Thursday, March 28, 2013

A Sweet Spot for US Equities: Opportunity and Dangers

The US equity markets are on a roll. Today, the S&P 500 hit an all time high, just weeks after the Dow also broke its record. While it has been less than five years since the crisis of 2008 and the epic collapse of equities in the last quarter of that year, the returns earned by those who stayed the course, even relative to pre-crisis price levels, is a testimonial to the dangers of staying out of equity markets for extended periods.  As with every other market surge, this one has brought with it the usual questions: Have stocks gone up too far, too fast? Are we due for a correction? Should we stay in the market or take profits? I could cop out and use the excuse that I am not a market timer, but that would be a lie. All investor are market timers, with the differences being one of degree. So, the honest truth is that I have a view about markets but that it does not dominate my investment decision process.

Since it is so easy to be swayed by story telling, when talking about equity markets, I try to bring the same tools to assessing markets that I do for individual stocks. The intrinsic value of equities, in the aggregate, is determined by four variables:
  1. Cash returned to equity investors: Ultimately, we buy stocks to get cash flows in return, with those cash flows evolving over the last three decades from almost entirely dividends to a mix of dividends and stock buybacks. Holding all else constant, the more cash that is returned to investors in the near term, the more you will be willing to pay for stocks
  2. Expected growth: The bonus of investing in equity, as opposed to fixed income, is that you get to share in the growth that occurs in earnings and cash flows in future periods. Other things held equal, the higher the expected growth in earnings and expected cash flows, the higher stock prices should be
  3. Risk free rate: The risk free rate operates as more than base from which you build expected returns as investors. It also represents what you would earn from investing in a guaranteed (or at least as close as you can get to guaranteed) investment instead of stocks. Consequently, stock prices should increase as the risk free rate decreases, if you hold all else fixed
  4. Risk premium: Equities are risky and investors will demand a “premium” for investing in stocks. This premium will be shaped by investor perceptions of the macro economic risk that they face from investing in stocks. If the equity risk premium is the receptacle for all of the fears and hopes that equity investors have about the future, the lower that premium, the more they will be willing to pay for stocks
Note that while it is easy to focus on each of these variables and draw conclusions about the impact on stock prices, they tend to move at the same time and often pull in different directions. For instance, stronger economic growth will push up earnings growth but interest rates will usually go up as well. In a similar vein, paying out more in cash flows to investors in the current period will often mean less being invested into businesses and lower growth in the future. It is the trade off that determines whether stock prices will go up or down as a consequence. On each of these variables, the US equity market is looking at "good" numbers right now: the cash returned to investors by US companies has rebounded strongly from post-crisis lows, earnings growth is reasonable, the risk free rate is at a historic low and the equity risk premium, while not quite at pre-crisis levels, has declined significantly over the last year. To explore both where we are and the potential dangers that we face as investors, let’s take a look at each variable.

1. Cash flows
a. Background: Until the early 1980s, the primary source of cash flows to equity investors in the United States was dividends. As I noted in this post from a while back, US companies have increasingly turned to returning cash in the form of buybacks. While there are some strict value investors who believe that dividends are qualitatively better than buybacks, because they are less volatile, the aggregate amount returned by US companies in buybacks is too large to be ignored. 
Over the last decade, buybacks have been more volatile than dividends but the bulk of the cash flows returned to stockholders has come in buybacks.
b. Level: In the most recent twelve months for which data is available (through December 2012), the companies in the S&P 500 bought back almost $400 billion worth of stock, much more than the $270 billion that they paid out in dividends. In terms of index units and as a percent of the level of the index, the aggregate cash flows have recovered fully from their post-2008 swoon.
c. Sustainability: While it is good that cash flows are bouncing back, we should worry about whether companies were over reaching and paying out too much in 2012, perhaps in advance of the fiscal cliff at the end of 2012, in which case you should expect to see a drop off in cash flows in the near term. There are three reasons to believe that this is not the case. First, as Birinyi Associates notes in this blog post, the pace of buybacks is increasing in 2013, not dropping off, with the buybacks authorized in February 2013 at an all-time high. Second, the cash returned in 2012 may have been a historic high in dollar value terms, but as a percent of the index, it is close to the average yield over the last decade. Third, the aggregate cash balances at the S&P 500 company amounted to 10.66% of firm value at the end of 2012, suggesting that companies have cash on hand to sustain and perhaps even increase cash returned to stockholders. While a portion of this cash is trapped, it is possible that corporate tax reform, if it happens, will release this cash for distribution to stockholders.

