A Powerful Stock Price Predictor

Exhaustive research shows that profit and revenue don’t actually predict stock price, but some other, little-used metrics do.

CFO.com:
David McCann

A new study provides perhaps the strongest evidence to date that certain human-capital metrics can predict a company’s performance in the stock markets.

The research was nothing if not robust. Through extensive use of regression analysis, it tested the relationships between a set of human-capital metrics and stock-price movements at 22,100 companies over a 16-year period, 1996 through 2011.

Graziadio School of Business and Management (Photo credit: Wikipedia)

A key finding of the study – performed by Jeff Higgins, CEO of the Human Capital Management Institute, and Pepperdine University professor Donald Atwater – may surprise investors, stock analysts and finance executives themselves.

Generally speaking, a company’s net income and to a lesser extent revenue are considered the gold standards for shaping expectations of its stock’s future performance. ... In fact, both are statistically insignificant, as is pure net profit without association with any human-capital metrics.

Instead, two metrics used by some human-capital analysts, ... are powerful predictors of stock price, the research found. One, called “Return on Human Capital Investment” (Return on HCI), compares “Total Cost of Workforce” (TCOW) to net operating profit. (TCOW includes: all direct and indirect cash or equity compensation for employees and contingent workers; paid employee benefits, perks and rewards; retirement-related costs for both current and former employees; and costs for worker training, recruiting, employee relations, and severance and legal settlements.)

The other highly predictive metric is “Human Capital ROI Ratio.” It measures the ratio of return on revenue (net of non-workforce expenses) to TCOW. For example, say a company has $1 billion in revenue and $800 million in total expenses, $500 million of which are people costs. To arrive at HC ROI ratio, subtract the $300 million nonpeople costs from revenue, leaving $700 million, and divide that by the $500 million in people costs.

English: Human Capital Investment Model!! (Photo credit: Wikipedia)

In essence, the two metrics are different ways of measuring the percentage return on $1 invested in the work force, assuming all other factors remain constant. In the above example for Human Capital ROI Ratio, the result is expressed as 1.40, or a 40-cents positive return on the invested dollar. ...

“Everyone thinks net profit drives stock price,” says Higgins, a former CFO, “and in my old finance world I thought so too. But what really drives stock price is productivity. Some might say Return on HCI and Human Capital ROI Ratio are synthetic profit metrics, but we see them as productivity metrics – the return on people’s productivity. And when those numbers improve, your stock price jumps.”...

On average, given a 10 percent gain in the three most predictive human-capital metrics – Return on HCI, Human Capital ROI Ratio and TCOW as a percentage of operating expense – stock price jumped by 5.73 percent. By comparison, a 10 percent boost in net income was associated with a stock-price increase of just 0.8 percent. ...

Good performance in profit or revenue per FTE can actually mask otherwise dismal results. For example, the investment banking subsector of the financial services and insurance sector saw median revenue per FTE climb by 21.8 percent over the study period. But median Human Capital ROI Ratio dropped by 29 percent while TCOW ballooned by 47.5 percent, negatively affecting investment banks’ share prices.

Those results, says Higgins – who got his start in the human-capital-management field when he left his finance career to take a job running compensation at IndyMac Bank – portray fewer and fewer high-earning employees getting paid an ever-larger share of industry revenue. It calls into question whether investment-bank shareholders have been properly rewarded for their investments, he notes.

Clearly, there are many reasons behind the rise and fall of stock prices, including macroeconomic ones not under a company’s control. In addition to net income for each company, variables controlled for by regression analyses included real gross domestic product, bank prime loan rate, actual vs. natural unemployment rate, producer price index, consumer price index, industrial production index and S&P 500 index. The study found that even after controlling for those variables, human-capital metrics had significant predictive capability.

But even better was a model employing those factors plus the three most predictive human-capital metrics mentioned above. The model explained from 35% to 64% of movements in stock price, depending on industry sector, according to the study report.

Net profit by itself, without a connection to any human-capital metrics, explained only 1 percent of stock-price movements, the authors wrote.

“If there is an actual statistical or causal link [showing that] human-capital investments do indeed positively impact financial outcomes, then it forms the foundation for ROI-based business cases for [such investments],” the study report states. ...

