The practical guide to wall street (2009)

Balance sheet: Summarizes the assets things owned and liabilities things owed of the company and how they are financed through amixture of debt borrowed money and equity funds contribute

The Practical

Guide to Wall Street

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The Practical

Guide to Wall Street

Equities and Derivatives

MATTHEW TAGLIANI

John Wiley & Sons, Inc.

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Copyright
C 2009 by Matthew Tagliani All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Tagliani, Matthew, 1974–

The practical guide to Wall Street : equities and derivatives / Matthew Tagliani.

p cm – (Wiley finance series) Includes index.

10 9 8 7 6 5 4 3 2 1

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To Nati, Sof´ıa, and Cosmo

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CHAPTER 2

Equity Fundamentals (Part 2): Financial Ratios, Valuation,

When Is Program Trading More Beneficial? 182

Technical Comment on the Accuracy of Approximations 263

CHAPTER 8

The Swap in Detail: Definitions and Terminology 272

What the Market Tells Us about the Economy 476

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What makes a good Wall Street trader or salesperson?

There is no magic formula Successful Wall Street professionalspossess a mixture of intelligence, common sense, attention to detail, busi-ness savvy, wit, presence, energy, enthusiasm, interpersonal skills, self-confidence, as well as other attributes that are not only difficult to quantify,but that vary from one person to the next Market conditions and client de-mands are constantly changing and success speaks as much to the person’sability to do a job well today as to the ability to adapt quickly and effectively

to the ever-changing markets and the evolving requirements of the job

In particular, success on “the Street” is not the result of a specific demic training The men and women who work on the trading floor comefrom enormously varied backgrounds In addition to the many MBAs andeconomics, finance, and business administration majors that one would ex-pect to find, I have also worked with traders and salespeople who helddegrees in English literature, art history, astrophysics, and everything in be-tween, including a few (all senior to me, I should add) with no universityeducation whatsoever

aca-Because the skills required for success on Wall Street are not easilydefined, or correlated to strength in a particular academic area, tradingfloors have always operated on an apprenticeship model Inexperienced hires(typically recent university graduates or newly-minted MBAs) are admitted

to analyst and associate training programs based on an assessment of thequality of the “raw material” they offer as a potential employee—brains,personality, work ethic, and so on They are then given a seat on a desk

as either a trader or salesperson where they develop their knowledge andunderstanding of the business by actually doing the job

Institutional finance is a broad and complex business and it takes years

to develop a clear understanding of the activities and interactions of allthe different groups around the trading floor, as well as the structure ofmarkets, the dynamics of trading, the relationship with clients, and theunique language used among traders to communicate orders The majority

of this knowledge is not gained through formal training seminars or classesbut through experience and informal explanations scribbled on napkins orscraps of paper by more senior coworkers

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Given the fact that almost every major investment bank and dealer uses this approach to hiring and training, the apprenticeship modelhas clearly proven its merit It is not, however, without its shortcomingsand it was my own experience with the inefficiencies of this model and theirconsequences for both new hires and experienced traders and salespeoplethat motivated me to write this book.

broker-N E W H I R E S

Under this apprenticeship model, there is a tremendous information gapbetween those with actual business experience and outsiders: The only peo-ple who truly understand what happens on a trading floor are the oneswho are already working there How, then, are potential candidates toknow whether a career in sales and trading would be interesting to them?The glamorized and greatly exaggerated image of Wall Street offered byHollywood, or found in the gossipy, tabloid-style memoirs of some formerindustry employees, while certainly entertaining, does not accurately depictthe day-to-day realities of a typical trader or salesperson in the equitiesdivision of an investment bank The surprising fact is that the majority ofapplicants seeking jobs on Wall Street do so with as much, or more, misinfor-

mation about what they think the role will entail than concrete knowledge

of what actually awaits them

The information gap also makes the recruiting and hiring process ficient It is difficult to effectively interview someone who, in practice, doesnot speak your language and knows almost nothing about the job he isapplying for One of the reasons why Wall Street job interviews containsuch notoriously obscure and seemingly random questions and requests as

inef-“Tell me how many ping-pong balls would fit inside a 747.” or “Let mehear you shout.” is that, if you cannot ask candidates questions specificallyrelated to the role, then it is only possible to get a sense for their skills andqualifications in very roundabout ways

Unfortunately, until now, even if new candidates have made a correctchoice and the sales and trading business is the place for them, there is noway they can prepare in advance Ask any trader or salesperson and youwill get a similar response: The Harvard MBA, the Princeton economicsmajor, the MIT physicist and every one of the other exceptionally bright,hardworking, and talented young people that come to Wall Street are, uponarrival on their first day of work, pretty much useless It is not that they arenot capable; they have simply studied the wrong things, and for the mostpart, lack applicable knowledge