2. Expected growth
a. Background: For dividends and buybacks to continue to grow in the future, there has to be growth in earnings. While that growth can be estimated by looking at history or by tracking analyst forecasts of earnings for the individual companies, it has to be earned by companies, reinvesting their earnings back into operations and generating a healthy return on equity on those investments.
Intrinsic growth rate = Equity Reinvestment Rate * Return on equity
Thus, while history can sometimes yield skewed values (up or down) on growth and analysts can become overly optimistic or pessimistic, the intrinsic growth rate will be grounded in reality.
b. Level: To look at earnings growth in the S&P 500, lets begin by looking at history. In the table below, we report on earnings growth rates over 5 years, 10 years, 20 years and 50 years in index earnings.

Arithmetic average
Geometric Average
Last 5 years
6.46%
4.42%
Last 10 years
9.66%
8.33%
Last 20 years
9.60%
8.28%
Last 50 years
8.30%
6.90%
Over the last 5 years, the compounded average annual growth rate in aggregate earnings for the S&P 500 has been 4.42%. As the most widely followed index in the world, analyst estimates of growth in earnings are widely available both for individual companies in the S&P 500 index and for aggregate earnings in the index. Using the former to construct a bottom-up estimate of growth yields 10.57% as the expected growth rate in March 2013. Since there is evidence that analyst estimates of growth are biased upwards at the company level, we also looked at the “top down” estimates of growth that analysts are forecasting for aggregate earnings in March 2013, obtaining a lower growth rate of 5.33% a year for the next 5 years.
c. Sustainability: Are analysts over estimating earnings growth? One way to check is to compute the intrinsic growth rate by computing the equity reinvestment rate and return on equity for the index. To compute the equity reinvestment rate, we use the aggregate cash returned to investors (75.31) in 2012 and the earnings on the S&P 500 (102.47) in 2012:
Equity Reinvestment Rate = 1 - 75.31/102.47 = 26.51%
To compute the return on equity on the index, we divide the aggregate earnings on the index in 2012 by the aggregate book value of equity on the index (613.14) at the start of 2012:
Return on equity = 102.47/613.14 = 16.71%
The product of the two yields a sustainable growth rate:
Sustainable growth rate = .2651 * .1671 = .0443 or 4.43%
While this number is lower than the top-down analyst estimate of growth, it is within shouting distance of the estimate. There is, of course, a concern that some investors and analysts have voiced about the operating earnings number reported for the S&P 500, arguing that it is over stated. If it is, then the equity reinvestment rate and ROE are both over stated, and the expected growth rate will be lower.
3. Equity Risk Premium (ERP)
a. Background: Put simply, the equity risk premium is the market price of equity risk. It is determined on the one hand by perceptions of the macro risk that surround investors, with greater risks going with a higher ERP, and on the other hand by the collective risk aversion of investors, with more risk aversion translating into a larger ERP. A larger ERP implies that investors will pay lower prices for the same set of equity cash flows. The conventional wisdom that this number is stable in mature markets was shaken by the banking crisis of 2008, as premiums in the US and European equity markets experienced unprecedented volatility.
b. Level: There are two ways in which ERP can be estimated. One is to look at a long period of history and to estimate the premium that stocks would have generated, over an above the treasury bond rate, over that period. This “historical” premium approach yields 4.20% as the ERP for US stocks in 2013, using data from 1928-2012. The other is to estimate an “implied” premium, by backing out an internal rate of return from current stock prices and expected cash flows. This approach yields much more volatile equity risk premiums over time, as can be seen in the graph below: 
The implied ERP at the start of 2013 was 5.78%, lower than the ERP at the start of 2012, but still at the high end of the historical range.
c. Sustainability: I have been estimating the monthly ERP for the S&P 500 since September 2008, and as can be seen in the figure below, the premium of 5.43% at the start of March 2013 represents a significant decline from a year ago. Note, though, that it is still much higher than the premium that prevailed in September 2008, just prior to the crisis. In fact, the average implied ERP over the last decade has been 4.71%, lower than the current implied ERP.
[I have an  long, not-very-fun update that I do on equity risk premiums that you can download and peruse, if you are so inclined. It includes everything that I know about ERP]