The idea that human-capital metrics are linked with performance in the equity markets is not new. Groundbreaking research showing a link between training expenditures and stock price was done in the 1990s, and later updated to include additional such links, by Laurie Bassi, a labor economist who is CEO of consulting firm McBassi & Co. Other leaders in the field have included Jac Fitz-enz and Nick Bontis (Fitz-enz actually invented the Human Capital ROI Ratio metric).

Bassi, a registered investment advisor, since 2001 has been operating a fund, populated with stocks of companies known to be leaders in the field of human-capital management, that has significantly outperformed the S&P 500 index.

'via Blog this'

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Dead Money

Cash has been piling up on companies’ balance sheets since before the crisis.

CFO.com (http://s.tt/1s892)
Economist Staff


...  In America, third-quarter profits and revenues for companies in the S&P 500 index appear to have fallen year on year for the first time since 2009, according to Thomson Reuters. Profits for roughly half the firms in the European Stoxx 600 have fallen short of expectations so far.

...  The four worries unnerving business are: the euro-zone crisis; upheaval in the Middle East; a possible recession in China; and America’s economic health and “fiscal cliff”—the combination of tax increases and spending cuts scheduled to occur at the end of this year.

.

Net Income (Photo credit: Wikipedia)

.. Investment has steadily risen since the recession ended, but not as vigorously as profits. In America, ... nominal capital expenditure this year (on an annualised basis) has risen by 6% compared with 2007; internal cash flow is up by 32%. ... Firms in the S&P 500 held roughly $900 billion of cash at the end of June, according to Thomson Reuters, down a bit from a year earlier but still 40% up on 2008.

... Japanese companies’ liquid assets have soared by around 75% since 2007, to $2.8 trillion, according to

buried cash (Photo credit: rick)

ISI Group, a broker. Cash stockpiles have continued to grow in Britain and Canada, too, ... “Dead money” is how Mark Carney, the Bank of Canada’s governor, has described the nearly $300 billion in cash Canadian companies now hold, 25% more than in 2008. Mr Carney admonished them to “put money to work and if they can’t think of what to do with it, they should give it back to their shareholders.”

No single factor seems to explain companies’ high savings. The Bank of England notes that natural-resource companies account for a disproportionate share of the cash build-up. That may reflect the boom in commodities prices and the paucity of promising new sources of supply.

Low interest rates have reduced borrowing costs, adding roughly a percentage point to American profit margins, according to BCA Research. ... The financial crisis has made firms more skittish about relying on banks or securities markets for funds. ...

A rapid reversal is unlikely. That’s because rising corporate saving has deeper roots than the crisis, the commodities boom or this interest-rate cycle. In a recent study Loukas Karabarbounis and Brent Neiman at the University of Chicago found that across 51 countries they examined between 1975 and 2007, companies’ share of private saving rose in aggregate by 20 percentage points. In countries where corporate saving rose, labour’s share of GDP in the corporate sector shrank, by five percentage points in aggregate.

Mr Karabarbounis and Mr Neiman link both rising corporate saving and labour’s shrinking share of GDP to a fall in the relative price of investment goods that began in the early 1980s. That drop may be down to the plunging cost of computing, or to the shift in capital-goods production towards lower-wage developing countries, or both.

Whatever the reason, firms have responded by substituting away from labour and towards capital, and by more than textbook economic models imply. And to finance this investment companies have steadily boosted saving over time. ...

The authors do not have comparable data for all 51 countries since 2007. But they do have numbers for the four largest economies (see chart). The data there show that the corporate share of private savings has since dipped a bit, in part because household savings have risen, although it remains high in absolute terms. (Labour’s share of GDP has stabilised at a low level.)

The urge to save may be lessening. Japanese firms, with few growth prospects at home, have been making foreign deals. Marc Zenner of JPMorgan Chase notes that in the past 18 months firms that announce acquisitions have been rewarded with higher share prices.