Without taking anything away from the enormous value of formaleducation, the fact is that the standard academic treatment of finance

specifically removes from consideration most of the contribution provided

by the sales and trading division In order to model the complexities ofreal-world finance, certain simplifying assumptions are made: investors areassumed to be perfectly rational and markets are modelled as “efficient,”meaning that the price of a stock incorporates all available informationabout the prospects for that company If that were the case, there would

be very little that a salesperson or trader could contribute to the investmentprocess What is more, the first assumption of virtually any stock valuation

or derivative pricing model is that there are no trading frictions of executioncosts However, it is precisely these frictions that are the primary sources ofrevenue for the trading floor The details academia excludes are actually thebread and butter of Wall Street.1 While in recent years many universitieshave taken steps to give a more “real world” focus to their curriculum, this

is still, in most cases, a nascent effort

Perhaps the most glaring example of the inefficiency caused by outsiders’lack of basic trading floor knowledge comes from the experience of WallStreet’s summer student interns Summer internship programs are considered

to be the highest-probability route to a Wall Street job for undergraduatesand MBAs and admission is extremely competitive, with acceptance rates attier-one institutions of as low as 2 to 3 percent Students prepare intenselyfor their 10-week programs, during which they rotate through various desks

on the trading floor, sitting beside the traders and salespeople, doing smalljobs, and learning about the business in the hope of making a good enoughimpression to receive a job offer for the coming year For students interested

in a career in financial markets, there is really no better learning opportunitythan to sit on the “front lines” of finance at a top tier investment bank andwatch firsthand how the institutional traders and salespeople actually make

it all happen

Unfortunately, for many students, this opportunity is largely wasted

On arrival, the typical summer intern has so little idea of what happens

on the trading floor that they spend most of their summer just trying toorient themselves Their time with traders is squandered asking very basicquestions that could be easily learned from a book, much to the frustration

of busy front-office employees Many interns finish their summer rotationswith little more than some vague notions of what they have been told, a fewnotes or handouts, and the sense that something very important was going

on, but that it was beyond their reach

The logic behind the Wall Street apprenticeship model is that the tleties and nuances of real-world finance can only be learned through experi-ence The inefficiency in the model is that, without an organized presentation

sub-to guide them, new hires and summer interns spend a great deal of time andeffort learning basic concepts, and it is only after many months of workingthat the more refined understanding begins to develop

In many ways, mastering the skills necessary for success in sales ortrading is like learning to drive a car: there is simply no other option than toget behind the wheel and do it—slowly at first, and then gradually building

up confidence, picking up speed, and taking on greater challenges Wherethe problem lies, and what this book endeavors to solve, is that, if working

in institutional trading and sales is like driving a car, historically there hasbeen no driver’s education course or handbook of road rules New hireshave been arriving on the job without knowing what the gas pedal, brake,

or steering wheel are for and having never seen a street sign in their lives.What few books have been available were designed for experts and were asuseful as a physics text on the thermodynamics of engine combustion would

be to someone learning to drive

E X P E R I E N C E D P R O F E S S I O N A L S

Many firms provide employees with opportunities for additional sional development, though for the most part, beyond the initial trainingprograms, learning is done on an ad hoc basis and in a fairly disorganizedmanner Some traders and salespeople take it upon themselves to be a student

profes-of the business, and extend the breadth and depth profes-of their understanding

as far as possible Most, however, assemble what can best be described as

a “mosaic” understanding of the sales and trading business: based on thecombination of a number of small pieces of information picked up fromvarious places over time, they put together a broad picture of the activities

on a trading floor which is fairly complete, but only from a certain distance.Drill down more closely and you will find that there are often significantholes in their comprehension and many areas are lacking in detail

So long as a trader’s or salesperson’s activities remain limited to his orher primary area of expertise, this lack of a more granular understanding ofother products is generally not a problem In recent years, however, many ofthe traditional distinctions between groups within the equities division havebeen blurred or outright eliminated Traders and salespeople whose expe-rience had been limited to one area have to contend with the full spectrum

of equity and derivative products including single stocks, portfolio trades,ETFs, futures, swaps, and options This challenge is even more exaggeratedfor new transfers into the equities division from other asset classes who face

a steep learning curve but lack a formal process by which to ascend it.Buy-side traders working at hedge funds, mutual funds, pension funds,endowments, retail brokers, and investment advisors face a similar challenge.While many have ample experience and product knowledge, often obtainedduring previous careers as Wall Street traders or through a construction of

their own mosaic, there are others who lack a detailed understanding of howthe sales and trading business works The lack of opportunity to obtain the

“Wall Street Education” that comes from working on a trading floor meansthey often work at a significant informational disadvantage to their brokers,which can be a source of friction Of particular importance are the caseswhere this lack of understanding manifests itself in a disagreement over how

to calculate a fair price or what are reasonable expectations of the broker:

It can be extremely difficult for parties with conflicting economic interests

to come to an agreement without an independent reference

W H Y D O W E N E E D A N O T H E R F I N A N C E B O O K ?

