Tuesday, April 20, 2021

The Corporate Tax Burden: Facts and Fiction

The Biden Administration's $ 2 trillion infrastructure plan, announced with fanfare a few weeks ago, has opened up a debate about not only what comprises infrastructure, but also about how to pay for it. Not surprisingly. it is corporate taxes that are the primary vehicle for delivering the revenues needed for the plan, with an increase in the federal corporate tax rate from 21% to 28% being the central proposal. I will leave the debate on what comprises infrastructure to others, and focus entirely on the corporate tax question in this post. I do this, knowing fully well that tax debates quickly turn toxic, as people have strong priors on whether corporations pay their fair share of taxes, and selectively find inforrmation to back their positions. I will begin by laying out the pathways through which corporate taxes affect company value, and then looking at how the 2017 tax reform act, which lowered the federal tax rate from 35% to 21%, has affected corporate behavior.

Taxes, Earnings and Value

At first sight, this section may seem useless, because the effect of tax rates on value seems blindingly obvious. As the corporate tax rate rises, all else being held constant, companies will pay more of their earnings in taxes, and should be worth less. That facile assessment, though, can falter for the following reasons:

  1. Feedback effect on taxable income: This may seem cynical, but it is nevertheless true that the amount that companies report as taxable income and how much they choose to defer taxes into future years is a function of the corporate tax rate. As tax rates rise, corporations use the discretion built into the tax code to report less taxable income and to defer more taxes to future years. It is for this reason that legislatures around the world over estimate how much additional revenue they will generate, when they raise taxes, and investors over estimate how much corporate earnings will rise when tax rates are decreased. 
  2. Contemporaneous changes in the tax code: When corporate tax rates are changed, it is a given that there will be other changes in the tax code that may either counter the tax rate change or add to it. For instance, the 2017 US tax reform act, in addition to lowering the corporate tax rate, also changed the way that foreign income to US companies was taxed and put limits on the tax deductibility of debt.
  3. Financing Mix: Companies can raise capital either from equity or debt, and the costs of equity and debt can be altered when the tax rate changes. That is because interest on debt is tax deductible, and as the corporate tax rate rises, the after-tax cost of debt falls, making debt more attractive as a financing option for companies, relative to equity.
The picture below maps out how tax rates can affect earnings, cash flows and value:

Note that it is the effective tax rate, determined by tax deferrals and other tax management tools, that drives after-tax earnings and cash flows, and the marginal tax rate, i.e., the tax rate on the last dollar of income earned that determines the corporate after-tax borrowing cost. It is this reason that the effect of raising or lowering corporate tax rates on value can get murky, with the following general propositions:
  • Tax Deferral Options: Companies that have more options when it comes to deferring taxes than others can buffer the impact of higher corporate taxes by choosing to defer taxes and report less taxable income. The most significant of those options, in my view, is foreign sales, with companies that generate more of their income overseas acquiring more tax freedom than purely domestic companies. There are other options embedded in the tax code allowing for tax credits and deductions for some investments and expenses, with sectors like real estate being prime beneficiaries.
  • Debt funding: Firms that are heavier users of debt financing will be able to offset some or even all of the impact of a higher corporate tax rate, by increasing their debt funding and using the tax advantages that come with the higher tax rate to lower their costs of capital.
Put simply, when corporate tax rates are raised, not all companies will lose equally, and there may even be a few companies that emerge as net winners.

Marginal Tax Rates

    Much of the discussion about corporate taxes is centered on the corporate tax rate, enumerated in the corporate tax code. As the proposal to raise the US corporate tax rate from 21% to 28% (or some number in the middle) is discussed, it is worth looking at the history of US corporate tax rates, going back to their inception early in the twentieth century:

For proponents of raising corporate taxes, this picture is their strongest suit, since corporate tax rates are now lower than they have been since the 1930s.  For much of this history, the US also adopted a global tax model, which required US companies to pay the US tax rate not just on income earned in the US, but also in foreign markets, with the caveat that the foreign income would be taxed, when repatriated to the US. In a predictable consequence, US multinationals chose to leave their foreign income outside the US, creating the phenomenon of trapped cash, i.e., income held in foreign locales to avoid taxes, but also trapped because that income could not be used to pay dividends, buy back stock or invest in projects in the United States.

While that system worked well for most of the twentieth century, it started to break down towards the end of that century, as the US became a less dominant player in the global economy, and other countries lowered their corporate tax rates. The first development meant that larger proportions of US corporate income was generated overseas, and the second increased the differential tax rates and thus the repatriation penalty. By 2014, when I wrote this post, the US tax code had become dysfunctional, as the trapped cash cumulated to trillions of dollars and some US companies sought to move their incorporation to other countries.  This history is worth emphasizing, because the change in the US corporate tax rate in 2021, from 35% to 21%, accompanied by the abandonment of the global tax model just brought the US closer to the rest of the world in terms of both tax rates and treatment of foreign income. In fact, at the start of 2021, the picture below summarizes corporate tax rates around the world:

Source: KPMG
Note that the marginal tax rate for US companies is close to 25%-27%, with state and local taxes added on, and is roughly equal to the average tax rates in almost every region of the world. 

Effective Tax Rates

Governments set corporate tax rates, but companies use the tax code to full advantage to try to minimize taxes paid and delay the payment of taxes. The effective tax rate measures the actual taxes paid, relative to taxable income, and it is the number that determines how much governments collect as tax revenues. 

Measures of Taxes Paid

To measure how much companies pay in taxes, you have to start with the financial statements of the company, recognizing that these are reporting documents, not tax documents. Put simply, what you see as taxable income in the annual report or public financial filing for a company can be very different from the taxable income in the tax filings made by the same company. Since we have no access to the latter, at least for individual companies, there are clues in the reported financials that can nevertheless help us assess how much a company pays in taxes:

Note that effective tax rate is computed based upon the income statement, and is computed by dividing the accrual measure of taxes by the accrual taxable income. While that is the tax rate that most databases report, it may fail to capture the true tax burden for two reasons:

  1. Accrual income: It is worth remembering that accrual income is after accounting expenses, some of which are related to operations (cost of goods sold, marketing), some to financial (interest expenses) and some of which are determined by the tax code (depreciation and amortization, write offs, special charges). A company that is savvy about using tax provisions to lower its accrual income may be able to look like it is paying a high effective tax rate, but is actually paying very little in absolute terms.
  2. Cash taxes versus Accrual taxes: The actual taxes paid by to the government (cash taxes) can be higher or lower than the accrual taxes, and the difference should be visible in the cash flow statement in the form of deferred taxes. 
  3. Past tax behavior: One final factor that can affect a company's tax burden is its past history. A company that has lost considerable amounts in prior years can accumulate net operating losses and reduce taxes paid in the current period. Alternatively, a company that has deferred taxes in prior years will find itself playing catch-up and paying more in taxes in the current year, just as companies that have pre-paid taxes in previous years may be able to pay far less in taxes in the current year.
As a result of these three phenomena, you can sometimes see effective tax rates that look implausible or even impossible, ranging from rates in excess of 100% to rates less than zero. You can already see, from this description, that computing effective and cash tax rates for individual companies and then averaging across those tax rates can be problematic for a few reasons. The first is that any grouping of companies, where a fairly large number are money-losing and not paying taxes, will give you an average tax rate that is low, even if companies are paying their fair share. The second is that extreme values on tax rates for some companies can skew averages, and if your grouping includes both small and large companies, looking at the average tax rate across companies will not accurately reflect whether companies collectively are bearing a fair burden. If it sounds like I am spending time in the weeds, it is because I face this challenge every year when I report average effective tax rates by sector for companies around the world on my website. To cater to different needs, I report four different tax measures, each of which can yield different values and come with different caveats:
  1. Taxes paid in dollar value (Accrual and Cash): This reflects the aggregate amount paid by all companies in a grouping  during the most recent year. Ultimately, this is the number that matters most from a tax collection perspective.
  2. Average effective tax rate across all companies: This is the average tax rate across all companies in a grouping, including money losing companies. Not surprisingly, the average will be pushed down as the number of money losing firms increases.
  3. Average effective tax rate across money making companies: This deals with the problem of money losing companies, but it is a simple average and it weights very small companies and very large companies equally.
  4. Aggregate tax rate: This is the tax rate that best captures how much companies pay in a sector, and is computed by dividing the sum of taxes paid by all companies in a sector by the sum of taxable income. It thus weights bigger companies more than smaller companies.
To illustrate, for US pharmaceutical companies, at the start of 2021, and using income from the trailing 12 months (through September 2020), we find that the these companies collectively paid $9.43 billion in accrual taxes and $15.98 billion in cash taxes. This translated into an average tax rate across all companies of 1.88%, an average tax rate of 16.30% across only money making companies, an aggregate tax rate of 18.19% with accrual taxes (and 32.96% based upon cash taxes).

US Effective Tax rates

The United States is fertile ground to examine how companies manage taxes for two reasons. The first is that until very recently, US companies faced among the highest marginal tax rates of companies anywhere in the world. The second is that the US tax code also has more credits and deductions, often put in by Congress with the best of intentions, that allow companies more discretion when it comes to computing taxable income and tax deferrals. To measure how much companies pay in taxes, I look at how much US companies have, in the aggregate, paid in taxes between 2016 and 2020, in the table below:

Note that while the corporate tax rate dropped by 14% (from 35% to 21%) from 2017 to 2018, the effective tax rate decreased by 6.8% and the cash tax rate by 2.75%. In a more telling statistic, the dollar value of taxes paid increased between 2017 and 2019 by 1.4% and cash taxes by almost 18%, as companies reported more taxable income. To put corporate tax behavior in larger perspective, I looked at corporate pre-tax income and taxes reported by the Bureau of Economic Analysis, going back to 1929:


While there are differences in year to year numbers, looking at this source rather than corporate filings, the story remains the same. Over time, the effective tax rate for companies has drifted down, with the decline accelerating over the last twenty years. It is also clear that the big disruptions in tax rates have come from economic shocks, with taxes collected and tax rates paid declining economic slowdowns and recessions. While the arguments about the right tax rate for US companies and whether they pay their fair share in taxes are legitimate ones, it has to start with a reality check. The perception that US companies are now paying significantly less in taxes than they were prior to 2017, while it may fit your preconceptions about corporate tax behavior, is not backed up by facts. Of course, you could believe that they should pay more than they have historically, but that discussion has to start with the recognition that lowering the tax rate in 2017 is not the reason, and that reversing it will not be the solution.

International Tax Behavior

There is a widespread belief that US companies pay less in taxes than their global counterparts, and to see if that is true, I look at effective tax rates paid by companies in different countries in the map below:

On this measure, I do think that those who believe that US companies pay less than their "fair" share have a point, since the effective tax rate paid by US companies is lower than the effective tax rates of companies in much of the rest of the world (barring Canada). The differences are smaller when you look at the cash tax rate, but there is evidence here of the drag created by the tax credits and deductions added over multiple tax reform acts to the US tax code. The differences in tax rates across the world also underlie the challenge that Janet Yellen will face in trying to get companies to agree to a global minimum tax rate. The countries with tax rates much lower than the global average benefit because they draw in corporate subsidiaries that hope to benefit from the lower tax rates.

Sector-specific Tax Behavior 

It is true that companies in different sectors are affected by the tax code differently, partly because there are tax credits and deductions that are directly specifically at specific sectors. To examine differences in tax rates paid by US companies in each industry grouping, I decided to go back to 2019, rather than 2020 numbers, because the COVID crisis wreaked havoc in some sectors. 

Data for all industries

There are clear differences in taxes paid across sectors, with some of the reasons being obvious (REITs are pass through entities that pay no federal taxes) and some not. For instance, technology companies and pharmaceutical businesses are mostly in the first two columns (with the lowest tax rates) and retail  companies pay much higher tax rates.  Pharmaceutical and technology companies do share a common characteristic, which is that their primary capital expenditure takes the form of R&D, which has historically been expensed at these companies, rather than capitalized and depreciated. To see if that has explanatory power, when it comes to effective tax rates, I broke down US companies into quintiles, based upon R&D as a percent of sales, again using 2019 data, and computed effective and cash tax rates, by quintile:

Companies that have the highest percent of R&D as a percent of sales not only have the smallest proportion of firms with taxable income, but also pay the lowest effective and cash tax rates. However, these are also younger, money-losing companies, and their tax behavior may just reflect where they are in the corporate life cycle. In fact, when you compare all firms with R&D expenses to those without those expenses, the results are mixed. A larger proportion of firms with R&D expenses report taxable income, and while they pay a lower effective tax rate than non-R&D firms, they pay a highest cash tax rate.

Finally, there seems to be a perception that it is the largest companies that are not paying their fair share in taxes, fed by anecdotal evidence of high profile companies that pay no taxes; in the last few years, those examples have included GE, Amazon and FedEx. To see if this is true, across companies, I broke US companies down my market capitalization into ten deciles and looked at the tax behavior in each grouping.
There is little evidence in this table to support the notion that larger companies are more likely to evade taxes than smaller ones. In fact, the percentage of companies with taxable income rises with market capitalization, and the effective tax rates of the top deciles are clearly higher than those of the bottom deciles.

