The IPO of the decade? My valuation of Facebook

The Facebook IPO gets closer and I don’t think I can put off this valuation much longer. While we don’t have an offering price yet, the preliminary estimates are that the company will be valued somewhere between $75 billion and $100 billion. As with my Skype, Linkedin and Groupon valuations, I will present my assumptions and valuation of Facebook, with the admission that I have no crystal ball and know that your estimates will be very different from mine. So, with that disclaimer out of the way, here are my valuation assumptions for Facebook.

1. Where Facebook stands right now: I started with the Facebook S-1 filing which contains their financials from last year. The pdf version is available here, with my highlights and annotations (just ignore my snarky comments... I cannot help them). Looking at the most recent year's numbers, here is what I see:
(a) Revenues in 2011 were $3,711 million, up  88% from revenues of $1,974 million in 2010, which, in turn, were up  150% from revenue of $777 million in 2009.
(b) The firm's pre-tax operating income increased from $1,032 million in 2010 to $1,756 million in 2011. The firm's net income increased from $ 606 million in 2010 to $ 1 billion in 2011, though a third of that net income was set aside for participating securities (convertible preferred and restricted stock units... More on that later...). Incidentally, Facebook paid 41% of its taxable income as taxes in 2011.
(c) The company is primarily equity funded and its book value of equity at the end of 2011 was $5,228 million; the only debt on the books was $398 million in capital leases. They did have operating lease commitments, which when capitalized yielded a value of $776 million. The total debt is therefor $1,174 million.

2. Future revenues: Facebook is on a "high growth" path, with revenues growing by 150% in 2010 and another 88% in 2011, but as even that sample of two observations suggests, the big question is how that growth rate will hold up as the firm becomes larger. I estimate a compounded revenue growth rate of 40% for the next five years and a scaling down of that growth rate to the nominal growth rate in the economy (set equal to the risk free rate of 2.01%)  by the end of ten years. While both assumptions may strike you as conservative, I am effectively assuming that Facebook will follow a revenue growth path close to Google's over the next 8 years, as evidenced in the chart below, where I compare Google's actual revenues in the 8 years since their IPO with Facebook's forecasted revenues for the next 8 years:

Since advertising revenues are the drivers of both firms' growth engines, and they may very well be competing for the same advertising dollars, I think a comparison of their competitive advantages is in order. Facebook's primary advantage is that they can use what they know about their users (which is a lot... scary thought!) to offer focused advertising. Google's advantage is that it has a more direct and easy business model, since its revenues come from user clicks. In contrast, Facebook has to be careful about making its focused advertising too obvious, since some users will find this creepy. Google has added other products to its mix, with the Android as the most prominent example, and Facebook also has potential avenues for expansion.

3. Operating margin: Facebook has a phenomenal pre-tax operating profit margin in excess of 45%. To provide a contrast, Google's operating margin is currently about 31% and has seldom exceeded 35%. However, Facebook's margins will come under pressure as they actively seek out more revenues and I am assuming that the pre-tax margin will decrease to 35% over the next decade. Even with this assumption, I am estimating operating income for Facebook will exceed Google's by a wide margin over the 8 years following the IPO:

4. Reinvestment: In one of a series of posts on growth, I argued that growth does not come free (or even cheap). That is true for even a company with the pedigree of Facebook. There is some information in the financial statements about reinvestment: the company had net capital expenditures of $ 283 million, an acquisition that cost $24 million and an increase in capital leases of about $ 480 million. To estimate reinvestment in future years, I assumed that the firm would be able to generate about $1.5 million in revenues for every million in additional capital investment. At this stage, it is impossible to tell what form the reinvestment may take, but looking at Google over the last few years should provide clues; the company has moved increasingly to using acquisitions to augment growth. Lest you feel that I am being too conservative, I am estimating that Facebook will generate a return on its capital of about 32% in year 10, up from just over 26% now.

5. Risk and cost of capital: Facebook is a company that is funded almost entirely with equity and while it is a young, growth company, it does have a business model that is working and delivering substantial profits. While we can start from the bottom and work up to a cost of capital, using parameters estimated for Facebook, I will employ a far simpler approach. Looking across the costs of capital of all US companies at the start of 2012 (you can find this on my website), I estimate a cost of capital of 11.42% for advertising companies. I will assume that Facebook will face a similar cost of capital to start. The median cost of capital for US companies is roughly 8% and as Facebook grows and matures, I do adjust the cost of capital down to 8%.

6. Cash and Debt: The assumptions above are sufficient to estimate the value of the operating assets. Discounting the cash flows back at the cost of capital (with changes over time) results in a value of $71,240 million. To get to equity value, I subtract out the outstanding debt ($1,174 million) and add the current cash balance ($1,512 million). While I would normally augment the cash balance with any cash proceeds from the IPO, Facebook is open about the fact (See S1, page 7) that the proceeds will be going to Mark Zuckerberg to cover tax expenses from option exercise and will not be coming to the firm.

Value of equity = $71,240 + $1,512 - $1,174 = $71,578 million

Based on my estimates, the values being bandied around ($75 billion- $ 100 billion) are not unreasonable. As with my Groupon valuation, I ran a simulation,making assumptions about distributions for my key assumptions (revenue growth, operating margin, cost of capital and reinvestment). The results are summarized below:

Note that the median value of $ 70 billion is close to the base case estimate (as it should) but there is a 10% chance that the value could be greater than $ 117 billion and a 10% chance of a value of $ 43 billion or less.

