The Market is Huge! Revisiting the Big Market Delusion

For the high-profile IPOs that have reached the market in 2019, with apologies to Charles Dickens for stealing and mangling his words, it has been the best and the worst of years. On the one hand, you have seen companies like Uber and Slack, each less than a decade old, trading at market capitalizations in the tens of billions of dollars, while working on unformed business models and reporting losses. On the other, many of these new listings have not only had disappointing openings, but have seen their market prices drop in the months after. In September 2019, we did see an implosion in the value of WeWork, another company that started the listing process with lots of promise and a pricing to match, but melted down from a combination of self-inflicted wounds and public market scrutiny. While these companies were very different in their business models (or lack of them), they shared one thing in common. When asked to justify their high pricing, they all pointed to how big the potential markets for their products/services were, captured in their assessments of market size. Uber estimated its total accessible market (TAM) to be in excess of $ 6 trillion, Slack’s judgment was that it had 5 million plus prospective clients across the world and WeWork’s argument was that the commercial real estate market was massive. In short, they were telling big market stories, just as PC makers were in the 1980s, dot com firms in the 1990s and social media companies a decade later. In this post, we will start by conceding the allure of big markets, but argue that the allure can lead to delusional pricing. (This post is a not-so short summary of a paper that Brad Cornell and I have written on this topic. You can find it by clicking here.)

The Ingredients

There is nothing more exciting for a nascent business than the perceived presence of a big market for its products and services, and the attraction is easy to understand. In the minds of entrepreneurs in these markets, big markets offer the promise of easily scalable revenues, which if coupled with profitability, can translate into large profits and high valuations. While this expectation is not unreasonable, overconfidence on the part of business founders and their capital providers can lead to unrealistic judgments of future profits, and overly high estimates for what they think their companies are worth, in what I will term the “big market delusion”. That initial overpricing is a common feature of these markets, but results in an inevitable correction that brings the pricing back to earth. In fact, there are three pieces to this puzzle, and it is when they all come together that you see the most egregious manifestations of the delusion.

1. Big Market: It is the promise of a big market that starts the process rolling, whether it be eCommerce in the 1990s, online advertising between 2010 and 2015, cannabis in 2018 or artificial intelligence today. In each case, the logic of impending change was impeccable, but the extrapolation that the change would lead create huge and profitable markets was made casually. That extrapolation was then used to justify high pricing for every company in the space, with little effort put into separating winners from losers and good from bad business models. 
2. Overconfidence: Daniel Kahneman, whose pioneering work with Amos Tversky, gave rise to behavioral finance as a disciple described overconfidence as the mother of all behavioral biases, for three reasons. First, it is ubiquitous, since it seems to be present in an overwhelming proportion of human beings. Second, overconfidence gives teeth to, and augments, all other biases, such as anchoring and framing. Finally, there is reason believe that overconfidence is rooted in evolutionary biology and thus cannot be easily countered. The problem gets worse with big markets, because of a selection bias, since these markets attract entrepreneurs and venture capitalists, who tend to be among the most over confident amongst us. Big markets attract entrepreneurs, over confident that their offerings will be winners in these markets, and venture capitalists, over confident in their capacity to pick the winners. 
3. Pricing Game: We will not bore you with another extended discourse on the difference between value and price, but suffice to say that young companies tend to be priced, not valued, and often on raw metrics (users, subscribers, revenues). As a consequence, there is no attempt made to flesh out the "huge market" argument, effectively removing any possibility that entrepreneurs or the venture capitalists funding them will be confronted with the implausibility of their assumptions.

The end result is that young companies in big markets will operate in bubbles of overconfidence, leading them to over estimate their chances of succeeding, the revenues they will generate if they do and how much profit they can generate on these revenues:

This does not mean that every company in the big market space will be over priced, since a few will succeed and exploit the big market to full effect, but it does mean that the companies will be collectively over priced. As is always the case with markets, there will be a time of reckoning, where investors and managers will wake up to the reality that the big market is not big enough to accommodate all their growth dreams and there will be a correction. In the aftermath, there will be finger-wagging and talk of "never again", but the process will be repeated, albeit in a different form, with the next big market.

Case Studies

We will not claim originality here, since the big market delusion has always been part of market landscapes, and big markets have always attracted overconfident start ups and investors, creating cycles of bubble and bust. In this section, we will highlight three high profile examples:

1. Internet Retail in 1999

The Big Market: As the internet developed and became accessible to the public in the 1990s, the promise of eCommerce attracted a wave of innovators, from Amazon in online retail in 1994 to Ebay in auctions in 1995, and that innovation was aided by the arrival of Netscape Navigator's browser, opening up the internet to retail consumers and PayPal, facilitating online payments. New businesses were started to take advantage of this growing market with the entrepreneurs using the promise of big market potential to raise money from venture capitalists, who then attached sky-high prices to these companies. By the end of 1999, not only was venture capital flowing in record amounts to young ventures, but 39% of all venture capital was going into internet companies.

The Pricing Delusion: The enthusiasm that entrepreneurs and venture capitalists were bringing to online retail companies seeped into public markets, and as public market interest climbed, many young companies found that they could bypass the traditional venture capital route to success and jump directly to public listings. Many of the online retail companies that were listed on public markets in the late 1990s had the characteristics of nascent businesses, with small revenues, unformed business models and large losses, but all of these shortcomings were overwhelmed by the perception of the size of the eCommerce market. In 1999 alone, there were 295 initial public offerings of internet stocks, representing more than 60% of all initial public offerings that year. One measure of the success of these dot.com stocks is that data services created indices to track them. The Bloomberg Internet index was initiated on December 31, 1998, with a hundred young internet companies in it, and it rose 250% in the following year, reaching a peak market capitalization of $2.9 trillion in early 2000. Because the collective revenues of these companies were a fraction of that value, and most of them were losing money, the only way you could justify these market capitalizations was with a combination of very high anticipated revenue growth accompanied by healthy profit margins in steady state, premised on successful entry into a big market. 

The Correction: The rise of internet stocks was dizzying, in terms of the speed of ascent, but its descent was even more precipitous. The date the bubble burst can be debated, but the NASDAQ, dominated in 2000 by young internet companies, peaked on March 10, 2000, and in the months after, the pricing unraveled as shown in the collapse of the Bloomberg Internet Index:

The Bloomberg Internet Index

Of the dozens of publicly traded retail companies in existence in March 2000, more than two-thirds failed, as they ran out of cash (and capital access) and their business models imploded. Even those that survived, like Amazon, faced carnage, losing 90% of their value, and flirting with the possibility of shutting down. 

2. Online Advertising in 2015 & 2019

The Big Market: The same internet that gave birth to the dot com boom in the nineties also opened the door to digital advertising and while it was slow to find its footing, the arrival of search engines like Yahoo! and Google fueled its growth.  The advent of social media altered the game even more, as businesses realized that not only were they more likely to reach customers on social media sites, but that social media companies also brought in data about their users that would allow for more focused and effective advertising. The net result of all these innovations was that digital advertising grew in the decade from 2005 to 2015, both in absolute numbers and as a percent of total advertising:

As digital advertising grew, firms that sought a piece of this space also entered the market and were generally rewarded with infusions of capital from both private and public market investors.

