Soon after cracking open this 600-pager from my Educate pile and working my way through the first several pages, a question arose: “Just how much wine had I had when I added this to my Amazon wishlist!?”
Honestly, if I’d bought this myself I think I would’ve lasted maybe 50 pages before orphaning it to the local library donation box. But my wife generously purchased it for me as a gift, and the darn thing wasn’t cheap, so I felt I had to stick with it.
The first 500 pages reminded me so much of CFA Level 2’s Financial Statement Analysis. Do you think you’re the rare bird who likes FSA and actually would enjoy this book? Let me reproduce just a single sentence from page 311 that will give you a taste of what every freaking page is like:
“If the likelihood of default is minimal and the debt is non-recourse such that the joint-venture entity has at least three times fixed-charge coverage and operating cash flow capable of servicing the principle debt, the analyst may exclude the debt from the owner’s balance sheet; otherwise, it could be included based either on the proportionate share of ownership or on exposure of repayment, which would be the case if one of the joint-venture partners was incapable of satisfying a claim.”
Waiter… More wine.
It wasn’t until around page 500 that I began to recall why I wanted this book so badly. It’s common for security analysts to poke fun at CAPM (a.k.a. Crap-m) for how poor a job it does in estimating cost of equity (“CAPM never disappoints, it always fails”) but it’s rare that someone will actually suggest something to replace it with. This book is the author’s answer and I congratulate him on the effort, even if he needs 500 pages to get warmed up.
(Side note: Bruce Greenwald has a nice CAPM replacement: look up what YTM the company’s long term bonds are trading at and add a few percentage points to it since equity holders are subordinate in claims. The simplicity! I love it! The author doesn’t love it. If memory serves, the YTM can change drastically with the economy, leading to a cost of equity that isn’t stable over time, just like CAPM.)
So what’s the author’s model? It’s a checklist of red flags, each one of which potentially raises the estimate of cost of equity by a little. But this isn’t your father’s simple checklist of low current ratio, high debt-to-FCF, etc. The author’s list is symptomatic of either a devastating intellect and high attention to detail, or… the Good Idea Fairy Gone Wild (I couldn’t decide). He took the list of 10 things that might make me add 1% each to a discount rate and turned it into almost 100 that add 0.1% per!
Did I say 0.1% per? That’s not precisely right – he doesn’t weight them all equally. In fact, he writes that his weighting scheme is “proprietary” and thus won’t be shared! Oh man, did that get my goat. For how much my wife spent?! But by the final page I concluded I’d probably want to come up with my own list and weight it my own way anyway.
So, it was a long, painful read but the book gave me a new way to think about estimating cost of equity, and I’m grateful for that. And what better way to be The Interesting Guy at the analysts’ party than to boldly state that the final frontier in DCF modeling is not to get better at the numerator (guessing the future) but rather the denominator (the handicapping). If you find yourself with a copy of Security Valuation and Risk Analysis, just read Chapters 7 and 8. I even think I recall the author saying you could do that in the book’s opening but I was too stubborn to listen.