Wednesday, March 8, 2023

Data Update 7 for 2023: Dividends, Buybacks and Cash Flows

This is the last of my data update posts for 2023, and in this one, I will focus on dividends and buybacks, perhaps the most most misunderstood and misplayed element of corporate finance. To illustrate the heat that buybacks evoke, consider two stories in the last two weeks where they have been in the news. In the first, critics of Norfolk Southern, the corporation that operates the trains that were involved in a dreadful chemical accident in Ohio, pointed to buybacks that it had done as the proximate cause for brake failure and the damage. In the second, Warren Buffet used some heated language to describe those who opposed buybacks, calling them “economic illiterates” and “silver tongued demagogues “. Going back in time to last year’s inflation reduction act, buybacks were explicitly targeted for taxes, with the perspective that they were damaging US companies. I think that there are legitimate questions worth asking about buybacks, but I don’t think that neither the critics nor the defenders of buybacks seem to understand why their use has surged or their impact on shareholders, businesses and the economy.

Dividend Policy in Corporate Finance

    To understand where dividend policy fits in the larger context of running a business, consider the following big picture description of corporate finance, where every decision that a business makes is put into one of three buckets - investing, financing and dividends, with each one having an overriding principle governing decision-making within its contours.

In my fifth data update for 2023, I focused on the investment principle, which states that businesses should invest in projects/assets only if they expect to earn returns greater than their hurdle rates, and presented evidence that using the return on capital as a proxy for returns and costs of capital as a measure of hurdle rates, 70% of global companies fell short in 2022. In my sixth data update, I looked at the trade off that should determine how much companies borrow, where the tax benefits are weighed off against bankruptcy costs, but noted that firm often choose to borrow money for illusory reasons and because of me-tooism or inertia. The dividend principle, which is the focus of this post is built on a very simple principle, which is that if a company is unable to find investments that make returns that meet its hurdle rate thresholds, it should return cash back to the owners in that business. Viewed in that context, dividends as just as integral to a business, as the investing and financing decisions. Thus, the notion that a company that pays dividends is viewed as a failure strikes me as odd, since just farmers seed fields in order to harvest them, we start businesses because we plan to eventually collect cash flows from them.
    Put in logical sequence, dividends should be the last step in the business sequence, since they represent residual cash flows. In that sequence, firms will make their investment decisions first, with financing decisions occurring concurrently or right after, and if there are any cash flows left over, those can be paid out to shareholders in dividends or buybacks, or held as cash to create buffers against shocks or for investments in future years:

In practice, though, and especially when companies feel that they have to pay dividends, either because of their history of doing so (inertia) or because everyone else in their peer group pays dividends (me-tooism), dividend decisions startthe sequence, skewing the investment and financing decisions that follow. Thus, a firm that chooses to pay out more dividends than it should, will then turn out and either reject value-adding projects that it should have invested in or borrow more than it can afford to, and this dysfunctional dividend sequence is described below:

In this dysfunctional dividend world, some companies will pay out far more dividends than they should, hurting the very shareholders that they think that they are benefiting with their generous dividends.

Measuring Potential Dividends

    In the discussion of  dysfunctional dividends, I argued that some companies pay out far more dividends than they should, but that statement suggests that you can measure how much the "right" dividends should be. In this section, I will argue that such a measure not only exists, but is easily calculated for any business, from its statement of cash flows.

Free Cash Flows to Equity (Potential Dividends)

    The most intuitive way to think about potential dividends is to think of it as the cash flow left over after every conceivable business need has been met (taxes, reinvestments, debt payments etc.). In effect, it is the cash left in the till for the owner. Defined thus, you can compute this potential dividend from ingredients that are listed on the statement of cash flows for any firm:

Note that you start with net income (since you are focused on equity investors), add back non-cash expenses (most notably depreciation and amortization, but including other non-cash charges as well) and net out capital expenditures (including acquisitions) and the change in non-cash working capital (with increases in working capital decreasing cash flows, and decreases increasing them). The last adjustment is for debt payments, since repaying debt is a cash outflow, but raising fresh debt is a cash inflow, and the net effect can either augment potential dividends (for a firm that is increasing its debt) or reduce it (for a firm that is paying down debt).

    Delving into the details, you can see that a company can have negative free cash flows to equity, either because it is a money losing company (where you start the calculation with a net loss) or is reinvesting large amounts (with capital expenditures running well ahead of depreciation or large increases in working capital). That company is obviously in no position to be paying dividends, and if it does not have cash balances from prior periods to cover its FCFE deficit, will have to raise fresh equity (by issuing shares to the market).

FCFE across the Life Cycle

    I know that you are probably tired of my use of the corporate life cycle to contextualize corporate financial policy, but to understand why dividend policies vary across companies, there is no better device to draw on. 

Young companies are unlikely to return cash to shareholders, because they are not only more likely to be money-losing, but also because they have substantial reinvestment needs (in capital expenditures and working capital) to generate future growth, resulting in negative free cash flows to equity. As companies transition to growth companies, they may become money-making, but at the height of their growth, they will continue to have negative free cash flows to equity, because of reinvestment needs. As growth moderates and profitability improves, free cash flows to equity will turn positive, giving these firms the capacity to return cash. Initially, though, it is likely that they will  hold back, hoping for a return to their growth days, and that will cause cash balances to build up. As the realization dawns that they have aged, companies will start returning more cash, and as they decline, cash returns will accelerate, as firms shrink and liquidate themselves.
    Of course, you are skeptical and I am sure that you can think of anecdotal evidence that contradicts this life cycle theory, and I can too, but the ultimate test is to look at the data to see if there is support for it. At the start of 2023, I classified all publicly traded firms globally, based upon their corporate ages (measured from the year of founding through 2022) into ten deciles, from youngest and oldest, and looked at free cash flows and cash return for each group:
As you can see, the youngest firms in the market are the least likely to return cash to shareholders, but they have good reasons for that behavior, since they are also the most likely to be money losing and have negative freee cash flows to equity. As firms age, they are more likely to be money-making, have the potential to pay dividends (positive FCFE) and return cash in the form of dividends or buybacks. 

Dividends and Buybacks: Fact and Fiction

    Until the early 1980s, there was only one conduit for publicly traded companies to return cash to owner, and that was paying dividends. In the early 1980s, US firms, in particular, started using a second option for returning cash, by buying back stock, and as we will see in this section, it has become (and will stay) the predominant vehicle for cash return not only for US companies, but increasingly for firms around the world. 

