Creative Accounting and Advanced Valuation

 Firm valuation may be the same depending on recognition of cash flows (i.e. earlier
recognition leads to higher valuation even if they have the same cash flows)

CFIMITYM
 Cash Flow Is More Important Than Your Mother

Revenue recognition
1. Requirements
a. Transfer of operating risk
b. Transfer of good/service itself
c. Persuasive evidence of arrangement (e.g. verbal or written contract)
d. Probable collection – if not reasonably assured, cannot be recognized; illegal
e. Set price – sale is not made if price is not set
2. Compare increase in cash flow with increase in sales
a. Bar selling products on credit has much higher sales than bar selling products
only for cash
3. Issue on probability of collection
a. Check collectability of receivables
b. May be selling products on bad credit
c. Good revenues but shitty cash positions
4. Productive cycle
a. Receive order
b. Produce good
c. Render good
d. ***Always check when they recognize revenue.
e. Receipt of cash
f. After-sales service
5. Look for comparable companies to compare revenue recognition methods
6. Client concentration of sales – is one customer driving a substantial portion of sales?
7. Friendly sales – sales driven by a subsidiary/political affiliate; if it disappears or gets
acquired, sales disappear
8. Distribution of sales – a dollar a day is better than 30 dollars right before reporting;
suspicious because done right before reporting
9. Take note if sales is driven by product sales or post-sales service revenue
10. Non-core revenues should be in OCI – check OCI as % of sales
11. Exception to the rule: barter transaction – swapping same kind of product/service
between two competitors to both boost revenues; to be recognized as revenue, proof of
demand of third-party is needed by auditor.
12. Net revenues never include taxes
13. Always recognize net commissions.
14. Channel stuffing – bill and hold transaction
15. Sales guaranteed by debt is similar to vendor financing – indicates quality of sales
(footnote 34 in Enron)
 16. Exclude sales based on conditional future events
17. Problem detection
a. Increase in sales should be coherent with increase in sales
b. % of non-performing sales
c. Backlog as % of sales
i. Orders received for future sales, found in footnotes
18. EV/Sales – implications in valuation, used instead of Price because it is not affected by
financial expenses, ensure that sales figure is real; if not, adjust.
a. Sales is driven by growth

Key question: from EBITDA, how much is transformed into cash flow?

Red flags in WorldCom

 No formal discussions with Board in acquisitions
o No right due diligence
 Goal to have high growth
o Only matters if achieved through organic growth
o In acquisitions, check goodwill for impairment through theoretical DCF valuation
 Conflict of interest on auditing ($14m) and consulting ($50m) arms for Andersens
o Dig deeper into claimed independence of auditors
 Internal auditors were not reporting to audit committee but instead to CFO (Sullivan)
o Like having fox watch over chickens
o Get people for audit committee who have a clean opinion; check backgrounds
for true independence
 Double-digit revenue growth
o “I am an owner of my silence but a prisoner of my words.”
o Pressure to manipulate accounts in the effort to fulfill promises
 Board composition
o 13 members, 9 independent
o Never believe that they are independent.
o Do your homework and form an opinion.
o Too much remuneration in a Board
o “Independent” directors are chairmen of subsidiaries, thereby reporting to the
Chairman of the Group Board
 Manipulation of research analysts
o Credit researcher
o DB experience: changed “Sell” to “Losing Momentum” due to pressure of being
fired, happens everywhere
 Salomon Brothers as key broker
o Destroyed due to business with WorldCom
o Independent Chairman of WorldCom is from Citi/Salomon
o Analyst Jack Grubman had insider information by accessing the board
o Right strategy: get people to tell you why your stock should be short
  Loans to board members
o Insider selling looks badly in market
o Loan given to executive backed by company’s stocks
 Level of EBITDA-based compensation
o Promotes aggressive accounting to manipulate EBITDA
o Asymmetry of interests – high incentive to take on risk but limited incentive to
temper risk
o Never pay based on a given metric and on a given date
 Sunk costs
o Huge incentive to cheat if things do not go well
 Leadership
o Leaders who believe that they are Napoleon
o Right for years then start to become wrong – begins to change the accounts
instead of admitting mistake
o Tesla prone to this if they do not deliver growth targets

