Monday, February 8, 2016

A Violent Earnings Season: Pricing and Value Perspectives

The earnings season is upon us once again, the quarterly rite of passage where companies report their earnings results, the numbers get measured up against expectations, expectations get reset and prices adjust. As an investor, I sometimes find the process unsettling, but as a market observer, I cannot think of a better Petri dish to illustrate both the magic of markets and the vagaries of human behavior. This earnings season has been among the violent, in terms of market reaction, in quite a few years, as tens of billions of dollars in market capitalization have been wiped out overnight in some high flyers. In order to get perspective during these volatile times, it helps me to go back to a contrast that I have drawn before between the pricing and value games and how they play out, especially around earnings reports.

Price versus Value: The Information Effect
In finance, we use the words price and value, as if they were interchangeable and I have sometimes been guilty of this sin. It is worth noting that price and value not only come from different processes and are determined by different variables, but can also yield different numbers for the same asset at the same point in time. I try to capture the difference in a picture:

The essence of value is that it comes from a company's fundamentals, i.e., its capacity to generate and grow cash flows; you can attempt to estimate that value using accounting numbers (book value) or intrinsic valuation (discounted cash flow). Fundamental information causes changes in a company's cash flows, growth or risk and by extension, will change its value. Pricing is a market process, where demand and supply intersect to produce a price. While that demand may be affected by fundamentals, it is more immediately a function of market mood/sentiment and incremental information about the company, sometimes about fundamentals and sometimes not.

In an earlier post, I drew a distinction between investors and traders, arguing that investing is about making judgments on value and letting the price process correct itself, and trading is about making judgments on future price movements, with value not being in play. While the line between fundamental and incremental information is where the biggest battles between investors and traders are fought, it is not an easy one to draw, partly because it is subjective and partly because there are wide variations within each group on making that assessment. For instance, consider Apple, a company followed closely by dozens of analysts, and its earnings report on January 26, 2016. The company beat earnings expectations, delivering the most profitable quarterly earnings in corporate history, but also sold fewer iPhones than expected; the company lost almost $30 billion in market capitalization in the immediate aftermath. An investor valuing the company based on dividends would conclude that it was an overreaction, since not only are dividends not under immediate threat but the cash balance of $200 billion plus should allow the company to maintain those dividends in the  long term. A different investor whose valuation of the company was based on its operating cash flows might have viewed the same information as more consequential, especially since 65-70% of Apple's cash flows come from iPhones. A trader whose pricing of Apple is based on iPhone units sold would have drastically lowered the price for the stock, if his expectations for sales were unmet, but another trader whose pricing is based on earnings per share, would have been unaffected.

Earnings Reports: The Pricing and Value Reaction
While almost any story (rumor, corporate announcement) can be incremental information, it is quarterly earnings reports that keep the incremental information engine running, as revelations about what happened to a company in the most recent three-month period become the basis for reassessments of price and value.

Earnings Reports: The Pricing Game
The way traders react to earnings reports is, at least on the surface, uncomplicated. Investors form expectations about what an earnings report will contain, with analysts putting numbers on their expectations. The actual report is then measured up against expectations, and prices should rise if the actuals beat expectations and fall if they do not. The picture below captures this process, with potential complications thrown in.

While the game is about actual numbers and expectations, it remains an unpredictable one for three reasons. The first is that the price catalyst in the earnings report, i.e, whether the market reacts to surprises on management guidance, revenues, operating income or earnings per share, can not only vary across companies but across time for the same company. The second is that while analyst expectations are what we focus on and get reported, the market's expectations can be different. The third is that the effect on stock prices, for a given surprise (positive or negative) can be different for different companies and in different time periods.
  1. Price Catalyst: It is easy enough to say that if the actual numbers beat expectations, it is good news, but actual numbers on what? While earnings reports two decades ago might have been  focused almost entirely on earnings per share, the range of variables that companies choose to report, and investors react to, has expanded to not only include items up the income statement, such as revenues and operating income, but also revenue drivers which can include units sold, number of users and subscribers, depending on the company in question.  In the last decade, companies have also increasingly turned to providing guidance about key operating numbers in future quarters, which also get measured against expectations. Not surprisingly, therefore, most earnings reports yield a mixed bag, with some numbers beating expectations and some not. Thus, Apple's earnings report on January 26, 2016, delivered an earnings per share that was higher than expected but revenue and iPhone unit numbers that were lower than anticipated.
  2. Whose expectations? News stories about earnings reports, like this one, almost always conflate analyst estimates with market estimates, but that may not always be correct. It is true that analysts spend a great deal of their time working on, finessing and updating their forecasts for the next earnings report, but it is also true that most analysts bring very little new information into their forecasts, are overly dependent on companies for their news and are more followers than leaders. To the extent that companies play the earnings game well and are able to beat analyst forecasts most or even in all quarters, the market seems to build this behavior into a "whispered earnings" number, which incorporates that behavior. 
  3. Effect of surprise: The market reaction to a surprise is also unpredictable, passing through what I call the market carnival or magic mirror, which can distort, expand or shrink effects, and three factors come into play in determining that image. The first is the company's history on on delivering expected earnings and providing guidance. Companies that have consistently delivered promised numbers and provided credible guidance tend to be cut more slack by markets that those that have a history of volatile numbers or stretching the truth. The second is the investor base acquired by the firm, with the mix of investors and traders determining the price response. On a pricing stock, it is traders who dominate the action and the market response is therefore usually more volatile, whereas on a value stock, it is investors who drive a more muted market reaction. The third has less to do with the company and more to do with the market mood. In a month like the last one, when fear is the dominant emotion, good news is oft overlooked or ignored, bad news is highlighted and magnified and the price reaction will tilt negative.
Earnings Reports: The Value Game
It is difficult to characterize the value game, precisely because it is played so differently by its many proponents. Some old-time value investors' concept of value is tied to dividends and other value investors are more open to expanding their measures of cash flows. To me, the one area where there should be agreement across investors is that every good intrinsic valuation should be backed by a narrative that not only provides structure to the numbers in the valuation, but also provides them with credibility. As I noted in this post from August 2014, it is this framework that I find most useful, when looking at earnings reports and I capture the "value" effect of earnings reports in this picture:

If you accept the notion that value changes when your narrative changes, the following propositions follow:
  1. An earnings report can cause big change in value: For an earnings report to significantly affect value, a key part or parts of the narrative have to be changed by an earnings report. This could be news that a company has entered and is growing strongly in a market that you had not expected it to be successful in or on the flip side, news that the market that you see it is in is smaller and/or growing less than anticipated. 
  2. Big value changes are more likely in young companies: These significant shifts in value are more likely to occur with young companies than where business models are still in flux than with more established firms. Consequently, you should not be too quick in classifying a big price move on an earnings report as a market overreaction, especially with young firms like GoPro and Linkedin.
  3. There is more to an earnings report than the earnings per share: The relentless focus on earnings per share can sometimes distract investors from the real news in the earnings report which can be embedded in less publicized numbers on product breakdown, geographical growth or cost patterns.
If you believe, like I do, that investing requires you to constantly revisit and revalue the companies that you have or wish you to have in your portfolio, new earnings reports from these companies provide timely reminders that no valuation is timeless and no corporate narrative lasts forever.

The Rest of the Story
This post has gone on long enough, but it will be the first in a series that I hope to do around earnings reports, built around four topics.
  1. Make it real: In the first set of posts, I will be looking at a few companies that I have valued before. I will start by looking at two companies, dueling for the honor of being the largest market cap company in the world, Alphabet (Google) and Apple, seemingly on different trajectories at the moment. I will follow up with Amazon and Netflix, two firms that are revolutionizing the entertainment business and were among the very best stocks to invest in last year. In the third post, I will turn my attention to two social media mainstays, one of which (Facebook) has unlocked the profit potential of its user base and the other (Twitter) that has (at least so far) frittered away its advantages. In the final post, I plan to pay heed to two high flyers, GoPro and Linkedin, that have hit rough patches and lost large portions of their value, after recent earnings reports.
  2. The Players: In the second set of posts, I will first focus on investors and traders and how they might be able to play the earnings game to their advantage, often using the other side as foil. I will then examine how corporations can adapt to the earnings game and look at different strategies that they use for playing the game, with the pluses and minuses of each. 
  3. The Government/Regulators/Society: In the final post, I will play a role that I am uncomfortable with, that of market regulator, and examine whether as regulator, there is a societal or economic benefit to trying to manage how and what companies report in their earnings reports and the investor reaction to these reports. In the process, I will look at the debate on whether the focus on delivering quarterly earnings diverts companies from a long term focus on value and how altering the rules of the game (with investor restrictions and tax laws) may make a difference.
YouTube Video

Blog posts in this series
  1. A Violent Earnings Season: The Pricing and Value Games
  2. The Race to the Top: Apple and Alphabet 
  3. The Disruption of Entertainment: Amazon and Netflix 
  4. Management Matters: Facebook and Twitter
  5. The Icarus Effect: LinkedIn and GoPro
  6. Investor or Trader? Finding your place in the Value/Price Game!
  7. The Perfect Investor Base? Corporation and the Value/Price Game
  8. Taming the Market? Rules, Regulations and Restrictions

Monday, February 1, 2016

January 2016 Data Update 8: Pricing, with an end of month update

If you have been tracking the posts that I have about my data updates, you probably noticed that early on, I had planned eight posts but that this shrunk to seven by the time I was done. The reason was that the last post that I was planning to make was going to be on pricing numbers, i.e., the multiples that companies are trading at around the world, relative to book value and earnings. However, as the market dropped in January, I decided that posting the PE and EV/EBITDA multiples from January 1, 2016, would be pointless, since the numbers would be dated. I was also considering a post on the stock market turmoil during the month, and during the weekend, I decided that I could pull off a combined post, where I could look at both the pricing on January 1, and how it has changed during January 2016, by region, country and sector.

The US story, as told through the ERP
In my very first post this month, I looked at the equity risk premium for the S&P 500 on January 1, 2016, and estimated it to be 6.12%, based on dividends and buybacks over the last 12 months. I noted my discomfort with the fact that the cash returned in those twelve months exceeded the earnings, and estimated a buyback adjusted ERP of 5.16%, with buybacks reduced over time to a sustainable level. As in prior volatile months, I computed the ERP at the end of each trading day, using both measures of cash flows (trailing 12 months and modified to reflect earnings). The numbers are in the table below:
Download spreadsheet
The ERP rose about 0.60% (on both measures) during the month to peak on January 20, though it dropped back again in the last few days of the month. It is true that I left the cash flows and growth periods unchanged over the trading days, and that the bad news of the month may reverberate, with lower buybacks and growth expectations in the coming months. thus, the increase in the ERP is exaggerated, but, in my view, the bulk of the change will remain. The essence of a crisis month, like this one, is that the price of risk will increase during the month.

The Five Trillion Dollar Heist: Who did it?
The month started badly, with the Chinese markets dropping on the first trading day of the year and taking other markets down with them. Much of the month followed in the same vein, with extended periods of market decline followed by strong up days. Oil and China continued to be the market drivers, with oil prices continuing their inexorable decline and news of economic slowdown from China coming in at regular intervals. The damage inflicted during the month is captured in the chart below:

The global equity markets collectively lost $5.54 trillion in value during the month, roughly 8.42% of overall value. The global breakdown of value also reflects some regional variations, with Chinese equities declining from approximately 17% of global market capitalization to closer to 15%. To the question of how the month measures up against the worst months in history, the good news is that there have been dozens of months that delivered worse returns in the aggregate. In fact, the US equity market's performance in January 2016 would not even make the list of 25 worst months in US market history, all of which saw double-digit losses or worse or even the 50 worst month list. 

Whodunnit? Surveying the Regional Damage
As you can see in the pie chart, the pain was not inflicted equally across the world. China was the worst affected market and the details of the damage by region are captured in the table below. 

Country Performance Spreadsheet
Not only did mainland Chinese stocks lose more than 20% of their market capitalization, more than 75% of all stocks in that country dropped more than 10% and 59% dropped by more than 20%; Hong Kong listings fared a little better, but still managed to come in second in the race for worst regional market. Indian and Japanese stocks were hard hit, but the rest of Asia (small Asia) did not do as badly. Among the developed markets, Australia was the worst affected but the UK, US and EU regions saw market capitalizations drop by 6-7%. 

