Wednesday, February 13, 2013

Hundred dollar bills are hard to come by!

It looks like I just I cannot stay away from the Apple story, with Tim Cook making a splash (or a belly flop) with his speech in New York yesterday and David Einhorn's proposal coming in for scrutiny from investors and the press. This article in the New York Times DealBook does a pretty good job of summing up the proposal and its underlying thesis, and I was surprised to see my name mentioned, with Mr. Einhorn quoted as having said that my analysis "brings to memory the old joke about the economist who refused to pick up a $100 bill on the street because in an efficient economy, there can’t be $100 bills lying around.” I am flattered that I was even part of this conversation, given that Mr. Einhorn has probably never heard of me nor read my thoughts about market efficiency. I am also grateful that this was all he said about me, because I have been accused of far worse than ignoring hundred dollar bills on the floor. (Just take a look at the comment section of my prior blog posts). My motives for this post are not defensive but I do have a weakness of not being able to let an analogy go, especially when it can be used to good effect. So, at the risk of being labeled an egghead, here is what I think about hundred dollar bills on floors.
  1. Location, location, location: Is it possible that you could find $100 bill on the street? Sure, but you have to get very lucky and the likelihood that you will find one is also going to vary depending on what street you are walking on. Your odds are probably better on Rodeo drive in Los Angeles, where there are wealthy shoppers and relatively few pedestrians (since no one in LA walks more than a block) than on a busy street in New York, where there are literally thousands of people, most of who don't have hundred dollar bills, walking with you. Apple is one of the most highly followed, most talked about stocks in the world and is more like Penn Station in New York City than Rodeo Drive.  I have gone through through Penn Station twice every week day, on my commute, for the last 20 years and have never found a hundred dollar bill on the floor. In fact, I don't think I have even found a twenty. I have found a few dollar bills, several quarters, lots of dimes and thousands of pennies.   It is entirely possible that this is because I am a finance professor and am blinded by my belief in efficient markets, but most of the readers of this blog are not. So here are my questions for you: Have you ever found a hundred dollar bill on the floor? How about a twenty dollar bill? Do you find a lot of these? (If so, could you please let me know the street that you walk on... I am willing to relocate... Incidentally, I put this question to my class of 400 today and there were three people who said that they had found $100 bills on the ground. Two of them were in bars at the time. There is a great analogy in here for investors but I am afraid to even go there.... So, I will leave it to your imagination....)
  2. There is a cost to looking for "free" money: Perhaps, Mr. Einhorn's point is that those of us who have never found hundred dollar bills on the floor have just not been looking, but there are people who do and I am not sure that it is a lucrative enterprise. Using the Penn Station analogy again, there are still a few public phones left in the station, and every day as I walk through, I see people doing the phone scan, where they check the change alcove for money that callers have left behind. Could you make money doing this? I guess so, but it depends upon how much value you attach to your time.
  3. And watch your back pocket: I have spent more of my life now in New York City than any other part of the world, and I guess that some of the native New Yorker has rubbed off on me. If I did see a hundred or twenty dollar bill on the floor in front of me, my scam detection antenna goes into high alert. From experience, I know that when something in this city looks like easy money, there is a catch. In this particular case, I would not be surprised to find out when I bend to pick up the "free" hundred dollar bill that it is (a) a fake bill and (b) that my back pocket will be picked while I am bending over.  
  4. Don't build expectations around luck: If I did find a hundred (or even a twenty) dollar bill on the floor and I felt safe enough to lean over and pick it up, I would feel "lucky" that I found it, but I would not mistake serendipity for skill. I would certainly not build my household budget on the assumption that I will find not one but three hundred dollar bills on the floor every month in Penn Station. That would be not only foolhardy but a recipe for a unbalanced budget.

