Thursday, November 20, 2014

Go where it is darkest: When company, country, currency and commodity risk collide!

You learn valuation (and find out how much you don't know) by valuing businesses and companies, not by talking, reading or ruminating about doing valuation. That said, it is natural to want to value companies with profit-making histories and a well-established business models in mature markets. You will have an easier time building valuation models and you will arrive at more precise estimates of value, but not only will you learn little about valuation in the process, it is also unlikely that you will find immense bargains, because the same qualities that made this company easy to value for you also make it easier to value for others, and more importantly, easier to price.

I believe that your biggest payoff is in valuing companies where there is uncertainty about the future, because that is where people are most likely to abandon valuation first principles and go with the herd. So, if you are a long-term investor interested in finding bargains, my advice to you is to go where it is darkest, where micro and macro uncertainty swirl around every input and where every estimate seems like a stab in the dark. I will not claim that this is easy or comes naturally to anyone, but I have a few coping mechanisms that work for me, which I describe in this paper

While I enjoy valuing companies with uncertain futures, there are cases where my serenity about valuation is disturbed by the coming together of multiple uncertainties, piling on and feeding of each other to create a maelstrom. In this post, I want to focus on two companies, one Brazilian (Vale) and one Russian (Lukoil), where bad corporate governance, a spike in country risk, currency weakness and plunging commodity prices have conspired to devastating effect on their stock prices. You could adopt the very dangerous contrarian strategy that Vale and Lukoil must be cheap simply because they have dropped so far, but I don't have the stomach for that. I do believe, though, that if I can find ways to grapple with this risk, there may be opportunity in the devastation.

Background, history and market standing

Vale is one of the largest mining companies in the world, with its largest holdings in iron ore, incorporated and headquartered in Brazil. Vale was founded in 1942 and was entirely owned by the Brazilian government until 1997, when it was privatized. In the last decade, as Brazilian country risk receded, Vale expanded its reach both in terms of reserves and markets well beyond Brazil, and its market capitalization and operating numbers (revenues, operating income) reflected that expansion. 
In US dollars
Notwithstanding this long-term trend line of growth, the last year has been an especially difficult period for Vale, as iron ore prices have dropped and Brazilian country risk has increased (leading into a presidential election that was concluded in October 2014). The graph shows Vale's stock price over the last 6 months (and contrasts it with another mining giant, BHP Billiton).

While declining commodity prices have affected both companies adversely, note that Vale’s stock price has dropped more than twice as much as BHP’s stock price has. In fact, Vale has lost approximately $130 billion in market capitalization since 2010.

Lukoil is a Russian oil company that has seen its profile, market capitalization and revenues rise as Russia's oil production has surged. While the company is not owned by the Russian government, it does have close ties to the Russian power structure and that connection, which has served it well during its lifetime, has become a liability in the aftermath of the Russian adventures in the Ukraine, compounded by the collapse of oil prices in the last few weeks: 
In US dollars
Though there are fundamental reasons for the stock price decline at both Vale and Lukoil, the fear factor is clearly also at play, because these companies are exposed to risk not only to commodity and country risk but there are also significant concerns about corporate (or is it political) governance at both companies as well as currency risk factors (as both the Brazilian Real and the Russian Ruble have slid over the last few months).

Corporate governance risk
In a post on Alibaba, I made the argument that corporate governance affects value by making it more difficult (if not impossible) to change management, and thus increasing the risk that a company that embarks on the wrong course may continue on that path unchecked. With both Vale and Lukoil, there are both explicit and implicit reasons to believe that investors in these companies will have little or no say in how the company is run. 

The place to start analyzing corporate governance is the ownership structures of the company. With Vale, the first sign that corporate governance is weak is the fact that they have two classes of shares (and yes, I would make this argument about Google and Facebook as well). In the graph below, I break down the top stockholders in both classes.

