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How to determine the quality of forecasting models by multiple

One thing that is difficult is whether the forecast of an "expert" is strong. In other words, is what this expert is really good in its ability to predict the future?

Well, it looks like that says that I speak of fortune teller. But I actually spoke to these economists and the market analysts tell us that if the economy will go well or not and whether the markets will be positive or not.

Consider the situation of an analyst that we call ABC. So ABC does not believe in equity markets in their current composition and leans on a very conservative assessment of the value of a stock. ABC works for a large company and one of his colleagues, DEF, has a totally opposite and still believes that markets are undervalued as ever. XYS is more tempered in his vision of markets and through its analytical capability, meaning it will always find the market. Finally, OPQ is the lead manager of the firm which ABC, DEF and XYZ make their recommendations. OPQ does at its head by suggesting to analysts that are important and chose his title by chance (throwing dart, dice, etc.).. It is just 1 out of 2 in its final selections no matter the market direction.

Evaluating the quality of a forecast
Can we say that 3 analysts are as good? No. But how to analyze their performance? While markets have been rising for 8 years and down for 2 years, can we say that ABC is right 20% of the time and DEF instead because 80% of the time??

Such an analysis would leave aside the material weakness ABC and DEF: there are always biased (from the top or bottom). Then we must evaluate the analyst twice. Once the bull market, and once in a bear market.

The CFA proposes to calculate the probability that the analyst is correct in bull market (PA) and it is true in bear markets (PB). Calculated once you add the two values and subtract 1. Thus, our three analysts would obtain scores:

• ABC: 0 + 1 - 1 = 0
• DEF: 1 + 0 - 1 = 0
• XYZ: 1 + 1 - 1 = 1
• OPQ: 0.5 + 0.5 - 1 = 0

While we note that the value maximum for this ratio is 1. This means that the analyst is correct every time. A quick scan of the formula allows us to understand that the minimum value is -1. However, a result should not be below 0, because that would mean that the analyst is really bad! Indeed, if an analyst is below 0, it means that the orientation by chance would be preferable in terms of accuracy.

You see that ABC and DEF are also 0? This is because they are excellent in their respective markets (up or down), they are exceedingly bad in another. Their predictive ability is nil. It is as if Cole was telling us every day that will fine tomorrow. It will be right just when it will be fine. Other days it will twist. Does she give good weather forecast? Well no!

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is the third article in a series of 4 on the evaluation of an action. In these volatile markets (I see no reason why they are the same, but this will be the subject of a future column), it may be interesting to see what is the value of his company.

Today I will talk with multiple models. The multiple most popular is undoubtedly the P / E. All know, but some use it without knowing what his involvement.

Before going further I should explain the difference between the sales comparison approach and the method based on the fundamental set. The first case is that you all know. The market price is $ 20, earnings per share (EPS) is $ 1 ... P / E = 20. The second situation is similar but slightly different. Instead of taking the values of markets, it takes values provided. For example, you estimate that your stock is worth $ 12 a discounted ( see my post on this type of model ) and that are estimated EPS of $ 0.80 ... your P / E is 15. The analysis is slightly different as well. In the first case, it seems that buying a business at 20 times earnings. In the second case, it seems that the company is worth 15 times earnings. Both methods are used on all multiples. Here I will focus on the sales comparison approach when describing ratios

And finally, before presenting each multiple, know that it would be very irresponsible to look the same ratio from 2 different sources. Ideally, you should calculate them yourself. It's not as if the calculation was difficult!

Yet another thing, such ratio can be compared to the history of the company, but also the present value of these peers.

Price / Earnings
I do not think at present this ratio. The denominator of the equation is obvious. The denominator ... a little less. For example, some data providers calculate a TTM-P / E. TTM means trailing twelve months therefore earnings are actually the sum of last 4 quarterly results. Others will take the last annual figure and some will make a serious error (can not see it anymore, but it's happened before) taking the last quarter and multiplying by 4. Personally, I prefer to use TMT.

Some say that the ratio is bad because it looks in the past while this is the future that interests us in finance. It is also possible to consider the prediction of earnings as your earnings. We then speak of a forward P / E.

An important problem of the P / E is that it is useless when earnings are negative, zero or unusually small. It is then possible to speak of an earnings yield (E / P) ratio is the reverse. The figure will now be economically significant, but will not be useful for comparative purposes. This is why companies with volatile earnings are not analyzed with the P / E.

There is also some love PEG ratio (P / E divided by growth) to separate firms according to their assessment based on their growth. Personally, I think that ratio is bad. It assumes a linear relationship between P / E and growth and the growth rate is unique. It's like the Gordon model (see model here) ... well thought out in theory, but no realistic practice.