Accounting issues
 Revenues
o Policy of getting difference in case floor is not reached, i.e. If floor is $60 and
consumption is only $18, consumer pays $42.
o $42 becomes Revenue and A/R
o Belongs to Extraordinary line, i.e. bullshit, leads to unreliable EBITDA
o Overbilling people and adjusts only if consumer claims mistake, any adjustments
are made below the line – $1.8 billion of fake revenues
 Feeds into EBITDA but not cash flows
o Leads to fake margins
 Provisions
o Always compare to sales and check trend
 CAPEX/OPEX
o If anything the asset produces is more than 1 year, it’s CAPEX.
o Should also be probable to collect
o Reason why capital-intensive firms ask for 2x EBITDA and non-capital-intensive
firms ask for 10x EBITDA
o Senseless to ask for price of French stock market depending on EBITDA –
depends per industry; French stock market has different industries
 Construction in Progress account
o Started not depreciating infrastructure linearly and used percentage method
instead
 Split group stock between WorldCom (growth) and MCI (value)
o Subjective demarcation
 Pro Forma accounts
o Biased focus on positive things
o Aka EWBS – earnings without bad stuff
 o Always go beyond pro forma FS
 Multiples
o EV/EBITDA
 Same sector, same country
 Company A: 7x
 Company B: 9x
 EBITDA margin is irrelevant because already embedded in multiple
 First question: What is the expected organic growth? – related to
competitive advantage, barriers to entry (Assume 5%)
 Second question: What is cash flow conversion? From EBITDA, how much
becomes FCF? (Assume 80%)
 Consider:
 Risk: WACC (Assume 8%)
 EV = Debt - Cash + Market Cap + Minorities - Associates - Contingent
Liabilities
 Use market value for equity and debt computations
 Book value is commonly used for debt but it is okay because may
be liquid
 Value creation
o Organic growth > Nominal GDP
o EVA = ROIC - WACC
 ROIC = NOPLAT/Capital Employed
 Capital Employed: Assets = NFA + Working Capital + Goodwill
 Capital Employed: Liabilities = Net Debt + Book Value + Associates –
Minorities
 Be consistent in computing ROIC: net if net; gross if gross
 Introduce new multiple: EV/opFCF multiple
o opFCF = EBITDA – maintenance CAPEX – changes in WC
 value of company should not be dependent on expenses due to
expansion, which is why expansion CAPEX is excluded
 Key points
o P&L starts from the bottom, not the top
o Great EBITDA, negative opFCF = bullshit company
o

Expense capitalization
 EBITDA shortfall – does not consider CAPEX

Asset valuation
Off-balance sheet assets
 Boeing leases planes to IAG as operating lease, i.e. rent
 It is not on the BS of IAG because doing otherwise reduces IAG’s ROIC
 Leads to lower debt
 Found in Notes, i.e. commitments
 Check FCF against maturity of commitments
 IAG borrows from GE due to strong balance sheet and borrowing ability
o Enters aviation financing to take advantage of taxes via depreciation of planes,
i.e. can offset taxes
 Do not look at whose balance sheet an asset belongs to but rather look at which firm is
affected when the value of its assets move

Enron Case

Red flags
 Andersen auditors leave to work for Enron
 Multiple SPVs
 CFO was not an accountant – best CFO in 1999, was in jail in 2001
 Management culture was similar to Worldcom’s
 Wendy Gramm – regulator that joined Enron
o Wife of US senator that repealed Glass-Steagall
 No back office function, i.e. traders were valuing their own trades
 BNP Paribas analyst with sell recommendation was fired
 Shitty bonus structure
 Culture of not being able to talk back
 Asset-heavy industry trying to become asset-light – major red flag
 Scrutinize hedges
 If assets move from Enron to SPV, check. Fairness opinions by ML were biased because
they had fees from the mergers. ML bankers were also on board of SPVs.
 No integration of acquired companies

Accounting funnies
 Using NPV with lower WACC for derivatives then booking it as profit
o Did not follow matching principle
 To be able to deconsolidate
o Book upfront profit to SPV
o 3% must be sold
o Independent directors needed
 28% of EPS was unrelated party transactions – bad quality earnings
 Used working capital to hide debt
o In debt-heavy industries, Q4 working capital is most likely fake
o Look at ROIC
 Getting minority share (49%) of a subsidiary – does not necessitate consolidation
  Non-recourse Factoring – selling receivables to banks
 Check if opFCF can match maturities
 Look for covenants – usually secret but can be found in prospectus

Identification of Off-Balance Sheet items

1. Stop looking at pictures and start looking at videos
a. Instead of BS, check P&L.
b. Check interest paid against debt on BS – must match.
c.