The Facts

    Four decades into the buyback surge, there are enough facts that we can extract by looking at the data that are worth highlighting. First, it is undeniable that US companies have moved dramatically away from dividends to buybacks, as their primary mode of cash return, and that companies in the rest of the world are starting to follow suit. Second, that shift is being driven by the recognition on the part of firms that earnings, even at the most mature firms, have become more volatile, and that initiating and paying dividends can trap firms into . Third, while much has been made of the tax benefits to shareholders from buybacks, as opposed to dividends, that tax differential has narrowed and perhaps even disappeared over time.

1. Buybacks are supplanting dividends as a mode of cash return

    I taught my first corporate finance class in 1984, and at the time, almost all of the cash returned by companies to shareholders took the form of dividends, and buybacks were uncommon. In the graph below, you can see how cash return behavior has changed over the last four decades, and the trend lines are undeniable;

The move to buybacks started in earnest in the mid 1980s and by 1988, buybacks were about a third of all cash returned to shareholders. In 1998, buybacks exceeded dividends for the first time in US corporate history and by last year, buybacks accounted for almost two thirds of all cash returned to shareholders. In short, the default mechanism for returning cash at US companies has become buybacks, not dividends. Lest you start believing that buybacks are a US-centric phenomenon, take a look at global dividends and buybacks, in the aggregate, broken down by region in 2022:

Note that while the US is the leader of the pack, with 64% of cash returned in buybacks, the UK, Canada, Japan and Europe are also seeing a third or more of cash returned in buybacks, as opposed to dividends. Among the emerging market regions, Latin America has the highest percent of cash returned in buybacks, at 26.90%, and India and China are still nascent markets for buybacks. The shift to buybacks that started in the United States clearly has now become a global phenomenon and any explanation for its growth has to be therefore global as well.

2. Buybacks are more flexible than dividends

    If you buy into the notion of a free cash flow to equity as a potential cash return, companies face a choice between paying dividends and buying back stock, and at first sight, the impact on the company of doing either is exactly the same. The same amount of cash is paid out in either case, the effects on equity are identical (in both book value and market value terms) and the operations of the company remain unchanged. The key to understanding why companies may choose one over the other is to start with the recognition that in much of the world, dividends are sticky, i.e., once initiated and set, it is difficult for companies to suspend or cut dividends without a backlash, as can be seen in this graph that looks at the percent of US companies that increase, decrease and do nothing to dividends each year:

Note that the number of dividend-paying companies that leave dividends unchanged dominates companies that change dividends every single year, and that when companies change dividends, they are far more likely to increase than cut dividends. The striking feature of the graph is that even in crisis years like 2008 and 2020, more companies increased than cut dividends, testimonial to its stickiness. In contrast, companies are far more willing and likely to revisit buybacks and slash or suspend them, if the circumstances change, making it a far more flexible way of returning cash:    

At the core, this flexibility is at the heart of the shift to buybacks, especially as fewer and fewer companies have the confidence that they can deliver stable and predictable earnings in the future, some because globalization has removed local market advantages and some because their businesses are being disrupted. It is true that there is a version of dividends, i.e., special dividends, that may offer the same flexibility, and it will be interesting to see if their usage increases as governments target companies buying back stock for punishment or higher taxes.

3. There are tax benefits (to shareholders) from buybacks, but they have decreased over time

    From the perspective of shareholders, dividends and buybacks create different tax consequences, and those can affect which option they prefer. A dividend gives rise to taxable income in the period that it is paid, and taxpayer have little or no way of delaying or evading paying taxes. A buyback gives investors a choice, with those opting to sell back their shares receiving a realized capital gain, which will be taxed at the capital gains tax rate, or not selling them back, giving rise to an unrealized capital gain, which will be taxed in a future period, when the stock is sold. For much of the last century, dividends were taxed in the US as ordinary income, at rates much higher than that paid on capital gains.

While the differential tax benefit in the last century is often mentioned as the reason for the rise of buybacks, note that the tax differential was even worse prior to 1980, when dividends essentially dominated, to the post-1980 period, when buybacks came into vogue. For much of this century, at least in the US, dividends and buybacks have been taxed at the same rate, starting at 15% in 2003 and rising to 23.8% in 2011 (a 20% capital gains rate + 3.8% Medicare tax on all income), thus erasing much of the difference between dividends and realized capital gains for shareholder tax burdens. However, shareholders still get a benefit with unrealized capital gains that can be carried forward to a future tax-advantageous year or even passed on in inheritance as untaxed gains.

    Until last year, there were no differences in tax consequences to companies from paying dividends or buying back stock, but the Inflation Reduction Act of 2022 introduced a 1% tax rate on buybacks, thus creating at least a marginal additional cost to companies that bough back stock, instead of paying dividends. If the only objective of this buyback tax is raising revenues, I don't have a problem with that because it will help close the budget gap, but to the extent that this is designed to change corporate behavior by inducing companies to not buy back stock or to invest more back into businesses, it is both wrong headed and will be ineffective, as I will argue in the next section.

The Fiction

    The fictions about buybacks are widespread and are driven as much by ideological blinders as they are by a failure to understand what a business is, and how to operate it. The first is that buybacks can increase or decrease the value of a business, with buyback advocates making the former argument and buyback critics the latter. They are both wrong, since buybacks can only redistribute value, not create it. The second is that surge in buybacks has been fed by debt financing, and it is part of a larger and darker picture of over levered companies catering to greedy, short term shareholders. The third is that buybacks are bad for an economy, with the logic that the cash that is being used for the buybacks is not being invested back in the business, and that the latter is better for economic growth. The final argument is that the large buybacks at US companies represent cash that is being taken away from other stakeholders, including employees and customers, and is thus unfair.    

1. Buybacks increase (decrease) value

   Value in a business comes from its capacity to invest money and generate cash flows into the future, and defined as such, the act of returning cash by itself, either as dividends or buybacks cannot create or destroy value. It is true that the way in which dividends and buybacks are funded or the consequences that they have for investing can have value effects, but those value effects do not come from the cash return, but from investing and financing dysfunction. The picture below captures the pathways by which the way dividends and buybacks are funded can affect value:

The implications are straight forward and common sense.  While a buyback or dividend, by itself, cannot affect value, the way it is funded and the investments that it displaces can determine whether value is added or destroyed.
  1. Leverage effect: If a company that is already at its right mix of debt (see my last post) choose to add to that debt to fund its dividend payments or buybacks, it is hurting its value by increasing its cost of capital and exposure to default risk. However, a firm that is under levered, i.e., has too little debt, may be able to increase its value by borrowing money to fund its cash return, with the increase coming from the skew in the tax code towards debt.
  2. Investment effect: If a company has a surplus of value-adding projects that it can take, and it chooses not to take those projects so as to be able to pay dividends or buy back stock, it is hurting it value. By the same token, a company that is in a bad business and is struggling to make its cost of capital will gain in value by taking the cash it would have invested in projects and returning that cash to shareholders.
Finally, there is a subset of companies that buy back stock, not with the intent of reducing equity and share count, but to cover shares needed to cover stock-based compensation (option grants). Thus, when management options get exercised, rather than issue new shares and dilute the ownership of existing shareholders, these companies use shares bought back to cover the exercise. The value effect of doing so is equivalent to buybacks that reduce share count, because not issuing shares each year to cover option exercises is effecting accomplishing the same objective of keeping share count lower. 

