Musings on Markets: January 2018

Monday, January 29, 2018

January 2018 Data Update 8: Debt and Taxes

In the United States, as in much of the rest of the world, and as has been true for most of the last century, the tax code has been tilted towards debt, rewarding firms that borrow money with tax savings, relative to those that use equity to fund their operations. While the original rationale for this debt bias was to allow the large infrastructure companies of the equity markets (railroads, followed by phone and natural resource companies) to raise financing to fund their growth, that reason has long dissipated, but a significant segment of the economy is built on debt. The most revolutionary component of the US tax reform package that passed at the end of last year is that it reduces the benefits of debt in multiple ways, and by doing so, challenges companies that have long depended on debt to reexamine their financing policies.

The Trade Off on Debt and the Tax Reform Package

In last year’s update on debt, I summarized the trade off on debt, listing both the real pluses and minuses of debt as well as what I called the illusory benefits. In the latter group, I included reasons like debt is cheaper than equity and dilution benefits:

The bottom line is that it is the tax advantage of debt that makes it attractive to equity, and the benefits to borrowing were greater in the United States than in any other country last year, for a simple reason. The US had the highest marginal corporate tax rate in the world, at 40%, and companies that borrowed effectively claimed their tax benefits at that rate. To the oft touted counter that no US companies pay 40%, that is true, but it actually makes the tax benefit of debt even more perverse. Companies in the United States have been able to pay effective tax rates well below 40%, while maximizing their tax benefits from debt. As an example, consider Apple, which paid an effective tax rate of less than 25% on its global income last year, partly because it left so much of its foreign income off shore (as trapped cash). Apple still managed to borrow almost $110 billion in the United States, and claim the interest expenses on that debt as a tax deduction against its highest taxed income (its US income). For those of you who find this unethical, please spare me the moralizing since your disdain should be directed at those who wrote the tax code.

As I noted in my post on the changes that tax reform is bringing, the biggest are going to be to the tax benefits of debt, which will be dramatically decreased starting this year, for two reasons:

Lower marginal tax rate: The marginal tax rate for the United States has gone from being the highest in the world to close to the middle. At a 24% marginal tax rate, which is where I think we will end up with state and local taxes added to the new federal tax rate of 21%, you are effectively reducing the tax benefit of debt by about 40% (from 40% to 24%). In the heat map below, I have highlighted marginal tax rates of countries, with a highlighting in shades of rec of those that will have lower marginal tax rates than the US after 2018. To provide a contrast, this picture would have been entirely in shades of red last year, before the tax rate change, since there was no other country with a corporate tax higher than 40%.

chartsbin.com

Limits on interest tax deductions: Until last year, as has been the case for much of the last century, US companies have been able to claim their interest expenses as tax deductions, as long as they have the income to cover these expenses. With the new tax code, there is a limit to how much interest you can deduct, at 30% of adjusted taxable income. Any excess interest expenses that cannot be deducted can be carried forward and claimed in future years, and that provision will help companies with volatile earnings, since they will be able to claim back deductions lost in a bad year, in good years. As is its wont, Congress has chosen to make up its own definitions of adjusted taxable income, with EBITDA standing on for operating income until 2021 and then transitioning to earnings before interest and taxes (EBIT).

There are two other provisions in the tax code which will also indirectly affect the debt trade off.

Capital Expensing: Attempting to encourage investments in physical assets, especially at manufacturing companies, the tax code will allow companies to expense their capital investments for a temporary period. The resulting tax deductions may be large enough to reduce the benefit to having the interest tax deduction. That effect will be magnified by the fact that the companies that are most likely to be using the capital expensing provisions are also the companies that have used debt the most in funding their operations.
Un-trapped Cash: As companies are allowed to pay a one-time tax and bring trapped cash back to the United States, the cash will be now available for other uses and reduce the need for debt as a funding source. Note that estimates of this trapped cash, collectively held by US companies, exceed $3 trillion and that even if only half of this cash is brought back, it would still be a substantial amount.

All in all, there are multiple provisions in the tax code that handicap the use of debt and very few, perhaps even none, that would make debt a more attractive source of financing.

Optimal Capital Structure

To quantify the impact of the tax code’s change on how much debt a company should have and how much value it adds, I used an old but flexible optimizing tool: the cost of capital. It is, of course, the number around which a post looking at how it varies around the world and sectors. In the follow up post, I used the cost of capital as a hurdle rate to judge the quality of a company’s investments. In this one, I will use it to talk about the right mix of debt and equity, and how it affects value:

Note that as you borrow more money, your costs of equity and debt go into motion, increasing as the debt increases and the trade off from the last section plays out, with the tax benefits showing up as an after-tax cost of debt and the bankruptcy costs partially captured in the higher costs of both equity and debt and partially as drops in operating income. Note that the key changes in the 2017 tax reform package, at least as they relate to the trade off, are highlighted. I used Disney as an illustrative example, and computed the costs of capital at every debt ratio under the old tax regime and the new one and the results are in the graph below:

Disney Capital Structure Spreadsheet

The cost of capital is a driver of the value of the operating assets, and since the costs of capital are higher at every debt ratio than they used to be, it should come as no surprise that the value added by debt has dropped at every debt ratio, with the new tax code.

Download spreadsheets: Disney, Facebook & Ford

The easiest way to see the effects of the new tax code are to look at how it plays out in the cost of capital and values of real companies. I will use Facebook, Disney and Ford as my examples, partly because they are all high profile and partly because they have widely divergent current debt policies, with Facebook having almost no debt, Disney a moderate amount and Ford more debt. With each firm, I computed the schedule of cost of capital, holding all else constant (both micro variables like EBIT and EBITDA and macro variables like the risk free rate and ERP.), with the old and new tax codes. I do this, not because I believe that these numbers will not be affected by the tax code, but because I want to isolate its impact on debt.

