tag:blogger.com,1999:blog-81529015751403110472024-03-19T05:19:06.509-04:00Musings on MarketsMy not-so-profound thoughts about valuation, corporate finance and the news of the day!Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.comBlogger625125tag:blogger.com,1999:blog-8152901575140311047.post-10378978677939464232024-02-16T14:21:00.019-05:002024-02-17T11:46:24.207-05:00Catastrophic Risk: Investing and Business Implications<p style="text-align: justify;"> In the context of valuing companies, and sharing those valuations, I do get suggestions from readers on companies that I should value next. While I don't have the time or the bandwidth to value all of the suggested companies, a reader from Iceland, a couple of weeks ago, made a suggestion on a company to value that I found intriguing. He suggested Blue Lagoon, a well-regarded Icelandic Spa with a history of profitability, that was finding its existence under threat, as a <a href="https://www.cbc.ca/news/world/iceland-volcano-blue-lagoon-grindavik-1.7108763">result of volcanic activity</a> in Southwest Iceland. In another story that made the rounds in recent weeks, 23andMe, a genetics testing company that offers its customers genetic and health information, based upon saliva sample, found itself facing the brink, after a hacker claimed to have <a href="https://fortune.com/2023/10/06/23andme-user-data-hacked/">hacked the site </a>and accessed the genetic information of millions of its customers. Stepping back a bit, one claim that climate change advocates have made not just about fossil fuel companies, but about all businesses, is that i<a href="https://www.bloomberg.com/news/articles/2024-02-08/hedge-funds-money-managers-crunch-data-to-put-a-price-on-climate-risk?embedded-checkout=true">nvestors are underestimating the effects that climate change</a> will have on economic systems and on value. These are three very different stories, but what they share in common is a fear, imminent or expected, of a catastrophic event that may put a company's business at risk. </p><p><b>Deconstructing Risk</b></p><p style="text-align: justify;"><b> </b>While we may use statistical measures like volatility or correlation to measure risk in practice, risk is not a statistical abstraction. Its impact is not just financial, but emotional and physical, and it predates markets. The risks that our ancestors faced, in the early stages of humanity, were physical, coming from natural disasters and predators, and physical risks remained the dominant form of risk that humans were exposed to, almost until the Middle Ages. In fact, the separation of risk into physical and financial risk took form just a few hundred years ago, when trade between Europe and Asia required ships to survive storms, disease and pirates to make it to their destinations; shipowners, ensconced in London and Lisbon, bore the financial risk, but the sailors bore the physical risk. It is no coincidence that the insurance business, as we know it, <a href="https://www.lloyds.com/about-lloyds/history">traces its history back to those days</a> as well.</p><p style="text-align: justify;"> I have no particular insights to offer on physical risk, other than to note that while taking on physical risks for some has become a leisure activity, I have no desire to climb Mount Everest or jump out of an aircraft. Much of the risk that I think about is related to risks that businesses face, how that risk affects their decision-making and how much it affects their value. If you start enumerating every risk a business is exposed to, you will find yourself being overwhelmed by that list, and it is for that reason that I categorize risk into the groupings that I described in an <a href="https://aswathdamodaran.blogspot.com/2024/01/data-update-4-for-2024-danger-and.html">earlier post on risk</a>. I want to focus in this post on the third distinction I drew on risk, where I grouped risk into <i>discrete risk and continuous risk</i>, with the later affecting businesses all the time and the former showing up infrequently, but often having much larger impact. Another, albeit closely related, distinction is between <i>incremental ris</i>k, i.e., risk that can change earnings, growth, and thus value, by material amounts, and <i>catastrophic risk</i>, which is risk that can put a company's survival at risk, or alter its trajectory dramatically.