There is an element where there dividends and buybacks can have contrasting effects. Dividends are paid to all shareholders, and thus cannot make one group of shareholders better or worse off than others. Buybacks are selective, since only those shareholders who sell their shares back receive the buyback price, and they have the potential to redistribute value. In what sense? A company that buys back stock at too high a price, relative to its intrinsic value, is redistributing value from the shareholders who remain in the company to those who sell their shares back. In contrast, a company that buys back shares at a low price, relative to its intrinsic value, is redistributing value from the shareholders who sell their shares back to those who stay shareholders in the firm. This is at the heart of Warren Buffet's defense of buybacks at Berkshire Hathaway as a tool, since he adds the constraint that the buybacks will continue only if they can be done at less than intrinsic value, and the assumption is that Buffet does have a better sense of the intrinsic value of his company than market participants. It is true that some companies buy back stock at the high prices, and if that is your reason, as a shareholder in the company for taking a stand against buybacks, I have a much simpler and more effective response than banning buybacks. Just sell your shares back and be on the right side of the redistribution game! 

2. Buybacks are being financed with debt

As I noted in my lead in to this section, a company that borrows money that it cannot afford to borrow to buy back stock is not just damaging its value but putting its corporate existence at risk. I have heard a few critics of buybacks contend that buybacks are being funded primarily or predominantly with debt, using anecdotal examples of companies that have followed this script, to back up their claim. But is this true across companies? To address this, I looked companies in the US (because this critique seems to be directed primarily at them), broken down by whether they did buybacks in 2022, and then examined debt loads within each group:

You can be the judge, using both the debt to capital ratio and the debt to EBITDA multiple, that  companies that buy back stock have lower debt loads than companies that don't buy back stock, at odds with the "debts fund buybacks" story. Are there firms that are using debt to buy back stock and putting their survival at risk? Of course, just as there are companies that choose other dysfunctional corporate finance choices. In the cross section, though, there is little evidence that you can point to that buybacks have precipitated a borrowing binge at US companies.

3. Buybacks are bad for the economy

    The final argument against buybacks has little to do with shareholder value or debt but is centered around a mathematical truth. Companies that return cash to shareholders, whether as dividends or buybacks, are not reinvesting the cash, and to  buyback critics, that fact alone is sufficient to argue against buybacks. There are two premises on which this argument is built and they are both false.

  • The first is that a company investing back into its own business is always better for the economy than that company not investing, and that misses the fact that investing in bad businesses, just for the sake of investing is not good for either shareholders or the economy. Is there anyone who would argue with a straight face that we would be all better off if Bed Bath and Beyond had built more stores in the last decade than they already have? Alternatively, would we not all have been better served if GE had liquidated itself as a company a decade ago, when they could have found eager buyers and returned the cash to their shareholders, instead of continuing as a walking dead company? 
  • The second is that the money returned in buybacks, which exceeded a trillion dollars last year, somehow disappeared into a black hole, when the truth is that much of that money got reinvested back into the market in companies that were in better businesses and needed capital to grow? Put simply, the money got invested either way, but by companies other than GE and Bed Bath and Beyond, and that counts as a win for me.
Watching the debate on buybacks in the Senate last year, I was struck by how disconnected senators were from the reality of buybacks, which is that they bulk of buybacks come from companies that have no immediate use for the money, or worse, bad uses for the monty, and the effect of buybacks is that this money gets redirected to companies that have investment opportunities and operate in better businesses.

4. Buybacks are unfair to other stakeholders

If the argument against buybacks is that the money spent on buybacks could have been spent paying higher wages to employees or improving product quality, that is true. That argument is really one about how the pie is being split among the different shareholders, and whether companies are generating profits that excessive, relative to the capital invested. I argued in my fifth data post that if there is backing for a proposition, it is that companies are not earning enough on capital invested, not that they are earning too much. I will wager that if you did break down pay per hour or employee benefits, they will be much better at companies that are buying back stock than at companies that don't. Unfortunately, I do not have access to that data at the company-level on either statistic, but I am willing to consider evidence to the contrary.

The Bottom Line

It is telling that some of the most vehement criticism of buybacks come from people who least understand business or markets, and that the legislative solutions that they craft reflect this ignorance. Taxing buybacks because you are unable to raise corporate tax rates may be an effective revenue generator for the moment, but pushing that rate up higher will only cause the cash return to take different forms. Just as the attempts to curb top management compensation in the early 1990s gave rise to management options and a decade of even higher compensation, attempts to tax buybacks may backfire. If the end game in taxing buybacks is to change corporate behavior, trying to induce invest more in their businesses, it will be for the most part futile, and if it does work, will do more harm than good.

YouTube Video

Data Links

  1. Dividend Statistics, by Industry: US and Global
  2. Dividends, Buybacks and FCFE, by Industry: US and Global

Data Update Posts for 2023

  1. Data Update 1 for 2023: Setting the Table!
  2. Data Update 2 for 2023: A Rocky year for Equities!
  3. Data Update 3 for 2023: Inflation and Interest Rates
  4. Data Update 4 for 2023: Country Risk - Measures and Implications
  5. Data Update 5 for 2023: The Earnings Test
  6. Data Update 6 for 2023: A Wake up call for the Indebted?
  7. Data Update 7 for 2023: Dividends, Buybacks and Cash Flows

Monday, February 27, 2023

Data Update 6 for 2023: A Wake up call for the Indebted?

We have an uneasy relationship with debt, both in our personal and business lives. While it is a financial decision, it is one that is freighted with moral overtones, since almost every religion inveighs against debt's sins, labeling those who lend as sinners and those who borrow as weak. That may reflect the concern that once a person or entity starts borrowing to fund its needs, it is easy to overuse debt, and risk its wellbeing in the process. All that said, businesses around the world have borrowed money though time to fund their operations, sometimes for good reasons and sometimes for bad, and over time, these businesses have also faced cycles of too much debt leading to painful cleansing. In this post, I will focus on corporate debt in 2023, keeping in mind that it was a year where the tradeoffs changed, as interest rates rose to pre-2008 levels, and putting at risk those firms that had borrowed to capacity, or even beyond, at low interest rates.