For all three firms, the effect of the new tax code is unambiguous. The value added by debt drops with the new tax code and the change is larger at higher debt ratios. Taking away 40% of the tax benefits of debt (by lowering the marginal tax rate from 40% to 24%) has consequences. Note, though, that the lost value is almost entirely hypothetical, for Facebook, since it did not borrow money even under the old code and did not have much capacity to add value from debt in the first place. It is large, for Disney and Ford, as existing debt becomes less valuable, with the new tax reform. Note, though, that both companies will also benefit from the tax code changes, paying lower taxes on income both domestically, with the lowering of the US tax rate, and on foreign income, from the shift to a regional tax model. Ford, in particular, could also benefit from the capital expensing provision. My guess is that both firms will see a net increase in value, with all changes incorporated. With these three firms, at least, the cap on the interest expense deduction (set at 30% of EBITDA for the near term) does not affect value at their existing debt ratios and is not a binding constraint until they get to very high debt ratios.

Debt Ratios- Cross Sectional Distributions

If you accept my reasoning that the new tax code will lower the value of debt in capital structure, and that the effect will be most visible at firms that borrowed a lot of money under the old tax regime, the only way to assess the tax code’s impact is to look how debt ratios vary across companies, and what type of firms and in what sectors borrow the most.

To get a measure of what comprises a high debt ratio, I started by looking at the distribution of debt ratios across companies, for both US and global companies:

I was surprised by how many firms in the global sample have little or no debit their capital structure, with more than half of all firms in the sample having total debt to capital ratios of less than 10%. In fact, netting cash out from debt would lead to even lower net debt ratios. That said, there is enough debt at the largest firms that the aggregated debt ratios across all firms is significantly higher. Looking at these aggregated debt ratios, you would expect US companies to have been borrowing more money than companies in other parts of the world, and to see if they did, I looked at measures of financial leverage, from debt scaled to capital to debt to EBITDA globally:

Sub Group	Debt/Capital (Book)	Debt/Capital (Market)	Net Debt/ Capital (Book)	Net Debt/ Capital (Market)	Debt/EBITDA
Africa and Middle East	45.23%	34.00%	30.27%	21.31%	5.99
Australia & NZ	61.66%	43.48%	57.82%	39.60%	8.57
Canada	55.35%	42.42%	52.46%	39.60%	7.16
China	51.63%	39.34%	41.83%	30.40%	8.52
EU & Environs	60.75%	47.17%	53.68%	40.07%	7.78
Eastern Europe & Russia	31.02%	38.05%	21.35%	27.05%	2.47
India	54.89%	20.85%	50.58%	18.15%	3.92
Japan	56.16%	49.11%	27.64%	22.35%	7.61
Latin America & Caribbean	51.67%	40.01%	46.23%	34.90%	5.74
Small Asia	44.04%	34.76%	36.01%	27.59%	4.54
UK	63.74%	46.39%	53.68%	36.33%	7.94
United States	64.06%	37.11%	60.86%	33.99%	7.09

The results are mixed. While US companies look like they are the most highly levered in the world, if you scale debt (gross and net) to book value, US companies don’t look like outliers on any of the dimensions. In fact, the only real outliers seem to be East European companies that borrow far less than the rest of the world, relative to EBITDA, and Indian companies, that borrow less, relative to market value. Looking across sectors, you do see clear differences, with some sectors almost completely unburdened with debt and others less so. While you can get the entire list from clicking on this link, the most highly levered sectors in the US are highlight below, relative to both market capital and EBITDA.

Download full sector spreadsheet

I removed financial service firms from this list, since debt to them is a raw material, not a source of capital, and real estate investment trusts, since they do not pay corporate taxes, under the old and new tax regimes. As I noted in my post on tax reform, it is the most highly levered sectors that will be exposed to loss of value and it is entirely possible that the net effect of the tax change can be negative for them.

Implications
You seldom get to observe a real world experiment of the magnitude that we will be faced with in 2018, with the tax code in change and the loss in value added from debt. Given the changes, I would expect the following:

Deleveraging at firms that have pushed to their optimal debt ratios, under old tax code: While there are many firms, like Facebook. where debt was never a source of added value, where the tax code will affect that component of value very little, there will be other highly levered firms where the value change will be substantial. In fact, many of these firms, which would have been at the right mix of debt and equity, under the old tax regime, will find themselves over levered and in need of paying down debt. Given that inertia is the primary force in corporate finance, it may them a while to come to this realization.
Go slow at firms that have held back: For firms like Facebook that have held back from borrowing, under the old tax code, the new tax code reduces the incentive to add to debt, even as they mature. As you can see from the numbers on Facebook, Disney and Ford, the benefits of debt have been significantly scaled down.
Transactions that derive most of their value from leverage will be handicapped: Since the mid-1980s, leveraged transactions have been favored by many private equity investors. While one reason was that they were equity constrained (and that reason remains), the bigger reason was that it allowed them to generate added value from recapitalization. At the risk of over generalizing, I will argue that for a large segment of private equity investors, this was the primary source of their value added and for these investors, the new tax code is unequivocally bad news, and I will shed no tears for them.

As I noted at the start of this post, debt is part of the fabric of business in the United States, and there are some businesses and asset classes that have been built on debt. Real estate and infrastructure businesses have historically not only used debt as a primary source of funding but as a value addition, with the added value coming from the tax code. Now that the added value is much lower, it remains to be seen whether asset values will have to adjust.

Conclusion
From financial first principles, there is nothing inherently good or bad about debt. It is a source of financing that you can use to build a business, but by itself, it neither adds nor detracts from the value of the business. It is the addition of tax benefits and bankruptcy costs that makes the use of debt a trade off between its benefits (primarily tax driven) and its costs (from increased distress and agency costs). The new tax code has not removed the tax benefits of debt but it has substantially reduced them, and we should expect to see less debt overall at companies, as a consequence. In my view, that is a positive for the economy, since debt magnifies economic shocks to businesses and not only creates more volatile earnings and value, but deadweight costs for society.

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Saturday, January 27, 2018

January 2018 Data Update 7: Growth and Value

I have spent the last few posts trying to estimate what firms need to generate as returns on investments, culminating in the cost of capital estimates in the last post. In this post, I will look at the other and perhaps more consequential part of the equation, by looking at what companies generate as profits and returns. Specifically, as I have in prior years, I will examine whether the returns generated by firms are higher than, roughly equal to or lower than their costs of capital, and in the process, answer one on the fundamental questions in investing. Does growth add or destroy value?