The common stockholders, who control the composition of the board of directors and the voting rights of the company, are held by Valepar, a shell entity controlled by inside investor groups. If you own Vale shares, as I do, it is very likely that you own the non-voting preferred shares and that you have no say in who sits on the board of directors and how the company is run. There is also a wild card in this equation in the form of a golden share that is owned by the Brazilian government, giving it veto power over major decisions and the line between corporate and political governance becomes a fuzzy one. While Vale is nominally an independent company, the Brazilian government reserves the right to intrude in its management, and that power can be used to good and bad effects. The positive is that it gives Vale a leg-up on competition in Brazil, giving it first dibs on Brazilian reserves of iron ore, and the negative is that the company can become a pawn in political games. Much of Vale's success in the last decade came from a willingness on the part of the Brazilian government to give it free rein to be run as a profit-making entity, but the machinations leading up to the last election (where the incumbent, Dilma Roussef, was viewed as more likely to interfere in the company's operations) have taken their toll. (The damage has been even greater at Vale's dysfunctional twin, Petrobras, Brazil's oil company). 

Lukoil's ownership structure provides some clues to both why it has been successful and the potential corporate governance nightmares ahead. The good news is that Lukoil has only one class of shares outstanding, with equal voting rights, but the bad news is that it is not quite clear whether you will ever get to vote for meaningful change, making it akin to a Russian political election:
Source: Bloomberg
The lead stockholder is Vagit Alekperov, formerly Russian deputy minister for oil production. It is entirely possible that he accumulated substantial knowledge about the oil business, while in the ministry, and brought that knowledge and entrepreneurial zeal into play in founding Lukoil, but it is also likely that he used his connections with the power elite to get reserves at well below fair-market prices in building up the company which would make him obligated to maintaining good relations with the inner circles of Russian government. In September 2004, ConocoPhilips bought 7.6% of Lukoil's shares to create what it termed a strategic alliance, which it increased to close to 20%, before selling its stake in 2011 at an undisclosed price, partly to Lukoil and partly in the open market. It is a sad commentary on corporate governance in Russia, that Lukoil, in spite of its flaws, is a paragon of stockholder accountability, relative to most other Russian companies. Notwithstanding this relative standing, if you are considering buying shares in the company, it should be with the recognition that you will have no role in how the company is run (no matter what you read about corporate governance on the company's website). 

Country risk
While investing is always risky, it is riskier in some countries than others, partly because of where the countries are in terms of its life cycle (with growing emerging markets being more volatile than established mature markets), partly because of the overlay of political risk in the countries and partly because of the effectiveness or lack thereof of legal protection and enforcement of property rights. When valuing companies, you have to factor in where the company operates to measure its exposure to country risk and incorporate that risk into an expected return.

As a commodity company, Vale does sell into a global market and as a producer of iron ore, it gets a significant portion of its revenues from China, which is the largest consumer of iron ore in the world. The country of incorporation in Brazil, and Vale is exposed disproportionately to Brazilian country risk not only because a significant proportion of its reserves are in Brazil, but also because the government has powers to intrude in the day-to-day running of the business. Not surprisingly, Vale has been affected  by changes in perceptions of Brazilian country risk. Using the sovereign CDS spread for Brazil as a proxy for country risk, and looking at the last decade, here is what we get. As Brazilian country risk has declined over much of the last decade, Vale benefited, but country risk is a double-edged sword. As Brazilian country risk has risen in the last few weeks, Vale has felt the pain in the market:

It goes without saying that Lukoil, which has 90.7% of its reserves in Russia, is affected by Russian country risk. Here again, the last decade has been a good one for both Russia and for Lukoil, as lower country risk (measured with the CDS spread) for the former has gone with higher market capitalization for the latter. To investors who were expecting more of the same, this year must have been a shock, as Russian country risk surged in the aftermath of the events in the Ukraine.

In both companies, country risk has clearly played a role in the drop in stock prices. With Vale, at least, it cannot explain the entire price drop, since Vale has dropped more than the Bovespa over the last few months and a lot more than the index over the last few years. With Lukoil, a greater portion of the blame can be attributed to country risk.