Yet even if they are loosening the purse strings a bit, companies are unlikely to abandon their frugal ways in the near future. Falling corporate-tax rates have increased the appeal of capital over labour; heightened uncertainty and capricious funding markets seem a recurring part of the landscape. That should make firms all the more determined to fund growth internally. Between now and 2016, GE expects to generate $100 billion in cash, enough to finance investment, acquisitions and dividends, and to buy back enough stock that shares outstanding will be lower than before the crisis. Asked recently if GE was tempted to spend more of its cash pile on acquisitions, Jeffrey Immelt, the chief executive, replied: “It’s not burning a hole in our pocket.”

© The Economist Newspaper Limited, London (November 3, 2013)

Bank Loans Driving Business Credit Expansion

The bulk of business capital needs are being met by bank balance sheets, as opposed to shadow banking firms or capital markets investors. Is that a good thing?

CFO Magazine
Vincent Ryan

After ceding a lot of corporate financing to shadow banking firms and capital-markets investors prior to the financial crisis, banks are driving corporate credit markets again, financing the bulk of credit expansion with their own balance sheets.




English: Components of the liability side of the Federal Reserve System balance sheet using statistical release dates from January 4, 2007 to Arpil 2, 2009. This is the liabilities of all 12 Federal Reserve Banks combined as reported by the Federal Reserve. This image was created using openoffice.org Calc spreadsheet program. See table below for source data. The data was obtained from: http://www.federalreserve.gov/releases/h41/ (Photo credit: Wikipedia)

The total volume of bank loans of all types increased at a 3.3% annual rate in the second quarter, according to the Federal Reserve, …a continuing trend since the fourth quarter of 2011. And the third quarter is off to a good start, with lending activity at U.S. commercial banks expanding by …13% annualized, in the week ended July 4.

In addition, commercial and industrial loans on U.S. banks’ balance sheets grew 12% in the second quarter, after an 11% rise in the first quarter, according to Fed data, and dollar volume on banks’ books was at its highest level in two years. Bank credit growth is skewed toward business lending, according to a recent equity research report from analysts at investment bank Keefe, Bruyette & Woods. “Businesses have begun to increase leverage to take advantage of low interest rates,” the report points out.

This trend is mostly positive, but is having so much of capital creation dependent on banks’ balance sheets good for business borrowers or for the U.S. economy?



English: Components of the asset side of the Federal Reserve System balance sheet using statistical release dates from January 4, 2007 to Arpil 2, 2009. This is the assets of all 12 Federal Reserve Banks combined as reported by the Federal Reserve. This image was created using openoffice.org Calc spreadsheet program. See table below for source data. The data was obtained from: http://www.federalreserve.gov/releases/h41/ (Photo credit: Wikipedia)

 

As banks are ascendant, capital markets are pulling back. Recent flow-of-funds data from the Federal Reserve show that the debt outstanding in the asset-backed securities market, for example, fell to $1.9 trillion, from $2.2 trillion a year ago and $3.3 trillion in 2009. There is still no securitization market for most private-sector loans, say KBW analysts, who see “a continued decline in the ABS market for the foreseeable future.”




Logo of the Securities Industry and Financial Markets Association. (Photo credit: Wikipedia)

Meanwhile, U.S. corporate securities issuance is down in a number of categories year to date, according to the Securities Industry and Financial Markets Association: … Straight corporate debt issues are flat with last year on a dollar basis, as are initial public offerings….

Even venture-capital investments are down in 2012, according to the MoneyTree report from Pricewaterhouse Coopers and the National Venture Capital Association. VC funds invested $5.75 billion in 758 deals in the first quarter, a decline from $6.7 billion in 861 deals invested a year ago.

The problem with relying on banks for funding is that the markets are signaling that banks are not good credit risks.

U.S. and European banks’ credit default swap (CDS) spread averaged 19 basis points between 2004 and 2007, but since then the average has been 230 basis points, writes David Munves, a managing director at Moody’s Analytics, in a report published Tuesday. The average European and U.S. bank credit rating, as implied by CDS spreads, is “Ba1,” defined by Moody’s as a credit “judged to have speculative elements and subject to substantial credit risk.”

“Banks are a key part of the global economy, and higher and more volatile spreads limit their ability to attract capital and to fund themselves at reasonable levels,” says Munves.