7. Value per share: At some stage in this IPO process, Facebook's investment bankers will have to arrive at a value per share (offered) and you and I will have to decide on whether to buy or not. That could be messy because Facebook has multiple claims on equity, starting with:

a. Equity options: There are 138.54 million options outstanding, from earlier year compensation schemes, with an average maturity of about 2 years and an exercise price of $0.75. My estimate of the value of these options collectively, net of the tax benefits that I see Facebook getting from the exercise, is $3,782 million. I will net this value out against the equity value to get to a value in the shares:

Value in shares = $71,578 million - $3,782 million = $67,795 million

b. Restricted Stock Units: In the last few years, Facebook (like many other tech companies) has shifted to granting restricted stock units. These are regular shares but the holders who receive have to first stay long enough with the company (vest) to lay claim to them and often face restrictions on trading. The liquidity restrictions, in particular, should make these shares less valuable than regular shares. There are 380.719 millions class B shares, in restricted stock units, that will eventually become regular shares and I will add them to current shards outstanding.

c. Class A and Class B shares: After the IPO, there will be 117.097 million Class A shares (with one voting right per share) and 1758.902 million Class B shares (with ten voting rights per share). Other things remaining equal, the latter should trade at a premium on the former, though I don't think that the expected value of control in this company is significant.

If I take the equity value, net of the value of options, and divide by the total number of class A, class B and RSU shares outstanding, the value per share that I get is $29.05. Allowing for a slight discount (3-5%) on the non-voting shares, I would anticipate that the class A shares in the IPO will have a value of about $28 (assuming that my share count is right... I will wait to get a firmer update as we get closer to the offering, before I close in on a per share value). You can access the excel spreadsheet with the numbers by clicking here. If you don't like my inputs or assumptions, don't stew about them. Go in and change them and see what you get as the aggregate value of equity in Facebook. If you can post it in the Google spreadsheet that I have created for this purpose, even better... Let's see if we can get a consensus value for the company.

If you are investing in Facebook, give credit to the company for being upfront and honest about where the power rests in this company. On page 20 of the filing, you will find this "Mr. Zuckerberg has the ability to control the outcome of matters submitted to our stockholders for approval, including the election of directors and any merger, consolidation, or sale of all or substantially all of our assets. In addition,  Mr. Zuckerberg has the ability to control the management and affairs of our company as a result of his position as our CEO  and his ability to control the election of our directors. Additionally, in the event that Mr. Zuckerberg controls our company at  the time of his death, control may be transferred to a person or entity that he designates as his successor." A little later on page 31, you will find this "We have elected to take advantage of the “controlled company” exemption to the corporate governance rules for publicly listed companies. Because we qualify as a “controlled company” under the corporate governance rules for publicly-listed companies, we are not required to have a majority of our board of directors be independent, nor are we required to have a compensation committee or an independent nominating function." Let's be clear about this: this is Mark Zuckerberg's company and you and I are just providing him with capital.

For those of you who are familiar with my valuations of Linkedin and Groupon, you will note that I am more positive about Facebook than those companies. Part of that can be attributed to Facebook being further along in developing a business model that works and delivers profits. Another reason, though, is that Facebook has a real chance at being the next “winner take all” company. What am I talking about? In conventional businesses, a company that gets a large portion of the market is subject to competitive assaults that cap the market share and reduce profitability over time. In some parts of the technology business, controlling a large share of a market seems to give the winner the capacity to take over the whole market. Consider three big winners from the last 30 years. Microsoft started off in the “office suites’ competing with many players in the word processing, spreadsheet and presentation program businesses, but at some point, its dominance drove the competition out. To a lesser extent, Amazon’s dominance of online retailing and Google’s ownership of online advertising (so far) reflect similar “winner take all” phenomena. I am not suggesting that Facebook has a lock on social media advertising, but it has a chance to get a big chunk of it, and if it does, the value that I estimated will be too low. Note that the simulation does yield values of $120 billion or higher for the company, if the stars align.

Would I buy Facebook stock, if its equity were valued at $75 billion? No, and not because I believe that the price is outlandish, but for two other reasons.

• The first is that the price reflects the expectation that Facebook will become a phenomenal success. Anything less than superlative will be viewed as a failure.
• The second is that what Facebook is brazen about the fact that they don't see any need for input from stockholders. In effect, they want my money but don't want me to have any say in how the company is run. This does not jell with the notion that stockholders are part owners of the companies that they owned stock in. You may be comfortable with Zuckerberg as CEO for life but I am not. I am sure that I am in the minority on this one, but different strokes for different folks....

In closing, Facebook has immense promise as a company and it is being priced on the premise that the promise will be delivered. Could it be worth $ 100 billion? Sure, but you are fighting the odds as an investor. Social media companies today collectively and Facebook in particular resemble stores with tremendous foot traffic (850 million users in the case of Facebook) but with nothing on the shelves. You are buying access to the foot traffic and hoping that you can get something on the shelves that they will stop and look at and buy. Given that social media is still in its infancy, we really don't know whether this promise will pan out, and that remains the basis for the uncertainty, and why short cuts that are based on value per member (a metric that I see with social media companies all the time) are fraught with danger.