4. Risk free rate
a. Background: As sovereigns increasingly face default risk, it is an open question whether any investment is risk free in today’s environment. However, for an investor in US dollars, the return you can expect to make on a long term treasury bond not only represents a base from which all other expected returns are computed but is an opportunity cost of investing in something risk free instead of stocks.
b. Level: By any measure, risk free rates are at historic lows in much of the developed world. On March 26, 2013, the ten-year US Treasury bond rate was at 1.91%, well below where it stood prior to the last quarter of 2008 and well below rates that prevailed a decade earlier. 
The average for the ten year bond rate for the last decade was 3.59% and lengthening the time period pushes the average up to 4.62% (last 20 years) and 6.58% (last 50 years)
c. Sustainability: Is the treasury bond rate destined to rise and if it does, will it bring down stocks? To answer this question, we have to look at what has kept rates low for such an extended period. While the answer to some is that it is the Fed’s doing, I, for one, don’t attribute that much power to Ben Bernanke. The Fed has played a role, but it has succeeded (if you can call it success) only because inflation has been benign and real economic growth has been abysmal for this period. There are at least four scenarios that I see for the future direction of interest rates, with differing implications for stocks. 
Scenario
Treasury bond rate
Outlook for stocks
More of the same (anemic economic growth, low inflation)
Stays low
Neutral
Stronger economic growth, low inflation
Rises to reflect higher real growth
If economic growth translates into earnings growth, neutral. If not, mildly negative.
Low economic growth, high inflation
Rises to reflect higher inflation
Negative. Higher required returns on stocks, no offsetting positive.
Higher economic growth, low inflation, Fed Magic
Stays low
Positive

If you believe that the Fed can keep a lid on interest rates, as economic growth returns, the outlook is positive for stocks. I think that the most likely scenario is that the interest rates will rise as the economy improved, and the outlook for stocks will depend in large part on whether earnings growth picks up enough to offset the interest rate effect.

Valuation of the S&P 500 Index
To see the interplay of these numbers and the resulting consequences for stocks, I valued the S&P 500, as of March 26, 2013, using the following inputs: 
Based upon my assumptions, the market’s current winning ways can be justified. Replacing the current implied equity risk premium with the average premium over the last decade (4.71%) yields a level of almost 1800 for the index, and using the analyst-estimated growth rate will make it even higher. Higher risk free rates have a negative, albeit muted, effect on value, if accompanied by higher growth rates, but do have a much more negative impact, if growth rates remain unchanged. You may have very different views on the market drivers and if you are interested, you can input your numbers into the attached spreadsheet to get an assessment of value for the S&P 500 index.

Bottom line
When stocks hit new highs, the natural impulse is to look for signs of over valuation, but there are good reasons why US stock prices are elevated: cash flows are high, growth looks good, the macro risks seem to have faded (at least some what) and the alternatives are delivering lousy returns. In the near term, stocks remain vulnerable to two possibilities. One is that another macro crisis will pop up (Italy, Spain, Portugal or a non-EU black sheet) that will cause equity risk premiums to jump back to the 6%+ levels that we have seen so often in the last 5 years. The other is a sudden surge in interest rates, unaccompanied by better earnings or higher earnings growth. Since all risky asset classes (corporate bonds, real estate etc.) will be also adversely affected by either of these developments, I don't see much point to shifting from equities to other risky assets to protect myself against these risks. I could, of course, choose to stay in cash, but as the last 5 years have indicated, waiting for the "right time" to invest can leave you on the sidelines for too long. So, I am going to stop worrying about the overall market and go back to finding under valued companies.

85 comments:

kgbraund said...

Lucid...thanks!

Wilson said...

Another great article. Thank you, Professor.

Blaine said...

Professor,

Have you seen the research from Tobias Carlisle, John Hussman, or Mebane Faber? What do you think about the historical validity of Graham/Shiller style PE10 models, CAPE models, or Tobin Q models?