Price / Book
This multiple is cherished by all investors values. We say that P / B \u0026lt;1 means that the company is really cheap. However, sometimes there are reasons for which P / B \u0026lt;1. A company that destroys value has a P / B under 1. Such a ratio can also raise questions about the quality of financial statements. Recall that the denominator is the book value of the shares. If the company's assets are overvalued, while the book value of the shares are too.

The reverse is also true. A company with a P / B of 5 is not necessarily expensive. A company like Becker Milk, who owns property purchased 50 years ago and has a fully depreciated book value far less than the resale value of assets.

The P / B has the advantage of not having the same problem as the P / E. The book value is relatively stable and not negative. Ok, some companies have negative book value ... in which case this ratio is useless. But saying do not have a PhD to understand that the situation is not rosy for the company. The P / B has a weakness ... Is that the book value is representative of the company? The answer is very rarely. This is besides the manipulation of figures in the balance sheet that may affect the book value.

Price / Sales
This multiple is less subject to manipulation (you can only manipulate sales ... the P / E is about the manipulation of sales and expenses). The comparison between peers here is somewhat more complex since not all companies the same cost structure. Also, some companies see their sales as net of certain expenses (discounts, returns, ...), while others will put these costs in expenditure (promotional and marketing collateral, ...).

Price / CashFlow
Which calculation of cash flow to here? Whatever you want! This is one reason why I told you to calculate it for yourself. Me, I'm normally Cash flow from operations . The advantage of cash flows on earnings is that they are less subject to accounting manipulations.


Price / Dividend
We are used inverse ratio (Div / Price) that gives the dividend yield . Some like to use it, but I do not like ... how to evaluate a business without dividends. This ratio is interesting to do method based on the fundamental set. Not for a comparable analysis.

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Why do we say that the euro is dying?

You hear it everywhere ... the euro is about to disappear. But why? At last news, the euro stood at U.S. $ 1.24. Considering that in January 2002 (the debut of the euro), the currency was worth approximately U.S. $ 0.88, I do not see the drama. In the words of leaders of European finance, the problem is not its current value (the euro worth U.S. $ 1.24 last year too), but rather the speed at which the currency has fallen.

How does the establishment of a currency for a country?
Before going to see what happens with the euro, explain how the establishment and maintenance of a currency operating in a context where one country adopts. Consider the Canadian dollar. That dollar is effective only in Canada and is governed by the Bank of Canada. The Canadian dollar is affected by two kinds of factors: internal factors and external factors. When evaluating a currency, is by comparing it to another. So inevitably, the value of $ CDN is influenced by another currency (external factors).

Canada does not control external factors, but can control the internal factors. Internally, the dollar value of a country is influenced by supply and demand. The offer is the country that makes it. The application is foreigners who want the Canadian dollar. Here is a list of economic factors that would increase the Canadian Dollar

• increase foreign tourism in the country (higher demand)
• Lower Canadian visits abroad (reduced supply)
• Exports Rise (increased demand for pay of $ CDN)
• Lower imports (Down the offer of $ CDN for pay)
• Reduction of government debt (reduced supply)
• Rising interest rates (higher demand)
• Reduction of currency in circulation ( decrease in supply)

course, all points would reduce the currency reversed. If Canadian authorities (banking and / or government) wanted to control (we could discuss at length the ability of authorities to effectively control a currency. Speaking here as a synonym for control supervision), what are their options?

The first 4 points are a bit out of control authorities. In extreme cases, governments could tax the imports / exports quite significantly, but such action would damage the local economy long term. There remains only the last three points, one of which is under government control. The last two are the responsibility of the Bank of Canada.

And what's different in Europe?
In Canada, if the value of our currency was becoming a serious problem, the government would act with the Bank of Canada. In Europe, if the situation becomes problematic for the euro, European Central Bank will act with 22 countries. Everyone should take the same side at the same time.

The problem in Europe is not the value of the euro, but his downfall (some see this fall as being the result of speculation, I rather think that the euro was heavily overvalued for years). To stop, the authorities should increase its value. However, as we saw above, the Bank controls interest rates and the amount of money in circulation. Governments control public debt.

To avoid a "disappearance" of its currency, a country must avoid the need for the machine to print money to pay his expenses. Zimbabwe has so abused that inflation was 100% at 24 hours in the last calculation (calculate inflation in Zimbabwe is now a crime!). This is one of the perverse effects of tests in a currency (and why I mentioned earlier and non-supervisory control).