If you are a knee-jerk contrarian, you may be tempted to jump into the Chinese market, especially since mainland Chinese stocks traded at 15.73 times earnings, on January 31, 2016, down from 20.28 times earnings at the start of the month, and Hong Kong based Chinese stocks look even cheaper. In the global heat map below, you can look up how stock markets fared in each country during January 2016 and pricing multiples at which equities are trading at the end of the month. 

The Sector Effects
Just as the market damage varied across countries in January 2016, it also varied across industry groupings. Using my industry categorization, I looked at the change in market capitalizations, by industry, and key pricing multiples (PE, Price to Book, EV to EBITDA, EV to Invested Capital) at the start and end of January 2016. The entire list can be downloaded at this link, but the fifteen industries that fared the worst, in terms of drop in market capitalization, are listed below:

Industry Spreadsheet
The biggest surprise, given the news about continued drops in oil prices, is that none of the oil groupings (I have four) showed up on the list, with integrated oil companies dropping only 4.20%  and oil distribution companies dropping 8.93% during the month. Not surprisingly, there are a host of cyclical companies on this list, but biotech and electronics companies also suffered large drops in value. Looking at the fifteen industries that fared the best during the month, tobacco topped the list, as one of the three industries that managed to post positive returns, with utilities and telecom services being the other two. 
Precious metals did well, reflecting the tendency of investors to flee to them during crisis, but most of the rest of the list reflects industries that sell the essentials (food and household products, health care).

Where next?

As investors, we often feel the urge to extrapolate from small slices of market history, and I am sure that there will be some who see great significance in the last month's volatility. They will dredge up temporal anomalies like the January effect to explain why stocks are doomed this year and that if Denver wins the Super Bowl, it is going to be catastrophic for investors. I am not willing to make that leap. What I learned from January 2016 is that stocks are risky (I need reminders every now and then), that market pundits are about as reliable as soothsayers, that the doomsayers will remind you that they "told you so" and that life goes on. I am just glad the month is over!

  1. ERP by day for the S&P 500 with ERP spreadsheet, if you want to do it yourself.
  2. Industry Price Performance (with multiples before and after)
  3. Country Price Performance 
Data Update Posts

Saturday, January 30, 2016

Corporate Finance 101: A Big Picture, Applied Class!

In my last seven posts, I played my version of Moneyball with company data from the end of 2015, looking at how companies invest their shareholders' money, how much they borrow and the determinants of how much cash they return to stockholders. That structure is the one that underlies the corporate finance class that I have taught every year since 1984, the first two years at UC Berkeley, and the last 30 years at the Stern School of Business. Each semester, for the last few years, I have also invited you, even if you are not a Stern MBA student, to follow the class online, if you so desire, in all its gory details. If you are considering this options, I thought it would make sense to take you on a mini-tour of corporate finance, as a discipline, and how I aim to tackle it in this class.

Corporate Finance: The Big Picture
There are many versions of corporate finance that are taught in class rooms. There is the accounting version of corporate finance, that uses the historical, rule-bound construct of accounting as the basis for corporate finance. Decision making is driven by accounting ratios and financial statements, rather than first principles. There is the banking version of corporate finance, where the class is structured around what bankers do for firms, with the bulk of the class being spent on areas where firms interact with financial markets (M&A, financing choices) and the focus is less on what's right for the firms, and more on how the deal making works. My version of corporate finance is built around the first principles of running a business and it covers every aspect of business from production to marketing to even strategy. In case you are skeptical about the big picture version of this class, here is what it looks like:
All of corporate finance boils down to three broad decisions, the investment decision, which looks at where you should invest your resources, the financing decision, where you decide the right mix and type of debt to use in funding your business and the dividend decision, where you determine how much to hold back in the business (as cash or for reinvestment) and how much to return to the owners of the business.

Applied, not Theory
I find theory for the sake of theory to be arid, and I build my classes around a very simple proposition: if it cannot be applied, I don't talk about it. That application focus may put you off, but my class is essentially the equivalent of a corporate finance lab, where when I introduce a model or a hypothesis,  I get to try it out on real companies in real time. I use six companies through the entire class to illustrate both the theory and how its application can vary across companies:

Thus everything I do in the class, from estimating hurdle rates to determining finance mix to assessing dividend policy, I try on Disney (a large, US, entertainment firm), Vale (a global mining company, based in Brazil, with a government interest in it), Tata Motors (an India-based auto company, part of a family group), Baidu (a Chinese search engine company, traded as a shell company on the NASDAQ), Deutsche Bank (a messy, money center bank, with regulatory constraints) and a small privately owned bookstore in New York City (owned by a third-generation owner).

The Class Structure
The class starts on February 1, with a session from 10.30 to 11.50, and continues through May 9, with sessions every Monday and Wednesday, with a break week starting March 14. The lectures are supplemented with slides and my book on applied corporate finance, with the latter being completely optional, since you can live without it.  The calendar for the class is at this link.

There will be three 30-minute quizzes in the class, each worth 10%, spread out almost evenly across the first 22 sessions, and each quiz will be non-cumulative, covering only the 6-7 sessions prior. In keeping with my view that this is not about memorizing equations and formulas, the quizzes will be open books and open notes. There is a two-hour final exam, which is cumulative and will be after the final session  in May that will account for 30% of the grade.

There will be two projects, with the first being an investment case (that I have not written yet) that will make you decide on whether to make a big investment or not (Apple in the electric car market, Google buying Twitter etc.) and the second being a semester-long exercise of trying every aspect of corporate finance on a company of your choice.

The Online Version
If you are in my class, there is little more to be said, since I will see you in class on Monday. If you are not, you can still partake in almost all of the class. The lectures will not be carried live, but will be recorded and the webcasts should be up by late in the day, Mondays and Wednesdays, through the entire semester. You can find those webcasts in one of three forums:
  1. My website: The links to the webcasts, as well as links to my other material (lecture notes, handouts, even emails to the class) can be found at this link
  2. iTunes U: If you prefer a more polished format, I will also be putting the class online on iTunes U, the app that you can download from the Apple store for any Apple device. The link to the class is here and if already have Apple iTunes U installed on your device, you can add this class with the enroll code of EPF-JFH-SHE. 
  3. YouTube Playlist: I will also be putting the classes up on a playlist on my YouTube account. With each session that I put up, I will also add links to the lecture notes used in the session and additional exercise. 
Not only can you watch the lectures and review the notes, you can also try your hand at the quizzes and final exam, when they are given. I will post the exams, after the class has taken them, online and  I will post the solution, with the grading template that I used in class. You will be your own grader and may be tempted to go easy on yourself, but that's your choice. You can even do the case and the project, but I will unfortunately not have the resources to review or grade either. The good news is that none of this should dent your pocket book, but the bad news is that you will not get class credit or a certificate.