Banks are also just generally riskier. “U.S. banks have higher risk profiles than before the financial crisis began, whether measured by credit spreads; equity prices; reputation, management and governance practices; or credit ratings,” Munves says.
A
nd JP Morgan’s trading losses and the LIBOR scandal have once again raised questions about the risk controls at large banks. This is occurring at a time when banks are having a tough time growing earnings and hitting return on equity targets, despite the boom in commercial and industrial lending.

The quality of commercial banks as counterparties is worrisome but not bad enough to make companies avoid having them as creditors. There are plenty of positive trends at commercial banks. Due to regulatory changes, banks’ capitalization ratios are rising, and the quality of their loan portfolios is improving, with loan delinquency and net charge-off levels falling across the board.

Though they may be a greater credit risk in the capital markets, the largest commercial banks also have plenty of low-cost funding from deposits with which to finance loan growth. In its second-quarter earnings report last week, Wells Fargo said its core deposits were up 9% from a year ago, and its deposit costs were 19 basis points, down 9 basis points from a year earlier.

On the other hand, it would be costly for a large commercial bank to raise equity capital in the current market climate. The average U.S. bank has a market-price-to-book value of 66%, compared with 171% in 2007, according to Moody’s Analytics. On the debt side, if banks’ ratings worsen, the cost of credit could become prohibitive also.

After their experience during the financial crisis, companies know how precarious bank funding can be. Many banks pulled back on lines of credit and reduced unfunded commitments drastically when they encountered pressures financing their own businesses. That is not a problem right now, but if the U.S. economy worsens and capital markets don’t revive, banks might turn off the business lending spigot once again. Companies should be careful not to rely too much on bank debt in their capital structure.

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Ten Laws Of The Modern World

Forbes.com
Rich Karlgaard, 04.19.05, 10:00 AM ET













Gordon Moore on a fishing trip (Photo credit: Wikipedia)

• Moore's Law. … This April marked the 40th anniversary of Gordon Moore's famous dictum. In 1965 Moore (he co-founded Intel three years later) noted that components on silicon chips were doubling every year. In 1975 he amended that to every two years. Today Moore's Law has transcended silicon chips. It has become a way of saying that all digital stuff, from PCs to cell phones to music players, get twice as good every 18 to 24 months--at the same price point. …

• The Back Side of Moore's Law. This one says that digital stuff gets 30% to 40% cheaper every year--at the same performance point. The back side of Moore's Law is why your $299 Treo 650 is as powerful as a $3,500 Compaq PC was in 1988. …




Moore's Law as applied to Intel processors, from the 4004 to the Pentium. (Photo credit: Wikipedia)

• Andy and Bill's Law. The origin of this was a funny one-liner told at computer conferences in the 1990s. It went like this: "What Andy giveth, Bill taketh away." It meant that every time Andy Grove--then chief executive of Intel (nasdaq: INTC - news - people )--brought a new chip to market, Bill Gates--then CEO of Microsoft (nasdaq: MSFT - news - people )--would upgrade his software and soak up the new chip's power. … Moore's Law constantly enables new software. Often the new software is just an incremental improvement. But every few years the world gets a wild breakthrough--graphic computing in the 1980s, Web browsers in the 1990s, fast search engines today. …

• Metcalfe's Law. This one's named after Robert Metcalfe, the inventor of the computer networking protocol Ethernet. Metcalfe said the usefulness of a network improves by the square of the number of nodes on the network. Translation: The Internet, like telephones, grows more valuable as more join in. …




Image via CrunchBase

• Gilder's Law: Winner's Waste. The futurist George Gilder wrote about this a few years ago in a Forbes publication. The best business models, he said, waste the era's cheapest resources in order to conserve the era's most expensive resources. When steam became cheaper than horses, the smartest businesses used steam and spared horses. Today the cheapest resources are computer power and bandwidth. Both are getting cheaper by the year (at the pace of Moore's Law). Google (nasdaq: GOOG - news - people ) is a successful business because it wastes computer power--it has some 120,000 servers powering its search engine--while it conserves its dearest resource, people. Google has fewer than 3,500 employees, yet it generates $5 billion in (current run rate) sales.




