FSR Forum 13-5

13th Volume August 2011 issue #5

Valuation Interview D. Zane Hurst Valuation: The vision of an expert

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fsrforum • volume 13 • issue #5

Valuation

Preface

Dear reader, Before you lies the last issue of the FSR Forum of this academic year. The theme of this FSR Forum edition is linked to a very interesting topic in today’s financial world: we will dive into valuation. As you expect from the FSR, we will look at it on a very broad way. Many students are interested in valuation because it is a very hot topic in today’s lectures and courses. In this issue we discuss a lot of material from all over the world. Views about risk premium at takeovers, currency behavior in the valuation process and stock behavior. As you may expect from previous issues, we also try to create a bridge between the theoretical part and the practical part of the theme, as always, we will try to create that bridge with an interesting interview.

As already discussed, the theme of this FSR Forum fifth issue will be valuation and we tried to look at it as broad as possible. In this issue you will find three interesting scientific aticles that have a link with valuation. To create a bridge to a more practical meaning of valuation, we interviewed D. Zane Hurst from Training The Street. Furthermore you can find content about activities and events of the FSR. The first article is written by David C. Smith, Associate Professor of the McIntire Center for Financial Innovation at the University of Virginia and Brain Calvert. David C. Smith is specialized in corporate finance and he and his co-writer will discuss company-specific risk premiums. In this article there will be a revived debate whether or not company-specific risk is priced into the cost of capital of a firm. It will show that there is evidence that supports original findings about the fact that variation in cross-sectional stock returns and that holders of risky securities do not appear to receive compensation for bearing company-specific risk.

The second article is written by Robert Comment MBA, PHD, AVA, he has studied data about restricted stocks. He will discuss the behavior and use of restricted stocks in a business valuation.

Restricted stocks are a hot topic in business valuation. Business analysts who are working with restricted stocks are always trying to estimate a discount for lack of marketability (DLOM). The writer discusses the many forms of discount, why it is used and especially when it can be used.

He describes the mistake which is made very often, that discount in sales of restricted stock are always due to restricted marketability, because discounts can also occur in private placements of free trading shares. In the end, the writer concludes about the way the discount should be measured and how analysts can use it in a deal.

In the last article Jamal Ibrahim Haidar discusses a special form of valuation. Currency valuation to be specific. The writer of this article is looking to different methods to depend the real purchasing power of money. At the beginning the writer is starting to discuss a measurement to compare purchasing power of different currencies. He first looked into a tool for making purchasing power comparisons made by The Economist, the wellknown ‘Big Mac Index’. Where the price of a regular McDonalds Big Mac bought in the United States is compared to the price of other Big Macs around the world. By this way you would get a simple, but good comparison about the purchasing power of different currencies, but Jamal Ibrahim Haidar looks further. The second part of his paper provides a literature study about this ‘Burgernomics’. He will summarize the debate about purchasing power parity and will discuss why the Big Mac Index is not a perfect measurement tool.

2 • Preface

In this issue of the FSR Forum you can also enjoy reading an interview to shorten the gap between theory and practice. We have interviewed D. Zane Hurst about challenging topics in today’s financial world. Mr. Hurst is an instructor at Training The Street. The company provides financial learning services and training in financial modelling for other companies, but also for universities and business schools. Training The Street provides courses at for example Harvard Business School, INSEAD, London Business School, Yale University and off course the Erasmus University Rotterdam in collaboration with the FSR during one of our events: the Investment Banking Masterclass. In his interview Mr. Hurst gives answers to interesting questions about problems and issues that can appear when valuing a company.

In this issue of the FSR Forum we also have a column from Dr. Marc B. J. Schauten Phd. Mr. Schauten is an assistant professor in finance and member of the Department of Finance at the Faculty of Economics from the Erasmus University Rotterdam. He wrote an interesting column about the creation of shareholder value and the maximization of short term profits.

When I look back at the fifth FSR Forum, I think this is a very interesting theme where we discuss a very hot and broad topic. For students it is a great way to get to know the broader meaning of valuation.

Looking back at a year as a board member of the FSR, I think I had a great experience and great opportunities to learn much about the Erasmus University and the corporate world. As treasurer of the association in combination with my role as editor in chief of the FSR Forum, I had a really busy time managing all the deadlines of articles, advertorials and invoices. But when I see all of this year’s FSR Forum issues, I think I can be proud of my attempt of creating a bridge between the theoretical part of some themes and the practical meanings of it in the other way.

I hope you will enjoy reading this last edition of the FSR Forum of the year 2010-2011 and I hope it will give you good insights in the broad way of valuation.

Sincerely, Kim de Vries Editor in chief FSR Forum FSR board 2010-2011

Preface • 3

fsrforum • volume 13 • issue #5

Valuation

Table of contents

A Skeptical Restricted-Stock Study Robert Comment, MBA, PHD, AVA

Data from restricted-stock studies are used by business-valuation analysts to estimate a discount for lack of marketability, or DLOM, applicable to the valuation of a private company. The intuition and standard rationale for the DLOM is that, even after an investor is compensated for the risk associated with holding an asset, an asset held under effective compulsion still must be worth less than if the asset were held by choice. This large-sample empirical study of privateplacement discounts avoids four common mistakes in restricted-stock studies and finds evidence for a DLOM no greater than 5.6%. This estimate is not statistically significantly different from 2.5%, which is the DLOM on the riskless asset as implied by the typical yield spread between 5-year bank CDs and 5-year U.S. Treasury securities.

15

Currency Valuation and Purchasing Power Parity Jamal Ibrahim Haidar

The analytical framework of currency valuation is an intellectual challenge and of influence to economic policy, smooth functioning of financial markets, and financial management of many international companies. The Economist magazine argues that the Big Mac Index (BMI) based on the price of a Big Mac hamburger across the world can provide “true value” of currencies. 22

K(r)anttekening Samen; de Europese schaduwprijs Drs. Joost Groeneveld RA RV

Als businessvaluator heb ik met regelmaat te maken met partijen die ooit hebben besloten samen te doen. (Bijna) niets is zo leuk als gedeeld enthousiasme. Iets gaan bewerkstelligen dat je samen beter kunt bereiken dan alleen. Je stimuleert elkaar. Je kunt door werkverdeling gebruik maken van elkaars sterke punten, terwijl ieders zwakke punten minder op de voorgrond ­hoeven te komen. Je netwerk is groter. Je kunt aan schaalvoordelen gaan denken. En je hebt een klankbord. De uitnodiging om iets samen te gaan doen, is bovendien een compliment. De ander komt naar jou toe.

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Colofon FSR FORUM appears five times a year and is an edition of the Financial Study Association Rotterdam KvK Rotterdam no: V 40346422 VAT no: NL 805159125 B01 ISSN no: 1389-0913 13th volume, number 5, circulation 1450 copies

4 • Table of contents

Editor in chief Kim de Vries Editorial department Rick Klootwijk Rishi Sripal Editorial advisory Dr. M. B. J. Schauten Dr. W. F. C. Verschoor Drs. R. Van der Wal RA

With the cooperation of Drs. J. G. Groeneveld RA RV M. Schauten Phd D.Z. Hurst R. Comment, MBA, PHD, AVA J. I. Haidar

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Table of contents • 5

fsrforum • volume 13 • issue #5

Company-Specific Risk Premiums and the Cost of Capital: What does the Science Tell Us? R. Brian Calvert & David C. Smith

6 • Company-Specific Risk Premiums and the Cost of Capital: What does the Science Tell Us?

This article summarizes the scholarly evidence on the efficacy of including a company-specific risk premium (CSRP) in estimates of the cost of capital.1 CSRPs are enormously popular among valuation practitioners and are a common component in cost-of-capital models used by many investment bankers, appraisers, business valuation specialists, and accountants. For instance, one bankruptcy valuation specialist has recently written, Company-specific risk should be considered in every bankruptcy valuation-related analysis of any investment that is: 1. not perfectly liquid, 2. not perfectly diversified, 3. not subject to limited liability.”2 Valuation practitioners have developed a commercially available “models” that claims to provide a quantitative and reliable calculation of the company-specific risk premium.3 And the organization responsible for providing continuing education credits to U.S. certified public accountants advises its members to include CSRPs in valuations of small and private companies.4 Yet, the motivation for the use of CSRPs by practitioners is often grounded in misguided interpretations of financial theory and a poor understanding of the existing empirical evidence relevant to CSRPs. We argue that the weight of theory and new evidence does not support the assertions of some practitioners that the CSRP should be included in the cost of capital.

Traditional thinking on company-specific risk In the context of company valuations, the cost of capital represents the average annual return that investors can ­ expect to make over time on their investment in a company.

Most investments are risky, in the sense that the actual return at any given point in time may differ from the average return expected over a long period. Because risk-averse investors will expect a return premium on investments that are riskier, higher risk companies should have a higher cost of capital than lower risk companies.

But a central question in finance and economics is what kind of risk matters to the cost of capital? The traditional answer to this question follows from recognizing that when investors can easily hold portfolios of many assets, company-specific risks – fluctuations that are unique to a particular company – are diversified away, in the sense that the unique fluctuations

across imperfectly correlated assets cancel each other out.

The exposure that remains after diversifying away companyspecific risks is market-wide risk common across companies, so-called systematic risk.5 Economic theory teaches us that when the cost of holding diversified portfolios is relatively low and markets are competitive, investors should only be compensated for the risk exposure that remains when holding a diversified portfolio; that is, systematic risk. Any premium for company-specific risk gets competed away by return-maximizing, diversified investors. Thus, traditional thinking teaches us that systematic risk matters to the cost of capital, in the sense that individuals investing in companies with higher systematic risk should earn a higher premium for bearing that risk. Company-­ specific risks should not matter, so that even when investors choose to bear company-specific risk (by not holding a diversified portfolio), they receive no premium for bearing that risk.6 Today, investors can select and buy at low cost a wide variety of assets through mutual funds, index funds, defined contribution pension plans, insurance companies, and can invest directly into a variety of equities through low-cost discount brokers. Investors have access to alternative assets markets beyond public equity markets via hedge funds, real estate funds, private equity funds, and a host of other investment vehicles. Thus, the traditional view that only systematic risks are compensable should hold in the real world for most assets, in most markets, most of the time.

New thinking on company specific risk: Theories and evidence Newer economic theories have taught us that there are certain conditions under which company-specific risk might be rewarded in the cost of capital, implying a positive CSRP. Specifically, company-specific risk might matter to the cost of capital when one of two conditions is met: (1) a marketwide friction exists that prevents investors from holding, as a group, the same set of risky securities in their portfolio, or (2) an investor chooses (or is forced) to hold an undiversified portfolio, in which case the valuation of the risky asset is different for that investor than other investors that hold diversified portfolios.

Could company-specific risk matter? Condition (1)

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Company-Specific Risk Premiums and the Cost of Capital: What does the Science Tell Us? • 7

fsrforum • volume 13 • issue #5

Since assets cannot be optimally diversified, company-specific risk matters.

Condition (1) challenges the traditional assumption that investors, in aggregate, can form well-diversified portfolios by assuming that certain groups of investors are constrained in the types of risky assets they can hold. Possible constraints include transactions costs, trading restrictions, incomplete information, behavioral biases towards undiversified portfolios, and the inability to diversify labor market income. Merton (1987) studies a model in which investors are constrained to gather information and invest in only a subset of all available securities. Theoretical models similar to Merton (1987) have also been explored by Levy (1978) and Malkiel and Xu (2004).

In these models, assumed constraints on trading prevent any one investor from holding an optimally diversified portfolio.

When such constraints are economically significant, they create an equilibrium pricing impact on all securities: When one group of investors is constrained to holding a subset of all diversifiable assets, other investors must necessarily hold in larger supply the assets excluded from the constrained group. Since assets cannot be optimally diversified, company-specific risk matters.

As a market equilibrium concept, condition (1) implies that company-specific risk will be important to the pricing of all companies in a market (large and small, public and private), and that higher company-specific risk implies a higher CSRP. The most important takeaway from condition (1) is that its implications are empirically testable: If we live in a world where frictions meaningfully constrain investment in diversified portfolios, then financial statisticians should be able to measure the magnitude of the CSRP and test whether the CSRP is positive and economically meaningful.

Tests of whether company-specific risk matters dates back at least to the late 1960s when researchers began to investigate empirically the – then new – capital asset pricing model (CAPM) developed by Sharpe (1964) and Lintner (1965). But the early tests used relatively small samples and poor statistical techniques. Fama and Macbeth (1973) was the first study to use a relatively large sample of stock returns and apply sound statistical techniques to examining the CAPM. As part of their study, Fama and Macbeth tested whether companyspecific risk earns a stock return premium once they have properly controlled for CAPM systematic risk (i.e., “beta”).

Fama and Macbeth find the CSRP to be statistically indistinguishable from zero.

8 • Company-Specific Risk Premiums and the Cost of Capital: What does the Science Tell Us?

For nearly 30 years, the findings in Fama and Macbeth (1973) lay to rest the question of whether company-specific risk is compensable.7 Interest reemerged in the early 2000s following a study by Campbell, Lettau, Malkiel, and Xu (2001) that showed that the average total risk, and in particular, company-specific risk of publicly listed companies more than doubled during the period 1962 to 1999. While the findings of Campbell, et al. (2001) did not imply anything about the compensability of company-specific risk, they did provide researchers in the early 2000s with an impetus to re-examine the original Fama and Macbeth (1973) results.

Table 1 provides summary information on the entire set of new studies of company-specific risk covered in Calvert and Smith (2011), including their publication outlet, primary finding, and comments and critiques associated with each study. Below, we simply highlight some of the most significant results in these studies.

Recent empirical studies: Public firms With an eye-catching title of “Idiosyncratic Risk Matters!,” Goyal and Santa Clara (2003) provide one of the first postCampbell et al. (2001) investigations of the relation between company-specific risk and return. Rather than look at the relation between risk and return across companies, Goyal and Santa Clara focus on how aggregate stock market returns vary with aggregate measures of risk through time. They show that aggregate stock market returns are higher when average company-specific risk is higher, but not when average systematic risk is higher. However, the Goyal and Santa Clara (2003) study suffers from two severe drawbacks, detailed in a follow-up study by Bali, Cakici, Yan, and Zhang (2005). First, Goyal and Santa Clara (2003) mix “apples and oranges” by weighing companies differently when they compute average market returns versus average total risk. Bali, et al. correct this issue of comparing differently weighted samples and show that when an apples-to-apples comparison is made the Goyal and Santa-Clara result disappears. Second, the Goyal and Santa Clara results appear to be highly sensitive to the choice of sample period used in their study. The study includes data from 1963 through the late 1990s, but excludes data from the early 2000s that includes the stock market crash during that period. Bali, et al. find that once you add monthly observations through the year 2001, the Goyal and Santa Clara findings no longer hold, even under their original apples-to-oranges weighting scheme.

Ang, Hodrick, Xing, and Zhang (2006) study the cross-sectional relation between company returns and company-specific risk by grouping firms into portfolios according to the firms’ company-specific risk. Sorting the firms into company-­ specific risk portfolios allows the researchers to maximize the variation in company-specific risk across the firms in their sample, while washing out measurement errors present at the individual firm level. The findings in Ang, et al. (2006) are surprising. They find that the average returns on portfolios with high company-specific risk have the lowest returns, suggesting that company specific risk premiums are negative.

The results are strong and statistically significant. For instance, the difference in returns between the highest and lowest company-specific risk portfolios is -1.01% per month.

This implies that in a trading strategy that buys the high company-specific risk portfolio (expecting high returns) and shorts the low company-specific risk portfolio (expecting low returns) will lose more than 12% of its value each year.