That leaves interest rates and government debt. Interest rates have an impact on the real economy. Raise rates pushed up the value of the currency, but decreases economic growth. That's why banking authorities intelligent (as in Canada) use interest rates to control inflation. That leaves only

debt public. Europe has long been known that the debt was what could bring down the currency and undermine the economic stability of the entire region. Therefore, all countries in the euro area have agreed to limit the annual deficit to a maximum of 3% of GDP. The problem is that it was a guideline . That was not the force of law and several countries irresponsible (sorry for the Greeks and others, but you do not deserve to be part of the euro area) are ignored. For example, the deficit in Greece is more than 4% per year for 5 years. In 2009, it reached 12% and this year is expected to reach 9%.

Europe has understood that there are countries where fiscal discipline is wrong (I wanted to say no to shit, but I'll be polite) and table currently on a law that would force all countries to respect the measures in place. There is even talk of strengthening these measures (because the debt problem is a serious problem in Europe).

And why not just leave these countries in the Eurozone and leave them with their problems? Because that would say that the single currency has been a failure. And we must admit that Germany likes it. A weak currency allows it to export to the ton!

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speculators responsible for the crisis in the euro area?

is what I read in the newspapers for some time. Sarkozy said that the need to control speculators who are breaking down the euro. The Greek finance minister says that those who speculate against Greece will bite the dust. And then goes on.

Speculation against the euro by selling it, which lowers the price of the currency. Speculation against Greece is asking a very high risk premium on government bonds (a bond of maturity 2 years Greece has an efficiency of 10-15% depending on the day ... in Canada, we're talking about 1.5 -2%).

But is that speculators are responsible? How? Why? Who? When? As questions, so few answers ...

• Is there any speculation on the euro and the Greek bonds? Answer: yes
• Are these speculators are now so important that they are partly responsible for the current declines? Answer: yes
• Does the presence of these speculators would affect the soundness of financial markets? Answer: No
• Are these speculators are responsible for the problems of contagion views on the markets? Answer: yes and no

I do not deny the presence speculation on the markets (and good, the definition of speculation can be relatively large ... if you're planning a trip to France and you're wondering whether you're better off buying your euros today or next week, do your Some of these speculators ...), but I do not think it would be healthy for the markets to prevent speculation. I answered yes to question 2, but much of the week declines are due to systemic change to which speculators have nothing to do.

Why say no to the third question? Because say yes is to say that markets are not efficient and ineffective. If the speculators have done too much lower prices, they rise in the short term (days or weeks) to achieve a balance. Speculators are therefore responsible for having unnecessarily increase volatility. If prices remain stable, while speculators have allowed markets to reach the new equilibrium price quickly, which is excellent.

Why this ambiguity in the answer to question 4? Because speculators are indeed responsible for having pointed out the country likely future problems. In fact, having seen that Greece was also in the hole, the European financial actors (That the world now call speculators) have searched the public finances of all countries in the euro area. Results: The acronym that presents the country with a debt "problem" goes the PIGS (for Portugal, Italy, Greece, Spain) in recent years STUPID (Spain, Turkey, UK, Portugal, Italy, Dubai). "Speculators" have indeed these names hammered in the markets and beginning to demand a risk premium higher in these countries (causing the phenomenon of contagion), but they are not responsible for the underlying problem.

An analogy to understand
I'm surrounded in my life everyday people who know nothing about finance and I have often find situations easier to explain any economic phenomenon. So here is my analogy of the crisis euro.

Take a big family. The father, mother and their children share a joint account. They also each have a personal bank account. Grandparents and other members have their own bank accounts, but does not participate in the joint account.

For those who have not seen ... family = European Union, parents + children = countries with the euro as its currency, other countries with own currency = (UK, Switzerland ...)

All goes well for the whole family. Together, they bought a house that everyone must pay according to their capabilities. Everyone can achieve the spending he wants, but the owners of the account-husband have adopted strict rules to avoid causing harm to other owners of the account partner. The house

= European Union, rules = rules to maintain maximum leverage single currency

But, one child wanted to live above the means despite the strict rules. It therefore pays significant care and returned to school for years. It takes advantage for travel (business class) in beautiful destinations (after 5-star hotels). One point, finding himself soon dry even to pay the minimum on his credit card, call a family meeting at the bank to say that in 5-10 weeks there will be more a cent. He wants help.

The child is irresponsible Greece. Expenditures represent the luxury of having lived beyond these means. The meeting at the bank is having said aloud "In late May, I go bankrupt if the EU does not help me. "

The whole family quick to lend money to the child to prevent it taints the joint account. Also avoid the loss of the house and save the family reputation. Bankers income of the family then decided to scrutinize the finances of each member and discovered that two other children are borderline, but not necessarily critical. Parents call an emergency meeting to create an emergency fund to protect the spouse account. The grandfather refuses to participate in this fund.