So clearly the way traders and salespeople acquire this large, unstructuredbody of knowledge is inefficient, but why do we need a new book? Don’t thehundreds of existing finance books already explain everything a trader or

salesperson needs to know? The answer is, strangely enough, no While there

exist books covering almost every aspect of academic and applied finance,the genre of “Introductory Institutional Finance,” which best describes thecontents of this book, has somehow not yet emerged

In the existing finance literature, the words “introductory” and

“institutional” have been treated as mutually exclusive Books targetingthe institutional (i.e., “professional”) investor tend to focus on sophisticatedpricing and risk management concepts appropriate only to those who arealready experts in their field, while introductory texts provide personal fi-nancial planning advice or trading strategies (“How to Get Rich TradingXYZ”) relevant only to the retail (“nonprofessional”) investor

A useful illustration of the dichotomy between the retail and tional viewpoints comes from the concept of liquidity, which measures howmany shares of a stock can be bought or sold in a given period of timewithout significant impact on the price Due to the large size of institu-tional order flow, the concept of liquidity is ubiquitous in the activities ofthe professional trader and salesperson; it is the most fundamental factor

institu-in the analysis of risk and the first consideration institu-in the execution of everyclient or proprietary order For retail investors, on the other hand, liquidity

is almost irrelevant due to the small size of their orders However, despiteits preeminent importance in institutional finance, liquidity considerationsreceive scarce attention in the existing literature because these books arewritten for professionals who, it is assumed, are already well versed in such

a basic concept

In writing this book, I have attempted to fill this gap in the literature

My intention is to provide the introductory explanation of the fundamental

workings of the trading floor that I was looking for when I began mycareer, and that new hires have asked for on countless occasions since then(and continue to ask for) It is also meant to serve as a reference text formore senior traders and salespeople for those situations where they find itnecessary to patch over a particular crack in their knowledge This book doesnot pretend to be a substitute for what is learned through an apprenticeship

on Wall Street Success as a trader or salesperson requires an understanding

of the subtleties of markets, risk management, and client relationships, whichcan only be learned through experience My goal is to provide a logicallystructured and detailed presentation of the basic terminology and concepts ofequities sales and trading so as to soften and shorten the steep learning curvethat new arrivals to the equities division have traditionally encountered

O V E R V I E W O F C O N T E N T S

This book provides an overview of the front office sales and trading ness of a typical Wall Street investment bank or broker-dealer In se-lecting and structuring the material to include, and the level of detail topresent, the primary criterion has been the probability that the reader wouldfind the information useful in practice, either in a front-office environment

busi-or as a buy-side client Anything I would not expect of the trader busi-or person sitting next to me on the trading desk, or that would not significantlybenefit his or her job performance, has been omitted to ensure the reader

sales-is not dsales-istracted from the relevant material The presentation and pace ofthe book are based on my own experience explaining this material to bothjunior and more senior professionals over many years

Throughout the book I have made an effort to introduce, whereverpossible, the language and terminology used by traders and salespeople inpractice Not only is there a great deal of vocabulary that is unique tothe trading floor, but the correct use of that language, down to the trading-specific interpretations of the prepositions “for” and “at” is essential for such

a fast-paced environment where it can easily mean the difference between asuccessful trade and an expensive error

So that the book is accessible and useful to the broadest possible ence, the prerequisites have been kept to a minimum The reader is assumed

audi-to have no particular familiarity with finance or economics beyond whatcould be considered the commonsense understanding of the dynamics ofsupply and demand (Specifically, that an increase in demand, or scarcity

of supply, for any good, tends to drive the price of that good up, while

a decrease in demand, or excess supply, leads to lower prices.) However,because modern finance is inherently mathematical, it is necessary that the

reader understand some of the basic concepts from calculus, probability,and statistics Fortunately, our interest is only at the conceptual level: Thereader must understand, to use one example, that the mathematical defi-nition of the derivative measures a rate of change and can be interpreted

as the slope of a line It will not, however, be necessary that the reader beable to actually calculate the derivative An appendix is included with a briefoverview of the relevant mathematical concepts for those readers in need of arefresher

A final observation is that, while the book is written from a U.S.-centricperspective, the structure of the equity sales and trading business globally isquite consistent and the concepts presented here can be easily extended tointernational markets, making the book relevant for both U.S and interna-tional readers

L A Y O U T

The ordering of the material across the whole book has been carefully sen so that, to the greatest degree possible, terminology and concepts areintroduced with an appropriate motivation and readers with no previousexperience will be best served by reading each chapter in sequence At thesame time, the structure of each chapter is designed to be a self-containedunit and readers with more experience can go directly to the chapters thatinterest them

cho-P a r t O n e : W h a t I s a S t o c k ?

The book begins by analyzing the most fundamental question about equities:what is a stock and what determines its price? We look at the first of thesequestions in Chapter 1, where we present the basics of financial accountingand the contents and structure of the standard financial disclosures made bycompanies (Balance Sheet, Income Statement, and Statement of Cash Flows)

In Chapter 2 we look at various valuation methods used to determine thefair price to pay for a share of stock While both of these subjects are amplycovered in many other texts, the focus here has been to narrow the scope ofthe material down to those concepts and terminology of greatest practicaluse to the average trader or salesperson

P a r t T w o : P r o d u c t s a n d S e r v i c e s

The main body of the text, consisting of Chapters 3 through 11, covers all

of the major equity and equity derivatives products Each chapter focuses

on a particular product or service (with the exception of Chapter 11, whichsummarizes several) and the ordering has been deliberately structured as aprogression from simple to more complex products The material can bedivided into four sections, each of which centers on a particular concept:

1 Single Stocks: The first section (Chapter 3) focuses on the “cash”

mar-ket for single stocks and provides a considerable amount of detailabout market conventions and the relationship between salespeople andtraders, much of which is directly applicable to the trading in otherproducts

2 Multiple-Stock Products: The next three chapters look at equity

prod-ucts that incorporate multiple underlying stocks This includes equityindices (Chapter 4), program trading (Chapter 5), and exchange tradedfunds, or ETFs (Chapter 6)