Thoughts on new tax laws

If Congress gets around to passing another tax reform act, I am sure that legislators will gets lots of opinions on what they should be doing, not to mention millions of dollars off lobbying directed at them. I am sure that my thoughts on what good tax legislation should look like matter little, but here they are:

  1. Pinpoint your mission: In keeping with the saying that if you do not know where you going, it does not matter how you get there, the starting point for all tax legislation has to be with the end game. Early on, legislators have to decide whether they consider corporate taxes to primarily a source of revenues to the government or a weapon to punish "bad" corporate behavior and to "reward" good corporate behavior. While I understand the urge to use the tax code to mete out punishment to "bad" companies or to encourage companies to pay a living wage and keep their operations in the United States, the resulting laws may actually result in less tax revenue to the government, with only fleeting benefits.
  2. All tax talk is agenda-driven: Undoubtedly, there will be research from the Congressional budget office on the revenue consequences of tax law changes and testimony from economists and tax experts. They will use numbers that back their arguments and look like facts, but in my experience, it is easy to lie with numbers, especially when it comes to taxes.  
  3. Focus on removing tax deductions/credits, not on increasing tax rates: If the end game is to get companies to pay more in taxes, removing tax deductions and credits will be more effective than increasing the tax rate. In fact, raising the tax rate will not only raise the effective tax rate paid by companies far less than expected, but it will also have disparate effects across companies, with sectors (like retail) that have fewer degrees of freedom, when it comes to changing taxable income or deferring taxes, bearing the brunt of the pain. I know that this is easier said than done, since every tax deduction/credit has a constituency that will plead for its preservation, but one reason why the tax code has become the convoluted mess that it has become, is because we have not frontally dealt with this problem. An added benefit of doing this will be that there will be less work for tax accountants and lawyers and fewer tax-driven investments and decisions.
  4. You operate in a global economy: No matter how careful you write the tax laws, multinationals will retain a substantial amount of freedom to move their operations and income around the world. A country that is an outlier when it comes to taxes, as the United States was prior to 2017, will lose out in the competition for new businesses. While I do think that a global corporate minimum tax can reduce this cost somewhat, getting countries to sign on, especially when they realize that they will be "net losers" from being part of it, will be difficult.
  5. Provide long-term predictability: Whatever Congress decides to do with the tax code, it should also provide a degree of predictability for an extended period. Changes to the tax law that are temporary or come with sunset provisions create uncertainty for businesses trying to make investment decisions for the long term. In addition, changes in tax law take a while to work their way into corporate behavior. One of the better features of the 2017 tax act was that it had provisions designed to make debt financing less attractive, relative to equity, but we will not get a chance to see if companies become less dependent on debt, if tax rates are hiked and/or the limitations on interest tax deductions are eliminated.
Am I hopeful that Congress will keep these in mind, while it writes new tax laws? Not really, but there is no harm in hoping!

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Datasets

Thursday, March 25, 2021

Interest Rates, Earning Growth and Equity Value: Investment Implications

The first quarter of 2021 has been, for the most part, a good time for equity markets, but there have been surprises. The first has been the steep rise in treasury rates in the last twelve weeks, as investors reassess expected economic growth over the rest of the year and worry about inflation. The second has been a shift within equity markets, a "rotation" in Wall Street terms, as the winners from last year underperformed the losers in the first quarter, raising questions about whether this shift is a long term one or just a short term adjustment. The answers are not academic, since they cut to the heart of how stockholders will do over the rest of the year, and whether value investors will finally be able to mount a comeback.

The Interest Rates Story 

To me the biggest story of markets in 2021 has been the rise of interest rates, especially at the long end of the maturity spectrum. To understand the story and put it in context, I will go back more than a decade to the 2008 crisis, and note how in its aftermath, US treasury rates dropped and stayed low for the next decade. 

Coming in 2020, the ten-year T.Bond rate at 1.92% was already close to historic lows. The arrival of the COVID in February 2020, and the ensuing market meltdown, causing treasury rates to plummet across the spectrum, with three-month T.bill rates dropping from 1.5% to close to zero, and the ten-year T.Bond rate declining to close to 0.70%. Those rates stayed low through the rest of 2020, even as equity markets recovered and corporate bond spreads fell back to pre-crisis levels. Coming into 2021, the ten-year T.Bond rate was at 0.93%, and I noted the contradiction in investor assessments for the rest of the year, with the consensus gathered around a strong economic comeback (with earnings growth following), but with rates continuing to stay low. In the first quarter of 2021, we continued to see evidence of economic growth, bolstered by a stimulus package of $1.9 trillion, but it does seem like the treasury bond market is starting to wake up to that recognition as well, as rates have risen strongly:



These rising rates have led to some hand wringing about why the Fed is not doing more to keep rates down, mostly from people who seem to have an almost mystical faith in the Fed's capacity to keep rates wherever it wants them to be. I would argue that the Fed has tried everything it can to keep rates from rising, and the very fact that rates have risen, in spite of this effort, is an indication of the limited power it has to set any of the rates that we care about in investing. To those who use the low interest rates of the last decade as proof of the Fed's power, I would counter with a graph that I have used many times before to illustrate the fundamental drivers of interest rates (and the Fed is not on that list):


The reason interest rates have been low for the last decade is because inflation has been low and real growth has been anemic. With its bond buying programs and its "keep rates low" talk, the Fed has had influence, but only at the margin. 

As for rates for the rest of the year, you may draw comfort from the Fed's assurances that it will keep rate low, but I don't. Put bluntly, the only rate that the Fed directly sets is the Fed Funds rate, and while it may send signals to the market with its words and actions, it faces two limits. 

  • The first is that the Fed Funds rate is currently close to zero, limiting the Fed's capacity to signal with lower rates. 
  • The second and more powerful factor is that the reason that a central bank is able to signal to markets, only if it has credibility, since the signal is more about what the Fed sees, using data that only it might have, about inflation and real growth in the future. Every time a Federal Reserve chair or any of the FOMC members make utterances that undercut that credibility, the Fed risks losing even the limited signaling power it continues to have. I believe that the most effective central bankers speak very little, and when they do, don't say much.
In particular, the Fed's own assessments of real growth of 6.5% for 2021 and inflation of 2.2% for the year are at war with its concurrent promise to keep rates low; after all, adding those numbers up yields a intrinsic risk free rate of 8.7%. While I understand that much of the real growth in 2021 is a bounce back from 2020, even using a 2-3% real growth yields risk free rates that are much, much higher than today's numbers. 

