Cardinal Economics & Finance, LLC is an economics and finance advisory firm based in Ann Arbor, Michigan. We have expertise in valuation, risk and return analysis, litigation support, and regulation.
We have experience in the implementation, research and teaching of:
· Discounted cash flow valuation
· Multiples-based valuation
· Real options valuation
We make our assumptions transparent and ensure they are justified by empirical evidence and market conditions, and are internally consistent. We start our analysis by understanding the business case and jointly develop a set of assumptions on economic growth, inflation, investment opportunities and competition that flow from the business case.
Our analysis applies across industries. For instance, the principles of valuation apply equally to mining, manufacturing, medical devices & pharmaceutical products and fast food.
Our analysis also applies across different types of securities, whether it be an entire business, shareholders’ stake within the business, preferred shares, debt or derivatives.
Our work is used in a number of ways. In some circumstances, project valuation is used for a large firm to select between competing projects. In other situations, share valuation is needed to settle a dispute between a taxation authority and a taxpayer. For financial reporting, valuation of an executive compensation package is needed.
In this latter situation, it is important to understand that most compensation packages cannot be valued using a single equation from a textbook. Most of the time the package does not fit the underlying assumptions upon which most equations are based. Thankfully, computing power has kept pace with the complexity of securities themselves, allowing us to apply the right valuation approach to the right security. We can value any executive compensation package, and any derivative security, by understanding the relationships between the payoff to the executive or derivative holder and an underlying asset (typically a stock).
Risk and Return
A comprehensive understanding of risk comprises three parts. We need to assess, manage and price the underlying business and financial risks faced by a business, shareholders or lenders.
· Risk assessment means quantifying the key triggers to an adverse event, whether that be at the macro level (for example, recession, currency shock, interest rate shift) or the micro level (for example, asset failure, development overrun)
· Management means determining which risks can be managed with contracts and insurance
· All contracts are incomplete so pricing residual risk remains the only way investors ensure that returns are at least commensurate with residual exposure
One characteristic of a well-functioning market is that risks are transferred to participants that are best placed to bear those risks. We perform analysis so that clients understand the risk exposure of assets and contracts. With this knowledge, clients can decide whether risk should be transferred elsewhere and at what price.
Our analysis of risk and return has included:
· Comparison of energy trading policies
· Analysis of the risk to a portfolio concentrated in a family-owned business
· Recommendations on retail electricity and gas margins
· Analysis of the value and risk exposure of electricity generation portfolios
· Estimation of optimal capital structure in electricity generation and distribution
Our approach to litigation support is premised on understanding the benefits and limitations of finance theory, empirical evidence and common sense. We provide clients, courts and tribunals with analysis that make sense of these components of decision-making.
· Finance theory provides a useful framework for thinking about risk, return and value, and for ensuring that all assumptions are considered in a consistent and complete manner. But any tractable theory is based upon a set of assumptions that are an abstract representation of real markets, so we need to ask how things can change when those assumptions are violated.
· Empirical evidence provides the large-sample basis for conclusions. It ensures that we do not reach conclusions on small, unrepresentative observations. But this evidence remains sample-specific, so we need to ask whether the case at hand is the average case or at the end of the distribution.
· Common sense does not imply conclusions in itself but tells us where to look. If common sense conflicts with theory or evidence we need to understand why? Is our theory too constrained by assumptions, is the empirical evidence inapplicable to the case at hand, or does common sense merely represent a set of conventions that can be overturned with a better examination of theory and evidence?
Regulation goes beyond writing a set of rules. It is the implementation of those rules and the engagement of businesses, consumers and investors that leads to well-functioning markets.
Our advice has encompassed all of the key elements of regulatory regimes including:
· The development of rules and guidelines
· The design and implementation of appeal mechanisms
· Impacts on market participants’ incentives from the overarching system of regulation and the form of control (for example, revenue cap vs. price cap)
· The treatment of all elements of building block models, namely asset valuation; cost of capital; cost allocation; assessment of efficient costs; design of incentive mechanisms; taxation; and total service long run incremental cost models
Recently, we have provided support in the following instances, among others:
· Advice on the asset asset stranding, default risk and cost of capital for a gas pipeline
· Estimation of the market risk premium
· Review of a regulator’s method for setting allowed returns
· Advice on cost escalation rates for materials inputs
· Assisted a regulator to write a comprehensive set of rules for energy network regulation