You could almost see the porcelain of the baths, metaphorically speaking, waiting to be pressed into use again. Note my deliberate use of the past tense when referring to the "Enron world". I strongly believe that we have entered the post-Enron world, although that world is largely yet to be defined.
The Debacle
Nor was it the first company to turn into a stock price pump and manipulate its numbers to artificially boost its appeal to “The Street”. He was unlucky enough to find himself in the spotlight, subjected to intense scrutiny and ranked among the vanquished. The question was to what extent was Enron an isolated case - one bad apple in the barrel? Almost everyone with a stake in the economy was hoping the stench emanating from the Houston energy trading giant would turn out to be an aberration.
The Innovators at Enron
The second safety mechanism relied on by Enron was not codified in law but was in place in most of the US. But the truth is that Enron transformed itself into an expert player in risk management.
Bandwidth and Stock Prices: A Cautionary Tale
Enron's stock price consistently followed the upward trend of the Nasdaq Index, which specializes in technology stocks (the "stock market of the 21st century," as some long-vanished ads used to call it). It wasn't until 2000 that Enron's stock price gained momentum and continued to rise for another six months—reaching a 300 percent growth rate—while the Nasdaq stalled at a relatively paltry 250 percent.
Does “Asset-Light” Equal “Corporate-Lite”?
Some of the great innovations in business history have been met with scorn and ridicule. However, can we really blame Enron for stepping aside and trying to inject itself into the hot, “happening” sector of the economy?
Andersen and the Chronology of Doom
In short, it became inevitable when the company's auditor, Andersen, decided that the financial results of some of those complicated Enron partnerships should have been consolidated with those of the parent company after all. On November 28, Standard & Poor's and Moody's Investors Service, the main rating agencies, downgraded Enron's debt to junk bond status, triggering the company's collapse.11 "A classic run on the bank,".
LESSONS FOR INVESTORS
The auditing firm Arthur Andersen was indicted on 18 March 2002 for its role in the Enron case. The board is fully aware," he declared in gloomy tones, "of the serious concerns that resulted in the Ministry of Justice's indictment against Andersen."4.
Blameless Victim or Repeat Offender?
Volcker, the highly respected former chairman of the Federal Reserve Board and chairman of Andersen's independent supervisory board, weighed in on the contrary. New York Times correspondent Kurt Eichenwald compiled a devastating portrait of Andersen's track record in the months and years leading up to the unfolding of the Enron drama, documenting the government's growing anger with an arrogant Andersen.
The Spirit and the Letter
And, you know, in tax accounting, if you follow the codes, whatever result you get, you're justified in using that treatment. In his appearance before the Senate, Jeffrey Skilling publicly wanted a shift to what he called the "European structure", in which - he asserted - "it is more what makes sense than the specific rules that govern transactions". However, the fact that the same ills are often attributed by Europeans to their own tax codes suggests that the explanation lies elsewhere.
Too Cozy for Comfort
Because after all, Enron and Andersen would be held to an ethical rather than a technical standard. This is a point that Enron and Andersen (and to some extent, the congressional inquisitors who came after the debacle) seemed to miss over and over again.
Beyond “Marking to Market”
In other words, the public was interested in the moral, rather than the mechanical, aspects of the Enron/Andersen affair. All of this is to say that valuing business assets—and auditing those valuations—is complicated, full of value judgments, and—ultimately—somewhat arbitrary.
From Enron to Andersen—To the Swoon
The stock market's steep decline in the first half of 2002 was partly the result of overvaluing stocks facing a faltering economy. That's what many investors did in the first half of 2002—they got out.
You and I Played a Part, Too
In theory, of course, a rising stock price can (and should) reflect a company rising in value. It turned out that in many cases the answer was 'never'. The survivors in the dotcom universe (the Amazons and eBays) accepted their responsibility to make money.
Buying, Selling, Leasing
If the transfer of ownership occurs before the price is paid, the transaction is a credit purchase. If the opposite is true - that is, if the price is paid before ownership or use changes hands - the transaction is a forward purchase.
Loans 101
The amount of money agreed upon between trading parties for the transfer of ownership or use is the price, and anything that has a price attached to it is a good or a commodity.