Debt's place in business

    To understand debt's role in a business, I will start with a big picture perspective, where you break a business down into assets-in-place, i.e., the value of investments it has already made and growth assets, the value of investments you expect it to make in the future. To fund the business, you can either use borrowed money (debt) or owner's funds (equity), and while both are sources of capital, they represent different claims on the business. Debt provides contractual claims, in the form on interest payments and principal repayments, whereas equity is a residual claim, i.e., you receive whatever cash flows, if any, that are left over after other claim holders have been paid:

This breakdown should take out the mystery out of debt, since it converts it into a source of capital, and the question of whether you should borrow to fund a business, and if yes, how much you should borrow becomes one of choosing between a source of capital that gives rise to contractual claims, with all of its pluses and minuses, and one that gives rise to residual claims, with all of its benefits and costs. Note that this framework applies for all businesses, from the smallest, privately owned businesses, where debt takes the form of bank loans and even credit card borrowing and equity is owner savings, the largest publicly traded companies, where debt can be in the form of corporate bonds and equity is shares held by public market investors. Even government-owned businesses fall under its umbrella, with the key difference being that equity is provided by the taxpayers.

Good Reasons for Borrowing

    What are the pluses and minuses of borrowing, if you take a clear-eyed look at it just as a capital source? First, borrowing money cannot alter the operating risk in a business, which comes from the assets that it holds, either in-place or as growth investments, but it will affect the risk to equity investors in that business, by making their residual claim (earnings) more volatile, In addition, the contractual claim that comes with debt can create truncation risk, because failing to make interest or principal payments can result in bankruptcy, and effective loss of equity. Second, borrowing money at a lower rate, by itself, cannot alter your overall cost of funding, since that cost is determined by the risk of your assets. Hence, the benefits of borrowing at a lower rate will always be offset by a higher cost for equity investors, leaving the cost of funding unchanged, unless a finger is put on the scale, giving one source special benefits. In much of the world, governments have written tax codes that do exactly this, by making interest payments on debt tax-deductible, while requiring that cash flows to equity be made out of after-tax cash flows. That tax benefit of debt will increase with the marginal tax rate, making it much more beneficial to borrow in countries with high tax rates (Germany, Japan, US) over those with lower tax rates (Ireland, much of Eastern Europe). The chart below lists the tax benefits as the primary benefit of borrowing and the expected bankruptcy cost as the primary downside of debt:

There are also ancillary benefits and costs that the chart notes, with debt operating as a disciplinary tool in some businesses, when managers consider taking new projects, since bad projects can plunge the firm into bankruptcy (and cause managers to lose their jobs), and the challenge of managing the conflicting interests of equity investors and lenders, that manifest in covenants, restrictions, and legal costs.

Bad Reasons for Borrowing

    There are many bad reasons for borrowing, and some companies seem intent on using these bad reasons. The first, and the one offered by most debt-heavy entities is that using more debt will result in higher returns on equity, since there is less equity at play. That is technically true, for the most part, but since the cost of equity rises proportionately, that benefit is an illusion. The second is that debt is cheaper than equity, to which your response should be that this is true for every business, and the reason lies in the fact that lenders have first claim on the cash flows and equity investors are last in line, not in some inherent cheapness of debt. The chart below lists these illusory benefits:

On the other side of the ledger, there are some companies that refuse to borrow money for bad reasons as well. The first is that borrowing money will lower net income, as interest expenses get deducted from operating income, but that lower net income will be accompanied by less equity invested in the firm, often leading to higher earnings per share, albeit with higher volatility. The second is that borrowing money will increase perceived default risk, and if the company is rated, lower ratings, and that too is true, but borrowing money at a BBB rating, with the tax benefit incorporated, might still yield a lower cost of funding that staying at a AA rating, with no debt in use.

The "Right" Financing Mix

     Is there an optimal mix of debt and equity for a business? The answer is yes, though the payoff, in terms of value, from moving to that optimal may be so small that it is sometimes better to hold back from borrowing. In this section, I will lay out a mechanism for evaluating the effects of borrowing on the cost of funding a business, i.e., the cost of capital, and talk about why firms may under or overshoot this optimal.

An Optimizing Tool

   In my second and third data posts for this year, I chronicled the effects of rising interest rates and risk premiums on costs of equity and capital. In computing the latter, I used the current debt ratios for firms, but made no attempt to evaluate whether these mixes were "right" or not. That said, the cost of capital can be used as an optimizing tool in assessing the right mix of debt and equity, with the optimal mix being the one that yields the lowest cost of capital. That computation, though, is a dynamic one, since both the cost of equity and the cost of debt will change as a business changes its debt ratio:

In effect, you are trading off the benefits of replacing more expensive equity with lower-rate debt against the resulting higher costs of equity and debt, when you borrow more. As you can see, the net effect of raising the debt ratio on the cost of capital will depend on where a firm stands, relative to its optimal, with under levered firms seeing costs of capital decrease, as debt ratio increases, and over levered firms seeing the opposite effect. 

As to the variables that determine what that optimal debt ratio is for a firm, and why the optimal debt ratio can range from 0% for some firms to close to 90% for others, they are simple and intuitive:

  1. Marginal tax rate: If the primary benefit of borrowing is a tax benefit, the higher the marginal tax rate, the higher its optimal debt ratio. In fact, at a zero percent tax rate, the optimal debt ratio, if you define it as the mix that minimizes cost of capital is zero. The picture below captures differences in corporate marginal tax rates, entering 2023, across the world:
    Download marginal tax rates, by country

     As you can see from the heat map and table, most countries have converged around a tax rate of 25%, with a few outliers in Eastern Europe and parts of Middle East having marginal tax rates of 15% or lower, and a few outliers, including Australia, India and parts of Africa with marginal tax rates that exceed 30%. Of these countries, Australia does offer protection from double taxation for equity investors, effectively endowing equity with some tax benefits as well, and reducing the marginal tax benefits from adding debt.
  2. Cash generating capacity: Debt payments are serviced with operating cash flows, and the more operating cash flows that firms generate, as a percent of their market value, the more that they can afford to borrow. One simplistic proxy for this cash generating capacity is EBITDA as a percent of enterprise value (EV), with higher (lower) values indicating greater (lesser) cash flow generating capacity. In fact, that may explain why firms that trade at low EV to EBITDA multiples are more likely to become targets in leveraged buyouts (LBOs) or leveraged recapitalizations..
  3. Business risk: Not surprisingly, for any given level of cash flows and marginal tax rate, riskier firms will be capable of carrying less debt than safer firms. That risk can come from many sources, some related to the firm (young, evolving business model, highly discretionary products/services), some to the sector (cyclical, commodity) and some to the overall economy (unstable). The company-specific factors show up in the risk parameters that you use for the firm (beta, rating) and the macro and market-wide factors show up in the macro inputs (riskfree rates, equity risk premiums)