The other two children are Portugal and Spain . The grandfather is the UK refuses to participate in an emergency fund to stabilize the euro area in case of future problems.

Bankers reassess income family where the whole family. Because all children (including irresponsible) have access to the account-spouse, banks lower the credit rating of the joint account. With regard to personal accounts, they are reviewed on a case by case and those irresponsible children have seen the interest rates on future borrowings increase.

Need I explain?


So ... would you want to bankers in the case of my analogy of doing so? It preventive some say, but said higher risk said performance required higher. Notice that they did not categorically refused to swear or demanded immediate payment of all scales ... just required risk premiums higher.

If you answered yes to my question, do you think the banks have done well in the United States to lend money to people who wanted to buy a home without passing the tests of creditworthiness (hence of making subprime) on terms as favorable as regular mortgages? If your answer to my last 2 questions is not the same, you are incoherent. (Normally, I expect no-no ... say yes-yes it does not understand the workings of finance)

In my analogy, some bankers may speculate on the difficulties of their customers (through higher interest rates, but long term the situation must necessarily reach equilibrium). And can we say that the crisis in the family is the fault of bankers? So why say that speculators are responsible for the crisis euro?

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models discount

In finance, the value of a property is the value of future cash flows that we will release the property in today's dollars. For example, a government bond that will give me $ 100 in 12 months could claims $ 98 today. For a more detailed explanation of the concept of discounting, see the note on the intrinsic value of a company blog Financial Portfolio.

can be divided into 2 main models types: models of dividends and free cash flow models. In reality, there are hundreds of models that are all derivatives of these basic forms. Therefore in business schools we just normally thereof.


dividend discount models
( Dividend discount model )

As its name suggests, these models update the value of future dividends on the company to determine the intrinsic value of the action. A major flaw is that it assumes that the dividend is the only form of shareholder remuneration. All businesses that pay no dividends (or do not pay in the foreseeable future) are not assessable by these models. But even for companies that pay dividends, it is difficult to clearly assess the value of a share. First, some companies pay dividends irregular, is making complex modeling. Then, several firms have dividends that are not correlated with company performance (and therefore unsustainable in the long term). For example, GM has paid 30% of its profits in dividends in 2000, but 113% in 2001 and paid from 2005 to 2008 despite operating losses. Using a dividend discount model in such a case is without interest.

The first step of a model dividend is to determine if the company lends itself to such analysis. Normally, only mature companies with steady growth and relatively low (we'll see why soon) are good candidates for a model with dividend.

Model Gordon
This is the simplest and most popular of the dividend discount model. To find the price of a stock (P), we need the next dividend (D), the rate of dividend growth (g) and the shareholder's required return (k). The formula is:

The greatest weakness of this model is mathematical. First, k and g must be constant over time. But mostly, kg must be positive and nonzero. However, many companies have an average growth over the past 5 years 20 to 30%. The application of the Gordon model is impossible.

The two-stage model ( Two-stage model )
To overcome the problem of excessive growth, some will prefer to do the evaluation in two stages. First, we will evaluate a series of growth "extraordinary" (ie where g> k) and then create a regular pattern of Gordon. For example, one could say that business will grow 30% annually for 10 years and then return to a normal level of growth (long term) of 8%. Mathematically, the model is written :

The first section (before the +) calculates the value of dividends that are extraordinary growth. The second calculates the value of the Gordon model is the extraordinary growth over time (and, of course, updated to today). gs represents the extraordinary growth rate (short term) with n like many of the period. gL is the rate of growth in the long term.

One weakness of this model is that it directly affects the rate of growth to another. In my example, it would therefore immediately from 30% to 8% overnight. It is for this reason that the next model was created.

Model-H (H-model )
The model assumes H as the previous rate of growth in the short term and long-term rates. But here, we assume that the rate will decrease linearly over the duration. In the numerical example above, the growth of 30% to 8% decrease over 10 years. So the growth rate decrease of 2.2% per year. The model is written:

The variable H is the half-life of extraordinary growth. In my numerical example, H would be 5 (or 10 / 2 !!!).


free cash flow models
( Free cash flow valuation )

As mentioned previously, models of dividends suffer a major problem: they evaluate dividends! One possible change is to use the same models, but replace the variable D CWF (or MLF for free cash flow). How to calculate cash flow? Which make? It is the purpose of this section.