Alternative Routes
Each semester, I know that quite a few people start with my classes, but life very quickly gets in the way. One of the problems of online classes is that without the discipline of having to get to a physical class or concern about credit/grades, it is difficult to persevere to the end. I entirely understand this problem and if, after trying one or two classes or even a few, you decide that your life is too full for more stuff to be added on. I do have a few suggestions, if you still feel that you will gain from the class:
  1. Stretch it out: The class will stay online on all three forums for at least a year or two. Thus, you can stretch out the class to match your time schedule, instead of taking it in calendar time. I had at least three or four people completing the Spring 2012 class, last year.
  2. Online Corporate Finance class: If you find the 80-minute class sessions that make up this class unendurable, I do have a compressed version of the class, where I take each session and do it in 10-15 minutes, instead of 80 minutes. In a testimonial to how much we bulk up college classes, it was not that tough to do and you can find it on my website at this link, on iTunes U at this one or on YouTube at this one.
  3. Executive Corporate Finance class: I just completed a three-day corporate finance class for executive MBAs that is only a mildly compressed version of my regular class and you can find the links to the webcasts for that class on my website.
The End Game
I know that some of you may wonder what the catch is and where I plan to hit you up for fees. While you search for my hidden agenda, I have only one request of you. If you find any of the material in these classes to be useful to you, rather than thank me for it, please pass the favor on, by helping someone else learn, understand or do something. Not only will you get far more out of this simple act of kindness than the person that you offer it to, but I hope that you will also get a sense of why teaching is its own reward.

YouTube Intro to Class

Class links (Spring 2016 MBA class)
  1. My website
  2. iTunes U
  3. YouTube Playlist
Lecture Notes for Class
  1. Syllabus and Project
  2. Lecture Note Packet 1
  3. Lecture Note Packet 2
 Book if you want it
  1. Applied Corporate Finance, 4th Edition (Warning: It is obscenely over priced but there is not much that I can do about it. Sorry!)

Wednesday, January 27, 2016

January 2016 Data Update 7: Dividends, Potential Dividends and Cash Balances

In the last six posts, I have tried to look at the global corporate landscape, starting with how the market is pricing risk in the US and globally, how much investors are getting as risk free returns in different currencies and then moving on to differences across companies on the costs of raising funding (it varies by sector and region),  the quality of their investments (not that good) and their indebtedness (high in pockets). In this, the last of these posts, I propose to look at the final piece of the corporate finance picture, which is how much companies around the world returned to stockholders in dividends (and stock buybacks) and by extension, how much cash they chose to hold on for future investments. 

Dividends, Potential Dividends and Cash
Dividend policy is often the ignored step child of corporate finance, treated either as an obligation that has to be met by companies or as a sign of weaknesses by those who believe that companies exist only to build factories and invest resources. The reality is that dividends are a central reason for investing and unless cash gets returned to investors, and I am willing to expand my notion of dividends to include buybacks, there is no real payoff to investing. That said, the question of how much a company can pay in dividends is affected in most businesses, by investing and financing choices. If equity is a residual claim, as it is often posited to be, dividends should be the end-result of a series of decisions that companies make:

If  you accept the logic of this process, companies that have substantial cash from operations, access to debt and few investment opportunities should return more cash than companies without these characteristics.

In practice, the sequencing is neither this clean, nor logical. Dividend policy, more than any other aspect of corporate finance, is governed by inertia (an unwillingness to let go of past policy) and me-too-ism (a desire to be like everyone else in the sector) and as a consequence, it lends itself to dysfunctional behavior. In the first dysfunctional variant, rather than be the final choice in the business sequence, dividends become the first and the dominant part driving a business, with the decision on how much to pay in dividends or buy back in stock made first, and investment and financing decisions tailored to deliver those dividends. 

Not surprisingly, dividends then act as a drain on firm value, since companies will borrow too much and/or invest too little to maintain them.  In a diametrically opposite variant, managers act as if they own the companies they run, are reluctant to let go of cash and return as little as they can to stockholders, while building corporate empires.

These companies can afford to pay large dividends, choose not to do so and end up, not surprisingly, with huge cash balances. It is worth noting that the corporate life cycle, a structure that I have used repeatedly in my posts, provides some perspective on how dividend policy should vary across companies.

Dividend Policies across Companies
As with my other posts on the data, I started by looking at the dividends paid by the 41,889 companies in my sample, with an intent of getting a measure of what constitutes high or low dividends. So, here were go..

1. Measures of dividends: There are two widely used measures of dividends. The first when dividends are divided by net income to arrive at a dividend payout ratio, a measure of what proportion of earnings gets returned to stockholders (and by inversion, what proportion gets retained in the firm). The distribution of dividend payout ratios, using dividends and earnings from the most recent 12 months leading into January 2016,  is captured below:
Source: Damodaran Online
Note that more firms (23,022) did not pay dividends, than did (18,867), in 2015. Among those companies that paid dividends, the median payout ratio is between 30% and 40%.

The other dividend statistic is to divide dividends paid by market capitalization (or dividends per share by price per share) to estimate a dividend yield, a measure of the return that you as a stockholder can expect to generate from the dividends, on your investment. The rest of your expected return has to come from price appreciation. Again, using trailing 12-month dividends leading into and the price as of December 31, 2015, here is the distribution:
As with the payout, the yield is more likely to be zero than a positive number for a globally listed company, but the median dividend yield for a stock was between 2% and 3% in 2015.