If you are interested in checking how this optimization works, download this spreadsheet, and try changing the inputs to see the effect on the optimal. I looked Adani Enterprises, the holding company for the Adani Group and estimated the cost of capital and estimated value at different debt ratios: 


In my assessment, Adani Enterprise carries too much debt, with actual debt of 413,443 million more than double its optimal debt of 185,309 million, and reducing its debt load will not just lower its risk of failure, but also lower its cost of capital. This company is part of a family group, where higher debt at one of the Adani companies may be offset by less debt at another. To deal with this cross subsidization, I aggregated numbers across all seven publicly traded Adani companies and estimated the optimal debt mix, relative to the combined enterprise values:

The Adani Group collectively carries about three times as much debt as it should, confirming that the group is over levered as well, but note that this is bad business practice, not a con. In fact, as you can see from the cost of capital graph, there is little, if any, benefit in terms of value added to Adani from using debt, and significant downside risk, unless the debt is being subsidized by someone (government, sloppy bankers, green bondholders).

    If you have taken a corporate finance class sometime in your past life are probably wondering how this approach reconciles with the Miller-Modigliani theorem, a key component of most corporate finance classes, which posits that there is no optimal debt ratio, and that the debt mix does not affect the value of a business. That theorem deserves the credit that it gets for setting up the framework that we use to assess debt today, but it also makes two key assumptions, with the first being that there are no taxes and the second being that there is no default. Removing debt's biggest benefit and cost from the equation effectively negates its effect on value. Changing your debt ratio, in the Miller-Modigliani world, will leave your cost of capital unchanged. In the real world, though, where both taxes and default exist, there is a "right" mix (albeit an approximate one) of debt and equity, and companies can borrow too much or too little.

Effect on value

    If you can see the mechanics of how changing debt ratio changes the cost of capital, but are unclear on how lowering the cost of capital changes the value of a business, the link is a simple one. The intrinsic value of a business is the present value of its expected free cash flows to the firm, computed after taxes but before debt payments, discounted back at its cost of capital:

As you borrow more, your free cash flows to the firm should remain unaffected, in most cases, since they are pre-debt cash flows, and a lower cost of capital will translate into a higher value, with one caveat. As you borrow more and the risk of failure/bankruptcy increases, there is the possibility that customers may stop buying your products, suppliers may demand cash and your employees may start abandoning ship, creating a death spiral, where operating income and cash flows are affected, in what is termed "indirect bankruptcy costs". In that case, the optimal debt ratio for a company is the one that maximizes value, not necessarily the one at which the cost of capital is minimized.

Do companies optimize financing mix?

        Do companies consider the trade off between tax benefits and bankruptcy costs when borrowing money? Furthermore, do they optimize they debt ratios to deliver the lowest hurdle rates. The answer may be yes for a few firms, but for many, debt policy is driven by factors that have little to do with value and more with softer factors:

  1. Inertia: In my view, at most companies the key determinant of debt policy, as it is of most other aspects of corporate finance, is inertia. In other words, companies continue the debt policies that they have used in the past, on the mistaken view that if it worked then, it should work now, ignoring changes in the business and in the macro economy. That, for instance, is the only way to explain why older telecom companies, which developed a practice of borrowing large amounts during their time as monopoly phone businesses, continue that practice, even as their business have evolved into intensely competitive, technology businesses. 
  2. Me-to-ism: The second and almost as powerful a force in determining debt policy is peer group behavior. Staying with the telecom firm theme, newer telecom companies entering the space feel the urge to borrow in large quantities, because other telecom companies borrow. It is for this reason that debt policy is far more likely to vary across industry groups than it is to vary within an industry group.
  3. Because lenders are willing to lend me money: There is a final perspective on debt that can lead companies to borrow money, even if that borrowing is inimical to their own well being, and it is that if lenders offer them the money, you cannot turn them away. In fact, it is the excuse that real estate developers use after every boom and bust cycle to explain away why they chose to borrow as much as they did. The "lenders made me do it" excuse for borrowing money is about as bad as the "the buffet lunch made me overeat" excuse used by dieters, and it just as futile, because ultimately, the damage is self inflicted.
  4. Control: In my post on the Adani Group, I noted that in their zeal for control, insiders, founders and families sometimes make dysfunctional choices, and one of those is on borrowing. A growing firm needs capital to fund its growth, and that capital has to come from equity issuances or new borrowing. When control becoming the dominant prerogative for those running the firm, they may choose to borrow money, even if it pushes up the cost of funding and increases truncation risk, rather than issue shares to the the public (and risk dilution their control of the firm). 
The bottom line is that since firms borrow based upon their own past histories and their peer group policies on borrowing, there will always be firms that have too much debt, given their capacity to borrow, just as there will be firms at the other end of the spectrum that refuse to borrow, even though they can, because they have never borrowed money or because they operate in industry groupings, where no one borrows.

Measuring Debt Loads

    With the long lead in on the trade off that animates the borrowing decision, let us talk about how to measure the debt load at a company. While the answer may seem obvious to you, it is not to me, and I will start by looking at debt scaled to capital, a measure of debt's place in the financing mix, and then look at debt scaled to cash flows or earnings, often a better measure of potential default risk.

Debt to Capital Ratios

    In the financial balance sheet that I used at the start of this post, I noted that there are two ways of raising capital to fund a business, debt, with its contractual claims on cash flows, or equity, with its residual claims. Following up, it does make sense to look at the proportions of each that a firm uses in funding and that can be measured by looking at debt, as a percent of capital in the firm. That said, there are (at least) four variants that you will see in practice, depending on the composition of total debt, and whether capital is obtained from an accounting balance sheet (book value) or a financial balance sheet (market value):

  1. Gross versus Net Debt: The gross debt is the total debt owed by a firm, long and short term, whereas the net debt is estimated by netting out cash and marketable securities from the total debt. While there is nothing inherently that makes one measure superior to the other, it is important to remember that gross debt can never be less than zero, but net debt can, for firms that have cash balances that exceed their debt.
  2. Book versus Market: The book debt ratio is built around using the accounting measure of equity, usually shareholder's equity, as the value of equity. The market debt ratio, in contrast, uses the market's estimate of the value of equity, i.e., its market capitalization, as the value of equity. While accountants, CFOs and bankers are fond of the book value measure, almost everything in corporate finance revolves around market value weights, including the debt to equity ratios we use to adjust betas and costs of equity and the debt to capital ratios used in computing the cost of capital.

There are sub-variants, within these four variants, with debates about whether to use only long-term debt or all debt and about whether lease debt should be treated as debt. My advice is that you consider all interest-bearing debt is debt, and that picking and choosing what to include is an exercise in futility. 