I have nothing personal against Mr. Einhorn, other than the standard New York lament that he is a Mets fan and not a Yankee fan. I have agreed with him more often than not and shared his disdain for the over-the-top assumptions that analysts were making for companies like Green Mountain Coffee. In fact, I will offer an argument for Mr. Einhorn's proposal that I think is more substantive than any that I have heard made yet. His suggestion that Apple issue preferred stock to its common stockholders is built on the presumption that, with interest rates at historic lows, there is a void in the market now for  investors (perhaps institutions that need the cash and get a break on taxes on preferred dividends) who would like to make a reasonable return on a safe investment. The assumption is that these investors will  pay a premium (over and above "fair" value, given the risk of the cash flow) for the 4% preferred stock that Apple will issue, and that common stockholders will capture this premium (by selling the preferred shares that they are granted by Apple to these "premium paying" investors). That is not an unreasonable argument, but my skepticism is based on two considerations. The first is that if this is true, we should be able to see the evidence in the preferred stock market, where preferred stock issued by companies that have solid balance sheets and substantive cash flows should be trading at premium prices. Is that happening? I don't know, but if Mr. Einhorn wants to make his case stronger, he should present evidence of the phenomenon, perhaps by comparing preferred dividend yields to earnings yields on common stock and corporate bond spreads. The second is the question of scalability. It is possible that Apple's common stockholders may be able to capture some of this premium with the first $50 billion of preferred stock issue, but will the premium persist as the issue gets scaled up to $100 billion or to $430 billion? I don't think it will, but I remain willing to be persuaded otherwise, and the onus is on Mr. Einhorn to provide the justification. In fact, much of the noise around this proposal comes from the misconception that a company can choose both the face value of its preferred stock and the dividend yield. If Apple issues $500 billion (face value) in preferred stock and sets the dividend yield at 4%, that preferred stock will not have a market value of $500 billion.

I started this post with the note that Tim Cook was in San Francisco yesterday, delivering a speech to a conference. Listening to what he said, I was reminded of why I continue to be frustrated with Apple's management. First, I don't think any CEO should be labeling a proposal by one his leading stockholders as a "silly sideshow", even if he disagrees with that plan. (Correction: As some of you have noted, Mr. Cook labeled the lawsuit as a silly sideshow, and not the proposal itself. A little more palatable, but Einhorn has the right to sue and Apple has the right to show, in court, that the lawsuit is frivolous and get it thrown out... )  Second, Mr. Cook made a highly publicized speech and told investors nothing of substance. I know that he dropped nuggets of information that may or may not be useful to investors, but talking about how much more money Apple will pay developers next year is the equivalent of a dinner party host with an elephant in the dining room talking to his guests about the the quality of the place settings. At the moment, investors in Apple are centered on the $137 billion in cash that the company has accumulated, and continues to add to, and they want to know what Apple's plans are for that cash. I am sure that Tim Cook has plenty of well paid consultants, giving him advice, but I will offer mine for free, knowing that it will be ignored. Mr. Cook, if you have nothing of substance to tell investors, it is best that you not talk at all, because if you do make more speeches like the one you delivered yesterday, you will more damage than good (as the market response showed)!

Returning to my central theme, what would I do if found a hundred dollar bill on the floor? First, I will check my surroundings to make sure that I am not the sucker in a con game, and I will then bend down and pick it up. Second, I hope (to be ethical is easy in the abstract, much more difficult in practice..) that I will remember what my mother taught me and look to see if I can find the legitimate owner of that cash. If I do not, I will think of it as my lucky find and treat it accordingly. I will, however, not spend the following days searching for hundred dollar bills on the floor, nor will I build my investment portfolio on the assumption that I will keep finding more free money on the floor.

65 comments:

Anonymous said...

I believe in Einhorn's plan simply because it passes the common sense test. I dont need to see evidence of high yield preferred stock of extremely solid companies trading at premium prices because there is obviously demand for them in the current environment. I dont understand why there should be any skepticism around this.

I share the frustration with Cook. If only Apple were a smaller company, it would be a perfect target for PE firms and activist investors.

Anonymous said...

One tiny correction - Tim Cook spoke in San Francisco yesterday at the Goldman Sachs Conference.

Frank

Highgamma said...

In general, I am skeptical of any type of "free money" argument"; however, I believe that there is a perception that Apple is going to burn this pile of cash. That's why people discount it. By committing to give cash to shareholders (through preferred dividends which cannot be suspended indefinitely without some repercussions), Apple would be sending a signal to the market that they are committed to returning value to their shareholders. Right now, I don't think people feel that Apple is committed to shareholder value. Isn't this a legitimate basis for such a proposal?

thelouthebronx said...

Actually, I think one would have best luck finding $100 bills not on Rodeo Drive, where most shoppers probably (if they pay cash) keep all their bills in a very fashionable wallet or purse and wouldn't want to be seen embarrassingly dropping anything, or simply pay on their bank card or have the pleasure of flashing their Amex black card.