2. The Buyback Option: For much of the last century, dividends were the only cash flows that stockholders in corporations received from the corporations. Starting in the 1980s, US companies have increasingly turned to a second option to returning cash to stockholders, buybacks. From an intrinsic value perspective, buybacks have exactly the same consequences to the company making them, as dividends, reducing cash in the hands of the company and increasing cash in the hands of stockholders. From the stockholders' perspective, there are differences, since every stockholder gets dividends (and has to pay taxes on it) while only those who sell their shares back get cash with buybacks, but leave the remaining stockholders with higher-priced stock. In the table below, I look at the proportion of the cash returned that took the form of buybacks for companies in different regions in the twelve months leading into January 2016:
While it is true that US companies have been in the forefront of the buyback boom, note that the EU and Japan are not far behind. Buybacks are not only here to stay, but are becoming a global phenomenon.

3. The Cash Balance Effect: Any discussion of dividends is also, by extension, a discussion of cash balances, since the latter are the residue of dividend policy. In this final graph, I look at cash balances at companies, as a percent of the market capitalizations of these companies. 
You may be a little puzzled about the companies that have cash balances that exceed the market capitalizations, but it can be explained by the presence of debt. Thus, if your market capitalization is $100 million and you have $150 million in debt outstanding, you could hold $150 million of that value in cash, leaving you with cash at 150% of market capitalization.

Industry Differences: The Me Too Effect
If a key driver of dividend policy is a desire to look like your peer group, it is useful to at least get a measure of how dividend policy varies across industries. Using my 95 industry groups as the classification basis, I looked at dividend yields and payout ratios, as well as the proportion of cash returned in buybacks and cash balances, and you can download the data here. While there are many measures on which you can rank industries on dividend policy, I decided to do the rankings based on the cash balances, as a percent of market capitalization, because it is the end result of a lifetime of dividend policy. In the table below, I list the 15 industries that have the lowest cash balances, as a percent of market capitalization, in January 2016.
While this is a diverse listing, most of these industries are in mature businesses, where there is little point to holding cash and one reason for the low cash balances is that many of the companies in these sectors return more cash than they have net income.

At the other end of the spectrum are industries, where cash accumulation is the name of the game. Below, I list the 15 industries (not including financial services, where cash has a different meaning and a reason for being) that had the highest cash balances as a percent of market capitalization.

In a few of these businesses, such as engineering and real estate development, the cash balances may reflect operating models, where the cash will be used to develop properties or on large projects and is thus transitional. There are other businesses, such as auto, shipbuilding and mining, where managers may be using cyclicality (economic or commodity) as a rationale for the cash accumulation. The ratio may also be skewed upwards in highly levered companies, since market capitalization is a smaller percent of overall value in these companies.

Regional Differences
If me-tooism is the driver of why companies in a sector often have similar dividend policies, can it also extend to regions? To examine that question, I started by looking at dividend statistics, by region:
Companies in Australia, Canada and the UK returned more cash collectively, in dividends, than they generated in net income, a reflection of both tax laws that favor dividends and a bad year for commodities (at least for the first two). Japanese companies are cash hoarders, paying the least in dividends and holding on to the most cash. Indian companies are cash poor on every dimension, paying little in dividends and having the least cash, as a percent of market capitalization, of any of the regional groupings. Finally, while much has been made about how much cash has been accumulated at US companies (about $2 trillion), the cash balance, as a percent of market capitalization, is among the  lowest in the world. Absolute values are deceptive, since they will skew you towards the largest markets.

I also computed dividend statistics (dividend yield, cash dividend payout, cash return payout and cash as a percent of market capitalization) by country and plotted them on a heat map:
Note that in some of these countries, the sample sizes are small and the statistics have to be taken with a lot of salt.

The Bottom Line
For both managers and investors, dividends are more than just a return of cash for which companies have no use. Dividends become a divining rod for the company's health, a number that companies stick with through good times and bad and one that has its roots in imitation more than fundamentals. Consequently, companies often get trapped in dividend policies that don't suit them, either paying too much and covering up the deficit with debt and investment cut backs or paying too little and accumulating mountains of cash.

Monday, January 25, 2016

January 2016 Data Update 6: Debt, the double edged sword!

In corporate finance, the decision on whether to borrow money, and if so, how much has divided both practitioners and theorists for as long as the question has been debated. Corporate finance, as a discipline, had its beginnings in Merton Miller and Franco Modigliani's classic paper on the irrelevance of capital structure. Since then, theorists have finessed the model, added real life concerns and come to the unsurprising conclusion that there is no one optimal solution that holds across companies. At the same time, practitioners have also diverged, with the more conservative ones (managers and investors) arguing that debt brings more pain than gain and that you should therefore borrow as little as possible, and the most aggressive players positing that you cannot borrow too much.

The Trade off on debt
The benefits of debt, for better or worse, are embedded in the tax code, which in much of the world favors borrowers. Specifically, a company that borrows money is allowed to deduct interest expenses before paying taxes, whereas one that is equity funded has to pay dividends out of after-tax earnings. This, of course, makes it hypocritical of politicians to lecture any one on too much debt, but then again, hypocrisy is par for the course in politics. A secondary benefit of debt is that it can make managers in mature, cash-rich companies a little more disciplined in their project choices, since taking bad projects, when you have debt, creates more pain (for the managers) than taking that same projects, when you are an all equity funded company.

On the other side of the ledger, debt does come with costs. The first and most obvious one is that it increases the chance of default, as failure to make debt payments can lead to financial distress and bankruptcy. The other is that borrowing money does create the potential for conflict between stockholders (who seek upside) and lenders (who want to avoid downside), which leads to the latter trying to protect themselves by writing in covenants and/or charging higher interest rates.

Pluses of DebtMinuses of Debt
1. Tax Benefit: Interest expenses on debt are tax deductible but cash flows to equity are generally not. The implication is that the higher the marginal tax rate, the greater the benefits of debt.1. Expected Bankruptcy Cost: The expected cost of going bankrupt is a product of the probability of going bankrupt and the cost of going bankrupt. The latter includes both direct and indirect costs. The probability of going bankrupt will be higher in businesses with more volatile earnings and the cost of bankruptcy will also vary across businesses.
2. Added Discipline: Borrowing money may force managers to think about the consequences of the investment decisions a little more carefully and reduce bad investments. The greater the separation between managers and stockholders, the greater the benefits of using debt.2. Agency Costs: Actions that benefit equity investors may hurt lenders. The greater the potential for this conflict of interest, the greater the cost borne by the borrower (as higher interest rates or more covenants). Businesses where lenders can monitor/control how their money is being used can borrow more than businesses where this is difficult to do.