The Stocks Story

As treasury rates have risen in 2021, equity markets have been surprisingly resilient, with stocks up  during the first three months. However, as with last year, the gains have been uneven with some  groups of stocks doing better than others, with an interesting twist; the winners of last year seem to be lagging this year, and the losers are doing much better. While some of this reversal is to be expected in any market, there are questions about whether it has anything to do with rising rates, as well as whether there may be light at the end of the tunnel for some investor groups who were left out of the market run-up in the last decade.  For much of the last year, I tracked the S&P 500 and the NASDAQ, the first standing in for large cap stocks and the broader market, and the latter proxying for technology and growth stocks, with some very large market companies included in the mix. Continuing that practice, I look at the two indices in 2021:

Both indices are up for the year, but they have diverged in their paths. In January, the NASDAQ continued its 2020 success, and the S&P 500 lagged, losing value. In February and March, the tide shifted, and the S&P 500 outperformed the NASDAQ. Looking at the market capitalization of all stocks listed in the United States, and breaking down the market action in 2021, by sector, here is what I see:
The two sectors where there is the biggest divergence between post-crisis performance in 2020 and market returns in 2021 are energy, which has gone from one of the worse performing sectors to the very best and technology, which has made a journey in the other direction. Using price to book ratios as a rough proxy for value versus growth, I looked at returns in the post-crisis period in 2020 and in 2021, to derive the following table:

It is much too early to be drawing strong conclusions, but at least so far in 2021, low price to book stocks, which lagged the market in 2020, are doing much better than higher price to book stocks. 

Interest Rates and Value

As interest rates have risen, the discussion in markets has turned ito the effects that these rates will have on stock prices. While the facile answer is that higher rates will cause stock prices to fall, I will argue in this section that not only is the answer more nuanced, and depends, in large part, on why rates are rising in the first place.

Value Framework

As with any discussion about value and the variables that affect it, I find it useful to go back to basics. If you accept the proposition that the value of a business is a function of its expected cash flows (with both the benefits and costs of growth embedded in them) and the risk in these cash flows, we are in agreement on what drives value, even if we disagree about the specifics on how to measure risk and incorporate it into value:


This equation looks abstract, but it has all of the components of a business in it, as you can see in this richer version of the equation:

In this richer version, the effect of rising rates can be captured in the components that drive value. The direct effect is obviously through the base rate, i.e. the riskfree rate, on which the discount rate is built, and it is the effect that most analysts latch on to. If you stopped with that effect, rising rates always lead to lower values for equities, since holding all else constant, and raising what you require as a rate of return will translate into lower value today. That misses the indirect effects, and these indirect effects emerge from looking at why rates rose in the first place. Fundamentally, interest rates can rise because investors expectations of inflation go up, or because real economic growth increases, and these macroeconomic fundamentals can affect the other drivers of value:

Higher real growthHigher inflation
Riskfree RateRiskfree rate will rise.Riskfree rate will rise.
Risk premiumsNo effect or even a decrease.Risk premia may rise as inflation increases, because higher inflation is almost always more volatile than low inflation.
Revenue GrowthIncreases with economic growth, and more so economy-dependent companiesIncreases, as inflation provides a backdraft adding to existing real growth.
Operating MarginsIncreases, as increased consumer spending/demand allows for price increasesFor companies with the power to pass through inflation to their customers, stable margins, but for companies without that pricing power, margins decrease.
Investment EfficiencyImproves, as the same investment delivers more revenues/profits.No effect, in real terms, but in nominal terms, companies can look more efficient.
Value EffectMore likely to be positive. Investors will demand higher rates of return (negative), but higher earnings and cash flows can more than offset effect.More likely to be negative. Investors will demand higher rates of return (negative), and while revenue growth will increase, lower margins will lead to lagging earnings.

Put simply, the effect of rising rates on stock prices will depend in large part on the precipitating factors. 

  • If rising rates are primarily driven by expectations of higher real growth, the effect is more likely to be positive, as higher growth and margins offset the effect of investors demanding higher rates of return on their investments. 
  • If rising rates are primarily driven by inflation, the effects are far more likely to be negative, since you have more negative side effects, with risk premiums rising and margins coming under pressure, especially for companies without pricing power. 
To see how changes in interest rates play out in equity markets, I started with a simple, perhaps even simplistic adjustment, where I look at quarterly stock returns and T.Bond rates at the start of each quarter, to examine the linkage.
Download data

While the chart itself has too much noise to draw conclusions, the correlations that I have calculated provide more information. The negative correlation between stock returns and rate changes in the prior quarter (-.12 with the treasury bond rate) provide backing for the conventional wisdom that rising rates are more likely to be accompanied by lower stock returns. However, if you break down the reason for rising rates into higher inflation and higher real growth increases, stocks are negatively affected by the former (correlation of -0.078) and positively affected by the latter (correlation of .087). It is also worth noting that none of the correlations are significant enough to represent money making opportunities, since there seems to be much more driving stock returns than just interest rates, inflation and real growth. 

I also updated my valuation (from January 2021) of the S&P to reflect current rates and earnings numbers, and played out the effect of changing rates on the intrinsic PE ratio for the index:
In making these computations, I looked at three scenarios, a neutral scenario, where changes in the T.Bond rate are matched by changes in the expected long term earnings growth rate, a benign scenario, where expected long term earnings growth runs ahead of the change in the T.Bond rate by 0.5%, in the long term, and a malignant scenario, where earnings growth lags changes in the T.Bond rate by 0.5%, in the long term. Note that in the best case scenario, at least with my range of outcomes, where rates drop back to 1.00%, but long term earnings growth runs ahead of riskfree rates by 0.5%, the intrinsic value for the index is 3919, just above current levels. In the worst case scenario, where rates rise to 3% or higher, and growth lags by 0.5%, the index is over valued significantly. Connecting to my earlier discussion of how inflation and real growth play out differently in earnings growth, I would expect a real-growth driven increase in rates to yield values closer to my benign ones, where an inflation-driven increase in rates will be far more damaging for stocks.

Rates and the Corporate Life Cycle

There is a surprisingly complicated relationship between interest rates and stock prices, with higher interest rates sometimes coexisting with higher stock prices and sometimes with lower. As rates rise, though, the effects on value will vary across companies, with some companies being hurt more and others being hurt less, or even helped. To understand why, I will draw on one of my favorite structures, the corporate life cycle, where I argue that most companies go through a process of birth, growth, aging and ultimate decline and death. To see the connection with interest rates, note that there are two dimensions on which companies vary across the life cycle:

  1. Cashflows: Young companies are more likely to have negative than positive cash flows in the early years, as their business models are in flux, economies of scale have not kicked in yet, and substantial reinvestment is needed to deliver the promised growth. As they mature, the cash flows will turn positive, as margins improve and reinvestment needs drop off. 

