Thursday, October 1, 2015

Putting a Price Tag on Scandal: Sturm und Drang at Volkswagen!

My Vale missteps illuminated for me some of the risks of going where it is darkest, but I will not let them stop me from trying again. This time, my focus is Volkswagen, a company that has, over the course of a month, gone from being just another mature company in a bad business (automobiles) to one beset on all sides by governments, lawyers and investors. In this case, though, unlike Vale and Lukoil, much of the uncertainty comes from self-inflicted wounds and as its stock price drops, it is worth looking at whether the market reaction has been overdone.

The setting
For the last decade, Volkswagen has worked hard to make itself a global automobile giant. Last year, the company was the leading auto company in the world, in terms of revenues, and second only to Toyota in units sold. In the US, it has a much lower profile, with a market share in the low single digits.

The company has been able to weather the 2008 crisis well, and has seen revenues and earnings climb, albeit at the moderate levels that befit a mature automobile company.
Source: S&P Capital IQ, Data
The company's operating margin of 6.07% in the last twelve months (ending June 30, 2015) was higher than its historical average margin of 4.21%. During the period, the Volkswagen auto offerings have expanded to include not only Audi and Skoda but also luxury brands including Bentley, Lamborghini, Porsche and Bugatti.

The Scandal, The Stock Price and Knee Jerk Contrarianism
In the last few weeks, the wheels have come off the Volkswagen bus. The trigger was a revelation that VW had designed the computer software on its diesel automobiles to fool the EPA, when it was testing for emissions; this BBC story explains it well. Once the story became public, Volkswagen admitted that it had screwed up big time, its CEO resigned, a whole host of top managers lost their jobs and Volkswagen's stock price collapsed, losing almost 40% of its value in the last month.

While both the ordinary and preferred shares have collapsed, the preferred shares seem to have taken more of a beating; the ordinary shares that used to trade at par with the preferred now trade at a premium of about 8% (and I will take more about this later in this post)

There is no doubt that this is more than a tempest in a  teapot, and that that there will be consequences, but are the consequences dire enough to cause a loss of more than 30 billion Euros in market capitalization? That remains the key question, as investors who are attracted to beaten up stocks look at Volkswagen. A knee jerk contrarian strategy may argue that history and empirical evidence is on your side and push for investment in Volkswagen now, but I am wary of using average returns from past studies, often based upon large samples of companies, to justify investing in one company that meets the criteria. 

The Costs
In the aftermath of Volkwagen's revelations, the news media have turned their full attention to the company's foibles, real and made up, with a skew towards putting the worst possible spin on the company's actions. Thus, the fact that the company has close ties to German lawmakers is viewed as a sign of the company's moral turpitude, as if other auto makers do not have their own stables of legislators pushing for preferential treatment.  Thus, the first step in assessing the impact of this scandal on Volkswagen is separating the wheat from the chaff, or in Nate Silver's words, the signal from the noise. It is quite clear that this scandal is going to cost Volkswagen, in many different arenas, starting with penalties being imposed by governments and regulators for the deception, continuing with the costs of recalling and fixing the cars and expanding to cover lost sales, as potential customers switch to competing car companies.
  1. The Legal Penalties: There is no question that there are legal penalties coming, with Volkswagen already setting aside $7.3 billion (6.5 billion Euros) to cover the fines/penalties it will face, and the EPA's potential fines could expand to $18 billion. There is talk in Europe of similar penalties being meted out by European governments, which will add to the cost. (Update: A reader sent me the link to this article that provides some perspective on the potential fine size being closer to $11 billion, rather than $18 billion.)
  2. Auto Recall Costs/ Legal Costs: It is estimated that Volkswagen has about 11 million vehicles that it might have to recall and refit, and that will be costly. Not surprisingly, talk of lawsuits fill the air, with both European and American shareholders considering suing the company for damages; even if the company wins all of these suits, it will be paying hefty legal fees along the way.
  3. Lost Sales/Operating Income: There is also talk of lost trust and tarnished brand names, but these remain PR buzzwords until they start showing up in lost sales/profits. Unlike the BP or GM scandals, where lives were lost, the impact of this scandal is more diffuse, though the New York Times segued into this argument (a little far fetched) that the cheating could have cost lives. 
At the moment, the magnitude of these costs is still murky, but waiting for them to be clearer, as some investors seem to be doing, is an investment cop out. The market is already imputing a cost , and investors who want to invest in Volkswagen have no choice but to make their own judgments on whether the market imputed cost is too high (in which case Volkswagen becomes a buy), just right or too low (Volkswagen will be over valued).

I know that the cases are dissimilar, but to get a measure of what a scandal can cost an auto company, I looked at Toyota's experiences in 2010 with faulty gas pedals, the press coverage and controversy and the subsequent costs to the company.

The ScandalGas pedals stuck, causing acceleration & accidents.Computer software fooled EPA on emissions tests, reporting emissions at lower than actual level.
Deaths/Fatalities37* (NHSTA)None
Number of cars affected9 million11 million
EPA fines/ Government Penalties$1.2 billionVW set aside $7.3 billion
EPA maximum fine $18 billion
Auto Recall Costs & Car Owner lawsuits$1.1 billionIf proportional to number of cars, $1.34 billion.
Shareholder lawsuits$25.5 millionLawsuits being considering in both US and Europe.
Effect on Revenues/OperationsRevenues dropped from $19.1 billion in 2009 to $17.8 billion in 2010 and stayed about that level through 2011 and 2012, before rebounding to $21 billion in 2013.Not known yet
Effect on stock priceMarket Cap dropped 20% between 2009 and 2012, but rebounded in 2013.Market capitalization down 40% in month since story broke

The Valuation
To evaluate how this scandal affects Volkswagen's value as a company, I will adopt a two-step process. In the first, I will go back a month and value Volkswagen before the revelations, but to isolate the effect of the scandal, I will assume that the market capitalization a month ago (on August 31) was right and back out the operating income that the market was imputing in the stock price. In the second, I will make judgments on the extent of the costs, with a bias towards over estimating, rather than under estimating them, and revalue Volkswagen.

The Pre-Scandal Volkswagen
To value the company prior to the scandal, I drew on Volkwagen's financial history, which is summarized here. If you truly want to numb yourself, try reading Volkswagen's annual report, a model of opacity and bulk. Once I had those numbers and examined the landscape of the auto business, my initial narrative for Volkswagen was a boring one: it is a mature firm that I expect to grow barely (at the same rate as the economy), earn no excess returns and an established capital structure and regional exposure. Rather than try to value the company, I took the market capitalization of 82 billion Euros that the company was trading at then, and solved for the operating income that the firm would need to generate to be trading at the prevailing market value, arriving at 8,423 million Euros in operating income, well below the 12,886 million Euros that the company earned in the trailing 12 months, and about 20% below the average operating income generated over the last five years.
Update: I added a worksheet to the spreadsheet to explain how I came up with the net asset value for the financial services company. Put simply, rather than let its numbers drown out and distract me from valuing Volkswagen, I separate all of the assets and liabilities that VW reported for its financial services business and estimated a net book value. My estimate is significantly lower than VW's own book value of equity estimate for its financial service firm, reflecting what I chose to include in the financial service firm's assets and liabilities.