Would you contend that "This time is different" for using these models for predicting future returns? If so, do you contend that the historically high profitability of US firms can be sustained due to gloabalization?

Does the following Buffett quote no longer apply in the modern overseas manufacturing, outsource world?

“In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%... Maybe you’d like to argue a different case. Fair enough. But give me your assumptions. The Tinker Bell approach – clap if you believe – just won’t cut it.”

Are profit margins no longer mean reverting in a capitalist economy?

If you haven't seen this work here are some excellent links:

http://www.hussmanfunds.com/wmc/wmc130318.htm

http://greenbackd.com/tag/shiller-pe10/

http://www.mebanefaber.com/2010/06/09/shiller-pe-ratios-and-10yr-annualized-real-returns/

I think you will enjoy poking around these blogs regardless if you haven't yet as the author's strive for to back there statements with real data, as you do.

For the record I am long stocks, so I hope you are right (of course hope doesn't matter in investing). I am just sticking to what I think is cheap: financials, foreign stocks, and dirt cheap microcaps. I appreciate your excellent blog and look forward to hearing your response!

Aswath Damodaran said...

Blaine,
I don't have a problem with any of these models, but here is the fundamental issue that they all have to confront. If you thinks stocks are over priced at 18 times earnings, because that is higher than the historic norm, then what is the alternative? Investing in treasuries and earning 2%? Investing in high yield and earning 5%?
My argument is not that this time is different. It is that I have to invest in the world that I am in, not the world I wished I was in. If the T.Bond rate were 4% or 5%, I may very have concluded that stocks were over valued at today's levels.

Blaine said...

Thanks for the quick response! I'm in the same boat. I have cash on hand for the optionality, but that never hurts.

Anonymous said...

Professor,

This is a great post!

1)If you are calculating intrinsic value, why should cash returned to equity investors be considered? Isn't returnable cash (free cash flow to equity,FCFE)rather more important?

I consider a case where returned cash (dividends and buybacks) as a percentage of FCFE is lower (which is a fact in many economies). Here returned cash is not an indicative input for calculating intrisic value. It could be an input for pricing, but not value.

That is why I have a major problem with dividend discount model. If fails if dividend payouts don't form a very, very significant portion of earnings. The retention ratio (1-payout)should only reflect cash required for reinvestments not more.

2) Risk-free rate: There could be a 5th scenario, ie.higher economic growth and higher inflation (though less likely scenario).

Fed may not be able to force-keep inflation and interest rate low for that long; US is experiencing one of the lowest interest rate periods in its 100-year history. Chances are far less that it will be able to sustain this for too long.

Much more likely scene is this: Higher interest rate; Higher inflation; with or without higher economic growth. Growth will depend on local and global environment.

3) PE ratio: Current PE is at 18 which is not very low, if not very high. 5.5% earnings yield is not bad when risk-free is below 2% and risky bonds are at 5%. So your conclusion about market is perfect.

Gitbul Tornbull said...

Professor,
As it turns out, you believe that equities are the only place to be just because everything else is rich or outright overvalued.
But, as history knows, if every asset class' return has been squeezed to the limit by the investors (or Central banks if you like), there's a good chance that the only asset class that looks relatively good would be overcrowded as well...
It's hard to accept this kind of logic and surrender the Hope, but isn't that the only thing that separates the prudent value investor from the crowd?
I'm long equities too, but not in US. I prefer real estate stocks with stable dividend cash flows with no or little debt. So, I'm not a permabear or kind of anti-risk-guy.
My last question relates to the ever interesting to me propensity of the analysts to calculate ROE using BV of equity. Aside from the problem of comparing this ratio between different firms, why do you use it to calculate implied growth in the above article? Why should debt be valued at market, but equity at book? ROE is, after all, the return on the equity that every investor has contributed to the firm. So, when the price of that contribution is, for example, $20 , why someone would use the accounting measure of $10? The claim of the investor is up to the price paid for investing in the venture and any subsequent return on that investment should be measured against the purchase price, not some dull accounting figure. But that's how the sell sided analysts on WS prefer to measure the so important ROE, aren't they?
Why are you comfortable with that?


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Aswath Damodaran said...