  2. Source of value: Drawing on another construct , the financial balance sheet, the value of a company can be broken down into the value it derives from investments it has already made (assets in place) and the value of investments it is expected to make in the future (growth assets). Young companies derive the bulk of their value from growth assets, whereas more mature firms get their value from assets in place. 

Connecting to the earlier discussion on interest rates and value, you can see why increases in interest rates can have divergent effects on companies at different stages in the life cycle. When interest rates rise, the value of future growth decreases, relative to the value of assets in place, for all companies, but the effect is far greater for young companies than mature companies. This will be true even if growth  rates match increases in interest rates, but it will get worse if growth does not keep up with rate increases. 

To illustrate this, I will use two firms, similar in asset quality (return on equity = 15%) and risk (cost of equity is 5% above the risk free rate), but different in growth prospects; the mature firm will grow 1% higher than the riskfree rate and the growth firm will grow 10% a year higher than the risk free rate, for the next 10 years. After year 10, both firms will be mature, growing at the risk free rate. As I increase the risk free rate, note that the costs of equity and growth rates will go up for both firms, and that their reinvestment needs will change accordingly. The effects of changing the T.Bond rate in this simplistic example are illustrated below:

Download spreadsheet

Both companies see a decline in PE ratios, as interest rates rise, but the high growth firm sees a bigger drop. This is captured in the growth premium (computed by comparing the PE ratio for the growth firm to the PE ratio for a mature firm). You can check out the effects of introducing malign and benign growth effects into this example, with the former exacerbating the differential effect and the latter reducing it.

The Rest of 2021

I hope that this discussion of the relationship between interest rates and value provides some insight into both why the equity market has been able to maintain its upward trend in the face of rising rates, as well as explain the divergences across growth and mature companies. The primary story driving interest rates, for much of 2021, has been one of economic resurgence, and it does not surprise me that the positives have outweighed the negatives, so far. At the same time, there is concern that inflation might be lurking under the surface, and on days when these worries surface, the market is much more susceptible to melting down. My guess is that this dance will continue for the foreseeable future, but as more real data comes out on both real growth and inflation, one or the other point of view will get vindication. Unlike some in the market, who believe that the Fed has the power to squelch inflation, if it does come back, I am old enough to remember both how stealthy inflation is, as well as how difficult it is for central banks to reassert dominance over inflation, once it emerges as a threat.

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Data links

  1. Treasury Rates; 1928 to 2020
  2. Intrinsic versus Actual T.Bond Rate: 1954-2020
  3. Stock Returns, Interest Rates, Inflation and Real Growth: 1960-2020

Spreadsheets

  1. S&P 500 valuation spreadsheet- March 23, 2021
  2. PE calculator for mature and growth companies


Wednesday, February 10, 2021

Data Update 4 for 2021: The Hurdle Rate Question!

What is a hurdle rate for a business? There are multiple definitions that you will see offered, from it being the cost of raising capital for that business to an opportunity cost, i.e., a return that you can make investing elsewhere, to a required return for investors in that business. In a sense, each of those definitions has an element of truth to it, but used loosely, each of them can also lead you to the wrong destination. In this post, I will start by looking at the role that hurdle rates play in running a business, with the consequences of setting them too high or too low, and then look at the fundamentals that should cause hurdle rates to vary across companies.

What is a hurdle rate?

Every business, small or large, public or private, faces a challenge of how to allocate capital across competing needs (projects, investments and acquisitions), though some businesses have more opportunities or face more severe constraints than others. In making these allocation or investment decisions, businesses have to make judgments on the minimum return that they would accept on an investment, given its risk, and that minimum return is referenced as the hurdle rate.  Having said that, though, it is worth noting that this is where the consensus ends, since there are deep divides on how this hurdle rate should be computed, with companies diverging and following three broad paths to get that number:

1. Cost of raising funds (capital): Since the funds that are invested by a business come from equity investors and lenders, one way in which the hurdle rate is computed is by looking at how much it costs the investing company to raise those funds. Without any loss of generality, if we define the rate of return that investors demand for investing in equity as the cost of equity and the rate that lenders charge for lending you money as the cost of debt, the weighted average of these two costs, with the weights representing how much of each source you use, is the cost of capital:

The problem with a  corporate cost of capital as a hurdle rate is that it presumes that every project the company takes has the same overall risk profile as the company. That may make sense if you are a retailer, and every investment you make is another mall store, but it clearly does not, if you are a company in multiple businesses (or geographies) and some investments are much riskier than others. 

2. Opportunity Cost: The use of a corporate cost of capital as a hurdle rate exposes you to risk shifting, where safe projects subsidize risky projects, and one simple and effective fix is to shift the focus away from how much it costs a company to raise money to the risk of the project or investment under consideration. The notion of opportunity cost makes sense only if it is conditioned on risk, and the opportunity cost of investing in a project should be the rate of return you could earn on an alternative investment of equivalent risk.

If you follow this practice, you are replacing a corporate cost of capital with a project-specific hurdle rate, that reflects the risk of that project. It is more work than having one corporate hurdle rate, but you are replacing a bludgeon with a scalpel, and the more varied your projects, in terms of business and geography, the greater the payoff.

3. Capital Constrained Clearing Rate: The notion that any investment that earns more than what other investments of equivalent risk are delivering is a good one, but it is built on the presumption that businesses have the capital to take all good investments. Many companies face capital constraints, some external (lack of access to capital markets) and some internal (a refusal to issue new equity because of dilution concerns), and consequently cannot follow this rule. Instead, they find a hurdle rate that incorporates their capital constraints, yielding a hurdle rate much higher than the true opportunity cost. To illustrate, assume that you are a company with fifty projects, all of similar risk, and all earning more than the 10% that investments of equivalent risk are making in the market. If you faced no capital constraints, you would take all fifty, but assume that you have limited capital, and that you rank these projects from highest to lowest returns (IRR or accounting return). The logical thing to do is to work down the list, accepting projects with the highest returns first until you run out of capital. If the last project that you end up accepting has a 20% rate of return, you set your hurdle rate as 20%, a number that clears your capital. 

By itself, this practice make sense, but inertia is one of the strongest forces in business, and that 20% hurdle rate often become embedded in practice, even as the company grows and capital constraints disappear. The consequences are both predictable and damaging, since projects making less than 20% are being turned away, even as cash builds up in these companies.

While the three approaches look divergent and you may expect them to yield different answers, they are tied together more than you realize, at least in steady state. Specifically, if market prices reflect fair value, the cost of raising funds for a company will reflect the weighted average of the opportunity costs of the investments they make as a company, and a combination of scaling up (reducing capital constraints) and increased competition (reducing returns on investments) will push the capital constrained clearing rate towards the other two measures. If you are willing to be bored, I do have a paper on cost of capital that explains how the different definitions play out, as well as the details of estimating each one.