Currency risk
When valuing individual companies, it is generally good practice not to be a currency forecaster and to value the company based upon prevailing exchange rates (current and forward, from the market). It is also undeniable that currency movements in your favor will make a bad investment into a good one, just as currency movements against you can turn a good investment into a bad one. 

With Vale, the stage was set in a decade where the Brazilian Real strengthened against the US dollar, even though inflation in Brazil was much higher than inflation in the US. As with country risk, the currency risk dragon has turned on investors and the last few weeks has seen a meltdown in the value of the Brazilian currency.
Source: Bloomberg
The story is similar for Lukoil. A decade of a strengthening ruble, in spite of fundamentals that would suggest otherwise, has been followed by the collapse in the last few months.
Source: Bloomberg
While the immediate effect of a currency decline is that your investment in these companies will be worth less in US dollar terms (simply because of the translation effect), it is debatable what the effect of a weakening currency will be on both companies over time. To the extent that their reserves are in Brazil (at least for iron ore, for Vale) and in Russia (for Lukoil), the costs are in the local currencies but their revenues are in global markets, denominated in US dollars. Thus, a weakening of the currency can improve profit margins and increase value.

Commodity price risk
Do commodity prices affect the value of commodity companies? Stupid question, right? Of course, they do, but the degree of impact can vary across companies. Higher commodity prices will generally push up revenues and to the extent that the cost of developing reserves stays stable, operating margins will increase. In some cases, though, and especially so with oil companies, the government can use a heavy hand (see political risk in the corporate governance section) and force the company to sell oil at subsidized prices to consumers in the country, effectively creating a subsidy cost for the company that will increase with oil prices. 

Vale's fortunes have risen as the Chinese economy has grown, primarily because China has become the largest consumer of iron ore in the world. It is robust Chinese growth that lifted iron ore prices in the last decade to hit highs in 2011, but that engine has slowed and as it has, iron ore prices have dropped in the last two years: 

This history shows why making a judgment about a normal price for iron ore is so difficult to do. If your historical perspective is restricted to just the last few years, the current price of iron ore (about $75/tonne) is low but extending that perspective to cover a longer time period (say 20-25 years) may suggest otherwise.

Lukoil also benefited from the increase in oil prices in the last decade, driven partly by geopolitics and partly by the explosive surge in automobile sales in emerging markets. Here again, though, the last few months have seen a decline in oil prices to less than $80/barrel. 
Source: Bloomberg
As with iron ore, the question of whether oil prices have dropped below a normal price is largely a function of perspective, with the answer being yes, if you have 2 or 3-year perspective but not if you have a ten-year or longer perspective. 

While it is easy to make the argument that commodity prices move in cycles and that what goes down has to go back up again, these cycles are unpredictable and can stretch over long time periods. Thus, you could have spent the entire 1980s waiting for oil prices to go back up, just as you would have waited the entire last decade for the drop back in prices.

Valuing Vale 
The value of Vale is a function of company, country, currency and commodity risks. To capture the effects, I valued Vale in US dollar terms and assumed that Vale was a mature company, growing at 2% a year in perpetuity. I varied the following inputs:
  1. Operating income: The operating income in the trailing 12 months, through November 2014, was $12.48 billion, well below the operating income in the last fiscal year ($17.6 billion) and the average operating income over the last five years ($17.1 billion).
  2. Return on capital: The return on capital in the last 12 months was 11.30%, higher than the cost of capital that I estimated of 8.59%, but lower than the return on capital in the most recent fiscal year (14.90%) and the average over the last five years (18.22%)
To estimate the cost of capital, I built off the US 10-year treasury bond rate as the risk free rate and used an equity risk premium of 8.25%, reflecting a weighted average of the equity risk premiums across the countries where Vale has its reserves (60% are in Brazil). You can check out the spreadsheet yourself and change the numbers. I have summarized the valuation in the picture below.