    I computed gross and net debt ratios for all publicly traded, non-financial service firms, at the start of 2023, relative to both book and market value, with the distribution of debt ratios at the start of 2023 below:

If you have been fed a steady diet of stories of rising indebtedness and profligate companies, you will be surprised by the results. The median debt ratio, defined both in book and market terms, for a global firm at the start of 2023 was between 10% and 20% of overall capital. It is true that there are differences across regions, as you can see in the table below, which computes the debt ratios based upon aggregated debt and equity across all firms and is thus closer to a weighted average. On a book debt ratio basis, the United States, as a region, has the highest debt ratio in the world, but on a market debt ratio basis, Latin America and Canada have the highest debt loads.
    The problem with using debt to capital ratios to make judgments on whether firms are carrying too much, or too little, debt is that, at the risk of stating the obvious, you cannot make interest payments or repay debt using capital, book or market. Put simply, you can have a firm with a high debt to capital ratio with low default risk, just as you can have a firm with low debt to capital with high default risk. It is one reason that a banking focus on total assets and market value, when lending to a firm, can lead to dysfunctional lending and troubled banks. To the retort from some bankers that you can liquidate the assets and recover your loans, I have two responses. First, assuming that book value is equal to liquidation value may let bankers sleep better at night, but it can be delusional in industries where they're no ready buyers for those assets. Second, even if liquidation is an option, a banker who relies on liquidating assets to collect on loans has already lost at the lending game, where the objective is to collect interest and principal on loans, while minimizing defaults and liquidations.

Debt to EBITDA, Interest Coverage Ratios

    If debt to capital is not a good measure for judging over or under leverage, what is? The answer lies in looking at a company's earnings and cash flow capacity, relative to its debt obligations. The interest coverage ratio is the first of two ratios that I will use to measure this capacity:

Interest Coverage Ratio = Earnings before interest and taxes/ Interest expenses

As a lender, higher interest coverage ratios indicate a bigger buffer and thus more safety, other things remaining equal, than lower interest coverage ratios. While the interest coverage ratio is a widely used proxy for default risk, and the one ratio that best explains differences in bond ratings for a firm, its limit is its focus on interest expenses, to the exclusion of debt principal payments that may be coming due. The second ratio remedies this problem by looking at debt as a multiple of EBITDA:

Debt to EBITDA = Total Debt/ EBITDA

The logic behind this measure is simple. The denominator is a measure of operating cash flows, prior to a whole host of cash outflows, but a firm that borrows too much relative to EBITDA is stretching its capacity to repay that debt. 

    I compute both ratios (interest coverage and Debt to EBITDA) for all publicly traded firms and the results are graphed below, with the important caveat that they move in opposing directions, when measuring safety, with safer firms having higher interest coverage rations and lower Debt to EBITDA multiples;

Not only do interest coverage ratios and debt to EBITDA multiples vary widely across firms, but they also vary across sectors. On a pure numbers-basis, utilities look like they are the most dangerous firms to lend to, with skintight interest coverage ratios (1.17, in the aggregate) and sky high total debt to EBITDA, but that can be misleading since many of these utilities are monopolies with predictable earnings streams and the capacity to pass interest costs down to their customers. At the other end of the spectrum, technology and energy companies look the safest on an interest coverage ratio basis, but with both groups, you worry about year-to-year volatility in earnings. 

    To get a closer look at difference across companies, I looked at the 94 industry groups that I break down companies into, and look at the most highly levered (with total debt to EBITDA as my primary sorting proxy, but reporting my other debt load measures) and least highly levered industry groups, looking at just US publicly traded companies:

Download all industry group data

Real estate and real estate-based business dominate he most levered industry groups, with utilities, auto and airports rounding out the list, reflecting their history as well as the willingness of bankers to lend on tangible assets. Technology and commodity industry groups proliferate on the least levered list, reflecting the higher uncertainty about future earnngs and banking unease with lending against intangibles. (at least with technology companies).

The Default Question

    The biggest downside of debt is that it increases exposure to default risk, and as the last part of this analysis, I will look at default rates over time, culminating in 2022, and then look ahead to the challenges that companies will face in 2023 and beyond.

Business Default: The what and the why

    In principle, any company that fails to meet a contractual commitment is in default, at least on that commitment, but there is wide gap between that act and legal default, where there is an official declaration of bankruptcy, and courts step in. Furthermore, there is a gap between legal default and liquidation, where the assets of a firm are liquidated to pay off creditors. There are many firms that default on contractual obligations, but find ways to evade declaring bankruptcy, and among firms that declare bankruptcy, a significant subset restructure and stay in operations. If there were not the case, there would probably be a handful of airlines still in operations since the rest would have been liquidated years or even decades ago. 
    No matter what definition of default you adhere to, it arises from a simple mathematical construct, which is that a firm does not have the cash flows to service its debt payments, but that can occur either because cash flows drop off or because debt payments soar. Default, as a consequence, can broadly be traced to four factors:

  1. Company-specific troubles: A deterioration in a company’s operating business, either because of competitive pressures or the company’s own mistakes, can cause operating cash flows to drop, putting a once-healthy company at risk of default. In some cases, the shock to the company’s earnings and cash flows can come from the loss of a lawsuit (giving rise to large new commitments), a regulatory fine or other unexpected cash outflow. 
  2. Sector-wide issues: If disruption is the word that has excited venture capitalists and investors across the world for much of this century, it comes with a dark side, which is that the disrupted businesses can find themselves with imploding business models (shrinking revenues and operating margins under stress). As a consequence, over time, these disrupted firms find themselves more and more exposed to default risk; Bed, Bath and Beyond has less debt outstanding now than they did a decade ago, but have gone from credit worthy to bankrupt over that period.
  3. Macroeconomic shocks/changes: Some businesses, especially in commodity and cyclical industry groups, have always been and will continue to be exposed to cycles that can cause operating earnings, even for the best run and most mature companies, to swing wildly from period to period. Oil companies, for instance, went from being money-losers (on an operating income basis) in 2020, when oil prices plunged, to among the biggest money-makers in the business world in 2022. Speaking of 2020, we all remember the COVID-driven shutting down of the global economy in the first half of the year and the havoc it wreaked on borrowers and lenders, as a consequence.
  4. Debt payment surges: There is a final reason for default, which a surge in debt payments arising from rising interest rates and the refinancing of existing debt at those higher rates. Put simply, a company with a billion dollars in debt outstanding, at a 2% interest rate, will see its interest payments double, if rates double to 4%, and the debt is refinanced. Historically, this has been more an issue in emerging markets, where businesses borrow short term and rates are volatile, than in developed markets, where a combination of longer-term debt and more stable interest rates has insulated businesses from the worst of this phenomenon. But as I noted in my data post on interest rates, the last year (2022) has been a most unusual one, in terms of interest rate moves, in developed markets.
While all companies are exposed in one way or another to all of these factors, borrowing more money (and increasing contractual commitments) will magnify the effects; a more levered oil company will be more exposed to default risk than a less levered oil company, holding all else constant.