Now, let's take an area like the south Bronx. A shady sort of place, where money changes hands without ever touching a bank. Violence? Check. Theft? Check. Illegal business? Check. This is the sort of place where $100 bills may in fact be lying around.

Or we can look at it from another angle. I read an article months ago about a man who searched for GOLD on the streets of Manhattan. Yes, flecks of gold in puddles on street corners or between the grates of a sewer drain. So maybe there really is some truth to the saying...

horn said...

Good post, but the value comes as much from the signaling effect, if not moreso, than the actual return of an extra $2bn a year on top of the $15bn a year they are planning to return via divy/buybacks.

I'm pretty sure you don't disagree with the effect of 'signaling' in general - splits, div raises, etc.

Anonymous said...

Dear Prof. Damodaran,

Could you do a post on Apple and the pros and cons of a large stock buyback when intrinsic value is much higher than stock price?

Many die hard Apple investors think it will not add value. I believe buying undervalued stock with hugely excess capital is value accretive. Also, it might send positive signals as well as set a floor for nervous investors.

Thanks and am huge fan of your class.

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RattyUK said...

"First, I don't think any CEO should be labeling a proposal by one his leading stockholders as a "silly sideshow", even if he disagrees with that plan."

Pretty certain that Tim Cook actually agreed with the proposal. The "silly plan" comment was related to the shareholders suing Apple to get it done.

Anonymous said...

On a tangent, I found approximately $300 tucked inside a pack of cigarettes in Philly. I was followed by a white van for a while, but nothing seemed to have happened.

Kemeny said...

Free $100 bills notwithstanding, I think Einhorn's proposal makes a lot of sense.

Basically, he's saying, interest rates are at historical lows. They may not get worse, but they are unlikely to get a lot better, so..

Let's borrow a large amount of money from the market forever.

Better yet, we can do so in a way that transfers the proceeds of that debt to our shareholders (since we at Apple certainly don't need the money) and reduces the cash pile, making our business easier to understand and invest in.

We can do all of this and at the same time reduce the temptation for our executives' to make value destroying acquisitions, invest in uncertain technologies, or try their hands at being fund managers.

This seems fairly sensible to me. Or at least should require more of a counter-argument than the fact that $100 bills are hard to find.

Anonymous said...

Epic comments Professor! I have followed your work for a few years now, and it is great to see your analysis going up against the hedge fund managers for some high profile names. Keep up the great work!

Anonymous said...

"..but Einhorn has the right to sue and Apple has the right to show, in court, that the lawsuit is frivolous and get it thrown out.."

I believe another reason for labeling it silly is that TC said aapl would submit such a major move as issuance of another class of stock for shareholder vote whether required to do so, or not.

John Daly said...

Excellent post Professor. But one thing continues to fascinate me. What does the extraordinary volatility of the Apple share price tell us about market efficiency? This is clearly the most followed, analysed, discussed and critiqued listed-company in the world, yet in roughly 6 months the share price has travelled from above $700 to below $500. And post the launch of the iPhone 5 and iPad Mini, there has been relatively little new major news (the launch of these new products also coincided with broker analysts valuing the stock - if we can say that a '12-mth price target' is based on valuation work - at $1,000.
Interested in your thoughts. Best wishes John

Anonymous said...

Over 62 years I found one hundred dollar bill about 12 years ago in a hotel parking lot in North Carolina at about 6 am going out for a morning jog. Decided to keep my day job and went to work that day. I'm with you Doctor, thank you for all the sharing you do including this blog!

Anonymous said...

Prof. Why should $100 preferred with cost of 4% with a coupon of $4should trade at premium?

Let's assume that there are other 4% coupon preferreds selling in the market at $110 and there is Apple with price of $100. Don't you think market will shift from $110 one to $100 one? And in the process bring down price of $110 one back to $100? Chances are low of $100 one to rise to $110. The same is true if one sells at discount.

The market for the preferreds is not like the one for bonds.

If coupon is $4 and cost of preferred is 4%, it cannot trade at premium or discount. Unless you change the cost of preferred to say, 3% or 5% (keeping coupon at $4), which is not reasonable.

The cost to the business is 4%. So it should logically trade at $100. Where is unlocking value here? Yes unlocking price may be there but that is a different game.


Aswath Damodaran said...