Options and Taxes: Is a "Facebook" tax next?

Facebook is in the news and I will do my usual pre-IPO valuation and posting in a few days on the company but I want to focus in on an interesting story in this morning's New York Times about option exercise and taxation (at both the individual and corporate levels).

The story itself focuses on two tax issues. The first is that Mark Zuckerberg is planning to exercise about $ 5 billion of options ahead of the offering, resulting in a tax bill of roughly $ 2 billion for him, about $1.5 billion in federal taxes and $ 500 million in California taxes.  The second is that Facebook will be claiming a tax deduction of roughly the same value, which will shelter them from taxes this year and allow them to claim tax refunds of about $ 500 million from prior years. All of this has some in Congress in full "indignation" mode, with Senator Carl Levin saying "“When profitable corporations can use the stock option tax deduction to pay zero corporate income taxes for years on end, average taxpayers are forced to pick up the tax burden,” he said. “It isn’t right, and we can’t afford it.” Before we embark on another tax policy change predicated on a sample of one (Facebook), it is worth examining the broader question of how employee options get taxed, especially at the corporate level.

At the moment, if you are a company that grants options to its employees, the accounting laws require you to value those options as options (rather than at exercise value) and expense them when you grant them (though you can amortize these expenses over a period of time). Thus, what you see reported as operating or net income for a company today is after employee options have been expensed. This, of course, is a sharp reversal of accounting policy prior to 2006, when firms had to show only the exercise value of the options at the time of the grant. Since at the time of the grant, employee options were usually at the money (strike price = stock price), this effectively meant that option grants had no effect on earnings when they were granted. However, if and when the options were exercised, companies were required to show the difference between the stock price and the strike price as an expense. 

To illustrate the difference, assume that you grant 100 million options with a strike price of $10, when the stock price is also $ 10, in 2008. Let's also assume that the options get exercised 2 years later when the stock price is $ 40. With pre-2006 accounting, you would not have shown an option expense in 2008 but you would have shown an expense of $ 3 billion [$40 - $10) (100)] in 2010. In the post-2006 time period, the company would have had to show an option expense in 2008, with the expense computed by valuing the options at the time. (For instance, an at-the-money option with five years to expiration on a stock with a price of $ 10 and a standard deviation of 40% would have a value of $3.36. Carrying this through, the company would have to record an expense of $336 million in 2008 and revisit this expense in subsequent years, as stock prices go up or down.  If you want to, you can try your hand at valuing options with the attached spreadsheet).
[Update: I have been taken to task by the accountants among my readers for being simplistic (and wrong) on the accounting rules, since they are far more complex than what I have described in this example. I confess to the crime but I feel no remorse. I think that I am being truer to the underlying accounting principle of matching expenses up to revenues than the current accounting rules claim to be. My point is that accounting has moved grudgingly to accept the fact that options have to be expensed when they are granted and not when they are exercised, though the accounting obsessions with smoothing and back filling finds their way into the rules. In fact, more on that in my next post]

So, what does this have to do with today's story? While the accounting treatment of options changed in 2006, the tax treatment did not. In effect, the tax authorities still use the pre-2006 convention, not allowing companies to expense options when they are granted but only when they are exercised. This creates a disconnect between accounting earnings and tax earnings, which can make valuation more difficult. But is it a loophole? Seems like it, if you only consider Facebook, which will save a billion dollars in taxes because its options will be exercised at a time when its stock price is sky high. But let's add to this sample of one. Take a company like Cisco, which has granted hundreds of millions of options over the last decade. Since the stock has stagnated over the period, many of these options are now under water and will either end up un-exercised or exercised for far less than the value at the time of the grant. If Cisco had been able to deduct these options at the time they were granted (at option value), they would have saved hundreds of millions of dollars, which they may now will lose forever, if these options remain under water. In the aggregate, with the current tax treatment of options, the government collects less in taxes from Facebook and more in taxes from Cisco.  

Do I think that the tax rules on options should be changed? Perhaps, but it is not because the tax law is unfair or because I think it creates a loophole. As I see it, here are the three choices:

1. Continue with the existing policy of taxing options when they are exercised. The net effect is that the most successful companies (at least in terms of creating market value) will get bigger tax deductions from option expensing than the least successful companies.
2. Change tax law to match accounting law and allow companies to expense options in the year that they grant them. It will smooth out tax collections, level the playing field across companies and create more consistency. But here is the follow up question that gives me a little pause:  Should employees who receive the options then have to show them as income in the year that they receive them? If you are being consistent, the answer is yes, but where will they come up with the cash to pay the taxes? After all, employee options are not liquid and the employee while wealthy (in terms of options) may be cash poor.
3. If you follow Senator Levin's logic that this is a loophole, and you try to craft legislation, I am not sure where it leads you. Should we ban the expensing of options by companies? I would accept that, if you stop taxing employees who receive these options. (If that had been in place this year, Facebook would have to pay about a billion more in taxes but the government would be collecting two billions less in taxes from Zuckerberg...)

As someone interested in valuation, I have wrestled with options and their effect on value for a while. I think that options are mishandled in many valuations, with flawed arguments (Options are non cash expenses...) and perilous short cuts (treasury stock and fully diluted value approaches) overwhelming common sense. In fact, I wrote a paper on the topic that you can download by clicking here. 