Gitbul,
You hit the nail on the head. My statement about stocks is a relative one and clearly does not hold up if there is an overall asset bubble, where every asset class is being over priced, partly because the Fed has skewed the game. When there is a reckoning, all asset classes will then lose. It used to be that real assets were relatively immune from financial asset bubbles, but it seems to me that with securitization, we have endowed real assets with financial asset properties.

Gitbul Tornbull said...

Professor,
So the more important question would be: Are we in the culmination of an all-asset class-bubble? And that should include the real estate because its readjustment isn't over yet.
How can one distinguish the "normality" from the "bubble" when almost every widespread valuation metric is a relative one?
Is there any "absolute" measure of value that must be sought for? As a value investor, could you define a state of undervaluation that would be fairly rewarding the risk it carries? It doesn't sound prudent, for me, that one should be happy with 5 per cent prospective annual equities return for the next 10 years just because bonds offer 1.8 per cent for the same time frame.
I know there's no universal recipe for successful investing, but, as Blaine mentioned above, some historical evidences suggest that something's very wrong with the financial markets.

Mr. Everyday Dollar said...

In the early 80's we were in a deep recession with > 10% unemployment and 30 year mortgage rates close to 20%. Budget deficits were high and national debt skyrocketed. Investing in stocks was shunned but it turned out it was a great time to invest in them.

We just had a housing bubble, deep recession, and unemployment at 10%. I remember very few investors keeping their money in common stocks in 2007-2009, but it turned out to be maybe the best opportunity to invest in our lifetimes.

Some of my best ever investment returns were because I stayed invested during the downturn and was regularly putting new money into common stocks (Starbucks @ $8 anyone?).

At that time, we were told "it’s different this time". But it turns out that the 80's playbook proved to be successful in 2007. The market has since roared back and has reached new highs as evident by the Dow and S&P indexes.

So what should we do now? Perhaps we go back to the 1950's: the U.S. economy had high unemployment, massive government debt, there were huge stimulus plans, and long term interest rates were capped.

With all those overwhelming problems, the Dow rose from 256 to 995 by 1966, almost a 4x increase. Investors who ignored the fiscal problems were well rewarded by investing in common stocks, while those who pulled their money out and sat on the sidelines lost the potential of creating great wealth.

Anonymous said...

Professor Damodaran,
Could you go into a little more depth on why you don't think the fed's QE program is causing a material distortion the rf rate? It seems to me if the fed was not a huge and ongoing buyer, treasuries would likely be yielding materially higher. Agree that fed control of short term rates don't control long term rates, but I think Fed active buying (paying more than anyone else is willing to pay) of longer term treasuries is distortionary.

You seem to downplay the possibility in the blog post, and mention it but are not convinced of it in the comments. Would you please elaborate on why you think what you do?
Daedalus Mugged

Burt said...

Prof:
Why do you assume a growth rate equal to the risk-free rate as of terminal value? Wouldn't it be more reasonable to assume average real economic growth?

Anonymous said...

We will go down to 1466 by May end, all risk assets have fallen and equities is being held up for Q1 savers money.

If we survive 1466 maybe we can see 1600...but don't bet on it yet!

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Anonymous said...

Dow 100,000 baby! This rocket ship is going to the moon, get on board!

Tangent Style said...

Concise, clear and insightful. Thanks as always.

Anonymous said...

Hi Professor
Thank you for such a clear picture of valuation factors.
And for sharing your views.
I wondered if investment flows from outside the US were a significant factor at times when alternatives and economic growth prospects elsewhere maynot appear as attractive.
Thanks

But What Do I Know? said...

Shouldn't you consider the amount of stock issued by corporations--restricted stock grants, options, etc,--to determine the net level of buybacks? In other words, if ABC buys back 10,000 shares but issues 6000 as part of its executive compensation program, isn't it effectively only buying back 4000 shares? Also, since share buybacks are generally conducted at higher prices than share issuance (options are priced in the money, restricted stock is granted at a discount), wouldn't it be more exact to remove the shares issued and the price delta from the "cash returned to shareholders" calculation?

I have no idea what the effect of this would be, but surely it would be more accurate in determining the "yield" of a stock. Shares given to employees and others at discounted prices may be an effective method of compensation, but they do have a cost.

QUALITY STOCKS UNDER 5 DOLLARS said...