Capitalism at Work
A gain or loss is generally expressed as an amount of cash related to a specific period: “There was a profit of $30,000 for the year.”. There is a conventional way to make profits (and losses) comparable: to assess them over a standard period – usually a year – with the profit (or loss) calculated as a share of the capital invested, which translates into a return .
Capital Growth Through Diversification
The profit rate for Julie, Inc., grew from 20 to 25 percent, and for Percy, Inc., grew from 10 to 12.5 percent (the combination of a 10 percent profit rate on $1 million and a 15 percent interest rate on other $1 million that was lent). Percy was able to make more money through a different allocation of his capital—in other words, through diversification, supplementing the profits he earned through Percy, Inc. with the interest collected through loan capital.
Why Julie and Percy Are Interesting
That $50,000 is her profit on the capital she borrowed, it is the reward she gets for being a successful entrepreneur. The mechanism underlying this is known in the financial literature as the price discovery process.
LESSONS FOR THE INVESTOR
The method by which we accumulate capital in this country is to have an investor in Bismarck, North Dakota—or anywhere in the country—buy a share of stock on the belief that the financial statements presented by this corporation are approved. on the part of the accountants, it is a fair representation and a fair representation of what is going on within this corporation. If that trust is broken—and I believe it was in the case of the Enron Corporation—when that trust is broken, it undermines the method by which you accumulate capital for our system of capitalism.
The Two Ways You Get Compensated
The first compensation method, which we have already examined, determines the return and calculates it pro rata based on the amount of the loan. With the second method, the compensation is calculated pro rata based on the capital growth that occurs during the term of the loan.
Getting Compensated on a “Share” Basis
The first method is called receiving rent; the interest forms the basis for the pro rata. This second system is called sharecropping; Percy is the sharecropper and Julie is the shareholder.
The Chance of Gain; the Risk of Loss
To the extent that Percy's access to capital was extremely limited - as it was for almost everyone when sharecroppers were invented - the Julies of the world had to improve not only the land but also everything else needed to make the land productive. . A parallel can be drawn here with a call option that gets "in the money" if the value of the underlying financial product increases and is "out of the money", meaning it is worthless if the value of the underlying position decreases.
Rents: Who Profits, and How?
The essential distinction between interest and equities lies in their different ways of dealing with the opportunity for capital growth gains: interest ignores this, while equities divide it between lender and borrower. In this scenario, Julie benefits significantly from the structure of the deal, which allocates all additional profits to her.
Shares: Who Profits, and How?
He invested $1 million at a rate of 15 percent and earned back the interest cash flow he was calculating. If the return on equity is as low as 10 percent, his share drops to 7.5 percent, or half of what he would have received through a direct lease arrangement.
Winning Strategies for Lenders and Borrowers
In the first case, when the capital growth rate is lower than the rental rate, the borrower has a loss. When capital growth is low, it is in the interest of the lender to charge rent and in the interest of the borrower to encourage the equity system.
The Straight Story on Bonds
When the rate of capital growth is slow, the lender gets less than if renting, but he or she spares the borrower the pain of incurring a loss. In the case of a Treasury, the borrower is the U.S. government and there is a 100 percent guarantee that the borrower will not default.
Thinking Straight about Shares
The dividend flow theory and the pie-in-the-sky theory are usually presented as competing concepts. Logically, there is no immediate valuation of a stock in the pie-in-the-sky theory; and actually it's not a theory at all.
Primary and Secondary Markets: IPOs and Aftermarkets
Very briefly, the dividend stream theory holds that the fair price of a stock is the present value of all future cash flows. in other words, all expected dividend payments and a final proportional share in the asset value of the company, should it elect or be forced to liquidate. The castle-in-the-air theory convincingly accounts for the price of a share of stock on the secondary market for stocks, also called the aftermarket, when a buyer buys stock on the open market from a seller.
The Primary Market for Shares: The IPO
Using the Dividend-Stream Theory
There is no effective way to determine that "expected market price at the end of the period". Calculating the present value of the cash flows of a fixed income debt instrument (the rent) is a relatively easy exercise.
