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Interview with Ken Hackel author of Security Valuation and Risk Analysis

Nov. 03, 2010 11:49 AM ET
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Kenneth S. Hackel is president of CT Capital LLC, an investment advisory firm, and founder and past president of Systematic Financial Management, Inc. An internationally recognized expert in security analysis, he has managed the nation's leading mutual fund, a very successful investment advisory firm, and has consulted and written on mergers and acquisitions and fairness opinions. Hackel lives in Alpine, NJ. He is the author of Security Valuation and Risk Analysis.

Tell us what your new book is about?

Rarely does a does a book on finance and investments “break important new ground.”  I believe Security Valuation and Risk Analysis, encompassing my four decades covering about every facet of security analysis and corporate finance, does so. In it I show that:

  1.  Cost of equity capital, a principal component of stock value, should not be determined by security volatility, as is widely practiced by public enterprises, investors, consultants and security analysts, but by the certainty related to the entity’s cash flows and credit health. A one percentage point change in cost of equity often results in a 25% or greater change to fair value and very often precedes turns in the underlying stock movements;
  2. Return on Invested Capital (ROIC), a principal component of valuation, should be measured as a function of the assets ability to produce free cash flows, as it should benchmark the expected cash return for cash expended (invested capital, as adjusted). It should not be based on Earnings before depreciation, taxes and depreciation (EBITDA). EBITDA, an income statement based accounting concept, is not a measure of the true economic return;
  3. Free cash flow should include cash the entity could easily free up, but to be correctly computed, must be adjusted for the many misclassifications and extraordinary items frequently found in reported financial statements.  Such adjustment procedures are explained
Why is the new valuation methodology you outline in the book revolutionary?

This book gets to the heart of how value should really be construed by the value investor. Popular fair value measurement tools often provide inaccurate assessments. An ongoing concern derives its value from its free cash flows and its ability to add (or destroy) value resulting in shifts to those cash flows. Existing tools do not provide for such measurement as they have been conceived by academics and accountants, often under the strong urging of large and persuasive corporations.

The book’s comprehensive cost of capital worksheet with detailed explanations of each metric provide a unique and common-sense solution to the measurement of the discount rate from which free cash flows are discounted and fair value established.  It is one based on credit, and compasses over 60+ such metrics, from sales stability to tax rate-from cash burn rate to insurance adequacy, yield spreads, sovereign risk,-and everything in between.

How can it be applied to today’s investing climate?

In today’s or tomorrows investing climate, the need to accurately access the firm’s normalized and current cash flows, along with the capital (and its cost)  necessary for their production are paramount  to the valuation process.

Because credit analysis is so important in the determination of risk and value, the book details a thorough analysis of the roles debt, equity and hybrid securities play in the capital structure including possible calls on capital such as commitments, contingencies, guarantees, convertible securities, exposure to lawsuits and other cash requirements, such as sinking funds. Also explored are contingent capital, debt covenants, adjusted debt, goodwill, special purpose entities, contingent liabilities, and the importance of sensitivity analysis in evaluating financial structure.

What are 3 reasons why financial planners and investment managers should buy your book?
  1. As the book’s advances become applied, early readers will be given a real advantage over other investors.
  2. Readers will come to understand stock movements they currently have trouble explaining, since significant movements are almost always led by changes in cost of equity capital and the perceived risk to the credit (cash flows). The text explains why entities having a low cash-defined ROIC resulting in small amounts of distributable cash flows are accorded lower valuations despite having higher rates of growth in revenues and/or earnings.
  3. The text is replete with examples to illuminate each topic.

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