David Ricardo Français : David Ricardo Deutsch: David Ricardo (Photo credit: Wikipedia)

• Ricardo's Law. The more transparent an economy becomes, the more David Ricardo's 19th-century law of comparative advantage rules the day. … Which means if your firm's price-value proposition is lousy, too bad. The world knows.

• Wriston's Law. This is named after the late Walter Wriston, a giant of banking and finance. In his 1992 book, The Twilight of Sovereignty, Wriston predicted the rise of electronic networks and their chief effect. He said capital (meaning both money and ideas), when freed to travel at the speed of light, "will go where it is wanted, stay where it is well-treated...." By applying Wriston's Law of capital and talent flow, you can predict the fortunes of countries and companies.




Laffer Curve (Photo credit: Wikipedia)

• The Laffer Curve. In the 1970s the young economist Arthur Laffer proposed a wild idea. Cut taxes at the margin, on income and capital, and you'll get more tax revenue, not less. Laffer reasoned that lower taxes would beckon risk capital out of hiding. Businesses and people would become more productive. The pie would grow. Application of the Laffer Curve is why the United States boomed in the 1980s and 1990s, why India is rocking now and why eastern Europe will outperform western Europe.

• Drucker's Law. Odd as it seems, you will achieve the greatest results in business and career if you drop the word "achievement" from your vocabulary. Replace it with "contribution," says the great management guru Peter Drucker. Contribution puts the focus where it should be--on your customers, employees and shareholders.




Cover of Ogilvy on Advertising

• Ogilvy's Law. David Ogilvy gets my vote as the greatest advertising mind of the 20th century. The founder of Ogilvy & Mather--now part of WPP (nasdaq: WPPGY - news - people )--left a rich legacy of ideas in his books, my favorite being Ogilvy on Advertising. Ogilvy wrote that whenever someone was appointed to head an office of O&M, he would give the manager a Russian nesting doll. These dolls open in the middle to reveal a smaller doll, which opens in the middle to reveal a yet smaller doll...and so on. Inside the smallest doll would be a note from Ogilvy. It read: "If each of us hires people who are smaller than we are, we shall become a company of dwarfs. But if each of us hires people who are bigger than we are, we shall become a company of giants." Ogilvy knew in the 1950s that people make or break businesses. It was true then; it's truer today.

Related articles

• The Other Moore's Laws (neatorama.com)
• Intel: End of Moore's Law 'always 10 years away' (oregonlive.com)
• How Moore's Law Affects Wall St. Trading (dealbook.nytimes.com)

A Look at Obama's JOBS Act

The Network Journal:

By: ANN BROWN

Wednesday, April 25, 2012

• Business

On the surface, President's Obama's recently signed the JOBS Act, for Jump-Start Our Business Start-Ups, which will roll back restrictions on the way start-up companies can raise money from individual investors, seems like a win-win for small businesses. But says management, strategy and branding consultant Steven Mason, president of the Brand Mason, there is more to it.

"The JOBS Act is a boon to private companies, which drive job creation and the GDP. The most significant impact of the recently passed JOBS Act is that private companies will be able to raise money from individuals who are not "accredited". This means that investors who have not been considered wealthy enough by the SEC to be designated an accredited investor will now be able to make direct equity investments in private companies,” says Brian Hamilton, CEO of financial information company Sageworks and a noted expert on privately-held companies. “It would be hard to overstate the implications of this legislation as it allows small investors access to a market that previously didn't exist to them. Additionally, it gives private companies access to millions of dollars they couldn't previously tap into. It introduces some risk for a new class of investors, but it is very positive for private companies."

BEA logo (Photo credit: willida)

Small businesses can throw a wider net for investors, says Mason. "If you are good at getting hundreds of people to invest small amounts of money, you can potentially raise a large amount of money," he says. Potentially, the bill gives more freedom to startups—and investors. “Small investors can direct investments to their community,” explains  David M. Williams, founding director of professional consultant firm Business Enhancement Associates. “It allows small businesses to go public without SEC filing. It also exempts small businesses from Sarbanes-Oxley audit requirements for five years.”

Among other things, it would allow them to raise small sums from investors via the Internet. According to Obama,  websites will be closely monitored by the Securities and Exchange Commission. Some critics say this component of the bill may leave people vulnerable to fraudulent online schemes. “The abundance of online options for connecting unaccredited investors with private companies presents an inherent potential for fraud and misrepresentation and may draw in undiscerning investors,” notes Hamilton.

