Capital Market History Lessons – Corporate Finance (part 1)
Capital Market History Lessons – Corporate Finance (part 1)
Joris Kersten, Place: Uden/ Netherlands, April 14th 2020
Consultant & Trainer Joris Kersten
I am an independent M&A consultant and Valuator from The Netherlands.
In addition, I provide training in “Financial Modelling”, “Business Valuation” and “Mergers & Acquisitions” all over the world (New York, London, Asia, Middle East).
This at leading (“bulge bracket”) investment banks, corporates and universities.
Feel free to contact me to provide inhouse training sessions on corporate finance in The Netherlands or anywhere on the globe.
Moreover, feel free to contact me to provide consulting in M&A and or valuation for medium sized companies in The Netherlands. [email protected] / +31 (0)6 8364 0527.
At last, my training in “Business Valuation & Deal Structuring” this March 2020 in The Netherlands is rescheduled due to the corona virus.
The my NEW training calendar in The Netherlands is as follows:
1. 17, 18, 19, 20 and 22, 23 June 2020: 6 days - Business Valuation & Deal Structuring. Location: Uden/ The Netherlands;
2. 24, 25, 26, 27 and 29, 30 June 2020: 6 days - Business Valuation & Deal Structuring. Location: Uden/ The Netherlands;
3. 28, 29, 30, 31 October 2020 + 2, 3 November 2020: 6 days - Business Valuation & Deal Structuring. Location: Amsterdam Zuidas/ The Netherlands;
4. 16, 17, 18, 19 November 2020: 4 days - Financial Modelling in Excel. Location: Amsterdam Zuidas/ The Netherlands.
All info on these open training sessions can be found on: www.joriskersten.nl
And 130 references on my training sessions can be found on: www.joriskersten.nl
Corporate Finance: An introduction
Next to my M&A/ valuation training sessions over the world (New York, London, Asia, Middle East) and M&A/ valuation consulting for companies (in The Netherlands) I like to write blogs and articles.
This probably comes from my passion for teaching, and I like to write them because it forces me to really think through the valuation concepts.
I write blogs in different “sequences” and my main topics (topics are still growing) are:
1. Net Debt: Cash & debt free + Cash like & debt like items;
2. Financial modelling with "keyboard excel shortcuts";
3. Various topics: Operating lease adjustments, acquisition finance, locked box/ completion accounts closing, purchase price allocation;
4. Bonds & bond markets;
5. Funding & Valuation of startups;
6. Cost of capital: Betas, equity market risk premium, country risk, illiquidity discount, control premium, minority discount, small firm premium;
7. Football field valuation: LBOs, DCF, comps, precedent transactions, accretion/ dilution (M&A model);
8. Valuation of Banks & Financial Institutions.
All the links to the blogs so far on the topics above (>40 blogs) can be found at the end of this blog!
In The Netherlands I am still teaching as “Adjunct Lecturer Accounting & Corporate Finance” at some Universities, like for example:
Maastricht School of Management (MSM), TIAS Business School and Nyenrode University.
And at the worldwide partner universities of MSM in: Lima/ Peru, Paramaribo/ Surinam, Ulaanbaatar/ Mongolia and Kuwait City/ Kuwait.
When teaching I realised that MBA students often struggle with the subject “Corporate Finance”.
For example, they often find it difficult to calculate a balanced WACC (Weighted Average Cost of Capital) out of different components.
I also experience this difficulty with professionals, sometimes even with professionals working in M&A and Private Equity.
This made me decide to write a sequence of blogs on how to calculate a WACC “step by step”.
And the topics in this sequence “Weighted Average Cost of Capital (WACC) step by step” will be:
1. Capital market history lessons (risk & return);
2. Efficient markets hypothesis;
3. The security market line (SML);
4. Cost of capital;
5. Capital structure;
6. Determining capital structure in the WACC in practice;
7. Determining the cost of debt in the WACC in practice;
8. Determining the cost of equity in the WACC in practice.
I have written many blogs already on “discount rates” and “WACCs” in the past, 12 blogs to be precise. And some of them are quite detailed and advanced.
In case you like to read these earlier blogs on “discount rates” you can find the links of these 12 blogs also at the end of this one.
This current sequence of blogs is different in a sense that I will now discuss “step by step” how to calculate a WACC. So it is more basic, this in order to avoid any confusion amongst (MBA) students and practitioners.