Free Cash Flow the firm (FCFF)
The first type of FML is the FCFF. It gives us the amount of cash flow that are available throughout the enterprise. Its formula is:

Why all these changes in net income (NI variable)? Because creditors and shareholders have no direct access to profits. In fact, some of that profit must be reinvested in the company. Also, part of the profit comes from non-monetary item. Let each of the variables of the formula. First, NCC is for Non-cash charges or, in French, non-cash charges. Often, this item such as depreciation. WCInv is investment in working capital ( Working Capital Investment ). Int represents interest expense and taxes the tax rate. It adds that element because we want to here all cash flows available to all donors of the company. We must add the burden of interest because it belongs to the creditors (but the tax savings remains in force). CAPEX investment is needed in long-term assets (for Capital Expenditures ). It also removes that amount of free cash flow because you have to reinvest the money in the company for its normal functioning. The insightful

have noticed that NI + NCC - WCInv = cash flow generated from operations. We could reduce the calculations by taking directly the number of the statement of cash flows.

As the flow of money we use is for the company, the rate k is taken to the enterprise. Normally, we take the weighted average cost of capital (WACC or WACC in English). Note that the calculation here does not give the share price, but the value of the whole enterprise. Suffice it to remove the value of debt and divide by the number of shares to find a value per share.


free cash flow available to shareholders (FCFE)
The FCFE FCFF is comparable except that it now seeks only the cash flows available for shareholders. Such a calculation has the advantage of keeping the same k that models dividend and give us directly the value of the shares. It will also take into account changes in capital structure already provided as shown by the formula:

The NetBorrowing represents the net of new borrowings. Just subtract the loan repayments to new issues to find the value of NetBorrowing.

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How to evaluate an action?

Before I begin, I must confess that future articles are designed primarily to enable me to properly review the various models for the CFA Level II. This is a form of summary for 750 book pages in 4 sections. It will discuss methodologies for financial analysis and the next three will address the following topics:

1. models discount
2. models by multiple
3. residual income (revenu residual )

The importance a comprehensive analysis
Have an overview on the economy is essential before starting the analysis of a title. Normally, we proceed in order:

1. Analysis of the global economy and / or local
2. Analysis of the global industry and / or local
3. Company analysis

Thus, before analyzing a company, we'll start to see in what universe it operates. The best company in an industry fail is still a company to avoid (eg the best company in the production of DVD discs and is doomed to failure today). The presence of "and / or" points 1 and 2 is that some companies operate around the world (and requires a global analysis) while others are smaller and only local.

In point 1, we try the economic and politico-economic factors that may affect the industry. For example, U.S. protectionism has an important impact in agriculture. Political instability in Africa could affect the operations of mining companies therein. In the same vein, the runaway inflation in Zimbabwe (98% per day at last count in 2008 ... so prices doubling every 24.7 hours) can quickly kill economic potential.

In point 2, it is important initially to define the industry. If one wants to study CN, we take as the rail industry, transportation or transportation of goods in general? And can we use as comparable European companies in the industry or whether to restrict themselves in Canada and the United States? Once the list of companies forming the defined area, we try to evaluate the following:

• stages (starting, growing, mature)
• External Factors Affecting the
• Technology: How technological advancements change the industry?
• Government: government regulation could it affect the industry?
• Demographics: demographic changes they will force the industry to adapt?
• Social Change: how social changes affect the industry?
• Development of demand and supply at the aggregate level
• Factors strengths and weaknesses points

If we take the example of the tobacco industry, we know that she is mature or even declining. The new laws banning the consumption of tobacco in public places and tax increases (as well as new and future regulations) result in lower sales in the industry. The aging population should mean lower sales. The change in public attitudes in relation to cigarette smoking makes it difficult for industry growth. With these new external factors, aggregate demand will decline over time. However, major barriers to entry protect reasonably well the current players of future competition, but the smuggling of cigarettes is a scourge that hurts the industry's sales.

With such an analysis of the industry, we are now able to analyze our business. This step will be described in future articles.

Top-Down vs.. Bottom-Up
The top-down method is to study the industry to extrapolate the overall situation in our company analyzed. For example, one could determine the expected sales for grocery stores in Quebec and use that with the market shares of Metro to evaluate its sales.

The Bottom-Up method rather seeks from micro variables. Thus, one could take the sales per square foot historic Metro and predict the next values of this ratio. For sales, simply multiply the number of square feet planned in the future.

The industry Either method seems more appropriate. For example, the Bottom-Up in the tobacco industry is unattractive. But in retail it is appropriate.

I tried here to write the process as possible as a recipe, but much of the work of an analyst is to see when certain "ingredients" are irrelevant and that others would be more relevant.