There are other cons, he points out. “Comparatively riskier investment opportunities will become available to unaccredited investors since new companies are always the least well known and many young companies fail,” he says. “As far as IPO investing is concerned, private conversations with the SEC about disclosures are not released immediately, and while the company may benefit, it's hard on investors seeking transparent information.”

Also, “crowd-funding platforms and this type of investing are so new that there is likely to be additional fraud. The risk factors of these investments should be made clear. Maximum amounts that individuals can invest based on their income is at a minimum now,” says Hamilton.

David M. Williams, founding director of professional consultant firm Business Enhancement Associates, agrees. “Crowdfunding investors would have no control in management decisions, and no guarantee that their interests would be represented. Small investors add liability, investors who would normally not be qualified or accredited. And the lack of SEC oversight or Sarbanes-Oxley guidelines make fraud or mismanagement more likely,” he says. There are other drawbacks to the bill he says. “It adds the burden of up to 200 shareholders to management used to closely-held ownership. It also complicates future equity raises, debt financing or recapitalization,” says Williams.

Among the other negatives, says Mason, are "you can raise a maximum of $1,000,000 in any 12-month period and individuals can't invest whatever they want. They are limited to investing percentages of their income and net worth and there's only so much they can invest in one year, across all crowdfunded companies." There are restrictions that may also hinder small businesses seeking funding under the new bill. "Funding Portals have to be registered with the SEC and the SEC hasn't even written all the regulations for them yet, so if the regulations are onerous enough, the entire point of this crowdfunding could be a chimera. Basically, the SEC and the government have the power to make this a complete boondoggle, because these Funding Portals are subject to so many restrictions that it's going to cost issuing companies real money just to comply," Mason points out. "There are significant accounting fees companies will have to incur, and if they are raising more than $500K, they'll need audited financial statements, which are very expensive."

Occupy the Jobs Act (Photo credit: DonkeyHotey)

Adds Mason, “What's happening is that a new surge of available capital will enter the market, making possible a far greater diversity of startups otherwise unable to get funding through other sources, at least in their early stage. At the same time, those funding these businesses will not be professional investors, and there are intriguing issues associated with their different expectations as well as with the ultimate success or failure of their endeavors. Last, while President Obama signed the bill, I would not characterize the bill as an "Obama policy" as the impetus for the main features of the bill did not come from the President. Further, the JOBS bill imposes a number of SEC reporting requirements on those seeking crowdsourced funding: it's not as easy as it sounds, but it certainly sounds great politically.”

The bill was supported by bipartisan lawmakers and entrepreneurs.

Related articles

• Crowdfunding. Who's In? Who's Not? (isellerfinance.wordpress.com)
• The Effect of the JOBS Act on Small Businesses and Investors (beamemphis.blogspot.com)
• More on the JOBS Act: Crowdfund Your Next Round (siliconbayounews.com)

The Effect of the JOBS Act on Small Businesses and Investors

Business Enhancement Associates AHA! Moments Blog
April 20, 2011
by David M. Williams

Job Act (Photo credit: Sasha Y. Kimel)

The Jumpstart Our Business Startups Act (JOBS Act) signed into law in early April is designed to create jobs by letting small companies raise capital without being required to meet all of the existing legislation. It allows a small company to offer public stock, to “go public” or make an Initial Public Offering, without having to file with the Securities and Exchange Commission. Allowing a small company to go public has broad implications for both the company and the investor.

For the Small Business

A small business must consider under what form of entity it wants to operate. Taxation, liquidity, control, and liability are all affected by a company’s form. Very small companies, the “Mom-and-Pop” shops, usually start as sole proprietorships. This form is the simplest to operate—the owner/operator and the operating entity are considered one and the same.

At the other end of the spectrum is a C Corporation. A C Corporation is generally considered a separate entity from any of its owners. Fractional ownership, “shares”, can be held by multiple individuals or entities and they can be conveyed for value (bought and sold) without disturbing the entity’s existence. It has its own income tax and tax rate table, which can exceed the marginal tax rates of any shareholders.