The Post-Scandal Valuation
There have been no major financial reports from the company over the last month and the macro environment has changed little, with the German 10-year Euro bond rate stuck at 0.60%. In effect,  the only thing that has changed is that the company has revealed its deception and the costs are starting to be tallied. Using the structure that I described in the last section, I  brought in the effects of the scandal in three layers.
  1. Government and Regulatory Fines/Penalties: In this layer, I look at the fines and penalties that Volkwagen has to pay, and it seems reasonable that the lower bound on this number would be the $7.3 billion that VW has already set aside, but the upper bound may be much higher, ranging to include the $18 billion (16.07 billion Euros) that would be the maximum fine (for the EPA) and other fines that may come from European governments that have also been deceived. In my assessment, I added 10 billion Euros, reflecting the tendency of governments to pile on, to the 16.07 billion Euros to arrive at a total penalty of 26.07 billion Euros.
  2. Auto recalls & Lawsuits: To estimate the costs that Volkswagen might face, as a result of this scandal, note that 11 million vehicles may need to be recalled and "fixed" and the costs will be high. Scaling up the $1.1 billion that Toyota spent recalling 9 million cars to fix gas pedals, adjusting for inflation and adding a buffer, I estimate a recall cost of $1.6 billion. In addition, a big company in the midst of a self-inflicted scandal is a ripe target for lawsuits, from both shareholders and affected customers, and while the end judgment may not be huge, the legal costs will accumulate along the way. With Toyota, these lawsuits created more noise than consequences, with the final settlement being only $25.5 million, but I am sure that the legal costs to the company were a multiple of this number. With Volkswagen, I will take the conservative tack and estimate a cost of $2.4 billion, matching the largest judgment ever in a shareholder suit,
  3. Reputation Loss: Will customers stop buying Volkswagen cars as a result of this fiasco? Again, using the Toyota gas-pedal problem as an illustrative example, the company saw its revenues drop by about 7% in 2010 and stay low until 2012, though other factors may have contributed to the decline as well. Volkswagen will lose sales, especially in its diesel car segment, because of this scandal, but the effect will fade over time, just as it has for Toyota, GM and Ford, each of whom has had a scandal (or two) in the past. In fact, the car business is full of fallen sinners and soon-to-be sinners, and it seems unlikely that any company will be tarred for life.  Again, in the interests of being conservative, I will assume that Volkswagen will lose 20% of its (imputed) operating income each year for the next 5 years; the present value of these lost profts amounts to $5.17 billion.
Note that  these costs will create tax savings, insofar as they are tax deductible. In my assessment, in keeping with the conservative estimation, I will assume that only half of the costs on the first two items (fines and legal costs) are tax deductible. Finally, note that if Volkswagen pays the fines and incurs recall/legal costs, they will show up as expenses in the near years, and that you should expect to see reported losses in the mega-billions.

There is one more potential cost, which is that the management of Volkswagen will be focused on managing the scandal so much that they will not be able to direct their attention towards managing the company. If this were a creative company in a good business, I would be calculating the cost of lost investments and foregone growth and reducing my value. With Volkswagen, a not-that-imaginative company in a bad business (at least based on my narrative), I am less concerned, since an auto management's effort to grow faster (by acquiring other companies, expanding market share, entering new markets) is just as likely to destroy value, as it is to add value. In a perverse way, Volkswagen's stockholders may be better served by managers doing too little rather than trying to do too much.
With these conservative (almost worst-case numbers), I revalued Volkswagen's equity at 52.2 billion Euros, about 10% higher than the market capitalization of $48 billion at the time of this assessment.  While that may not seem impressive, that is with an extremely conservative assessment of costs. Incorporating  the full tax benefit from the government penalties and auto recall increases the value to 56.7 billion Euros, and assuming a smaller penalty or less in legal costs will push the value up even further. (Negative numbers in the last column indicate under valued.)

AssumptionsValue of Equity (billions of Euros)% under or over valued
Worst CaseMaximum EPA Penalty + 10 billon in Other Government Fines, 4 bilion Euros in recall/legal costs, 20% loss in operating income forever, Fines and Legal costs not deductible.30.10 €59.47%
Base CaseMaximum EPA Penalty + 10 billon in Other Government Fines, 4 billion Euros in recall/legal costs, 20% loss in operating income for 5 years, Fines and Legal costs only 50% deductible52.20 €-8.05%
Better CaseMaximum EPA Penalty + 10 billon in Other Government Fines, 4 bilion Euros in recall/legal costs, 20% loss in operating income for 3 years, Fines and Legal costs 100% deductible58.50 €-17.95%
Likely CaseHalf of maximum EPA Penalty + 5 billon in Other Government Fines, 2 bilion Euros in recall/legal costs, 20% loss in operating income for 3 years, Fines and Legal costs 100% deductible69.10 €-30.54%
Best CasePenalties proportionate to Toyota, 20% loss in operating income for 3 years, Fines and Legal costs 100% deductible73.60 €-34.78%

For the final question of whether to buy the ordinary or preferred shares, here is the trade off. The preferred shares have dropped by more than the ordinary shares and have historically been more liquid, but in times when you want a say in who runs the company and how it is run, it is better to own the ordinary shares. In fact, I would argue that the reason the common shares are trading at an 8% premium over the preferred shares now, as opposed to trading at par just a month ago, can be traced to the reawakening of interest in control and corporate governance that comes out of every scandal.

The End Game
This may be a reflection on my moral compass, but I find it difficult to muster the outrage that some people seem to feel about Volkswagen's deception. I think that the company's acts were stupid, short-sighted and greed-driven, but there have been far more appalling acts in corporate history, that are more deserving of my outrage. Volkswagen should be punished and the market has already meted out a hefty penalty, but looking at the possible costs of this scandal, I think that the market has over reacted. My market order for ordinary shares in Volkswagen went through yesterday, as my desire to have a say in management (with the ordinary shares) overwhelmed the bargain hunter in me (which was attracted to the preferred shares). I am investing in Volkswagen, but this will be a bumpy ride, for quite a while. This is the scandal du jour, of the moment, but there will be other news stories that draw the rubber necking crowd away. I have neither the desire, nor the inclination, to talk you into buying the stock. If you work through the numbers and come to the same conclusion that I did, I will be glad to have your company, but if your judgment leads you to a different assessment, I have no quarrels with you. To each, his (or her) own!


  1. Volkswagen: Financial Data (History)
  2. Volkswagen: Annual Report

  1. Volkswagen: Pre-scandal valuation (to get imputed operating income)
  2. Volkswagen: Post-scandal valuation

Friday, September 25, 2015

No Mas, No Mas! The Vale Chronicles (Continued)!

Some of my Brazilian readers seem to be upset that I used "No Mas", Spanish words, rather than Portuguese ones, in the title. To be honest I was not thinking about language, but instead about a boxing match from decades ago, where Roberto Duran used these words to give up in his bout with Sugar Ray Leonard

I have used Vale as an illustrative example in my applied corporate finance book, and as a global mining company, with Brazilian roots, it allows me to talk about how financial decisions (on where to invest, how much to borrow and how dividend payout) are affected by the ups and downs of the commodity business and the government’s presence as the governance table. In November 2014, I used it as one of two companies (Lukoil was the other one) that were trapped in a risk trifecta, with commodity, currency and country risk all spiraling out of control. In that post, I made a judgment that Vale looked significantly under valued and followed through on that judgment by buying its shares at $8.53/share. I revisited the company in April 2015, with the stock down to $6.15, revalued it, and concluded that while the value had dropped, it looked under valued at its prevailing price. The months since that post have not been good ones for the investment, either, and with the stock down to about $5.05, I think it is time to reassess the company again.

