Enron Case Study Analysis. Ask Why? Why?

Enron3

Case-Study-So-What-is-It-Worth    Prior Post where students discussed the case.

Turn up the VOLUME: Don’t believe the …..?

Enron-Case-Study-So-What-is-It-Worth  My walk-through. I go straight to the balance sheet then calculate the returns on total capital in the business. These financial statements were easy to discard because of the size of the business and the poor returns. My estimate of $5 to $7 per share worth or 90% less than the current share price, was wrong. The company was worth $0.  This is more a case of institutional imperative and incentive-based bias. Wall Street was feeding at the financial trough to keep raising money for Enron (to keep the bad businesses afloat) so guess what the financial analysts (CFAs and MBAs) suggested? Buy!   I guess the market is not ALWAYS efficient.

Forget accounting scandals, this was a crappy business based on trading so no way to determine normalized earnings.   When I was in Brazil and saw Enron’s newly-built generating plant sitting idle, I asked why.   A project developer said he got paid by doing deals by their size not profitability, therefore, the bigger the white elephant, the better.  When I called mutual funds who owned Enron as it was trading $77 per share to ask the analyst if he/she was aware of Enron’s declining businesses coupled with absurd price, I was told to shut up. As one analyst (Morgan Stanley?) told me, “I only believe what I want to believe and disregard the rest.”

Enron Annual Report 2000  Ha, ha! and Is Enron Overpriced?

The above august panel never answered why anyone would give capital to Enron?  No one mentions the elephant in the room.  Sad.

What does the above case have to do with net/nets and our course. Everything! Look at the numbers, think for thyself, ignore Wall Street, and be aware of incentives.   Buying bad businesses at premium prices is a guarantee of financial death.

This is an aside, but based on the above Enron example, does value investing serve a SOCIAL purpose or benefit? Prof. Greenblatt doesn’t think so–you are just trading pieces of paper, but what do YOU think?

See these two venture capitalists explain the social purpose of their business:

11 responses to “Enron Case Study Analysis. Ask Why? Why?

  1. John, I am interested in how you define return on total capital.

  2. In response to your question about the “social purpose or benefit” of value investing…

    I’d say capital markets are analogous to a Democracy. Both deliver value to the populations which enjoy them. Both can endure a majority of “free riders” in the population that enjoys them. But neither can survive without a significant minority of “true believers” who are willing to do extra work to maintain the system’s efficiency.

    In capital markets one could say that momentum or index investors are free riders. Similarly one could say that short sellers or value investors are “true believers”.

    To the extent that true believers are willing to do extra work to identify and correct inefficiencies in the system and to the extent that system delivers value to the population, it follows that true believers generate a social benefit.

    • Thanks for your comment. Yes, I concur. Capital markets exist to raise capital for new ventures and to allocate capital. Secondary markets if, more efficiently priced, will send the proper signals to investors and provide a better market for IPOs. New capital can’t be raised without the secondary market providing liquidity. However, if all were rational investors then opportunities for mis-pricings would lessen. We would have less opportunity to step in and correct the mis-pricings.

  3. I simply took total assets of 65 billion as a short-hand, I didn’t take Net working Capital and Net Property, plant and equipment. No matter, huge asset base with microscopic returns for years running.

  4. So you’re using
    ROTA = EBIT /Total Net Assets
    where EBIT = Net Income + Interest Expense + Taxes

    Is that right?

    • Yes, Operating income (EBIT) divided by total Assets. If you deduct the equity ($11 billion off the top of my head so look it up), you can see that this is leveraged heavily. I didn’t even bother with the duration and terms of the debt. Why even spend the time unless to short.

  5. Thanks for posting this exercise John. It’s helpful to do “blind” company analysis, as its a perfect example of balancing the high topline revenue growth vs the pitiful returns earned on them. Even if we ignore the accounting fraud and off balance sheet items, we can still pass on this stock, although that may be more of a psychological challenge in the 90s as everyone at the time seemed to be paper millionaires due to this stock.

  6. Don’t anchor on price or the story. Focus on the numbers FIRST.

  7. I do not think investing as a professional career has any social purpose though. The bottomline is that the funds are just focused on looking for returns, hence more clients, more fees etc. And sometimes it gets a bit too much.

  8. John, you’re hilarious. PE (Public Enemy, not Price/Earnings) is so relevant.As I strive to incorporate Howard Mark’s second level thinking, I wish this song could automatically start playing like a movie audio track when I fall into crowd-think.

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