The source of this blog is the book mentioned below, it is one of my favourite books that I use for teaching to MBA students at different universities in The Netherlands and over the globe:
· Book: Fundamentals of Corporate Finance – 3rd edition (2017). Authors: David Hillier, Iain Clacher, Stephen Ross, Randolph Westerfield, Bradford Jordan. Publisher: Mc Graw Hill.
Returns: An introduction
When we discuss historical returns of different types of financial assets, then the first question is: How to calculate returns from investing?
Well, returns will generally have two components:
First, you may receive some cash directly while you own the investment. And this is the “income component” of the return.
And second, the value of the asset bought will often change. And this is the “capital gain” or “capital loss” part of the investment.
So for example, you buy a share in the stock market for 25 euro, and you receive a 2 euro dividend on the share in one year. Moreover, the price of the share will go up from 25 euro to 35 euro in one year.
The return you made on this share is called the “dividend yield” + “capital gain yield”.
The dividend yield = 2/ 25 = 8%
The capital gain yield = (35-25)/ 25 = 40%
Total return = 48%
(Hillier, Clacher, Ross, Westerfield and Jordan, 2017)
Historical returns
Now knowing what returns are, we can take a look at the historical “rates of return” of a number of different securities in different countries.
Well, I am from the Netherlands, so for the Netherlands we can take a look at:
· The Amsterdam Stock Exchange (SE), all shares.
And we can take a look at the “returns” un-adjusted for: Taxes, transaction costs and inflation. And this for example in the time period: 2006-2016.
For example we can take a look at the growth of an investment in the Dutch stock market during 2006-2016.
This shows what the worth of the investment would have been, if the money that was initially invested had been left in the stock market, including re-investment of the yearly dividends in that same market.
When looking at the stock market data we can use “index values” for every year between 1 January 2006 and 1 January 2016.
With index values we put 1 January 2006 on 100%, and then we look at subsequent years in relation to the 100% of the 1st of January 2006.
And as we all can remember, the “credit crunch” also affected The Netherlands.
Because of this, the “stock market index level” of “Amsterdam SE, all shares” was at the 1st of January 2009 only about 55% of what it was at the 1st of January 2006.
So from this perspective, the value invested in the Dutch stock exchange almost halved in only three years of time due to the credit crunch.
On top of index values, we can look at the different returns per year based on the index values.
(Hillier, Clacher, Ross, Westerfield and Jordan, 2017)
Average returns
When we look at the different returns per year, based on the index values, we can then also calculate the “average yearly returns”.
In the example given above on the Dutch stock exchange, we would look at the 10 yearly returns over 2006 until 2015 (10 years) and then sum them, and in the end divide them by 10.
In case of The Netherlands, this would then be about 1.83 % average annual return (2006-2015).
But what does this average tell us ??
Well, nothing more, nothing less, than that if you were to pick a year randomly from the 10 year stock market history, and you would have to guess what the return was in that year, then the best guess would be: 1.83%.
(Hillier, Clacher, Ross, Westerfield and Jordan, 2017)
Risk premiums on equities
Now that we get a little feel of average returns on shares, let’s start comparing them to other returns.
And we often like to compare them (returns of shares) with government issued securities. Since these are free of much of the variability that we see back in the stock markets.
Governments borrow money by issuing bonds in different forms. The so called “treasury bills” (T-bills) have the shortest time to maturity of the different government bonds.
And because governments can always raise taxes to pay its bills, the debt represented by T-bills is virtually free of any default risk over its short life.
So we like to call the return on such debt the “risk free rate”.
The return on long term government bonds is slightly more risky because the period of borrowing is about 10 years. This means that investors need to bear the risk longer than on T-bills.
Well, what we find interesting is the following:
We like to compare the return on ordinary equities (shares) with virtually risk free rates on T-bills and 10 year government bonds.
And the difference between these returns can be seen as the “excess return” you make on an “average risky assets” like shares of large corporations listed on the stock exchange.
This “excess return” can be seen as a reward for bearing risk, and that’s why corporate finance practitioners like to call it the “Equity Risk Premium” (ERP).
When we are looking at the situation in The Netherlands, as this is where I am from, the ERP is yearly on average about 4% above bond returns and about 3.5% above T-bill returns.
This depending on how we exactly measure and calculate this (more on this later on). And calculated on the very large time period: 1900 – 2010.