Moneyball and Investing: Data, Information and my 2012 Update

I loved Moneyball, both the book, by Michael Lewis, and movie starring Brad Pitt, because they bring together two things I love: baseball and numbers. At the risk of shortchanging the book, the central story in the book is a simple one. For most of baseball’s hundred plus years of existence, insiders (baseball managers, scouts and experts) have used stories and narratives to keep themselves above the riff raff (which is where you and I as fans belong). Thus, scouts claimed to have special skills (based on their long history of having done this before) to find potential superstars in high schools and the minor leagues, and managers justified their personnel decisions and game day choices with gut feeling and baseball instincts. Billy Beane, the general manager of the Oakland As, a storied but budget-constrained franchise, upended the game by shunting hoary tradition and putting his faith in the numbers.

I think that financial markets and baseball share a great deal in common. Equity research analysts are our baseball scouts, asking us to trust their story telling skills when picking stocks. Executives at companies are our baseball managers, flaunting their industry experience and asking us to trust their gut feeling and instincts, when it comes to big decisions. Like Billy Beane, I trust the numbers far more than either analyst stories or managerial instincts, and it is for that reason that I started gathering raw data on individual companies about two decades ago and computing industry averages for a few key inputs into investments: risk, return and growth. Initially, it was a limited exercise, where I looked at only US companies and  a handful of statistics. I put those numbers online, not anticipating many downloads, but was pleasantly surprised at how many people seemed to find the data useful (I won’t flatter myself. The fact that it was free did help…)

Each year my coverage has expanded, driven partially by external demand and mostly by easier access to raw data. Starting in 2003, I went global and a year or two later started providing data on the individual companies as well. So, here is where the long windup is leading. I have just finished the January 2012 update to my data. You can get to it by going to the updated data page on my website:
http://www.stern.nyu.edu/~adamodar/New_Home_Page/data.html
My sample includes all (a) publicly traded firms, (b) listed on any global exchange and (c) have data on the data sources that I use (Value Line for US companies, Capital IQ and Bloomberg for non-US companies). In January 2012, there were 41,803 companies in my overall dataset. 

 I have computed industry averages for about 35 variables, covering a wide range of inputs:
a. Risk measures and hurdle rates: Betas and standard deviations, as well as costs of equity and capital, by sector.
b. Profitability measures: Profit margins (net and operating), tax rates and returns on equity and capital.
c. Growth measures/ estimates: Historical growth rates in revenues and earnings, as well as forecasted growth rates (where available)
d. Financial leverage (debt) measures: Book value and market value debt to equity and debt to capital ratios.
e. Dividend policy measures: Dividend yields and payout ratios, as well as cash statistics (cash as a percent of firm value).
f. Equity multiples: Price earnings ratios (current, trailing, forward), PEG ratios, Price to Book ratios and Price to Sales ratios.
g. Enterprise value multiples: Enterprise value to EBIT, EBITDA, revenues and invested capital.
I generally stay away from macro economic data but I do report equity risk premiums (historical and implied) over time and marginal tax rates across countries.

You are welcome to use whatever data you want from this site, but please keep in mind the following caveats:
1. Data yields estimates, not facts: In these days of easy data access and superb tools for analysis, it is easy to be lulled into believing that you are looking at facts, when you are really looking at estimates (and very noisy ones at that). Every number that is on my site, from the historical equity risk premium to the average PE ratio for chemical companies is  an estimate (and adding more decimal points to my numbers will not make them more precise).
2. Data has to be measured: That is again stating the obvious, but implicit in this statement are two points. The first is that someone (an accountant, a data service, me) is doing the measurement and imposing his or her judgment on the measured value. The second is that there can be error in measurement. Thus, with my data, you can be assured that there are errors and mistakes in the final numbers. While I can blame some of these mistakes on the data services that I get my raw data from, many are mine. So, if you find a mistake or even something that looks like a mistake, please let me know and I promise you two things. First, I will not be defensive about it and will take a look at the issue you have raised. Second, if I do find myself in error, I will fix the error as soon as I can. (With a staff of one (me), this data service can get stretched sometimes… So, please have some patience).
3. Data for post-mortems versus data for predictions: As I see it, data can be used in two ways. The first is to generate post-mortems (about past performance) and the other is make forecasts for the future. Given my focus on corporate finance and valuation, I am more interested in the latter than the former. Thus, my data definitions are more attuned to forecasting than to after-the-fact analysis. Just to provide an example, the cost of capital that I am interested in computing for a company is the cost of capital that I can use for the next five years, not the one for the last three years. 

4. Data anchoring: Whether we like it or not, our instinct when confronted with a number, and asked to decide whether it is high or low, is to compare it what we consider reasonable numbers (at least in our minds). Thus, if I came to you with a stock with a PE of 10, your determination of whether the stock is cheap or expensive will depend largely on what you think the average PE is across all stocks and what comprises a high or low PE and all too often, in the absence of updated and comprehensive data, these are guesses.  It is for this reason that analysts and investors create rules of thumb: a EV/EBITDA of less than six is cheap, a PEG ratio less than one is cheap or a stock that trades at less than book value is cheap. But who comes up with these rules of thumb? And do they work? The only way to answer these questions is to look at the data across all companies and make your own judgments.