The Ang, et al. paper is not without weaknesses. First, the study calculates monthly measures of volatility by taking averages of daily volatilities. While this methodology can sharpen the estimates of monthly volatility (because the researcher is using more data), it can also lead to biased estimates of monthly volatility if daily price swings are affected by market frictions such as infrequently traded stocks.

Second, they do not actually measure the relation between returns and contemporaneous measures of company-specific risk. Instead, they examine the relation across companies in returns in one month against company-specific risk measured in the previous month. In an extensive follow up to Ang, et al., Bali and Cakici (2008) study estimates of the CSRP under a variety of different scenarios related to choice of data, weighting of the data, and the periods over which the data are calculated. Using a variety of specification tests, Bali and Cakici argue that volatilities calculated using monthly data are a better predictor of volatility patterns than those based on daily data and should be therefore the favored period over which to estimate risk. Importantly, the robust finding across all Bali and Cakici specifications is that the relation between company returns and company-specific risk is statistically and economically indistinguishable from zero.

The implication from their tests is that there is no evidence of a CSRP.

The findings in the Bali and Cakici study have not precluded further endeavors to document a relation between companyspecific risk and returns. Thus far, the only published study is Fu (2009), which reexamines the Ang, et al. results using a forward-looking “EGARCH” predictor of company-specific risk and finds a strong positive cross-sectional relation between company-specific risk and returns. But Guo, Kassa, and Ferguson (2010) and Fink, Fink, and He (2010) show that the Fu results are driven by a “look ahead” bias that arises because Fu uses information from the future in his forecasts that would be unavailable to an actual investor at the time the forecast was produced. Both Guo, Kassa, and Ferguson and Fink, Fink, and He show that once Fu’s predictive model is corrected for the look-ahead bias, no relation exists between the forward-looking measure of idiosyncratic risk and returns.

To sum up, while condition (1) provides a natural impetus for thinking about why company-specific risks might matter to the cost of capital of publically traded firms, the bulk of the new evidence rejects the thinking in condition (1) and, more or less, supports Fama and Macbeth’s original finding that the CSRP is zero.

Could company-specific risk matter? Condition (2) Under condition (2), an investor chooses (or is forced) to hold an undiversified portfolio, in which case the valuation of the risky asset is different for that investor than other investors that hold diversified portfolios. In contrast to condition (1), condition (2) may imply that company-specific risk may be important only to a smaller set of assets that are held by undiversified investors. For instance, company-specific risks may matter to investors in small, private companies, if these investors are more likely to hold undiversified portfolio positions. By their very nature, these types of investors are overlooked in the studies discussed above that focus on CSRPs in publically traded companies. So it is certainly possible that condition (2) holds even when condition (1) appears to be rejected by the data.

Condition (2) has been studied by a variety of financial researchers, typically for situations in which an entrepreneur chooses to put most of her wealth and human capital into her business, or when a executive of a company is required to hold most of his wealth (compensation in the

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Company-Specific Risk Premiums and the Cost of Capital: What does the Science Tell Us? • 9

fsrforum • volume 13 • issue #5

form of stock options, shares and pension holdings) and salary in one company.8 These studies show that the company-specific component of a private cost-of-capital -- the cost internalized by the entrepreneur -- can be large for an entrepreneur eschewing a diversified portfolio in favor of being undiversified. The private cost is large because the entrepreneur requires a large premium for giving up diversified holdings in favor of holding a single risky asset.

But condition (2) has limited applicability to evaluating the cost of capital for purposes of a market valuation if markets are competitive. By definition, a market value is the price paid in exchange for an asset between a willing buyer and willing seller. An undiversified seller, say, the entrepreneur from above, will not want to sell her assets at a price that reflects company-specific risk. This is because a diversified bidder can always offer her a higher price than an undiversified bidder. The diversified bidder can offer the higher price because he requires less return for bearing the risk of the entrepreneur’s company than an undiversified bidder. Thus, competition, or potential competition, from a diversified bidder will again force the market compensation for companyspecific risk to be zero.

Of course, markets for assets held by undiversified investors may not be so competitive. Diversified bidders may shy away from small, opaque, illiquid, or assets held by undiversified investors, preferring instead to trade only in transparent and liquid claims securities markets of publically listed companies. The question of whether condition (2) holds then becomes an empirical question: Do the observed returns earned by undiversified sellers reflect company-specific risk?

While it is much harder for researchers to observe and analyze the returns earned on investments in small or privately held assets, the existing scientific studies of private-market returns suggests that the these markets are competitive enough to force the CSRP to zero. For instance, Moscowitz and Vissing-Jørgensen (2002) combine comprehensive data on private equity holdings from the U.S. Survey of Consumer Finances, National Income and Product Accounts, and Flow of Fund Accounts to study the returns to entrepreneurs investing in private businesses. They show that while these investors hold highly undiversified portfolios and expose themselves to significant company-specific risk, they earn a

10 • Company-Specific Risk Premiums and the Cost of Capital: What does the Science Tell Us?

return on private equity that is no higher than the market return of public traded stocks.

Meanwhile, Jones and Rhodes-Kropf (2003), Kaplan and Schoar (2005), Cochrane (2005), and Korteweg and Sorenson (2010) study the returns to private equity investors using the reported performance of venture capital and leveraged buyout firms. Jones and Rhodes-Kropes (2003) and Kaplan and Schoar (2005) show that net-of-fee returns to limited partners in these private equity funds are comparable to market returns to publicly traded investors. Gross-of-fee returns to general partners of venture capital firms tend to exceed returns on publicly traded firms, but Kaplan and Schoar (2005) argue that this probably reflects superior investment selection or higher systematic risk, rather than compensation for idiosyncratic risk. In line with Kaplan and Schoar’s conjecture, Korteweg and Sorensen (2010) show that investments in private firms exhibit high systematic risk and no additional reward beyond what can be explained by systematic risk alone.

Thus, existing studies of the returns to private owners and private equity investors suggest that markets for private assets are competitive enough to drive CSRPs to zero.

Conclusion Valuation, in practice, is a frustrating endeavor. It relies on forecasts of future outcomes that are far from known at the time they are made and on inputs that are often unobservable, even after the fact. Discerning the cost of capital for a company or project is particularly elusive. Financial scholars have a good sense for what types of risks – systematic risks – should be compensable in the cost of capital, but are often unsuccessful in capturing all important systematic risks into one coherent model. This leads to understandable confusion among practitioners and leaves room for filling in gaps left by science with practical experience.

However, on the question of whether company-specific risks should be incorporated into the cost of capital, economic principles are backed by well-founded empirical investigations. Robust data, sophisticated statistical techniques, and over forty years of published studies show consistently that company-specific risks are not compensable in the cost of capital. The studies show this to be true among both public and private firms, small and large companies, and among

Given the preponderance of evidence, the company-specific risk premium should be one tool left out of the credible practitioner’s toolbox.

both diversified and undiversified investors. Given the preponderance of evidence, the company-specific risk premium should be one tool left out of the credible practitioner’s toolbox.

Table 1: Summary of Recent Scholarly Empirical Studies of the Company Specific Risk Premium This table summarizes the publication outlets, findings, and criticisms of recent empirical studies of the company-specific risk premium (CSRP). The table includes studies on both public and private firms. Panel A lists those studies reporting evidence of a positive CSRP. Panel B lists those studies finding no evidence of a positive CSRP. Panel A: Studies reporting to find a positive company-specific risk premium (CSRP) Study

Publication outlet

Data source

Primary Finding

Goyal and Santa Clara (2003)

Journal of Finance

Publicly traded U.S. firms

Aggregate stock market returns are higher when average companyspecific risk is higher.

Jones and Rhodes-Kropf (2003)

Unpublished working paper

Reported returns earned by private equity funds

Malkiel and Xu (2004)

Unpublished working paper

Publicly traded U.S. firms

Fu (2009)

Journal of Financial Economics

Publicly traded U.S. firms

Cao and Xu (2010)

Unpublished working paper

Publicly traded U.S. firms

Comments/Critiques

Mixes different weighting methods and uses a specific sample period.

Bali, et al. (2005) show result dissappears using corrected weights or longer sample period.

Net returns and 'alphas' are Net returns are not risk adjusted; positively correlated with company- assumes a beta of 1.0 on all private specific risk. investments. Korteweg and Sorensen (2010) show that VC investments tend to have betas in the range of 2.0 to 4.0 and find no evidence of a CSRP. Positive CSRP using firm-level Mixes portfolio-level measure of regressions when sorting firms first company-specific risk with firminto size and beta portfolios. level returns. Portfolio measure of company-specific risk could be capturing systematic variable related to size and beta.

Strong evidence of a positive CSRP Suffers from a "look-ahead" bias by using a forward-looking EGARCH using information on future volatilities model of conditional companyto calculate current measure of risk. specific risk.

Guo, et al. (2010) and Fink, et al.

(2010) show that once look-bias is corrected, CSRP is zero.

Finds no relation between usual Company-level returns are measure of company-specific risk positively related to a measure of the long-run component of and returns. Short- and long-run company-specific risk. decomposition likely suffers from look-ahead bias.

Panel B: Studies reporting to find no evidence of a positive company-specific risk premium (CSRP) Study

Publication outlet

Data source

Primary Finding

Moscowitz and Vissing-Jørgensen (2002)

American Economic Review

Returns to U.S. individuals holding equity in single firms.

Returns on private holdings no higher than return on aggregate public stock market returns.

Cochrane (2005)

Journal of Financial Economics

Bias-corrected returns to private venture capital funds

Kaplan and Schoar (2005)

Journal of Finance

Reported returns earned by private equity funds

Ang et al. (2006, 2009)

Journal of Finance (2006); Journal of Financial Economic (2009)

Publicly traded U.S. firms (2006); publicly traded firms in 23 markets around the world (2009).

Bali and Cakici (2008)

Journal of Financial and Quantitative Analysis

Publicly traded U.S. firms.

Comments/Critiques

Suggests that entrepreneurs take on substantial unsystematic risk for reasons other than earning proper risk-adjusted returns.

Venture capital return performance More robust models of sample no higher than a small publicly selection developed by Korteweg traded company. and Sorensen (2010) show that VC investment betas are much higher, and adjusted performance much lower, than shown by Cochrane (2005) Net-of-fee returns to limited Net returns are not risk adjusted; partners in these private equity assumes a beta of 1.0 on all private funds are comparable to market investments. Korteweg and returns to publicly traded investors Sorensen (2010) show that VC investments tend to have betas in the range of 2.0 to 4.0 and find no evidence of a CSRP. Negative relation between oneDaily measures of volatilty can be month forward portfolio returns problematic for estimating volatility and portfolio measure of company- at monthly frequency. Measure of specific risk, suggesting CSRP is risk not contemporaneous with negative. returns.

Addresses many of the statistical CSRP is statistically not different and data shortcomings of earlier from zero under a variety of different scenarios related to choice papers reporting to find positive or of data, weighting of the data, and negative CSRPs. the periods over which the data are calculated that.

»

Company-Specific Risk Premiums and the Cost of Capital: What does the Science Tell Us? • 11

fsrforum • volume 13 • issue #5

References on request

Notes 1 The article is based on a more comprehensive analysis and synthesis of the literature conducted by the authors in a current working paper, see Calvert and Smith (2011).

2 See Reilly (2008), p. 48.

3 See Butler and Pinkerton (2006, 2007 a,b).

4 For instance, see Trugman (2008).

5 The benefits to diversification do not rest on any strong assumptions about investor behavior beyond assuming that they prefer higher returns and lower risk. Rather, the “canceling out” that occurs from diversification results from consider the risk and return on a portfolio of imperfectly correlated risky assets. As more assets are added to the portfolio, the riskiness of the portfolio declines without necessarily lower the expected return on the portfolio. These and related “portfolio theory” insights earned Harry Markowitz and William Sharpe the Nobel Prize in Economics in 1990. For an extension introduction to portfolio theory, See, Berk and Demarzo (2007), Chapters 10-12.

6 In their popular corporate finance textbook Berk and Demarzo (2007) characterize the reason why a CSRP should not exist in a competitive market as follows: If the diversifiable risk of stocks were compensated with an additional risk premium, then investors could buy the stocks, earn the additional premium, and simultaneously diversify and eliminate the risk. By doing so, investors could earn an additional premium without taking on additional risk. This opportunity to earn something for nothing would quickly be exploited and eliminated. (p. 305).

7 Two exceptions are Longstaff (1989) and Lehmann (1990). Longstaff (1989) studies the crosssectional relation between returns and total variance by first sorting stocks into portfolios based on market capitalization. He finds no significant relation between returns and company-specific risk. Lehmann (1990) corrects for measurement error in market model parameter estimates and examines estimates using individual, rather than grouped securities. Lehmann (1990) finds a positive association between residual risk and return in some of cases, but finds his results to be sensitive to the benchmark and methodology selected for the test.

8 For instance, see Brennan and Torous (1999), Hamilton (2000), Benartzi (2001), Meulbrook (2001), Heaton and Lucas (2001), Hall and Murphy (2002), Jones and Rhodes-Kropf (2003), Kerins, Smith, and Smith (2004), and McConaughy and Covrig (2007, 2009). An investor exposed to scenario (1) risk will price that risk according to a “total beta” model, as discussed in Damodaran (2006) and below in the “Inferences

12 • Company-Specific Risk Premiums and the Cost of Capital: What does the Science Tell Us?

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fsrforum • volume 13 • issue #5

A Skeptical Restricted-Stock Study

Robert Comment, MBA, PHD, AVA

Data from restricted-stock studies are used by business-valuation analysts to estimate a discount for lack of marketability, or DLOM, applicable to the valuation of a private company. The intuition and standard rationale for the DLOM is that, even after an investor is compensated for the risk associated with holding an asset, an asset held under effective compulsion still must be worth less than if the asset were held by choice.

This large-sample empirical study of private-placement discounts avoids four common mistakes in restricted-stock studies and finds evidence for a DLOM no greater than 5.6%.

This estimate is not statistically significantly different from 2.5%, which is the DLOM on the riskless asset as implied by the typical yield spread between 5-year bank CDs and 5-year U.S. Treasury securities.

Business appraisers are mostly CPAs who, in my view, have not brought to the DLOM the skepticism typical of their profession. I covered a range of issues in my previous paper on the DLOM,1 focusing on the problem of redundancy, and follow up here with a large-sample private-placement study that exploits the power of regression analysis. I find little ­evidence that average discounts in private placements of common stock are directly (i.e., reliably) related to the restricted nature of restricted stock. In addition, I provide historical evidence (1998-2011) regarding the DLOM on the riskless asset.

Restricted-stock studies are the keystone of the DLOM edifice, and provide the only data that Shannon Pratt could cite to buttress his rejection of my well-supported finding that the DLOM is substantially redundant to the ample discounting for lack of size in core valuation methods.2 This study avoids four mistakes that have afflicted restricted-stock studies.

First and foremost, it is a mistake to assume that discounts in sales of restricted stock are due solely to restricted marketability – when discounts also occur in private placements of free-trading shares. My data include private placements of free-trading shares (28% of all deals) and restricted stock. It is only the differential discount that can be attributed reliably to SEC-imposed limits on the marketability of restricted stock, and then, only after controlling for determinants of discounts that are common to placements of restricted stock and free-trading shares.