Hurdle Rate - The Drivers

For the rest of this post, I will adopt the opportunity cost version of hurdle rates, where you are trying to measure how much you should demand on a project or investment, given its risks. In this section, I will point to the three key determinants of whether the hurdle rate on your next project should be 5% or 15%.  The first is the business that the investment is in, and the risk profile of that business. The second is geography, with hurdle rates being higher for projects in some parts of the world, than others. The third is currency, with hurdle rates, for any given project, varying across currencies.

A. Business

If you are a company with two business lines, one with predictable revenues and stable profit margins, and the other with cyclical revenues and volatile margins, you would expect to, other things remaining equal, use a lower hurdle rate for the first than the second. That said, there are two tricky components of business risk that you need to navigate:

  1. Firm specific versus Macro risk: When you invest in a company, be it GameStop or Apple, there are two types of risks that you are exposed to, risks that are specific to the company (that GameStop's online sales will be undercut by competition or that Apple's next iPhone launch may not go well) and risks that are macroeconomic and market-wide (that the economy may not come back strongly from the shut down or that inflation will flare up). If you put all your money in one or the other of these companies, you are exposed to all these risks, but if you spread your bets across a dozen or more companies, you will find that company-specific risk gets averaged out. From a hurdle rate perspective, this implies that companies, where  the marginal investors (who own a lot of stock and trade that stock) are diversified, should incorporate only macroeconomic or market risk into hurdle rates. For small private firms, where the sole owner is not diversified, the hurdle rate will have to incorporate and be higher.
  2. Financial leverage: There are two ways you can raise funding for a company, and since lenders have contractual claims on the cash flows, the cost of debt should be lower than the cost of equity for almost every company, and that difference is increased by the tax laws tilt towards debt (with interest expenses being tax deductible). Unfortunately, there are many who take this reality and jump to the conclusion that adding debt will lower your hurdle rate, an argument that is built on false premises and lazy calculations. In truth, debt can lower the hurdle rate for some companies, but almost entirely because of the tax subsidy feature, not because it is cheaper, but it can just as easily increase the hurdle rate for others, as distress risk outweighs the tax benefits. (More on that issue in a future data update post...)

I know that many of you are not fans of modern portfolio theory or betas, but ultimately, there is no way around the requirement that you need to measure how risky a business, relative to other businesses. I am a pragmatist when it comes to betas, viewing them as relative risk measures that work reasonably well for diversified investors, but I have also been open about the fact that I will take an alternate measure of risk that accomplishes the same objective. 

To illustrate how costs of capital can vary across businesses, I used a very broad classification of global companies into sectors, and computed the cost of capital at the start of 2021, in US $ terms, for each one:

If you prefer a more granular breakdown, I estimate costs of capital by industry (with 95 industry groupings) in US $ and you can find the links here. (US, Europe, Emerging Markets, Japan, Australia/NZ & Canada, Global)

2. Geography

As a business, should you demand a higher US $ hurdle rate for investing in a project in Nigeria than the US $ hurdle rate you would require for an otherwise similar project in Germany?  The answer, to me, seems to be obviously yes, though there are still some who argue otherwise, usually with the argument that country risk can be diversified away. The vehicle that I use to convey country risk into hurdle rates is the equity risk premium, the price of risk in equity markets, that I talked about in my earlier post on the topic. In that post, I computed the equity risk premium for the S&P 500 at the start of 2021 to be 4.72%, using a forward-looking, dynamic measure. If you accept that estimate, a company looking at a project in the US or a geographical market similar to the US in terms of country risk, would accept projects that delivered this risk premium to equity investors. 

But what if the company is looking at a project in Nigeria or Bangladesh? To answer that question, I estimate equity risk premiums for almost every country in the world, using a very simple (or simplistic) approach. I start with the 4.72%, my estimate of the US ERP, as my base premium for mature equity markets, treating all Aaa rated countries (Germany, Australia, Singapore etc.) as mature markets. For countries not rated Aaa, I use the sovereign rating for the country to estimate a default spread for that country, and scale up that default spread for the higher risk that equities bring in, relative to government bonds. 

That additional premium, which I call a country risk premium, when added to the US ERP, gives me an equity risk premium for the country in question. 

Download country ERPs

What does this mean? Going back to the start of this section, a company (say Ford) would require a higher cost of equity for a Nigerian project than for an equivalent German project (using a US $ risk free rate of 1% and a beta of 1.1 for Ford).

  • Cost of equity in US $ for German project = 1% + 1.1 (4.72%) = 6.19%
  • Cost of equity in US $ for a Nigerian project = 1% + 1.1 (10.05%) = 12.06%
The additional 5.87% that Ford is demanding on its Nigerian investment reflects the additional risk that the country brings to the mix.

3. Currency

I have studiously avoided dealing with currencies so far, by denominating all of my illustrations in US dollars, but that may strike some of you as avoidance. After all, the currency in Nigeria is the Naira and in Germany is the Euro, and you may wonder how currencies play out in hurdle rates. My answer is that currencies are a scaling variable, and dealing with them is simple if you remember that the primary reason why hurdle rates vary across currencies is because they bring different inflation expectations into the process, with higher-inflation currencies commanding higher hurdle rates. To illustrate, if you assume that inflation in the US $ is 1% and that inflation in the Nigerian Naira is 8%, the hurdle rate that we computed for the Nigerian project in the last section can be calculated as follows:

  • Cost of equity in Naira for Nigerian project (approximate) = 12.06% + (8% - 1%) = 19.06%
  • Cost of equity in Naira for Nigerian project (precise) = 1.1206 * (1.08/1.01) -1 = 19.83%

In effect, the Nigerian Naira hurdle rate will be higher by 7% (7.77%) roughly (precisely) than a US $ hurdle rate, and that difference is entirely attributable to inflation differentials. The instrument that best delivers measures of the expected inflation is the riskfree rate in a currency, which I compute by starting with a government bond rate in that currency and then cleaning up for default risk. At the start of 2021, the riskfree rates in different currencies are shown below:

Download government-bond based riskfree rates

These risk free rates are derived from government bond rates, and to the extent that some of the government bonds that I looked at are not liquid or widely traded, you may decide to replace those rates with synthetic versions, where you add the differential inflation to the US dollar risk free rate. Also, note that there are quite a few currencies with negative risk free rates, a phenomenon that can be unsettling, but one you can work with, as long as you stay consistent.

Implications

As we reach the end of this discussion, thankfully for all our sakes, let's look at the implications of what the numbers at the end of 2020 are for investors are companies. 