Vale: A Valuation Retrospective
In November 2014, in a post titled “Go where it is darkest”, I repeated a theme that has become a mantra in my valuation classes. While it easiest to value mature, money-making companies in stable markets, I argue that the payoff to doing valuation is greatest when uncertainty is most intense, whether that uncertainty comes from the company being a young, start-up without a business model or from macroeconomic forces. The argument is based on the simple premise that your payoff is determined not by how precisely you value a company but how precisely you value it, relative to other people valuing the same company. When faced with boatloads of uncertainty, investors shrink from even trying to do valuation, and even an imprecise valuation is better than none at all.

It is to illustrate this point that I chose Vale and Lukoil as my candidates of doom, assaulted by dropping commodity prices (oil for Lukoil and iron ore prices for Vale), surging country risk (Russia for Lukoil and Brazil for Vale) and plummeting currencies (Rubles for Lukoil and Reais for Vale). I valued both companies, but it is the valuation of Vale that is the focus of this post and it yielded a value of $19.40/share for a stock, that was trading at $8.53 on that day. The narrative that drovemy valuation was a simple one, i.e., that iron ore prices and country risk would stabilize at November 2014 levels, that the earnings over the last twelve months (leading into November 2014), which were down 40% from the previous year’s numbers, incorporated the drop in iron ore prices that had happened and that eventually Vale would be able to continue generating the mild excess returns it had as a mature mining company.
I did buy Vale shares after this analysis, arguing that there was a buffer built into earnings for further commodity price decline.

In April 2015, I revisited my valuations, as the stock prices of both companies dropped from the November 2014 levels, and I labeled the post “In search of Investment Serenity”. The post reflected the turmoil that I felt watching the market deliver a negative judgment on my initial thesis, and I wanted to check to see if the substantial changes on the ground (in commodity prices, country risk and currency levels) had not changed unalterably changed my thesis. Updating my Vale valuation, the big shifts were two fold. First, the trailing 12-month earnings that formed the basis for my expected value dropped a third from their already depressed levels six months earlier. Second, the implosion in Petrobras, the other large Brazilian commodity company, caused by a toxic combination of poor investments, large debt load and unsustainable dividends, raised my concern that Vale, a company that shares some of the same characteristics, might be Petrobrased. Again, I made the assumption that the trailing 12-month numbers reflected updated iron ore prices and revalued the company, this time removing the excess returns that I assumed in perpetuity in my earlier valuation, to arrive at a value per share of $10.71. 
I concluded, with a nod towards the possibility that my conclusions were driven by my desire for confirmation bias (confirming my earlier judgment on Vale being under valued), that while I might not have been inclined to buy Vale in April 2015, I would continue to hold the stock.

Vale: The September 2015 Version
The months since my last valuation (in April 2015) have not been good for Vale, on any of the macro dimensions. The price of iron ore has continued to decline, albeit at a slower rate, over the last few months. That commodity price decline has been partially driven by the turmoil in China, a country whose massive infrastructure investments have been responsible for elevating iron ore prices over the last decade.  The political risk in Brazil not only shows no signs of abating, but is feeding into concerns about economic growth and the capacity of the country to repay its debt. The run-up that we saw in Brazilian sovereign CDS prices in April 2015 has continued, with the sovereign CDS spread rising above 4.50% this week. 

Source: Bloomberg
The ratings agencies, as always late to the party, have woken up (finally) to reassess the sovereign ratings for Brazil and have downgraded the country, Moody’s from Baa2 to Baa3 and S&P from BBB to BB+, on both a foreign and local currency basis. While both ratings changes represent only a notch in the ratings scale, the significance is that Brazil has been downgraded from investment grade status by both agencies.

Finally, Vale has updated its earnings yet again, and there seems to be no bottom in sight, with operating income dropping to $2.9 billion, a drop of more than 50% from the prior estimates.  While it is true that some of the write offs that have lowered earnings are reflections of iron ore prices in the past, it is undeniable that the earnings effect of the iron ore price effect has been much larger than I estimated to be in November 2014 or April 2015. Updating my numbers, and using the sovereign CDS spread as my measure of the country default spread (since the ratings are not only in flux but don’t seem to reflect the assessment of the country today), the value per share that I get is $4.29.
I was taken aback at the changes in value over the three valuations, separated by less than a year, and attempted to look at the drivers of these changes in the chart below:

The biggest reason for the shift in value from November 2014 to April 2015 was the reassessment of earnings (accounting for 81% of my value drop), but looking at the difference between my April 2015 and September 2015 valuations, the primary culprit is the uptick in country risk, accounting for almost 61% of my loss in value.

Vale: Time to Move on?
If I stay true to my investment philosophy of investing in an asset, only if its price is less than its value, the line of no return has been passed with Vale. I am selling the stock, but I do have to tell you that it was not a decision that I made easily or without fighting through my biases. In particular, I was sorely tempted by two games:
  1. The “if only” game: My first instinct is to play the blame game and look for excuses for my losses. If only the Brazilian government had behaved more rationally, if only China had not collapsed, if only Vale’s earnings had been more resilient to iron ore prices, my thesis would have been right. Not only is this game completely pointless, but it eliminates any lessons that I might be extract from this fiasco.
  2. The “what if” game: As I worked through my valuation, I had to constantly fight the urge to pick numbers that would let me stay with my original thesis and continue to hold the stock. For instance, if I continue to use the rating to assess default spreads for Brazil, as I did in my first two valuations, the value that I get for the company is $6.65. I could have then covered up this choice with the argument that CDS markets are notorious for over reacting and that using a normalized value (either a rating-based approach or an average CDS spread over time) gives me a better estimate.
After wrestling with my own biases for an extended period, I concluded that the assumptions that I would need to make to justify continuing to hold Vale would have to be assumptions about the macro environment: that iron ore prices would stop falling and/or that the market has over reacted to Brazil’s risk woes and will correct itself. If there is anything that I have learned already from my experiences with commodity companies and country risk, it is that my macro forecasting skills are woeful and making a bet on them magically improving is wishful thinking. In fact, if I truly want to make a bet on these macro movements, there are far simpler, more direct and more lucrative ways for me to exploit these views that buying Vale; I could buy iron ore future or sell the Brazil sovereign CDS. I like Vale's management but I think that they have been dealt a bad hand at this stage, and I am not sure that they can do much about the crosswinds that are pummeling them. If you have more faith in your macro forecasting skills than I do, it is entirely possible that Vale could be the play you want to make, if you believe that iron ore prices will recover and that the Brazil's risk will revert back to historic norms. In fact, given my abject failure to get these right over the last few months, you may want to view me as a contrary indicator and buy Vale now.