So at least we can conclude that over the long term (>100 years) risky assets, like equity in corporations on the Dutch stock exchange, earns on average a “risk premium”.
So there is a reward for bearing risk! ??
(Hillier, Clacher, Ross, Westerfield and Jordan, 2017)
Return variability/ Measuring risk
I have discussed that year to year returns on equities (shares in corporations in The Netherlands for example) are more volatile than returns on 10 year government bonds.
And “risk” tells us something about the “variability” of these equity returns.
So basically we like to know the “spread in returns”.
For example, we have found that the average yearly returns on the Dutch stock exchange were about 1.83% (2006-2015).
But now we find it very interesting to know how much the actual return deviates from this average in a typical year.
In other words, we like to know how “volatile” the return is!
And in corporate finance for this we use the statistical measure “variance” and also it’s square root, called the “standard deviation”.
Let’s now take a look at the calculations.
(Hillier, Clacher, Ross, Westerfield and Jordan, 2017)
Historical variance and standard deviation
The variance actually measures the “average squared difference” between the actual returns and the average returns.
The bigger this number is, the more the actual returns tend to differ from the average return.
In addition, the larger the variance (or standard deviation) is, the more spread out the returns will be.
Let’s now take a look at historical returns, so we will look at how to calculate the historical variance and standard deviation.
What we need is the following:
1. Actual returns;
2. Average returns that can be calculated from the actual returns;
3. The “deviation”, that is: actual return – average return;
4. The squared deviation.
When we then sum the squared deviations of for example a certain amount of years, we get the “sum of the squared deviations from the average”.
And for people who followed a statistics class in the past, you might remember that for the “variance” you need to divide this number by: “(N – 1)”.
In which N stands for the certain number of years of returns taken into account.
After we have calculated the “variance” (also called “sigma squared”) we like to calculate the “standard deviation” (SD).
SD simply is the square root of the variance. And the SD is used because the variance is measured in “squared” percentages and therefore hard to interpret.
In the end the SD comes out as a normal percentage, for example 7%.
In the next blog on returns, I will pick it up from here, at least for now we have discussed the important concept of average returns and SDs in corporate finance! ??
(Hillier, Clacher, Ross, Westerfield and Jordan, 2017)
To be continued !
Lots more to come in this sequence on the WACC about: Capital market efficiency, the security market line, cost of capital and capital structure.
This in order to determine the WACC in a practical way in this sequence of blogs on the WACC!
Check out my other blogs on valuation (>40), and find all the links just below!
Source of this blog
The source of this blog is the book mentioned below, it is one of my favourite books that I use for teaching to MBA students at different universities in The Netherlands and over the globe:
· Book: Fundamentals of Corporate Finance – 3rd edition (2017). Authors: David Hillier, Iain Clacher, Stephen Ross, Randolph Westerfield, Bradford Jordan. Publisher: Mc Graw Hill.
Under here you can find my previous blogs (over 40) on valuation:
Earlier blogs on “net debt” (cash & debt free)
Article 1: Valuation: Introduction to "net debt" (cash & debt free)
https://www.dhirubhai.net/pulse/valuation-introduction-net-debt-cash-free-joris-kersten-msc-bsc-rab/
Article 2: Valuation: Net debt (cash & debt free)
https://www.dhirubhai.net/pulse/valuation-net-debt-cash-free-joris-kersten-msc-bsc-rab/
Article 3: Valuation: Adjusted net debt – Cash like items
https://www.dhirubhai.net/pulse/valuation-adjusted-net-debt-cash-like-items-kersten-msc-bsc-rab/