Note that I have attempted to incorporate the effect of commodity price declines and currency devaluation in the base-year operating income, choosing to value the company, using the depressed income from the last 12 months. The effects of corporate governance are captured in the investment and financing choices made by the firm (with reinvestment and ROIC measuring the investment policy and the debt mix in the cost of capital reflecting financing policy). Finally, the country risk is incorporated into the equity risk premium (where I used risk premium weighted by the geographic distribution of Vale’s reserves) and the default spread in the cost of debt. The value per share that I get with this combination of assumptions is $19.40, well above the share price of $8.53 on November 18, 2014.

It is entirely possible that I am under estimating how much further iron ore prices can drop and the damage that the Brazilian government can (to Vale, the Brazilian real and to country risk). I tried varying the numbers to see the impact of changes in my inputs on the value per share:

I am sure that I am missing something but at the stock price of $8.53 on November 18, 2014, it looks grossly under valued. Even in my worst case scenario, where operating income drops another 20% from the already depressed LTM number and the company earns only its cost of capital from this point on, my value per share is $13.60.

Valuing Lukoil
I followed a similar path for Lukoil. In my base case, I left operating income at 20% below the estimated 2014 and valued the firm as a stable growth firm (with a 2% growth rate) and with a cost of capital that reflects an updated equity risk premium for Russia (9.50%). Even if I assume that oil prices drop by another 20% and that the standoff over Ukraine will not end soon (translating into higher equity risk premiums), the value per share that I get is $50.56, higher than the stock price of $45.30.

At $45.30 a share on November 18, 2014, I am again either missing something profound or the stock is massively under priced. Here again, you can download the spreadsheet and make your own choices.

What now?
It is easy to come up with reasons not to buy Vale and Lukoil right now and wait for things to get better. Could things worse? Of course? With Vale, there are two Doomsday scenarios. In the first, and I hope that this does not happen, more for the sake of my Brazilian friends more than because of concerns about my investment portfolio, Brazil could become Argentina, with spiking country risk and shaky ownership rights. In the second, Chinese infrastructure investment comes to a standstill and iron ore prices drop back to pre-2003 levels. I think that these are low-likelihood events and that is precisely why I already own Vale (and I am not in the least bit ashamed to admit that I bought my shares at $12/share) and plan to add to my holdings.

With Lukoil, there is the Putin wild card, where the troubles in Ukraine expand into Poland, Hungary and the rest of the old Soviet empire. That, combined with a collapse in oil prices, would make me regret my investment, but I plan to buy Lukoil to my portfolio, and live with the discomfort of having no power to exert change. After all, at the right price, you can live with a lot of discomfort!

If you are tempted to complain about how much uncontrollable risk you face investing in Vale and Lukoil, keep in mind two facts. The first is that they are bargains precisely because of the uncertainty, as global investors flee from he companies, abandoning good sense along the way. The second is that it could be worse, since you could be holding Petrobras (instead of Vale) and Rosneft (instead of Lukoil) where the concerns are multiplied.

Vale: Financial Summary (Historical)
Lukoil: Financial Summary (Historical)
Valuation of Vale (November 2014)
Valuation of Lukoil (November 2014)


Em said...
This comment has been removed by the author.
mrahmani said...

Vale will invest a lot in the next two years preventing the company to make fcf in this period.

Unknown said...

Hi professor,

Great post. I noticed that you used the Brazilian corporate tax rate of 34% for the cost of debt but the effective tax rate of 20% for the perpetuity formula. Can you explain the intuition behind this? Thanks!

Anonymous said...

Thanks professor. From your excel analysis and the financials it seems like Vale is profitable. Why does it have a negative earnings per share? In the latest quarter Vale had 1.6 billion in operating income but total net income of -1.4 billion...

Kapil said...

I am also pretty certain that this is part of a portfolio of investments that are spread over various countries and spanning multiple industries. So unsystematic risk (which is your doomsday scenario) is getting diversified away. I would have thought that his would be the most comforting point (unless the the market knows something that you don't)


memyselfandi007 said...