There is one final point generally about data that I have to make, and it relates back to Moneyball. Much as I agree with Billy Beane on the importance of data, I think that his mistake was focusing far too much on the data. The data should be the starting point for your assessments, but not the ending point. Stories do matter, if they can be backed up by the data, or to draw implications from it. The secret to great investing is a happy marriage between plausible investment stories and numbers, with the recognition that even the best sounding stories have to be abandoned at some point, if the numbers don’t back them up. So, explore the data and make it your own!!

My small challenge to the "university" business model

I am not a great fan of the university business model as a delivery mechanism for learning. The model can be traced back to the middle ages and is built around physical location and arbitrary requirements for graduation (that have less to do with learning and more to do with maximizing university revenues and faculty comfort). I know! I know! I am a beneficiary of the system and I gain from the low teaching loads and a tenure system that is indefensible. With four children, I am also a consumer of the same system and I am flabbergasted at how little accountability is built into it. How many classes have you taken (or your children taken) where you should have received your money back because of the quality of the learning experience? How often have you been able to get your money back?

For hundreds of years, we (as consumers) have had no choice. Universities have operated with little competition and substantial collusion. There is no other way that you can explain how little variation there is in tuition fees across US universities and the rise in these fees over time. Outside the US, the fees may be subsidized by governments, but the quality of the learning experience is often worse, with the rationale being that if you paid little or nothing for your education, you should eat whatever crumbs fall of the table in you direction. But I think that the game is changing, as technology increasingly undercuts the barriers to entry to this business. I am not just talking about online universities (which, for the most part, have gone for the low hanging fruit) or the experiments in online learning from MIT, Stanford and other universities. These are evolutionary changes that build on the university system and don't challenge it. I am talking about a whole group of young companies that have made their presence felt by offering new tools for delivering class content and learning. I am convinced that the education market is going to be upended in the next decade and that the new model is going to do to universities what Amazon has done to brick and mortar retailers.

To back up my point, I am running an experiment this semester with the classes that I am teaching at the Stern School of Business: Corporate Finance, a first-year MBA class, and Valuation, an elective. I have taught these classes for more than 25 years now and have tried to make the material and the lectures available to the rest of the world, but I have never formally tracked those taking these classes online. In fact, if you were not an MBA student in the class, taking the class online would have required you to forage through my website for materials and keep track of what's going on. And I would have no idea that you even were taking the class... So, I want to change that..

Last semester, I used a company called Coursekit to package and organize my class and was impressed with their clean look and responsiveness to my requests. This semester, which starts in a few days, I have created a coursekit page for each class that is focused on just online students. I will use this page to deliver content (lecture notes, handouts and assignments that those who are in my physical class get), webcasts of lectures (though not in real time, but the links should show up about an hour after the actual class ends ) and even the exams (you can take them and grade them yourself). The site also has a social media component, where you can start or join discussion topics, which I hope will provide the element of interaction that is missing when you do an online course. When you do get to the home page for Coursekit, you will notice my mugshot in the entry way. I promise you that I have zero financial interest in the company but I really want to see it succeed, because I think the education business needs to be shaken up.

The first session for both classes is on Monday, January 30. If you want to take these classes online, here is what you need to do:
a. Corporate finance class
What is it? This is my "big picture" class about how financial principles govern how a business should be run. It looks at everything that a business does, through the lens of finance, and classifies them into investment, financing and dividend decisions.
Who can use it? I am biased but I think that everyone can use a corporate finance class: entrepreneurs starting new businesses, managers at established businesses and investors valuing these businesses.
How do you join? Go to the site (http://coursekit.com/finance). Enter RWHZYG as your code and you can then register for the class. Once you are registered, you will automatically be put into this page, every time you enter the site.

b. Valuation

What is it? This is a valuation class and it is about valuing any type of business: private or public, large or small and across markets. My focus is on providing the tools that will allow you to create your solution to valuation challenges, since new ones keep popping up.

Who can use it? While investors interested in valuing companies may be the obvious target, I teach the class more generally to be useful (I hope) to managers running the businesses and those who are just curious about value.

How do you join? Go to the site (http://coursekit.com/app#course/b40.3331.damodaran). Enter EH7WZN as your code and you can then register for the class. Once you are registered, you will automatically be put into this page, every time you enter the site.

Just to be clear, my first obligation is to the students in my MBA classes and I will not stint or compromise on that obligation, but I view delivering a great learning experience to those taking the class online as a close second. Note also that you will not get any credit from NYU for taking this class. While I will give you the grading templates to grade your own exams and evaluate your own assignments, I will not be able to give you direct feedback on your work. But then again, the price (at zero) is set right. So, these classes definitely come with a money back guarantee. In fact, the more the merrier... So, pass the message in this post on to any friends who may be interested. See you in cyber space on Monday.

Snowmen and Shovels: Investing Lessons?

I live near New York and woke up this morning to our first snowstorm of the winter (we had a freak one in the fall but no snow in November and December). As I looked out of my window, I heard two sounds. The first was of small children squealing in delight, as they tromped through the snow and started building snowmen and throwing snowballs. The second was the grating sound of snow shovels being used by their (mostly morose) parents to clear the snow from their driveways. Three things came to mind. The first was the oddity of the same phenomenon (a snow storm) evoking such different reactions from two different groups. The other was the irony  that the parents were one day (long ago in the past) happy to see the snow and today's  happy children will one day grow up and be wielding their own snow shovels. The third is that a week from now when it warms up, the snowmen will melt away, and the unshoveled driveways will look just as good as the shoveled ones.