The Pricing Delusion: In a post in 2015, I looked at how the size of the online advertising market skewed the companies of companies in this market, by looking at publicly traded companies in the space and backing out from the market capitalizations what revenues would have to be in 2025, for investors to break even. To do this, I made assumptions about the rest of the variables required to conduct a DCF valuation (the cost of capital, target operating margin and sales to capital ratio) and held them fixed, while Ie varied the revenue growth rate until I arrived at the current market capitalization. With Facebook in August 2015, for instance, here is what I estimated:

Put simply, for Facebook's market capitalization in 2015 to be justified, its revenues would have to rise to $129,318 million in 2025, with 93% of those revenues coming form online advertising. Repeating this process for all publicly traded online ad companies in August 2015:

Imputed Revenues in 2025 in millions of US $

The total future revenues for all the companies on the list totals $523 billion. Note that this list is not comprehensive, because it excludes some smaller companies that also generate revenues from online advertising and the not-inconsiderable secondary revenues from online advertising, generated by firms in other businesses (such as Apple). It also does not include the online adverting revenues being impounded into the valuations of private businesses like Snapchat, that were waiting in the wings in 2015. Consequently, we are understating the imputed online advertising revenue that was being priced into the market at that time. In 2014, the total advertising market globally was about $545 billion, with $138 billion from digital (online) advertising. Even with optimistic assumptions about the growth in total advertising and the online advertising portion of it climbing to 50% of revenues, the total online advertising market in 2025 comes to $466 billion. The imputed revenues from the publicly traded companies in August 2015 alone exceeds that number, implying that the companies in were being overpriced relative to the market (online advertising) from which their revenues were derived.

The Correction? The online ad market has not had a precipitous fall from the heights of 2015, but it has matured. By 2019, not only had investors learned more about the publicly traded companies in the online advertising business, but online advertising matured. Using the same process that we used in 2015, we imputed revenues for 2029 using data up through November 2019. Those calculations are presented in the table below:

Imputed Revenues in 2029 in millions of US $

There are signs that the market has moderated since 2015. First, the number of companies shrank, as some were acquired, some failed, and a few consolidated. Second, the market capitalizations had been recalibrated and starting revenues in 2019 are much greater than they were in 2015. As a result, the breakeven revenue in 2029 is $573 billion, only slightly higher than the imputed revenues from the 2015 calculation, despite being four years further into the future. This suggests that the market is starting to take account of the limits imposed by the size of the underlying market. Third, more of the companies on the list have had moments of reckoning with the market, where they have been asked to show pathways to profitability and not just growth numbers. Two examples are Snap and Twitter. For both companies the market capitalizations have languished because of the perception that their pathways to profitability are rocky. In short, if there is a correction occurring in this market, it seems to be happening in slow motion.

3. Cannabis in October 2018

The Big Market: Until recently, cannabis, in any of its forms, was illegal in every state in the United States in most of the world, but that is changing rapidly. By October 2018, smoking marijuana recreationally and medical marijuana were both legal in nine states, and medical marijuana alone in another 20 states. Outside the United States, much of Europe has always taken a more sanguine view of cannabis, and on October 17, 2018, Canada became the second country (after Uruguay) to legalize the recreational use of the product. In conjunction with this development, new companies were entering the market, hoping to take advantage of what they saw as a “big” market, and excited investors were rewarding them with large market capitalizations.  The widespread view as of October 2018 was that the cannabis market would be a big one, in terms of users and revenues. There were concerns that many recreational cannabis users would continue to use the cheaper, illegal version over the regulated but more expensive one, and that US federal law would be slow to change its view on legality. In spite of these caveats, there remained optimism about growth in this market, with the more conservative forecasters predicting that global revenues from marijuana sales will increase to $70 billion in 2024, triple the estimated sales in 2018, and the more daring ones predicting close to $150 billion in sales.

The Pricing Delusion: In October 2018, the cannabis market was young and evolving, with Canadian legalization drawing more firms into the business. While many of these firms were small, with little revenue and big operating losses, and most were privately owned, a few of these companies had public listings, primarily on the Canadian market. The table below lists the top ten cannabis companies as of October 14, 2018, with the market capitalizations of each one, in conjunction with each company’s operating numbers (revenues and operating income/losses, in millions of US $).

Cannabis Stocks on Oct 14, 2018 ($ values in millions of US$)

Note that the most valuable company on the list was Tilray with a market cap of over $13 billion. Tilray had gone public a few months prior, with revenues that barely register ($28 million) and nearly equal operating losses, but had made the news right after its IPO, with its stock price increasing ten-fold in the following weeks, before subsequently losing almost half of its value in the following weeks. Canopy Growth, the largest and most established company on the list, had the highest revenues at $68 million. More generally, all of them trade at astronomical multiples of book value, with a collective market cap in excess of $48 billion, more than 20 times collective revenues and 10 times book value. For each company, the high market capitalization relative to any measure of fundamental value was justified using the same rationale, namely that the cannabis market was big, allowing for huge potential growth. 

The Correction: In the of the cannabis market, the overreach on the part of both businesses and their investors caught up with them. By October 2019, the assumptions regarding growth and profitability were being universally scaled back, business models were being questioned, and investors were reassessing the pricing of these companies. The best way to see the adjustment is to look the performance of the major cannabis exchange-traded fund, ETFMG, over the period depicted in the figure below:

Note that within a period of approximately one year, cannabis stocks lost more than 50% of their aggregate value. The damage cut across the board. Tilray and Canopy Growth, the two largest market capitalization companies in the October 2019 saw their market capitalizations decline by 80.7% and 38.6% respectively. Given that there was no significant shift in fundamentals, the apparent explanation is that investors came to realize that the “big market” was not going to deliver the previously expected growth rates or the profitability for the expanding group of individual companies.

Common Elements

The three examples that we listed are in very different businesses and have different market settings. That said, there are some common elements that you see in all three, and will in any big market setting:

1. Big Market stories: In every big market delusion, there is one shared feature. When asked to justify the pricing of a company in the market, especially young companies with little to show in terms of fundamentals, entrepreneurs, managers and investors almost always point to macro potential, i.e., that the retail or advertising or cannabis markets were huge. The interesting aspect is that they rarely express the need to go beyond that justification, by explaining why the specific company they were recommending was positioned to take advantage of that growth. In recent years, the big markets have gone from just words to numbers, as young companies point to big total accessible markets (TAM), when seeking higher pricing, often adopting nonsensical notions of what accessible means to get to large numbers. 
2. Blindness to competition: When the big market delusion is in force, entrepreneurs, managers and investors generally downplay existing competition, thus failing to factor in the reality that growth will have to be shared with both existing and potential new entrants. With cannabis stocks in late 2018, much of the pricing optimism was driven by the size of the potential market in the United States, assuming legalization, but very few entrepreneurs, managers and investors seemed to consider the likelihood that legalization would attract new players into the market and that illegal sources of supply would maintain their hold on the market.
3. All about growth: When enthusiasm about growth is at its peak, companies focus on growth, often putting business models to the side or even ignoring them completely. That was true in all three of our case studies. With internet stocks, companies typically based their entire pricing pitch on how quickly they were growing. With social media companies, it took an even rawer form, with growth in users and subscribers being the calling cards for higher pricing. Investors, both private and public, not only went along with the pitch but often actively encouraged companies to emphasize growth at the expense of profits.
4. Disconnect from fundamentals: If you combine a focus on growth as the basis for pricing with an absence of concern at these companies about business models, you get pricing that is disconnected from the fundamentals. In all three case studies presented in this paper, at the peak of the pricing run up, most of the stocks in each group had negative earnings (making earnings multiples not meaningful), little to show in assets (making book value multiples difficult to work with) and traded at huge multiples of revenues. Put simply, the pricing losing its moorings in value, but investors who look at only multiples miss the disconnect.

The one area where the three case studies diverge is in how the pricing delusion corrects itself. For instance, the dot com bubble hit a wall in March 2000 and burst in a few months, as public markets corrected first, followed by private markets, but the question of why it happened at the time that it did remains a mystery. The online advertising run-up has moderated much more gradually over a few years, and if that trend continues, the correction in this market may be smooth enough that investors will not call it a correction. With cannabis stocks, the rise and fall were both precipitous, with the stocks tripling over a few months and losing that rise in the next few months.