The market has increased by a enormous amount over the last six months or so. Caution should be used going foreward. We have been making highs on a regular basis.

Kaushik said...

Prof Damodaran, quick doubt.
While calculating intrinsic growth rate, shouldn’t we adjust for cash hoarding while multiplying ROE with retention rate?

According to an article (http://www.reuters.com/article/2012/01/30/us-investing-kingcash-idUSTRE80T07420120130) cash hoard has gone up by 63% in 5 years – amounting to an increase of 385 bn.
Last year’s S&P earnings were around 1 trillion. If we keep retention rate same and average the cash hoard increase, the reinvestment rate comes to 18.8%:
(1000*26.51% - 385/5)/1000 = 18.8%

Keeping RoE same, intrinsic growth rate comes down to 3.14% and hence the index is overvalued by 4.54%.

Please let me know if I’m making a mistake here.

Gitbul Tornbull said...

Dear Mr. Everyday Dollar,

As it is true that the early '80s were a wonderful time to invest, so is the fact that during that time the Schiller CAPE stood around 7-8x. In the '50s the ratio girated between 10-12x.
I'm not so old to remember it, but I can't really imagine how could one not invest "all-in" in stocks and bonds during these periods?
So, with the current CAPE at 23.xx I wonder how come this looks like '80s or '50s? It's like comparing apples with ... nokias
regards,

Laramie said...

Gitbul - Interesting point on ROE calculation. Perhaps the professor can shed some more light on it.

My view is that market value of a company refers to the price paid, not necessarily the value of the equity that the company has.

Management effectiveness and performance in deploying that equity, namely ROE, should be judged based on what equity he has at his disposal for deployment (retained earnings + capital contribution). It should not be judged on what the market is willing to pay at the moment, or even the average of what the market is willing to pay over the last 12 months.

Would love to hear more from you or others on this.

mullacc said...

While there are some strict value investors who believe that dividends are qualitatively better than buybacks, because they are less volatile

I know this is somewhat of an aside in your post, but I take issue with it. The problem with buybacks is the propensity for companies to acquire their own stock when it's expensive. So even if cash direct to buybacks was kept steady year-to-year, I would would still prefer dividends. In fact, dedication to steady buybacks is in some ways the worst of all scenarios. It indicates that management is dedicated to investing cash flows without regard to the rate of return. A lot of tech companies have policies like this which are pitched as offsets to option dilution. To me, that's a double offense.

Nathan Kowalski said...

What is the "net" buyback amount? IN your blog you quote gross buybacks but the problem is the constant share issuance amounts that are pervasive. How can I get the "net" amount?

Zagen Germaine said...

I'm starting to put my tax brackets together now and looking for ways to reduce earned income. Good thing I can contribute to an IRA until April.

John DiLemme said...

What a nice post. I enjoyed the article from the beginning to the end. I really want to thank you for your great deed. I hope to read more from you on this article.

John Di Lemme

Anonymous said...

thanks for share..

Anonymous said...

Proff,

How would you react to Goldman's recent view of Apple? Are you adding more shares to your portfolio at $430?

Anonymous said...

I think there is something very wrong about the 75/25 split of dividends and buybacks/reinvestment - surely it must be the other way around!

If the s&p500 is trading at roughly 15x earnings or a 7% earnings yield and distributes a dividend yield of 2%, how can the 75/25 hold up?

Also, I don't understand why professors have to make this so long-winded with talk of ERPs, expected growth rates, etc. - the simple question is, where are you going to go other than stocks? 10-year treasuries yielding 1 and change % ?? rofl ....

Anonymous said...

How does the model in the attached spreadsheet work for back testing. So, if we apply all the inputs from March 2009, what would the model forecast (undervalued by what %)?

Thanks in advance for your reply.

Simieline said...

Great article. There's so much to learn about the models.

Vineet said...
This comment has been removed by the author.
Vineet said...

Hi,

There seems to be a problem of double counting the cashflows to investors when you add cash returned through buy backs and dividends. As an investor, if one has participated in the buyback, the number of shares that one holds would go down and would not receive the dividends next year on that. Hence, adding buybacks to dividend per share and assuming a growth rate on that amounts to double counting, don' you think?

Nagarajan S said...