Second, the dominant feature on the private-placement landscape has long been the high participation by OTC companies (those with Pink-Sheet or OTCBB-traded shares). OTC companies account for 41% of the 1,103 private placements

of common stock during 2004-2010 (in my data). This is down from 82% of 88 deals during 1990-1995.3 This matters because almost all of the largest discounts (those above 50%) occur in deals by OTC companies. The prevalence of OTC deals means that discounts are often calculated relative to prices set in trading venues that are not often thought of as efficient markets. It is a mistake to overlook the effect of OTC status, especially insofar as such data provide the very juice of the analysis. I use multiple regression analysis to control for the higher average discounts seen in deals by OTC companies.

The third mistake is related to the second. It is a mistake to overlook the change in the market price of the stock over the several weeks before the deal. The rationale is straightforward.

Buyers may disbelieve a market price, and discount more heavily off that market price, insofar as it has recently ­increased. It turns out that the percentage change in stock price over the 30 days before the deal closes explains privateplacement discounts better than any other explanatory ­variable that I consider.

Fourth, the dispersion in discounts from one deal to the next is wide and it may be tempting to overlook this attribute of private-placement discounts when reaching conclusions. It is because the dispersion is wide, however, that it is necessary to address this feature of the data. I consider the “known or potential rate of error,” which is one of the several non-exclusive indicia of reliability mentioned by the Supreme Court in Daubert.4 Because t-statistics increase with sample size, algorithmically, statistical significance presents a low bar in a sample as large as mine.

While my study is novel in several respects, it otherwise follows a line of scientific research that includes Wruck (1989), Silber (1991), Hertsel and Smith (1993), Bajaj, Denis, Ferris and Sarin (2001), Barclay, Holderness and Sheehan (2007), and Huson, Malatesta and Parrino (2009).5

THE MISTS OF TIME The SEC has gradually deregulated post-IPO issuances of common stock. The thresholds to qualify for the use of shelf registration now mainly exclude OTC companies with a public float below $75 million. Earlier, during 1992-2007, all companies with float below $75 million had been excluded.

The minimum holding period before restricted stock can be resold to the general public, absent registration, was reduced from to six months in early 2008 after being reduced from two years to one year in early 1997.

Robert Comment, MBA, PHD, AVA, has taught finance and business valuation in several MBA programs, and previously served as the SEC’s Deputy Chief Economist.

He testifies frequently as an expert witness in securities litigation.

E-mail: bobcomment@ msn.com.

» A Skeptical Restricted-Stock Study • 15

fsrforum • volume 13 • issue #5

One might imagine that the private placements most informative of the DLOM are those before 1997 when the regulatory holding period was longest. The catch is that these deals mostly pre-date electronic filing, which was phased in around 1995. Information on these deals was limited to what issuers disclosed in press releases. The press releases are vague on the initial and subsequent registration status of shares being sold. Due to these data limitations, it is difficult to determine in these deals if a marketability restriction applied for the full two-year term, or if one ever applied at all.

Moreover, these ancient data are of dubious relevance in the modern era. For one thing, the frequency of deals has increased ten-fold, from 15 per year during 1990-1995 to 158 per year during 2004-2010. The modern market is competitive and buy-side competition, along with the shift in composition away from OTC companies (with high discounts), may have reduced discounts over time. In any event, data originating when the regulatory restriction was most severe offer little or no advantage over modern data.

FREE-TRADING SHARES Private placements of free-trading shares occur pursuant to a shelf registration, a type available since 1982. A shelfregistration differs in that it authorizes generic, future issuances rather than one specific, immediate issuance. Being generic, a shelfregistration filing does not include deal-specific information. That gets disclosed in a prospectus supplement filed later, at time of sale, which can be several years later. Finally, while the buyers in private placements of free-trading shares need not be accredited investors, they mostly are anyway.

The same sort of institutions and wealthy individuals that buy restricted stock appear to be the buyers in private placements of free-trading shares.

Private placements are sold to a single buyer just 18% of the time (201 of 1,103). In the extreme, when there are 10 or more buyers, the total shares sold averages 22.1% of prior shares outstanding while the typical block sold averages 0.9% of prior shares outstanding. Alternatively denominated, when there are 10 or more buyers, the total shares sold typically amounts to 201% of one month’s volume while the actual blocks sold each typically amount to 9% of one month’s volume. A discrepancy of this magnitude means that any correlation between discounts and the overall size of the deal, the macro-block, cannot be indicative of a blockage discount.

I nevertheless include the shares sold per deal (expressed as a percentage of prior shares outstanding) as an explanatory variable in my multiple regression, but not as a measure of blockage. I see it as a measure of potential dilution. Dilution will depend partly on how many shares are sold and partly on

Most private placements of common stock are sold to groups of accredited investors. the magnitude of the discount, but one cannot use the discount itself to construct an explanatory variable, so I settle for a measure of potential dilution rather than actual dilution. Also, there may be other explanations besides blockage or dilution.

WHY REGRESSION ANALYSIS? BLOCKAGE DISCOUNTS Three-quarters of all the common stock of U.S. public companies is held by institutional investors, making blockage discounts implausible as a general matter. In any event, most private placements of common stock are sold to groups of accredited investors assembled by private-placement agents.

It is unlikely that group members would eventually sell in unison. They are unlikely to seek to exit their investments at the same time by chance, and unlikely to conspire to flood the market with coordinated sales if doing so will reduce their sale proceeds.

16 • A Skeptical Restricted-Stock Study

Estimating the DLOM as a differential effect (the average discount on restricted stock minus the average on free-trading shares, after controlling for extraneous factors) is proper because the alternative entails an assumption: that restricted stock is sold at a discount from the prevailing market price solely due to an artificial limit on marketability. This assumption is counterfactual because discounts to market value also are typical in private placements of free-trading shares.

One reason that multiple regression analysis is ubiquitous in science is that the estimated coefficient for any one explanatory variable measures the separate effect of that factor after

c­ ontrolling for effects statistically attributable to the other explanatory variables included in the analysis. Accordingly, the purpose of regression analysis in the present study is to isolate the separate/direct effect of the regulatory restriction on the average discount in private placements after controlling for various factors unrelated to the regulatory restriction. I limit my control variables to ones of a practical nature.

MY DATA I analyze 1,103 private placements of common stock that closed over the seven-year period from January 1, 2004 through December 30, 2010. These deals were completed by 724 different companies. I found these private placements using various keyword searches of Bloomberg’s archive of SEC filings.

The common stock sold in private placements is often packaged with warrants (a right to buy more shares at a set price over, typically, five years). Warrant-sweetened deals are more frequent than are stock-only deals. I follow standard practice and exclude sweetened deals. In any event, stock-only deals are plentiful.

The full version of my paper provides a table showing attributes of the deals and the companies in my sample. The real eye-opener here is that four-fifths of the companies report negative net income over the last four quarters before the deal closes, with the average loss being $10.9 million. Losses are equally frequent for the companies that sell free-trading shares and restricted stock, but the average loss is three times greater among the companies that sell free-trading shares ($21.0 million) compared to those that sell restricted stock ($7.0 million). It may well be that the second-best way to identify smaller, loss-plagued companies is to screen on private placements of common stock.

Of all deals, 5% are done by NYSE companies, 13% by Amex companies, 30% by Nasdaq Global Market companies (regular Nasdaq), 11% by Nasdaq Capital Market companies (the junior tier) and 41% by OTC companies. Companies that pay cash dividends comprise 6% of the sample. As previously noted in the literature, the typical company that sells common stock in a private placement is a comparatively small, cash-burning “growth” company.

It is conventional in private-placement studies to exclude the smallest companies, albeit indirectly by excluding those with stock prices below $1 or $2 per share. In contrast, my sample includes companies with stock prices as low as $0.10 per share (but they must trade on the day of the close, which e­ xcludes quite a few OTC companies), and I then control for OTC status in my regression analysis.

INCLUDED VARIABLES The dependent variable in the regression analysis is the private-placement discount, which compares the pershare deal price to the prevailing market price. In calculating the discount, I measure the prevailing market price as the volume-weighted average price (VWAP) on the day the deal closes. The discount is the difference between the deal and market prices expressed as a percentage of the market price, having a positive value when the deal price is below the market price.

In its Institutional Investor Study in 1971, the SEC found that restricted-stock discounts were most dependent on (1) net income, (2) sales, (3) OTC status, and (4) registration rights. My explanatory variables are inspired by these four. I use 15 explanatory variables: five for solvency (more or less), three for buyer disbelief, one for potential dilution, one for deals done possibly

» A Skeptical Restricted-Stock Study • 17

fsrforum • volume 13 • issue #5

not at arm’s length, and five to cover aspects of the regulatory restriction on marketability.

Ten of the 15 explanatory variables are simple indicator variables (sometimes called dummy variables). An indicator variable is a construct that equals one when a given condition prevails and zero otherwise. The estimated coefficient on an indicator variable is an average for those observations coded one, albeit an average after having controlled for the effects of all the other explanatory variables. The included explanatory variables, and brief rationales, are as follows:

Solvency Low solvency may weaken a company’s bargaining position when negotiating a sale price. These variables include: • net income (mostly losses) over the last four quarters before the sale, expressed as a percentage of market capitalization; • an indicator variable for negative net income; • Sales revenue over the last four quarters before the sale, expressed as a percentage of market capitalization; • an indicator variable for zero revenue; • holdings of cash, marketable securities and shortterm investments last reported before the sale, expressed as a percentage of market capitalization.

Buyer Disbelief The sophisticated buyers in private placements may demand a discount from the trading price out of disbelief in that benchmark price. These variables include: • an indicator variable for OTC companies; • an indicator variable for Nasdaq Capital Market companies (the junior tier of Nasdaq and the next closest category to OTC status); • the percentage change in the market price over the 30-calendar-day period ended the day of the close, measuring the market price by the VWAP for the day.

Potential for Dilution See the section above entitled “Blockage Discounts.” This variable is: • the total number of shares sold expressed as a percentage of pre-sale shares outstanding.

Possibly Not at Arm’s Length I exclude deals where the buyer is an affiliate of the company, insofar as that is disclosed, but disclosure of ulterior motives

18 • A Skeptical Restricted-Stock Study

is incomplete. Also, the company might reveal positive inside information to select buyers, perhaps inappropriately. This variable is: • an indicator variable for deals sold to a single buyer.

Restricted Marketability I measure every aspect of the marketability restriction I can.

These variables include: • an indicator variable for whether the shares are restricted stock at the outset; • an indicator variable for whether buyers receive registration rights at the outset; • an indicator variable for restricted stock that ends up converting into free-trading shares within three months (1 to 90 days); • an indicator variable for restricted stock that ends up converting into free-trading shares in four to six months (91 to 183 days); • an indicator variable for restricted stock that ends up converting into free-trading shares in seven to twelve months (184 to 365 days).

REGRESSION RESULTS The following table provides the results of three formulations of multiple regression analysis. The estimated coefficients for most of the control variables are statistically significant, as expected in a sample as large as this. Statistical significance is reported in the table as a P-value that tells you whether the estimated coefficient is significantly different from zero in a sample of this size. It is conventional to accept a coefficient as being significantly different from zero if the associated P-value is at or below 0.05 or 0.10, as these corresponds to confidence levels of 95% and 90% (one minus the P-value, expressed as a percent).

I discuss the estimated coefficients of my control variables in my full paper. Notably, the coefficient for holdings of cash and shortterm investments is negative, which is intuitive.

The more cash on hand, the lower the discount. More cash on hand implies greater bargaining power, as the company is less desperate for funding to continue its operations. One reward for better planning and more-deliberate fundraising is a lower discount. Statistically, the most significant explanatory variable (the one with the highest t-statistic) is the percentage change in the market price during the 30 calendar days before the closing date of the deal.

More cash on hand implies greater bargaining power, as the company is less desperate for funding to continue its operations.

In addition to all of the control variables included in Regression 1, the base regression, Regression 2 includes the indicator variable for restricted stock sold without registration rights, along with the companion indicator variable for restricted stock sold with registration rights. Because registration rights serve to mitigate the effects of the regulatory restriction, the estimated coefficient on the first of these two indicator variables (without registration rights) should reflect the effect of the regulatory restriction on discounts more fully than will the second indicator variable (with registration rights).

After controlling for determinants of discounts unrelated to the regulatory restriction, the portion of the typical discount that can be tied directly to the regulatory restriction in its most severe form is 5.2%, which is significantly different from zero but much smaller than the double-digit DLOMs commonly applied in business appraisals. As for the companion indicator variable, when the regulatory restriction is mitigated through a grant of registration rights that could serve to accelerate the conversion of the restricted stock into freetrading shares, discounts are 3.5% higher instead of 5.2% higher.

In Regression 3, the regulatory restriction is represented by the realized delay before free-trading status obtains. This information is not available to participants at the time of the deal, but these data may proxy for the expectations of the participants at the time of the deal. Discounts are 3.2% higher when conversion occurs within 90 days, 3.6% higher when conversion occurs within 91 to 183 days, and 5.6% higher in the remaining cases where restricted stock ends up converting into free-trading shares 184 to 365 days following the close.

The last two of these estimates of the DLOM is significantly different from zero. Accordingly, discounts depend some, but not much, on the realized delay before the regulatory restriction is lifted.

As I explain below, data on the CD-Treasury yield spread imply a DLOM on the riskless asset of 2.5%. Of the two coefficient estimates in Regression 2 that relate to the regulatory restriction, even the higher of the two estimates, 5.2%, is not statistically significantly different from 2.5% (t-statistic of 1.44, P-value of 0.150). Likewise, the highest of the three estimates in Regression 3 is 5.6% and this is not statistically significantly different from 2.5% (t-statistic of 1.61, P-value of 0.110).

Finally, and transcendently, one can ask if the inclusion of the several explanatory variables related to the regulatory

Multiple Regression Analysis Dependent Variable is Percentage Private-Placement Discount Regression 1 Explanatory Variable:

Regression 2

Regression 3

Coefficient

P-value

Coefficient

P-value

Coefficient

Intercept

6.2806

0.000

4.0754

0.017

3.9382

P-value 0.021

Net Income as a % of Mkt. Cap.

0.0455

0.000

0.0449

0.000

0.0444

0.000

Indicator for Net Income < 0

5.3568

0.001

5.6004

0.000

5.6984

0.000

Revenue as a % of Mkt. Cap.

-0.0021

0.339

-0.0025

0.271

-0.0025

0.273

Indicator for Revenue = 0

4.9152

0.001

4.9914

0.001

5.1861

0.001

Cash & STI as a % of Mkt. Cap.

-0.1380

0.000

-0.1298

0.000

-0.1289

0.000

Indicator for OTC

13.9617

0.000

11.5748

0.000

11.8416

0.000

Indicator for Junior Tier of Nasdaq

2.5227

0.188

2.1450

0.263

2.2836

0.235

% Change in Market Price over 30 Days

0.1072

0.000

0.1054

0.000

0.1048

0.000

Total Shares Sold as a % of Prior Shares

0.0942

0.000

0.0934

0.000

0.0904

0.000

Indicator for One Buyer

-8.8342

0.000

-9.2387

0.000

-9.1470

0.000

1.85

1.22

3.70

0.24

65.40

65.40

5.2382

0.006

1.85

1.22

65.40

65.40

Indicator for Restricted Stock Sold without Registration Rights Indicator for Restricted Stock Sold with Registration Rights

3.70

0.24

3.4639

0.021

Indicator for Free Trading in 9-90 Days Indicator for Free Trading in 91-183 Days Indicator for Free Trading in 184-365 Days

3.2318

0.066

3.5511

0.040

62.20

5.5692

0.004

65.40

R Square

0.270

0.276

0.276

Adjusted R Square

0.264

0.268

0.268

Standard Error

18.96

18.90

18.91

Number of Observations

1,103

1,103

1,103

CD-Treasury Yield Spreads, Monthly from June 1998 through June 2011

Âť A Skeptical Restricted-Stock Study â&#x20AC;˘ 19

fsrforum • volume 13 • issue #5

The advocates of double-digit DLOMs seem to believe they enjoy a king-of-the-hill status that empowers them to brush aside challenging evidence.

restriction adds to the overall explanatory power of the multiple regression analysis. The relevance of additional explanatory variables is established by comparing the adjusted R-square statistics of two alternative models. R-square is the fraction of the total variance in the dependent variable that is explained in a given regression. The adjusted R-square statistic differs from the raw R-square statistic in that the adjusted R-square increases only if the added explanatory variables improve the model more than would be expected by chance.