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Implications
If the big market delusion is a feature of big markets, destined to repeat over time, it behooves us as entrepreneurs, managers, investors and regulators to recognize that reality and modify our behavior.
1. Entrepreneurs and Venture Capitalists
The obvious advice that can be offered to entrepreneurs and venture capitalists, to counter the big market delusion, is to be less over confident, but given that it is not only part of their make up but the driver for exploiting the big market, it will have little effect. Our suggestions are more modest. First, testing out the plausibility of your market size assumptions and the viability of the business model you plan to use to exploit the market on people, whose opinion you value but don't operate in your bubble, is a sensible first step. Second, when you get results from your initial business forays that run counter to what you expected to see, don't be quick to rationalize them away as aberrations. By keeping the feedback loop open, you may be able to improve your business model and adjust your expectations sooner, to reflect reality. Third, build in safety buffers into your model, allowing you to keep operating even if capital dries up (as it inevitably will when the correction arrives), by accumulating cash and avoiding cost commitments that lock you in, like debt and long term cost contracts. Finally, while you may be intent on delivering the metrics that are priced highly, such as users or subscribers, pay attention to building a business model that will work at delivering profits, and if forced to pick between the two objectives, pick the latter.

2.Public Market Investors
The big market delusion almost never stays confined to private markets and sooner or later, the companies in the space list on public markets and are often priced in these markets, at least initially, like they were in private markets. While a risk averse investor may feel it prudent to entirely avoid these stocks, there are opportunities that can be exploited:

• Momentum investors/traders: The big market delusion is one explanation for the momentum of young, growth stocks. When fascination with a big market like “transportation” takes hold, it can produce momentum in the prices of innovative companies in that space such as Uber and Lyft, and significant profits along the way. The risk, of course, is that the big market delusion fades and the market corrects as has happened in the case of both Uber and Lyft. As we have emphasized, however, there appears to be no way to time such corrections. 
• Value investors:  The  obvious advice is to avoid young, growth stocks whose value is based on big market stories. But that carries its own risk. In the twelve year stretch beginning in 2007, growth stocks have dramatically outperformed value stocks. As one example, during this period the Russell 1000 growth index outperformed the Russell 1000 value index by an astonishing 4.3% per year. That outperformance was driven in part by stories regarding how technology companies were going to disrupt or invent big markets from housing to entertainment to automobiles. There is a riskier, higher payoff, strategy. Since the big market delusion leads to a collective over pricing, value investors can bet against a basket of stocks (sell short on an ETF like the ETFMG) and hope that the correction occurs soon enough to reap rewards.

In sum, though, young companies make markets interesting and by making them interesting, they increase liquidity and trading.

3. Governments and Market Regulators 

In the aftermath of every correction, there are many who look back at the bubble as an example of irrational exuberance. A few have gone further and argued that such episodes are bad for markets, and suggested fixes, some disclosure-related and some putting restrictions on investors and companies. In fact, in the aftermath of every bursting bubble, you hear talk of how more disclosure and regulations will prevent the next bubble. After three centuries of futility, where the regulations passed in response to one bubble often are at the heart of the next one, you would think that we would learn, but we don't. In fact, over confidence will overwhelm almost every regulatory and disclosure barrier that you can throw up. We also believe that these critics are missing the point. Not only are bubbles part and parcel of markets, they are not necessarily a negative. The dot com bubble changed the way we live, altering not only how we shop but how we travel, plan and communicate with each other. What is more, some of the best performing companies of the last two decades emerged from the debris. Amazon.com, a poster child for dot com excess, survived the collapse and has become a company with a trillion-dollar market capitalization.  Our policy advice to politicians, regulators and investors then is to stop trying to make bubbles go away. In our view, requiring more disclosure, regulating trading and legislating moderation are never going to stop human beings from overreaching. The enthusiasm for big markets may lead to added price volatility, but it is also a spur for innovation, and the benefits of that innovation, in our view, outweigh the costs of the volatility. We would choose the chaos of bubbles, and the change that they create, over a world run by actuaries, where we would still be living in caves, weighing the probabilities of whether fire is a good invention or not.

Conclusion

Overconfident in their own abilities, entrepreneurs and venture capitalists are naturally drawn to big markets which offer companies the possibility of huge valuations if they can effectively exploit them. And there are always examples of a few immense successes, like Amazon, to fuel the fire. This leads to a big market delusion, resulting in too many new companies being founded to take advantage of big markets, each company being overpriced by its cluster of founders and venture capitalists. This overconfidence then feeds into public markets, where investors get their cues on price and relevant metrics from private market investors, leading to inflated values in those markets. This results in eventual corrections as the evidence accumulates that growth has to be shared and profitability may be difficult to achieve in a competitive environment. This post is a long one, but if you find it interesting, Brad Cornell and I have a paper expounding a more complete picture here. As always, your feedback is appreciated!

Paper on the big market delusion

1. The Big Market Delusion: Valuation and Investment Implications

Previous posts relating to the big market delusion

1. Big Markets, Over Confidence and the Macro Delusion (October 2015)
2. High and Higher: The Money in Marijuana (October 2018)

A Teaching Manifesto: An Invitation to my Spring 2020 classes

If you have been reading my blog for long enough, you should have seen this post coming. Every semester that I teach, and it has only been in the spring in the last few years, I issue an invitation to anyone interested to attend my classes online. While I cannot offer you credit for taking the class or much direct personal help, you can watch my sessions online (albeit not live), review the slides that I use and access the post class material, and it is free. If you are interested in a certificate version of the class, NYU offers that option, but it does so for a fee. You can decide what works for you, and whatever your decision is, I hope that you enjoy the material and learn from it, in that order.

The Structure

I will be teaching three classes in Spring 2020 at the Stern School of Business (NYU), a corporate finance class to the MBAs and two identical valuation classes, one to the MBAs and one for undergraduates. If you decide to take one of the MBA classes, the first session will be on February 3, 2020, and there will be classes every Monday and Wednesday until May 11, 2020, with the week of March 15-22 being spring break. In total, there will be 26 sessions, each session lasting 80 minutes. The undergraduate classes start a week earlier, on January 27, and go through May 11, comprising 28 sessions of 75 minutes apiece. 

1. The Spring 2020 Classses: With all three classes, the sessions will be recorded and converted into streams, accessible on my website and downloadable, as well as YouTube videos, with each class having its own playlist. In addition, the classes will also be carried on iTunes U, with material and slides, accessible from the site. The session videos will usually be accessible about 3-4 hours after class is done and you can either take the class in real time, watching the sessions in the week that they are taught, or in bunches, when you have the time to spend to watch the sessions; the recordings will stay online for at least a couple of years after the class ends. There will be no need for passwords, since the session videos will be unprotected on all of the platforms. 
2. The (Free) Online Version: During the two decades that I have been offering this online option, I have noticed that many people who start the class with the intent of finishing it give up for one of two reasons. The first is that watching an 80-minute video on a TV or tablet is a lot more difficult than watching it live in class, straining both your patience and your attention. The second is that watching these full-length videos is a huge time commitment and life gets in the way. It is to counter these problems that I created 12-15 minute versions of the each session for online versions of the classes. These online classes, recorded in 2014 and 2015, is also available on my website and through YouTube, and should perhaps be more doable than the full class version.
3. The NYU Certificate Version: For most of the last 20 years, I have been asked why I don’t offer certificates of completion for my own classes and I have had three answers. The first is that, as a solo act, I don’t have the bandwidth to grade and certify the 20,000 people who take the classes each semester. The second is that certification requires regulatory permission, a bureaucratic process in New York State that I have neither the stomach nor the inclination to go through. The third is, and it is perhaps the most critical, is that I am lazy and I really don't want to add this to my to-do list. One solution would be to offer the classes through platforms like Coursera, but those platforms work with universities, not individual faculty, and NYU has no agreements with any of these platforms. About three years ago, when NYU approached me with a request to create online certificate classes, I agreed, with one condition: that the free online versions of these classes would continue to be offered. With those terms agreed to, there are now NYU Certificate versions of each of the online classes, with much of the same content, but with four add ons. First, each participant will have to take quizzes and a final exam, multiple choice and auto-graded, that will be scored and recorded. Second, each participant will have to complete and turn in a real-world project, showing that they can apply the principles of the class on a company of their choice, to be graded by me. Third, I will have live Zoom sessions every other week for class participants, where you can join and ask questions about the material. Finally, at the end of the class, assuming that the scores on the exams and project meet thresholds, you will get a certificate, if you pass the class, or a certificate with honors, if you pass it with flying colors.