Investing Lessons
It is said that you can learn more from your losses than from your wins, but the people who like to dish out this advice have either never lost or don’t usually follow their own advice. Learning from my mistakes is hard to do, but let looking back at my Vale valuations, here is what I see:
  1. The dangers of implicit normalization: While I was careful to avoid explicit normalization, where I assumed that earnings would return to the average level over the last five or ten years or that iron ore prices would rebound, I implicitly built in an expectation of normalization by taking the last twelve-month earnings as indicative of iron ore prices during that period. At least with Vale, there seems to be a lag between the drop in iron ore prices and the earnings effect, perhaps reflecting pre-contracted prices or accounting lethargy. By the same token, using the default spread based on the sovereign rating provided a false sense of stability, especially when the market's reaction to events on the ground in Brazil has been much more negative.
  2. The Stickiness of Political Risk: Political problems need political solutions, and politics does not lend itself easily to either rational solutions or speed in resolution. In fact, the Vale lesson for me should be that when political risk is a big component, it is likely to be persistent and can easily multiply, if politicians are left to their own devices. 
  3. The Debt Effect: All of the problems besetting Vale are magnified by its debt load, bloated because of its ambitious growth in the last decade and its large dividend payout (Vale has to pay dividends to its non-voting preferred shareholders). While the threat of default is not looming, Vale's buffer for debt payments has dropped significantly in the last year, with its interest coverage ratio dropping from 10.39 in 2013 to 4.18 in 2015.
There are two lessons that I had already learned (and that I followed) that helped me get through this experienced, relatively unscathed. 
  1. Spread your bets: The consequences of the Vale misstep for my portfolio were limited because I followed my rule of never investing more than 5% of my money in any new stock, no matter how alluring and attractive it looks, a rule that I adopted  because of the uncertainty that I feel in my valuation judgments and that the market price moving towards my value. In fact, it is the basis for my post on how much diversification is the right amount.
  2. Never take investment risks that are life-style altering (if you fail): Much as I would like to make that life-altering investment, the one whose payoff will release me from ever having to think about investing again, I know it is that search that will lead me to take "bad" risks. Notwithstanding the punishment meted out to me by my Vale investment, I am happy to say that it has not altered my life choices and that I have passed the sleep test with flying colors. (I have not lost any sleep over Vale's travails).
Closing Thoughts
If I had known in November 2014 what I know now, I would obviously have not bought Vale, but since I don’t have that type of hindsight , that is an empty statement. I don’t like losing money any more than any one else, but I have no regrets about my Vale losses. I made the best judgments that I could, with the data that I had available in my earlier valuations. If you disagreed with me at the time of my initial valuation of Vale, you have earned the right to say "I told you so", and if you went along with my assessment, we will have to commiserate with each other.

This is not the first time that I have lost money on an investment, and it will not be the last, and I will continue to go where it is darkest, value companies where uncertainty abounds and hope that my next excursion into that space delivers better results than this one.


Previous Blog Posts

  1. Go where it is darkest (November 2014)
  2. In search of Investment Serenity (September 2015)
Vale Valuations

  1. Valuation of Vale (November 2014)
  2. Valuation of Vale (April 2015)
  3. Valuation of Vale (September 2015)

Wednesday, September 9, 2015

What's in a name? Of Umlauts, The Alphabet and World Peace!

As the title should forewarn you, this is a post that will meander from eating spots to basketball players to corporate name changes. So, if you get lost easily, you may want skip reading it. It is triggered by two events that occurred this summer. One is Google's widely publicized decision to rename itself Alphabet and to reorganize itself as a holding company. The other is the much less public news that the eating place across the street from the building where I teach will be reopening with a new name "Bröd Kitchen", a new menu, and (probably) higher prices.

Coffee Shop to Eatery to Bröd Kitchen

In my post on my valuation class, I noted that this is my 30th year at New York University and I have seen the neighborhood around the school transition over time. When I started in 1986, I had my office and did the bulk of my teaching in the graduate school campus, which was downtown, but I lived near and still taught some classes at the undergraduate school. Right across the school was the Campus Coffee Shop (Yes! This is exactly what it looked like!) and it was exactly what its name suggested, an unpretentious coffee shop. The menu was primarily breakfast food, served all through the day, and the coffee came in one flavor (bitter), one texture (sludge) with only two add-ons (cream & sugar). The waiters and waitresses were all crotchety and old, viewed service as a foreign concept and I can only pity the poor person who tried to order a cappuccino or latte. To compensate, the coffee was only 50 cents, the egg sandwich about a dollar and you got what you paid for.

About 15 years into my stint at Stern, the building's landlord (a brutally oppressive tyrant named New York University) decided that the campus coffee shop was too downscale and it was replaced by the Campus Eatery. This place offered fewer seats, a wider menu with paninis replacing sandwiches (as if putting a bad sandwich in a hot press can make it a  good one) and machine-made cappuccinos that had neither milk nor espresso in them. Not surprisingly, the prices went up to reflect the name change from coffee shop to eatery, though the only edible items on the menu remained the breakfast items, albeit at twice the price you paid at the coffee shop.

At the start of this summer, I noticed that the Campus Eatery had closed and that the space was being renovated for a new restaurant. The restaurant has not opened yet (at least as of last Thursday, which was the last day I was in the city) but the name went up a few weeks ago and when I saw that it was Bröd, the umlaut made me suspicious. My trusted Google search engine found another eating place with the same name in New York, and I was able to find the company's website. It looks like a bakery with a Scandinavian tilt and Northern European prices, but the only consolation price is that it could have been worse. This could have become a Le Pain Quotidien, a New York based food chain with a pretentious French name and prices to match. (A reader points out to me that it is in Brussels, but according to the company's website, it is a New York based company with branches all over the world!)
Update: I did a trial run this morning, since Bröd opened. Bought an iced coffee and a Cherry Danish (in keeping with the Scandinavian theme). Cost me $9.53 and it tasted just like the iced coffee and Danish that I get from the street cart that I usually go to.. and pay $2.50 for.. So, lesson learned!

While these are three different businesses, with three different owners, they have all occupied the same space and I tend to think of them as the same eating place with three different names. That started me ruminating about why people and businesses change names and whether those name changes can affect the values that you attach to the entities involved. 

Reasons for Name Changes
I must confess that I have changed my name, though the change was more the result of happenstance than design. I grew up in South India in a period where caste names had been abandoned, but family names were not in vogue yet, and went through much of my school and college years known only by my first name (Aswath) and without a last name. It was as I was filling out my I-94 form on the my flight into the United States that I faced the question of what to use as my family name, and I used my father's first name, Damodaran, as the filler. Since then, I have seen friends and acquaintances change their names, mostly as a result of marriages, and businesses change names, with mergers being the most common trigger. However, there are other, more interesting reasons for name changes, though, and here are a few of them:
  1. To decontaminate or escape: In some cases, a name may get contaminated to the point that changing it is the only way to escape the taint. When Philip Morris changed its name to Altria in 2001, it was partly an attempt to remove the taint of tobacco (and its associated lawsuits) from its then food and beverage subsidiaries (Kraft and Miller Brewing). While there may have been other reasons for Tyco Electronics to rename itself TE Connectivity in 2010, one reason may have been to disassociate itself from the accounting scandals at its parent company
  2. To change: Changing your name can sometime make it easier for you to change yourself, as a person or how you operate, as a business. In this context, corporate name changes can cover the spectrum. Some  name changes reflect changes that have already happened, as was the case when Apple Computer became Apple in 2007, a concession to the reality that it was deriving more of its revenues and profits from its smartphones, tablets and retail than from its computer business. It can sometimes be a precursor of changes to come, as was the hope at International Harvester, when it sold off its agricultural division to Tenneco, renamed itself Navistar in 1986, and worked to make a name for itself in the diesel engine and truck chassis markets.  Finally, there is an escapist component to the some name change, where the firm is trying to  get away from troubles and hopes that changing its name will help it in the endeavor. When Research in Motion changed its name to Blackberry in 2013, it was in an attempt to divert attention from declining sales and a business in trouble. 
  3. To market: To make money, you have to sell your products and services, and not surprisingly, companies are drawn to names that they perceive will make it easier for them to market. In some cases, this may require simplifying your name to make it easier for customers to relate to; Tokyo Tsushin Kogyo did the right thing in 1958, when it renamed itself Sony. In still others, it may be designed to have a name that better fits your product or service; we should all be thankful that Larry Page and Sergey Brin changed their search engine's name from Backrub to Google a year into development. Finally, the name change may be to something more exotic, in the  hope that this will give you pricing power; the only surprising thing about L’Oréal renaming of its US subsidiary, Cosmair,  to L’Oréal USA was that it took so long to happen. After all, it must be a marketing maxim that having an accent in your name (the é in L’Oréal), in an Anglo-Saxon setting and that adding a apostrophe can only add to your cachet.
  4. To fool: In one of the more publicized frauds of the last century, a German named Christian Gerhartsreiter managed to fool East Court elite (both society and business) into thinking that he was Clark Rockefeller, using the last name to open doors to country clubs and financial opportunities. Corporations have played their own version of this game, incorporating the hot businesses of the moment to their names, whether it be in the 1990s, oil in the last decade or social media today. 
There are two points to note. The first is that these reasons are not mutually exclusive and more than one may apply for a given name change. The other is that the lines of separation between the reasons can also be fuzzy, with the one separating marketing and fooling investors being perhaps the most difficult one to delineate.
Valuing and Pricing Name Changes
Can changing your name change your value as a business or you as an individual? You may scoff, but I do believe that there are pathways to changing behavior or increasing value that begin with a name change. You will not find them if the name change is purely cosmetic or if your reason is to fool customers or investors, but you may, with any of the other reasons. Thus, if your rationale for the name change is to remove the taint of an old name or to market your product more easily,  it should show up as higher revenues and profits, if you are right. If the name change is the first step in changing the way you run as a business, it should be manifested in your investing, financing and dividend decisions, and consequently in value. The proof, though, is in the results and it is true that the benefits are either transient or illusory in many cases.