The adjusted R-square statistics for Regression 2 and Regression 3 are both 0.268, which is very close to the adjusted R-square of 0.264 for Regression 1, the base model with no explanatory variables related to the regulatory restriction.

That these adjusted R-square statistics are very close means that the several explanatory variables related to the regulatory restriction, considered as a group, add very little to the explanatory power of the model. Accordingly, data on discounts in private placements of common stock, insofar as it relates to the size of the DLOM, do not imply a DLOM different from that on the riskless asset, or 2.5%.

DLOM ON THE RISKLESS ASSET There is one measure of the DLOM – that on the riskless asset – that can be calculated directly (without need of multiple regression analysis) and used reliably without introducing redundancy. The DLOM on the riskless asset can be calculated from the difference in yields between a 5-year bank certificate of deposit (illiquid due to penalties for early with-drawal) versus a 5-year U.S. treasury security (highly liquid). Here, the requisite calculations transcend mere arithmetic only in that one must use an average of the yields on CDs offered by some sample of banks.

Data on yields offered on CDs by various banks are compiled by bankrate.com, which reports averages that are available from Bloomberg. Bloomberg also offers a screen for a yield curve based on “U.S. Treasury Actives” from which the yield on a hypothetical security of exactly five years maturity can be obtained, as of any given date, via interpolation.

The CD-Treasury yield spread equals the CD yield minus the Treasury yield. This yield spread is shown in my scatterplot, which compares the yields on 5-year bank CDs versus 5-year U.S. Treasuries as of the end of each month for the past 13 years. A normal, positive yield spread (one that compensates for restricted marketability) will plot above the diagonal. The plot shows that CD yields tend to track Treasury yields less

20 • A Skeptical Restricted-Stock Study

closely when Treasury yields are at extreme levels (high or low, but mostly high), and shows that the CD-Treasury spread is nearly always positive when the Treasury yield is below 5%.

Mainly, the CD-Treasury spread is just small. It averages an implausible -0.053% per year in the 26 months when the yield on 5-year Treasuries ex-ceeded 5.0%, but still averages only 0.49% in the other 131 months. My takeaway from these data is that a typical CD-Treasury spread is no greater than 0.5%.

A CD-Treasury yield spread of 0.5% could be included as an illiquidity premium in an implementation of the Ibbotson buildup method of finding an annual discount rate for use in a core valuation analysis (e.g., a discounted cash flow or capitalized earnings method). Equivalently, one can convert the CD-Treasury yield spread into a DLOM applied supplementally to the results of a core valuation methodology. An initial investment of $97,500 in the average 5-year CD would result in approximately the same ending balance (including reinvested interest) after five years as would an initial investment of $100,000 in a 5-year Treasury security. So, a CD-Treasury yield spread of 0.5% implies a supplemental, non-redundant illiquidity discount, or DLOM, of 2.5% ($97,500 being 2.5% lower than $100,000).

The fact that the DLOM on the riskless asset approximates 2.5% leads inescapably to the conclusion that any discounting for lack of marketability beyond 2.5% constitutes a second round of discounting for the risk associated with holding an asset over time. That a DLOM in excess of 2.5% is a second round of discounting for risk frames the reliability issue.

How confident can one be that a second round of discounting is not redundant to the first? The requisite confidence cannot be found in restricted-stock studies.

CONCLUSION The purpose of this study has been to determine if the data on the discounts in private placements of restricted stock imply a DLOM different from the DLOM on the riskless asset.

This is a skeptical analysis, by which I mean an analysis not configured to document what is presumed. Specifically, this study allocates to the DLOM only that portion of the ­restricted-stock discount that can be tied to restricted marketability directly. No portion is allocated to the DLOM by default or presumption. This is the only approach that can produce a result that is reliable. My skeptical, scientific

approach yields estimates of the DLOM no larger than 5.2% or 5.6%, which is consistent with the latest findings by others (a little higher, actually). My estimates are not statistically significantly different from the DLOM on the riskless asset of approximately 2.5%.

The advocates of double-digit DLOMs seem to believe they enjoy a king-of-the-hill status that empowers them to brush aside challenging evidence. In the Supreme Court’s Daubert decision governing the admissibility of expert opinion6, however, there is no grandfather clause that permits continued reliance on methods that are seasoned but unreliable. In Daubert, the Supreme Court demoted general acceptance from being the sole requirement for the admissibility of expert opinion, as it had been under Frye7, to one of several non-exclusive indicia of the ultimate goal of reliability. Moreover, although some would prefer to contemplate general acceptance among clinicians, the acceptability contemplated by the Supreme Court is that within the ­“relevant scientific community.”

Daubert requires reliability and fealty to the scientific method. In its follow-on decision in Kuhmo Tire8, the Supreme Court told the clinician critics of its Daubert ruling, in effect, to get with the program. Yet, two decades after Karen Wruck’s study, proponents of large DLOMs continue to rely on purported evidence that depends entirely on a counterfactual assumption: that the regulatory restriction is the sole cause of the discounts reported in restricted-stock studies.

Absent this assumption and its consequences, little or none of the average discount can be tied, directly and reliably, to the regulatory holding period for restricted stock.

Private-company status may merit a discount below what core valuation methods would indicate. Private-company status may even merit a double-digit discount, but that merited large discount is not a discount for lack of marketability. The DLOM is not reliably different from 2.5%.

Notes 1 Robert Comment, “Business Valuation, DLOM and Daubert: The Issue of Redundancy,” Business Valuation Review, 29 (2010).

2 See the section entitled “Comment Claims DLOMs ‘Re-dundant’” in Shannon Pratt, “In Defense of Discounts for Lack of Marketability,” Business Valuation Review, 29 (2010).

3 See Table 4 of Bajaj, Denis, Ferris and Sarin, “Firm Value and Marketability Discounts,” Journal of Corporation Law 27 (2001).

4 Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579 (1993).

5 Wruck, “Equity Ownership Concentration and Firm Value,” Journal of Financial Economics 23 (1989); Silber, “Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices,” Financial Analysts Journal 47 (1991); Hertsel and Smith, “Market Discounts and Shareholder Gains For Placing Equity Privately,” Journal of Finance 48 (1993); Bajaj, Denis, Ferris and Sarin, “Firm Value and Marketability Discounts,” Journal of Corporation Law 27 (2001); Barclay, Holderness and Sheehan, “Private Place-ments and Managerial Entrenchment,” Journal of Corpo-rate Finance 13 (2007); and Huson, Malatesta and Par-rino, “The Decline in the Cost of Private Placements,” working paper available at SSRN.com (June 2009).

6 Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579 (1993).

7 Frye v. United States, 293 F. 1013 (D.C. Cir. 1923), 8 Kumho Tire Co. v. Carmichael, 526 U.S. 137 (1999).

A Skeptical Restricted-Stock Study • 21

fsrforum • volume 13 • issue #5

Currency Valuation and Purchasing Power Parity Jamal Ibrahim Haidar1 April, 2011

22 • Currency Valuation and Purchasing Power Parity

1. Introduction The analytical framework of currency valuation is an intellectual challenge and of influence to economic policy, smooth functioning of financial markets, and financial management of many international companies. The Economist magazine argues that the Big Mac Index (BMI) based on the price of a Big Mac hamburger across the world can provide “true value” of currencies.

The purchasing power parity (PPP) theory postulates that national price levels should be equal when expressed in a common currency. Since the real exchange rate is the nominal exchange rate adjusted for relative national price levels, variations in the real exchange rate represent deviations from PPP. It has become something of a stylized fact that the PPP does not hold continuously. British prices increased relative to those in the US over the past 30 years, while those of Japan decreased. According to PPP theory, the British pound should have depreciated (an increase in the pound cost of the dollar), and the Japanese yen should have appreciated. This is what in fact happened. Despite deviations in the exchange rate from price ratios, there is a distinct tendency for these ratios to act as anchors, for exchange rates. Thus, exchange rate reverts to the price ratio, which can be considered the “true value” of the currency.

In 1986, The Economist magazine created a tool for making PPP comparisons. This tool uses the price of a Big Mac hamburger at home and abroad as the price ratio that reflects the “true value” of the currency. This ratio represents the BMI; it is the nucleus of “burgernomics”. The BMI gives a signal about under-valuation and over-valuation of currencies, relative to the actual exchange rate. The PPP school of thought is among the oldest research areas in international finance.

The PPP stands as a general form of the law of one price in the geographical arbitrage presence for the same goods at different location. The PPP holds only within strict circumstances – i.e. lack of central bank interventions, trade restrictions, transaction costs, and taxes. A reference to PPP helps determine whether foreign exchange market precisely prices a currency because a currency, typically, revert to its PPP value over time. The BMI currency pricing model is well embedded in the PPP theory. It is a case of interaction between financial journalism, basic economic research, and foreign exchange markets.

This paper uses the occasion of the 25th anniversary of the introduction of the Big Mac Index to provide a broad evaluation of its workings and performance. While the BMI is not perfect, it provides hints about the operation of foreign exchange markets. Part 2 provides a literature review about “Burgernomics”, presents evidence about the BMI, and summarizes the PPP theory debate. Part 3 discusses a set of BMI methodological limitations and clarifies the BMI bias. Part 4 concludes.

2. Evidence to date The literature on PPP is large and growing. Froot and Rogoff (1995), Lan and Ong (2003), Rogoff (1996), Sarno and Taylor (2002), Taylor and Taylor (2004) and Taylor (2006) are a subset of available literature reviews on the matter. Click (1996), Ong (1997) and Pakko and Pollard (1996) are among

the early contributors to academic research on the BMI while more recent papers include Chen et al. (2007) and Clements et al. (2010). Empirically, studies found heterogeneous results while testing PPP. Frankel (1979) studied the correlation between exchange rates and inflation (proxied by CPI and then by WPI)2 in 1920s, finding PPP-supportive results in hyperinflation economies. However, using same inflation indicators, the same author, among others,3 rejects PPP for developed countries during 1970s. Nonetheless, inflation and exchange rate nonstationarity invalidates these findings by showing the shortcomes of conventional testing methods.

Meanwhile, more recent research4 rejected PPP validity (i.e. real exchange rate mean reversion) by utilizing cross-country datasets while Frankel and Rose (1996) empirically validated PPP existence.

The North American

relationship with the Big Mac is much more ingrained into culture then it is in Asian cultures.

The above studies, which use CPI or WPI, have at least two shortcomings. First, non-tradable goods affect CPI and WPI relative usage across countries. Second, regardless of whether the law of one price holds in a certain market for a specific commodity, CPIs and WPIs behave differently when consumption bundles are not identical, leading to PPP tests biased outcomes. Hence, these price indices can lead to heterogeneous results while testing PPP validity. Recent ­ studies have shifted their attention to using another price index as a study target. Cumby (1996) used The Economist's BMI, given its uniform composition feature as the Big Mac ingredients are identical across countries, to assess PPP. The use of the Big Mac decreases the estimation bias given it meets the “identical good” requirement in the law of one price testing process. However, it does not meet all the requirements of the law of one price – i.e. barriers to trade, wage rate, taxes, and productivity differentials.

3. Methodological limitations of the BMI 3.1 Demand variability The demand for fast food varies across countries. For instance, the North American relationship with the Big Mac is much more ingrained into culture then it is in Asian cultures. For this reason, a direct comparison using Big Mac Index (BMI) has some problems. First, food regulations differ across countries. For example, Switzerland and the Euro area have much more strict food regulation laws (Switzerland in particular) than United States. This fact means the cost of "better" beef or other parts of a Big Mac is higher in the Euro area. Second, there is the social perception and price differential

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of McDonalds in the different countries. In Switzerland and much of Europe, McDonalds is more of a "nice" place. It is not surprising for McDonalds in Europe to have multiple stories and in Switzerland there are video game systems and lounges. In Ukraine, one of the places to meet and relax is McDonalds. This matter means that, in general, they are located in better places and have higher rent payments in Europe. Also, richer people visit the McDonalds in Switzerland and the Euro area and will continue to pay for such goods despite the price. In the United States, however, McDonalds is typically a cheaper place to eat and restaurants would lose a lot more money by increasing prices than European McDonalds’. With variations like this, the BMI perpetuates a false idea that a critical analyst can discover anything at all about purchase power parity by comparing hamburgers.

3.2 Product comparability The theory of purchasing-power parity (PPP), the notion that a dollar should buy the same amount in all countries, implies that in the long run, the exchange rate between two countries should move towards the rate that equalizes the prices of an identical basket of goods and services in each country. However, the United States, along with most developed economies, subsidize meat, bread (which is made of wheat), lettuce, tomato, eggs, potatoes, and all farm products in a Big Mac burger. Also, these countries exercise protectionism on those products as well as adopt a mercantilist approach in the international market. Thus, how can a Big Mac be a comparable item? For any product to be useful on that purpose, it should be freely-tradable between countries, with no country subsidizing or taxing it more than another country. Therefore, the Big Mac is less appropriate to compare the prices since it would be cheaper in countries who subsidize farm products - and it may lead to a distorted comparison.

rency misalignments. Since the BMI is based on the idea of purchasing-power parity, and 14.5 Yuan can buy as much burger as $3.71, a Yuan should be worth $0.26 on the foreignexchange market. In fact, it costs just $0.15, suggesting that it is undervalued by about 40%. In Brazil a Big Mac costs the equivalent of $5.26, implying that the real is overvalued by 42%. The index also suggests that the euro is overvalued by about 29%. And the Swiss franc is the most expensive currency, according to the BMI list. The Japanese are so far the only rich country to intervene directly in foreign exchange markets to weaken their currency. But according to BMI, the yen is only 5% overvalued.

How can The Economist justify this misalignment? It can rely not on Big Macs, but on three less digestible approaches.

First, it can calculate the real exchange rate that would steadily bring a country's current-account balance (equivalent to the trade balance plus a few other things) into line with a “norm” based on the country's growth, income per person, demography and budget balance. Second, it can ignore currentaccount balances and instead calculate a direct statistical relationship between the real exchange rate and things like a country's terms of trade (the price of its exports compared with its imports), its productivity and its foreign assets and liabilities. The strength of Brazil's currency, for example, may partly reflect the high price of exports such as soya beans. Third, it can also calculate the exchange rate that would stabilize the country's foreign assets and liabilities at a reasonable level. If, for example, a country runs sizeable trade surpluses, resulting in a rapid build-up of foreign assets, it probably has an undervalued exchange rate. Indeed, the raw index did a poor job of predicting exchange rates: undervalued currencies remain too cheap and overvalued currencies remain too expensive. And, such misalignments are remarkably persistent. They give a signal of a systematic bias showing that the BMI may itself be undervalued.