</p><p style="text-align: justify;"><span> </span>There are a multitude of factors that can give rise to catastrophic risk, and it is worth highlighting them, and examining the variations that you will observe across different catastrophic risk. Put simply, a volcanic eruption, a global pandemic, a hack of a company's database and the death of a key CEO are all catastrophic events, but they differ on three dimensions:</p><p></p><ol style="text-align: left;"><li style="text-align: justify;"><u>Source</u>: I started this post with a mention of a volcano eruption in Iceland put an Icelandic business at risk, and <i>natural disasters can still be a major factor </i>determining the success or failure of businesses. It is true that there are insurance products available to protect against some of these risks, at least in some parts of the world, and that may allow companies in Florida (California) to live through the risks from hurricanes (earthquakes), albeit at a cost. <i>Human beings add to nature's catastrophe</i>s with wars and terrorism wreaking havoc not just on human lives, but also on businesses that are in their crosshairs. As I noted in my post on country risk, it is difficult, and sometimes impossible, to build and preserve a business, when you operate in a part of the world where violence surrounds you. In some cases, a <i>change in regulatory or tax law</i> can put the business model for a company or many company at risk. I confess that the line between whether nature or man is to blame for some catastrophes is a gray one and to illustrate, consider the COVID crisis in 2020. Even if you believe you know the origins of COVID (a lab leak or a natural zoonotic spillover), it is undeniable that the choices made by governments and people exacerbated its consequences. </li><li style="text-align: justify;"><u>Locus of Damage</u>: Some catastrophes created<i> limited damage</i>, perhaps isolated to a single business, but others can create damage that extends <i>across a sector geographies or the entire economy</i>. The reason that the volcano eruptions in Iceland are not creating market tremors is because the damage is likely to be isolated to the businesses, like Blue Lagoon, in the path of the lava, and more generally to Iceland, an astonishingly beautiful country, but one with a small economic footprint. An earthquake in California will affect a far bigger swath of companies, partly because the state is home to the fifth largest economy in the world, and the pandemic in 2020 caused an economic shutdown that had consequences across all business, and was catastrophic for the hospitality and travel businesses.</li><li style="text-align: justify;"><u>Likelihood</u>: There is a third dimension on which catastrophic risks can vary, and that is in terms of <i>likelihood of occurrence</i>. Most catastrophic risks are <i>low-probability events</i>, but those low probabilities can become <i>high likelihood event</i>s, with the passage of time. Going back to the stories that I started this post with, Iceland has always had volcanos, as have other parts of the world, and until recently, the likelihood that those volcanos would become active was low. In a similar vein, pandemics have always been with us, with a history of wreaking havoc, but in the last few decades, with the advance of medical science, we assumed that they would stay contained. In both cases, the probabilities shifted dramatically, and with it, the expected consequences.</li></ol><p></p><p style="text-align: justify;">Business owners can try to insulate themselves from catastrophic risk, but as we will see in the next sections those protections may not exist, and even if they do, they may not be complete. In fact, as the probabilities of catastrophic risk increase, it will become more and more difficult to protect yourself against the risk.</p><p><b>Dealing with catastrophic risk</b></p><p style="text-align: justify;"><b> </b>It is undeniable that catastrophic risk affects the values of businesses, and their market pricing, and it is worth examining how it plays out in each domain. I will start this section with what, at least for me, I is familiar ground, and look at how to incorporate the presence of catastrophic risk, when valuing businesses and markets. I will close the section by looking at the equally interesting question of how markets price catastrophic risk, and why pricing and value can diverge (again).