3 One-Delta Derivatives: In this section, we encounter our first true

deri-vatives, but restrict our focus to those that directly replicate exposure

to the underlier (so called, one-delta derivatives): forwards and futuresare covered in Chapter 7, and equity swaps in Chapter 8

4 Derivatives with Variable Delta: In the last section (Chapters 9 and 10),

we look at options, which have a varying sensitivity to the movements

of the underlying stock (delta not equal to one)

The final chapter of Part Two is Chapter 11, which contains an overview

of the various other groups that are either on, or interact with, the tradingfloor, and the services they offer

P a r t T h r e e : E c o n o m i c s

In the last section, we look at the interrelationships between economic data,market movements, and investor behavior from the point of view of thetrader Chapter 12 presents an overview of the structure of the economy andintroduces some of the important terminology and concepts from macroeco-nomics This then allows us to focus in Chapter 13 on what are some of themost important, market-moving data announcements—the daily economicdata releases We present an overview of all the major U.S releases, theirsource, and what they tell us about the economy and an analysis of some

of the factors that determine the market’s reaction to these announcements

We then present a brief overview of the most salient data points for the rest

of the globe We end the chapter by reversing the direction of the inference

to look at how certain market indicators can provide useful insights into thecurrent state of the economy

Note: Throughout the text I use the terms investment bank and broker-dealer

to refer to the financial services firms that provide equity and equity tive sales and trading services to clients In light of the sweeping changes inthe industry that occurred in the latter part of 2008, many of these compa-nies should be properly called “banks.” Readers should interpret the words

deriva-“investment bank” and “broker-dealer” as referring to those parts of banksthat provide these services

AN IMPORTANT CLARIFICATION: The contents of this book

rep-resent my own views of generally accepted market practices in thepricing, trading, and risk management of a variety of equity and eq-uity derivative products, in the context of the institutional client’sbusiness The information is a blend of objectively verifiable facts andsubjective opinions that, while undoubtedly influenced by my profes-sional experience, are entirely my own and should not be interpreted

as representing the policies or practices of any of my employers, past

or present

I welcome any questions, comments, or feedback on the book Readerscan contact me at matthew.tagliani@gmail.com

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A Comment on the Events of 2008

The changes that have occurred in the global financial markets while thisbook was being written were unlike anything experienced since the GreatDepression The loss of confidence triggered by the deflation of a speculativehousing bubble brought the market for short-term lending to a standstill,jeopardizing the solvency of financial institutions globally Governmentsand central banks around the world took unprecedented actions includingbailouts, nationalizations, and stimulus packages worth trillions of dollars.The consequences of these interventions will not be fully understood orappreciated for many years

This uncertainty has raised many questions about the future of thefinancial services industry with gloom-and-doom prognostications of the end

of Wall Street While perhaps representative of the sentiment of the moment,these concerns are greatly exaggerated The painful lessons learned aboutcredit risk, leverage, and speculation will undoubtedly change the industry,but the recent market conditions are no more an indication of the end

of financial services than the imploding of the technology bubble in 2000spelled the end of the Internet The industry will evolve and improve, butthe trading, pricing, and risk management of the products described in thisbook will remain largely the same

MATTHEWTAGLIANI, CFA

November 2008

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There are countless individuals who have assisted me throughout my reer and to whom I hold tremendous gratitude While they have not beendirectly involved in the making of this book, which has been a rather soli-tary effort, they have helped to make it possible either by directly enhancing

ca-my understanding of the business or simply making the environment where

I have worked and learned more enjoyable Particular thanks go to GeoffCraig, Sam Kellie-Smith, David Russell, Craig Verdon, and Ben Walker,who provide me with my current opportunities to continue developing pro-fessionally, and to Guy Weyns, who kindly reviewed several chapters andmade many helpful recommendations Special thanks also go to Bill Geraceand Bill Leonard, who were instrumental in the development of my criticalthinking skills

I am greatly indebted to all the people at John Wiley & Sons whomade this book possible, particularly Bill Falloon, Stacey Fischkelta, EmilieHerman, Joan O’Neil, Todd Tedesco, and Laura Walsh

The writing of this book consumed most of my evenings, weekends,vacation time, and holidays over a period of slightly more than two years—the time and effort required to bring it to completion having far exceededany of my initial estimates, which I now see were wildly overoptimistic That

I should, for so long, voluntarily sacrifice what little free time I am affordedoutside of my day-to-day work as a trader to pursue this project could beconsidered somewhat deranged, certainly masochistic and, at the very least,

a bit imbalanced

However, that my wife Nati should not only tolerate such an extendedperiod of my virtual nonexistence, but actively encourage, support, andmotivate me along the way is simply beyond explanation While I spent mytime reclused in intellectual La-La Land, she brilliantly managed the veryreal-world responsibilities of raising a family and managing a home, whilekeeping me free from the distracting realities of daily life This was no smallfeat, considering that between starting and finishing this book, we relocated

to the United Kingdom and added a second child to our family roster.Hers has been a truly superhuman effort which, quite frankly, I haven’t thevaguest idea how to repay

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I must also thank my daughter Sof´ıa, who has accepted lame “Daddycan’t play, he has to work.” excuses on far too many sunny Saturday after-noons and yet somehow has still not given up on me, and my son Cosmo,who had the bad luck of arriving just as I immersed myself in the final intensepush to complete this book You have both given me far more than I everhad the right to ask of you.