Defaults – Historical

    In my lead in to this section, I noted that defaulting on a loan or contractual obligation does not always lead to business default or bankruptcy, and that many bankruptcies do not conclude in liquidations. That said, though, the three data series (loan delinquencies, business defaults and business liquidations) do move together, with spikes in one coinciding with spikes in the other, In the graph below, I look at bank loan delinquencs in the United States and default rates among speculative grade companies over time:
Sources: Loan Delinquencies from Federal Reserve Site (FRED) and Corporate Defaults from S&P
Note that the series go through cycles, with increases in delinquencies and defaults triggered by macroeconomic or market-wide factors. In the late 1990s, it was an economic recession that was the precipitating factor, but the last three increases in delinquencies have had their origins in other forces. The increase in delinquencies in the early part of the 2000s started with the dot-com bust and made worse by the 9/11 attack, and subsequent economic weakness. The 2008 market crisis had the most damaging and longest lasting effect on defaults, partly because it originated with banks, and partly because of the long term damage it did to housing prices and the economy. The 2020 increase in default rate was triggered by the COVID shutdown, but was not only milder, but also passed quickly, with large bailout packages from the government being the difference.
    Looking at 2022, the most striking aspect of the time series is that there is almost no discernible change in delinquencies or defaults in the year, with both remaining at the low rates that we have seen for much of the decade. It is true that in the last half of the year, there were signs of trouble, with an uptick in delinquencies and an increase in the number of corporate defaults. Since interest rates rose during the year, the absence of an effect on defaults may surprise you, but there are two considerations to keep in mind. The first is that rising interest rates usually have a lagged effect on defaults, since it is only as companies refinance that they face the higher costs. The second is that the US economy stayed strong through 2022, notwithstanding headwinds, and corporate earnings stayed resilient. 

Ratings Actions and The Year Ahead

    If defaults measure the inability of companies to meet their contractual obligations, the actions taken by ratings agencies to change the bond ratings of the companies that they rate can operate as a leading indicator of expected defaults in the future. Put simply, ratings agencies are more likely to downgrade companies, if they foresee a potential uptick in defaults, and upgrade them, if they expect defaults to decline. While the actual defaults in 2022 remained low, it is clear that ratings agencies were becoming more concerned about the future, as can be seen in the number of ratings downgrades in the later parts of 2022, relative to upgrades:

S&P Default and Distress, Feb 2023

Note again that the downgrades in 2022 are nowhere near the downgrades that you saw in 2008, during the banking crisis, and one reason was that rising interest payments notwithstanding, the economy stayed robust during the year.

    Looking ahead to 2023, ratings agencies are forecasting rising default rates, perhaps because they see an economic slowdown coming. As with my forecasts for the S&P 500 and interest rates, you see a familiar duo of macroeconomic forces driving default risk:

Not surprisingly, a combination of high inflation and a steep recession will create the most defaults, as the vice of lower earnings and higher interest rates will ensnare more firms. At the other end of the spectrum, a swift drop off in inflation with no recession will create the most benign environment for lenders, allowing default to remain low. 

A Wrap

    In both our personal and business lives, there are good reasons for borrowing money and bad ones. After all, the politicians who lecture businesses about borrowing too much are also the ones who write the tax code that tilts the playing field towards debt, and by bailing out businesses or individuals that get into trouble by borrowing too much, they reduce its dangers. That said, there is little evidence to back up the proposition that a decade of low interest rates has led companies collectively to borrow too much, but there are some that certainly have tested the limits of their borrowing capacity. For those firms, the coming year will be a test, as that debt gets rolled over or refinanced, and there are pathways back to financial sanity that they can take. 

YouTube Video


  1. Debt ratios, by industry groupings (US, Global)
  2. Delinquency rates on bank loans, by Quarter (US): 1985- 2022

Wednesday, February 15, 2023

Data Update 5 for 2023: The Earnings Test

As I have argued in all four of my posts, so far, about 2022, it was year when we saw a return to normalcy on many fronts, as treasury rates reverted back to pre-2008 levels, and risk capital discovered that risk has a downside. During the course of the year, investors also rediscovered that the essence of business is not growing revenues or adding users, but making profits from that growth. In this post, I will focus on trend lines in profitability at companies in 2022, with the intent of addressing multiple questions. The first is to see how the increase in inflation in 2021 and 2021 has played out in profitability for companies, since inflation can increase profits for some firms, and lower them for others. The second is on whether these profit effects vary across geographies and sectors, by estimating profitability measures across regions and industries. The third is to revisit the link between profitability and value at companies, since making money is a first step for any business to survive, but making enough money to create value in business is a much more stringent test for businesses, and one that many fail.

Profits: Levels and Trends

   The end game for any business, no matter how noble its mission and how much good its products and services do, is to make money, since without profits, the business will soon run out of capital and sink into oblivion. That said, if you own the business, you may decide to accept less profits in return for social good, as you pursue your business, but you may not get the same degrees of freedom, if you are a manager at a publicly traded company, since you will now be doing good, with other people's money. Even in these cases, where you constrain your profits for the greater good, you still cannot stay on an endless path of losses. That said, there is surprising confusion about what it means for a company to make money, with different measures of profit used by investors, analysts and companies to bolster their priors about companies. To set the stage, I will start by laying out the differences measure of earnings that reported on an income statement:

At the top of the profit ladder is gross income, the earnings left over after a company has covered the direct cost of producing whatever it sells. Netting out other operating expenses, not directly related to units sold but still an integral part of operating a business (like selling and G&A expenses) yields operating income. Subtracting out interest expenses, and adding interest income and income from non-operating assets results in taxable income or pre-tax profit, and after taxes, you have the proverbial bottom line, the net income
    Not surprising, there is many a cost between the gross and the net versions of earnings, and while there remain a few firms, especially young and start-up, with negative gross income, the likelihood of losses gets progressively greater as you move down the income statement. In the graph below, I look at all publicly traded firms, listed globally at the start of 2023, and at the percent of firms, within each sector, that have positive earnings using gross, pre-tax operating and net income:

Not surprisingly, while more than 85-90% of all firms report positive gross income, that number drops down to just about 60%, with net income. All of the sectors are subject to the same phenomenon, but there are outliers in both directions, with health care have the highest drop off in money makers, as you go from gross to net income, and real estate and utilities having the smallest.
    Finally, I look at the aggregated values across all companies on all three income measures, across all global companies, again broken down by sector:

Collectively, global companies reported $16.9 billion in gross profit in the last twelve months leading into 2023, but operating income drops off to $6.4 billion and need income is only $4.3 billion. With financial service firms, where gross and operating income are meaningless, we report only net income, and the sector remains the largest contributor to net income across companies.