Valuing the Stock of Companies That Do Not Pay Dividends
Jeremy Siegel, in his influential Stocks For the Long Run, argues that valuing the stock price for a company that does not pay dividends should be done in the same way as for a company that does pay dividends: the stock value, he argues, should be the discounted value of the coming cash flows of dividends, because, he assumes, there will necessarily be a time when there will be dividends. An interesting question in many cases is: are they leading from a general point of view?).
Long Run or Short Run?
The Problem with Buying Recycled Shares
Well, that non-negotiable price may have little or nothing to do with the price a dividend stream theory valuation would suggest. For all practical purposes, then, the dividend stream theory is not particularly relevant to stock price valuation in the secondary market for public company stocks.
The Role of Capital Gains
Income depreciation, based on book values, is a very rough approximation of the deterioration of the economic value of a physical plant. But there's simply no good way to value stocks based on capital gains, either realized or potential.
One More Time: Seek Out Dividends!
Surprisingly, the interviewer did most of the talking, focusing on all the exciting times the company was going through. At the end of the interview, I was asked the standard question: "Is there anything you would like to ask about the company?".
The Legacy of Carlo Ponzi
At the height of the dot-com craze, I was interviewing for an executive position at an Internet company. In other words, if a complex financial instrument can be equated with the structure of simpler instruments, the price of the complex instrument will converge with the price of the simpler structure.
Two Fish Stories
More on this in Chapter 6. Understand the tools available to you to relate value to price—and understand their limitations. The dividend stream theory's valuation of a share of stock suggests a breakeven value for a stock; it is therefore the maximum an investor should pay for the stock. In particular, this chapter will show you how a filter strategy (also known as swing trading) can help you deal with the excesses of earnings-obsessed companies—the Enrons of the world—while succeeding in the investing game.
The Tug of War
Is There a Pattern?
Price variation is studied in economics and finance using methods borrowed from physics. If price variation behaves in a way that is indistinguishable from chance, how can the price process be assumed to be "efficient".
Types of Markets: Organized and Over-the-Counter
Traders
The value of a particular trading book is difficult to estimate with any certainty because it depends entirely on where the market will go in the future - and as we just saw, a trader's own trading book affects the market. In January 2002, a month after Enron filed for bankruptcy, UBS Warburg bought Enron's trading deck and trading book.
What Actually Happens
Instead, the deal took the form of a stock deal: Enron would receive 33 to 45 percent of future profits over the next 10 years. When asked to estimate the value of Enron's stake in the business, Enron's adviser—the Blackstone Group—estimated it to be worth somewhere between $40 million and $2.87 billion.2 This huge range of possible valuations shows how difficult it is to make such estimates.
Traders’ Responses to New Prices
Bid, Ask, Settle Price, and Volume
Again, this is a contingent, dynamic universe – not at all like the static world of the supply and demand model. Still, in a thin trading context, they may well end up bending the market in the hoped-for direction.
Uncertainty and the Market
We buy in the hope that the price will rise and sell in the fear that it will fall. The reason is that there is a threshold at which the majority judges and "takes all." The push in one direction or another is short-lived; this is realized through the formation of one single settlement price.
The Filter or Swing Trading Strategy
On the "long" part of this strategy, there are two signals: the uptrend buy - which decides when to move in - and the trailing sell order or stop loss - which is the drop you will allow in price before you cut your losses. The downtrend sell can be the same signal as the trailing stop loss of the long part of this strategy.
The Benefit of the Doubt?
- An Entrepreneurial Culture Run Amok
- The Failure of Project Summer
- Broadband and Model Risk
- California, Energy, and Nomads
- Buying Time with Derivatives
- Hooked on a Bull Market
For example, for Enron's strategy to succeed, the company had to remain the most important player in the market. A year later, she joined Enron's board and also became a member of the board's audit committee.
LESSON FOR INVESTORS
Stock options are defined in the following terms in Statement 123 of the Financial Accounting Standards Board (FASB): “Stock-based employee compensation plans. This text highlights the source of the problems: we have now assigned four parts out of three.
The Low-Down on Earnings
To cast this arrangement in its worst light, it is as if the arrangement allocated two-thirds to the investor in the form of dividends and one-third to the entrepreneur in the form of a bonus and then one-third out again. out of three for the entrepreneur in the form of stock options. A favorite smoke and mirrors approach is to make the investor's two-thirds appear to be two-thirds, but actually be less than that.