3.3 Exchange rate predictability A “weak” currency, despite its appeal to exporters and politicians, is no free lunch. But it can provide a cheap one. In China, for example, a McDonald's Big Mac costs just 14.5 Yuan on average in Beijing and Shenzhen, the equivalent of $2.18 at market exchange rates. In United States, in contrast, the same burger costs, on average, $3.71. A difference of this significance makes China's Yuan one of the most undervalued currencies in the most recent Big Mac index, leading to cur-

24 • Currency Valuation and Purchasing Power Parity

3.4 Elements non-tradability The Big Mac Index does have other shortcomings. A Big Mac's price reflects more than just the cost of bread and meat and vegetables. It also reflects non-tradable elements - such as rent and labor. For that reason, the Big Mac Index probably is best when comparing countries at roughly the same stage of development. In any case, there is no theoretical reason why prices of non-tradable goods and services should be

equal in different countries. This fact explains why PPPs are different from market exchange. The BMI is an interesting way to get a snapshot of comparative countries and their exchange rates. However, domestic prices (inflation) and the local domestic economy also play a role in determining the prices.

In the absence of trade barriers, dollar price of a certain good should be identical across countries, according to the PPP theory. Given the price of a Big Mac captures more than the (tradable) components cost – i.e. restaurant space lease, heating and cooling utilities, electricity costs, and wages – the price of the good would be expectedly different across countries. These are non-tradable goods examples. For

3.5 Transportation costs Although the cost of transporting corn oil needed for the Big Mac may not be high, transporting perishable components such as beef, cheese, and lettuce is more costly. Thus, Transportation costs may drive price differential for same good across markets. In 2002, a Big Mac cost $2.38 in the euro area, 11 cents less than the price in the United States.

Although such price differential may violate PPP, Big Macs (or Big Mac components) transportation across borders may not necessarily occur. In theory, trade may occur, in this case, conditional on whether the Big Mac transportation cost is less than 11 cents. Hence, one might expect absolute PPP to hold only approximately, with prices diverging within a range determined by the transport costs6.

In the absence of trade barriers, dollar price

of a certain good should be identical across countries, according to the PPP theory. instance, the location of the property cannot be traded although the property itself can be traded and transferred between owners. Also, the use of labor is non-tradable goods given labor restrictions to move across borders to benefit from wage differentials. Thus, although the price of a restaurant rent space is lower in Sofia than in Paris, it would not be feasible to do so if the purpose is to serve meals in Paris. Rent and utilities contribute to the cost (and price) of a Big Mac, causing deviations from PPP by reflecting cost differences across countries. Non-tradable goods represent 94 percent of the Big Mac price5. The Big Mac provides evidence about why systematic deviations from PPP exist.

The next section considers a key PPP failure explanation: the existence of barriers to trade. The PPP does not hold, at minimum in the absolute terms, partly because of high cost of trading goods across borders. The limitations of international movement of goods include tariffs, export taxes, transportation costs, and other government-imposed trade barriers, which contribute to price differentials.

3.6 Trade restrictions Using tariffs while practicing protectionism, countries impose import restrictions, for instance, on farm products to protect certain industries. The presence of tariffs on imported goods and import quotas constitutes another significant factor of trade restrictions. Cassel (1921) studied the effects of trade restrictions, stating, “If trade between two countries is more hampered in one direction than in the other, the value of the money of the country whose export is relatively more restricted will fall, in the other country, beneath the purchasing power parity.” The author noted that export and import restrictions have opposite effects on PPP. In monetary terms, on a PPP basis, the economies with fewer restrictions on imports will have relatively undervalued currencies. In simpler language, the BMI would be informative on which economies impose more restrictions on agricultural products trade, assuming no other PPP deviation drivers, compared to United States. For instance, among the countries that imposed high import tariffs on beef during the BMI life are Korea and Japan. Beef imports to Japan, until 1991, were

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subject to quotas and tariffs. In addition, tariffication came into place in Japan during 1991 and in Korea during 1995.

On a related side, Korea imposed a 30 percent tariff on beef imports, for 5 years up to 1994, along with other trade barriers.

It cancelled the import quote and set the tariff rate at 41% in 2001, allowing it to decrease to 40% by 2004. A key driver of the beef price differential between Japan and Korea, and other countries, in this case, is factored by such trade barriers, which provide partial reasoning, as well, to the Japanese yen and the Korean won overvaluation against the dollar until late 1990s. However, the United States also restricts the volume of beef imports from all countries apart from Canada and Mexico . In April 2002, McDonald's began buying some imported beef from Australia and New Zealand for its U.S. operations. The quota, however, limits the extent to which McDonald's can use imported beef to offset hamburger price

In fact, the dollar

should be overvalued against the currencies of low income countries. pressures. In addition, the higher barriers to trade in beef in the United States may partly explain why the U.S. dollar has been consistently overvalued relative to the Australian and New Zealand dollars. In a nutshell, compared to United States, economies with less trade restrictions would be expected to be associated with undervalued currencies.

Mac rose from C$2.19 to C$2.35. As a result, the Canadian dollar moved from being undervalued by 14 percent against the U.S. dollar to being undervalued by only 9 percent. It would be misleading, however, to say that the imposition of this new tax brought United States and Canada closer to PPP.

3.8 Productivity differentials The BMI and other price indices include non-tradables. Samuelson (1964) and Balassa (1964) proved that non-traded goods systematically influence PPP deviations due to productivity differences across countries, industries, and sectors.

They also showed that low-income countries will have undervalued currencies compared to high-income countries, assuming that economies with higher GDP per capita levels reflect, to a certain extent, higher labor productivity.

Moreover, given competition for workers in each of nontraded and traded goods sectors, wages are higher in high income economies, which are associated with more labor productivity in traded goods sectors. Wages in the service sector are lower in low income economies, leading to lower prices in low income economies. The, regardless of whether prices of traded goods are identical across countries, lower service prices transmits to lower price levels in low income economies. In different terms, the currencies of low income economies would appear undervalued compared to currencies of high income economies. Turning to Big Macs, it is unlikely that there are large differences in the productivity of workers cooking burgers regardless of the country of location of the McDonald's. There are, however, large differences in the wages earned by these workers. This difference in wage costs may partly explain why the yuan and the zloty have been consistently undervalued against the dollar as measured by BMI. In fact, according to the Balassa-Samuelson theory, holding all other things constant, the dollar should be overvalued against the currencies of low income countries.

3.7 Taxes The existence of different taxation schemes across countries contributes to PPP deviations. The Economist BMI uses sales and VAT (value added taxes) tax-inclusive prices. Thus, ceteris peribus, higher taxes would be associated with overvalued currencies on the BMI. Simultaneously, tax adjustments would lead to BMI parities shifts. For example, in 1991 Canada imposed the Goods and Services Tax, a national 7 percent sales tax. Between 1990 and 1991, the price of a Big

26 â&#x20AC;˘ Currency Valuation and Purchasing Power Parity

3.9 Government expenditures and current account deficits Differences in government expenditures across economies may lead to relative prices deviations from exchange rate.

Governments spend less on traded goods than does the private sector (households and businesses). When government spending, for instance, in the United States decreased compared to government spending in other countries, the price

of non-traded goods in the United States will decrease as will the overall price level. If PPP held prior to this expenditures decline, the United States currency will be undervalued relative to its PPP level. Another role for non-traded goods in explaining deviations from PPP comes through the current account. Krugman (1990) argued that, as a country runs a current account deficit, its spending on traded goods increases relative to other countries. This argument results in a decline in the relative price of non-tradable goods in the deficit country. Thus, if PPP had held prior to the current account deficit, the country's currency would then be undervalued.

3.10 Pricing to market Firms can optimize profits by charging different prices across countries when they are capable of pricing to market depending on product demand elasticity. When demand of a good is inelastic (elastic), prices and sales revenues are positively (negatively) associated. At the same time, firms that price to market across countries or markets may limit exchange rate pass-through, the extent to which changes in the exchange rate result in changes in import prices.

When imports prices do not change exactly according to foreign currency valuation patterns, then exchange rate passthrough is incomplete, leading to a price differential between domestic and foreign markets. In order to sustain relative sales and profit margin levels when currency value changes, a firm may control pass-through in markets where demand is relatively elastic. Certain factors shape firms ability to price to market - i.e. warranty restrictions, the resale probability across markets, business regulations, safety standards, wholesalers authorizations, and pollution criteria. In the case of the Big Mac sandwich, obviously, unlike its ingredients, it is not subject to resale across markets. While ingredients can be purchased to create a competing sandwich, in many countries there are few substitutes to Big Mac sandwich, unlike the case in United States. Thus, it is reasonable to conclude that the Big Mac is not all about the ingredients.

Other factors, including people's interests, shape Big Mac demand curve - and such factors shape also the pricing-tomarket strategies. For instance, while young Koreans perceive McDonald's as a fancy place to hang out at, their peers in United States perceive it as no more than a low priced fastfood destination.

4. Conclusion The Economist magazine has been publishing the Big Mac Index for the last quarter a century. The purpose of the indicator, according to The Economist, is to show "real valuation" of currencies, mainly by assuming PPP theory holds. This paper shows why the BMI does poorly as a valuation tool as well as a forecasting mechanism. It presents various angles of the PPP theory and highlights how each of them reduces the effectivity of one-product currency valuations indicators such as the BMI. Various studies assessed the validity of PPP theory by using different inflation measures across countries.

This paper adds to the literature by showing, using PPP theory framework, why the The Economist's BMI currency valuation indicator should be perceived with caution, by highlighting its characteristics from tradable commodities and non-tradable service components. It clarifies that the BMI can actually be perceived as a good example of how, when, and why the PPP does not hold. Prices differ across countries for reasons not related to the value of currency.

For instance, even the price of one product (i.e. Big Mac sandwich) is not constant within the same country (i.e.

United States). In this case, the BMI says that the value of dollar, compared to other countries, is not the same across two differnt areas in the United States. This observation is hard to digest as a credible currency valuation mechanism.

Future research can look further at the contributions of country borders tp PPP deviations.

References on request

Notes 1 World Bank, International Finance Corporation.

2 The study considered PPP valid when the regression coefficient is 1.

3 Frenkel (1981), Lehman (1983), and Isard (1977) 4 O'Connell (1998), Wu and Chen (1999) and Pedroni (2004) 5 Ong (1997) 6 Hummels (2001) estimates that transportation costs add 7 percent to the price of United States imports of meat, 6 percent to the import price of dairy products, and 16 percent to the import price of vegetables.

7 Tariffication is an effort to convert existing agricultural non-tariff barriers to trade (NTBs) into bound tariffs and to reduce these tariffs over time. A bound tariff is one which has a "ceiling" beyond which it cannot be increased.

8 Imports beyond the quota limit face a 26.4 percent tariff rate.

Currency Valuation and Purchasing Power Parity â&#x20AC;˘ 27

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fsrforum • volume 13 • issue #5

Interview D. Zane Hurst Valuation: The vision of an expert

By Bart Lips (July 18, 2011)

First, your job at Training The Street is about providing professional financial training.

Why did you decide to join a financial training provider, instead of continuing your career at an investment bank?

Prior to joining Training the Street, I had been giving consideration to a change in career and the catalyst that bought it about was merger between Bank of America and Merrill Lynch. I have always had a passion for teaching and found the role very rewarding when working for a previous employer. Blending both teaching and corporate finance skills, two disciplines I am passionate about, was a great combination. The Training The Street opportunity happened by chance as they were searching for a London based instructor to help them build out their European franchise. Since joining the firm it has been very rewarding and it has placed me in a leadership role where I am responsible for growing and building a business.

It is sometimes argued that Mergers and Acquisitions doesn’t create additional value to a company and is only good for the shareholder. What is your opinion about this statement?

Depends on the success of the merger or acquisition. If successful, ultimately the shareholders will be rewarded in the form of capital appreciation or higher dividends. Unfortunately, value creation is not always immediate so it does require patience on the part of shareholders. Just as

Zane joined Training The Street with more than 10 years of investment banking experience. Since joining the firm’s London office, he has led both full time and ­intern analyst and associate training programs globally for investment banking clients. These training programmes cover accounting, corporate valuation and financial modelling. He has also delivered courses for various academic clients in the UK and Europe which have ranged from Corporate Valuation workshops to Financial Modelling seminars.

Prior to joining Training The Street, he worked in the London office of Bank of America Merrill Lynch where he served as Vice President in the firm’s EMEA Loan Execution and Management division. He has significant experience in structuring, documenting and executing loan transactions for companies in the telecommunications, industrial, oil & gas and insurance sector.

Zane commenced his investment banking career at J.P. Morgan as an analyst in their Financial Sponsors Group. Throughout his career at J.P. Morgan he held various roles. He worked in the firm’s training and development team as a fulltime instructor in the valuation section of the J.P. Morgan Investment Banking Training Programs for Analysts and Associates. He also taught credit risk analysis and the firm’s proprietary financial projection model in the United States, Europe, Asia, and Australia. Following his promotion to associate, he then joined the firm’s EMEA Restructuring & Asset Recovery division.

Zane holds a B.B.A. degree with a concentration in Accounting from Georgia State University.

30 • Interview

To be successful in a takeover process I believe one requires good negotiations skills and knows how to unlock value in a business.

there is upside there is also the downside risk if the transaction does not go according to plan or expectations.

Within the DCF Model, what are the main drivers to value a company?

The following are key value drives in a DCF Model.

In valuing a company, different methods are used.

Methods like DCF, CCA, CTA and LBO, which one is the most reliable and most useful in determining the company its value?

The different valuation methods have their benefits and each technique is unique to a particular situation. I refer to the different results under the various techniques as data points which provide valuation ranges to work within bearing in mind the specific situation. I don’t rely on one or assume one is more reliable than the other as each method has their advantages and disadvantages.

Let me elaborate further by discussing two of the following methodologies under a scenario were a subsidiary is being sold by its parent and as an advisor we have been asked to discuss the advantages and limitations of each. For this example let’s focus on the comparable transaction and the LBO analyses.

The comparable transactions analysis is a historical analysis or “look back” of premiums and multiples paid to assume control of a company. Individual buyer synergies and structure of transaction will also impact these multiples. One of the draw backs of this analysis is timing. Market conditions at the time of a transaction have substantial influence on valuation (i.e. competitive environment or scarcity of assets).

Information on premiums and multiples paid does provide a historical perspective on what buyers have paid for these kinds of assets in an M&A context.

The LBO analysis establishes a "floor" valuation for the company. It is used to determine what a financial sponsor can afford to pay for a target and still realise an adequate return (typically 20 – 25%) on its initial investment. What underpins a LBO is the ability to raise the required amount of debt (bank and bonds) typically 60 - 70% of the transaction value, subject to market conditions. The balance of the purchase price is funded with sponsor equity. The sum of debt raised and sponsor equity contributed will get you to an all-in purchase price. This analysis is heavily dependent upon leveragability, cash flow profile of the company, and the financial sponsor exit value assumptions.

• Free cash flow (FCF): FCF is often referred to as unlevered free cash flow, as it represents cash flow available to all providers of capital and is not affected by the capital structure of the company. FCF is based on several operating assumptions (i.e. sales, operating margins, working capital and capital expenditures).

• Terminal value – Value of the company’s cash flow beyond the forecast period. There are two widely used methods for calculating this value: • Exit Multiple Method: Assumes that at the end of the forecast period, the company can be sold for a multiple of an operating statistic (i.e. EBITDA).

• Perpetuity Growth Rate: Assume that the company’s free cash flow will grow at a moderate constant rate indefinitely.

• Discount rate – The rate used to discount projected FCFs and terminal value to their present values.

Although based on an objective calculation the assumptions are subjective hence one of the reasons the DCF typically yields the highest valuation.

Isn’t the value range of a company by using multiples not influenced by the economic conditions? In bull markets companies have higher multiples than in bear markets?