In the Miller-Modigliani world, which is one without taxes, bankruptcies or agency problems (managers do what's best for stockholders and equity investors are honest with lenders), debt has no costs and benefits, and is thus irrelevant. In the world that I live in, and I think you do too, where taxes not only exist but often drive big decisions, default is a clear and ever-present danger and conflicts of interests (between managers and stockholders, stockholders and lenders) abound, some companies borrow too much and some borrow too little.

The Cross Sectional Differences
Looking at the trade off, it is clear that 2015 tilted more towards the minus side than plus side of the equation for debt, as the Chinese slowdown and the commodity price meltdown created both geographic and sector hot spots of default risk. As in prior years, I started by looking at the distribution of debt ratios across global companies, in both book and market terms:
Debt to capital (book) = Total Debt/ (Total Debt + Book Equity)
Debt to capital (market) = Total Debt/ (Total Debt + Market Equity)
In keeping with my argument that all lease commitments should be considered debt, notwithstanding accounting foot dragging on the topic, I include the present value of lease commitments as debt, though I am hamstrung by the absence of information in some markets. I also compute net debt ratios, where I net cash out against debt, for all companies:
Damodaran Online
While debt ratios provide one measure of the debt burden at companies, there are two other measures that are more closely tied to companies getting into financial trouble. The first is the multiple of debt to EBITDA, with higher values indicative of a high debt burden and the other is the multiple of operating income to interest expenses (interest coverage ratio), with lower values indicating high debt loads. In 2015, the distribution of global companies on each of these measures is shown below:

By itself, there is little that you can read into this graph, other than the fact that there are some companies that are in danger, with earnings and cash flows stretched to make debt payments, but that is a conclusion you would make in any year.

The Industry Divide
To dig a little deeper into where the biggest clusters of companies over burdened with debt are, I broke companies down by industry and computed debt ratios (debt to capital and debt to EBITDA) by sector. You can download the entire industry data set by clicking here, but here are the 15 sectors with the most debt (not counting financial service firms), in January 2016.
Damodaran Online, January 2016
There is a preponderance of real estate businesses on this list, reflecting the history of highly levered games played in that sector. There are quite a few heavy investment businesses, including steel, autos, construction shipbuilding, on this list. Surprisingly, there are only two commodity groups (oil and coal) on this section, oil/gas distribution, but it is likely that as 2016 rolls on, there will be more commodity sectors show up, as earnings lag commodity price drops.

In contrast, the following are the most lightly levered sectors as of January 2016.
Damodaran Online, January 2016
The debt trade off that I described in the first section provides some insight into why companies in these sectors borrow less. Notice that the technology-related sectors dominate this list, reflecting the higher uncertainty they face about future earnings. There are a few surprises, including shoes, household products and perhaps even pharmaceutical companies, but at least with drug companies, I would not be surprised to see debt ratios push up in the future, as they face a changed landscape.

The Regional Divides
If the China slow-down and the commodity pricing collapse were the big negative news stories of 2015, it stands to reason that the regions most exposed to these risks should also have the most companies in debt trouble. The regional averages as of January 2016 are listed below:
Damodaran Online, Data Update of 41,889 companies in January 2016
The measure that is most closely tied to the debt burden is the Debt to EBITDA number and that is what I will focus on in my comparisons. Not surprisingly, Australia, a country with a disproportionately large number of natural resource companies, tops the list and it is followed closely by the EU and the UK.  Canada has the highest percentage of money-losing companies in the world, again due to its natural resource exposure. The companies listed in Eastern Europe and Russia have the least debt, though that may be due as much to the inability to access debt markets as it is to uncertainty about the future. With Chinese companies, there is a stark divide between mainland Chinese companies that borrow almost 2.5 times more than their Hong Kong counterparts. If you are interested in debt ratios in individual countries, you can see my global heat map below or download the datasets with the numbers.

If the biggest reason for companies sliding into trouble in 2015 were China and Commodities, the first three weeks of 2016 have clearly made the dangers ever more present. As oil prices continue to drop, with no bottom in sight, and the bad news on the Chinese economy continue to come out in dribs and drabs, the regions and sectors most exposed to these risks will continue to see defaults and bankruptcies. These, in turn, will create ripples that initially affect the banks that have lent money to these companies but will also continue to push up default spreads (and costs of debt) for all firms. 

The Bottom Line
Debt is a double edged sword, where as you, as the borrower, wield one edge against the tax code and slice your taxes, the other edge, just as sharp, is turned against you and can hurt you, in the event of a downturn. In good times, companies that borrow reap the benefits of debt, slashing taxes paid and getting rewarded with high values by investors, who are just as caught up in the mood of the moment. In bad times, which inevitably follow, that debt turns against companies, pushing them into financial distress and perhaps putting an end to their existence as ongoing businesses.  One constraint that I will bring into my own investments decisions in 2016 is a greater awareness of financial leverage, where in addition to valuing businesses as going concerns, I will also look at how much debt they owe. I will not reflexively avoid companies that have borrowed substantial amounts, but I will have to realistically assess how much this debt exposes them to failure risk, before I pull the "buy" trigger.

  1. Debt Ratios, by sector (January 2016)
  2. Debt Ratios, by country (January 2016)

Wednesday, January 20, 2016

January 2016 Data Update 5: Making a case for corporate governance

In my last post, I looked at the cost of capital, a measure of what it costs firms to raise capital. That capital, if put to good use by businesses, should earn returns higher than the costs to generate value. Simply put, the end game in business is not just to make money but to make enough to cover a risk-adjusted required return. In publicly traded companies, it is managers at these companies, for the most part, who are investing the capital that comes from stockholders and bondholders (or banks), and corporate governance is a measure of whether these managers are being held accountable for their investment decisions.

