepts (BEC), Financial Accounting & Reporting (FAR), and Regulation (REG). Other sources will better explain the content of each exam. Each consists of four testlets, the first two have three multiple choice sets with 24 questions. AUD is followed by six simulation questions which test application of the material. BEC’s fourth testlet is a writing sample in which you must complete three short pieces that are scored on both technical content and grammatical structure. FAR and REG both have four testlets as well; however, each of the three first multiple choice sets have 30 questions and the fourth is again a simulation set. AUD and BEC both offer the tester three hours to complete, while FAR and REG offer four hours. Again, outside sources can offer a more detailed explanation of the structure, as this is simply an overview.

When it comes to registering for the CPA exam, you must first have completed the required education for your respective state; details can be found here. For my state (Michigan) and many others, you apply through NASBA. After applying and being approved, you will receive a Notice to Schedule (NTS), this allows you to register with Prometric to take the exam. Remember that testing is only offered in the first two months of each quarter, so plan ahead. I believe a key to success is to register for the exams ahead of time, as doing this adds a level of “stress” to stop the procrastination.

When to take each exam and the amount of time you will need to study for each will vary depending on your situation. For me, I took the exams over the summer of 2013 and in the following order: BEC, FAR, AUD and REG. I planned to spend the summer studying full-time, so this worked out well for me. The one piece of advice I can offer is to take your anticipated “hardest” sections first. When you get to the last exam you are most likely going to be burnt out from CPA exams and your motivation levels will be at all-time lows. Thus, taking your “strongest” sections last will make it that much easier to study. When deciding how much time to dedicate to study, just be honest with yourself. Don’t over plan study time, but don’t short yourself.

When it comes down to study techniques, I recommend using a prep program like Becker. Full disclosure, I am a campus representative for the program and did receive the material at no cost. However, I can confidently say that I believe that they offer the best prep program for the CPA. Regardless of your prep program you use, make sure you first watch or read the lectures then complete as many multiple choice questions as possible. The multiple choice questions are KEY. Most prep programs license their questions for previously used AICPA exam questions, which makes them very relative to the potential exam questions. The more multiple choice questions you complete, the better your retention rate and recall speeds will be on exam day, which is essential to success. I personally completed thousands of questions over the three months I spent studying; but I would like to think that my exam scores reflect this well.

One of the best study habits that I can offer is to set time aside for it. This is imperative to making sure you complete all the necessary preparation prior to exam day. Life offers you a multitude of distractions and more attractive opportunities. You will have to learn to give up your social life for a few months and be willing to turn down the night at the bar in exchange for reviewing IFRS standards. Yes, this will be undesirable, but in the end it will be worth it. As with everything, balance is a necessity, but don’t let this be an excuse to skip on studying in exchange for a few beers or dinner and a movie.

A great way to ensure you stay focused and have the physical and mental energy to get through your day is not only exercise regularly but to also eat healthy. I am neither a dietitian nor a personal trainer, so I will leave the details to the professionals: I will only offer the idea of plentiful cardiovascular exercise combined with a balanced diet. It will be very easy to snack on “junk” all day long while you’re cramming for the CPA, DON’T DO IT!

You will also need the support of your family and friends along the way. If you are in a relationship, prior to starting the exams explain the entire thing to your significant other. Doing this will help him or her better understand not only the importance of this exam, but also the tremendous time dedication it will require. Most people won’t understand how in-depth this exam is and why you can’t socialize more. You can try to explain it to them, but you’ll quickly get sick of this. Accept the fact that they will pressure you and you must be able to say no and ignore their comments and maintain focus. Once you’re done with the exams take them all out to the bar to celebrate and insist on each of them buying you a drink to celebrate, win-win.

For support and focus, I also utilized Another71.com. This site offers a great forum board filled with motivation and support. It is also a great place to either ask or answer questions. During my studying, I would ask questions on topics I did not understand to other members. I also would answer as many questions as I could on material that I understood. Doing this allowed me to reinforce my knowledge and I believe helped improve my performance on the exams.

When prepping for exam day, be ready for stress. The stress level for the first exam will be the worst, as you don’t know exactly what to expect. Don’t worry, they get less and less stressful as you get through them. Make sure you get a good night’s sleep before the exam and stay away from sleep aids as they leave you with “medicine head” the next morning. I am a huge coffee guy and believe that it is necessary for life; however, make sure you know how you react to caffeine prior to taking too much before the exam. You will be stressed as it is, you don’t need a case of the jitters to compliment the stress. Simply put, just relax. If you are prepared, you’ll do fine and there will be no need to worry.

To help alleviate the stress, I recommend packing everything you need in a clear plastic bag the night before. You must have both your state issued ID along with your NTS to get into the testing center. Forgetting either of these will leave you taking the exam at a different time. Weeks prior to exam day, make sure your ID matches your NTS name perfectly, you don’t want any issues on exam day. I am not sure if this applies to all Prometric centers, but mine allowed me to bring snacks in and leave them in the locker. I brought a few power bars to eat in between testlets; remember that these are three and four hour exams and your brain needs power.

I recommend dressing is layers, you will never know how the testing room will be. You will be checked for metal prior to entering the room. Leave hats, belts, watches, rings, etc. at home. Just make sure you are comfortable. I wore athletic shorts, a tee and my Jesus cruiser-style flip-flops to two of my exams. Being comfortable makes the four hours of hell a bit easier to handle.