Lehman Brothers

Red flags
 Corporate culture
 Highly leveraged with substantial debt in multiple SPVs: 33x
o One small mistake and you are bust
 OTC derivatives
o Valued via DCFs
 Aggressive M&A
 Multiple CFOs in one year
 Earnings driven by trading – highly volatile
 Rating-intensive business – similar to Enron

Accounting funnies
 Rules-based treatment for repos in the UK allowed them to be off-balance sheet
o Never would have happened if reported in the US
o Moved off balance sheet to look less levered
 Acquisitions
o Paid $24 billion with book value at $18 billion
o Goodwill is not $6 billion because book value needs to be audited for possible
asset write-ups – may include capital gains so goodwill may be higher or lower
than $6 billion
o Perpetual growth rate g should be at most the nominal GDP
 Cash
o When computing cash – determine excess cash (i.e. belongs to shareholders) and
cash used for financing clients (i.e. working capital)
o For DCF models, operating cash is normally one month’s worth of sales
 ROE = 21% - fantastic or fishy?
o Immensely leveraged
o Apply DuPont
 Huge MBS positions – how to value?
o Lehman’s valuation is via DCF
 Accounts receivable – how to challenge?
 o Check which part is uncollectible
o Check DSO if > 90 days

Valuation
 Assets – what is an asset?
o Must generate future cash flows
o Goodwill – why is it an asset? – because it is expected to create synergies
 If not synergies, write off goodwill.
o Check R&D – why does Lehman have R&D?
o Check subsidiaries – check two largest ones
 Check valuation vs book value
o DTAs
 Only applicable if there will be EBT to offset in next reporting period
 Firm needs to convince auditors that this will happen through a business
plan
o Toxic assets
o Intangibles
 Subjective
o Pensions
 Understand real long-term return of assets
o Trading book
 Things not in banking book
 Move assets from trading book to banking book – can only be done once
o Debt Valuation Adjustment
 Last accounting entry of Lehman Brothers - profit
 Was used by all BBs to avoid bankruptcy
 MTM assets so MTM liabilities
 Lower debt, higher equity
 Prohibited now

 Metrics
o Price-to-Book
 Higher than one if ROE > Ke
 Never invest in companies well above 2x
 Higher PB – higher EBITDA
o EV to CE
 Use everywhere except banking
 ROIC-WACC – huge competitive advantage, for how long can this be
kept?

Valuation Methods from most to least transparent

1. Trading
 2. Comparables
3. DCF

Parmalat
1. Red flags
a. CFO left after eight months on the job (Tonna)
b. Deloitte for Parmalat and Grant-Thornton for Bonlat
i. Deloitte indicates in its audit letter that Bonlat has been audited by GT
and is thus not their responsibility.
c. Intergroup loans
i. Loans will disappear in consolidation.
d. Debt to equity swaps
e. 49% to avoid consolidation
f. New CEO has turnaround background
2. Accounting funnies
a. Gross Debt – needed to compute to which degree is cash true or untrue
i. Net Debt is used for EV but not useful for cash position
ii. Preferred stock is debt
iii. Treat all hybrids as debt unless perpetual
iv. When acquiring minority share, ensure liquidity so that you do not get
stuck. Examples: put option, tag/drag-along clause (e.g if majority
shareholder sells so does minority shareholder)
v. Off-balance sheet commitments
vi. Factoring should increase in proportion to sales
b. High rating but high return – risk is not as low as it seems
c. Cash – they have investments in PE that is accounted for “Cash Equivalents”, not
liquid because average PE duration is seven years
d. P&L
i. Currency swap – investment in PE fund which is in USD but company is in
EUR. Long USD for PE fund. Should be reported below EBIT (40m EUR)
but was reported under Other Income
ii. Football player – amortization issues
3. Lessons
a. Accounting manipulation can lead to short-term gains but market will be
discounting you in the long-term.
b. EUR 11 billion accounting scandal led to recession in Italy.
4. Trading strategies
a. When shorting for accounting issues, anticipate a catalyst to gain from position.
b. One way to confirm is if company refuses accounts.
c. Never use rumor without mentioning the source.
d. Strategy is to short stocks then publishes comprehensive note – used by equity
research house Gotham.
Advanced Valuation
 All multiples are a proxy of cash flows.
 Underlying assumption is that those with better multiples should generate more cash
flows.
 All multiples are relative.
o Solution: DCFs but quite dangerous.
o So use multiples in conjunction with DCFs.