PART One What Is a Stock?

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CHAPTER 1 Equity Fundamentals (Part 1)

Introduction to Financial Statements

I N T R O D U C T I O N

In this chapter and the next we lay out a general framework for answeringthe most fundamental question for anyone working in equities or equityderivatives: “What is a share of stock and how much is it worth?” The goal

is to develop sufficient understanding of the relevant concepts and nology from financial accounting to ensure that the reader can understand,participate in, and benefit from, the sort of general stock analysis and valu-ation discussions that are held on a trading floor

termi-The presentation of the material is deliberately of a general character—the focus is on developing a clear conceptual understanding without gettingbogged down in the details that, while essential to the work of an equityresearch analyst, are unnecessary for our purposes Readers interested in amore detailed presentation can consult any of the many well-written booksavailable on equity analysis or financial accounting

It is worth clarifying that while the material in the first two chapters isbasic, that does not mean it is easy Readers with no previous exposure tofinancial accounting or valuation may find the writing rather dense—many

of new concepts are introduced in a small number of pages Because thematerial is conceptually fundamental, it is presented at the beginning of thebook It is not, however, a prerequisite for understanding the contents ofsubsequent chapters and readers who find this first section challenging canjump straight to Chapter 3 and come back to these first two chapters either

as a reference or for more careful study at a later time

3

E Q U I T Y A N D C O R P O R A T I O N

By definition, a share of stock is a unit of ownership in a corporation This

definition does not help us much unless we understand what a corporation

is.1A corporation is actually a rather curious concept: It is an independent

legal entity, with its own rights and responsibilities, but distinctly dent from the people who run and own it In many ways a newly establishedcorporation is like a new citizen born into the state in which it is incorpo-rated Like people, corporations have rights and responsibilities, and can beheld legally liable for their actions Whether the question is over the pur-chase of a piece of property, the payment of a tax, or the pollution of a river,the answers “Archibald Gricklegrass did it” or “XYZ Incorporated did it,”while not identical, are similarly valid

indepen-Although businesses may adopt any one of many different legal tures, there are two very important characteristics of corporations that make

struc-it by far the most popular option The first is that a corporation can be

di-vided into fractional units (shares) that can be owned by multiple parties

and purchased or sold freely between them These shares give ownership

of the “equity” in the corporation—that is, the benefits that remain afterpaying off all debts, taxes, and other obligations, both now and for theindefinite future They also give the holders a fractional say in the decisions

of the corporation (voting rights) The holder of even one share of stock

has the right to attend the annual shareholders’ meeting and ask whateverquestions they choose of the management and, if enough other sharehold-ers agree, to replace the management or even dissolve the corporation andliquidate its assets It is, in the truest sense, ownership of the corporation

in fractional percentage with the number of shares held and the number ofshares outstanding

The second important concept is that the fractional owners—the

shareholders—have limited liability in the event of financial or legal

chal-lenge to the corporation While the holder of a share of stock is, in fact,

a partial owner of the company, the most that he or she can lose in theevent the company were sued or faced financial hardship is the value ofthe stock he holds This makes stock ownership a remarkable concept: theholder of stock gets all the benefits of owning the company with no morerisk than the invested capital Once a stock’s price has gone to zero, there isnothing more that can be done to reclaim additional responsibility from the

shareholder—a stock price can never go below zero Were this not the case,

stock ownership would be significantly more risky and trading on the stockmarket would be considerably less active as investors would have to assessmuch more carefully the potential risks of association with the activities andmanagement of the company in question

While the owners of the corporation are actually the shareholders, theactual day-to-day running of the business is left in the hands of the officers

of the corporation (from the President on down) whose actions are thensupervised by an executive board whose job it is to insure that the actions

of the corporation are in the best interest of the shareholders

I N T R O D U C T I O N T O F I N A N C I A L S T A T E M E N T S

For a potential investor to make an informed decision as to whether topurchase shares of a company, he or she needs some information about itsinternal operation and financial status What does the company own? Whatdoes it owe to others? How much money is it making? How is it usingthat money? In the United States, publicly traded companies are required topublish, and make available to investors, a quarterly report summarizing allthe financial details of the company To ensure that this report is accurateand understandable to investors and can be compared with the equivalent

disclosures by other firms, there is a set of generally accepted accounting principles (GAAP) that specify the definitions and conventions that must

be adhered to in presenting the information Because these quarterly lic disclosures are generally the only information the public has about theinternal operations of the company, they must be verified by an externalindependent auditor who verifies that the information is accurate and thatthere is no attempt by the management to deceive investors by manipulatingthe data

pub-There are three statements that provide the majority of the information

in the quarterly financial disclosures, which we will examine in more detailhere:

1 Balance sheet: Summarizes the assets (things owned) and liabilities

(things owed) of the company and how they are financed through amixture of debt (borrowed money) and equity (funds contributed bythe shareholder owners)

2 Income statement: Summarizes the revenue, expenses, and resulting

in-come in the period

3 Statement of cash flows: Summarizes the sources and uses of cash.

In this chapter, samples of each of these three financial statements are sented, along with definitions and explanations of their contents

pre-Because all publicly traded companies in the United States must adhere

to GAAP, the structure of the financial statements, and the definitions ofthe various components are deliberately general This “one size fits all”

approach facilitates the comparison of different companies but in doing so,removes a great deal of important detail In practice, companies usuallyprovide many clarifications and additional insights through footnotes to thestatements and supplementary disclosures.