It does depend on the sector as there are sectors that are less affected by macro-economic conditions. Companies in these sectors are referred to as defensive stocks and some sector examples are healthcare, consumer staples and utilities.

In the corporate world there are some famous dealmakers who are well known about their ability to in most cases win a takeover process. Is their quality determined by strong valuation techniques or personal capabilities?

To be successful in a takeover process I believe one requires good negotiations skills and knows how to unlock value in a business. Being able to identify a buying opportunity or knowing when a company is undervalued are skills that are developed. Personal capabilities are equally important as once you succeed in acquiring a business the next step is to successfully integrate the two companies.

» Interview • 31

fsrforum • volume 13 • issue #5

Between sectors, there are a lot of differences about the valuation, what are the main technical differences when you valuate companies in different sectors? In other words, are you using similar DCF models to value a utility company or a fast moving consumer goods company?

There are certainly different valuation techniques around and they need to be adopted for the specific situation. For example, financial institutions use a Market Cap / Book Value metric. The key when valuing a sector is to understand the valuations metrics that drive value. For technology firms it maybe the number of subscribers or a multiple of sales while for a consumer goods company it could be EBITDA or EPS. Valuation metrics across industries differ and using a DCF application is not always applicable.

Take for example a technology company that is in the early stages of development and has no record of earnings. Using a DCF is not applicable as you don’t have any cash flows to value.

Whereas a stable company with mature cash flow is a more suitable candidate for a DCF.

Did overvaluation, in terms of corporate takeovers and investment decisions, influence the economic downturn in the last crisis?

I believe the recent economic downturn had less to do with corporate takeovers and more to do with excessive risk taking on the part of investors who did not understand or were unaware of the true risk of their investments. A good example of such an investment is the MortgageBacked-Security (“MBS”). In the case of this security, once the underlying assets (cash flow

32 • Interview

I believe several investors are adopting a “wait-and-see” strategy until the market jitters.

from the assets serviced the MBS obligations the securities) began to default and the rate at which they did it was a scenario not anticipated my market participants. As the value of these securities began to decline the repercussion were felt across all sectors and eventually the real economy. Eventually this also affected the volume of corporate takeovers as several investors that would fund these kinds of corporate events withdrew from the market and the equity markets became volatile making it more difficult for an acquirer to raise capital.

Nowadays there are many rumours and news about the value of social media companies like Facebook and Linkedin, they are valued at enormous amounts.

Do you believe these firms are overvalued and are we heading for similar ITBubble or are those companies valued right?

There have been several articles on this topic as of recent and social networking is the latest buzz word these days. I was in banking during the time of the internet bubble and am surprised as the same investment thesis is appearing in recent IPOs which is that despite no track record of earnings or the path to profitability is evolving, the valuations are based on some future expected results.

In my opinion, each company needs to be evaluated on its merits. In 2000, it was almost as if anything goes. A company did not need a business plan or customers base to come to market.

Anything with a dot com attached to its name performed well at IPO launch. This time around it appears companies with a proven ability to grow sales and draw up a respectable business plan are pursuing the IPO route.

From an investor’s standpoint, we have been here before and the best we can do now is to be aware of it and try to avoid the same investments mistakes of over a decade ago.

After the crisis, many investors are searching for opportunities, in which sector(s) are a lot of opportunities at this time?

At the moment, I believe several investors are adopting a “wait-and-see” strategy until the market jitters, especially in the debt market, abate. I am not a market investors, but in this current climate, I would look at defensive stocks, commodities like gold, or companies with emerging market exposure.

If students are interested in corporate valuation and would like to pursue their career in this field. What are the main technical skills they have to develop and how could they further train themselves during their studies?

Accounting is the language of business and also serves as the basis for valuation. Knowing how to read and interpret financial statements is critical. Other skills I encourage students to develop are financial modelling skills and being familiar with the different valuation methodologies. There are many corporate valuation techniques around, but I recommend that you focus on those that are commonly used by practioners. Training The Street has a self-study manual titled Fundamentals of Corporate Valuation. A Handbook that provides an introduction to the commonly used valuation concepts and is great for laying the foundation and introducing these concepts.

For more information on Training The Street and its products or services please visit their website at www.trainingthestreet.com.

Interview • 33

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fsrforum • volume 13 • issue #5

The creation of shareholder value and the maximization of short term profits Marc Schauten PhD

Even Jack Welch (former CEO of General Electric) seems to have abandoned his beliefs and he has distanced himself from shareholder value creation. ‘Obsession with shareholder value was a ‘dumb idea’ did the Financial Times’ headlines portray. It would lead to short-term profit maximization that would endanger a healthy long-term strategy. This conclusion is unjustified and reflects an unjust understanding of the words ‘shareholder value’ and ‘shareholder value creation’.

The cause of the confusion lies in the value that is unjustly attributed to ‘short-term gains’ or ‘short-term profits’ – often expressed in earnings per share (EPS). It seems as if shareholder value creation is thought of as the maximization of short-term earnings. And that is not the case. Shareholders clearly do want a positive return. And the higher and the faster this return can be realized, the better. But – once again – this is not obtained by maximizing short-term earnings.

The value of an enterprise is determined by all the expected future cash flows. This means that a short-term project can possibly create a lot of money, but if a competing long-term project demands an equally big investment and generates money during a longer period, the shareholder could as well prefer this long-term project. Even if this long-term project has a relatively unfavorable influence on the EPS on the short-term.

But don’t shareholders pursue the highest possible return?

And preferably within the shortest time period? That is true.

If I invest money for the studies of my children, then I prefer to obtain the desired amount next year rather than in 15 years. And what is more, if I achieve a higher return than planned, that is even better. Even if I am a long-term investor – no matter how small – I will give preference to shares of enterprises that ensure I will quickly achieve my end goal. Of course, the same holds for pension funds and other institutional investors.

How can it be that long-term projects deliver (high) positive returns for investors on the short-term? The clue can be found in financial markets. In a well-functioning market, the share price reflects the value of all the projects that are executed by the enterprise. Suppose that an enterprise announces a new long-term project that will deliver a lot of money during a number of years. Then the announcement of this project will immediately lead to a stock price jump (rise).

Even if the cash flows will expectedly be realized far in the

future, the net present value of this investment is immediately expressed in the price of the relevant share. At the announcement, the investor thus immediately benefits from the long-term project. In other words, there has been direct shareholders value creation. Shareholders are thus not by definition better off with short-term projects that maximize short term EPS. As long as financial markets work well and enterprises provide sufficient information about the projects that they execute, good short-term and long-term projects will lead to positive share price adaptations. The net present value of long-term projects is clearly not always as big as that of short-term projects. It is even possible that the expected cash flows of a long-term project are so low that the shareholders prefer that the project is not executed. But that obviously also holds for short-term projects. If the investment does not even out the value that it creates, it will not be executed.

Note that instead of investing in positive net present value projects, firms can also choose to buy back shares with an increase in the EPS as a result. This however, would not be an action that makes shareholders – in theory – better off. The EPS would be higher, as the financial risk for the shareholders.

In conclusion, it can be said that both short-term and longterm projects are worth being executed, given that they create more value than they cost. Long-term projects can lead to positive returns for shareholders even if they do not immediately contribute to the EPS on the short-term. Therefore, the attention on short-term earnings should be replaced by attention for both short- and long-term cash flows. The value of the enterprise is not determined by the short-term earnings but by all the expected future cash flows. It would be beneficial if enterprises could provide more information about those cash flows. If this provision of information stays limited, it is possible that short-term gains are used, without reasons, as predictors of short- and long-term expected cash flows. And if that is the case, it can lead to unjust valuations by investors and to unjust investment decisions by enterprises. It is then obvious that enterprises will prefer projects that maximize short-term gains above projects that (could) benefit the enterprise and its shareholders much more.

The creation of shareholder value and the maximization of short term profits • 35

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fsrforum • volume 13 • issue #5

Company presentation Do you have what it takes to become our next trader at Optiver?

Nelleke van ‘t Hoff

Optiver is een internationaal en innovatief handelshuis. Onze core business is electronische Market Making en arbitrage in financiële producten, zoals derivaten, aandelen en obligaties. We handelen voor eigen rekening, op eigen risico en we hebben geen klanten. Met kantoren in Amsterdam, Sydney en Chicago, 600 medewerkers en 30 verschillende nationaliteiten, wordt er wereldwijd 24 uur per dag gehandeld.

Sven Hubens is sinds maart 2011 werkzaam als Trader bij Optiver. Dit interview is voor hem een ideale gelegenheid om te vertellen wat zijn functie bij Optiver inhoudt en wat zijn ervaringen tot nu toe als starter op de arbeidsmarkt zijn.

Waarom heb je gekozen voor Optiver?

Op jonge leeftijd was ik al erg geïnteresseerd in de beurs en belegde ik al in aandelen. Ik heb altijd de drive gehad om ooit eens op de beurs te mogen handelen. Tijdens het laatste jaar van mijn studie ben ik me gaan oriënteren op mogelijke banen gerelateerd aan de beurshandel. Ik wist van mezelf dat ik goed ben met cijfers en ik houd van het werken met geld.

In mijn zoektocht kwam ik al snel uit bij Optiver. Ik ben toen naar een presentatie gegaan en het werd me al snel duidelijk dat Optiver een erg dynamisch bedrijf is waarin resultaat telt en werknemers snel kunnen groeien. Ik was erg onder de indruk en wist vanaf dat moment dat ik bij Optiver wilde solliciteren.

Wat is je functie binnen Optiver?

Mijn werk is het handelen in opties. Met behulp van computermodellen en marktinformatie geef ik prijzen af waarop de markt een bepaalde optie kan kopen of verkopen. Op deze manier verschaffen we liquiditeit in de markt. Daarnaast probeer je als handelaar ook op andermans prijzen te handelen indien die winstgevend blijken te zijn of van belang kunnen zijn voor je handelspositie. Naast het handelen an sich, is het erg belangrijk om in staat te zijn de posities die je zelf hebt te kunnen managen en je risico limieten te beperken. Ik maak deel uit van het CODEC team. In dit team handelen we vooral in fixed income en currencies. Hierbij kun je denken aan het handelen in opties op bijvoorbeeld de Duitse staatslening, de EUR/Dollar, et cetera.

bracht en tijdens deze interactieve periode wordt ook je inzicht getest. Het meteen toepassen van nieuwe kennis of ideeën is wat Optiver zo uitdagend maakt. De maand erna staat in het teken van simulatiehandel. Hierbij leer je gevoel te krijgen hoe de handel in elkaar steekt. Na twee maanden maak je echt deel uit van een team op de handelsvloer. De leercurve is steil; je krijgt binnen korte tijd veel verantwoordelijkheid op je eigen ‘spot’.

Waarom zouden studenten voor Optiver moeten kiezen?

Ten eerste is Optiver een bedrijf met veel jonge mensen van veel verschillende nationaliteiten. Daarnaast hebben werk­ nemers allerlei verschillende studieachtergronden; velen hebben echter wel een economische of een abstracte studie gevolgd.

Er heerst een innovatieve, open en informele cultuur die mij erg aanspreekt. Verder ben je hier als trader het overgrote deel van je tijd bezig met je passie: handelen. Optiver is een uitstekend bedrijf als je wilt werken in een dynamische omgeving waarin je snel veel verantwoordelijkheid kan krijgen en resultaatgericht kan werken.

Do you have what it takes?

Voor afgestudeerden die gedreven en competitief zijn hebben we verrassende carrièremogelijkheden. Heb jij affiniteit met financiële markten, ben je analytisch sterk, in het bezit van een winnaarsmentaliteit en ben je in staat om onder druk beslissingen te maken? Misschien ben jij de versterking die Optiver zoekt: we accepteren het hele jaar door sollicitaties voor de positie van Trader.

Kijk op www.optiver.com voor meer informatie of neem contact op met Kim Ruijer (Recruiter Trading) via 020 708 70 00.

Hoe heb je de eerste maanden ervaren bij Optiver?

De trainee periode duurt twee maanden. De eerste maand is theoretisch erg intensief. De totale optieleer wordt je bijge-

Company presentation Optiver • 37

fsrforum • volume 13 • issue #5

Samen; de Europese schaduwprijs

K(r)anttekening | Drs. Joost Groeneveld RA RV

Als businessvaluator heb ik met regelmaat te maken met partijen die ooit hebben besloten samen te doen. (Bijna) niets is zo leuk als gedeeld enthousiasme. Iets gaan bewerkstelligen dat je samen beter kunt bereiken dan alleen. Je stimuleert elkaar. Je kunt door werkverdeling gebruik maken van elkaars sterke punten, terwijl ieders zwakke punten minder op de voorgrond hoeven te komen. Je netwerk is groter. Je kunt aan schaalvoordelen gaan denken. En je hebt een klankbord. De uitnodiging om iets samen te gaan doen, is bovendien een compliment. De ander komt naar jou toe. Hij zou ook een ander hebben kunnen kiezen. Dus je bent geneigd op die uitnodiging in te gaan. Je stelt samenwerkingsvoorwaarden op en maakt een overeenkomst. Daarna ga je aan de slag. Dat kan heel lang goed gaan. In een traditioneel huwelijk beloof je trouw tot de dood je scheidt. In een zakelijke samenwerking, duurt het vaak korter. Vaak is het terugtrekken een kwestie van pensionering en opvolging. Ook vaak ontstaat een breuk doordat partijen ruzie krijgen. En dan blijkt dat de samenwerkingsovereenkomst van weleer daar geen handleiding voor geeft. Dat komt denk ik door dat aanvankelijke enthousiasme. En het komt door een advies dat bij de start hierin is tekortgeschoten.

Drs. Joost G. Groeneveld RA RV is directeur van Wingman Business Valuators B.V. te Breda en voorzitter van de Stichting WBO (register van business valuators). Hij was hoofddocent aan de Economische Faculteit van de Erasmus Universiteit te Rotterdam.

38 • Samen; de Europese schaduwprijs

dit geval een drama. De moraal? Samenvoegen is niet zo moeilijk. Maar als je instapt, zul je ooit weer moeten uitstappen. Regel dat meteen goed. Die kans krijg je vaak maar één keer, namelijk voorafgaand aan de start. En als je niet van elkaar af kunt, en scheiding dus geen oplossing kan bieden, is een regeling voor als het mis loopt nog veel belangrijker.

Het zijn micro-ervaringen. Zo heet dat in economie. Als het om aggregaten gaat, wordt het macro genoemd. Europese samenwerking zal dus wel macro zijn. Maar de parallellen zijn zichtbaar. Met na-oorlogs enthousiasme hebben landen besloten samen te werken. De Benelux was een goed voorbeeld. Daarna kwamen de EGKS en Euratom, met in het kielzog de E.E.G.: een economische gemeenschap van 6 landen.

Daarna kon het niet op. Inmiddels is de beperking tot de economie vervallen en is de club gegroeid tot 27 landen met 5 kandidaat-landen en nog eens 4 potentiële kandidaat-landen.

Het kan nauwelijks nog groter worden, tenzij we de E van Europa los laten. Of we moeten nieuwe landen maken, respectievelijk oude landen opnieuw uitvinden. Dat is een tegenvaller voor die politici die van uitbreiding van de EU hun beroep hebben gemaakt. Die wel van toetredings-voorwaarden spreken, maar pas achteraf willen vaststellen dat daaraan niet werd voldaan. En dan is het te laat. De rest van Europa betaalt inmiddels alimentatie, terwijl scheiding is uitgesloten.