Alternative Uses for Earnings
The word income used without any qualification refers to “as reported income” or “reported net income,” that is, after taxes and interest income have been accounted for. There are at least three justifiable alternative uses for income, other than its distribution as dividends and entrepreneurial compensation.
Reinvestment versus Acquisition
Chapter 4 – on the subject of share capital growth – introduced the idea that the distribution of earnings as dividends is one common way of allocating earnings within an equity system, the other method being to compensate the entrepreneurs who are the active agents of capital growth . Let's look at each of these alternative uses and then at some uses that are more difficult to justify.
Retirement of Debt
Share Buyback and Executive Compensation
The reason is that there is a conflict between the goal of the shareholders, which is to increase the share price, and the goals of management, which are prestige, control of markets, and other objectives. After the Enron debacle, institutional investors have become increasingly vocal, and they have found an articulate and outspoken representative in Sarah Teslik, executive director of the Council of Institutional Investors.
Stock Options as Compensation
By 2001, wages had fallen to 18 percent of the total; bonuses still represented 17 percent, and long-term incentives rose to 65 percent. According to a Federal Reserve Board publication, in 1998, among the 144 largest corporations in the Standard & Poor's (S&P) 500, shares resulting from the company's stock option plan represented 6.2 percent of outstanding stock.
Repricing of Stock Options
Thus, the alleged "alignment" between the interests of stock option beneficiaries and shareholders only exists when the stock price rises. CEOs are similarly in a position to start boosting the share price just before the time when they plan to sell shares.13.
Digging Deeper: The Value of a Stock Option
Now investigators want to know why the company overstated its earnings for the periods immediately before and after the stock awards.14. The bottom line: because the company granted the stock option to its employee, it is the company that pays a premium and incurs a loss on potential interest cash flow.
Losing Money with Stock Options
It is also possible to pay tax on realized gains and then lose the money when the share price falls. There will be margin calls if the stock price falls and the stock ceases to be of sufficient value to guarantee the loan.
The Tax Treatment of Stock Options
The paradox is that the tax deduction is justified by the fact that the profit from the exercise of stock options is considered compensation paid by the company. This would not affect the tax deductions that stock options currently allow; instead, it would simply provide that for the tax deduction to apply, the stock option must be included in the expense.
Share Buybacks: An Antidote
The answer to this last question is 'yes'. In addition to the tax incentive, stock options offer companies the opportunity to avoid large compensation expenses under that label, which would otherwise have to be deducted from reported profits. Another sponsor of the bill, Republican Senator Peter Fitzgerald (of Illinois), stated: “The bill does not reduce revenues.
Stock Options in Financial Statements
Under the intrinsic value method, compensation cost is the excess, if any, of the quoted market price of the shares on the grant date or other valuation date over the amount an employee must pay to acquire the shares.' The value of the option here is simply the 'intrinsic value' of the option: the difference - if positive - between the current price and 'the quoted market price of the share on the grant date'. It therefore assumes – contrary to popular belief today – that an at-the-money option (where the current price is equal to the strike price) is worthless.
Greenspan: Expense Them!
The fair value method is defined in statement 123 as follows: "For stock options, the fair value is determined using an option pricing model that takes into account the share price on the grant date, the exercise price, the expected life of the option, the volatility of the underlying stock and expected dividends on it and the risk-free interest rate during the expected lifetime of the option.” The fair value of the option in statement 123 is therefore the current standard way of determining the price of the option (Black-Scholes method). in particular, an at-the-money option still has value: the premium price that would have to be paid to purchase it.
Standard & Poor’s Weighs In
In fiscal year 2001, Cisco Systems, Inc. reported an earnings loss per share of 14 cents; under the new standards the loss would have been 35 cents. Either way, reform was in the air, and Standard & Poor's standard seemed like a good one.
Stock Options at Enron
According to Bear Stearns & Co. Enron's 2000 operating profit would have been 8 percent lower if the company had not granted $155 million worth of stock options. That was it in a nutshell: Cut compensation costs – but not executive compensation, of course! – and increase your profitability.