Profitability

The simplest and most direct measures of profitability remain profit margins, with profits scaled to revenues for most firms. That said, there are variants of profit margins that can be computed depending on the earnings measure used:

At the risk of stating the obvious, the margins you compute will look larger and healthier, for any firm, as you climb up the income statement. As to which of these various measures of profitability you use, the answer depends on the following:

What are you trying to value? If your focus is on just equity investors and you are either doing a DCF built around equity cash flows (Dividends or Free Cash Flow to Equity) or using an equity multiple (PE, Price to Sales or Price to Book), your focus will be on profits to equity investors, i.e,, net margin. In a DCF valuation built around pre-debt cash flows (FCFF) or if you are working with enterprise value multiples EV/FCFF, EV/EBITDA or EV/Sales), your focus will shift to income prior to interest expenses, leaving you with a choice between operating income and EBITDA multiples.
What are you trying to measure? If you are attempting to compare production efficiency across firms, the gross margin is your best measure, because it looks at the profits you will generate, per unit sold, after you have covered the direct cost of production. If you are attempting to compare operating efficiency, at the business level, the operating margin is a better device. That is because for companies that have to spend substantially on sales, marketing and other structural operating costs, the operating income can be substantially lower than the gross income. The net margin is almost never a good measure of operating efficiency, simply because it is affected significantly by how you finance your business, with more debt leading to lower net profits and net margins.
Where are you in the life cycle? I use the corporate life cycle as a vehicle for talking about transitions in companies, from the right type of CEO for a firm to which pricing metric to use. The profit margins you focus on, to measure success and viability, will also shift as a company moves through the life cycle:
What are you selling? For better or worse, business people who are seeking your capital try to frame the profitability of their businesses by pointing to the profit margins. Since margins look better as you move up the income statement, business promoters are more inclined to use gross and EBITDA margins to make their cases than after-tax operating or net margins. While that is perfectly understandable, and even justifiable, for a young company that is scaling up (see life cycle bullet above), it is a sign of desperation when companies continue to point to gross margins as their measures of profitability as they age.

With that long set up, let's look at the profitability of publicly traded companies around the world on three dimensions: across time, across companies and across sectors. At the start of 2018, as I have in prior years, I computed gross, EBITDA, operating (pre and post-tax) and net profit margins for every publicly traded company in my sample. The distribution of net and pre-tax operating margins, across all companies globally, can be seen below:

Not only are there no surprises here, but it is not easy to use this cross sectional distribution to pass judgment on your company's relative profitability for a simple reason. The median operating margin across all companies is 4.16% bu it varies widely across different businesses, partly because of differences in operating structure and scaleablity, partly because of competition and partly because of differences in the use of financial leverage (at least for net margins. The picture below reports gross, operating and net margins, by sector, for global companies at the start of 2018:

Download spreadsheet with all margin data

I find profit margins to be extraordinarily useful, when valuing companies, both for comparison purposes and as the basis for my forecasts for the future. If you look at almost every valuation that I have done on this blog or in my classes, a key input that drives my forecast of earnings in future years is a target margin (either operating or net). It is also the metric that lends itself well to converting stories to numbers, another obsession of mine. Thus, if your story is that your company will benefit from economies of scale, I reflect that story by letting its operating margins improve over time, and if your narrative is that of a company with a valuable brand name, I endow it with much higher operating margins than other companies in the sector, but there is one limitation of profit margins. If your focus is on answering the question of whether your company is a "good" or a "bad" company, looking at margins may not help very much. There are "low-margin" good companies, like Walmart, that make up for low margins with high sales turnover and "high-margin" bad companies, that invest a great deal and sell very little, with many high-end retailers and manufacturers falling into this grouping. It is to remedy these problems that I will turn to measuring profitability with accounting returns, in the next section.

The Excess Return Picture - Global

Unlike profit margins, where profits are scaled to revenues, accounting returns scale profits to invested capital. Here, while there are multiple measures that people use, there are only two consistent measures. The first is to scale net income to the equity invested in a company, measured usually by book value of equity, to estimate return on equity. The other is divide operating income, either pre-tax or post-tax, by the capital invested in a company, to estimate return on invested capital. While you will see both in user, there are two key factors that should color which one you focus on and how much to trust that number.

Claimholder Consistency: As to which measure of accounting return you should use to measure investment quality, the answer is a familiar one. It depends on whether you are measuring returns from an equity or from a business perspective:
Accounting Numbers: The first is that no matter how carefully you work with the numbers, the return on equity and return on capital are quintessentially accounting numbers, with both the numerator (earnings) and denominator (book value of equity or invested capital) being accounting numbers.

Consequently, any accounting actions, no matter how well intentioned, will affect your return on invested capital. For instance, an accounting write off of a past investment will reduce book value of both equity and invested capital and increase your return on capital. If you want to delve into the details, my condolences, but you can read this really long, really boring paper that I have on measurement issues with the return on equity and capital.

Since accounting returns can vary, depending upon your estimation choices, it is important that I be transparent in the choices I made to compute the returns for the 43,884 firms in my sample:

Once I have the measures of these returns, I can compare them with the costs of equity and invested capital that I have estimated already for these companies to estimate excess returns (ROIC - Cost of Capital) for each firm. The distribution across all firms is reported below:

With all the caveats about accounting returns in place, this comparison is one of the most important ones in valuation and finance, for a simple reason. If the accounting return is a good measure of what you actually earn on your invested capital, and the cost of capital is the rate of return that you need to make on that invested capital to break even, a "good" company should generate positive excess returns, a "neutral" company should earn roughly its cost of capital and a " bad" company should have trouble earning its cost of capital. Using 2017 numbers, 22,062 companies, representing 61.7% of the 35,738 companies that I was able to estimate returns on capital for, would have fallen into the "bad" company category. It is true that my accounting returns are based upon one year's earnings, and that even good companies have bad years, and using a normalized return on capital (where I use the average return on capital earned over 10 years) does brighten the picture a bit:

Note, that this is a comparison biased significantly towards finding good news, since by using a ten-average for the return on invested capital, I am reducing my sample to 14,502 survivor firms, more likely to be winners than losers. Even in this more optimistic picture, 2524 firms (30.2%) earn less than the cost of capital and have done so for a decade. Put simply, there are lots of companies that are bad companies, either because they are in bad businesses or because they are badly managed, and many of these companies have been bad for a long time. If there is a better reason for pushing for stronger corporate governance and more activist investors, I cannot think of it.