The Classes

I have absolutely no desire to waste your time and your energy by trying to get you to take classes that you either have no interest in, or feel will serve no good purpose for you. In this section, I will  provide a short description of each class, and provide links to the different options for taking each class.

I. Corporate Finance

Class description: I don’t like to play favorites, but corporate finance is my favorite class, a big picture class about the first principles of finance that govern how to run a business. I will not be egotistical enough to claim that you cannot run a business without taking this class, since there are many incredibly successful business-people who do, but I do believe that you cannot run a business without paying heed to the first principles. I teach this class as a narrative, staring with the question of what the objective of a business should be and then using that objective to determine how best to allocate and invest scarce resources (the investment decision), how to fund the business (the financing decision) and how much cash to take out and how much to leave in the business (the dividend decision). I end the class, by looking at how all of these decisions are connected to value.

Chapters: Applied Corporate Finance Book, Sessions: Class session

I am not a believer in theory, for the sake of theory, and everything that we do in this class will be applied to real companies, and I will use six companies (Disney, Vale, Tata Motors, Deutsche Bank, Baidu and a small private bookstore called Bookscape) as lab experiements that run through the entire class.

I say, only half-jokingly, that everything in business is corporate finance, from the question of whether shareholder or stakeholder interests should have top billing at companies, to why companies borrow money and whether the shift to stock buybacks that we are seeing at US companies is good or bad for the economy. Since each of these questions has a political component, and have now entered the political domain, I am sure that the upcoming presidential election in the US will create some heat, if not light, around how they are answered.

For whom?

As I admitted up front, I believe that having a solid corporate finance perspective can be helpful to everyone. I have taught this class to diverse groups, from CEOs to banking analysts, from VCs to startup founders, from high schoolers to senior citizens, and while the content does not change, what people take away from the class is different. For bankers and analysts, it may be the tools and techniques that have the most staying power, whereas for strategists and founders, it is the big picture that sticks. So, in the words of the old English calling, "Come ye, come all", take what you find useful, abandon what you don't and have fun while you do this.

Links to Offerings

1. Spring 2020 Corporate Finance MBA class (Free)

• Webpage for the class
• My website & streaming
• YouTube Playlist
• iTunes U class (Download the iTunes U app and use enroll code of FLJ-MLN-XZL)

2. Online Corporate Finance Class (Free)

• My website & streaming
• YouTube Playlist
• iTunes U class (Download the iTunes U app and use enroll code of HAS-CCR-FRA)

3. NYU Certificate Class on Corporate Finance (It will cost you...)

• NYU Entry Page

II. Valuation

Class description: Some time in the last decade, I was tagged as the Dean of Valuation, and I still cringe when I hear those words for two reasons. First, it suggests that valuation is a deep and complex subject that requires intense study to get good at. Second, it also suggests that I somehow have mastered the topic. If nothing else, this class that I first taught in 1987 at NYU, and have taught pretty much every year since, dispenses with both delusions. I emphasize that valuation, at its core, is simple and that practitioner, academics and analysts often choose to make it complex, sometimes to make their services seem indispensable, and sometimes because they lose the forest for the trees. Second, I describe valuation as a craft that you learn by doing, not by reading or watching other people talk about it, and that I am still working on the craft. In fact, the more I learn, the more I realize that I have more work to do.  This is a class about valuing just about anything, from an infrastructure project to a small private business to a multinational conglomerate, and it also looks at value from different perspectives, from that of a passive investor seeking to buy a stake or shares in a company to a PE or VC investor taking a larger stake to an acquirer interested in buying the whole company. 

Finally, I lay out my rationale for differentiating between value and price, and why pricing an asset can give you a very different number than valuing that asset, and why much of what passes for valuation in the real world is really pricing. 

Along the way, I emphasize how little has changed in valuation over the centuries, even as we get access to more data and more complex models, while also bringing in new tools that have enriched us, from option pricing models to value real options (young biotech companies, natural resource firms) to statistical add-ons (decision trees, Monte Carlo simulations, regressions). 

For whom?

Do you need to be able to do valuation to live a happy and fulfilling life? Of course not, but it is a skill worth having as a business owner, consultant, investor or just bystander. With that broad audience in mind, I don't teach this class to prepare people for equity research or financial analysis jobs, but to get a handle on what it is that drives value, in general, and how to detect BS, often spouted in its context. Don't get me wrong! I want you to be able to value or price just about anything by the end of this class, from Bitcoin to WeWork, but don't take yourself too seriously, as you do so.

Links to Offerings

1a. Spring 2020 Valuation MBA class (Free)

• Webpage for the class
• My website & streaming
• YouTube Playlist
• iTunes U class (Download the iTunes U app and use enroll code of FSN-WWJ-RAH)

1b. Spring 2020 Valuation Undergraduate class (Free)

• Webpage for the class
• My website & streaming
• YouTube Playlist
• iTunes U class (Download the iTunes U app and use enroll code of ENT-ZXA-JYL)

2. Online Valuation Class (Free)

• My website & streaming
• YouTube Playlist
• iTunes U class (Download the iTunes U app and use enroll code of K7X-VD9-5KE)

3. NYU Certificate Class on Valuation (Paid)

• NYU Entry Page

III. Investment Philosophies

Class description: This is my orphan class, a class that I have had the material to teach but never taught in a regular classroom. It had its origins in an couple of observations that puzzled me. The first was that, if you look at the pantheon of successful investors over time, it is not only a short one, but a diverse grouping, including those from the old time value school (Ben Graham, Warren Buffett), growth success stories (Peter Lynch and VC), macro and market timers (George Soros), quant players (Jim Simon) and even chartists. The second was that the millions who claim to follow these legends, by reading everything ever written by or about them and listening to their advice, don’t seem to replicate their success. That led me to conclude that there could be no one ‘best’ Investment philosophy across all investors but there could be one that is best for you, given your personal makeup and characteristics, and that if you are seeking investment nirvana, the person that you most need to understand is not Buffett or Lynch, but you.  In this class, having laid the foundations for understanding risk, transactions cost and market efficiency (and inefficiency), I look at the entire spectrum of investment philosophies, from charting/technical analysis to value investing in all its forms (passive, activist, contrarian) to growth investing (from small cap to venture capital) to market timing. With each one, I look at the core drivers (beliefs and assumptions) of the philosophy, the historical evidence on what works and does not work and end by looking at what an investor needs to bring to the table, to succeed with each one.

I will try (and not always succeed) to keep my biases out of the discussion, but I will also be open about where my search for an investment philosophy has brought me. By the end of the class, it is not my intent to make you follow my path but to help you find your own.

For whom?
This is a class for investors, not portfolio managers or analysts, and since we are all investors in one way or the other, I try to make it general. That said, if your intent is to take a class that will provide easy pathways to making money, or an affirmation of the "best" investment philosophy, this is not the class for you. My objective in this class is not to provide prescriptive advice, but to instead provide a menu of choices, with enough information to help you can make the choice that is best for you. Along the way, you will see how difficult it is to beat the market, why almost every investment strategy that sounds too good to be true is built on sand, and why imitating great investors is not a great way to make money.

Links to Offerings

1. Online Investment Philosophies Class (Free)

• My website & streaming
• YouTube Playlist
• iTunes U (Download the iTunes U app and use enroll code of J6Z-AD7-NX3)

2. NYU Certificate Class on Valuation (Paid)

• NYU Entry Page (Coming soon)

Conclusion

I have to confess that I don't subscribe to the ancient Guru/Sishya relationship in teaching, where the Guru (teacher) is an all-knowing individual who imparts his or her fountain of wisdom to a receptive and usually subservient follower. I have always believed that every person who takes my class, no matter how much of a novice in finance, already knows everything that needs to be known about valuation, corporate finance and investments, and it is my job, as a teacher, to make him or her aware of this knowledge. Put simply, I can provide some structure for you to organize what you already know, and tools that may help you put that knowledge into practice, but I am incapable of profundity. I hope that you do give one (or more) of my classes a shot and I hope that you both enjoy the experience and get a chance to try it out on real companies in real time.