Het kan erger. Dat is het geval wanneer één van de partijen zich wel degelijk heeft gerealiseerd dat de samenwerking niet voor eeuwig zal zijn. En dus wijzen in dat geval de scheidingsvoorwaarden in zijn voordeel. Hij heeft zich bij voorbaat ingedekt. Zo worden formules afgesproken die geen recht doen aan de voorafgaande samenwerking en de daarmee behaalde resultaten. Soms zo scheef dat de wederpartij zich niet eens kan veroorloven zich uit de samenwerking terug te trekken. Dat kan dan de vooropgezette bedoeling geweest voor de zittende partij. Soms zo ingewikkeld dat niemand die meer begrijpt. Soms gewoon misleidend.

In een traditioneel huwelijk beloof je trouw tot de dood je scheidt.

Een voorbeeld? 10 * de gewogen gemiddelde winst van de laatste 3 jaren met als minimum de intrinsieke waarde. Een en ander gebaseerd op jaarrekeningen die door een accountant zijn goedgekeurd. Zo’n formule zal menig verkoper als muziek in de oren klinken. Maar wat te denken als de koper een calloptie heeft, en de onderneming in een startfase verkeert? Op de initiële investeringen wordt afgeschreven: dus verlies en een geringe intrinsieke waarde. De beloftevolle onderneming wordt op basis van deze mooie regeling voor een schijntje onteigend. Voor de verkopende partij was dat in

Je zou denken dat Europa zo sterk is dat het geld voor zo’n kleine Griekse economie wel kan worden opgebracht. Europa heet een bolwerk te zijn. Maar kennelijk kunnen “speculanten” (hedgefunds zouden de verdachten zijn) dat bolwerk aan het wankelen brengen. “Misdadige speculanten” worden zij ergens op internet genoemd. Waarom eigenlijk? Zij houden zich keurig aan de regels van het spel. Zij stellen de kracht van de kudde op de proef. Soms als eenlingen en soms als

meute. Soms zonder succes en soms met succes. Dat succes hangt in hoge mate af van het gedrag van de kudde. Griekenland is ten prooi gevallen. We doen net of het beestje nog onder ons is. Maar het is verorberd waar we bij stonden. Het zal uit zijn as moeten herrijzen. Ach, het was een beetje een scharminkeltje. De kudde werd er niet veel zwakker door. Inmiddels wordt wel op nieuwe prooien gejaagd, ook al zijn die wat groter en wat sterker. En met verbazend veel succes.

“Griekenland had nooit aan de Euro gemoeten”.

Het wordt hoog tijd dat Europa zich versterkt. Europa is als zodanig een monopolist, of dan toch ten minste een kartel. Maar Europa verdedigt zich slecht. Het zal de angst zijn voor de aloude vraag: “Wie zal dat betalen?”. De banken? De pensioenfondsen? De 27 overheden? Het is een academische vraag. Want hoe het ook zij: achter al die instellingen schuilen de burgers die het gaan betalen. En al aan het betalen zijn: door een eurokoers die zich in hun nadeel ontwikkelt; door inhoudingen op pensioenen; door lagere beurskoersen, door bezuinigingen. Bij elkaar bepalen zij de hoogte van de schaduwprijs voor de adequate verdediging van wat nu Europa is. Griekenland, Italië, Portugal, Spanje: stations die de Europa-express in volle vaart is gepasseerd.

Minister de Jager in De Volkskrant van 13 juli 2011: “Griekenland had nooit aan de Euro gemoeten”. Dat had ik graag tijdig willen horen van zijn CDA, toen de Euro werd ingevoerd.

Door - zoals hij - nu steeds maar te praten over steun voor die landen gaan we voorbij aan de kern van het probleem. Het gaat niet om Griekenland. Het gaat niet om steun. Het gaat om Europa en om het instrumentarium dat je voor Europa wil inzetten. En Europa? Dat zijn wij nu allemaal samen: “for better and for worse”.

Samen; de Europese schaduwprijs • 39

fsrforum • volume 13 • issue #5

Word of the chairman

Luc Gerretsen

Dear members, This is already the last FSR Forum edition of the academic year 2010-2011. At the time of writing. the last re-sits are examined and some of you might be struggling with their bachelor- or master thesis in H3 or the library. As far as the weather concerns you probably won’t be having a problem with typical Dutch summer since it’s raining cats and dogs. Hopefully, the weather Gods will bring out the sun in August.

The theme of this FSR Forum is valuation, I would like to make a the metaphor for valuating or better, evaluating our board year. As cliché as it might sound, time really flies as a board member. After the extremely busy starting period in September and October with a Master Kick Off Day, the International Banking Cycle, Big 4 Cycle, start ups of other events, drinks etcetera, it’s Christmas before you realize it. The Christmas break was the first moment that my colleagues and I evaluated the organised events. We also did an 360 degree feedback session on each other’s performance. Looking back on the year this feedback session was in my opinion one of the most contributing aspects. This was a moment when you could truly feel that the board functioned as a hardened team that could concur any challenge. The next half year we had a lot of events, among which a couple of new events and two international trips. Besides this, we also started the lookout for six talented and enthusiastic students to become our successors.

After an intensive selection process consisting of interviews we were proud to announce the new board on the 10th of June. The members of the XIVth FSR board are Wessel Ploegmakers, Jordy Streng, Lizzy Veldt, Gerbert Bos, Anne van Driesum and Bas Lips. Special attention might go to Bas Lips, he is the third ‘Lips’ after his brothers Bram (XII) and Bart (XIII) in the FSR board. From June onwards we have been working with our successors to make sure they know all the ins and outs of the association. On Thursday the 1st of September the XIVth board will officially be installed at the General Members Assembly in Restaurant Kip. I would like to invite you all for this special moment from 20.00 hours onwards. The official invitation will be sent within a couple of days. Further in this FSR Forum the new board members will introduce themselves.

At the moment, the XIVth board is working very hard to make the upcoming academic year even better than the previous. The destinations of the International Research Project and European Finance Tour are determined, the International Banking Cycle is being improved, our social media activities are expanded and many more exciting developments take place. An association like the FSR never stands still and is therefore interesting to follow. Each board can bring new aspects into the association and it will take at least five years to be able to see what the radical changes are that my board has made. However, I am sure that we can look back very satisfied on the previous twelve months.

After forming the board for the academic year 2011-2012, the FSR is on the lookout for new committee members. A year as committee member includes a wide range of new experiences from the first contacts with the corporate world to improving your organizing skills. However, it’s not only organising activities, since it also includes an active members day, active members weekend and numerous drinks and dinners. A year as committee member is a very strong asset

40 • FSR news

on your C.V. At the same time you build a strong network among students who will also start working in your field of interest within 1 or 2 years. The search for new committee member is being led by the new board. If you have any interest you can send an e-mail to hr@fsr.nu. For more specific details I advise you to look on the website www.fsr.nl. Not convinced yet? You can also have an informal talk with one of the board members first to find out whether it fits you to become active at the FSR. The year for the XIIIth board is coming to an end and on behalf of the whole board I would like to thank all our members, partners, teachers, the Secretary at H-14 and our active members. It was an unforgettable year which I consider to be essential in the academic development of a student. For myself, within three hours from now I catch my flight to ‘sunny’ Italy and will enjoy a relaxing holiday. I hope to see you next year and wish the new board all the success! Enjoy your summer!

fsrforum • volume 13 • issue #5

FSR Former board member

Nelleke van ‘t Hoff

Passport Name: Nelleke van ‘t Hoff Age: 26 Residence: Rotterdam Employed at: Ernst & Young Current position: Audit Which FSR Board: 9th (2006/2007) Board function: Commissioner International Research Project Studies: Accounting, Auditing and Control (Bsc. &Msc.) at Erasmus School of Economics Year of graduation: 2008 Which car do you drive: Seat Ibiza What do you drink on a Friday night: (dry white) wine Life motto: Live every day as if it were your last and never regret a thing!

I enjoyed every moment of our FSR Board year: organizing and presenting our activities, spending time together, having that many enthusiastic committee members around us and the intensive contact with our sponsors and with the university staff. As a commissioner IRP, I had the fortunate position to enjoy the FSR Board year the longest. While the others were practically handing over their board tasks to the members of the 10th board in June, I was still preparing and looking forward to the trip to South Korea!

Our best Board performance? I think that we have been able to organize good quality activities during our Board year: many enthusiastic participants and record breaking sponsor participation! Personally, I am proud of the IRP. It went all very well with the group, we were very welcome in South Korea, spoke to interesting people, have seen much of the city Seoul and its surroundings and we can all be proud of the book that is published with all our papers on the subjects of the IRP! And above all, it was a great time!

The moments I remember most of the social activities, are (of course) the IRP to South Korea and the active members weekends to Antwerp, Paris and Köln. During those weekends you get to know your committee members and board members from a whole different perspective! Some jokes or events are still brought back when we meet with the Board. Furthermore, I also remember one of our activities: flowriding and rafting at Dutch Water Dreams. The flowriding went well, although no one seemed a natural talent in it, but it was fun!

But then: the rafting! Together with my co-Board members and one committee member, I shared a raftboat. The rafting was not that successful for me; I learned not to be too helpful to others all the time. During the rides down the simulated river, I tried to help everyone back in the boat but ended up in the water myself three times out of four!!!

The FSR took indeed a great part in my career path. During the Board year, I came in contact with the Big 4 accountancy firms, of which also Ernst & Young. Events such as the Big 4 Cycle, Bachelor Accountancy day or Accountant Firms Day enable you to get to know your possible future employer and to network.

After many inhouse days and other activities with the four firms during my studies and the Board year, I noticed that I liked Ernst & Young as an organization and the employees

that I came across with during the activities most. Therefore, in my Masters I applied for an internship to write my master thesis. For me this was the perfect opportunity to get to know the people at Ernst & Young and to finish my thesis in a short time period.

After the internship and after graduating from the university, I received a job offer and have been working at Ernst & Young since then, in the position of assistant auditor. When I started working in 2008, I started the study to become a certified auditor (Register Accountant (RA) in Dutch) at the Erasmus university as well. It was nice to be back at the university for one day a week and to be able to develop my skills and knowledge directly from the start of my career with external and internal studies and trainings!

My average work day? Because we are auditing the clients’ financial figures, we spend most of the time at our clients’ offices. Those who do not know what auditors actually do, think that it is all about bookkeeping and financial figures!

On the contrary, it is really a people-business. Contact with the client and within the audit team is very important, and we spend a lot of time on interviews with the client and communication of results to and discussions with the team. The variety in clients, clients’ businesses, team members/colleagues and the great share of knowledge that you gain during the years are a real advantage of my job!

The culture at Ernst & Young reminds me of the FSR: many different kinds of people, all young, dedicated, very ambitious and trying to get the best result out of their work, but they are all up for a drink and other social activities! Ernst & Young is still participating in the activities of the FSR such as the Big 4 Cycle and the IRP and with some of them I am involved as well. It is nice to see the FSR from ‘the other side’ and find out that the FSR is doing so well and is able to attract that many enthusiastic board members, committee members and participants for their activities every year again! The FSR is still ‘my’ association and I am extremely proud to have been able to be part of all this during my Board year!

FSR news • 41

fsrforum • volume 13 • issue #5

FSR Activity report International Research Project 2011 Mattis Ooms

In the afternoon of the 1st of May the participants of the IRP 2011 gathered at Schiphol Airport for the start of the International Research Project 2011. After the celebrations of Queens’s day the day before, some looked a bit paler than others, but nonetheless the luggage was checked in and the last goodbye-hugs and kisses were given to the relatives and friends staying behind. A last word of wisdom and encouragement by Chairman Luc Gerretsen and the group wanders towards the gate. An unforgettable journey is about to begin.

After a flight of 12 hours we arrived in the late afternoon in Singapore, where we were welcomed by Ellis and Niels, two committee-members who had already left for Singapore two days earlier to do the last on-location preparations. After checking in and a quick shower at the hotel, the group travelled to the New Asia Sky Bar in the Stamford Tower, one of the highest bar's in Singapore, for a welcome drink and speech.

The view of the Singapore skyline by night, while enjoying the typical "Singapore Sling" cocktail, was the perfect place to kick off our two-week adventure in these two vibrant cities in booming Asia. Cocktails on an empty stomach got everyone hungry, so the time had come to get acquainted with local food. This was done in one of the many and cheap food courts, where a diversity of food was available; from typical chicken 'n rice to multiple kinds of organ meat. After this, the group split up for some quiet drinks or an early sleep since the next day the first company visits were planned.

The next morning the group stepped into the crowded subway during rush hour, where we got a good feel of the busy economy of Singapore. Lucky for us we were heading to the outskirts, where we would visit the Dutch, family-owned multinational: Van Leeuwen Pipe and Tube. Here we were welcomed by one of the three Dutch employees/managers of Van Leeuwen Singapore, who told us about his experience of living in Singapore and how this was different from the Netherlands. After him, we received a presentation on what kind of business Van Leeuwen Pipe and Tube practices and how they were doing business as a Dutch multinational in Asia. Ending the morning with a lunch and a tour around their storage facilities, the group was given some time off to explore the beautiful city of Singapore before gathering again at Ernst & Young. Here we had a short tour around the office, followed by an informal drink with the employees of E&Y where we had the opportunity to ask questions about their line of work.

This turned out to be a useful moment to gather information

42 • FSR news

which would later be used in the participants' researches. In the evening, a group dinner was organized in the city centre after which the programme of the day ended. The next day it was again a day with Dutch multinationals, this time; Vopak and ABN-Amro. We started off with an introduction at the Vopak headquarters in Singapore, after which we were transferred to the Vopak terminal plant in the harbour of Singapore, the heart of Singapore’s industry. After this impressing tour around the terminal plant, the next stop was ABN-Amro.

Here we were given several presentations by amongst others the ABN-Amro country manager of Singapore, about the

booming and on-going growth-potential of Singapore in the financial markets. The day was ended with a case-study, ­followed by a social drink with the 'Hermeskring Singapore' at the colonial Singapore Cricket Club. Since this was already our last night in Singapore, it was time to discover the extensive Singapore nightlife. This turned out a successful and unforgettable night, which included the experience of witnessing Singaporeans getting 'sick' in the middle of the club, about every 10 minutes. After a short night, the suitcases were packed and direction was set for Central Station, where we said our goodbyes to Singapore and departed for our next destination: Kuala Lumpur. It was a long journey of 7 hours through everlasting palm oil fields, but after having arrived at our hotel, with infinity-edged swimming pool with a view on the Petronas Twin Towers, it turned out worth the trip.

Opposed to Singapore, which was very clean, strictly organized and Western-like, this city was much more chaotic and dirty. The smell of the open sewage system was not uncommon and the hawkers on the street left their raw chicken and meat open for display for questionable lengths. This gave a

more Asian feeling to the city and highlighted the cultural differences between Malaysia and the Netherlands. To evenout the culture shock, we had planned a visit to the Dutch Embassy for the Friday morning. However, due to preparations for the celebration of Liberation day, the staff at the Embassy did not have time to receive us and therefore instead invited us for the celebration later that day. So our first company visit in KL was at the Malaysian Palm Oil Board. Since Malaysia is the number one producer of palm oil in the world and 60% of the land area of Malaysia is used as palm oil plantations, we were highly interested to get to know more about this. After a presentation on MPOB, we were given a fascinating tour on how palm oil is produced and a demonstration on the infinite possible applications of palm

» FSR news • 43

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oil. By now, the celebration of Liberation Day at the home of the Ambassador had started, so we headed that direction.