Exploring the Differences in Returns

As you digest the bad news in the cross section, if you are a manager or investor, you are probably already looking for reasons why your company or business is the exception. After all, excess returns can vary across parts of the world, different business or company size. It is in pursuit of that variation that I decided to look at excess returns, broken down on these dimensions.

1. Geographical

Are companies in some parts of the world likely to earn better returns on investments than others? Generally, you would expect companies in markets that are more protected from competition (either domestic or global) to do better than companies in markets where competition is fierce. In the table below, I look at excess returns, broken down by region:

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Sub Group	Number of firms	Return on Capital	Cost of Capital	ROIC - Cost of Capital	% with +ve Excess Returns
Africa and Middle East	2,277	5.88%	8.76%	-2.88%	34.55%
Australia & NZ	1,777	4.71%	7.97%	-3.26%	31.88%
Canada	2,850	5.69%	8.39%	-2.70%	19.07%
China	5,552	5.11%	8.13%	-3.02%	45.57%
EU & Environs	5,399	5.50%	7.74%	-2.24%	43.80%
Eastern Europe & Russia	558	9.63%	9.03%	0.60%	41.67%
India	3,511	10.33%	8.96%	1.38%	40.24%
Japan	3,755	5.63%	7.74%	-2.11%	45.06%
Latin America & Caribbean	880	6.68%	8.80%	-2.12%	43.63%
Small Asia (wo China, India & Japan)	8,630	7.21%	9.33%	-2.12%	32.60%
UK	1,412	5.53%	7.78%	-2.24%	47.62%
United States	7,247	6.75%	7.50%	-0.75%	36.41%

If you are holding out hope that your region is the exception to the rule, this table probably dispels that hope. One of the two regions of the world where companies earn more than their cost of capital is India, which the cynics will attribute to accounting game playing, but may also reflect the protection from competition that some sectors in India, especially retail and financial services, have been offered from foreign competition. The sobering note, though, is that as India opens these sheltered businesses up for competition, these excess returns will come under pressure and perhaps dissipate. It is interesting that the other part of the only other region of the world where companies earn more than their cost of capital is Eastern Europe and Russia, where competitive barriers to entry remain high. China, the other big market in terms of population, does not seem to offer the same positive excess returns, and that should be a cautionary note for those who tell the China story to justify sky high valuations for companies growing there. With US companies, the returns on capital reflect the effective tax rate paid last year (about 26%) and, if you hold all else constant, you should see an increase in the return on capital in 2018, a point I made in my post on taxes.

2. Business or Sector

It stands to reason that it is easier to earn excess returns in some businesses than others, mostly because there are barriers to entry. Thus, you should expect businesses built on patents and exclusive licenses to offer more positive excess returns than businesses where there are no such barriers. To examine differences across sectors, I looked at excess returns, by sector, for US companies, in January 2018, and classified them into good businesses (earning more than the cost of capital) and bad businesses (earning less than the cost of capital). While the entire sector data is available for both US and Global companies, the list below highlights the non-financial service sectors that earn less than the cost of capital:

Industry Name	ROC	Cost of Capital	(ROC - WACC)
Electronics (Consumer & Office)	-5.54%	7.67%	-13.21%
Oil/Gas (Production and Exploration)	0.09%	7.76%	-7.67%
Oil/Gas (Integrated)	2.15%	8.45%	-6.30%
Green & Renewable Energy	1.94%	5.77%	-3.83%
Shipbuilding & Marine	4.88%	8.26%	-3.38%
Real Estate (Development)	2.27%	5.21%	-2.93%
Insurance (General)	2.82%	5.38%	-2.55%
R.E.I.T.	3.08%	4.43%	-1.35%
Real Estate (General/Diversified)	4.32%	5.58%	-1.26%
Auto & Truck	3.97%	5.06%	-1.09%
Oilfield Svcs/Equip.	6.42%	7.44%	-1.02%
Telecom (Wireless)	5.43%	5.72%	-0.29%

Some of the sectors that fall into the bad business column did not surprise me, since they have been long standing members of this club. The automobile and shipbuilding businesses have been bad businesses,almost every year that I have looked at it for the last decade. Some of the sectors on this list will attribute their place on the list to macro concerns, with oil companies pointing to low oil prices. There are still others, though, that are recent entrants to this club, and represent the dark side of disruption, where their businesses have been altered by either technology or new entrants. The electronics business is one example, where margins have collapsed and returns have followed The telecommunications business, was for long a solid business, where big infrastructure investments were funded with debt, but the companies (whether they be phone or cable) were able to use their quasi or regulated monopoly status to pass those costs on to their customers, but it has now slipped into the bad business column, as technology has undercut its monopoly powers. With financial service firms, where the excess returns are better measured by looking at the difference between ROE and cost of equity, the excess returns remain positive for the moment, but the future hold sthe terrifying prospect of unbridled competition from the fin tech startups.

3. Size

Are smaller companies likely to earn larger or smaller excess returns than large companies? I could tell you stories that can answer this question differently, but the answer lies in the numbers. I broke global companies down into deciles, based upon market capitalization, to see if I could eke out some answers:

Market Cap Class	Number of firms	Return on Capital	Cost of Capital	ROIC - Cost of Capital	% with +ve Excess Returns
Smallest	4,384	-8.37%	8.38%	-16.75%	9.97%
2nd decile	4,366	-9.71%	8.71%	-18.42%	14.13%
3rd decile	4,388	-3.93%	8.53%	-12.46%	20.58%
4th decile	4,399	-0.34%	8.38%	-8.72%	27.66%
5th decile	4,387	2.15%	8.32%	-6.17%	32.86%
6th decile	4,384	3.94%	8.27%	-4.33%	39.65%
7th decile	4,384	2.74%	8.07%	-5.33%	44.30%
8th decile	4,386	5.50%	8.05%	-2.55%	48.22%
9th decile	4,385	6.08%	7.90%	-1.81%	54.12%
Largest	4,385	5.75%	7.48%	-1.73%	62.24%

For proponents of small companies, the results in this table are depressing. Small companies constantly earn much more negative excess returns than large companies. In fact, the largest companies earn positive excess returns, and while I am loath to make too much of one year's results, and recognize that there is some circularity in this table (since the companies with the highest excess returns should see their values go up the most), there is reason to believe that in more and more sectors, we are seeing winner-take-all games played out, where a few companies win, and find it easier to keep winning as they get larger. The Amazon phenomenon, which has so thoroughly upended the retail business, seems to be coming to other businesses as well. It also has implications for investing, and specifically for small cap investing, where investors have historically earned a return premium. The disappearance of this small cap premium, that I have pointed to in this post, may be a reflection of the changing business dynamics.