Defining a good investment
It is true that there are differences of opinion about how best to measure the cost of raising funds, but disagreements about the cost of capital are drowned out by disputes on how best to measure the returns that are generated by investing this capital. There are two widely used proxies for profitability. One is the profit margin, obtained by dividing the earnings by the revenues of the firm, and it can be estimated using either operating income (operating margin) or net income (net margin). Since the latter is a function of both the profitability of businesses and how much they have chosen to borrow, I will focus on operating margins and report on the distribution of both pre-tax and after-tax operating margin in the graph below:
Source: Damodaran Online
The second measure of profitability, and perhaps the more useful one in the context of measuring the quality of an investment, is obtained by scaling the operating earnings to the capital invested in a project or assets to estimate a return on invested capital. The capital invested is usually computed by aggregating the book values of debt and equity in a business and netting out the cash. The resulting return on invested capital can be compared to the cost of capital to arrive at the excess return (positive or negative) earned by a firm. In the figure below, I look at the mechanics of the return on capital computation in the picture below.

Note the caveats that I have added  to the picture, listing the perils of trusting two accounting numbers: operating income and invested capital. I did try to correct for the accounting misclassifications, converting leases into debt and R&D into capital assets, and also computed an alternate return on capital measure, based on average earnings over the last ten years. Notwithstanding these adjustments, I am still exposed to a multitude of accounting problems and I have to hope and pray that the law of large numbers will bail me out on those.

I computed the return on invested capital for each of the 41,889 firms in my sample and subtracted out the cost of capital for each one to arrive at an excess return. The graph below captures the distribution of this excess return across global firms in 2015:

Overall, more than half of all publicly traded firms, listed globally, earned returns on capital that were lower than the cost of capital in 2015 and this conclusion is not sensitive to using average income or my adjustments for R&D and leases. The return on capital is a flawed measure and I have written about the adjustments that are often needed to it. That said, with the corrections for leases and R&D, it remains the measure that works best across businesses in capturing the quality of investments.

Industry Excess Returns
In the second part of the analysis, I broke down the 41,889 companies into 95 industry grouping and computed the excess returns for each industry group.  The full results are at this link, but I ranked companies based on the magnitude of the excess returns. Again, with all the reservations that you can bring into this measure of investment quality, the businesses that delivered the highest spreads (over and above the cost of capital) are listed below.

The best-performing sector is tobacco, where companies collectively earned a return on capital almost 22% higher than the cost of capital. One potential problem is that many of the businesses on this list also happen to be asset-light, at least in the accounting sense of the word, and some of these returns may just reflect our failure to fully capitalize assets in these businesses.

Looking at the other end of the spectrum, the following is a list of the worst performing businesses in 2015, based on returns generated relative to the cost of capital.

Note that oil companies are heavily represented on this list, not surprising given the drop in oil prices during the year. That, of course, does not make them bad businesses since a turning of the commodity price cycle will make the returns pop. There are other businesses that have been affected by either the slowing down of the China growth engine, such as steel and shipbuilding, and the question is whether they can bounce back if Chinese growth stays low. Finally, there are some perennially bad businesses, with auto and truck being one that has managed to stay on this list every year for the last decade, grist for my post on bad businesses and why companies stay in them.

In computing this excess return, I deliberately removed financial service firms from the mix, because computing operating income or invested capital is a difficult, if not impossible task, at these firms. Lest you feel that I am giving managers at these firms a pass on the excess return question, I would replace the excess return spread (ROIC - Cost of capital) with an equity excess return spread (ROE - Cost of Equity) for these companies.

Regional Differences
Are firms in some parts of the world  better at putting capital to work than others? To answer that question, I broke my global sample into sub-regions and computed both operating margins and excess returns (return on invested capital, netted out against cost of capital) in each one.

Looking at the list, the part of the world where companies seem to have the most trouble delivering their cost of capital is Asia, with Chinese companies being the worst culprits and India being the honorable exception. US and UK companies do better at delivering returns that beat their hurdle rates than European companies.

Again, I would be cautious about reading too much into the differences across regions, since they may be just as indicative of accounting differences, as they are of return quality. It is also possible that some of the regions might have a tilt towards industries that under performed during the year and their returns will reflect that. Thus, the excess returns in Australia and Canada, which have a disproportionate share of natural resource companies, may be reflecting the drubbing that these companies took in 2015. 

A Case for Corporate Governance
I have been doing this analysis of excess returns globally, each year for the last few, and my bottom line conclusions have stayed unchanged.
  1. The value of growth: If the value of growth comes from making investments that earn more than your hurdle rate, growth in a typical publicly traded company is more likely to destroy value than to increase value (since more than 50% of companies earn less than their cost of capital). For investors and management teams in companies, I would view this as a signal to not rush headlong into the pursuit of growth.
  2. Bad management stays bad: In my sample, there are firms that have been earning excess returns year after year for most of the last decade, casting as a lie any argument that managers at these firms might make about "passing phases" and "bad years" affecting the numbers. To the question of why these managers continue to stay on, the answer is that in many parts of the world, it is almost impossible to dislodge these managers or even change how they behave.
  3. Bad businesses: There are entire businesses that have crossed the threshold from neutral to bad businesses, but management seems to be in denial. These are the businesses that I have described in my corporate life cycle posts as the "walking dead" companies and I have explored why they soldier on, often investing more into these investing black holes.
Is good corporate governance the answer to these problems? In much of the world, the notion that stockholders are part owners of a company is laughable, as corporations continue to be run as if they were private businesses or family fiefdoms, and politics and connections, not stockholder interests,  drive business decisions in others.. Even in countries like the United States, where there is talk of good corporate governance, it has become, for the most part, check-list corporate governance, where the strength of governance is measured by how many independent directors you have and not by how aggressively they confront managers who misallocate capital. Institutional investors have been craven in their response to managers, not just abdicating their responsibility to confront managers, where needed, but actively working on behalf of incumbent managers to fight off change. The sorry record of value creation at publicly traded companies around the globe should act as a clarion call for good corporate governance. In the words of Howard Beale, from Network, we (as stockholders) should be "mad as hell and should not take it any more".

  1. Paper on measuring ROIC, ROC and ROE (Warning: Extremely boring but could be cure for amnesia. Don't read for excitement value!)

Wednesday, January 13, 2016

January 2016 Data Update 4: The Costs of Capital

In this post, the fourth in my data update series, I turn my focus to the cost of capital. While the discussion of cost of capital is often obscured by debates about risk and return models, it is a number central to much of what we do in corporate finance and valuation, and it predates modern portfolio theory. You cannot run a business without a sense of what you need to make on your investments to break even and you cannot value a business without a measure of your opportunity cost. 