Anonymous,
I am not making the claim that it will. Implicitly, that is the claim that is being made when you use preferred stock instead of just raising the common dividend by exactly the dividend you would have paid on the preferred. After all, the net effect from a cash flow standpoint is exactly the same... but if there are people dying to buy preferred, perhaps they will pay more than they should.

Aswath Damodaran said...

Anonymous,
I am not making the claim that it will. Implicitly, that is the claim that is being made when you use preferred stock instead of just raising the common dividend by exactly the dividend you would have paid on the preferred. After all, the net effect from a cash flow standpoint is exactly the same... but if there are people dying to buy preferred, perhaps they will pay more than they should.

Anonymous said...

Dear Professor,

There is one key point your analysis fails to capture regarding Apple and its valuation. The Apple business model succeeds or fails based on the ability of its management to a) protect existing markets, b) disrupt new markets and/or c) keep launching new products within existing markets.

The problem is that all of these decisions rely on management having to continually make good and correct decisions re new products and markets. There is a large risk of future mistakes. This makes it a fundamentally different company to invest in than say Coca Cola. In essence, Apple needs geniuses to be on top of their game at all times, whereas Coca Cola could be (almost) run by monkeys. I would feel much safer investing in a Coca Cola type company, at the right price.

Your posts never seem to touch on this issue and I would love to know your thoughts. It makes predicting the future for Apple a very risky affair...

Aswath Damodaran said...

You are absolutely right. There is a much greater risk in Apple than there is in P&G and Coca Cola. That is why I attach a 12.5% cost of capital to the company in my valuation, at the top decile of costs of capital for companies. If I had used the 7.5% cost of capital that is more typical of a company like P&G, I would get a value of almost $800/share for the company. Perhaps, I am not adjusting for risk enough, and that is a fair critique. That is why I argued in my earlier post that I do not take issue with those who build in the expectation of a "technology cliff" and attach a lower value to Apple.

Erik said...

I have found a $100 bill on the ground.
It was in Vail Village in Colorado.

Anonymous said...

Einhorn wants this deal because 1) it will increase the stock price in the short run. 2) the preferred will be worth considerably less if interest rates return to long-run averages (say 6% for discussion). Einhorn's proposal is in the interest to short to medium-run investors and screwing the long-run investor.

This is not a serious proposal of a true long term partner.

Anonymous said...

Hi Aswath,

Great analysis and common sense argument, again.

I am intrigued by the Apple story as it stands now. I thought it was grossly over-valued last Summer, with a market cap >$700bn.

With the drastic fall over the last few months; I am starting to think that Apple may be at about fair value now (I know you think value is more around $550-600 p/s, with potential for more upside).

My problem with Apple is that I just do not think they are capable any more of creating those disruptive new products that revolutionise industries. To make products like that, you need a maverick at the top who is obsessed with perfection, and willing to take risks to back his (or others') ideas to the hilt. Steve Jobs was one such person (I think).

So, if we believe that this upside catalyst is remote; the rest of Apple's business doesn't look as appealing any more:
- Apple's share of the smartphone market will erode though cheaper competitors and because wireless carriers, who are suffering in most markets around the world, will not subsidise the (relatively) expensive iphone as much any more. This will also mean that people will not automatically just switch to the new iphone as soon as it comes out (at the rate they have been doing in the past)
2. I think Apple's products will start cannibalising themselves. Why really does someone who has an iphone need an ipod?
3. Apple has saturated developed markets. I recently had a "hand rickshaw" driver in London tell me directions from his iphone 5. Growth can only come from emerging markets, where margins will be squeezed.
4. The Apple story/image is not suited to a price war. They will lose their appeal to some (maybe irrational) customers.

In sum, I think there is a real chance that, like some other tech giants of the past, who were meant to deliver us in to the future (Nokia/RIM/Microsoft), Apple will fade away in the future (i.e. 10 years or so).

Am I being too pessimistic?

Thanks,
GB

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gareth wong said...

As ever, I shall forever be a student in front of you Prof.

I did highlight in the NYTimes post your response and below is link to my post(or would you have preferred me to cut & paste here next time!?): My response & predictions 4 Tim re Unusual Moves in Confronting Apple's Huge Pile of Cash - NYTimes.com http://bit.ly/12KT3RO

BR
@GarethWong

UniverseofRisks said...