Dear Aswath,

why do you value Vale by using the US interest rate curve as basis ?

Why didn't you use the Brazilian Real curve instead ?

Alot of their cost is subject to Brazilian inflation so houldn't one use a higher risk free rate for the company ?


Anonymous said...

Vagit Alekperov, chief executive of Lukoil, recently told Prime Minister Dmitry Medvedev that 25 per cent of Russian oil production involved fracking and relied on western service companies. “This is the most fragile part, that could be the first to cause damage to the oil industry,” he said.

Anonymous said...

great brave post
many thanks

mrahmani said...

Vale will invest a lot in the next two years preventing it to generate fcf (or as much fcf) in this period

Anonymous said...

Congratulations, you helped create over $5B in shareholder value today with your post.

Anonymous said...

Congratulations, you helped create over $5B in shareholder value today with your post.

Anonymous said...

Are you favoring Vale more over Lukoil since the former is severely undervalued in your analysis?

Anonymous said...

Excellent article but sad to see that you have to protect your blog from spam.

Having said this, suppose that all the spammers out there worked for one single company. How would you value it?

Anonymous said...

Hi Aswath,

Why do you use USD curve to build your cost of capital? Aren't underlying cash flows in BRL and RUB?

Anonymous said...

What are the operating leverage on these names? For example, a 10% drop in iron ore prices could drop Vale's operating income by far more than 20%. Thus it doesn't seem right to me given volatility in the commodities markets right now to sensitize on a 20% drop.

Anonymous said...


Only ~10% of Vale's sales are to brazilian customers. Doesn't that somewhat offset the currency risk?

Thanks for the great work,

Anonymous said...

Hi Professor,

I have a housekeeping question. In you valuation spreadsheet, the operating income for 2013, 2012 and 2011 are 17,596m, 13,346m and 30,206m, respectively.

However, if you look up the numbers in VALE's 20F, they are different by a fair amount. On top of the operating income, your revenue numbers are different from the figures in their financial statements.

Could this be a result of forex conversion when you downloaded the financial data?

Thanks for sharing!

rukawa said...

Or you could just own RSX/RSXJ and reduce the idiosyncratic company risk considerably.

Anonymous said...

What you are missing on Lukoil isnt just the governance risk and the country risk but also the politics risk. Sistema just lost Bashneft with no recourse and its CEO was placed under house arrest. As you can see its performance on its London listing (, the price risk of the war/sanctions and oil drops were priced in. What wasnt was the possibility that Putin would arrest the owner and take away the asset.

Aswath Damodaran said...

1. On the currency issue, while I usually prefer to value companies in the local currency, commodity companies are generally easier to value in US dollars, because their revenues are dollar-based. My cash flows are therefore done in US dollars as is my discount rate. (I could have valued Vale in nominal Reails and Lukoil in Rubles. My discount rates would have been higher but so is my growth rate, with higher inflation in both).
2. On profits, I am focusing on operating income. Vale has extraordinary charges and interest expenses that made their net income negative in the last period.
3. On the question of why I used only a 20% drop in operating income to sensitize my valuation, this is not a one-year but a permanent drop. That is a pretty drastic lowering in earning capacity for a commodity company.
4. On the issue of the Putin risk to Vale, I am glad to see some details popping up. It is one reason that I feel better about my Vale investment than I do my Lukoil investment.

Anonymous said...

Why are you using tax rate of 20% as perpetuity instead of marginal tax rate of 40%?

Do you think 20% is sustainable that long?

Aswath Damodaran said...

What marginal tax rate of 40%? Neither company is a US company and Brazil & Russia follow a territorial tax model where you pay taxes based on where you make your income, not based on where you are incorporated.

Anonymous said...

In Vale, why do you use 20% tax rate in perpetuity formula but 34% in Cost of Capital calculation?

Aswath Damodaran said...

You pay the effective tax rate on your cash flows (which are global and are taxed at a weighted average tax rate across the globe) but you can choose to park your debt in the country where you get the highest tax benefit (with the highest marginal tax rate).