Growth
 Single most important factor that can explain higher multiples
 Organic, not from acquisitions
 Sustainable high growth rate depends on barriers to entry
 High growth can make company cheap due to high demand
 To value, take forward the existing P&L of the company
o Take current industry multiple
o Apply to projected EBITDA x years from now
o Discount back using WACC to value growth

When choosing between companies using just multiples, ask:

1. By how much will it grow?
a. Future sales
b. Includes barriers to entry – including competitors and regulation

2. What is its capital intensity?

a. For auto industry, 80% of EBITDA flows to CAPEX, 20% for shareholders. Thus,
cheap compared to other industries.
b. Other sanity check: why do they need to spend high/low on CAPEX? Maybe
factories are old thus higher CAPEX – explains why stock may be cheap.
c. CAPEX/Sales – directly proportional to CE/Sales
d. Capital Employed/Sales
3. What is its working capital intensity?
4. ROIC-WACC
a. ROIC says something about management
b. WACC – different when business is in France or Russia
c. Check regulation.
d. In the long-term, ROIC = WACC = NOPLAT/CE
i. ROIC < WACC = people exit business
ii. ROIC > WACC = new competitors show up; if not, check regulation.
iii. CE: NWC + NFA + GW = BV + Net Debt + Minorities - Associates
1. Uses replacement values, not existing book value
iv. Sanity check: given ROIC and CE, use goal seek to find NOPLAT.
 v. Check how WACC was computed – some segments of operations may be
in high-risk countries; use WWACC – first W refers to weighting of
geographies, useless in global companies such as GE; use WACC from
where the capital is employed, capital raised in Spain but used in Brazil
should use WACC appropriate for Brazil
vi. Assuming that WACC is stable especially in emerging markets is incorrect;
use dynamic WACC – first year is 40% then normalizes over time
e. Always engage in projects with ROIC above WACC.
i. After identifying this, look for high growth rate.
f. ROIC = NOPLAT/CE
5. How much of Sales will be used to pay for taxes?
6. Are their revenues cyclical? – but embedded in the WACC
a. Useful for credit analysis – investors prefer revenues with low volatility

Key multiples
1. EV/Sales
a. Driven by growth and cash flow conversion (i.e. how much of sales reaches FCF)
i. On average, opFCF/Sales = 8%
ii. Given same growth and EBITDA, pay higher for company with higher FCF
conversion
iii. Do not assume high FCF conversion for perpetual g
b. Suppose company = 3x, industry = 1.5x
c. Higher future growth (i.e. increasing sales) leads to lower multiple
d. Company continues to grow until Sales is high enough for the multiple to reach
1.5x
2. EV/EBITDA
3. EV/EBIT
a. Advantages
i. Takes into account capital intensity – more PPE leads to higher D&A
b. Disadvantage
i. Not impacted by working capital, which is important
c. Main difference with EV/EBITDA
i. Different methods of D&A
4. EV/opFCF
a. opFCF = EBITDA - maintenance CAPEX - operating working capital
i. Hard to estimate and separate maintenance CAPEX from operating
CAPEX
5. P/E
a. Advantages
i. Simple to compute
ii. Comparable across industries
b. Disadvantages
 i. PEG ratio is shit – because we do not know for how long the growth can
be sustained; requires that the company have legitimate competitive
advantages; relationship between PE and growth does not need to be
linear
ii. Earnings can be manipulated; cash flow is a fact. Check which earnings
are recurring.
iii. If a company incurring loss because it has high debt, PE may look shit but
the company may be good.
iv. Better to use CAPE – cyclically adjusted PE
6. P/B
a. Key driver: ROE - Ke – explains whether you pay more or less for P/B
b. Book value is starting point.
c. If more than 2, check fundamentals. If more than 3, suspicious and make sure
that they have an extremely good business.
d. If distressed, P/B > 1 is expensive unless turnaround is expected
7. EV/CE
a. Driven by growth and EVA (i.e. ROCE-WACC, ROIC-WACC)
i. ROIC = NOPLAT/CE – similar to ROCE but considers entire business
ii. ROCE – similar to ROIC but adjusted for amount invested for operations
iii. The two can be used interchangeably
b. Industries such as five-star hotels, semiconductors, airlines consistently destroy
value (ROIC-WACC) but never fails because it is subsidized by the government.
Not good for strategic investing but good for troughs.