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Regime Change and Value: A Follow up Post on Aramco

In my post from a couple of days ago, I valued Aramco at about $1.65 trillion, but I qualified that valuation by noting that this was the value before adjusting for regime change concerns. That comment seems to have been lost in the reading, and it is perhaps because (a) I made it at the end of the valuation and (b) because the adjustment I made for it seemed completely arbitrary, knocking off about 10% off the value. Since this is a issue that is increasingly relevant in a world, where political disruptions seem to be the order of the day in many parts of the world, I thought that a post dedicated to just regime changes and how they affect value might be in order, and Aramco would offer an exceptionally good lab experiment.

Going Concern and Truncation Risks

Risk is part and parcel of investing. That said, risk came come from many sources and not all risk is created equal, to investors. In fact, modern finance was born from the insight that for a diversified investor, it is only risk that you cannot diversify away, i.e., macroeconomic risk exposure, that affects value. In this section, I want to examine another stratification of risk into going concern and truncation risk that is talked about much less, but could matter even more to value.

DCF Valuation: A Going Concern Judgment

The intrinsic value of a company has always been a function of its expected cash flows, its growth and how risky the cash flows are, but in recent decades a combination of access to data and baby steps in bringing economic models into valuation has resulted in the development of discounted cashflow valuation as a tool to estimate intrinsic value. Put simply, the discounted cash flow value of an asset is:

Extended to a publicly traded company, with a potential life in perpetuity, this value can be written as:

If you are a reader of my posts, it should come as no mystery to you that I not only use DCF models to value companies, but that I believe that people under estimate how adaptable it is, usable in valuing everything from start ups to infrastructure projects.  There is, however, one significant limitation with DCF models that neither its proponents nor its critics seem be aware of, and it needs to be addressed. Specifically, a DCF is an approach for valuing going concerns, and every aspect of it is built around that presumption. Thus, you estimate expected cash flows each year for the firm, as a going concern, and your discount rate reflects the risk that you see in the company as a going concern. In fact, it is this going concern assumption that allows us to assume that cash flows continue for the long term, sometimes forever, and attach a terminal value to these cash flows.

Truncation Risks

If you accept the premise that a DCF is a going concern value, you are probably wondering what other risks there may be in investing that are being missed in a DCF valuation. The risks that I believe are either ignored or incorrectly incorporated into value are truncation risks. The simplest way of illustrating the difference between going concern and truncation risks is by picking a year in your cash flow estimation, say year 3. With going concern risk, you are worried about the actual cash flows in year 3 being different from your expectations, but with truncation risk, you are worried about whether there will be a year 3 for your company. 

So, what types of risk will fall into the truncation risk category? Looking at the corporate life cycle, you will see truncation risk become not just significant, but is perhaps the dominant risk that you worry about, age both ends of the life cycle. With start ups and young companies, it is survival risk that is front and center, given that approximately two thirds of start ups never make it to becoming viable businesses. With declining and aging companies, especially laden with debt, it is distress risk, where the company unable to meet its contractual obligations, shutters its doors and liquidates it assets. Looking at political risk, truncation risk can come in many forms, starting with nationalization risk, where a government takes over your business and pays you nothing in some cases and less than fair value in the rest, but extending to other expropriation risks, where you still are allowed to hold equity, but in a much less valuable concern.

Since truncation risk is more the rule than the exception, and it is the dominant risk in some companies, you would think that investors and analysts valuing these companies will have devised sensible ways of incorporating the risk, but you would be wrong.

• The most common approach to dealing with truncation risk is for analysts to hike up the discount rate, using the alluring argument that if there is more risk, you would demand a higher return. The problem, though, is that this higher discount rate still goes into a DCF where expected cash flows continue in perpetuity, creating an internal contradiction, where you increase the discount rate for truncation risk but you do nothing to the cash flows. In addition, the discount rate that these analysts use are made up, higher just for the sake of being higher, with no rationale for the adjustment. With venture capitalists, this shows up as absurdly high target rates of 40%, 50% or 60%, fiction in a world where these VCs actually deliver returns closer to 15-20%. Discount rates are blunt instruments and are incapable of carrying the burden of truncation risk, and should not be made to do so.
• Some analysts take the more sensible approach of scenario analysis, allowing for good and bad scenarios (including failure or nationalization) but never close the loop by attaching probabilities to the scenarios. Instead, they leave behind ranges for the value that are so wide as to be useless for decision making purposes. 

My suggestion is that you use a decision tree approach, where you not only allow for different scenarios, but you make these scenarios cover all possibilities and then attach a probability to each one. In the case of a start up, then, your two possible outcomes will be that the company will make it as a going concern and that it will not, and you will follow through with a DCF, with a going concern discount rate, yielding the value for the going concern outcome, and a liquidation providing your judgment for what the company will be worth, in the failure scenario:

Since you have probabilities for each outcome, you can compute an expected value. If you do this, you should expect to see discount rates for companies prone to failure (young start ups and declining firms) be drawn from the same distribution as that for healthy companies, but the adjustment for failure will be in the post-DCF adjustments. Put more simply, you should see 12-15% as costs of capital for even the riskiest start-ups, in a DCF, never 40-50%, but your post value adjustments for failure and its consequences will still take their toll.

The Aramco Valuation: Bringing in Truncation Risk 

In my last post, I valued Aramco in a DCF, using three measures of cash flows from dividends to potential dividends to free cash flows to the firm and arrived at values that were surprisingly close to each other, centered around $1.65 trillion, for the equity. Note, though, that these are going concern values, and reflect the expectation that while there may be year to year changes in cash flows, as oil prices changes, management recalibrate and the government tweaks tax and royalty rates, the company will be a going concern and that it will not suffer catastrophic damage to its core asset of low-cost oil reserves. For many investors in Aramco, the prime concern may be less on these fronts and more on whether the House of Saud, as the backer of the promises that Aramco is making its investors, will survive intact for the next few decades.

DCF Valuation: Going Concern Risk

Reviewing my discounted cash flow valuations of Aramco, you will notice that I began with a risk free rate in US dollars, because my currency choice was that currency. I then adjusted for risk, using a beta for Aramco, based upon REITs/royalty trusts for the promised dividend model and integrated oil companies for the potential dividends/free cash flow models, and an equity risk premium for Saudi Arabia of only 6.23%, with a country risk premium of 0.79% estimated for the country added to the mature market premium estimated for the US. The end result is that I had costs of equity ranging from 4.82% for promised dividends to 8.15% for cash flows.

The biggest push back I have had on my valuations is that the cost of equity seems low for a country like Saudi Arabia, and my response is that you are right, if you consider all of the risk in investing in a Saudi equity. However, much of the risk that you are contemplating in Saudi Arabia is political risk, or put more bluntly, the risk of regime change in the country, that could have dramatic effects on value. In fact, if you remove that risk from consideration and look at the remaining risk, Aramco is a remarkably safe investment, with the safety coming from its access to huge oil reserves and mind-boggling profits and cash flows. The DCF values that I have estimated, centered around $1.65 trillion, are therefore values before adjusting for the risk of regime change.