4. Growth

The excess returns that we computed are particularly relevant when we think about growth, since for growth to create value, it has to be accompanied by excess returns. If more than 60% of companies have trouble earning their cost of capital, it follows that growth in a company is more likely to destroy value than to add to it. If companies are taking this maxim to heart and responding accordingly, you should expect to see companies with the highest growth also have the most positive excess returns and the companies that are shrinking or have the lowest growth to be the ones that have the most negative returns. I broke companies down into deciles, based upon revenue growth over the last five years, and looked at excess returns, by decile:

Growth Class	Number of firms	Return on Capital	Cost of Capital	ROIC - Cost of Capital	% with +ve Excess Returns
Lowest Growth	2,796	1.68%	8.65%	-6.98%	10.04%
2nd decile	2,823	6.03%	8.48%	-2.46%	21.47%
3rd decile	2,814	5.60%	8.07%	-2.48%	30.79%
4th decile	2,803	6.33%	7.88%	-1.54%	36.72%
5th decile	2,815	4.93%	7.94%	-3.01%	44.19%
6th decile	2,808	6.39%	7.97%	-1.58%	49.17%
7th decile	2,816	6.44%	8.06%	-1.62%	52.35%
8th decile	2,766	6.59%	8.09%	-1.50%	53.27%
9th decile	2,850	4.13%	8.22%	-4.09%	53.76%
Top decile	2,821	9.54%	8.20%	1.33%	45.49%

There is a semblance of good news in this table. Companies in the highest growth class have the most positive excess returns, but as you can see in the table, the results are mixed as you look at the other deciles. The excess returns, in deciles six through nine are about as negative as excess returns, in deciles two through five. It behooves us, as investors, to be wary of growth in companies.

Conclusion

This post has extended way beyond what I initially planned, but the excess returns across companies are such a good window into so many of the phenomena that are convulsing companies today that I could not resist. Not only do the numbers here cast as a lie the notion that growth is always good, but they also let us see how disruption is changing businesses around the world. If there is a common theme, it is that change is now par for the course in almost every business and that inertia on the part of management can be devastating. As I look, in my next two posts, at how companies set debt ratios and decide how much to pay in dividends, where policy seems to be driven by inertia and me-toois, do keep this in mind.

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Friday, January 26, 2018

January 2018 Data Update 6: A Cost of Capital Primer

I have long described the cost of capital as the Swiss Army Knife of finance, since it shows up in so many places in finance, albeit in different forms. In corporate finance, it is not only the cost of raising funding for a business but also the hurdle rate to use in capital budgeting and an optimizing tool for capital structure and dividend policy. In valuation, it is the discount rate that we use to value a business and the only mechanism for incorporating the risk of a business into its value. Along the way, it picks up a variety of other names that are used to describe it (with my least favorite one being the WACC acronym) and gets confused or used interchangeably with the cost of equity. In short, it is not surprising that there seems to be little consensus on how to estimate the cost of capital for a business.

The Cost of Capital: Definition

It is unfortunate that the name that we have attached to this ubiquitous number is the cost of capital, since it seems to suggest that it is the cost of raising funding for a company. While that definition may sometimes fit, it often leads to destructive consequences, where companies that are safe and can raise equity or borrow money at low rates (and hence have a low cost of funding) think that they are adding value when they go out and take risky investments that earn more than that cost. A company that has a 5% cost of capital is not always adding value if it takes an investment that generates an 8% return, if the investment is risky enough to require a much higher return. A healthier definition of the cost of capital is to think of it as an opportunity cost, i.e., a rate of return that you (as an investor or by extension, a company that the investor has put money in) can make on an investment of equivalent risk. The key words in this definition are "equivalent risk", because that effectively eliminates the subsidy mistake that occurs when a safe company's cost of capital is used to justify taking a risky investment. This is, of course, one of the first principles of finance and it is astonishing that it is open for debate and that so many companies violate it, in their practices. If you are skeptical of my claim, consider the following manifestations of this malpractice:

Many multi-business companies continue to have a "single" hurdle rate in capital budgeting: In a survey of "best" practices across companies and advisors, the authors note that almost half of all companies (and advisors) surveyed used a single cost of capital across all investments. That is not only not good practice, but over time, it will ensure that your entire company will become a riskier company that takes bad investments. While I appreciate the work that went into this survey, I would suggest that the authors seriously reconsider using the word "best" to describe many of the horrendous practices that companies use in computing cost of capital. Looking at surveys of how companies compute costs of capital around the world, it seems clear to me that bad practices drive out good ones, a manifestation of Gresham's law in corporate finance practice.
In acquisitions, it is routine for companies (and bankers) to use the acquiring company's cost of capital to value the target company: While I cannot point to surveys to back up this statement, in my experience, this happens in more than 60% of acquisitions, with the logic being that it is the acquiring firm that raises the capital and that its costs should therefore be covered. The fact that will lead safe firms to find any risky firm that they look at to be cheap is glossed over. If you are waffling, let me be absolutist. Valuing a target company using an acquiring company's cost of capital is valuation malpractice, and if you do it, you should be stripped of your license to do valuation.
Cash is viewed as a value destroying asset: If you follow GAAP or IFRS, for an asset to be categorized with cash and short term investments, it has to be invested in liquid and close to riskless assets. In the last decade, these investments, not surprisingly, have generated extraordinarily low returns, but it is true, no matter what interest rate environment you are in, that cash will earn lower returns than operating investments. There are analysts, and I use the word loosely, who compare the returns generated on cash to the cost of capital of the firm to conclude that cash is a value-destroying asset and that it should be returned. While there are legitimate arguments that can be made that companies should return cash to stockholders, this is not one of them. In fact, cash, if invested in treasury bills or commercial paper, is a value-neutral investment, earning exactly the return that you need it to earn, given its liquid, diskless status.
A company that earns a higher return on its projects (higher ROIC) should be valued more highly than a company that earns a lower return on its projects: Without controlling for risk, this is not true. In fact, the right assessment would require comparing the ROIC to the cost of capital to estimate an excess return and a company that earns a higher positive excess return should be valued more highly than one that earns a lower excess return.