M&A
 Weight synergies
o Revenues by zero
o Costs by 80%
o Taxes through higher leverage: multiply debt by tax rate then discount using cost
of debt, gives you marginal tax shield
o Compare synergies with control premium – obtained by looking at price not just
before the merger but three months before
o Look at APV – how much paying for business and how much for synergies
 EPS accretion is bullshit
 All about EVA: ROIC-WACC
o ROIC = NOPLAT + synergies
o WACC = capital paid
 Goodwill – difference between acquisition price and adjusted book value
o Taking face value book values can lead to fake creation of value through write-
backs (e.g. valuing at 1 today then 100 tomorrow – value “creation” of 99); being
conservative
o Higher asset valuation leads to lower premium
o D&A for tax shields
 o DTAs
o Check hidden liabilities like off-balance sheet debt, environmental clauses, labor
liabilities, and unfunded pension liabilities found in footnotes
o Higher tax volatility leads to higher taxes thus hedging may be a cause to lower
taxes
 Acquisitions push through despite destroying value due to ego – empire-building
o Short them

DCF Analysis
 UMTS case
 Goodwill have value because cash is expected from the synergies
 Never take WACC for granted – cost of equity of 15% is low for a startup in which VCs
usually expect at least 40% IRR
 No way that startup with no cash flow can be financed with 50% debt – usually it is
purely equity
 Key assumption that can be manipulated: cash flow conversion is unrealistic at 30%
o FCF = NOPLAT + Depreciation – CAPEX +/- Changes in Working Capital
 ROIC = NOPLAT/CE
o Assumption that ROIC will be 23% in perpetuity with WACC at 20% - does not
happen
o Growth rate is unrealistic at 4.5% while Spanish GDP growth rate is at 2%
o Remember that in long-term: ROIC = WACC
 How did they destroy value (USD 170 billion in six months?
o Behavioral finance – FOMO
o Herding effect
o Winner’s curse – foregoing a higher bid because the bid that you have right now
is good enough
 Problem in valuation – multiples are relative
o To know if this is correct, do a DCF for comparison.
o The fancier the multiple, the more chances for mistakes
 DCF
o 80% of DCF depends on terminal value valuation; on future value
o Do not use Year 5 as is for perpetuity. Normalize it first by adjusting margins –
what would be the case in mid-cycle?
 Depreciation = CAPEX; if not, your balance sheet disappears
 Working capital/Sales in a normal year
 Check if NOPLAT/Sales is reasonable
 Check if FCF/Sales is reasonable
 Set ROIC=WACC
 Depends on Capital Employed – must be constant; check Capital
Employed/Sales
 EV/CE becomes 1x
 Implies that there is no value creation in the long-term
 o Apply exit multiples – which one do you use?
o If ROIC < WACC, check linear relationship with CE to know which multiple to
apply.
o Another method is to look at last year’s book value.
o Can be:
 FCF to EV – use WACC
 FCF to EqV – use Ke; restrict P/B = 1
 DDM aka Gordon Growth; also uses 1x
 Discount rate is also Ke
 APV
 Can be PV FCF – uses unlevered beta
 Can be PV shares – uses cost of unlevered equity
 Growth valuation
o Take the case of Uber, valued at 52 billion
o Pre-IPO, use value at ¼ of maximum
o Applying traditional DCF valuation does not capture technological innovation like
Uber’s autonomous cars
o To circumvent, use three-stage DCF:
1. Five-year DCF
2. Interim where g is high and ROIC > WACC; from year 6 to 10
3. Year 11 onwards: perpetual growth rate where g is reasonable and ROIC =
WACC
 Useful multiples
o PV = CF/(WACC-g)
o PB = (ROE-g)/(Ke-g)
o EV/CE = (ROIC-g)/(WACC-g)
o PE= (ROE-g)/(ROE*(Ke-g))
o 1/PE = E(y) = E/P = earnings yield
o EV/NOPLAT = (ROIC-g)/(ROIC*(WACC-g))
 Xfera aftermath
o Valuation is lower by 2 billion because expectations are lower – multiples
dropped
o In April – worth 3 billion
o September – -0.5 billion
o So be careful of multiples and avoid behavioral finance
o Be skeptical.
o Cannot be sold 8x to 10x EBITDA

Final report pointers:

1. Select one listed company.
a. Easy to falsify P&L and BS
 b. Focus more on CFS, which is a rec between P&L and BS
c. P&L and BS are opinions whereas CFS is fact.
2. Page 1: Red flags in corporate governance
a. Multiple CFOs in one period
3. Page 2: Accounting minefields – what may be legal is not necessarily proper accounting
a. Revenues
b. Expenses
c. Assets
d. Liabilities
4. Page 3: Valuation Issues

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