I don't understand why its a good thing for Apple to increase dividends or issue preferreds. From what little I know, a culture of dividend payouts equates to a culture of "no innovation." I don't think anyone in the last 8-10 years purchased apple expecting dividends. I don't think it should change. I'd much rather see Apple diversify into various other businesses (anything that doesn't hurt their margins).

Anonymous said...

Isn't Einhorn contradicting when he wants to unlock cash and at the same time let's management keep that cash?

http://valueanalyst.blogspot.com/2013/02/whats-wrong-with-apple.html

Statspotting said...

Maybe there are other factors at play here. How will the scenarios change if Apple is split into two companies for example?

http://statspotting.com/should-apple-just-break-itself-into-two-companies/

Anonymous said...

Off Topic, but slightly nearby:

The frequency of finding $100 bills is heavily dependent on the purchasing power of a $100 bill, I am sure the Zimbabwe $100 bill was often discarded as easily as New Yorkers say keep the change when talking about a few pennies.

Professor Damodoran, would you do a post on the impact of Fed policy and QEnfinity on trying to conduct valuations? It seems like one of the key challenges to doing valuation is the uncertainty in the value of the dollar (or any other major currency, JPY, EUR, GBP etc) in a world of central bank printing. Any thoughts on how currency stability effects appropriate discount rates and valuations?

Daedalus Mugged

Vishal Agrawal said...

Professor,

I do not understand how apple can issue $500 bn worth of preferred shares. They do not have so much reserves. Won't the $500 bn get added to the liability side of the balance sheet, even if they never have to return it? What will be it's equivalent in the assets side (or alternatively, which reserves on the liability side would it replace)?

Vishal

Marcus Chung said...

Professor Damodaran your last past on Einhorn was fantastic but you're analogy here has gotten off the beaten path. As another person who has commented has said using comparable companies and their preferred stock isn't a fair metric in this case. It's Apple specific and their use of their cash. I don't think Einhorn is saying it's 'Free money' and yes I know it was he who used the analogy, he is saying either use it or lose the cash or provide a better mix of spending and returning.

Einhorn’s thesis is that the market prices Apple lower than it would because it’s not currently happy with its mix of saving and returning cash. Improve it and the market will therefore assign a higher price to the stock.

Scotto said...

Professor,

With all due respect, I think you're missing the point when relating the merits of Einhorn's plan to the existence of unfilled demand in the market for preferred shares.

I think the fact pattern is:
a) apple is undervalued;
b) the divergence in the intrinsic value and the market value appears to be due to investors haircutting cash; and
c) returning cash to shareholders would unlock that value.

Preferred shares are just one method and I wouldn't be surprised if Einhorn would be opposed to other methods of unlocking the value of cash on the balance sheet.

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Anonymous said...

Dear Prof.,

Can you do a follow up post following the Einhorn call and address the capital allocation strategies in general? Pls address the behavioral aspects too

Many Apple Investors would appreciate you considering it?'

Thanks!

Confused Apple Holder

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Hi Prof,

Just wanted to thanks you for your insightful articles and writings. They have helped me immensely.

Just had a few questions that are unrelated to this article but has been bugging me...

How do i resolve discrepancies between the Cash Flow Statement and the Balance Sheet regarding non cash working capital? I often find that there are clear differences and am unsure which set of numbers to use when calculating reinvestment.

Also how to you calculate CAPEX on PPE, is it just what is said on the CF statement or do you also look at the balance sheet to see the changes in gross PPE? And what if these two sets of number differ? which do I use.

Lastly I completely agree with your decision to capitalise R&D, should I extend this same logic to investment in intangibles (which you always see on the CF statement).

Thank you for your help!

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Rich

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Anonymous said...

Hi Prof. Damodaran,

It is a little embarrassing to admit, given that I am actually a lecturer in valuation...

But although I understand and teach valuation, it is always very difficult to point to the students (and to myself!) the key metrics that are really important to have a good overview of the value of the company.

So, if you were thinking about those 20% variables that explain 80% of the value of the company, which would they be?

I can think of some of them, but I am really not sure... For instance, operational profit? Historical (or industry historical) operational profits as a benchmark? Betas and D/E ratios for the cost of capital? Retained earnings? (Investments)? ROE (and variations), historical growth, etc?

Anyway, if you can share your ideas about these "key" metrics, I would really appreciate it.

All the best!

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