I am sure that there are some deep life lessons in this phenomenon but I am not a philosopher. I do see some investing and valuation lessons in snowmen and shovels. After all, you can divide the world of active investors into two broad camps: growth investors and value investors. Consider the extremes in each camp. Extreme growth investors (you know the ones.. they go for momentum, love IPOs and are dazzled by high growth) remind me of the happy children, looking at snow and seeing snowmen, whereas extreme value investors (and you also know these ones.. they love net net investing and read Ben Graham's Security Analysis for inspiration)  more closely resemble the snow-shoveling parents. Each group views the other with disdain. Extreme value investors consider growth investors to be dilettantes, unserious and unwilling to grow up, who see the world through rose-colored lens. Extreme growth investors view value investors as boring, stuck-in-the-mud pessimists, who see only the dark side of things.

So, which side is right? I think both sides are right and both are wrong. While each side sees a portion of reality, each side is also missing a piece of the real world. While the value investing group is right in its view that most growth companies will not make it through the challenges of the real world, the growth investing group is also right in its view that some of these growth companies will be the big winners of the future. By staying dogmatic, both groups open themselves to significant investing/valuation mistakes. A growth investor who closes his eyes to the very real likelihood that a growth company will not survive will over value that company. By the same token, a value investor who insists on incorporating only the worst case scenarios, estimates cash flows “conservatively” and then applies a huge “margin of safety” before investing will never find growth companies to be bargains.

The key to investing, as in so much in life, is to maintain balance, recognizing that dreams sometimes come true, while keeping your feet grounded in reality. Put in valuation terms, the key to valuing a company well is to estimate what will happen (to earnings and cash flows) not only in good scenarios (let’s call these the snowman scenarios) but also in bad ones (the shovel scenarios).  It is a challenge I face whenever I do valuation. As I value a company, I have to constantly stop and look at the assumptions I am making and whether I am tilting too much to one side (snowman or shovel). If I find myself tipping too much into the “snowman” camp, I have to bring in some of my “shovel” side to play to get back to synch. If, on the other hand, I am letting my pessimistic shovel side dominate, I have to consciously force my fun snowman side come into play. 

So, here is how I am going to start today’s path back to balance. I shoveled this morning, just before I came in and wrote this post. My kids are too “old” to enjoy building snowmen, but I am not. I am going to go out and build a snowman, make a snow angel and perhaps throw some snowballs. Why should those kids have all the fun?

Private Equity: Hero or Villain?

The battle for the Republican presidential nomination seems to have claimed another "financial markets" casualty, at least in public opinion. In the last few weeks, we have seen Mitt Romney, who made his fortune at Bain Consulting, attacked for being a heartless, job-destroying private equity investor. I prefer not to enter political debates, but some of the critiques of private equity are so misdirected and over the top that I have to believe that these critics have no sense of what private equity is, the companies that they target and what they do at these companies. 


What is private equity?
If asked to provide a prototype of a private equity investor, many critics present you with Gordon Gekko , endowed with all of the characteristics that they want to attribute to a villain: a greedy, immoral man who delights in inflicting pain on the less fortunate. I could tell you that most private equity investors that I know don't even come close to that stereotype, but that is unlikely to convince anyone. In my view, here are the three ingredients for an investor to qualify to be a private equity investor:

1. Equity: At the risk of stating the obvious, to be a private equity investor, you have to be an investor in equity, either in publicly traded companies (as stock) or in private business (as owners' equity). So any criticism of private equity that segues into mortgage backed securities, which are generally debt, or into overreach at investment banks prior to 2008 is mixing up its villains.
2. Activist: A second feature of that separates private equity investors from most other equity investors is that they are activist, rather than passive investors. Thus, you and I, as passive investors, may buy stock in a company, believing it to be under valued or sub optimally managed, and then sit back and hope that the price moves up. An activist investor would buy stock in the same company and put in motion actions aimed at changing the way the company is managed (shutting down bad businesses, take on more debt, pay more dividends) or in fixing the reasons for under valuation (spin off, split offs, divestitures).
3. Private: While activist equity investors have been around as long as markets have been around, there is a third aspect to private equity investing that sets it apart. Private equity investors preserve the option (though they don't always use it) of "taking private" some of their targeted publicly traded companies. In effect, they remove these companies from the public space, run them as private companies for a period of time (during which they make changes), and then either go public again or sell them to other public companies.

With this definition in place, you still see diversity within this group. Broadly speaking, private equity investors can be classified into three categories: lone wolves (like Carl Icahn, Nelson Peltz and Bill Ackman), institutional activists (mutual funds and pension funds that trace their lineage back to the Calpers fund in the 1980s and are activist on the side) and activist hedge funds (which is where I would put Romney's Bain fund, KKR and Blackstone).


What types of companies do private equity investors target?
If activist investors hope to generate their returns from changing the way companies are run, they should target poorly managed companies for their campaigns.