Compensation for Services Rendered
Dump the company that is repricing its stock options. Repricing makes a mockery of the principle that stock options constitute a management incentive aligned with the shareholders' interest. Choose your moment. If you believe—for whatever reason—that the price of the stock may still rise, do not exercise your option.
No Down Escalator?
In March 2002, for example, FleetBoston announced a new compensation package for its CEO—a package that was immediately condemned as scandalous in light of the bank's faltering performance. FleetBoston claimed that its CEO's package was simply being matched with that of competitors and was less than 75 percent of the average for CEOs in the top 15 U.S.
Even More Compensation
The magic of the split-dollar arrangement lies in the division of premium payments between employee and employer. An unintended consequence of the logic of life insurance is clearly being taken advantage of.
And for Dessert, Some Perks
We agree that electric cars are becoming increasingly popular as fuel prices rise. Conversely, if the oil price rises, the put is out of the money, but electric car sales offset the unrealized oil price gains.
Cause for Hope?
Overcompensating a company's executives is wrong; it expropriates the investments of the people who make the enterprise possible. In a new industry, observed Henny Sender of the Wall Street Journal, it's hard to tell what's conservative and what's aggressive.
Reporting Styles: The Menu
According to the SEC, "There is no prohibition preventing public companies from publishing interpretations of their results." Nevertheless, the SEC says, "'pro forma' financials. The Economist explained the discrepancy by the companies' use of generally accepted accounting principles for regulators, and the clearly more favorable New Age 'pro forma' accounting for owners of their shares.
Where’s the Truth?
And as IBM was also aware, the SEC moved forcefully against Trump Hotels & Casino Resorts in that case. On January 16, 2002, the SEC issued a press release titled “SEC Brings First Pro Forma Financial Reporting Case.
Hiding the Bad News: Off the Balance Sheet
If so, they could knowingly publish bad numbers – and we investors would have to deal with those numbers.
Fair Value: The Elusive Holy Grail
First, there is the issue of slippage, mentioned earlier: If I chose to sell this large amount of stock, how much would my transactions move the market price unfavorably against me. And second, there's the issue of trading frequency: How old is the last current transaction.
The Land of Make-Believe
Can you respond to the Wall Street Journal article claiming that we posted more mark-to-market revenue in the second quarter than we had in revenue, and that without mark-to-market in the second quarter, we would have suffered a loss? th quarter. And one of the comments they had in there was that we had more market value revenue than our total revenue.
Good Hiding Places
Adelphia's peculiar situation – the astronomical loans made to the company by its founders, the Rigas family – was first revealed in a footnote. This was the implication of a comment about Global Crossing's demise: “The ending was gruesome.
Targeted by the SEC
Purchases. Companies that have acquired others may be tempted to report improved overall earnings that actually only reflect the good health of the acquisitions. Do you think you would create a true picture of the economic value of the company you are investing in?
Financial Reports and Reporting
In financial circles, there is a fairly firm consensus that if management wants to hide from the shareholder what is really going on, it can. However, now that dividends are all but extinct, the value of a stock derives primarily from its assumed power to generate capital gains: the difference between the price of the stock tomorrow compared to today's price.
Enron’s Financial Statements: Accurate but Incomplete
There is a two-page description of the winnings that were eligible or related to those vehicles. That debt should have been fully disclosed in the minority interest notes," Olson said.
Earnings Management”: Enron’s Marketable Skill
Former Enron employees who marketed the services said their mission was clear: to sell a form of "structured financing" that could accelerate a client's earnings or otherwise dress the company's books.
Massaging Cash Flow
When profits became a problem at Enron, the emphasis shifted from earnings to cash flow: "In an emergency meeting in October," reported the New York Times, "the two top executives, Mark A. Mark Frevert said, 'Earlier, cash flow was not 'Important, it was always profits.' A manager on the trading desk who attended the meeting said, 'Now we would have to have a whole new paradigm.'”12 The point, again, is that although cash. flow is a relatively good barometer of fiscal health, it can be manipulated.
Massaging Figures for the Quarterlies
Insider Trading: One Way of Taking the Corporation’s Pulse
This form must be filed with the SEC no later than the forty-fifth day after the end of the fiscal year. Chairman Kenneth Lay sold $70.1 million worth of shares back to the company between February and October last year.
