Retirement And Time Value Of Money

A recent article at Bankrate.com discusses how saving earlier in your IRA can mean big money at retirement, which we hope you already know this. As the article discusses, many people make their IRA deposit right before April 15th each year when taxes are due. However, if the deposit were made a year earlier, the difference under Bankrate's assumptions would be $113,985 at retirement. The assumptions used in the article are a $5,500 annual deposit at 8 percent for 40 years. Check for yourself that if the deposits are at the end of the period, the future value is $1,242,810.85 and if the deposits are an annuity due, the future value is $1,538,795.72. So, Bankrate's article presents a set of calculations that we hope you are already familiar with. Of course, the future value will increase another $30,000 or so if you make your deposits on January 1st of each year, 15 months before the last date April 15th of the following year.  

Clawbacks And Restatements

A major provision of the Dodd-Frank Act requires corporate executives to certify the accuracy of financial statements, in part to help reduce restatements. Another provision of the Act requires that all public companies have a "clawback" provision that permits the recovery of any incentive compensation paid to executives if the restated financial statements show that the incentive compensation should not have been paid. In 2012, 87 percent of publicly traded companies had a clawback provision. Previous research has found that companies with a clawback provision are less likely to have restatements. This was attributed to executives doing a more diligent job when certifying the original financial statements. However, new research indicates that the drop in restatements may also be due to executives fighting restatements. Often, restatements are the result of auditors disagreeing with the original financial statements because of the accounting choices made. Since a restatement that reduces the company's reported performance can cause the initiation of the clawback, corporate executives appear more likely to fight restatements.

Corporate Leverage Increases

According to Goldman Sachs, the level of debt on corporate balance sheets has risen to a level not seen since before 2008. With record low interest rates, companies have increasingly borrowed to fund buybacks and acquisitions. During 2014, about 10 percent of debt issues were used to fund buybacks. And, so far during 2015, about 8 percent of debt issues have been used for buybacks. Meanwhile, goodwill, which is created from mergers and acquisitions, has risen 32 percent since 2010 and more than $1 trillion in goodwill has been added to corporate balance sheets since 2008. While goodwill can represent real value, such as a brand name, it could also indicate that companies have made negative NPV acquisitions.

WACC And Acquisitions

An article on CFO discusses the WACC for S&P 500 companies and the use of the WACC in mergers and acquisition. An interesting number in the article is that, according to research by Bain & Company, the average WACC for a company in the S&P 500 has dropped from 10 percent in 2010 to 8 percent in 2014. Much of this is likely due to lower interest rates. The article also discusses how companies add a risk premium of 200 to 300 basis points to the WACC (the subjective approach) when analyzing a potential acquisition, plus another 50 to 100 basis points due to conservatism about the WACC calculation. Although the article is not specific, we should reiterate the correct WACC to use when analyzing a potential acquisition is the WACC of the target company, not the WACC of the acquiring company. To clarify terminology, the hurdle rate used in the article is the required return, or cost of capital.  

The Market Return For The Next Decade

So what will the stock market return be going forward? John Bogle, founder of Vanguard Mutual Funds and proponent of index investing, recently stated that investors should only expect about a 4 percent annual return from the S&P 500 for the next decade. According to Bogle, he expects a 2 percent dividend yield and earnings growth of 5 percent, for a 7 percent return. However, he also expects the PE ratio on the S&P 500 to fall from its current level of 20 times earnings to 15 times earnings. This decrease in the PE ratio will cause a 3 percent decrease in stock prices, resulting in his estimate of a 4 percent annual return. So is Bogle right? Check back with us in 2025 and we will let you know.

Democratization Of IPOs

So you have read about IPO "pops" in this chapter and want to buy IPOs. A major problem is that the majority of IPO allocations are sold to institutional investors like banks, mutual funds, and high-net worth investors who have an established relationship with the underwriter. JP Morgan has decided to change the IPO investing landscape. The company has teamed with online brokerage Motif Investing to allow small investors to participate in IPOs. Motif will allow investors to submit commission-free orders in IPOs underwritten by JP Morgan with a minimum order of $250. One risk of the new process is that while IPOs typically have very heavy trading on the first day, institutional investors tend to hold the securities for a relatively long time. Small investors may be hoping for the IPO pop and sell the stock quickly, which could lead to even larger trading volume early in the life of the IPO, with more price instability.  

Bond LIquidity And Yields

Many observers believe that the Federal Reserve may increase interest rates in December. According to a recent article, that could be the worst time for the bond market. During December, bond trading slows dramatically as banks clean up balance sheets in preparation for year-end stress tests. As a result, banks are less likely to enter into large trades. Strategists at RBC Capital Markets argue that the large jump in yields on bonds in late September was due to the lack of liquidity in the bond market because of banks preparing for quarterly reporting. If this is true, an increase in interest rates by the Federal may result in larger increases in bond yields than might be expected due to lack of liquidity, at least temporarily.