The key, then, to estimating cost of capital is to to link it directly to a risk measure that can be computed not just for entire companies but for individual projects. It is that pursuit that will drive my estimation process for cost of capital, described in the next section.

The Cost of Capital: Estimation Process

There are ultimately only two ways of raising funds to finance a business. One is to borrow the money (debt) and the other is to use your own money (equity). This is captured in one of my favorite corporate finance devices, the financial balance sheet:

With a small private business, the debt will take the form of a bank loan and the equity will be your savings, but as businesses scale up, debt may expand to include corporate bonds and equity may transition to venture capital, private equity and publicly traded stock. The structure also allows us to boil the cost of capital down to its three ingredients: a cost of equity, an after-tax cost of debt and the weights to attach to the two.

Cost of equity

The End game: In principle, the cost of equity is the rate of return that equity investors in your business need to make to compensate for the risk that they are exposed to.

The Practice: For the last few decades, corporate finance has tried, with mixed success, to devise a risk and return model to estimate the cost of equity. While these models vary in complexity and inputs, they generally share a common theme. They estimate the cost of equity to the marginal investors in the business, i.e., investors who own and trade large blocks of shares, and assume that these investors are diversified. These models all share a common structure; they start with a risk free rate and then estimate a risk premium for an investment, by measuring its relative risk (on one or more market risk factors) and the price of risk or risk premiums (for these factors). While it is the subject of substantial abuse, the capital asset pricing model continues to be the default model that most practitioners use in estimating cost of equity. The resulting inputs are shown below:

I still use the capital asset pricing model in my valuations and I offer no apologies for doing so, since I find it simple, intuitive and at least as effective as the next best alternative models, most of which add more complexity and deliver little in results. For those who are truly disturbed by the CAPM's limitations, there is an alternative approach worth considering that is agnostic in its assumptions about investor diversification and risk aversion. It is to back out the "implied" cost of equity for stocks within a sector and to use that implied number as the cost of equity in individual companies. If you are puzzled about what this implies, take a look at how I estimated the implied equity risk premium for the S&P 500 in my second data post from a couple of weeks ago and consider extending that approach to the banking index, to get an implied cost of equity for banks, and the energy sector, to estimate the cost of equity for oil companies.

Cost of Debt

The End Game: The cost of debt for a firm is the rate at which it can borrow money, long term and today. The after-tax cost of debt is this borrowing rate, adjusted for any tax benefits that accrue to borrowing money.

The Practice: By defining the cost of debt as a current cost of borrowing, rather than the rate at which the firm has borrowed money in the past, I have simplified my estimation problem, since the cost of debt can then be written as the sum of the riskless rate and a default spread, reflecting the company's credit risk:

Pre-tax cost of debt = Risk free Rate + Default Spread for the Company

To estimate the default spread, you can use one of three approaches, in order of ease.

If the firm in question has corporate bonds outstanding, you can use the interest rate on the bond as your pre-tax cost of debt for the firm since it is a current, market-set rate.
If a firm has corporate bonds and they are not traded enough or have features that skew the interest rate, you can use the bond rating for the company to estimate a default spread.
If the firm has neither bonds nor a rating, a combination that holds for most companies, I would assess a "synthetic rating" for the company, based upon the strength of its financials and its capacity to repay debt.

To bring the tax benefit of debt into the after-tax cost of debt, you should use the marginal tax rate, since interest expenses save you taxes at the margin:

After-tax cost of debt = (Risk free Rate + Default Spread) (1- Marginal Tax Rate)

This cost of debt will be much lower than your cost of equity, for almost all firms.

Debt & Equity Weights

Market or Book? This choice, at least for me, is an easy one. The cost of capital is a measure for what it will cost you to raise money to fund the business, investment or project today, and since you can raise money only at market value, it is the only relevant number.

Current or Target? This is an argument that often consumes analyst time and often misses the point. It is true that the debt ratio for a company can change over time, and if management does have a target, the actual debt ratio may move to the target. Unless this change is instantaneous, it is likely to occur over time and my answer to the question is to use the current debt ratio to estimate the cost of capital at the start of the investment and as the debt ratio is changed over time to the optimal, to change the cost of capital as well.

Cross Sectional Estimation

In choosing my estimation approach to getting cost of capital, do keep in mind that there are 43,848 firms in my sample and since looking at each one individually is out of the question, I will have to make some bludgeon assumptions (that I would not have made if I were estimating the cost of capital for an individual company). The table below summarizes my estimation choices, with the limitations of each:

	Estimation Approach used	Possible limitations
Risk Free Rate	US T.Bond Rate	Cost of equity estimated in US dollars.
Beta	Started with unlevered beta for sector & levered up using company's D/E (including leases as debt)	Used only the primary business that the company was in. With multi-business companies, I am missing the effect of oither businesses on beta.
ERP	ERP of country that the company is incorporated in.	If company operates in other countries, the ERP should be a weighted average.
Default Spread	Used bond rating, if available, to estimate the default spread. Used interest coverage ratio to estimate ratings and default spread, otherwise.	Interest coverage ratios may not capture default risk fully, Bringing in other ratios might have provided more refined estimate.
Marginal tax rate	Use the statutory tax rate of the country in which the company is incorporated.	If company operates in many countries, it may be able to place its debt in a country with the higher marginal tax rae.
Weights	Current market value of equity and debt (including leases) used for weights.	Insufficient information to estimate market value of interest-bearing debt.