Professor Aswath Damodaran

Very interesting blog on Musings on Markets. Thank you.

However, in your calcuations by using the implied equity risk premium for the index as of early March, presumably assuming the same cashflows, isnt there a circularity of logic whereby the computed value of the index would equal its present level? I am a bit confused on this point.

Can you enlighten, pl?

Nagarajan

तुषार भारद्वाज said...

Hello Professor,
This is my first post on your blog, and would like to thank you for the knowledge that you have spread around in the form of books, blogs etc.
However, I have a query regarding a methodology that you have provided in your book for estimating beta busing bottoms-up approach.
You have mentioned that while estimating "Beta" once should assess the "Regression Beta" of others firms operating in the same business, then take an average of the their "Beta" and their "D/E ratios" and then calculate the Beta for the target company using its weights of operating margin from different business and multiplying the percentage to respective "Beta", but this method will apply when the company we are valuing is having diversified businesses, what about when we are valuing a company that is in the same category or say industry like "FMCG", how would I take the Beta of companies like "Britannia, HUL, ITC, Marico and others" to find out the Beta for another FMCG company, lets say "Jubiliant foodworks". Please throw some light on this area, I am really confused regarding this.

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Maxim said...

Thanks for the article!
"Sustainable growth rate = 4.43%"

GDP growth rate is below 2% (http://www.bloomberg.com/markets/economic-calendar/).

Isn't there a flaw in that economy growth is less than businesses growth (twice!)?

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Thanks for the useful information! It was very interesting...

Wise Investor said...

Sir, majority of the analysis in the blog pertain to global markets. Would it be possible for you to also write on BSE/NSE index/stocks?

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Easily digestible and intelligent as always. Keep up the good work.

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Anonymous said...

Hi Prof Damodaran,

I have a question about what Apple can do with it's cash abroad.
I understand that companies cannot hold stocks of themselves, but can Apple invest all the cash abroad into an offshore fund that actually holds stocks of apple (only)?

This fund could do something like a stock "buy back" without paying the taxes in the US, maybe?

This would definitely put the cash to a productive use, right?

What do you think?

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Excellent chat w/ Bloomberg.

Wish you blog more about it. You under-estimate the influence you have.

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Very cool Professor.

Simplistic, and yet, intelligent data based approach to evaluating the market.

And, yet, at the end, talking about the summary so that everyone can understand, with a personalized view.

Too many people need help from 'teachings' from you, and I am so glad, I found your website/blog.

Thanks a ton, and please keep writing as often as time allows, to the tune of one article per week (or more).

Guidance in a world of too much information is 'lacking', since it is information overload, but guidance-lacking.

Kenny

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Unknown said...

Hi Professor,

When accessing the sustainability of cash flow returned to investors, shouldn't we also focus on increase in leverage? If many companies are leveraging up their balance sheet in this low interest rate scenario to pay cash dividends/ stock buybacks. May be thats the reason for higher cash balance also. If the interest rate increases in such situation, companies will not be able to increase/maintain the level of captial return as it will not be cost advantageous to increase the leverage then and earnings will also decrease due to higher interest expense.

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Shiv said...

I think your valuation for SP is over-optimistic. Value returned via buybacks & dividend at present are high, more because of strong balance sheets.

You are being paid today what you should have been paid yesterday and you may not receive it tomorrow.

I'd value the index at closer to 1,300. This is 78.64 82.13 85.77 89.57 & 93.53 discounted at 7.34% for 347 value on the index. Residual, I have reduced sustainable dividend & buybacks to $74.48/0.543 = 962. So total SP500 value is 1309 (962+347).

The terminal $74.48 + G annual will represent return of 60% earnings via a combination of dividends & buy backs assuming earnings grow from $98 presently at 4.42% annual. History says payouts high as present are unusual; and I believe its as high as it is, because value retained during the crisis due to fear, is now slowly being returned; the payout ratio is not sustainable.

Shiv said...

Of course a 1309 value has defects in that I am assuming a return to normalcy in 5 years on payout rations & value returned. If the ERP also narrows to 4.25% so returning to normalcy, the value is 1576 now! I guess 1300 is a bear case, while 1576 is a level justifiable because of a lack of better yielding alternatives.

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