The Swiss Army Knife of Finance
I teach two classes, corporate finance and valuation, and I wear different hats, when looking at the same questions. In corporate finance, my focus is on how to run a business, using fundamental financial principles, and in valuation, I shift my attention to how value that business, using the same principles. Like Waldo, the cost of capital is a constant part of both classes, playing a key role in almost every discussion.

In the corporate finance class, it shows up in each of the three big questions that every business has to answer. It helps you answer the first one, on where you should direct your investments, by suppling your business with a hurdle rate or rates for investments, with riskier investments having to meet a higher threshold, to be acceptable.

In capital structure, the cost of capital  becomes an optimizing tool that helps you decide the right mix of debt and equity.

In dividend policy, the cost of capital becomes the divining rod for whether you should be returning more or less cash to your stockholders. If you operate in a business where your returns on new investments consistently fall short of your cost of capital, you should be returning more cash to your investors. 

In the valuation class, the cost of capital is the discount rate that you use to bring operating cash flows back to today, to arrive at a value for a business. It has, unfortunately, also become the instrument that analysts use to bring their hopes, fears and worries into value, adding premiums to the discount rate, if an asset is illiquid, or reducing it, if it provides other benefits.

In short, it is difficult to do financial analysis without at least getting a sense of what the cost of capital is, for a business. The many uses to which it is put has also meant that it has become all things to all people, a number that is misused, misestimated and misunderstood.

The Mechanics of Estimating Cost of Capital
About a year ago, in the context of my 2015 data update, I had an extensive post on the mechanics of computing cost of capital. Rather than repeat that post, I will direct you to it and summarize the process in a picture, for estimating the cost of capital for a company in US dollars:

Thus, the cost of capital is a composite cost of equity and debt and incorporates the tax benefits of debt (through the after-tax cost of debt) and the risk added by debt in increased costs for both equity and debt. If you want to estimate the cost of capital in a different currency, you have two choices. The first is to replace the US dollar risk free rate with the other currency's risk free rate (seem my earlier post on currencies) or to add the differential inflation rate between the US dollar and the currency in question to a US dollar cost of capital. Thus, if your US dollar cost of capital is 10%, the inflation rate in rubles is 9.5% and the US dollar inflation rate is 1.5%, your Russian ruble cost of capital will be approximately 18%. (It is a little more precise to compute this rate allowing for the compounding: (1.10) (1.095/1.015) -1, but I will leave it up to you to decide whether it is worth the effort.)

The Cost of Capital - US companies
Let me start off with the US-centric portion of this post, where I look at the distribution of costs of capital across my sample of 7480 firms that are listed in the United States. In making my assessments, I made some simplifying assumptions:
  1. I used the US 10-year bond rate of 2.27%, on January 1, 2016, as my risk free rate. I don't like to play games normalizing risk free rates.
  2. I used the average unlevered beta for the sector as the beta for the company and levered this beta with the current debt to equity ratio of the firm.
  3. I used the implied equity risk premium for the S&P 500 (6.12% on January 1, 2016, rounded down to 6%) as the equity risk premium for all US companies in estimating the cost of equity. I know that some US companies have operating risk exposure outside the US, but I see no easy way that I can compute regional-weighted ERPs for this many companies.
  4. For the cost of debt, I used the S&P bond rating, if one was available, to estimate the default spreads and pre-tax cost of debt of the firm. For non-rated company, I used the standard deviation in equity in conjunction with a look up table (see the cost of capital spreadsheet) to estimate the default spread and pre-tax cost of debt. I used 40% as the marginal tax rate for the US in estimating the after-tax cost of debt.
  5. I used the current market capitalization as the value of equity and added up all interest bearing debt with the present value of lease commitments (for the next 5 years and beyond) to get to the debt, in computing the weights for debt and equity.
The resulting distribution of costs of capital across US companies is summarized below. Note that 90% of US firms have costs of capital between 5.23% and 10% and 50% of US firms have costs of capital between 6.60% and 9.20%.

If you are skeptical about betas and don't like computing costs of equity based upon them, I have a suggestion. Use the distribution of costs of capital in this graph, as your basis, for estimating a cost of capital for your firm. Use the cost of capital at the 90th percentile as your cost of capital for a risky firm, 8% as your cost of capital for a mature firm and 5.23% as your cost of capital for a very safe firm, and you should be relatively safe.

The Cost of Capital - Global Distribution
I also computed the cost of capital differences across global regions. Note that the differences are not rooted in currency, since the cost of capital for every firm is computed in US dollars. As to why costs of capital vary across countries, the answer can be traced back to two factors. The first is that debt ratios vary across the world, and that this may explain some of the variation. The second is that the regions of the world with higher sovereign default spreads and equity risk premiums (they go together in my approach) will have higher costs of capital than regions that have less risk. The table below summarizes the difference.

US companies have the lowest costs of capital, on average, in the world and East European and Russian companies carry the highest costs of capital. These are all in US dollars, but you can use the differential inflation approach to convert them into other currencies.

The Cost of Capital - Sector Differences
 Starting with the 41,889 firms that I have in my global sample at the start of 2016, I estimated the cost of capital for each company in dollar terms and then looked at the average costs of capital by sector. While you can find the entire sector list for cost of capital at the bottom of this post, I have listed the ten non-financial sectors with the highest costs of capital and the ten with the lowest:
Source: Damodaran Online
So, what now? If you have to estimate the cost of capital for a sector or a company in that sector, in US dollar terms, you could use the cost of capital for any companies that you value, in this sector. Again, adding the inflation differential will give you the cost of capital in any other currency. 

The Bottom line
The cost of capital may be the most used number in finance, but it is also the most misused. Companies often use one cost of capital to assess investments with different risk profiles, acting on the presumption that the cost of capital is the cost of raising company, rather than a risk adjusted required return for investing in a  risky asset. Investors use the cost of capital as a dumping ground for all their fears about investments, augmenting the standard risk-adjusted discount rate with premiums for liquidity, small market capitalization and opacity. We can do better!

  1. Cost of Capital: Misused, Misestimated and Misunderstood