SEC (Photo credit: Wikipedia)

There are certain advantages to the C Corporation entity, and there are certain disadvantages. A business founder needs to weigh both of these to determine whether a C Corporation would be advantageous to the business. Nonetheless, a company must be a C Corporation to benefit from the provisions of the JOBS Act.

The JOBS Act permits a company to sell public shares under certain circumstances without filing with the SEC. It can advertise the sale of shares, and it can sell shares to individuals who make less than $200,000 annually or have less than $1 million in assets excluding home and personal assets (an accredited investor). The Company is exempt from meeting Sarbanes-Oxley requirements for 5 years or until its revenue reaches $1 billion.

The provision of crowdfunding, a capital-raising strategy in which investors buy stakes in closely held companies over the Internet, appears to be a good thing at first blush. However, first off, each shareholder is limited to investing $10,000 (or 10% of income if lesser). The most a Company can raise is $1 million ($2 million if they file with the SEC) by means of crowdfunding. That means that raising $1 million would add 100 owners to the business.

While the language of the JOBS Act is not clear on the matter, it appears that any subsequent equity raise would require filing with the SEC and meet all of the reporting requirements, since the company is now a Public Company.

Michael Oxley , U.S. Senator from Maryland. (Photo credit: Wikipedia)

From the business standpoint, the JOBS Act simplifies the process of going public for a small company. However, a small company would be required to switch to a C Corporation, with its additional complexity and tax cost. A business could end up with a large number of shareholders who would be considered unsuitable to own stock of a start-up company if it weren’t for the JOBS Act. While the business wouldn’t have to meet Sarbanes-Oxley requirements, the shareholders will still hold the CEO, CFO and Board of Directors liable. Overall, the burdens may not be offset with the limited amount that can be raised.

Additionally, the business would not get the benefit of investment banking professionals as the business owners try to raise capital on their own. The potential for issues is great, which could make the JOBS Act a very expensive way to raise capital.

For the Investor

Number of the High Net Worth Individuals (HNWIs) hold at least US$1 million in financial assets, excluding collectibles, consumables, consumer durables and primary residences. Utra-High Net Worth Individuals (Ultra-HNWIs) hold at least US$30 million. (Photo credit: Wikipedia)

The provisions of the JOBS Act offer small investors the chance to invest into opportunities that were only available to High Net Worth individuals and institutions. It also lets them to direct their investment dollars into their own geographic area.

There are many drawbacks to the opportunities made available. First off, a small investor would be investing in a very risky enterprise. An institutional investor knows that some of their portfolio companies will fold up. A few others will be “walking wounded,” able to continue operating but not profitable enough to return capital to the institutional investor. They count on one out of seven portfolios to provide them with a risk adjusted return. Unless a small investor can invest in 7 or 8 small companies, the odds are that their investment will either fail or be “walking wounded.”

Although the JOBS Act gives the investor public stock, there is no market for it. The investor can’t trade it on any stock market. They can only hold the stock until the company buys them out or it goes bust.

Sarbanes-Oxley was put into place because of accounting abuses epitomized by Enron. These small companies won’t have to have the degree of auditing that Sarbanes-Oxley requires. Therefore, the small company could fail by accident or imprudent management that wouldn’t be caught. This does not even consider unethical individuals who form false companies to collect capital, and then disappear.

The small investor would have no control. Most likely, the 100 shares (from crowdfunding) would represent no more than 49% of the company. The small investor would therefore own 0.49% of the company. They would have no say in company governance, short of suing the company.

The JOBS Act removes many of the safeguards that have been put in place to protect the small investor. These safeguards were enacted because of the risk of abuse or loss. Small investors need these protections more than ever. It would appear, then, that the JOBS Act opens risks and problems for both the offering company and the small investor.

Related articles

• Much Ado About the JOBS Act: Fear Mongering vs. Idealism Cloud (pandodaily.com)
• JOBS Act: 5 things to look forward to (and 5 to dread) (news.cnet.com)
• The JOBS Act, Groupon, and Gullible Investors (blogs.hbr.org)

Is Financial Leverage Good for Shareholders?

