Cash Flow Cost of Capital Financial Performance and Options

Cash Flow

The different authors use a number of quantitative approaches to understanding firm performance. Paunovic (2013) discusses the pricing and valuation of swaps. The author seeks to "demystify the structure of these financial derivatives (swaps) by presenting their valuation methods and by showing how they are used in practice." Thus, the author is presenting textbook explanations of swaps to her audience. Swaps are priced at par at the present time. The counterparties are swapping fixed rate obligations for floating rate, and make differential payments. Neither party would enter into the agreement at an unfavorable rate, but over time the changes in interest rates will mean that one party or the other will pay more. The floating rate is often based on LIBOR, or other common floating rate. Since banks are almost always intermediaries in swaps, they might seek to take a spread on the rate. Thus, a company setting up a swap agreement is likely paying fair value on the day for the swap, plus the bank's spread. The company might choose to do this because it needs to exchange its floating rate obligation for a fixed rate, or vice versa. This is usually based on operational or financial needs, as companies would seldom enter a swap agreement simply on a gamble about the direction of future interest rate changes. The author provides basic, accurate information about the nature of swaps and how they are used.

The second paper is Wang and Hwang (2011), where they discuss the use of options to control corruption and counterfeiting of drugs in emerging markets. Their quantitative work is weakened by a fundamental misunderstanding of options markets. They propose options as a means of helping firms to hedge pharmaceutical prices. While they understand how options work and how they are priced, they miss out on a fundamental difference between pharmaceuticals and products where options currently exist. Options are used for stocks and commodities, where prices fluctuate and future price movements are generally unpredictable. Such markets conform, more or less, to the efficient market hypothesis, and the commodity nature of the asset in question makes it close to the condition of perfect competition. Pharmaceuticals do not exist in such conditions. Price movements are not subject to market conditions, as there are very high market entry costs, namely drug development costs. A truly free market in drugs would provide zero incentive for firms to engage in drug development -- drug companies require patent protection to provide monopoly that allows for cost recovery. When the market is not subject to free market conditions, options are useless. Options exist to help asset owners handle uncertainty. Wang and Hwang assume that such uncertainty exists in pharmaceutical markets, but it does not. Their quantitative work is fundamentally flawed by their misunderstanding of the fundamentals of pharmaceutical pricing. The authors may understand the mechanics of option pricing, but they do not understand the underlying fundamentals of a functioning options market.

Engsted and Pedersen (2010) test the hypothesis that the dividend-price ratio can be used to predict dividend growth. They find that in the U.S. It can when real returns on considered, the dividend-price ratio is effective at predicting long-horizon returns, and that the same holds in Europe. The dividend-price ratio can be a predictor of price changes based on the expected dividend growth on a real basis (d-k). The authors used inflation data (CPI or equivalent) in their study, to adjust nominal figures to real. Their technique was therefore robust. The authors also controlled for dividend policy, noting that were dividend policy was more predictable (in Scandinavia) the use of the dividend-price ratio as a predictor of stock price was more accurate.

Giacotto, Golec and Vernon (2011) studied the cost of capital for pharmaceutical firms. The authors argue that CAPM does not apply perfectly to pharmaceutical firms because it assumes that cash flows take a "random walk." In this industry, cash flows are less randomized, because of the long duration of projects and the impact that high-revenue "hit products" have on the firm's cash flows. The authors study of cash flows for pharmaceutical companies allow them to come to the conclusion that risk is higher for firms in this industry, and that CAPM does not adequately capture this risk. Their work is strong from a quantitative perspective.

Enekwe, Okwo and Ordu (2013) write about financial ratio analysis as a determinant of profitability in the Nigerian pharmaceutical industry. The wording "determinant" is poor -- financial ratio analysis determines nothing; a better word would have been "indicator." That said, they run statistical analysis on a number of financial ratios and find that only a few ratios are strongly related to profitability. There are only six firms in the study, so it is not statistically significant. However, they do illustrate that there are different paths to profitability even within firms in the same country and industry. The use of regression is acceptable and desirable for a study of this nature, but ideally a larger sample size would be needed to give more robust results. The authors should have expanded their study to improve it.

Turcsanyi & Sisaye (2013) study CSR and its links to financial performance. The authors studied only one company, Johnson & Johnson, over time. They operationalized CSR with product recalls. Performance is operationalized as stock performance over the short run around the time of the recalls. Neither of these operationalizations are particularly robust. CSR goes way beyond product recalls; they have chosen a shorthand operationalization that does not capture CSR at all, so the title of their report is misleading. They also study long-range returns vs. The Dow Jones Sustainability Index. There was high correlation noted, as there should be, but they should also have included firms without CSR programs if CSR is their independent variable. They did this when they compared JNJ vs. other pharma firms, but in doing this they rested on the spurious and unsubstantiated assumption that "Johnson & Johnson must be attracting investors through additional benefits the company provides that others within the industry are not providing. This could be directly related to the implementation of CSR practices." They fail to explore that hypothesis at all -- to make such a conclusion would have required gathering information about the CSR practices of other firms, rather than simply assuming JNJ enjoys superiority in that respect.