Aswath Damodaran said...

An excellent comment and my response below:


I would like to point out some possible hidden assumptions in your work, that invalidates your final conclusion.

1. Taking VALE LTM operating earnings contains the hidden assumption of iron ore prices average 110 USD/ton, the average price over the last LTM. Stretching that to the infinitum creates a dangerous assumption of iron ore prices above 100 USD /ton built into the valuation, to infinity.

2. To take a "margin of safety" you considered a 20% drop in the operating earnings of VALE. But iron ore dropped much more than 20% than the average price on which your thesis is bulit on -110 USD/ton (see #1). Moreover, a percentage drop in the value of the commodity will cause a much larger drop in operating income due to operational leverage. Since iron ore is trading at about 70 USD / ton, 40% less than the average on the recent LTM price, a more deep discount would be warranted - like a 50 or 60% drop in operating income.

3. You can see that during the last quarter VALE's underlying earnings (earnings adjusted to special charges) dropped 80% comparing to previous quarter (avg iron ore prices of ~120 USD/ton), which empirically proves my point - your valuation assumes iron ore prices to rise to 110 USD, LTM average.

4. I think a much deeper valuation of the business itself is required than a simple average of operating income. To make for a margin of safety, one would first calculate or estimate VALE's earnings power under adverse scenarios, like iron ore at 50 USD per tonne or below, for his thesis to include a margin of safety.

Right now I suspect that this thesis fails to do so as it tries to value a commodity company with extremely generous hidden assumptions on the underlying commodity price, conditions that were not met even during the last 9 months, before a large supply will enter the market in 2015.

If you do this exercise I suspect you will see that VALE is currently overvalued or at least does not supply a margin of safety.


You are right. There is the real danger that iron ore prices could collapse to $50, but to do your valuation with that scenario is to assume that they will collapse and stay collapsed. That is possible, but if that were the case, you would make far more money selling short on BHP Billiton, since it would require that the Chinese economy come to a standstill and perhaps fall into a long-term recession.

I think you have a good point on the immediate effect of the iron ore price collapse being greater than the 20% that I have estimated though extrapolating from the last quarter's data (when everything was caving in for Vale) is not fair. I think it will make more sense to look at the earnings of global iron ore producers during the period to get a measure of how sensitive earnings are to iron ore prices.

Finally, I personally don't much care for margin of safety. While there are some who use it sensibly (I love Seth Klarman's writings on it), for most value investors, it is the shield that they use from ever acting. They do conservative (often worst case) valuations of companies and then knock 20% of these valuations and then complain that the price is too high. I am not suggesting that you are guilty of it, but if I waited for the absolute worst case scenario to unfold, the value will also reflect that worst case scenario, and I am not sure that the price/value ratio is going to be better there than it is now.

Aswath Damodaran said...

Ref: US dollar versus Brazilian Real valuations

Here is the comment and my response:

"1. On the currency issue, while I usually prefer to value companies in the local currency, commodity companies are generally easier to value in US dollars, because their revenues are dollar-based. My cash flows are therefore done in US dollars as is my discount rate. (I could have valued Vale in nominal Reails and Lukoil in Rubles. My discount rates would have been higher but so is my growth rate, with higher inflation in both)."

One follow up question on that: The real interest rate (nomminal rate -inflation) is much higher in Brazil compared to the US, around 6-7% compared with 0-1% in US.

So wouldn't a Real based cost of capital rate lead to a lower NPV for Vale ?


My response:
When you say the real interest rate in Brazil is 6-7%, I think you must be getting there by subtracting out the actual inflation rate (as reported by the Brazilian government) from the nominal Real long term government bond rate to get to that value. I think that number is over stated because the (a) official inflation rate in Brazil understates actual inflation, as is common in most countries, where governments are not unbiased arbiters of this number and (b) the nominal Real government bond includes a default spread. If you net these out, it is amazing how close real interest rates become across the world.

Assaf Nathan said...

Thank you Professor.