To maximize the comprehension and retention of the material, I wouldstrongly recommend that readers choose a simple small business with whichthey feel comfortable and think about what the definition of each new con-cept would mean in this specific context (Personally, I find a bakery aparticularly useful example.) I have deliberately not provided my own ex-ample because it is the act of thinking about the meaning of each conceptand applying it to the tangible example that actually leads to understandingand retention Readers who make the effort should find that these first twochapters provide sufficient foundation in financial accounting and funda-mental analysis (the subject of the next chapter) to be able to understand atypical analyst’s research report or discuss investment ideas with coworkers

T H E B A L A N C E S H E E T

The balance sheet summarizes the assets and liabilities of the company at

the time of publication Unlike the income statement and statement of cashflows, the balance sheet is a freeze-frame snapshot of the company, ratherthan an analysis of the performance over the period The changes in the mix

of assets and liabilities of the company can be seen by comparing the currentcomposition of the balance sheet with that of previous periods While thesechanges are not explicitly shown on the balance sheet, the previous quarterand one-year ago data are usually presented alongside for comparison.The contents of a sample balance sheet for a hypothetical company,XYZ Inc., are shown in Exhibit 1.1 While our example is deliberatelysimple, the structure and layout of the balance sheet of even a large multi-national corporation would be quite similar (which emphasizes the need foradditional disclosures) To make the example as clear as possible, the format-ting and notation are somewhat nonstandard and the potentially distractingprevious period values have been excluded

gener-BALANCE SHEET (Figures in $mm)

LIABILITIES & SHAREHOLDERS’ EQUITY ASSETS

Current Assets Current Liabilities

Cash and Mktable Securities $2,400 Accounts Payable $2,100 Accounts Receivable $1,750 Short Term Financing (Notes Payable)

$7,350 Inventory + Current Portion of Long-Term Debt $4,750

Total Current Assets $11,500 Total Current Liabilities $6,850

Long-Term Assets (Fixed Assets) Long Term Debt

Plant, Property, and Equipment $37,200 Long-Term Financing (Bonds Payable) $36,350 Long Term Investments $26,600 Deferred Income Tax Liability $6,400 Intangible Assets $5,350 Total Long-Term Debt $42,750

$4,200 Goodwill

Shareholders' Equity

Common Shareholders' Equity Retained Earnings $21,650 Paid-in Capital $10,500 Less: Treasury stock ($900)

TOTAL SHAREHOLDERS' EQUITY $33,750 TOTAL LIABILITIES

+ SHAREHOLDERS’ EQUITY

$84,850

E X H I B I T 1 1 Balance Sheet for XYZ Inc

acquired in the past that require economic sacrifices in the future The ference between the assets and liabilities of the company is what is left over

dif-for the owners (shareholders) of the company This is called shareholders’ equity This leads us to one of the fundamental identities of accounting:

Assets= Liabilities + Shareholders’ equityThat is, the things a company has (assets) are either paid for with borrowedmoney (liabilities) or belong to the owners (shareholders’ equity) This iden-tity means that the sum of the items on each side of the balance sheet must

be the same—that’s why it’s called the “balance” sheet

In order for the two sides of the balance sheet to remain equal, theassets and liabilities of the company must be recorded using a process called

double-entry bookkeeping A single item cannot be added to the balance

sheet in isolation—there must always be an equal and offsetting adjustmentsomewhere else to keep things balanced This offsetting entry can be anequivalent addition to the other side of the balance sheet, or a reduction inanother item on the same side

This is best illustrated by an example Consider a brand new companythat has yet to begin operation and whose only asset is $1,000 of cashinvested by the founders The company’s balance sheet looks quite simple:

man-
Pay with cash: Two equal and offsetting adjustments are made to the

left-hand side of the balance sheet The Equipment line is increased by

$600 while the Cash line is reduced by an equivalent amount The assets

of the company have simply changed shape from cash to machines

Pay with borrowed funds: If the machine is purchased with borrowed

funds (credit), then the offsetting adjustment to the addition of $600

to the equipment line on the left-hand side would be an increase in theliabilities of the company (the borrowed funds) on the right-hand side.This has the additional effect of increasing the total size of the balancesheet from $1,000 on each side to $1,600 (The balance sheet is now

leveraged by the addition of borrowed funds.)

