Financial Engineering Examples

This week I share two advanced examples of Financial Engineering!

VIDEO SUMMARY:

In last week’s video, I introduced Financial Engineering, and talked through some beginning examples of what Financial Engineering looks like. In this video, I am going to walk through two examples that are a little bit more advanced. This video is really about giving you insight into what is possible with Accounting and Corporate Finance.

But before we jump into the example, I want to talk a little bit more about the name. Financial Engineering. This term came about, because somebody decided to combine the words “Finance” and “Engineering” to create Financial Engineering. And the whole idea here is that Finance professionals can design a company the same way an Engineering designs a machine. Now this is not a perfect pairing of words, because businesses are full of people, and people are not the same thing as parts in a machine. However, it is still a powerful idea to approach business with the same rigor and use of advanced mathematics as the field of Engineering.

Now I bring up the term, because unfortunately, Financial Engineering has developed a negative connotation. If you talk to a lot of people, they think Financial Engineering is a scam. And it is important to understand why people think that. Because what most people see, is finance professionals walking into a company somewhere. And what these financial professionals do, is radically restructure the financial statements. So they take the financial statements and flip them around, and turn them inside out, and restructure the company. And when the financial professionals walk out, the stock price doubles. However, nothing about the operations of the company has actually changed. The only thing that is different is these pieces of paper. So people look at that and they think it looks a little fishy. But I think people just don’t understand what is happening. In fact, these changes on pieces of paper are actually creating a lot of value for everyone involved in the company, and that is what I’m going to explain.

So in my first example, we’re going to walk through this. Imagine there is a business with two divisions. One division operates a chain of restaurants. The second division manufactures washing machines. These are two very different things. There are many different reasons this can happen in a business. This could have been a husband and wife that were both business owners and joined there businesses. But whatever the reason, these kind of things develop over time as businesses grow. Now imagine you were to take this business and split it up into two separate businesses. One restaurant chain and one manufacturing company. The benefit is that both businesses will instantly become more attractive to investors in capital markets. Why is that? Imagine it from the investor’s perspective. They are looking at many different companies, and they find this one company and don’t know how to value it. They think “Do I value it as a restaurant? Or do I value it as a manufacturing company?” On top of that, there are different types of investors. There are investors looking for restaurants, and investors looking for manufacturing. There are very few investors looking for a combination of the two. So in splitting up these two companies, you are making it easier for investors to find your company. Capital markets work the same as everything else, with supply and demand. So if you can get more investors to want your stock by cleaning up your accounting, your stock price will likely go up.

Here is the point: Your accounting is a product. You are selling this accounting product to investors. You need to be as thoughtful with the accounting you are presenting to your investors, as you are with the product you are presenting to your customers. I know that a lot of business owners spend a lot of time thinking about whether their products are meeting their customer’s needs. Well you have to also think whether your accounting is meeting your investor’s needs.

Now there are a couple of warnings to this example. I am not advocating that you split every business apart. Please be aware these examples are not one-size fits all. Every business is different, so you have to be very thoughtful about Financial Engineering. There might be very good reasons to keep the business together rather than split it apart. Second, I make this sound very easy, and this is not easy at all. At the very least, you are going to have to go through your last three years of accounting records and split apart the two businesses. This is not an easy task.

Now you might think to yourself, my company is too small, this doesn’t apply to me. But if you understand financial engineering, you can think 10 years ahead and set up your accounting to get the biggest bang for your buck when your company is large enough.

A massive company restructuring is a dramatic example of Financial Engineering. Let me switch to a more common example. Pricing. Pricing is a very difficult topic. A lot of businesses set their pricing with their gut. However, pricing can be done more effectively by taking a methodical financial engineering approach, and using advanced mathematics and statistics to set your prices. And in fact, this is what most major companies do. You can set up mathematical models. You can use statistics. You can use algorithms programmed into computer software to help you in your pricing decisions.

So these are just two examples of Financial Engineering. More and more, this is what accounting looks like at the highest levels. Financial Engineering is about using all the financial tools and techniques at your disposal, to create the most value in our businesses.

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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.