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April 10, 2014

2

Answer the Question Big Guy

As I was applying for jobs this past week (yes, it is that stage in my life), one firm asked me to complete a written exam. Since I found the questions quite thought-provoking, I am going to dedicate this post to what I thought were the best answers. Please leave a comment if you agree or disagree with my reasoning.

Question 1: Financial Crisis Impact

In 2008, the financial world convulsed as liquidity left the marketplace, wealth management shops redeemed investor funds, and Lehman Brothers collapsed. In less than 500 words, explain the impact this financial crisis has had on your life as well as the financial services industry.

recession

The financial crisis opened up opportunities not just in my life but also in that of shrewd investors. Though unemployment during the crisis was devastating, and the financial markets crumbled (e.g. stock market, measured by the S&P index, fell by 57% from the high of 2007 to the trough of 2009), the crisis led to a stronger and more lucrative market for several of us in the form of lower inflation rates, a tighter regulatory framework and an abundance of under-valued firms. Therefore, it is important to not just look at the bankruptcies (e.g. Lehman Brothers) caused by industry malpractices prior to the crisis, but instead learn from the event and highlight the lucrative opportunities it brought forth.

Lower inflation rates led to a more inexpensive college education than what would have been if the economy grew at pre-recession levels. The year I joined university (2010), the increase in college tuition, room and board at Clark was one of the lowest of the decade. Low inflation, coupled with a generous financial aid package, allowed my family and me to afford the cost of university.

The crisis also put pressure on the Federal Reserve, the SEC and other regulatory boards to set a tighter compliance framework against certain financial practices (e.g. subprime mortgage lending). Such a regulatory framework leads to safer and more sustainable financial markets, not only for the public but also for banks and other investment firms, who have an equal interest in avoiding financial trouble. Though stricter liquidity measures goes against laissez faire, and the theory of market efficiency, such a framework will decrease future risks of moral hazard and limit the impacts of a similar crisis.

Time and time again, shrewd investors have shown the ability to not just survive recessions, but make money immediately after it. Barring those who do make money during recessions through the shortening financial instrument (e.g. John Paulson in the subprime mortgage market), value investors (e.g. Warren Buffett) who were able to buy under-valued stocks during the recession were heftily rewarded for their astute and patient investment strategy. Likewise, such economic downturns provide great entry points for those who look into the fundamentals of investing.

The financial crisis was catastrophic, but it was an equally important learning tool for the world. The change that the crisis brought forth in terms of market regulation has set for a more viable financial system. The crisis has also provided evidence as to why value investors should be commended yet again for their fundamentals-based buying strategy. Last but not least, such cyclical occurrences limit extended levels of high inflation.

Question 2: Valuation

Tesla Motors Inc (TLSA) currently trades at ~$160 per share with 121.45M shares outstanding, resulting in a $19.4B market capitalization. salesforce.com, inc. (CRM) trades at ~$54 per share with 496M shares outstanding, pushing its market cap to $31.8B. Both are considered high growth companies based in Silicon Valley with visionary CEOs. They attract the best and brightest talented employees in their respective industries.

If you had $500K to invest in one company or the other at the current price, which would you choose and why? If you had the opportunity to work at one company or the other, which would you choose and why? Are your choices for part 1 and 2 the same? Answer the questions in less than 700 words.

Valuation

Neither the price nor the market cap is a solid indicator of whether or not I should invest in the company; the former is just a number, and the latter distinguishes whether the firm is one of the following: large-cap, mid-cap or small-cap. In order to determine which company I would invest in, and which company I would like to work for, which go hand-in-hand in my opinion, I would have to take into consideration the fundamental value of each company. Basic valuations examples would include P/E ratios (relative to the industry), debt to equity standing, operating margins (by itself and relative to the industry), market-share relative to the industry, cash flow position, breakthrough products and the market demand dynamics. However, note that since both of these firms are considered high growth companies, we cannot put them in the same category as a ‘value-buy;’ future earnings potential may be given precedence by growth investors. So, it is first important to acknowledge that I shall  take the view of a value-investor in answering this question.

First, I would like to explain why my choices for part I and part 2 are the same, and then move on to the valuation strategy. A company that does well in the long run generally displays a price growth that follows it. Moreover, a company that does well offers a positive environment for its workers, as well as better job security than those that do not. Such an enterprise is able to offer its employees stock options as a form of payment, than one that is not performing as well as it would have liked. Last but not least, a firm that excels reduce redundancy; though some may find that this is not favorable to employees, it is in fact better to be at a firm where your work counts/is valued than at a firm where your experience is limited. All of these points prove that the answer for part 1 and part 2 are the same.

Due to limited time and knowledge to create my own FSM and DCF models, I shall make general predictions based on the available data, and explain why certain indicator indicators provide good cues. P/E ratio is a solid indicator to begin with, particularly with relation to its estimated earnings growth rate and to the P/E of competitor firms. Tesla had a P/E ratio of above 1000 in 2013ttm and an estimate P/E of 100+ at the end of 2014 (NASDAQ), which on their own, show that Tesla does not have the current earnings nor the earnings potential in 2014 to back up its price value. Even in relation to its competitors, Tesla’s P/E is extremely overvalued as the current industry P/E is 12.42ttm (NASDAQ). Salesforce has a similarly high P/E, though the competitors P/E average is not as far off as that of Tesla’s (NASDAQ). Both firms, however, show earnings growth potential according to analysts (Yahoo Finance), which may support its current price in the eyes of growth investors. But, I, as a value-investor, would hold out on buying either of these stocks based on their current P/Es, .

Debt to equity is also a significant indicator that an investor should utilize when purchasing the shares of either company. Debt to Equity, which is the best pointer of the company’s ability to pay off its debt (in the short run by liquidating assets) is better when it’s smaller. Both firms have high debt to equity ratios; Tesla is at 90% and Salesforce is at 82% (Yahoo finance). Though some may be convinced that these two firms will be able to comfortably pay off their debts in the future, I personally would not buy either of these stocks based on their unattractive debt to equity ratios.

Demand dynamics should play a crucial role in investment strategy. With the world demand slowly moving towards more eco-friendly vehicles, one can safely estimate that Tesla’s electric vehicles are likely to have a strong future in the years to come. Similarly, with the demand for cloud products picking up, sales of salesforce would naturally do well. Therefore, both these firms are positioned in a growing industry, and may explain the current prices according to certain investors.

All in all, looking at just some of the above-mentioned stock gauges, I would not recommend buying either of the stocks. Even though the two firms are placed in growing industries, they are currently overvalued. In brief, I would invest my $500k elsewhere given the current prices for these stocks.

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2 Comments Post a comment
  1. Jul 14 2014

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    Reply
  2. Jul 16 2014

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    Reply

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