If you want to estimate the cost of capital, using more refined estimates (country weightings for ERP and business mixes for betas), you are welcome to try my cost of capital calculator. If you are working in another currency, converting my estimates of cost of capital to an alternate currency should be a simple exercise of adding the differential inflation rate between the currency in question and the US dollar to my estimate.

The Cost of Capital - Going Concern Concept

There is one important caveat to add about cost of capital specifically and discount rates, in discounted cash flow valuations, more generally. In a discounted cash flow valuation, we are implicitly assuming that the business that we are valuing is a going concern that will either survive for a long time or is on its path to a specified and clearly determined liquidation point.

So what? The reality is that business is risky and the essence of risk is that it can sometime deal out bad enough outcomes to put a company out of business. With a young start up, this may take the form of running out of cash and access to capital. With a declining company, it can be the failure to make a debt payment and the resulting financial distress. With a bank, it can take the form of a drop in regulatory capital below levels acceptable to the regulatory authorities and a shutting down of the bank. With an emerging market company, even a healthy company may see its survival threatened by a nationalization. These are risks that I call truncation risks and analysts often struggle with how best to bring them into value. One path that they try is to push discount rates (or costs of capital) higher for companies that face significant amounts of truncation risk, but discount rates are blunt instruments for dealing with this type of risk and my suggestion is that you not try to adjust them for the risk. Instead, you should consider using a decision tree front on your valuation, where you can bring in your truncation risk concerns separately from your DCF. With a distressed firm or start up, for instance, where you worry about survival risk, the decision tree will look as follows:

This will not only relieve you of the stress of trying to adjust discount rates for risk that they were never meant to convey but will allow you to focus on the truncation risk more directly. Thinking about the probability that you will not survive as a firm and what you will get, if you don't, is a much healthier exercise than arbitrarily pushing up your discount rate another 2%, because you feel the firm is riskier.

The Cost of Capital - Perspective

The cost of capital discussion is permeated with rules of thumb about what comprises reasonable, high or low numbers, many developed in a different time, and for a different market. These rules of thumb skew estimates, since analysts feel the urge to adjust the costs of capitals that they get from models or metrics to match their preconceptions about what they should be. It is my primary objection to the build-up approach for the cost of capital, where analysts add multiple premiums (small cap, illiquidity, company specific) to arrive at a cost of capital that matches what they would have liked to see in the first place. It is to counter this temptation that I will compute costs of capital for US and global companies and present both sector averages as well as the entire distributions for the market.

US Companies

To provide perspective on what the cost of capital for the median US company will look like, start with the US 10-year T.Bond rate of 2.41% on January 1, 2018, as the risk free rate and my estimate of the implied ERP of 5.08% for the US on the same date. For an average risk stock, with a beta of one, that would translate into a cost of equity of 7.49%. Bringing in the debt ratio of 23.51% for the typical US firm and a pre-tax cost of debt of 3.91% (1.5% higher than the risk free rate), results in a cost of capital of 6.43%, if we use the marginal tax rate of 24%, post tax reform:

Cost of capital for median US firm = (2.41%+5.08%)(1-.2351)+3.91%(1-.24) (.2351) = 6.43%

Using the sector-specific debt ratios and betas yields costs of capital for US companies in individual sectors and the resulting costs of capital are reported in the table below:

Download full sector cost of capital spreadsheet

You can download the spreadsheet with the details of the cost of capital calculation by clicking on the link below. There is information in the company-specific costs of capital estimates that I have for 7.247 US firms in my sample that I try to capture in a histogram:

To the question of what comprises a high, low or average cost of capital, I would offer the deciles for the cost of capital estimation in 2018, also shown in the histogram.

Global Companies

I estimate the costs of capital for global companies, in US dollars, and using the same template that I use for the US. There are two key differences. The first is that I shift from using the US ERP of 5.08% to a GDP-weighted global average ERP of 6.20%, from a US-average debt ratio of 23.51% to to a global-average debt to capital ratio of 26.67%, from a pre-tax cost of debt of 3.91% to 4.91% (reflecting country default risk) and from a marginal tax rate of 24% to a weighted average of 24.63%. The resulting cost of capital for a median global firm is higher than for the US:

Cost of capital for median global firm = (2.41%+6.20%)(1-.2667)+4.91%(1-.2463) (.2667) = 7.30%

As with the US data, I compute sector averages, using sector average betas and debt ratios and the results are summarized in the picture below:

Download full sector cost of capital spreadsheet

Finally, the distribution of costs of capital across global companies are captured in the histogram, with deciles specified:

Here again, I would use this distribution to make judgments of what a high, low or average cost of capital would look like in January 2018, and adding inflation differentials would provide analogous numbers in other currencies.

The Conclusion

Notwithstanding the length of this post, and the ones leading up to it, I do not believe that the cost of capital is the biggest driver of the value of companies. When you make mistakes in valuation, it is almost always true that the big mistakes are in your cash flow and growth estimates, rather than in your cost of capital. This is especially true when you value young companies, and it is one reason that I am almost casual in my choice of costs of capital in my valuation of Twitter, Uber and Snap, where I have attached costs of capital reflective of the 90th percentile in risk. It is true that as companies mature, the cost of capital becomes a more critical input, but even in these valuations, I would argue that if you are spending more than 20% to 25% of your time estimating it, you have lost your way.

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Thursday, January 25, 2018

January 2018 Data Update 5: Country Risk Update

In my last post, I looked at the currency confusions that globalization has brought into financial analysis, and how to clean up for them. In this post, I discuss the other aspect of globalization that is forcing analysts to change long accepted practices in estimating equity risk premiums for companies. Taking what they have learned from finance textbooks blindly, practitioners have taken what they learned about equity risk premiums to emerging and frontier equity markets, often with disastrous results. Not only have they practiced denial when it comes to the additional risk that investors face in many markets, from political, economic and legal sources, but they have also considered risk by looking at where a company is incorporated, instead of where it does business. In this post, I will update my country risk measures for the start of 2018, and build on them to measure the equity risk premiums for companies.