Regarding the price of iron ore, I would argue that a price of below 50 USD / ton is not such an extreme scenario as you imply from your response.

25 year, inflation adjusted price average for iron ore will give you an average of 52 USD per ton.

The longer you stretch the average, the lower the price you get, even after adjusting for inflation. Nowhere in Human history iron ore saw such a rise as it saw in the last 10 years.
This suggests that the current, abnormally high prices of iron ore are a mere result of a "blip" in history, in which a relatively short time of about 10 years imbalance of supply and demand occurred.

Otherwise, it is impossible to explain how VALE and RIO and others are mining iron ore for about 20-40 USD per ton and sell it for 100, enjoying margins like Louis Vitton. Iron ore is abundant in our planet, there is no "peak ore" like for other commodities, it is not of limited supply like wheat that has limited growing areas and - iron is recyclable.

High margins cause more competition and more recycling.

I would also argue that it is incorrect to adjust past prices of iron ore to inflation. On October 1989 a ton of iron ore cost 14 USD. Since then, technology has improved, recycling technology has improved, mining is more efficient, and world population grows at a much slower pace. Taking all those into account, I would argue that the "Normal" Iron ore price should be lower than the inflation adjusted price. USD Inflation was about 100% since 1989, which means Adjusted price would be 28 USD per Ton. I would regard this price as the Maximum normal price, and not as a Minimum.

I have analyzed the supply that will enter the market in the coming years and the situation does not look bright. In the coming 2 years more than 400 million tons of ore supply will be added to the market, increasing world supply by 30%. The Chinese Giant need not standstill for prices to collapse further, it is enough that the next 2 years China will not grow fixed assets investments at the rate of 20%.

Another factor your thesis neglected to mention is the market structure. VALE is very distant from its primary customer - China. RIO and BHP enjoy a much greater proximity working in Australia and S.E Asia. This gives them a competitive advantage over VALE - since shipping prices are fixed, and VALE's already low mining cost, they have much more room for cost savings then VALE.

I think your thesis will enjoy a temporary tailwind from recent rate cut in China and maybe more stimulus but for the long term I think your Thesis will be proven overly optimistic by a wide margin.

I would calculate VALE fair price at about 5-6 USD over the long term, maybe even less, under 70-50 USD *optimistic normal* price per tone of Iron ore.

Thank you again,

Assaf Nathan said...

Just one more thing -
China is consuming more iron ore per capita than any other nation in the world, by a far margin.

If it were to cut its consumption by a half or more will not mean that it will fall into a long recession. It will just mean that it will base its economy on viable growth models other than infrastructure investments.

Take EU iron ore consumption or other Asian nations like Vietnam, they consume a fraction of Chinese iron ore per capita, even if you look at Europe's happy days back in 2005.

Aswath Damodaran said...

I am not ruling out this possibility. My only point is if this is the way you see the world unfolding, there is a load of pain in commodity stocks, and especially among those that have not suffered as much as Vale has.
I do think that you have a point about what the norm is in commodity companies. If you go back long enough, the normal price (even if corrected for inflation) can be very different than if you go back a shorter periods. Perhaps, there are long cycles and short cycles in commodities and we don't keep track of the long cycles.

Stanley said...

Hello Professor,

I agree that Lukoil appears attractive at its current valuation, but I don't think that the price is as disconnected with value as you think.

Lukoil, and oil companies generally, have significant divergences between depreciation and capex. Your model, which is EBIT-based, won't catch the disconnect, and the cash flow implications can be very large.

More concerning, even though capex has exceeded depreciation over a long time period (10 years or more, if memory serves), production has hardly grown, and has shrunk for many of the Western oil majors.

It is not entirely clear what is going on, but it seems that as oil gets more difficult to extract, companies are depreciating old, easier-to-develop, less expensive barrels, but are capitalizing their investments into new more difficult projects. As depreciation "catches up" with capex, the true earnings number may be far lower than you would expect.

Unknown said...