Owners contribute more capital: The third option is that the

own-ers of the company contribute additional capital to pay for the chine In this case, the offsetting adjustment to the $600 addition to theequipment line is an addition of $600 to the shareholders’ equity Thebalance sheet increases in size from $1,000 to $1,600 but there is noleverage

to whom it belongs (the owners of the company or the creditors)

Of the four items in this very simple balance sheet, three can be jectively measured: the cash holdings, the value of the equipment, and theamount of money the company owes Shareholders’ equity is effectivelydefined as everything that is left over Suppose, for example, that duringinstallation the newly purchased machinery is damaged and its value is re-duced from $600 to $400 The asset side of the balance sheet is now reduced

ob-by $200 and there must be an equal and offsetting adjustment to the hand side If the machine was paid for on credit, the debt does not changejust because the machine is worth less than before The only place where theloss of $200 on the asset side can be reflected is in the shareholders’ equityline The owners of the company take the loss, not the creditors

right-In general, the shareholders’ equity line is calculated as a “plug.” That

is, once all the assets and liabilities have been added up, the shareholders’equity is defined to be whatever value makes the two sides of the balancesheet equal

B a l a n c e S h e e t C o n t e n t s

On both the asset and liability sides of the balance sheet, the contents are

categorized as either current, consisting of liquid assets and short-term bilities that will be used or paid off within one year, and long term, which

lia-includes everything else

L e f t - H a n d S i d e Beginning on the asset side of the balance sheet, some of

the standard items and their definitions are presented here (Note: Not all

items are included in the sample balance sheet in Exhibit 1.1.)

Current Assets

Cash and marketable securities: Liquid short-term bank deposits and

securities tradable in the market such as bonds or stocks (Things thateither are cash or could become cash quickly.)

Accounts receivable: Money owed to the company for products or

ser-vices that have been delivered but for which the company has not yetreceived payment

Inventory: Completed items ready for sale as well as the raw materials

for production

Prepaid expenses: Cash that is “stored” in the form of prepayment of

future obligations

Long-Term Assets (also called Fixed Assets)

Plant, property and equipment: The physical resources used in the

run-ning of the business

Long-term investments: Assets owned by the company that are not

directly related to the functioning of the business (e.g., a piece of unusedland)

Intangible assets: Money paid by the company for rights, patents,

trade-marks, and the like, which can produce value but do not have a physicalpresence

One particular intangible asset that is often given its own line on the

balance sheet is goodwill This is a slightly slippery accounting concept that

requires a bit of explaining

We first need to introduce the concept of book value This is the

sim-plest measure of the value of a company and is computed as the sum of thecompany’s assets less its liabilities The book value is the accounting-basedmeasure of what the company is worth Because of the way in which ac-counting standards require certain items to be recognized on the balance

sheet, the book value is very different from the liquidation value of the

com-pany, which uses the market value of all assets and liabilities to determinewhat would be left if an investor bought the company, broke it up, and soldoff all the buildings, inventory, and other “stuff” and paid off all the bills

In reality, however, the market value of a company, as determined by thetotal value of all outstanding shares, is many times (i.e., 10 to 20 times)both its book value and its liquidation value The reason for this is becausethe benefit of owning shares of a company is not just the ownership ofthe equipment, inventory, and other “stuff,” but the right to a proportionalshare of all the benefits that can be produced with those assets for the life ofthe company

The concept of goodwill arises when one company acquires another formore than its book value Let us assume Company X pays $10 billion in

cash to acquire Company Y, which has $8 billion in assets and $5 billion inliabilities, for a book value of $3 billion When Company X recognizes thepurchase of Company Y on its balance sheet it will reflect both the cost—adecrease in cash assets of $10 billion—as well as what it has acquired forthat price: $8 billion in assets and $5 billion in liabilities The net effect will

be a decrease in assets of $2 billion and an increase in liabilities of $5 billionfor a net “loss” of $7 billion in shareholders’ equity

The problem is that the balance sheet knows nothing about the futureeconomic opportunity presented by the ownership of Company Y; it justsees a $10 billion price tag on $3 billion of book value, which results in

a $7 billion loss To correct for this, a $7 billion intangible asset called

“goodwill” is added to the asset side of the balance sheet Goodwill is theaccounting convention used to recognize the intangible benefit of owningall the future earnings that will be produced by Company Y The standardaccounting convention is that the value of the goodwill is retained on thebalance sheet indefinitely but must be periodically tested by an auditor Ifthe value of the goodwill—the present value of all the benefits of owning the

acquired assets—is judged to have decreased, then a goodwill impairment

is recognized, in which the value of the goodwill is written down to itscurrent value

R i g h t - H a n d S i d e ( T o p ) The right-hand side of the balance sheet is dividedinto two parts: current and long-term liabilities on the top, followed by thedetails of the shareholders’ equity Standard classifications of liabilities andtheir definitions are as follows:

Current Liabilities

Short-term financing: Notes payable, lines of credit, and other

short-term debt obligations to be paid off within a year

Accounts payable: Money owed by the company for products or services

that have already been received but for which it has not yet paid

Current portion of long-term debt: The portion of long-term debt

obli-gations that is payable in the current period

Long-Term Liabilities

Long-term debt: Any long-term debt obligation of the company For

a smaller firm, this is likely to consist mostly of bank loans while for

a larger company it can also include bonds and other debt obligationsissued by the company itself

Deferred income tax liability: The method by which revenue and

ex-penses are accounted for under GAAP is very different from what isrequired by the Internal Revenue Service (IRS) As a result, companieswill usually show a larger profit on their accounting statements (where

it looks good) than on their income tax statements (where it means ahigher tax bill) The difference between the two represents revenue thathas not yet been taxed, but will be at some point The deferred taxliability indicates the pending IRS bill that will need to be paid whenthis happens.