It is much easier to see a price effect from a name change, and especially so, if your end game is fooling investors. The highest profile studies of this phenomenon have centered around the dot com era, when the renaming was visible for all to see (adding a .com to an existing name or removing it), and the evidence was striking. The first study looked at companies that added to their names in the late 1990s and found that stock prices surged by astonishingly large amounts on the news, often with no accompanying change in operating focus or business practices. The second study looked at companies that removed from their names after the bust in 2000 and 2001 and uncovered an equally unsetting market reaction, i.e., that stock prices surged on the removal, again with no really accompanying shift in fundamentals. The results from both studies are graphed below:

To back up the proposition that this is not just a phenomenon in technology stocks are unique to that time period in market history, a study looked at US and Canadian companies that added "oil" or "petroleum" to their names between 2000 and 2007, a period when oil prices are booming, and found that stock prices reacted positively to the addition, with US investors greeting the name change more effusively than Canadian investors. If history is any guide, these companies will now gain by removing "oil" from their names today, with oil prices at historic lows.

What are the lessons from these studies? The first is that names do matter in markets and that companies sometimes choose names to please markets. The perils, as you can see even from the limited evidence that I have presented, is that investors are fickle and can change their minds and that a name that is value additive today can become value destructive in a while. 

Google's Alphabet Soup
A few weeks ago, Google shook up markets with its announcement that it was revamping the structure of the company, creating a holding company (Alphabet), with the core products of Google including Search, Ads, Maps, Apps, Android and YouTube, in one subsidiary (Google) and its experimental ventures in new businesses in other subsidiaries (though we will have to wait on the specifics). The immediate market reaction was positive, but as we noted in the last section, that effect can fade quickly. The longer term questions are two fold. Why did Google change its corporate name? Will the name change work?

On the first question, it is my view that three of the reasons listed earlier can be ruled out almost immediately. Given how successful Google has been as a company, in terms of generating earnings and value for its investors, it is implausible that the company would want to disassociate itself from on of the most recognized brand names in the world. From a marketing perspective, it seems inconceivable to me that it will be easier to sell an "Alphabet" product than a "Google" product, and I don't think that there are very many investors out there who see lots of money making potential in the alphabet. Thus, the only motive that we are left with is that the name change is designed to  change the way the company operates. 

If change is the rationale, the timing seems odd, given that Google just reported exceptional results in its last earnings report, triggering a 16% increase in market capitalization on the news. It is true, though, that Google is still a single-business company, deriving almost all of their revenues from advertising, and that all of its attempts to diversify its business mix have generated more publicity than profits. It is possible that the renaming and reorganization are designed to fix this problem, but will it work? I am skeptical, partly because there is talk that Page and Brin were using Berkshire Hathaway as a model, which makes no sense to me, since the two organizations have very little in common (other than large market capitalization). As I see it, Berkshire Hathway is a closed-end mutual fund, funded with insurance capital, and run by the best stock picker(s) in history, and its holding structure is consistent with that description, where Buffet and Munger have historically picked up under valued, well managed companies as investments, and left the managers in these companies alone. Google, in contrast, is composed of one monstrously successful online advertising business (composed of Google search, YouTube and add ons) and several start-ups that so far have been more adept at spending money than generating earnings.

If this name change is designed to alter that reality, it has to attack what I see as Google's two big problems. The first is what I term the Sugar Daddy Syndrome, where the earnings power and cash flow generating capacity of Google's advertising business has made its start ups too sloppy in their investments, secure in the knowledge that they have access to an endless source of additional capital.  (Update: Those who are more knowledgeable about Google's ways have pointed out to me that it is quick to lop of projects that don't work, which then makes its new product failures an even bigger mystery. Perhaps, this is a case of a Sugar Daddy with Attention Deficit Disorder!) The second is that Google, for better or worse, has been run as a Benevolent Dictatorship, with Larry Page and Sergey Brin calling the shots at every turn. The fact that Sundar Pichai, the new CEO of the Google portion of the Alphabet, is little known can be viewed as a sign of his modesty and self-effacing nature, but it is also a reflection of the outsized profiles that Page and Brin have had at Google.  So, for this name change to work, it has to solve both problems, and here are the signs that will indicate that it is working. First, I would like to see Google refuse to invest in one or more of its start-ups, on the grounds of non-performance and invest in or acquire a competing start-up in the same business.   Alphabet's new ventures become more like good start-ups, lean, mean and looking for pathways to make money, and Google Advertising behave more like a seasoned VC, looking for the best place to invest its money, inside or outside the company. (For those in the tech business who schooled me on Google's ways, thank you! I have much to learn!) Second, I would also like to see Mr. Pichai deny capital to a project that is prized by Page and Brin, and have them not over rule that decision. Given the history of Google's founders, the likelihood of these events happening is low, but I give Google better odds than I did Ron Artest, an NBA player with anger management issues, when he changed his name to Metta World Peace in 2011.

What's in a name?
If value is driven by substance (cash flows, growth and risk), it seems absurd that name changes can affect your value, but I have learned not to dismiss them as non-events. Name changes can lead to shifts in investment, financing and dividend policy that can affect value, but more important, they can have substantial price effects. That may seem irrational, but it is ironic that academics in finance would be so quick to make the judgment that what you name something cannot alter its value or significance. After all, these same academics have learned that attaching letters from the Greek alphabet to their measures of risk (beta) or performance (alpha) provide these measures with a power that they would never possess otherwise. So, who knows? These name changes may all work: Bröd Kitchen might deliver delicious and cheap food, Page and Brin may actually be willing to give up control at Google and Ron Artest could become a Buddhist monk!