Profit Margins

    While absolute profits are a useful measure of profitability,  you have to scale profits to a common scaling variable, to compare companies of different scale.  One common scaling measure is revenues, and that scaling, of course, yields profit margins. The graph below draws a distinction between a medley of margins that are in use:

In addition to scaling gross, operating and net profits to revenues, to get to gross, operating and net margins, I have also added two variants. One is to compute the taxes you would have paid on operating income, if it had been fully taxable, to get after-tax operating income and margin, and the other is to add back depreciation to operating income to get EBITDA and EBITDA margin.
    Starting with gross margins, and computing the number for all non-financial service firms, we report the distribution of gross margins across publicly traded companies at the start of 2023, again based upon gross income and sales in the most recent twelve months:

While the median gross margin across all publicly traded global firms is about 30%., there are variations across the globe, with Chinese companies reporting the lowest gross margins and Australian companies having the highest. Some of that variation can be attributed to different mixes of businesses in different regions, since unit economics will result in higher gross margins for technology companies and commodity companies, in years when commodity prices are high, and lower gross margins for heavy manufacturing and retail businesses. 
    To explore differences in profit margins across industry groups, I broke stocks down into 94 industry groups, and sorted industries, based upon operating margin, from highest to lowest. In the table below, I list the ten industry groups with the lowest margins in the twelve months leading into 2023 and the ten industry groups with the highest:

Download spreadsheet with margins for all industry groups

The money-losers include four industry group from the retail space, a business with a history of low operating margins, a young industry in online software, a couple of industries in long-term trouble in airlines and hotel/gaming. The money makers include a large number of energy groupings, reflecting oil prices being elevated through much of the reporting period (October 2021-September 2022), a few technology groupings (software and semiconductors) and a declining, but high-profit business in tobacco.

Accounting Returns

    While profit margins tell a part of the profitability story, a high margin, by itself, may be insufficient to make a judgment on whether a business is a good one, i.e,, a business that consistently generates returns that exceed the cost of funding it. It is to remedy this defect that analysts scale profits to invested capital, with equity and capital variants:

In the equity version, you divide net income by book equity to estimate a return on equity, a measure of what equity investors are generating on the capital they have invested in a company. In the firm version, you divide after-tax operating income, again acting like the entire operating income would have been taxable, by total invested capital, the sum of book equity and book debt, with cash netted out, to obtain return on capital. The latter has several different names (return on capital employed, return on invested capital) with some mild variants on calculation, but all sharing the same end game. Both accounting returns are computed based upon book value, not because we have suddenly developed trust in accounting, but because the objective is to estimate what investors have earned on what they originally invested in a company, rather than an updated or a marked-to market value. I know that ROIC has acquired a loyal, perhaps even fanatical, following among financial analysts, and there are a few like Michael Mauboussin who use it to extract valuable insights about business economics and value creation, but I find that many analysts who use the measure are unaware, or unwilling, to learn about the limits of accounting returns. I have a long and extremely boring paper on the fixes that you need to make to the computation, especially with older companies and companies where accounting is inconsistent in its classification of expenses.
    Notwithstanding its many limits, I do think there is value in knowing what return on invested capital a company is generating, and I do compute the return on invested capital for every publicly traded non-financial firm in the world, and the calculation details are below:

The distribution of resulting returns on capital for the 42,000 publicly traded, non-financial firms are shown below:

The after-tax returns on capital, at least in the aggregate, are unimpressive, with the median return on capital of a US (global) firm being 7.44% (5.19%). There are a significant number of outliers in both directions, with about 10% of all firms having returns on capital that exceed 50% and 10% of all firms delivering returns that are worse than -50%.

Excess Returns

    If your reaction to the median return on capital being 7.44% for US companies and 5.19% for global companies is that they are making money, you are right, but when you invest capital in risky businesses you need to not just make money, but make enough to cover what you could have earned on investments of equivalent risk. It was in attempting to estimate the latter that I computed the costs of equity in my second post and costs of capital in my third. In fact, comparing the accounting returns from the last section to the costs of equity and capital that we computed earlier allows us to compute excess returns to equity and the firm:

Put simply, value creation comes from delivering returns on equity and capital that are higher than the costs of equity and capital, and while you can take issue with using accounting returns from the most twelve months as a proxy for long term returns, the comparison is still a useful one to make:

As you can see in this table, almost 70% of all listed companies earned accounting returns that were lower than their costs of equity or capital. On a regional basis, US companies have the highest percent of companies that earn more than the cost of capital, but still falling short of 50%, and Canadian companies performed the worst, with more than 80% of companies delivering returns that were lower than the cost of capital.
    It is certainly true that while the typical company had trouble making its costs of equity or capital, there are industry groups that generate returns that significantly exceed their costs, just as there are industry groups that operate as drags on the market. I look at the ten industry groups with the most positive and the most negative excess returns in the table below:
Download spreadsheet with excess returns for all industry groups

The rankings are similar to those that we got with margins, but it is clearly an ESG advocate's nightmare, as the list of companies that deliver the most positive excess returns are a who's who of companies that would be classified as bad, with tobacco, oil and mining dominating the list. 

  If 2022 was a reminder to investors that the end game for every business is to not just generate profits, but to generate enough profits to cover its opportunity costs, i.e, the returns you can make on investments of equivalent risk, and that game became a lot more difficult to win  in 2022. As I noted in my second and third posts, a combination of rising risk free rates and surging risk premiums (equity risk premiums and default spreads) has conspired to push the cost of capital of both US and global companies more than any year in my recorded history (which goes back to 1960). A company generating a 7.44% return on capital (the median value at the start of 2023) in the US, would have comfortably cleared the 5.60% cost of capital that prevailed at the start of 2022, but not the 9.63% cost of capital at the start of 2023. There will be, and  has already been, investor remorse about investments taken a year or more ago, but hoping that the cost of capital will come back to 2021 levels is not the solution. While there is little that can be done about past mistakes, we can at least stop adding to those mistakes, and one place to start is by updating hurdle rates, as investors and businesses, to reflect the world we live in,  rather than some normalized past version of it.

YouTube Video

Data Links
  1. Profit Margins (US, Emerging Markets, Europe, Japan, Global)
  2. Excess Returns (USEmerging MarketsEuropeJapanGlobal)