Country Default Risk

The more widely measured and accessible measures of sovereign risk are related to sovereign default, and as we noted in the post on currency risk free rates, there are three ways in which default risk in countries can be measured. The first is to use government bonds, denominated in US dollars or Euros, issued by sovereigns and to compare the rates on these bonds to a US treasury or German Euro bond rate. The second is to use the sovereign CDS spreads for countries, market-driven numbers, as default risk measures. The third is to use the sovereign ratings of countries as proxies of default risk and to convert these ratings to default spreads.

1. Sovereign Rating/Spread

The leading ratings agencies including S&P, Moody’s and Fitch have long since expanded their business of rating bonds for default risk from corporations to looking at entire countries. These “sovereign” ratings are estimated on both foreign currency and local currency terms, with the ratings spectrum ranging from Aaa to D, just as with corporate bonds. One way of capturing the default risk variations across the world is with a heat map, based upon local currency sovereign ratings:

via chartsbin.com

Note that while there are clear differences across regions, with Latin America and Africa containing more risky (red) areas than Europe and North America, there are also differences within regions. You can download the S&P and Moody's ratings, by country, at the start of 2018, by clicking on this link.

2. Sovereign CDS Spreads

While sovereign ratings provide accessible measures of default risk in countries, they come with limitations. The ratings agencies are not only sometimes wrong in their default risk assessments, but they are often late in reassessing default risk (and sovereign ratings), when conditions change quickly in countries. It is these weaknesses that are remedied, at least partly, by the sovereign credit default swap (CDS) market, where investors can buy insurance against sovereign default. The market-set prices for sovereign credit default swaps provide updated measures of default risk, at least for the 70 countries that they exist for, and the levels of these spreads are in the table below:

Download spreadsheet

I don’t want to oversell these CDS spreads as better proxies of default risk. While they are certainly more dynamic and reflective of current risk that sovereign ratings, they are market numbers and like all market numbers, they are volatile and reflect market mood and momentum, as much as they do fundamentals.

Country Equity Risk

Sovereign or country equity risk measures are more difficult to come by than sovereign default spreads. First, there are services that try to measure the political and economic risk in countries with scores, albeit with no standardization. Second, the default risk measures can be converted into equity risk measures by scaling them for the additional risk in equities.

a. Risk Scores

The World Bank, Political Risk Services (PRS) and the Economist, among others, try to measure the total risk in countries. Those scores have no standardization and cannot be compared across services, but they still represent more comprehensive measures of risk than sovereign ratings or CDS spreads. In the heat map below, you can see the country risk scores reported by PRS, with higher scores indicating lower risk.

via chartsbin.com

Comparing this picture to the sovereign ratings map, there are clearly overlaps, where the country risk scores from PRS and the ratings deliver the same message; Latin America, Eurasia and Africa remain high risk zones and European countries have lower risk.

b. Equity Risk Premiums

The problem with risk scores is that they cannot be easily converted into risk premiums to use in cost of equity calculations. It is to overcome this problem that I return to sovereign default spreads, not as measures of equity risk, as is often the practice, but to use them as starting points for measuring the equity risk in countries. In particular, I estimate the relative equity market volatility, computed by scaling the volatility or standard deviation in equity to the standard deviation of government bond, and use that to scale up sovereign default risk to sovereign equity risk:

Using this approach does require traded government bonds, available for only a handful of countries. To generalize this approach, I use the ratio of the volatility in an emerging market equity index to the volatility of an emerging market government bond index, using the most recent five years of data. That ratio, which is 1.12 at the start of January 2018, is used to convert sovereign default spreads to country risk premiums.

These country risk premiums, when added to the implied US equity risk premium of 5.08%, yield equity risk premiums for countries. The picture below summarizes equity risk premiums around the world.

via chartsbin.com

If the heat map does not provide enough specifics, this picture may be better:

Finally, if you prefer the data as a table, you can download the spreadsheet with the data or my more detailed country risk premium dataset.

Company Equity Risk

A company's risk does not come from where it is incorporated, but where it does business. If we adopt this perspective, it is clear that to value a company, you need to see its risk exposure to different countries, either because it has its production and operations in those countries or because it sells its products or services there. That risk exposure, in conjunction with the equity risk premiums of the countries estimated in the earlier section, can be used to compute the company's equity risk premium. To illustrate this concept, consider LATAM, the Chile-based airline. To compute its equity risk premium, I would compute the weighted average of the countries that LATAM derives revenues from which includes most of Latin America and the US. For companies like Coca Cola, which may be in too many countries for this approach to be easily applied or where the country breakdowns are not available, you can use regional equity risk premiums. In the table above, I report on the GDP-weighted average ERP for regions of the world. If you accept this rationale, the following implications follow:

A company cannot change its risk profile by delisting in one market and resisting in another: It is a common play for emerging market companies to delist on their "risky" local markets and to re-list on a more developed markets. While there are some good reasons for doing so, which can potentially increase value, like increased liquidity and transparency, one reason that does not stand up to scrutiny is that the company has become safer, just because of the listing change. A South African mining company that delists in Johannesburg and lists on the London Stock Exchange is still exposed to South African country risk, after the move.
A company's equity risk premium should change, as its geographic exposure changes: In estimating the equity risk premium for a company today, we need to consider where it operates today. If we expect that geographic mix to change over time, as it usually will, the equity risk premium that we use in future years should reflect these expected changes. And yes, that will mean that your cost of equity and capital can change over time. Welcome to globalization!
When multinationals assess projects, their hurdle rates should vary across geographies: When multinationals assess hurdle rates for projects, those hurdle rates should vary, depending upon where a project will be, even if the hurdle rates are estimated in the same currency. Thus, the US dollar cost of equity that Coca Cola should use for a Canadian beverage expansion should be far lower than the US dollar cost of equity for a Russian investment.

It is a pity that accounting disclosure requirements have been so focused on trivial matters that have little effect on value and have not really paid attention to the type of information companies should be disclosing to investors on geographic operations.

Conclusion

If, as the Chinese symbol (危机) for crisis suggests, danger plus opportunity equals risk, it is not surprising that the most risky parts of the world also often provide the most potential for growth. By demanding higher equity risk premiums for investing in these parts of the world, I am not suggesting that you hold back from investing in these risky regions, but only that you demand enough of a premium for exposing yourself to additional risk. After all, investing should never be bungee jumping, where you take risk for the sake of taking risk!

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