YouTube Webcast

Friday, September 4, 2015

The Fed, Interest Rates and Stock Prices: Fighting the Fear Factor

If it feels like you are reading last year’s business stories in today's paper, there is a simple reason. The Federal Reserve's Open Markets Committee (FOMC) meeting date is approaching, and in a replay of what we have seen ahead of previous meetings, we are being told that this is the one where the Fed will lower the boom on stock markets, by raising interest rates. While this navel gazing may keep market oracles, Fed watchers and CNBC pundits occupied, I think that the Fed’s role in setting interest rates is vastly overstated, and that this fiction is maintained because it is convenient both for the Fed and for the rest of us. I think that there are multiple myths about the Fed’s powers that have taken hold of our collective consciousness, and led us into an investing netherworld. So at the risk of provoking the wrath of Fed watchers everywhere, and repeating what I have said in earlier posts, here are my top four myths about central banks.

1. The Fed sets interest rates
Myth: The Federal Reserve (or the Central Bank of whichever country you are in) sets interest rates, short term as well as long term. In my last post on this topic, I mentioned my tour of the Federal Reserve Building, with my wife and children, and how sorely tempted I was to ask the tour guide whether I could see the interest rate room, the one where Janet Yellen sits, with levers that she can move up or down to change our mortgage rates, the rate at which companies borrow from banks and the market and the rates on US treasuries. 
Reality: There is only one rate that the Federal Reserve sets, and it is the Fed Funds rate. It is the rate at which banks trade funds, that they hold at the Federal Reserve, with each other. Needless to say, not only is this an overnight rate, but it is of little relevance to most of us who don't have access to the Fed windows. While there is a tenuous link of Fed Funds rate to short term market interest rates,  that link becomes much weaker when we look at long term rates and their derivatives.
Why preserve the myth: Giving the Fed the power to set interest rates gives us all a false sense of control over our economic destinies. Thus, if rates are high, we assume that the Fed can lower them by edict and if rates are too low, it can raise it by dictate. If only..

2. Low interest rates are the Fed’s doing
Myth: Interest rates are at historic lows not just in the United States but in much of the developed world, and it is central banking policy that has kept them there, through a policy of quantitative easing The myth acquires additional sheen when accompanied by acronyms such as QE1 and QE2, which bring ocean liners to my mind and a nagging fear that the next Fed move will be titled the Titanic!
Reality: The Fed has had a bond-buying program that is unprecedented and large, but only relative to the Fed's own history. Relative to the size of the US treasury bond market (about $500 billion a day in 2014), the Fed bond-buying (about $60-$85 billion a month) is modest and unlikely to have the influence on interest rates that is attributed to it. So, what has kept rates low? At the risk of rehashing a graph that I have used multiple times, it is far simpler and more fundamental, and it lies in the Fisher equation, which decomposes the nominal interest rate into its expected inflation and real interest rate components:
Nominal Interest Rate = Expected Inflation + Expected Real Interest Rate
If you make the assumption that in the long term, the real interest rate in an economy converges on real growth rate, you have an equation for what I call an intrinsic risk free rate.  In the graph below, I graph out the actual US 10-year treasury bond rate against this intrinsic risk free rate and you can make your own judgment on why rates have been low for the last five years.'

To me, the answer seems self evident. Interest rates in the US (and Europe) have been low because inflation has been non-existent and real growth has been anemic, and it is my guess that rates would have been low, with or without the Fed’s exertions. In fact, the cumulative effect of the Fed's exertions can be measured as the difference between the intrinsic risk free rate and the US treasury bond rate, and during the entire quantitative easing period of 2008-2014, it amounted to about 0.13%. It is true that the jump in US GDP in the most recent quarter  has widened the difference between the treasury bond rate and the intrinsic interest rate, but it remains to be seen whether this increase is a precursor to more healthy growth in the future, or just an one-quarter aberration. 
Why preserve the myth: I think it is much more comforting for developed market investors to think of low interest rates as an unmitigated good, pushing up stock and bond prices, rather than as a depressing signal of future growth and low inflation (perhaps even deflation) in much of the developed world. That problem will not be fixed by Fed meetings and is symptomatic of shifts in global economic power and a re-apportioning of the world economic pie.

3. The reason stock prices are so high is because rates are low
Myth: Stock prices are high today because interest rates are at historic lows. If interest rates revert back to normal levels, stock prices will collapse. 
Reality: Low interest rates have been a mixed blessing for stocks. The low rates, by themselves, make stocks more attractive relative to the alternative of investing in bonds. But if the low rates are symptomatic of low inflation and low real growth, they do have effects on the cash flows that can partially or completely offset the effect of low rates. One way to decompose the effects is to compute forward-looking expected returns on stocks, given stock prices today and expected cash flows from dividends and buybacks in the future to see how much of the stock price effect is fueled by interest rates and how much by cash flow changes. If this bull market has been entirely or mostly driven by the drop in interest rates, the expected return on stocks should have declined in line with the drop in interest rates. In my most recent update on this number at close of trading on August 31, 2015, I estimated an expected return of 8.50%, almost unchanged from the level in 2009 and higher than the expected return in 2007. 
At least based on my estimates, the primary driver of stock prices has been the extraordinary fountain of cash that companies have been able to return in the last few years, combined with a capacity to grow earnings over the same period. By the same token, if you are concerned about cash flows, it should be with the sustainability of these cash flows, for two reasons. The first is that earnings will be under pressure, given the strength of the dollar and the weakness in China, and this is starting to show up already, with 2015 earnings about 5-10% below 2014 levels.  The second is that companies will not be able to keep returning as much as they are in cash flows; in 2015, the cash returned to stockholders stood at 91% of earnings, a number well above historic norms. In the table below, I check to see how much the index, which was at 1951.13 at the close of trading on September 3, would be affected by an increase in interest rates (increasing the US 10-year T.Bond rate from the 2.27% on September 3, to 5%) as contrasted with a drop in cash flows (with a maximum drop of 25%, coming from a combination of earnings decline and reduced cash payout):
Base: S&P 500 on September 3= 1951.13, T.Bond rate = 2.27%; ERP = 6.34%, g=6.30%
If you hold cash flows constant, an increase in interest rates has a relatively small effect on stock prices, with stock prices dropping 8.76%, even if the US T.Bond rate rises to 5%.  In contrast, if cash flows drop, the index drops proportionately, even if interest rates remain unchanged. You are welcome to make your own "bad news" assumptions and check out the effect on value in this spreadsheet.
Why preserve the myth: For perpetual bears, wrong time and again in the last five years about stocks, the Fed (and low interest rates) have become a convenient bogeyman for why their market bets have gone wrong. If only the Fed had behaved sensibly and if only interest rates were at normal levels (though normal is theirs to define), they bemoan, their market timing forecasts would have been vindicated. 

4. The biggest danger to the Fed is that the market will react violently to a change in its interest rate policy
Myth: The biggest danger to the Fed is that, if it reverses its policy of zero interest rates and stops its bond buying, stock and bond markets will drop dramatically.
Reality: While no central bank wants to be blamed for a market meltdown, the bigger danger, in my view, is that the Fed does what it has been promising to for so long, and nothing happens. That is a good thing, you might say, and while I agree with you in the short term, the long-term consequences for Fed credibility are damaging and here is why. The best analogy that I can offer for the Fed and its role on interest rates is the story of Chanticleer, a rooster that is the strutting master of the barnyard that he lives in, revered by the other farm animals because he is the one who causes the sun to rise every morning with his crowing (or so they think). In the story, Chanticleer’s hubris leads him to abandon his post one morning, and when the sun comes up anyway, the rooster loses his exalted standing. Given the build up we have had over the last few years to the momentous decision to change interest rate policy, think of how much our perceptions of Fed power will change, if stock and bond markets respond with yawns to an interest rate policy shift.
Why we hold on to the myth: If you buy into the first three myths, this one follows. After all, if you believe that the Fed sets interest rates, that it has deliberately kept interest rates low for the last five years and that stock prices are high because interest rates are low, you should fear a change in that policy. Coupled with China, you have the excuses for your underperformance this year, thus absolving yourself of all responsibility for your choices. How convenient?