  1. Get currency nailed down: We all have our frames of reference, based often upon where we work, and not surprisingly, when we talk with others, we expect them to share the same frames of reference. When it comes to hurdle rates, that can be dangerous, since hurdle rates will vary across currencies, and cross-currency comparisons are useless. Thus, a 6% hurdle rate in Euros may look lower than a 12% hurdle rate in Turkish lira, but after inflation is considered, the latter may be the lower value. Any talk of a global risk free rate is nonsensical, since risk free rates go with currencies, and currencies matter only because they convey inflation. That is why you always have the option of completely removing inflation from your analysis, and do it in real terms.
  2. A low hurdle rate world: At the start of 2021, you are looking at hurdle rates that are lower than they have ever been in history, for most currencies. In the US dollar, for instance, a combination of historically low risk free rates and compressed equity risk premiums have brought down costs of capital across the board, and you can see that in the histogram of costs of capital in US $ of US and global companies at the start of 2021:

    The median cost of capital in US $ for a US company is 5.30%, and for a global company is 5.78%, and those numbers will become even lower if you compute them in Euros, Yen or Francs.  I know that if you are an analyst, those numbers look low to you, and the older you are, the lower they will look, telling you something about how your framing of what you define to be normal is a function of what you used to see in practice, when you were learning your craft. That said, unless you want to convert every company valuation into a judgment call on markets, you have to get used to working with  these lower discount rates, while adjusting your inputs for growth and cash flows to reflect the conditions that are causing those low discount rates. For companies and investors who live in the past, this is bad news.  A company that uses a 15% cost of capital, because that is what it has always used, will have a hard time finding any investments that make the cut, and investors who posit that they will never invest in stocks unless they get double digit returns will find themselves holding almost mostly-cash portfolios. While both may still want to build a buffer to allow for rising interest rates or risk premiums, that buffer is still on top of a really low hurdle rate and getting to 10% or 15% is close to impossible.
  3. Don't sweat the small stuff: I spend a lot of my time talking about and doing intrinsic valuations, and for those of you who use discounted cash flow valuations to arrive at intrinsic value, it is true that discount rates are an integral part of a DCF. That said, I believe that we spend way too much time on discount rates, finessing risk measures and risk premiums, and too little time on cash flows. In fact, if you are in a hurry to value a company in US dollars, my suggestion is that you just use a cost of capital based upon the distribution in the graph above (4.16% for a safe company, 5.30% for an average risk company or 5.73% for a risky company) as your discount rate, spend your time estimating revenue growth, margins and reinvestment, and if you do have the time, come back and tweak the discount rate. 

I know that some of you have been convinced about the centrality of discount rates by sensitivity analyses that show value changing dramatically as discount rates changes. These results are almost the consequence of changing discount rates, while leaving all else unchanged, an impossible trick to pull off in the real world. Put simply, if you woke up tomorrow in a world where the risk free rate was 4% and the cost of capital was 8% for the median company, do you really believe that the earnings and cash flows you projected in a COVID world will remain magically unchanged? I don't!

YouTube Video


Spreadsheets

  1. Cost of capital, by industry - January 2021 (US, Europe, Emerging Markets, Japan, Australia/NZ & Canada, Global)
  2. Equity Risk Premiums, by Country - January 2021 
  3. Risk free rates by currency - January 2021

Wednesday, February 3, 2021

The Price-Value Feedback Loop: A Look at GME and AMC!

There are three topics that you can write or talk about that are almost guaranteed to draw a audience, stocks (because greed drives us all), sex (no reason needed) and salvation. I am not an expert on the latter two, and I am not sure that I have that much that is original to say about the first. That said,  in my niche, which is valuation, many start with the presumption that almost every topic you pick is boring. Obviously, I do not believe that, but there are some topics in valuation that are tough to care about, unless they are connected to real events or current news. One issue that I have always wanted to write about is the potential for a feedback loop between price and value (I can see you already rolling your eyes, and getting ready to move on..), but with the frenzy around GameStop and AMC, you may find it interesting. Specifically, a key question that many investors, traders and interested observers have been asking is whether a company, whose stock price and business is beleaguered, can take advantage of a soaring stock price to not just pull itself out of trouble, but make itself a more valuable firm. In other words, can there be a feedback loop, where increasing stock prices can pull value up, and conversely, could decreasing prices push value down?

Price, Value and the Gap

For the third time in three posts, I am going to fall back on my divide between value and price. Value, as I have argued is a function of cash flows, growth and risk, reflecting the quality of a company's business model. Price is determined by demand and supply, where, in addition to, or perhaps even overwhelming, fundamentals, you have mood, momentum and revenge (at least in the case of GameStop) thrown into the mix. Since the two processes are driven by different forces, there is no guarantee that the two will yield the same number for an investment or a company at a point in time:

Put simply, you can have the price be greater than value (over valued), less than value (under valued) or roughly the same (fairly valued). The last scenario is the one where markets are reasonably efficient, and in that scenario, the two processes do not leak into each other. In terms of specifics, when a stock's value is roughly equal to its price:

  • Issuing new shares at the market price will have no effect on the value per share or the price per share, dilution bogeyman notwithstanding.
  • Buying back shares at the market price will have no effect on the value per share or price per share of the remaining shares, even though the earnings per share may increase as a result of decreased share count.
I know these implications sound unbelievable, especially since we have been told over and over that these actions have consequences for investors, and so much analysis is built around assessments of accretion and dilution, with the former being viewed as an unalloyed good and latter as bad.

The Feedback Loop
In the real world, there are very few people who believe in absolute market efficiency, with even the strongest proponents of the idea accepting the fact that price can deviate from value for some or many companies. When this happens, and there is a gap between price and value, there is the potential for a feedback loop, where a company's pricing can affects its value. That loop can be either a virtuous one (where strong pricing for a company can push up its value) or a vicious one (where weak pricing for a company can push down value). There are three levels at which a gap between value and price can feed back into value:
  • Perception: While nothing fundamentally has changed in the company, a rise (fall) in its stock price, makes bondholders/lenders more willing to slacken (tighten) constraints on the firm and increase (decrease) the chances of debt being renegotiated. It also affects the company's capacity to attract or repel new employees, with higher stock prices making a company a more attractive destination (especially with stock-based compensation thrown into the mix) and lower stock prices having the opposite effect.
  • Implicit effects: When a company's stock price goes up or down, there can be tangible changes to the company's fundamentals. If a company has a significant amount of debt that is weighing it down, creating distress risk, and some of it is convertible, a surge in the stock price can result in debt being converted to equity on favorable terms (fewer shares being issued in return) and reduce default risk. Conversely, if the stock price drops, the conversion option in convertible debt will melt away, making it almost all debt, and pushing up debt as a percent of value. A surge or drop in stock prices can also affect a company's capacity to retain existing employees, especially when those employees have received large portions of their compensation in equity (options or restricted stock) in prior years. If stock prices rise (fall), both options and restricted stock will gain (lose) in value, and these employees are more (less) likely to stay on to collect on the proceeds. 
  • Explicit effects: If a company's stock price rises well above value, companies will be drawn to issue new shares at that price. While I will point out some of the limits of this strategy below, the logic is simple. Issuing shares at the higher price will bring in cash into the company and it will augment overall value per share, even though that augmentation is coming purely from the increase in cash.  Companies can use the cash proceeds to pay down debt (reducing the distress likelihood) or even to change their business models, investing in new models or acquiring them. If a company's stock price falls below value, a different set of incentives kick in. If that company buys back shares at that stock price, the value per share of the remaining shares will increase. To do this, though, the company will need cash, which may require divestitures and shrinking the business model, not a bad outcome if the business has become a bad one.
I have summarized all of these effects in the table below:


These effects will play out in different inputs into valuation, with the reduction in distress risk showing up in lower costs for debt and failure probabilities, the capacity to hire new and keep existing employees in higher operating margin, the issuance or buyback of shares in cash balances and changes in the parameters of the business model (growth, profitability). Looking at the explicit effect of being able to issue shares in the over valued company or buy back shares in the under valued one, there are limits that constrain their use:
  1. Regulations and legal restrictions: A share issuance by a company that is already public is a secondary offering, and while it is less involved than a primary offering (IPO), there are still regulatory requirements that take time and require SEC approval. Specifically, a company planning a secondary offering has to file a prospectus (S-3), listing out risks that the company faces, how many shares it plans to issue and what it plans to use the proceeds for. That process is not as time consuming or as arduous as it used to be, but it is not instantaneous; put simply, a company that sees its stock price go up 10-fold in a day won't be able to issue shares the next day.
  2. Demand, supply and momentum: If the price is set by demand and supply, increasing the supply of shares will cause price to drop, but the effect is much more insidious. To the extent that the demand for an over valued stock is driven by mood and momentum, the very act of issuing shares can alter momentum, magnifying the downward pressure on stock prices. Put simply, a company that sees it stock price quadruple that then rushes a stock issuance to the market may find that the act of issuing the shares, unless pre-planned, May itself cause the price rise to unravel.
  3. Value transfer, not value creation: Even if you get past the regulatory and demand/supply obstacles, and are able to issue the shares at the high price, it is important that you not operate under the delusion that you have created value in that stock issuance. The increase in value per share that you get comes from a value transfer, from the shareholders who buy the newly issued shares at too high a price to the existing shareholders in the company.
  4. Cash and trust: If you can live with the value transfer, there is one final hurdle. The new stock issuance will leave the company with a substantial cash balance, and if the company's business model is broken, there is a very real danger that managers, rather than follow finding productive ways to fix the model, will waste the cash trying to reinvent themselves.
With buybacks, the benefits of buying shares back at below value are much touted, and Warren Buffett made this precept an explicit part of the Berkshire Hathaway buyback program, but buybacks face their own constraints. A large buyback may require a tender offer, with all of the costs and restrictions that come with them, the act of buying back stock may push the price up and beyond value. The value transfer in buybacks, if they occur at below fair value, also benefit existing shareholders, but the losers will be those shareholders who sold their shares back. Finally, a buyback funded with cash that a company could have used on productive investment opportunities is lost value for the company.

Reality Check

With that long lead in, we can address the question that many of those most upbeat about GameStop and AMC were asking last week. Can the largely successful effort, at least so far, in pushing up stock prices actually make GameStop or AMC a more valuable company? The answer is nuanced and it depends on the company:
  • Perception: For the moment, the rise in the stock price has bought breathing room in both companies, as lenders back off, but that effect is likely to be transient. Perception alone cannot drive up value.
  • Implicit effects: On this dimension, AMC has already derived tangible benefits, as $600 million in convertible debt will become equity, making the company far less distressed. For those Redditors primed for revenge against Wall Street, it is worth noting that the biggest beneficiary in this conversion is Silver Lake, a hedge fund that invested in these bonds in the dark days for the company. GameStop's debt is more conventional borrowing, and while bond prices have gone up, the benefits don't accrue as directly to the company.
  • Explicit effects: On this dimension again, AMC is better positioned, having already filed a prospectus for a secondary offering on December 11, well ahead of the stock run-up. In that offering, AMC filed for approval for issuance of up to 178 million additional shares, from time to time, primarily to pay down debt. If the stock price stays elevated, and that is a big if, AMC will be able to issue shares at a price > value and increase its value per share. It is unclear whether GameStop has the time to even try to do this, especially if the stock price rise dissipates in days or weeks, rather than months.
To incorporate the feedback loop, I had modified my base case GameStop valuation (not the best case that you saw in my last post), and allowed for two additional inputs: new shares issued and an issuance price. Note that the value per share that I get with no additional shares issued is $28.17, and you can see how that value per share changes, for different combinations of issuance share numbers and issuance share prices:

Note that if the issuance occurs at my estimate of intrinsic value of $28.17, the share issuance has no effect on value per share, since the increase in share count offsets the increased cash balance exactly. Even in the more upbeat scenarios, where the company is able to issue new shares at a price above this value, let's be clear that the game that is playing out is value transfer. To see this, take the most extreme scenario, where GameStop is able to issue 50 million new shares (increasing their share count from 65.1 million to 115.1 million) at a stock price of $200, viable perhaps on Friday (when the stock traded about $300) but not today, the value effect and transfer can be seen below:

The value transfer can be intuitively explained. If new shareholders pay well above value, that increment accrues to existing shareholders. Since the new shareholders are buying the shares voluntarily, you may be at peace with this transfer, but if these new shareholders are small individual investors drawn in by the frenzy, the entire notion of this price run-up being a blow for fairness and justice is undercut. 

Investing Endgames!
The anger and sense of unfairness that animated many of those who were on the buying end of GameStop and AMC last week has roots in real grievances, especially among those who came of age in the midst or after the 2008 crisis. I understand that, but investing with the intent of hurting another group, no matter how merited you think that punishment is, has two problems. The first is that markets are fluid, with the winners and losers from an investing episode representing a quickly shifting coalition, The people who are helped and hurt are not always the people that you set out to help or hurt. The second is that if you truly want to punish a group that you think is deserving of punishment, you have to find a way to do damage to their investment models. Hurting some hedge funds, say the short sellers in GameStop, while helping others, like Silver Lake, will only cause investors in these funds to move their money from losing funds to winning funds. Thus, the best revenge you can have on funds is to see investors collectively pull their money out of funds, and that will happen if they under perform as a group. 

YouTube Video

Spreadsheet