Enron’s Version of “Full Disclosure”
Throughout and deep in his heart, the spokesman emphasized, Lay never doubted that Enron's shares would rise again. In financial statements, the upper part is better and the lower part is worse. The closer the information is to the beginning of the statement, the less processed and more likely the information will be.
The Role of Analysts
Research analysts took the spotlight after they unanimously failed to send sell signals during the collapse of the speculative dot-com bubble. Even more embarrassing, a portfolio of the worst stocks (as rated by professional research analysts in 2000) would have outperformed the market by 49 percent.
The Conflict of Interest Between Research and Investment Banking
At least before the fall of Enron, the likelihood that the public would be offered an unfettered expression of the analysts' opinion was close to zero. The investing public, of course, knew nothing of the inherent conflict of interest underlying the Merrill Lynch rating system, and was deprived of the analysts' honest opinions.3.
No Chinese Wall Here
Immediately after the court order against Merrill Lynch was issued, Brown said in a statement that he had recently spoken with Mr. At one point, Blodget himself became so irritated that he threatened his superiors at Merrill Lynch that he would henceforth release honest recommendation. - recommendations, regardless of the financial consequences: "The more I read about these,".
One Conclusion, a Different Recommendation
Negotiating Recommendations with Company Representatives
For example, investment bankers encouraged analysts to push the stock price up to a level where - according to internal policy - it was allowed to start research, which was usually at least $10 per share. Well, it's in the initial increase in price to an undeserved level - something north of $10 - and then they tell investors to buy the inflated commodity.
Three Sad Stories
Spartis, one of the plaintiffs, was the manager of WorldCom's stock option plan for Salomon; he had joined the firm in 1984 and had held WorldCom's account for Salomon since 1997. In the lawsuit they brought against Salomon, they claimed that Grubman's positive assessment of WorldCom stock had persuaded them to recommend to their clients that they keep their stock . while the share price fell.
So How Good Are Analysts?
Unfortunately for Glassman's argument, the authors of the study he cited updated it in 2000 and came up with a remarkably different story. The researchers concluded that "in 2000, the most highly recommended stocks underperformed the market by an average of 31.2 percent, while the least favorably recommended stocks outperformed the market by nearly 49 percent." As one of the authors of the report, Maureen McNichols, elaborated: "While we cannot say that the poor 2000 performance is necessarily the result of increased analyst involvement in investment banking, our findings should certainly contribute to the current debate about the utility of analysts' stock recommendations for investors.”.
Finding Solid Research
A press release from the Haas School of Business at the University of California at Berkeley — where two of the researchers were based — was titled "Study Sheds Value of Analysts' Stock Recommendations, Finds 2000 Was a Disaster." A report usually includes an examination of the share price and the company's earnings targets.
So Where Does This Leave Us?
On the subject of Blodget's insincerity—my choice of word, and a good one—the writer commented, "Big surprise." The hedge fund, the brainchild of former Enron CEO Jeffrey Skilling, did quite well, according to a report in the Wall Street Journal, “with an average annual return of more than 20 percent after it was launched in 1996.
Enron and the Rating Agencies
The deal was largely dependent on the stock continuing to rise, or at least not losing value. The rest was, as its former chief executive officer (CEO) would have said, "a dead end".
Living on the Cliff Edge
Enron was named in three: "Event-Specific Dependencies", "Trust-Sensitive Entities" and "Rating Trigger Situations". Furthermore, as I will show, two other types of credit cliff – “Capital Intensive Entities” and “Structured Finance” – clearly apply to Enron as well.
Ratings and Why They Matter
Thus, the pricing of debt involves what might be called the logic of risk: to the price paid by the less creditworthy for borrowing is added a premium that compensates for the additional risk involved. This is the equivalent of an insurance premium for the lender, offsetting the risk that the borrower will not be able to meet the terms of the outstanding debt.
Rating Agencies and Corporate Credit Ratings
Provisions have been made that, within limits, allow companies to negotiate their rating with rating agencies. On balance, however, I would argue that rating agencies perform a crucial function, and perform it well.
Back to the Cliffs