Regime Change Concerns

If you invest in Aramco, you clearly have an interests in who rules and runs the country, since every aspect of your valuation is dependent on that assumption. If the House of Saud continues to rule, I believe that the company will be the cash cow that I project it to be in my DCF and the values that I estimated hold. If the Arab spring comes to Riyadh and there is a regime change, the foundations of my value can either crack or be completely swept away, with cash flows, growth and risk all up for re-estimation. In fact, to complete my valuation, I need to bring both the probability of regime change and the consequences into my final valuation:

Consider the most extreme case. If you believe that regime change in imminent and certain, and that the change will be extreme (with equity being expropriated and Aramco being brought back entirely into the hands of the state), my expected value for equity becomes zero:

If at the other extreme, you either believe that regime change will never happen, or even if it does, the new regime will not want to hurt the goose that lays the golden eggs and leaves existing terms in place, the value effect of considering regime change will be zero. The truth lies between the extremes, though where it lies is open for debate. I believe that there remains a non-trivial chance (perhaps as high as 20%) that there will be a regime change over the long term and that if there is one, there will be changes that reduce, but not extinguish, my claim, as an equity investor, on the cash flows. 

That, in an entirely subjective nutshell, is why I think Aramco's equity value is closer to $1.5 trillion than $1.7 trillion.  As with all my other valuations, I understand that your judgments on Aramco will be different from mine, but I think that the disagreements we have are not so much on the going concern estimates of cash flows and risk but on the likelihood and consequences of regime change. 

Democracies versus Autocracies

I am not a political scientist, but I have always been fascinated by the question of how political structure and economic value are intertwined. Specifically, would you attach more value to a company or project operating in a democracy or in an autocracy? The approach that I have described in this post to deal with going concern and regime change risk allows me one way of trying too answer the question. 

• Democracies are messy institutions, where governments change and policies morph, because voters change their minds. Put simply, a democracy generally cannot offer any business iron clad guarantees about regulations not changing or tax rates remaining stable, because the government that offers those promises first has to get them approved by legislatures, often can be checked by legal institutions and, most critically, can be voted out of office. Consequently, companies operating in democracies will always complain more about the rules constantly changing, and how those changing rules affect cash flows, growth and risk. 
• Autocracies offer more stability, since autocrats don't have to get policies approved by legislators, often are unchecked by legal institutions and don't have to worry about how their decision poll with voters. Companies operating in autocracies can be promise rules that are fixed, regulations that don't change and tax rates that will stay constant. The catch, though, is that autocracies seldom transition smoothly, and when change comes, it is often unexpected and wrenching.

In valuation terms, democracies create more going concern risk and autocracies create more worries about regime change. The former will show up as higher discount rates in a DCF valuation and the latter as post-DCF adjustments. While I prefer democracies to autocracies, there is no way, a priori, that you can argue that democracies are always better than autocracies or vice versa, at least when it comes to value, and here is why:

• The going concern risk that is added by being in a democracy will depend on how the democracy works. If you have a democracy, where the opposing parties tend to agree on basic economic principles and disagree on the margins, the going concern risk added will be small. In the United States, in the second half of the last century, both parties (Republicans and Democrats) agreed on the fundamentals of the economy, though one party may have been more favorable on some issues, for business, and less favorable on other issues. In contrast, if you have a democracy, where governments are unstable and the opposing parties have widely different views on the very fundamentals of how an economy should be structured, the effect on going concern risk will be much higher. 
• The regime change risk in an autocracy will vary in how the autocracy is structured and how transitions happen. Autocracies structured around a person are inherently more unstable than autocracies built around a party or ideology, and transitions are more likely to be violent if the military is involved in regime change, in either direction. In addition, violent regime changes feed on themselves, with memories of past violent meted out to a group driving the violence that it metes out, when its turn comes.

In summary, when you are trying to decide on whether a business is worth more in a democracy than in a dictatorship, you are being asked to trade off more continuous, going concern risk in the former for the more stable environment of the latter, but with more discontinuous risk. I have deliberately stayed away from using specific country examples in this section, because this argument is more emotion than intellect, but you can fill your own contrasts of countries, and make your own judgments. 

Conclusion

I have often described valuation as a craft, where mastery is an elusive goal and the key to getting better is working at doing more valuation. I am glad that I valued Aramco, because it is an unconventional investment, a company where I have to worry more about political risks than economic ones. The techniques I develop on Aramco will serve me well, not only when I value Latin American companies, as that continent seems to be entering one of its phases of disquiet, but when I value developed market companies, as Europe and the US seem to be developing emerging market traits.

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Blog Posts

1. A coming out party for an Oil Colossus: Aramco's IPO

Valuation Links

1. Aramco Valuation(s)

A coming out party for the world's most valuable company: Aramco's long awaited IPO!

In a year full of interesting initial public offerings, many of which I have looked at in this blog, it is fitting that the last IPO I value this year will be the most unique, a company that after its offering is likely to be the most valuable company in the world, the instant it is listed. I am talking about Aramco, the Saudi Arabian oil colossus, which after many false starts, filed a prospectus on November 10 and that document, a behemoth weighing in at 658 pages, has triggered the listing clock.

Aramco: History and Set Up
Aramco’s beginnings trace back to 1933, when Standard Oil of California discovered oil in the desert sands of Saudi Arabia. Shortly thereafter, Texaco and Chevron formed the Arabian American Oil Company (Aramco) to develop oil fields in the country and the company also built the Trans-Arabian pipeline to deliver oil to the Mediterranean Sea. In 1960, the oil producing countries, then primarily concentrated in the Middle East, created OPEC and in the early 1970s, the price of oil rose rapidly, almost quadrupling in 1973. The Saudi Government which had been gradually buying Aramco’s assets, nationalized the company in 1980 and effectively gave it full power over all Saudi reserves and production. The company was renamed Saudi Aramco in 1988.

To understand why Aramco has a shot at becoming the most valuable company in the world, all you have to do is look at its oil reserves. In 2018, it was estimated that Aramco had in excess of 330 billion barrels of oil and gas in its reserves, a quarter of all of the world’s reserves, and almost ten times those of Exxon Mobil, the current leader in market cap, among oil companies. To add to the allure, oil in Saudi Arabia is close to the surface and cheap to extract, making it the most profitable place on oil to own reserves, with production costs low enough to break even at $20-$25 a barrel, well below the $40-$50 break even price that many other conventional oil producers face, and even further below the new entrants into the game. This edge in both quantity and costs plays out in the numbers, and Aramco produced 13.6 million barrels of oil & gas every day in 2018, and reported revenues of $355 billion for the year, on which it generated operating income of $212 billion and net income of $111 billion. In short, if your complaint about the IPOs that you saw this year was that they had little to show in terms of revenues and did not have money-making business models, this company is your antidote.

Aramco, Saudi Arabia and the House of Saud!
The numbers that are laid out in the annual report are impressive, painting a picture of the most profitable company in the world, with almost unassailable competitive advantages, investors need to be clear that even after its listing, Aramco will not be a conventional company, and in fact, it will never be one. The reason is simple. Saudi Arabia is one of the wealthier countries in the world, on a per capital basis, and one of the 20 largest economies, in terms of GDP, but it derives almost 80% of that GDP from oil. Thus, a company that controls those oil spigots is a stand in for the entire country, and over the last few decades, it should not surprise you to learn that the Saudi budget has been largely dependent on the cash flows it collects from Aramco, in royalties and taxes, and that Aramco has also invested extensively in social service projects all over the country. The overlap between company and country becomes even trickier when you bring in the Saudi royal family, and its close to absolute control of the country, which also means that Aramco’s fortunes are tied to the royal family’s fortunes. It is true that there will still be oil under the ground, even if there is a change in regime in Saudi Arabia, but the terms laid out in the prospectus reflect the royal family’s promises and may very well be revisited if control changed. Should this overlap between company, country and family have an effect on how you view Aramco? I don’t see how it cannot and it will play out in many dimensions:

1. Corporate governance: After the IPO, the company will have all the trappings of a publicly traded company, from a board of directors to annual meetings to the rituals of financial disclosure. These formalities, though, should not obscure the fact that there is no way that this company can or ever will be controlled by shareholders. The Saudi government is open about this, stating in its prospectus that “the Government will continue to own a controlling interest in the Company after the Offering and will be able to control matters requiring shareholder approval. The Government will have veto power with respect to any shareholder action or approval requiring a majority vote, except where it is required by relevant rules for the government.” While one reason is that the majority control will remain with the government, it is that it would be difficult to visualize and perhaps to dangerous to even consider allowing a company that is a proxy for the country to be exposed to corporate control costs. After all, a hostile acquisition of the company would then be the equivalent of an invasion of the country. The bottom line is that if you invest in Aramco, you should recognize that you are more capital provider than shareholder and that you will have little or no say in corporate decision making.
2. Country risk: Aramco has a few holdings and joint ventures outside Saudi Arabia, but this company is not only almost entirely dependent on Saudi Arabia but its corporate mission will keep it so. Put differently, a conventional oil company that finds itself overdependent on a specific country for its production can try to reduce this risk by exploring for oil or buying reserves in other countries, but Aramco will be limited in doing this, because of its national status.
3. Political risk: For decades, the Middle East has had more than its fair share of turmoil, terrorism and war, and while Saudi Arabia has been a relatively untouched part, it too is being drawn into the problem. The drone attack on its facilities in Shaybah in August 2019, which not only caused a 54% reduction in oil production, but also cost billions of dollars to the company was just a reminder of how difficult it is to try to be oasis. On an even larger scale, the last decade has seen regime changes in many countries in the Middle East, with some occurring in countries, where the ruling class was viewed as insulated. The Saudi political order seems settled for the moment, with the royal family firmly in control, but that too can change, and quickly.

In short, this is not a conventional company, where shareholders gather at annual meetings, elect boards of directors and the corporate mission is to do whatever is necessary to increase shareholder well being, and it never will be one. For some, that feature alone may be sufficient to take the company off their potential investment list. For others, it will be something that needs to be factored into the pricing and value, but at the right price or value, presumably with a discount built in for the country and political risk overlay, the company can still be a good investment.

IPO Twists
Before we price and value Aramco, there are a few twists to this IPO that should be clarified, since they may affect how much you are willing to pay. The prospectus, filed on November 10, sheds some light:

1. Dividends: In the ending on September 30, 2019, Aramco paid out an ordinary dividend of $13.4 billion, entirely to the Saudi Government, and it plans to pay an additional interim dividend of at least $9.5 billion to the government, prior to the offering. The company commits to paying at least $75 billion in dividends in 2020, with holders of shares issued in the IPO getting their share, and to maintaining these dividends through 2024. Beyond 2024, dividends will revert back to their normal discretionary status, with the board of directors determining the appropriate amount. As an aside, the dividends to non-government shareholders will be paid in Saudi Riyal and to the government in US dollars.
2. IPO Proceeds: The prospectus does not specify how many shares will be offered in the initial offering, but it is not expected to be more than a couple of percent of the company. None of the proceeds from the IPO will remain in Aramco. The government will redirect the proceeds elsewhere, in pursuit of its policy of making Saudi Arabia into an economy less dependent on oil.
3. Trading constraints: Once the offering is complete, the shares will be listed on the Saudi stock exchange and its size will make it the dominant listing overnight, while also subjecting it to the trading restrictions of the exchange, including a limit of a 10% movement in the stock price in a day; trading will be stopped if it hits this limit.
4. Inducements for Saudi domestic investors: In an attempt to get more domestic investors to hold the stock, the Saudi government will give one bonus share, for every ten shares bought and held for six months, by a Saudi investor, with a cap at a hundred bonus shares.
5. Royalties & Taxes: In my view, it is this detail that has been responsible for the delay in the IPO process and it is easy to see why. For all of its life, Aramco has been the cash machine that keeps Saudi Arabia running, and the cash flows extracted from the company, whether they were titled royalties, taxes or dividends, were driven by Saudi budget considerations, rather than corporate interests. Investors were wary of buying into a company, where the tax rate and the royalties were fuzzy or unspecified and the prospectus lays out the following. First,  the corporate tax rate will be 20% on downstream taxable income, though tax rates on different income streams can be different. The Saudi government also imposes a Zakat, a levy of 2.5% on assessed income, thus augmenting the tax rate. In sum, these tax rate changes were already in effect in 2018, and the company paid almost 48% of its taxable income in taxes that year. Second, the royalties on oil were reset ahead of the IPO and will vary, depending on the oil price, starting at 15% if oil prices are less than $70/barrel, increasing to 45% of the incremental amount, if they fall between $70 and $100, and becoming 80%, if the oil price exceeds $100/barrel.

A Pricing of Aramco
The initial attempts by the Saudi government to take Aramco public, as long as two years ago, came with an expectation that the company would be “valued” at $2 trillion or more. Since the IPO announcement a few weeks ago, much has been made about the fact that there seem to be wide divergences in how much bankers seem to think Aramco is worth, with numbers ranging from $1.2 billion to $2.3 trillion. Before we take a deep dive into how the initial assessments of value were made and why there might be differences, I think that we should be clear eyed about these numbers. Most of these numbers are not valuations, based upon an assessment of business models, risk and profitability, but instead represent pricing of Aramco, where assessment of price being made by looking at how the market is pricing publicly traded oil companies, relative to a metric, and extending that to Aramco, adjusting (subjectively) for its unique set up in terms of corporate governance, country risk and political risk. In the table below, I look at integrated oil companies, with market caps in excess of $10 billion, in October 2019, and how the market is pricing them relative to a range of metrics, from barrels of oil in reserve, to oil produced, to more conventional financial measures (revenues, earnings, cash flows):

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The median oil company equity trades at about 13 times earnings, and was a business, at about the value of its annual revenues, and the market seems to be paying about $23 for every barrel of proven reserves of oil (or equivalent). In the table below, I have priced Aramco, using all of the metrics, and at the median and both the first and third quartiles:

You can already see that if you are looking at how to price Aramco, the metric on which you base it on will make a very large difference: 

• If you price Aramco based on its revenues of $356 billion or on its book value of equity of $271 billion, its value looks comparable or slightly higher than the value of Exxon Mobil and Royal Dutch, the largest of the integrated oil companies. 
• That pricing, though, is missing Aramco’s immense cost advantage, which allows it to generate much higher earnings from the same revenues. Thus, when you base the pricing on Aramco’s EBITDA of $224 billion, you can see the pricing rise to above a trillion and if you shift to Aramco’s net income of $111 billion, the pricing approaches $1.5 trillion. 
• The pricing is highest when you focus on Aramco’s most valuable edge, its control of the Saudi oil reserves and its capacity to produce more oil than any other oil company in the world. If you base the pricing on the 10.3 billion barrels of oil that Aramco produced in 2018, Aramco should be priced above $1.5 trillion and perhaps even closer to $2 trillion. If you base the pricing on the 265.9 billion barrels of proven reserves that Aramco controls for the next 40 years, Aramco’s pricing rises to sky high levels.

If you are a potential investor, the pricing range in this table may seem so large, as to make it useless, but it can still provide some useful guidelines. First, you should not be surprised to see the roadshows center on Aramco’s strongest suits, using its huge net income (and PE ratios) as the opening argument to set a base for its pricing, and then using its reserves as a reason to augment that pricing. Second, there is a huge discount on the pricing, if just reserves are used as the basis for pricing, but there are two good reasons why that high pricing will be a reach:

• Production limits: Aramco not only does not own its reserves in perpetuity, with the rights reverting back to the Saudi government after 40 years, with the possibility of a 20-year extension, if the government decides to grant it, but it is also restricted in how much oil it can extract from those reserves to a maximum of 12 billion barrels a year.
• Governance and Risk: We noted, earlier, that Aramco’s flaws: the government’s absolute control of it, the country risk created by its dependence on domestic production and the political risk emanating from the possibility of regime change. To see how this can affect pricing, consider how the five companies on the integrated oil peer group that are Russian (with Gazprom, Rosneft and Lukoil being the biggest) are priced, relative to the global average:
  

Russian oil companies are discounted by 50% or more, relative to their peer group, and while Saudi Arabia does not have the same degree of exposure, the market will mete out some punishment.