• Institutional and individual activists do seem to follow the script, targeting companies that are less profitable and have delivered lower returns than their peer group. 
•  Hedge fund actvists seem to focus their attention on a different group. A study of 888 campaigns mounted by activist hedge funds between 2001 and 2005 finds that the typical target companies are small to mid cap companies, have above average market liquidity, trade at low price to book value ratios, are profitable with solid cash flows and pay their CEOs more than other companies in their peer group. Another study of the motives of activist hedge funds uncovered that the primary motive is under valuation, as evidenced in the figure below.

In summary, the typical activist hedge fund behaves more like a passive value investor, looking for under valued companies, than like an activist investor, looking for poorly managed companies. Activists individuals are more likely to target poorly managed companies and push for change.

What do they do at (or to) these targeted companies?

The essence of activist investing is that incumbent maangement is challenged, but on what dimensions is the challenge mounted? And how successfully? A study of 1164 activist investing campaigns between 2000 and 2007 documents some interesting facts about activism:

• Two-thirds of activist investors quit before making formal demands of the target. The failure rate in activist investing is very high.
• Among those activist investors who persist, less than 20% request a board seat, about 10% threaten a proxy fight and only 7% carry through on that threat.
• Activists who push through and make demands of managers are most successful (success rate in percent next to each action) when they demand the taking private of a target (41%), the sale of a target (32%), restructuring of inefficient operations (35%) or additional disclosure (36%). They are least successful when they ask for higher dividends/buybacks (17%), removal of the CEO (19%) or executive compensation changes (15%).  Overall, activists succeed about 29% of the time in their demands of management.

A review paper of hedge fund activist investing finds that the median holding for an activist hedge fund is 6.3% and even at the 75^th percentile, the holding is about 15%. Put differently, most activist hedge funds try to change management practices with well below a majority holding in the company. The same paper also documents an average holding period of about 2 years for an activist investment, though the median is much lower (about 250 days).

Following through and looking at companies that have been targeted and sometimes controlled by activist investors, we can classify the changes that they make into four groups as potential value enhancement measures:

1. Asset deployment and aperating performance: There is mixed evidence on this count, depending upon the type of activist investor group looked at and the time period. Divestitures of assets do pick up after activism, albeit not dramatically, for targeted firms. There is evidence that firms targeted by individual activists do see an improvement in return on capital and other profitability measures, relative to their peer groups, whereas firms targeted by hedge fund activists don’t see a similar jump in profitability measures.
2. Capital Structure: On financial leverage, there is a moderate increase of about 10% in debt ratios at firms that are targeted by activist hedge funds but the increase is not dramatics or statistically significant. There are dramatic increases in financial leverage at a small subset of firms that are targets of activism, but the conventional wisdom that activist investors go overboard in their use of debt is not borne out in the overall sample. One study does note a troubling phenomenon, at least for bond holders in targeted firms, with bond prices dropping about 3-5% in the years after firms are targeted by activists, with a higher likelihood of bond rating downgrades.
3. Dividend policy: The firms that are targeted by activists generally increase their dividends and return more cash to stockholders, with the cash returned as a percentage of earnings increasing by about 10% to 20%.
4. Corporate governance: The biggest effect is on corporate governance. The likelihood of CEO turnover jumps at firms that have been targeted by activists, increasing 5.5% over the year prior to the activism. In addition, CEO compensation decreases in the targeted firms in the years after the activism, with pay tied more closely to performance.

Do private equity investors make high returns?

The overall evidence on whether activist investors make money is mixed and varies depending upon which group of activist investors are studied and how returns are measured.

• Activist mutual funds seem to have had the lowest payoff to their activism, with little change accruing to the corporate governance, performance or stock prices of targeted firms. Markets seem to recognize this, with studies that have examined proxy fights finding that there is little or no stock price reaction to proxy proposals by activist institutional investors.  Activist hedge funds, on the other hand, seem to earn substantial excess returns, ranging from 7-8% on an annualized basis at the low end to 20% or more at the high end. Individual activists seem to fall somewhere in the middle, earning higher returns than institutions but lower returns than hedge funds.
• While the average excess returns earned by hedge funds and individual activists is positive, there is substantial volatility  in these returns and the magnitude of the excess return is sensitive to the benchmark used and the risk adjustment process. Put in less abstract terms, activist investors frequently suffer setbacks in their campaigns and the payoff is neither guaranteed nor predictable.
• Targeting the right firms, acquiring stock in these companies, demanding board representation and conducting proxy contests are all expensive and the returns made across the targered firms have to exceed the costs of activism. While none of the studies that we have reference hitherto factored these costs, one study that did concluded that the cost of an activist campaign at an average firm was $10.71 million and that the net return to activist investing, if these costs are considered, shrink towards zero. 
• The average returns across activist investors obscures a key component, which is that the distribution is skewed with the most positive returns being delivered by the activist investors in the top quartile; the median activist investor may very well just break even, especially after accounting for the cost of activism.