Article 4: Valuation: Adjusted net debt – Debt like items
https://www.dhirubhai.net/pulse/valuation-adjusted-net-debt-like-items-joris-kersten-msc-bsc-rab/
Earlier blogs on “valuation of banks”
Article 1: Valuation of Banks: Business models of Banks
https://www.dhirubhai.net/pulse/valuation-banks-business-models-joris-kersten-msc-bsc-rab/
Earlier blogs on Financial Modelling
Article 1: Financial Modelling in Excel: Circular references, interest calculations and iterations
https://www.dhirubhai.net/pulse/financial-modelling-excel-circular-references-kersten-msc-bsc-rab/
Article 2: Excel basics for Finance: SUM, MAX, MIN, AVERAGE, IF, cell referencing, named ranges
https://www.dhirubhai.net/pulse/excel-basics-finance-sum-max-min-average-cell-named-joris/
Article 3: Excel for Valuation: COUNTIF, VLOOKUP, INDEX and MATCH
https://www.dhirubhai.net/pulse/excel-valuation-countif-vlookup-index-match-kersten-msc-bsc-rab/
Article 4: Excel for Business Valuation: OFFSET, FORECAST and CHOOSE
https://www.dhirubhai.net/pulse/excel-business-valuation-offset-forecast-choose/
Article 5: Excel for Business Valuation: NPV, IRR, PMT and EOMONTH
https://www.dhirubhai.net/pulse/excel-business-valuation-npv-irr-pmt-eomonth-kersten-msc-bsc-rab/
Earlier blogs on “various topics”
Article 1: Financing a M&A transaction: An introduction
https://www.dhirubhai.net/pulse/financing-ma-transaction-introduction-joris-kersten-msc-bsc-rab/
Article 2: Valuation: How to adjust for “Operating Lease” (under Dutch GAAP)
https://www.dhirubhai.net/pulse/valuation-how-adjust-operating-lease-under-dutch-gaap-joris/
Article 3: M&A closing mechanisms: Locked Box & Completion Accounts
https://www.dhirubhai.net/pulse/ma-closing-mechanisms-locked-box-completion-accounts-joris/
Article 4: Scoping a financial model built primarily for business valuation:
https://www.dhirubhai.net/pulse/scoping-financial-model-built-primarily-business-joris/
Article 5: Consolidation of M&A targets and Purchase Price Allocation (PPA)
https://www.dhirubhai.net/pulse/consolidation-ma-targets-purchase-price-allocation-joris/
Earlier blogs on “bonds”
Article 1: Bonds - An introduction
https://www.dhirubhai.net/pulse/corporate-finance-bonds-introduction-joris-kersten-msc-bsc-rab/
Article 2: Bonds & Bond Markets
https://www.dhirubhai.net/pulse/bonds-bond-markets-corporate-finance-joris-kersten-msc-bsc-rab/
Article 3: Bonds, Rating Agencies and Credit Ratings
https://www.dhirubhai.net/pulse/bonds-rating-agencies-credit-ratings-joris-kersten-msc-bsc-rab/
Earlier blogs on “Valuation & funding of start-ups”
Article 1: Valuation & funding of start-ups - Funding rounds
https://www.dhirubhai.net/pulse/valuation-funding-startups-rounds-joris-kersten-msc-bsc-rab/
Article 2: Startup valuation: Pre-money and post-money valuation
https://www.dhirubhai.net/pulse/startup-valuation-pre-money-post-money-joris-kersten-msc-bsc-rab/
Article 3: Valuation methods for Startups (early stage) – Part 1
https://www.dhirubhai.net/pulse/valuation-methods-startups-early-stage-part-1-kersten-msc-bsc-rab/
Article 4: Valuation methods for Startups (early stage) – Part 2
https://www.dhirubhai.net/pulse/valuation-methods-startups-early-stage-part-2-kersten-msc-bsc-rab/
Article 5: Startups in Silicon Valley: The beginning – Part 1
https://www.dhirubhai.net/pulse/startups-silicon-valley-beginning-part-1-joris-kersten-msc-bsc-rab/
Article 6: Startup Funding & Convertible Debt (part 1)
https://www.dhirubhai.net/pulse/startup-funding-convertible-debt-part-1-joris-kersten-msc-bsc-rab/
Earlier blogs on the “cost of capital”
Article 1: Valuation & Betas (CAPM)
https://www.dhirubhai.net/pulse/valuation-betas-capm-joris-kersten-msc-bsc-rab/
Article 2: Valuation & Equity Market Risk Premium (CAPM)
https://www.dhirubhai.net/pulse/valuation-equity-market-risk-premium-capm-joris-kersten-msc-bsc-rab/
Article 3: Is the Capital Asset Pricing Model dead ? (CAPM)
https://www.dhirubhai.net/pulse/capital-asset-pricing-model-dead-capm-joris-kersten-msc-bsc-rab/