With Heineken beer in one hand, and a 'bitterbal' and herring in the other, the national anthem was sung. Having got acquainted with many other Dutch people, it was time to set forth the evening to discover the nightlife in KL. This, already at the start, infamous evening turned into a great success and the next morning everyone was grateful no company visits were planned since it was weekend. This Saturday everyone had the day off, so many stepped onto the KL Hop-on hop-off bus to discover KL and do the typical touristy sightseeing activities. In the evening, the group gathered again from all over town for an exquisite diner, after which another night of partying began.

Another programme-free day gave everyone the opportunity to get some extra sleep, chill out and do some more sightseeing.

In the late afternoon, the group met again to see the sunset from the KL Tower, after which a bar was found to see a game of football and at twelve o'clock celebrate Pieter Oudshoorn's 21st birthday!

The next morning a new and fully-booked week started.

Monday started off with a visit at software developer Exact.

44 • FSR news

After various presentations, the visit was followed by a tour through the office (including its research department). In the afternoon, we were received by the Malaysian stock exchange, Bursa Malaysia. Here we received a presentation on the stock exchange and a professional trader, Kevin Tan, shared his experiences as a trader. The next day, Tuesday, we headed for the outskirts of Malaysia for a visit to Bufori, an exclusive handmade car manufacturer. Here we got a presentation on the history and market of the firm, after which we were given a tour through the factory to see the interesting production process of the exclusive Bufori cars.

After this it was already time to head for the Petronas Twin Towers for our visit to Petronas, the Malaysian national oil company. This oil company turned out to be one of its kind since, unlike other state-owned oil companies, their objective is to make high profits, instead of directly providing cheap oil to the people of Malaysia. After the company presentation and intensive Q&A session, we were brought to the famous Skybridge, at stafflevel, to witness the view of KL. This evening, the group had dinner at a typical Malaysian food restaurant, where Bas gave an emotional evaluation of how the participants of the IRP 2011 by now had turned into a group of close friends through sharing this amazing experience on the other side of the world.

The next morning we headed off for the University of Malaya, by far the biggest university in Malaysia, for a tour around their 900 acre campus and the university museum. This Wednesday afternoon no company visit was planned, so everyone had time off to visit the Batu Caves or do some shopping.

This evening, another dinner, this time Japanese, was planned, followed by probably the most memorable night of the IRP, at Club Rootz, where we 'had the time of our lives'...

The next day it was time for our visit to Chartis, where we toured around their call-centre. This call-centre with bright coloured balloons and cheering and clapping employees was something none of us had ever experienced. In the afternoon we were brought to a major client of Chartis; SenQ. The founder of this Malaysian version of the Dutch Mediamarkt came to tell his story of success; how he, from a broke young men, built a chain store of electronic goods with revenues of $900 million per year, without ever taking out a loan from a bank. This evening it was time to go to bed relatively early, but when the men found out there was a model party at club Bedroom, they just had to take a look, wearing their bathrobes...

The last Friday started with a visit to the Islamic bank; Kuwait Finance House. First we had a look on their trading floor, where most of us were surprised by the relatively many women working there. After this we received a presentation on the concept of Islamic Banking, which was unfamiliar to us and therefore created an interesting and somewhat awkward Q&A session. Our final company visit was at Cargill, one of the largest commodity trading and processing firms in the world. Again we were welcomed by a Dutchman, who gave us a presentation on their business, after which the country manager of Malaysia came to answer our remaining questions. The afternoon was ended with a short social drink before we headed off back to the city centre for a last evening together. This started with a final exquisite dinner, including an amusing story from the group thanking the committee for the organisation of such a successful project. After this we headed back to the hotel to freshen up and celebrate Jordy Streng's birthday, yet again IRP-style, followed by a final night of unforgettable clubbing. The next morning the suitcases were packed and the group headed for the airport, to say a last goodbye before a part of the group flew back to Amsterdam, while the rest scattered all over South-East Asia, for another two weeks of traveling.

It has been an amazing project, starting with the in-house days in the Netherlands, where the group merely existed as pairs or individuals, turning into a group of close friends during the unforgettable, once-in-a-lifetime experience in Kuala Lumpur and Singapore. This project would not have been possible without the support of our partners and the Financial Study association Rotterdam and of course the participants of the International Research Project 2011! Many thanks to them and a special thanks to Ellis Heijboer for the amazing job she did leading the organization of this fantastic project!

FSR news â&#x20AC;˘ 45

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FSR Activity report Corporate Finance Competition 2011

On Monday May 30 the last FSR event of the academic year 2010-2011 named the Corporate Finance Competition started in the luxurious five star hotel Duin & Kruidberg. During this three-day business course four teams compete against each other by solving corporate finance oriented cases prepared by ABN AMRO Corporate Finance & Capital Markets, BDO Corporate Finance B.V., Ernst & Young, Rabobank International and The Royal Bank of Scotland.

On Monday 20 participants travelled to Santpoort where they were welcomed in Duin & Kruidberg. After a lunch in the garden, The Royal Bank of Scotland was the first company to kick off the competition. After a presentation the participants could show their skills while working at a mergers and acquisition case. You could already feel the tension and competition between the teams. After this case the participants could get to know each other while enjoining a lovely Italian buffet on the balcony in the garden while the sun was still shining.

After dinner it was time for a case presented by Ernst & Young. During the case the teams had to work with a LBOmodel on a laptop. You could already see that the teams were becoming attuned to each another. At the end of the first day

‘Team Yellow’ was the team that acquired the first place. The day ended with some drinks in the lounge bar where the participants could talk informally with the employees of Ernst & Young and ask all their questions.

The next day started early with a delicious breakfast, after which the third case presented by ABN AMRO Corporate Finance & Capital Markets started. All teams were deliberating and dividing the tasks among themselves. The cases involved one selling team and three bidding teams, and after a lot of negotiating the selling team finally made a deal. After the case the participants could enjoy lunch together with the employees of ABN AMRO Corporate Finance & Capital Markets.

On Tuesday afternoon it was time for some relaxation. With

» FSR news • 47

fsrforum â&#x20AC;˘ volume 13 â&#x20AC;˘ issue #5

the whole group we left in taxis to recreation park Spaarnwoude where it was time for some physical exertion. We went canoeing after which we could relax in the sun.

Beside the presentations, cases and drinksm the Corporate Finance Competition also includes a dinner together with all five participating companies. Tuesday evening this dinner, where the participants switched tables after each course, took place. During this dinner the participants were able to talk to three companies in an informal way and the companies had the opportunity to tell more about their work field and the company culture. The evening concluded with several drinks at the bar where the participants could talk with the companies they did not spoke with yet.

48 â&#x20AC;˘ FSR news

Wednesday was the last day of the Corporate Finance Competition with still two cases left. Rabobank International started the day with their presentation, after which the students had to work on the case. You could really feel the competition among the teams and they all worked hard to get the last points to finish on the first place and to win the bottle of champagne Rabobank International would hand out to the winning team. The competition ended with a very interactive case presented by BDO Corporate Finance B.V.. The students had to interview clients and eventually make a deal under a lot of time pressure. The teams were really enthusiastic about the case and put all their effort in it to win.

After the final case the points were added and it was time for

» FSR news • 49

fsrforum • volume 13 • issue #5

the prize ceremony. We ended the competition with a big toast on ‘Team Yellow’ that won the Corporate Finance Competition 2011. On behalf of the FSR I would like to congratulate Willemijn Wijne, Robert Swart, Caspar Bijleveld, Sierd Bron and Pete Schelevis with their excellent result!

After three intensive but also enjoyable days with presentations, cases, lunches, drinks and dinners we can look back at a successful corporate finance event. If you have an interest in corporate finance, make sure to subscribe for the upcoming edition. During this event you will get to know five different companies who all work in the field of corporate finance.

Because of the variety of cases and presentations, as well as the drinks, dinner and lunches you are able to get to know more about working in corporate finance and what the informal atmosphere is like in different companies.

On behalf of the Corporate Finance Competition Committee I would like to thank ABN AMRO Corporate Finance & Capital Markets, BDO Corporate Finance B.V., Ernst & Young, Rabobank International and The Royal Bank of Scotland, the participants and Duin & Kruidberg for their effort and enthusiasm. We hope that all participants have received valuable information and an impression of five companies they might be working for in the future.

50 • FSR news

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fsrforum • volume 13 • issue #5

XIVth FSR Board 2011-2012

Wessel Ploegmakers My name is Wessel Ploegmakers and I will be this year’s chairman of the XIVth FSR board. I was born 22 years ago in Amersfoort and currently live in Delft. Started off studying Architecture at the TU Delft but decided after one year that drawing buildings was not my greatest talent.

Therefore, I switched to the International Business Administration bachelor programme at the Erasmus University in 2008 and successfully finished it in three years. As a participant in the Investment Banking Masterclass, I became involved with the FSR. During last year I was part of the Corporate Finance Competition committee and went to cultural hotspot Paris with the European Finance Tour. These experiences encouraged me to increase my involvement with the FSR. I am looking forward to the next year with great enthusiasm and hope to see you around at one of our events.

Jordy Streng Hi there, my name is Jordy Streng (22) and I will be the secretary of the fourteenth FSR board.

Next to this function I will also organize the Accountants Firm Day and the two corporate dinners.

Currently, I am a Masters Financial Economics student and I intent to graduate during my board year. Last year I got connected with the FSR by participating in the International Banking Cycle committee. Because of the fact that I enjoyed and learned a lot in this committee, I decided to apply for a board function. I hope to extend this experience from the IBC committee in a great board year with a lot of learning, great activities and fun with my fellow board members and the active committee members!

Lizzy Veldt My name is Lizzy Veldt , I am 21 years old and I just completed the bachelor Business Administration at the Rotterdam School of Management. After having lived for 18 years in Bergen, a picturesque town in the North of Holland, I moved without hesitation to Rotterdam when I finished secondary school. In the third year of my bachelor I went on exchange for four months to Queens University in Kingston (Canada), which was a great time and a great learning experience as well. When I got back from exchange I got the opportunity join a committee of the FSR, which also gave rise to a new challenge: Becoming member of the XIVth board of the FSR! During the academic year 2011-2012 I will be the treasurer. Besides that, I will organize some events together with a committee. I expect that, together with the other five board members, we will make this year a very successful one! A year with a lot of challenges, great events, a new, inspiring network and hopefully even more growth of the FSR.

52 • FSR news

Gerbert Bos My name is Gerbert Bos. I'm 20 years old and I just finished my bachelor International Business Administration. I already live in Rotterdam for 3 years and last year I have been on an exchange to Bangkok. I haven't been active within the FSR before. I have done several committees within my fraternity, so now it was time to get some more professional experience. For the upcoming year I will be the Commissioner of External Relations. The main reason for applying at this function was the contact with so many different interesting companies. To give a professional presentation to those companies and ensuring their commitment, also for the longer term, to the FSR was what really attracted me. Making clear the special value of the FSR to the companies and the students is another really challenging aspect. Next to spending 5 days a week on the FSR I spend a lot time on running and mountain biking. Iâ&#x20AC;&#x2122;m really looking forward to the next year, having the contacts with the companies, having a great time with my fellow board members and learn a lot.

Bas Lips Hi, my name is Bas Lips and in the XIVth FSR board I will fulfil the position Commissioner Finance Activities. Starting with Econometrics at the Erasmus University in 2008 and already allowed to enter the masters, I decided to take a short break in studying. After a year in which I organised the International Banking Cycle and participated in the International Research Project, I knew the FSR board was the only right choice. Starting this year on common grounds organising the IBC 2011, I am looking forward to organise all the challenging activities this year has to offer.

Anne van Driesum Hi, my name is Anne van Driesum, I am 21 and I come from a small town called Zaltbommel.

After living there for 18 years it was time for a change and I moved to Rotterdam to study Economics & Business Economics. Wanting to meet new people I became a member of the fraternity R.S.V. Sanctus Laurentius. Besides my study I have been active within several committees.

In my third year I went on exchange to Universidade Nova de Lisboa and it was then that I decided that I would take a year off to further develop myself. Or rather a year ON...

Because this year I am getting the opportunity to fully commit myself to the continuity of the FSR as the new Commissioner Activities. And I am lucky because I have two predecessors: Ellis Heijboer and Kim de Vries. Besides the IRP 2012 I am also responsible for the FSR Forum and the Female Business Tour. I am looking forward to a year full of new challenges and I am sure that me and my fellow board members are going to make this year a year of successes!

FSR news â&#x20AC;˘ 53

WANTED: COMMITTEE MEMBERS

Interested? Mail to hr@fsr.nu The FSR is looking for enthusiastic committee members for the academic year 2011-2012. As a committee member you have the opportunity to distinguish yourself from other students and to get connected to the corporate world.

Are you a Bachelor 3 or a Masters student the coming year and do you have affinity with finance, accountancy or controlling? Grab this chance to become an active member at the FSR in one of the following committees: Accountancy Committee Corporate Finance Competition Committee European Finance Tour Committee FAN Committee

Finance Committee FSR Forum Redaction Committee International Banking Committee International Research Project Committee

fsrforum • volume 13 • issue #5

FSR Alumni Association The value of the FSR alumni

In the financial world, valuating is one of the most import and also most difficult tasks. On the one hand important since in for instance acquisitions it is vital to ascribe a clear value to an object and in formulating corporate goals a value appreciation is often seen as a sign of management competence, while on the other hand difficult since numerous objects are hard to value accurately and this allows a degree of subjectivity to enter the valuation which is often hard to counter with the current most frequent used valuation methods. Although in financial markets we rely on the market forces of supply and demand to establish a correct valuation, it is much more difficult to obtain a good valuation in acquisitions of non-traded firms. In case of firms with stable and clearly defined cash flows valuating is relatively easy, but in cyclical industries day-to-day changes can have a huge impact on the value of a corporation. Especially when future value increases are being estimated and already incorporated in the price to be paid there is a big chance of overestimation of the true underlying value. The valuator can then easily fall into the “winners curse”, a recurring problem in auctions of objects whose value is difficult to estimate. The winner will be the person who ascribes the highest value to an object, but when this value is higher than the intrinsic value there is overestimation and overpayment and the bidder becomes the victim of the “winner’s curse”.

It is becoming more and more clear that sentiment plays an important role in valuations. We saw this during the dot.com crisis at the turn of the century and more recently in the overvaluation of the (US) housing markets. The fact that reputation of a seller can influence the price to be paid counters rational economic thought and has led to re-evaluation of economic models from prescriptive to descriptive in which human behavior is incorporated.

Valuating an organization like the FSR alumni is much more difficult as the value is not easily captured in profit or loss numbers. No, the value of the FSR alumni lies within the members and the bonds between them, which in certain times prove to be highly valuable. From an economic perspective difficult to see, but for the members clearly observable at one of the alumni events!

F.T. chairman FSR Alumni Association Joris Kill

FSR news • 55

fsrforum • volume 13 • issue #5

FSR Activity Agenda 2011-2012

September/October/November Big 4 Cycle

April/May National Investment Competition

Meet the 4 largest accounting companies.

Invest and be a winner!

International Banking Cycle The investment in your career.

May Investment Banking Masterclass

November Traders Trophy

Learn to valuate, like an investment banker.

Can you handle the pressure?

Will you choose accountancy?

Multinational Diner Get to know the leading Dutch multinationals.

Accountant Firms Day Create your own goodwill!

Female Business Tour It might be a men’s world but it would be nothing without a woman.

January/February Financial Business Cycle Explore the financial opportunities.

February Young Financials Diner Get to know interesting financial companies.

March Multinational Battle Five multinationals, five battling cities, are you part of it?

European Finance Tour Milan, managing uncertainties.

56 • FSR news

Bachelor Accountancy Day Corporate Finance Competition Five star event: hotel, companies and participants!

International Research project The Asia Experience.

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