Although high debt levels are touted to be shareholder-friendly, highly levered companies do not deliver higher returns.

CFO Magazine:
Gregory V. Milano, Joseph Theriault

Ever since the 1980s wave of leveraged buyouts, it has been commonplace for investors, 
academics, and commentators to suggest that levering up the balance sheet by taking on more debt financing is beneficial for shareholders. Our capital-market research suggests otherwise....

The appeal of debt originates in university corporate-finance classes where students are taught that an important driver of shareholder value is to minimize the weighted average cost of capital (WACC) based on the proportions and costs of debt and equity capital. The U.S. tax code allows a deduction for interest payments, so WACC tends to be lower for more highly levered companies, as long as the risk of financial default doesn’t become excessive. A lower WACC increases the calculated present value of anticipated future cash flow, which is projected to increase the share price.

Theoretical corporate finance aside, a behavioral argument suggests that debt disciplines the otherwise free-spending ways of management. It is said to reign in capital spending, improve cost efficiency, and lead to superior performance.

...Yet our research shows that highly levered companies tend to deliver lower returns to shareholders.

We started with the 1,000 largest nonfinancial U.S. companies and eliminated those without full financial and market data for 2001 through 2010, which left us with 512 companies. We separately explored two subsets of time to examine different points in the economic and credit cycle.

Simply sorting companies based on leverage seemed to produce industry distortions: some industries tend to use either more or less debt. In fact, some of the industries that deliver the highest total shareholder return (TSR) based on dividends and share price appreciation also happen to be those that tend to use less debt. That is true for food retailing, pharmaceuticals and biotechnology, software, and technology hardware.

Understanding Financial Leverage (Photo credit: Wikipedia)

To avoid any industry distortions, we compared companies within each industry that carried above- and below-industry-average leverage based on three different measures and averaged the results. Those measures were: (1) debt to debt plus equity, (2) debt to market value of equity, and (3) debt to earnings before interest, taxes, depreciation, and amortization (EBITDA). Over the full 10-year period, the companies with above-average leverage within their industry delivered 0.6%lower annualized TSR.

The analysis was repeated for 2008 through 2010, when credit was less available, credit spreads were generally higher, and the use of debt was more highly scrutinized by investors. As expected, highly leveraged companies performed even worse during this tighter credit period by delivering annual TSR 1.7% lower than their less-leveraged peers.

As also expected, during the credit boom from 2004 through 2006, highly levered companies performed better with 1.2% higher TSR per year.

Over the full 10 years, leverage had a negative impact, ... Does this imply the theory behind WACC and its impact on valuation are wrong? We do not think so, but we do question the behavioral implications of carrying higher debt levels.

A close examination of performance shows those with higher debt tend to deliver 3% lower revenue growth per year than the less-leveraged companies in the same industry. ...[We] have demonstrated a strong linkage between revenue growth and TSR for both the market as a whole and for many specific industries, so revenue growth is an important point of differentiation in value creation.

Indeed, the failure of higher leverage to lead to higher TSR may not be due to a misinterpretation of how leverage affects valuation but rather the misconception that managerial behavior is unaffected by leverage. Perhaps at least some companies carrying more debt are more conservative in their strategies and this leads to less revenue growth, and that’s why share-price performance is no better despite the tax benefits that reduce WACC.

... Can leverage be beneficial? We believe it can be in a limited number of cases where desirable reinvestment in the future is not readily available.

English: Diagram of leveraged buyout transaction structure for Private equity, Leveraged buyout (Photo credit: Wikipedia)

We further believe temporary higher debt levels that facilitate the investment in desirable growth opportunities, such as successful acquisitions, can be beneficial as long as the debt level is subsequently reduced.

But for most companies, increasing leverage tends to make management more conservative, which seems to reduce the propensity to be strategically opportunistic ... Leverage constricts revenue growth, which leads to worse share-price performance on average.

Despite the touted benefits of leveraging up the balance sheet, most companies would deliver better share-price performance over time if they were more prudent with the amount of leverage taken on.

Gregory V. Milano, a regular CFO columnist, is the co-founder and chief executive officer of Fortuna Advisors LLC, a value-based strategic advisory firm. Joseph Theriault is an associate at the firm.

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