Here is an indisputable fact. If you are a stockholder in a publicly traded company, the entry of a private equity investor into your stockholder ranks is good news, since stock prices go up substantially:

Is private equity good or bad for the markets? How about for the economy? And for society?
For some of you, this entire post may be missing the point of the criticism, which is that private equity investors are job killers, not job creators. To me, that criticism is misplaced, because you cannot measure the success of a business by the jobs it creates or saves, but by the value it creates for its stockholders, by making money, and for its customers, by providing a needed product or service to customers. In the process, if it is successful, it will hire people and create jobs.
In fact, today's New York Times carries a story about one of the companies targeted by Bain in its Romney days, where 150 people lost their jobs, and it specifies that the company primary products was photo albums. Thus, while it is easy to blame Bain for the layoffs, the real reasons lay in a shifting market, where digital photography and computerized albums were replacing conventional photographs. The story's bigger point is that the people in the town have moved on, found other businesses to work for and are frankly surprised by the attention.
Since the critics are using fictional characters to beat up private equity investing, I will use one of my favorite fictional characters, from a great movie, "Other People's Money", to counter:


If private equity investors are primarily interested in slimming down companies and creating value for stockholders, do they create value for society? I believe that they do, and for two reasons. First, they are the battering rams that we use as passive investors to initiate and create change at public companies, and especially at companies that need to change. Second, even when private equity investors target companies, force them to divest assets, slim down and pay out the cash to stockholders, the cash does not disappear into thin air. The stockholders who receive the cash use it to pay for products and services (which creates jobs) and to invest in other companies with better growth prospects (which in turn hire more people).
In fact, my response to those who have a problem with private equity would be to ask the following question: Which aspect of private equity investing do you want to ban? Assuming that it is not equity investing collectively, it has to be either the activism or the "taking private" components. And what would that accomplish? Banning these practices would leave incumbent managers ensconced at publicly traded companies, unchallenged and unwilling to make changes, and the only jobs saved will be theirs.

Bottom line: If you don't like Mitt Romney, don't vote for him. Find a good reason, though! The fact that he worked at a private equity firm, and was good at his job, should not be that reason. In fact, since the US government looks more and more like a badly managed enterprise in need a major restructuring, a "good private equity investor" in charge may be just what the doctor ordered. 

Auld Lang Syne: Remembering 2011

There are only a couple of hours left in 2011 in New York and it is already the new year in many parts of the world. Let me spend my last post for this year, looking back at the year that was and looking forward to the year to come, using a few of my favorite market props: cash flows/earnings, market prices, risk free rates and risk premiums.

1. It was a good year for earnings at US companies, with earnings on the S&P 500 companies rising about 16%. That makes what happens to stock prices a little puzzling, since the S&P 500 index started the year at 1257.64 and ended the year at 1257.60. As a result , the aggregate PE ratio for the index declined from 15.03 at the start of the year to 12.96 at the end. 
2. It was an even better year for cash flows: dividends on the S&P 500 companies rose 12.5%, but buybacks surged more than 80%. The total dollar buybacks in 2011 (at least for the four quarters ending September 2011) almost matched buybacks in 2006, though they still remained well below the historic highs set in 2007. While the dividend yield on the index remained anemic (2.07%) the total cash flow (including buybacks) yield on the index was 5.90%, again well above the ten-year average of 4.72%.
3. The ten year treasury bond which started the year at 3.29% ended the year at 1.87%, the first time it has ended a year at below 2% in the last 50 years. The drop in the  rates also made US treasuries one of the better investments for the year, with the ten year bond returning 16.04% for the year; the price appreciation component accounted for 12.75%. Ironic, don't you think? After all, this was the year of the great S&P downgrade of the US sovereign rating that I talked about on my summer vacation in August. Are lower interest rates good news? I don't think so and I posted on the point earlier this year.
4. As many of you know, I have been estimating an implied equity risk premium for the S&P 500 for a long time, annually until 2008 and monthly since September 2008. I back out the premium using the level of the index and expected cash flows in the future. The premium started the year at 5.20%, surged during the summer to hit a high of 7.64% at the end of September and ended the year at 6.04%. The fact that stocks were flat for the year (the return with dividends was 2.07%) had the opposite effect on the historical risk premium (where you look at the difference between annual returns on stocks and treasuries over long periods of past history), with the historical risk premium dropping to 4.10%. After a long period (1981-2007), where historical risk premiums exceeded implied premiums, this is the fourth year in a row that implied premiums have exceeded historical premiums.

So much for last year! What does all this tell us about next year? It strikes me that the numbers are sending discordant messages. The earnings and cash flows point to a recovery, at least in corporate earnings, the treasury bond market is awfully pessimistic about future growth and the stock market vacillates between euphoria and despair. I really have no idea what next year will bring, but I am willing to make a guess. I expect the treasury bond market to grudgingly acknowledge higher economic growth prospects and move up (to 3%), equity risk premiums to become less volatile and move back towards lower numbers (5-5.5%). Buybacks and dividends will stay strong but will stabilize and earnings growth will moderate. The net effect will be to make the stock market a more hospitable place to invest and the bond market a less attractive investment. So, I am adding to my equity exposure, selling my treasury bonds and praying that the Eurozone does not turn my predictions to dust.

I apologize for both the US-centric and macro nature of this post but I am starting on my annual data update this week. Over the next ten days, I will be exploring the raw data that I have downloaded on 50,000+ companies globally, since the close of trading yesterday, and will be generating my industry average tables. During that analysis, I will be looking at how equities have moved globally and world-wide trends in both valuation multiples (PE, Price to book, EV/EBITDA etc.) and corporate finance variables (dividends, debt ratios, returns on equity/capital). I will have a much more detailed post when I am done but I look forward to learning a great deal more from the numbers than from listening to expert prognostications. 

So, happy New Year! I wish you, your families and your loved ones the very best for the coming year! Be happy and healthy!