What next?
Over the last five years, we have developed an unhealthy obsession with the Federal Reserve, in particular, and central banks, in general, and I think that there is plenty of blame to go around. Investors have abdicated their responsibilities for assessing growth, cash flows and value, and taken to watching the Fed and wondering what it is going to do next, as if that were the primary driver of stock prices. The Fed has happily accepted the role of market puppet master, with Federal Bank governors seeking celebrity status, and piping up about inflation, the level of stock prices and interest rate policy. Market watchers, journalists and economists have found stories about the Fed to be great fillers that they can use to fill financial TV shows, newspaper and opinion columns.

I don't know what will happen at the FOMC meeting, but I hope that it announces an end to it's "interest rate magic show". I think that there is enough pent up fear in markets that the initial reaction will be negative, but I am hoping that investors move on to healthier, and more real, concerns about economic growth and earnings sustainability. If the Fed does make its move, the best news will be that we will not have to go through more rounds of obsessive Fed watching, second-guessing and punditry.

YouTube Video

  1. The Fed did it!
  2. Slides to accompany video

Past Posts
  1. The Fed and Interest Rates: Lessons from Oz (June 21, 2013)
  2. Dealing with Low Interest Rates: Investing and Corporate Finance Lessons (April 2015)
  1. Interest Rates, Stock Prices and Expected Returns

Friday, August 28, 2015

Big Markets, Over Confidence and the Macro Delusion!

In early October of 2013, I was sitting in CNBC, waiting to talk about Twitter, which had just filed its prospectus (for its initial public offering). I was sharing the room with an analyst who was very bullish on the company, and he asked me what I thought Twitter was worth. When I replied that I had not had a chance to value the company yet, he suggested that I should save myself the trouble, and that the stock was worth at least $60 a share. Curious, I asked him why, and he said that Twitter would use its large user base to make money in the "huge" online advertising market. When I questioned him on how huge the market was, his answer was that he did not have a number, but he just knew that it was "really big". I am thankful to him, since he framed how I started my valuation of Twitter, which is with an assessment of the size of the online advertising market globally. Since I talked to that analyst, I have also become more more aware of the big market argument, and I have seen it used over and over in other markets, often as the primary and sometimes the only reason for assigning high values to companies in these markets. These analysts may very well be right about these markets being very big, but I think that suggesting that a company will be assured growth and profits, just because it targets these markets, not only misses several intermediate steps, but also exposes investors and business-owners to the macro delusion.

Big Markets! Really, Really Big Markets!
Would I rather that my company operate in a big market than a small one? Of course. Increasing market potential, holding all else constant, is good for value, but for that value to be generated, a whole host of other pieces have to fall into place. First, the company has to be able to capture a reasonable market share of that big market, a task that can be made difficult if the market is splintered, localized or intensely competitive. Second, the company has to be able to generate profits in that big market and create value from growth, also a function of the firm's competitive advantages and market pricing constraints. Third, once profitable, the company has to be able to keep new entrants out, easier in some sectors than in others.

It is therefore dangerous to base your argument for investing in a company and assigning it high value entirely on the size of the market that it serves, but that danger does not seem stop analysts and investors from doing so. Here are four examples:

China: A billion-plus people makes any market large, and if you add rapid economic growth and a
burgeoning middle class to the mix, you have the makings of a marketing wet dream. Visions of millions of cell phones, refrigerators and cars being sold were enough to justify attaching large premiums to companies that had even a peripheral connection to China. The events of the last few weeks have made the China story a little shakier, but it will undoubtedly return, once things settle down.
Online Advertising: It is undeniable that more and more of business advertising is moving online, and this shift has not only pushed Google, Facebook and Alibaba to the front lines of large market cap companies but has been the impetus behind Twitter, Yelp, Linkedin and a host of other social media companies capturing market capitalizations that seem outsized, relative to their operating metrics.

The Sharing Economy: Even as private businesses, Uber and Airbnb have not only captured the attention of investors, with multi-billion dollar valuations, but have also disrupted conventional approaches to doing business. In the process, they have opened up the sharing paradigm, where private property (car, house) owners can put excess capacity in what they own to profitable use. 

The Cloud: This is a recent entrant to the "big" market parade, as both technology titans such as Intel, Google and Amazon and new entrants such as Box vie to put our music, video, data and even our computing capabilities on large shared computers. Bessemer Venture Partners, which tracks companies that generate revenues from cloud computing, estimated a collective market capitalization of $170 billion for these companies in August 2015.

I am sure that you will find more examples add to the list. For example, just a couple of weeks ago, Morgan Stanley issued a strong buy recommendation on Tesla and based it entirely on its potential growth in the "mobility services" market. It took me two readings of the report for me to figure out that the mobility service market was a hybrid of the car sharing and driverless car markets, a potentially huge market, that would have become even enormous, if you were able to slap ads on the cars and put them in China.

The Macro Delusion: Individual Rationality, Collective Irrationality
When you label a market as a bubble, you take the easy way out, since a market bubble suggests that the investors who push prices to unsustainably high levels are being irrational, crazy and perhaps even stupid. It is for that reason that I have used the word guardedly (and when I have, regretted it), and taken issue with "market bubblers" in earlier posts. Even if you believe that assets (real estate, stocks, bonds) are being over priced, you will almost always be better served assuming that investors setting these prices have their own reasons for doing so, and understanding those reasons (even if you disagree with them).

To see how (almost) rational and (mostly) smart individuals can be fooled by big market potential into being collectively irrational, assume that you are an entrepreneur who has come up with a product that you see as having a large potential market and that, based on that assessment, you are able to convince venture capitalists to fund your business.

Note that everyone in this picture is behaving sensibly. The entrepreneur has created a product that he sees as fulfilling a large market need and the venture capitalists backing the entrepreneur see the potential for profit from the product.

Now assume that six other entrepreneurs see the same big market potential at about the same time you do, and create their own products to fulfill that market need, and that each finds venture capitalists to back his or her product and vision. 

To make the game interesting, let's make each of these entrepreneurs bright and knowledgeable about their products, and let's make the VCs also smart and business savvy. If this were a rational market place, each entrepreneur and his/her VC backers should be valuing his/her business, based on assessments of market potential and success, and the existence of current and future competitors.

Let's now add the twist that causes the deviation from rationality and make both the entrepreneurs and VCs over confident, the former in the superiority of their products over the competition, and the latter in their capacity to pick winners. This is neither an original assumption, nor a particularly radical one, since there is substantial evidence already that both groups (entrepreneurs and venture capitalists) attract over confident individuals.  The game now changes, since each business cluster (the entrepreneur  and the venture capitalists that back his or her business) will now over estimate its capacity to succeed and its probability of success, resulting in the following. First, the businesses that are targeting the big market will be collectively over valued. Second, the market place will become more crowded and competitive over time, especially with new entrants being drawn in because of the over valuation. Thus, while revenue growth in the aggregate may very well match expectations of the market being big, the revenue growth at firms will fall below collective expectations and operating margins will be lower than expected. Third, the aggregate valuation of the sector will eventually decline and some of the entrants will fold, but there will be a few winners, where the entrepreneurs and VCs will be well rewarded for their investments.