Have you ever tried to write with a dried up dry-erase marker on a flimsy laminated sheet of graph paper? Well guess what! You will get the opportunity to very soon. Yes, it is as bad as I make it sound, they will give you two markers and I can ensure you that one will be completely dried up and the other will be darn close. Luckily you shouldn't need to write too much down; just be aware of what you will have to use. You can go and get new markers or sheets, but this will consume some of your valuable testing time.

Once you’re in the exam, you will be allowed to leave for breaks between testlets; however, your time does not stop ticking. I do recommend taking breaks between each to stretch your legs and get the blood flowing, and bathroom breaks are great too. Each time you leave, you will need to sign back in using your ID and a finger print, so make sure to factor this time into your plans.

Waiting for your exam score will feel like an eternity, but don’t worry it will come sooner or later. If you have more sections to take, stay focused and keep studying. If you are all done, crack open an ice cold beer and relax. While I am confident that you’ll pass them all on your first attempt if you dedicate the time, if you don’t—just relax. You can retake exams in the next testing window, just make sure you put more time into preparation for the next round. Passing isn't as much a function of smarts as a function of time dedicated to expanding your knowledge.

Best of luck to all you test takers!

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Financial Statement Flow

Having a strong understanding of the “flow” through financial statements is essential in the valuation process. One must create forecasts and make assumptions that will impact pro-forma financials and should be able to identify how these will flow through the three primary financials. I thought it would be worthwhile to create a post covering the basic flow between each of the primary financials. As with many of my posts, this will have an emphasis on valuation uses and therefore will include certain details that are of particular concern to valuation modeling. Enjoy.

To help guide our conversations, I have created a simple graphic that outlines the most important flows between statements.  I will reference these flows and their colors through the post to help the reader gain a better understanding.

 

Due to the web of flows that is created here, I will start at the top of the income statement and work my way through these in what will hopefully be a coherent manner. Let’s get started.

The income statement starts with revenue less Cost of Goods Sold (COGS) to get gross income and then Sales, General and administrative (SG&A) along with Depreciation and Amortization (D&A) expenses are subtracted to get earnings before interest and tax (EBIT). In some financials D&A in consolidated within SG&A so be on the lookout for this. D&A (purple line) has two primary flows, first of which is to the balance sheet into the Accumulated Depreciation account. The amount of D&A expense will be added to the accumulated depreciation account to calculate Net PP&E. Remember too that only the “D” portion will flow into accumulated depreciation account, not the amortization. If a firm has no intangible assets to amortize, this is easy; however if they consolidate this you might have to dig into the footnotes to determine what amount is actually attributable to depreciation. The second flow for D&A is into the Statement of Cash Flows as an add-back to operating cash flow. Since D&A is a non-cash expense, it must be added back to net income.

Now let’s look at Interest Expense and Income (orange and brown lines). Interest Expense/Income can be found as a line item on historical financials, thus this commentary only applies to forecasting future financials. The general rule of thumb is to calculate interest expense as the average debt—(beginning balance+endining balance)/2—multiplied by the interest expense for the given debt. The same calculation is used for interest income but based on the average cash balance. You can also see the dark orange flow line from payments and issuance of Long-Term Debt (LTD), this will impact the balance and thus the interest expense.

Net Income (NI) is arguable the most important flow to understand. NI is represented by the light-red line and flows into two primary areas. First, NI is used as the starting basis for the indirect cash flow statement creation. The second flow is one that is most often forgotten, NI flows into the Retained Earnings on the balance sheet. Jumping over to the statement of cash flows, we can also see the flow between dividends under the cash flow from financing section to retained earnings (dark red line). Dividends paid will reduce the retained earnings balance while net income will increase it.

Let’s now turn out attention to some balance sheet accounts that have yet to be addressed. The Accounts Receivable (A/R), Inventory, and Accounts Payable (A/P) are all considered working capital (W/C). There may be other items such as accruals, however this is a simplified example. The change in these account balance (light blue) will flow into the statement of cash flows under the cash flow from operations section. I used the term “delta in W/C” to indicate that the change in these could either be an increase in cash flow or a decrease in cash flow. If there is an increase in net working capital (current assets less current liabilities) then this will be a use of cash and therefore a subtraction from net income; the opposite applies if it was a decrease in net working capital. We must also remember that in this instance the net working capital calculation does not include cash.

Next let’s look at the Property, Plant and Equipment (PP&E) account on the balance sheet. We can see the flow between the investing section of the statement of cash flows and the PP&E account on the balance sheet (yellow). If a firm has CapEx it will be an outflow of cash on the statement of cash flow but will be capitalized as an asset and added to PP&E on the balance sheet. Conversely, if a firm sells a piece of equipment it will be a cash inflow on the statement of cash flows while it will reduce the PP&E account on the balance sheet (both the PP&E and accumulated depreciation will be reduced as they relate to the asset being sold).

Lastly, we take a look at the bottom of the statement of cash flows to see that the ending cash balance (green line) will flow back to the balance sheet for the respective period ending. The beginning cash balance comes from the cash balance on the opening balance sheet (not shown in the image).

While this is a very simplified explanation of the flow between the statements, I do hope it puts its all in prospective and helps you better understand the process. Again, I did not list every single flow, only those most important to creating pro-forma forecasted financials. If you have questions or need clarifications, feel free to ask.