Hi PRofessor, great analysis, quick question, how do you arrive at the country risk premium of 8,5%?

Thank you

Thierry said...

Hi guys,

I was wondering how come you could simply do a "terminal value" gordon growth model to value the operations of Vale and skip the DCF part of the calculation.


Anonymous said...

I am long 15% of my holdings in greece..and also own the leveraged BRZU and RUSL which have holdings in the stocks mentioned.

" greedy when others are fearful, and fearful when others are greedy..."
Hopefully i have quoted Warren Buffet accurately.

Ayron said...

Hi professor!

Great post!

I don´t know if you are following up with last days in Brazil, but I have a suggestion to post: it is happening an investigation about irregular payments, from building sector (big company: Odebrecht, OAS, Camargo Correia, etc) to directors of Petrobras (they can contracts through those payments), so, what do you believe with valuation/effects in the enterprises? There are any possibles consequences like disabled contracts with Petrobras and Government Brazilian, etc.

Maybe, the Brazil will have big risk in next years, because the enterprises are big five to build, airports, roads, trains, bridges, etc.

I like your comments with brainstorm between valuation and risk of project.


Anonymous said...

Dear Aswath, all the best for thanksgiving. Didn't go through all numerical calculations but having to mention that dollar (currency risk) and oil price as both determinants of revenues where until lately self hedged (up to a significant level). That changed lately by the FEDs policy but I donot thing will last for long. In a distressed world economy I believe the 2% CAGR for demand is far too high (unless india break even china's declining rate of growth). Those factors along with the others expectations in the firm's domestic exchanges might explain part of the premium in the "fair"/expected" price for each share with the actual. But dear Aswath what is the consensus for this prices by the market?

Unknown said...

Hi Professor,

I am one of your MBA students (Class of 2014) and also a Lukoil investor for a long time (since 2004).

The main risk that I see is indeed the political risk mentioned above by one of the anonymous guys. Recent events show that the owner / management of the company can be accused of buying some of the production assets and below-market prices, which you mentioned in your post, eventually leading to Lukoil becoming part of Rosneft.

I personally think there is a high probability that all major Russian oil companies will sooner or later become part of Rosneft. Having that in mind, I think we can use the same metrics and multiples for Lukoil as we use for Rosneft.

Still, as an "insider" in Russia, I believe that the geo-political situation (Ukraine crisis) will improve in the first half of 2015, and thus we should see the country risk premium (CDS) drop back to normal levels, which should positively affect the stock price.

Thank you for your posts. I really enjoy them.

Kind regards,

Anonymous said...

Hello Sir,
I am your new student in valuation.
I love the way you involve us in your thesis. thank a lot
I have a question that why you did not consider the working capital requirement and capex while calculating free cash flow ?

Sergei said...

Adn what you think about recent developments in us shale oil sector? What about companies like CLR? Is it still expensive/risky or it is good instrument to catch up oil prices from 60 to 80?

Ayron said...



This is my suggestion to next post.

Anonymous said...

Hi Prof.
you may maid an author mistake
the value per share that I get is $50.56, higher than the stock price of $45.30.
it should be 80.74$ as in your excel and not 50.56$


Unknown said...


given current oil prices, don't you think your Lukoil valuation is overly optimistic, do you?

Anonymous said...

Dear Mr. Damodaran,

Thanks for your great Analysis of Vale S.A..
But what you think about the current stock Price movement compared to the market efficient hypothesis?
Furthermore there are big capex-projects ongoing. Don't you think this is to much oversuply to the iron ore market?
And what you think about the cash generating ability of Vale S.A.?
Thanks in advance.

Anonymous said...

Dear Professor,

could you do an update after yesterdays Vale S.A. financial report release?
It seems to me that oversupply lasts for verly long time. Just see the giant new iron ore projects (Rio, BHP and Vale's S11D-Project etc.). I think Vale need also more debt to fund the new projects.

Moreover what do you think of the planned divestment of assets? What are the consequences for the value?
Thank you in advance.

Best regards