Deferred pension obligations: This is the present value of the expected

future cost of the retirement benefits the firm has committed to provide

to its employees

Another liability that often appears on the balance sheet is something

called minority interest This entry appears on the balance sheet of a parent

company that does not own 100 percent of one of its subsidiaries When acompany acquires a sufficiently large portion of another company (usuallymore than 50 percent), the full assets and liabilities of the acquired com-pany are listed on the balance sheet of the acquiring (parent) company Anaccounting adjustment is then necessary on the liabilities side since there is

a portion of the subsidiary that is not owned by the parent

As an example, assume that Company B has a book value of $100consisting of $100 in assets and no debt and that Company A is able topurchase an 85 percent stake in Company B for $85 Because it owns a

controlling stake, Company A will now add all the assets of Company B

to its balance sheet The purchase price for 85 percent of the company isequal to 85 percent of the book value so there is no goodwill adjustment

to be made However, when the full assets and liabilities of Company B aretaken onto Company A’s balance sheet, there will be a net increase of $15

in assets as the $100 of assets of Company B is added and the $85 reduction

in cash is recognized The imbalance comes from the fact that 100 percent

of Company B has been added to the balance sheet but only 85 percenthas been purchased Company A would then recognize a $15 liability forminority interest to adjust for the 15 percent of the company that is stillowned by the previous owners

R i g h t - H a n d S i d e ( B o t t o m ) The last section of the balance sheet contains thedecomposition of shareholders’ equity Given the total assets and liabilities ofthe company, we already know what the total value of shareholders’ equitymust be, simply by rearranging the fundamental accounting relationshipstated at the start of the section:

Shareholders’ equity= Assets − Liabilities

In general terms, the shareholders’ equity can come from two sources:either the money was put into the company by the owners or the company

earned the money from its business activities but has not yet paid it out tothe owners These two forms of shareholders’ equity appear on the balancesheet as follows:

1 Paid-in capital: This represents the money paid by investors in return for

fractional ownership of the benefits of the company, through ownership

of common shares, either purchased in an initial public offering or asecondary share issuance If a company issues 1 million shares of stockand sells them in an initial public offering (IPO) at $25 each, then thecompany will have $25 million of common equity

2 Retained earnings: Profits earned by the company that have not been

distributed to the shareholders via dividends are recognized on the ance sheet as retained earnings This entry is not actually calculated inthe preparation of the balance sheet but is the “plug” value whose value

bal-is determined by the difference between the assets, liabilities, and theother elements of shareholders’ equity whose value can be objectivelydetermined

Companies will sometimes repurchase their shares in the open market.When this occurs, the repurchased shares are represented on the balance

sheet as treasury stock in the statement of shareholders’ equity The value

assigned is the repurchase price of the shares and carries a negative sign asthey are effectively an offset to the paid-in capital (they were sold and thenbought back) These shares no longer represent an actual obligation sincethey are held by the company itself and not outside investors

The sum of paid-in capital and retained earnings, less treasury stock, is

the common shareholders’ equity In addition to common stock, some firms will also issue shares of preferred stock This is a special type of non-voting

stock that has priority over common shares in the event of a bankruptcyand liquidation of the company’s assets Preferred shares usually carry afixed dividend that must be paid before any dividends are paid out onthe common stock Preferred dividends are similar to interest payments ondebt but with the important caveat that, should the firm be unable to paythe dividend, this does not force it into bankruptcy—the dividend obligationsimply accumulates and must be paid out in the next period While preferredstock is, in many ways, more like a bond, it is recognized as an equityissuance and therefore shows up under the shareholders’ equity rather than

as part of long-term debt The book value of preferred stocks is added tocommon shareholders’ equity to arrive at the total value of shareholders’equity

Some companies will provide an additional document called the ment of Shareholders’ Equity, which provides more complete detail of

State-the composition of State-the shareholders’ equity than what is shown on State-thebalance sheet.

While it is not recognized as part of the shareholders’ equity, a minorityinterest is technically a source of equity funding—it offsets the portion ofthe assets of the acquired company that are not owned by the parent but

does not represent a debt obligation The total equity of a firm is the sum

of shareholders’ equity and minority interest and can be thought of as theportion of the asset side of the balance sheet that can be associated to owners

of the firm (parent and acquired subsidiaries), rather than creditors

Total equity= Shareholders’ equity + Minority interest

C a p i t a l

A firm’s capital consists of the financial resources at its disposal that can

be applied to the production of the goods or services it offers There aretwo common definitions of capital derived from the balance sheet The first

of these is working capital, which measures the short-term liquidity of the

company and is equal to the difference between the current assets and currentliabilities A company must maintain an adequate buffer of working capital

to guarantee that current assets are enough to cover short-term liabilities andavoid an interruption in operations due to an inability to make payments onits obligations This underscores the significance of “current,” as it appliesboth to assets (they should be liquid and readily convertible into cash) andliabilities (anything that is coming due in the near term, including the currentportion of long-term debt)

Working capital= Current assets − Current liabilities

A broader measurement of the resources a company has at its disposal

is total capital, which is composed of all borrowed funds (short- and

long-term) and cash supplied by the owners (shareholders’ equity) The only itemfrom the right-hand side of the balance sheet that is not included is MinorityInterest, which is an accounting entry and does not represent an actualsource of funds

Total capital= Current liabilities + Long-term debt

+ Shareholders’ equity