Article 4: Valuation & the cost of debt (WACC)
https://www.dhirubhai.net/pulse/valuation-cost-debt-wacc-joris-kersten-msc-bsc-rab/
Article 5: Valuation & Capital Structure (WACC)
https://www.dhirubhai.net/pulse/valuation-capital-structure-wacc-joris-kersten-msc-bsc-rab/
Article 6: International WACC & Country Risk – Part 1
https://www.dhirubhai.net/pulse/valuation-international-wacc-country-risk-part-1-joris/
Article 7: International WACC – Part 2
https://www.dhirubhai.net/pulse/valuation-international-wacc-part-2-joris-kersten-msc-bsc-rab/
Article 8: Present Values, Real Options, the Dot.com Bubble
https://www.dhirubhai.net/pulse/valuation-present-values-real-options-dotcom-bubble-joris/
Article 9: Valuation: Different DCF & WACC techniques
https://www.dhirubhai.net/pulse/valuation-different-dcf-wacc-techniques-joris-kersten-msc-bsc-rab/
Article 10: Valuation of a company abroad
https://www.dhirubhai.net/pulse/valuation-company-abroad-joris-kersten-msc-bsc-rab/
Article 11: Valuation: Illiquidity discounts, control premiums and minority discounts
https://www.dhirubhai.net/pulse/valuation-illiquidity-discounts-control-premiums-joris/
Article 12: Valuation: Small firm premiums
https://www.dhirubhai.net/pulse/valuation-small-firm-premiums-joris-kersten-msc-bsc-rab/
Earlier blogs on “Business valuation to Enterprise Value”
From June until August I have written the following blogs on valuation:
1) Leveraged Buyout (LBO) Analysis:
https://www.dhirubhai.net/pulse/leveraged-buyouts-lbos-joris-kersten-msc-bsc-rab/
2) M&A Analysis – Accretion/ Dilution:
https://www.dhirubhai.net/pulse/ma-model-accretion-dilution-joris-kersten-msc-bsc-rab/
3) Discounted Cash Flow Valuation:
https://www.dhirubhai.net/pulse/discounted-cash-flow-valuation-dcf-joris-kersten-msc-bsc-rab/
4) Valuation Multiples 1 – Comparable Companies Analysis:
https://www.dhirubhai.net/pulse/valuation-multiples-1-comparable-companies-analysis-joris
5) Excel Shortcuts & Business Valuation:
https://www.dhirubhai.net/pulse/excel-shortcuts-business-valuation-joris-kersten-msc-bsc-rab
6) Valuation Multiples 2 – Precedent Transaction Analysis:
https://www.dhirubhai.net/pulse/valuation-multiples-2-precedent-transaction-kersten-msc-bsc-rab
Earlier blogs on Wall Street
Article 1: Wall Street – A general introduction
https://www.dhirubhai.net/pulse/wall-street-general-introduction-joris-kersten-msc-bsc-rab/
Article 2: Wall Street – The Federal Reserve banking system
https://www.dhirubhai.net/pulse/wall-street-federal-reserve-banking-system-kersten-msc-bsc-rab/
Consultant & Trainer Joris Kersten
I am an independent M&A consultant and Valuator from The Netherlands.
In addition, I provide training in “Financial Modelling”, “Business Valuation” and “Mergers & Acquisitions” all over the world (New York, London, Asia, Middle East).
This at leading (“bulge bracket”) investment banks, corporates and universities.
Feel free to contact me to provide inhouse training sessions on corporate finance in The Netherlands or anywhere on the globe.
Moreover, feel free to contact me to provide consulting in M&A and or valuation for medium sized companies in The Netherlands. [email protected] / +31 (0)6 8364 0527.
At last, my training in “Business Valuation & Deal Structuring” this March 2020 in The Netherlands is rescheduled due to the corona virus.
The my NEW training calendar in The Netherlands is as follows:
5. 17, 18, 19, 20 and 22, 23 June 2020: 6 days - Business Valuation & Deal Structuring. Location: Uden/ The Netherlands;
6. 24, 25, 26, 27 and 29, 30 June 2020: 6 days - Business Valuation & Deal Structuring. Location: Uden/ The Netherlands;
7. 28, 29, 30, 31 October 2020 + 2, 3 November 2020: 6 days - Business Valuation & Deal Structuring. Location: Amsterdam Zuidas/ The Netherlands;
8. 16, 17, 18, 19 November 2020: 4 days - Financial Modelling in Excel. Location: Amsterdam Zuidas/ The Netherlands.
All info on these open training sessions can be found on: www.joriskersten.nl
And 130 references on my training sessions can be found on: www.joriskersten.nl