A Valuation of Aramco

The value of Aramco, like that of any company in any sector, is a function of its cash flows, growth and risk. In fact, the story that underlies the Aramco valuation is that of a mature company, with large cash flows and concentrated country risk. That said, the structuring of the company and the desire of the Saudi government to use its cash flows to diversify the economy play a role in value. 

General Assumptions
While I will offer three different approaches to valuing Aramco, they will all be built on a few common components.

• First, I will do my valuation in US dollars, rather than Saudi Riyals, since as a commodity company, revenues are in dollars and the company reports its financials in US dollars (as well as Riyal). This will also allow me to evade tricky issues related to the Saudi Riyal being pegged to the US dollar though the reverberations from the peg unraveling will be felt in the operating numbers. 
• Second, I will use an expected inflation rate of 1.00% in US dollars, representing a rough approximation of the difference between the US treasury bond rate and the US TIPs rate. Third, I will use the equity risk premium of 6.23% for Saudi Arabia, representing about a 0.79% premium over my estimate of a mature market premium of 5.44% at the start of November 2019. 
• Finally, rather than use the standard perpetual growth model, where cash flows continue forever, I will use a 50-year growth period, representing the fact that the company's primary asset, its oil reserves, are not infinite and will run out at some point in time, even if additional reserves are discovered. In fact, at the current production level, the existing reserves will be exhausted in about 35 years.

Valuation: Promised Dividends
While the dividend discount model is far too restrictive in its assumptions about payout to be used to value most companies, Aramco may be the exception, especially given the promise in the prospectus to pay out at least $75 billion in dividends every year from 2020 and 2024, and the expectation that these dividends will continue and grow after that. There is one additional factor that makes Aramco a good candidate for the dividend discount model and that is the absolute powerlessness that stockholders will have at the company to change how much it returns to shareholders. To complete my valuation of Aramco using the promised dividends, I will make two additional assumptions:

1. Growth rate: I will assume a long term growth rate in dividends set equal the inflation rate, and since this valuation is in US dollars, that inflation rate will be 1%.
2. Discount rate: Rather than use a discount rate reflecting the risk of an oil company, I will be one that is closer to that demanded by investors in REITs and oil royalty trusts, investments where the bulk of the returns will be in dividends and those dividends are backed up by asset cash flows.

The valuation picture is below:

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Based upon my assumptions, the value of Aramco is about $1.63 trillion. Seen through these lens, this stock is a dressed-up bond, where dividends will remain the primary form of return and there will be little price appreciation.

Valuation: Potential Dividends
The reason that dividend discount models often fail is because they look at the actual dividends paid and don’t factor in the reality that some companies pay out more than they can afford to do in dividends, in which case they are unsustainable and will fall under that weight, and some companies pay too little, in which case the cash that is paid out accumulates in the firm as a cash balance, and equity investors get a stake in it. While I noted that Aramco has signaled that it will pay at least $75 billion in dividends over the next five years, it has not indicated that it will cease investing and with potential dividends, you value the company based upon its capacity to pay dividends, rather than actual dividends.  In computing the potential dividends, I assumed that the company would be able to grow earnings at 1.80% a year, and be able to do so by continuing to generate sky high returns on equity (its 2018 return on equity was about 41%). However, the shift from promised dividends to potential dividends will also expose investors to more of the risk in an integrated oil company and I adjust the cost of equity accordingly:

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The value of equity, using potential dividends, is $1.65 trillion, reflecting not only Aramco’s capacity to pay much higher dividends than promised but also the higher risk in these cash flows.

Valuation: As a Business

When you value a business, you effectively allow for the options that the firm has to make changes to how much and where it invests, how it finances it business and how much it pays in dividends. One reason that this may provide only limited benefits in the Aramco case is that the company is significantly constrained, both because of its ownership and governance structure as well as its mission, on all three dimensions. Thus, it is likely that Aramco will remain predominantly a fossil fuel company, tethered to its roots in Saudi Arabia, is unlikely to alter its policy of being predominantly equity funded and its dividend policy is sticky even at as it starts life as a public company.  Following through with these assumptions, I assumed that the debt ratio for Aramco will stay low at 1.80% of overall capital, as will the cost of debt at 2.70%, in US dollar terms, based upon its bond rating. To get the reinvestment, I switch to using the return on capital of 44.61% that the company generated in 2018, as my base:

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Adding the cash and cross holdings and then subtracting out the debt and minority interests in the company yields an equity value of $1.67 trillion, that is close to what we obtained with the FCFE model, but that should not be surprising, given that the company has so little debt in its capital structure.

Final Valuation Adjustments
In summary, what is surprising about the valuations of Aramco, using the three approaches, is how close they are in their final assessments, all yielding values around $1.65 trillion. That said, there are three additional considerations that none of these models have factored in.

1. Political Risk: While these models adjust for country risk in Saudi Arabia, I have used the default spread of the country as a proxy, but that misses the risk of regime change, a discontinuous risk that will have very large and potentially catastrophic effects on value. While you may believe that this risk is low, it is definitely not zero. 
2. Upside limits: When you invest in any large integrated oil company, you are making a bet on oil prices, with the expectation that higher oil prices will deliver higher income and higher value. While that assumption still holds for Aramco, the royalty structure that the Saudi government has created, where the royalty rate will climb from 40% at current oil prices to 45% if they rise above $ 70 and 80% if they rise above $100/barrel will mean that your share of gains, as an equity investor, on the upside will be capped, dampening the value today.
3. Price setter/taker: While the largest publicly traded oil companies in the world are still price takers, Aramco has more influence on the oil price than any of them, as a result of Saudi Arabia's role in the oil market. Put simply, while the power of the Saudi government to set oil prices has decreased from the 1970s, it does continue to wield more influence than any other entity in this process.

The first two factors are clear negatives and should lead you to mark down the value of Aramco, but  the third factor may help provide some downside protection. Overall, I would expect the value of equity in Aramco to be closer to $1.5 trillion, after these adjustments are made. (I am assuming a small chance of regime change, but if you attach a much higher probability, the drop off in value will be much higher).

Aramco: To invest or not to?
Over the weekend, we got a little more clarity on the IPO details, with a rumored pricing of $1.7 trillion for the company's equity and a planned offering of 1.5% of the outstanding shares. That price is within shouting distance of my valuation, and my guess is that given the small size of the offering (at least on a percentage basis), it will attract enough investors to be fully subscribed. At this pricing, I think that the company will be more attractive to domestic than international investors, with Saudi investors, in particular, induced to invest by the company's standing in the country. It will be a solid investment, as long as investors recognize what they are getting is more bond than stock, with dividends representing the primary return and limited price appreciation. They will have no say in how the company is run, and if they don't like the way it is run, they will have to vote with their feet. If they are worried about risk, the research they should do is more political than economic, with the primary concerns about regime stability. The one concern that you should have, if you are a Saudi investor, with your human capital and real estate already tied to Saudi Arabia's (and oil's) well being, investing your wealth in Aramco will be doubling down on that dependence.

In case you care about my investment judgment, Aramco is not a stock for me for two reasons. First, I am lucky enough not to be dependent on cash flows from my investment portfolio to meet personal liquidity needs, and have no desire to receive large dividends, just for the sake of reaching them, since they just create concurrent tax burdens. Second, if I were tempted to invest in the company as a play on oil prices, the rising royalty rates, as oil prices go up, imply that my upside will be limited at Aramco.  Finally, it is worth noting that this company will be the ultimate politically incorrect investment, operating both as a long term bet on oil, in a world where people are as dependent as ever on fossil fuels, but seem to be repelled by those who produce it, and as a bet on Saudi royalty, an unpopular institution in many circles. As a consequence, I am willing to bet that not too many college endowments in the United States will be investing in Aramco, and even conventional fund managers may avoid the stock, just to minimize backlash. I don't much care for political correctness nor for investors who seem to believe that the primary purpose of investing is virtue signaling, and I must confess that I am tempted to buy Aramco just to see their heads explode. However, that would be both petty and self-defeating, and I will stay an observer on Aramco, rather than an investor.

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