The collective over valuation of the companies in the big market will bear resemblance to a bubble, and the correction will lead to the usual hand wringing about bubbles and market excesses, but the culprit is over confidence, a characteristic that is almost a prerequisite for successful entrepreneurship and venture capital investing. That is one reason that I feel no need to inveigh against bubbles in the social media space, since this is a feature of investing in young, start-up businesses in big markets, not a bug. That said, the extent of the over pricing will vary, depending upon the following:
  1. The Degree of Over Confidence: The greater the over confidence exhibited by entrepreneurs and investors in their own products and investment abilities, the greater will be the over pricing. While both groups are predisposed to over confidence, that over confidence tends to increase with success in the market. Not surprisingly, therefore, the longer a market boom lasts in a business space, the larger the over pricing will tend to get in that space. If fact, you can make a reasonable argument that the over pricing will be greater in markets where you have more experienced venture capitalists and serial entrepreneurs.
  2. The Size of the Market: As the target market gets bigger, it is far more likely that it will attract more entrants, and if you add in the over confidence they bring to the game, the collective over pricing will increase.
  3. Uncertainty: The more uncertainty there is about business models and the capacity to convert them into end revenues, the more over confidence will skew the numbers, leading to greater over pricing in the market. 
  4. Winner-take-all markets: The over pricing will be much greater in markets, where there are global networking benefits (i.e., growth feeds on itself) and winners can walk away with dominant market shares. Since the payoffs to success is greater in these markets, misestimating the probability of success will have a much bigger effect on value.
The Online Ad Market and Social Media Company Valuations
The market that best lends itself to run this experiment today is the online advertising market, with the influx of social media companies into the marketplace in the last few years. To run my experiment, I took the market capitalization of each company in the online advertising space and backed out of the expected revenues ten years from now. To do this, I had to make assumptions about the rest of the variables in my valuation (the cost of capital, target operating margin and sales to capital ratio) and hold them fixed, while I varied my revenue growth rate until I arrived at the current market capitalization. 

The figure below illustrates this process using Facebook with the enterprise value of $245,662 million from August 25, 2015, base revenues of $14,640 million  (trailing 12 months) and a cost of capital of 9%. Leaving the existing margins unchanged at 32.42%, we can solve for the imputed revenue in year 10:
I assume that Facebook's current proportion of revenues from advertising (91%) will remain unchanged over the next decade, yielding imputed revenues from advertising for Facebook of $117,731 million in 2025. The assumption that the advertising proportion will remain unchanged may be questionable, at least with some of the other companies on the list below, where investors may be pricing in growth in new markets into the value. You undoubtedly will disagree with this and some of my other assumptions, which is why I will let you make your own in the attached spreadsheet and solve for your estimate of future revenues.

I repeat this process with other publicly traded companies with significant online advertising revenues, using a fixed cost of capital and a target pre-tax operating margin of  either the current margin or 20%, whichever is higher, for every firm. Note that both assumptions are aggressive (the cost of capital may have been set too low and the operating margin is probably too high, given competition) and both will push imputed revenues in year 10 down.
Numbers & Valuations in US dollars for all companies (Folder with valuations)
The collective online advertising revenues imputed into the market prices of the publicly traded companies on this list, in August 2015, was $523 billion.  Note that this list is not comprehensive, since it excludes some smaller companies that also generate revenues from online advertising and the not-inconsiderable secondary revenues from online advertising, generated by firms in other businesses (such as Apple). It also does not include the online adverting revenues being imputed into the valuations of private businesses like Snapchat, that are waiting in the wings. Consequently, I am understating the imputed online advertising revenue that is being priced into the market right now.

To gauge whether these imputed revenues are viable, I looked at both the total advertising market globally and the online advertising portion of it. In 2014, the total advertising market globally was about $545 billion, with $138 billion from digital (online) advertising (Sources: Zenith Optimedia. eMarketer). The growth rate in overall advertising is likely to reflect the growth in revenues at corporations, but online advertising as a proportion of total advertising will continue to increase. In the table below, I allow for different growth rates in the overall advertising market over the 2015-2025 time period and varying proportions moving to digital advertising to arrive at these estimates of digital/online advertising revenues in 2025:
Even with optimistic assumptions about the growth in total advertising and the online advertising portion of it climbing to 50% of revenues, the total online advertising market in 2025 is expected to be $466 billion. The imputed revenues from the publicly traded companies on my list is already in excess of that number, and it seems reasonable to conclude that these companies are being over priced, relative to the market (online advertising) that they are expected to profit from.

As more companies line up to enter this space, this gap between the size of the market that is priced in and the actual market will continue to grow, but investors will continue to fund these companies, even if they are aware of the gap. After all, the nature of over confidence is that founders and investors are convinced that the over pricing is not at their firms, but in the rest of the market. There are two threats to this over confidence and they are inevitable. The first is that as companies in this space continue to report earnings and revenues, you will see more negative surprises (lower revenue growth, shrinking margins and more reinvestment) and some price adjustment. The second is that there is no better deflator of investors over confidence than a market panic, and if the China crisis does not do it, there will be others down the road.

What now?
Even if you accept my argument that big markets can create macro delusions and that these delusions can lead to a gap between collective expectations and reality, what you should do, in response, will depend on how you approach investing. If you are a trader, playing the pricing game, you may not care about the gap, since your returns will be based on timing, i.e., entering the market at the right time and exiting before the delusion is laid bare. It is possible that a lot of public investors and venture capitalists in this space are playing this pricing game and some of them will get very rich doing so. 

If you are a founder/owner or private investor interested in the long term value of your business, you may not be able to do much about your over confidence but there are a few simple steps that you can take to keep it in check. I do know that many in the start-up community view intrinsic valuations (or DCFs) with suspicion, but done right, a DCF is more than a valuation of a company. It provides a template for how you hope to convert products/users/downloads into revenues and profits, how much capital you will need to deliver the growth you so eagerly seek, and how competition will impinge on your best laid plans (by affecting growth and margins).  

If you are a public market investor, surveying a "big market" group of companies, this post is not a clarion call to abandon the group, but to approach it differently. You can still make money investing in this sector, but only if you are selective about the companies that you invest in (which requires that you grapple with estimating the size of the big market and make your best judgments on winners and losers)  and are cognizant of the price that you are paying, not only when you buy the stock but while your hold it. In fact, your very best investments may come from mis-pricing in this segment.

No matter which group you belong to, it is time that we stop labeling each other. If you are on the outside (of these big markets) looking in, don't be so quick to categorize players in the market as irrational, shallow and naive. If you are on the inside looking out, stop thinking of anyone who does not buy into your big market thesis as a Luddite, out of touch with technology and stuck in the past. You and I should be able to disagree about the values of Uber, Snapchat and Twitter, without our motives being impugned, our intelligence questioned and our sanity put to the test.

YouTube Version
I know that this is a long post and that your attention may have flagged half way through. To remedy that, I decided to make a YouTube video around this post. I hope you enjoy it!

  1. Imputed Online Ad Revenues by Company (with raw data on the companies)
  2. Spreadsheet to compute Imputed Online Ad Revenues
  3. Folder with imputed revenue spreadsheets for companies