</p><p><i>Catastrophic Risk and Intrinsic Value</i></p><p style="text-align: justify;"><i> </i>Much as we like to dress up intrinsic value with models and inputs, the truth is that intrinsic valuation at its core is built around a simple proposition: the value of an asset or business is the present value of the expected cash flows on it:<br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg3v_Hcg1oj-VwOINJj3Q_PNVmf-kw9ycGVRC5fbzNEFtYSCZyEqM9qWeFTqNLD3fbsedR0hyphenhyphenCa29J0Tp4W5Sy_BwXYq4_GyRkIjZwclKUWxlgnnVUgHvZtBqk0fZahS5SZqYWmmoTIx2D_ZLmRnrQFJWY_F_v_WQsFTHnhCT5Q5hRf9jPF4KQFuLOZpH0/s288/DCFEquation.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="114" data-original-width="288" height="126" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg3v_Hcg1oj-VwOINJj3Q_PNVmf-kw9ycGVRC5fbzNEFtYSCZyEqM9qWeFTqNLD3fbsedR0hyphenhyphenCa29J0Tp4W5Sy_BwXYq4_GyRkIjZwclKUWxlgnnVUgHvZtBqk0fZahS5SZqYWmmoTIx2D_ZLmRnrQFJWY_F_v_WQsFTHnhCT5Q5hRf9jPF4KQFuLOZpH0/w320-h126/DCFEquation.jpg" width="320" /></a></div><p style="text-align: justify;">That equation gives rise to what I term the "It Proposition", which is that for "it" to have value, "it" has to affect either the expected cashflows or the risk of an asset or business. This simplistic proposition has served me well when looking at everything from the value of intangibles, as you can see in <a href="https://aswathdamodaran.blogspot.com/2023/10/invisible-yet-invaluable-valuing.html">this post that I had on Birkenstock</a>, to the emptiness at the heart of the claim that ESG is good for value, in <a href="https://aswathdamodaran.blogspot.com/2020/09/sounding-good-or-doing-good-skeptical.html">this post</a>. Using that framework to analyze catastrophic risk, in all of its forms, its effects can show in almost every input into intrinsic value:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhJnUbVoIJIQ4NtWUa83hANIgACJDu4QZlmXNVvKuNZoL93SvJv_dOhyek6g4EQTkiRHRKASY30qb5cfTxNqKthcX0J3ee0SXQDLQMU4qEcXMbdVvr3YQGDlk138a37_CSy-KEhKNUb1p4HE_dNGJRkrnJHE_Htkhem7lXMP4PkDMc4-Cc5oQBkrDWhtHg/s742/catriskandvalue.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="559" data-original-width="742" height="301" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhJnUbVoIJIQ4NtWUa83hANIgACJDu4QZlmXNVvKuNZoL93SvJv_dOhyek6g4EQTkiRHRKASY30qb5cfTxNqKthcX0J3ee0SXQDLQMU4qEcXMbdVvr3YQGDlk138a37_CSy-KEhKNUb1p4HE_dNGJRkrnJHE_Htkhem7lXMP4PkDMc4-Cc5oQBkrDWhtHg/w400-h301/catriskandvalue.jpg" width="400" /></a></div><br /><p style="text-align: justify;">Looking at this picture, your first reaction might be confusion, since the practical question you will face when you value Blue Lagoon, in the face of a volcanic eruption, and 23andMe, after a data hack, is which of the different paths to incorporating catastrophic risks into value you should adopt. To address this, I created a flowchart that looks at catastrophic risk on two dimensions, with the first built around whether you can buy insurance or protection that insulates the company against its impact and the other around whether it is risk that is specific to a business or one that can spill over and affect many businesses.</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEivz6n-Oowjxq8EBahCiYhxuD_BHywvLu5qIQKwZy7NYa0u9WeixTkzWTu1H2MWwNXpCLkoRHLUM-fRxtKiMunh2K3gP6ceYNK3Y1ek7LWZdF-s9Z4d1MMskZsrf80kY8l4b8wgpUNdGerWWRT6uIJ9-CC1C5UmHCwhtrgkJCnxkm6lMc9PZGMH-bj2dTQ/s756/CaatRiskFlowChart..jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="552" data-original-width="756" height="293" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEivz6n-Oowjxq8EBahCiYhxuD_BHywvLu5qIQKwZy7NYa0u9WeixTkzWTu1H2MWwNXpCLkoRHLUM-fRxtKiMunh2K3gP6ceYNK3Y1ek7LWZdF-s9Z4d1MMskZsrf80kY8l4b8wgpUNdGerWWRT6uIJ9-CC1C5UmHCwhtrgkJCnxkm6lMc9PZGMH-bj2dTQ/w400-h293/CaatRiskFlowChart..jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: justify;">As you can see from this flowchart, your adjustments to intrinsic value, to reflect catastrophic risk will vary, depending upon the risk in question, whether it is insurable and whether it will affect one/few companies or many/all companies. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><span><i><b>A. Insurable Risk:</b></i></span> Some catastrophic risks can be insured against, and even if firms choose not to avail themselves of that insurance, the presence of the insurance option can ease the intrinsic valuation process. </div><ul style="text-align: left;"><li style="text-align: justify;"><u>Intrinsic Value Effect</u>: If the catastrophic risk is fully insurable, as is sometimes the case, your intrinsic valuation became simpler, since all you have to do is bring in the insurance cost into your expenses, lowering income and cash flows, leave discount rates untouched, and let the valuation play out. Note that you can do this, even if the company does not actually buy the insurance, but you will need to find out the cost of that foregone insurance and incorporate it yourself. </li><li style="text-align: justify;"><u>Pluses</u>: Simplicity and specificity, because all this approach needs is a line item in the income statement (which will either exist already, if the company is buying insurance, or can be estimated). </li><li style="text-align: justify;"><u>Minuses</u>: You may not be able to insure against some risks, either because they are uncommon (and actuaries are unable to estimate probabilities well enough, to set premiums) or imminent (the likelihood of the event happening is so high, that the premiums become unaffordable). Thus, Blue Lagoon (the Icelandic spa that is threatened by a volcanic eruption) might have been able to buy insurance against volcanic eruption a few years ago, but will not be able to do so now, because the risk is imminent. Even when risks are insurable, there is a second potential problem. The insurance may pay off, in the event of the catastrophic event, but it may not offer complete protection. Thus, using Blue Lagoon again as an example, and assuming that the company had the foresight to buy insurance against volcanic eruptions a few years ago, all the insurance may do is rebuild the spa, but it will not compensate the company for lost revenues, as customers are scared away by the fear of volcanic eruptions. In short, while there are exceptions, much of insurance insures assets rather than cash flow streams.</li><li style="text-align: justify;"><u>Applications</u>: When valuing businesses in developed markets, we tend to assume that these businesses have insured themselves against most catastrophic risks and ignore them in valuation consequently. Thus, you see many small Florida-based resorts valued, with no consideration given to hurricanes that they will be exposed to, because you assume that they are fully insured. In the spirit of the “trust, but verity” proposition, you should probably check if that is true, and then follow up by examining how complete the insurance coverage is.</li></ul><div style="text-align: justify;"><span><i><b>2. Uninsurable Risk, Going-concern, Company-specific:</b></i></span> When a catastrophic risk is uninsurable, the follow up questions may lead us to decide that while the risk will do substantial damage, the injured firms will continue in existence. In addition, if the risk affects only one or a few firms, rather than wide swathes of the market, there are intrinsic value implications.</div><div><ul style="text-align: left;"><li><div style="text-align: justify;"><u>Intrinsic Value Effect</u>: If the catastrophic risk is not insurable, but the business will survive its occurrence even in a vastly diminished state, you should consider doing two going-concern valuations, one with the assumption that there is no catastrophe and one without, and then attaching a probability to the catastrophic event occurring. </div><i>Expected Value with Catastrophe = Value without Catastrophe (1 – Probability of Catastrophe) + Value with Catastrophe (Probability of Catastrophe)</i><br /><div style="text-align: justify;">In these intrinsic valuations, much of the change created by the catastrophe will be in the cash flows, with little or no change to costs of capital, at least in companies where investors are well diversified.</div></li></ul></div><p style="text-align: left;"></p><ul style="text-align: left;"><li style="text-align: justify;"><u>Pluses</u>: By separating the catastrophic risk scenario from the more benign outcomes, you make the problem more tractable, since trying to adjust expected cash flows and discount rates for widely divergent outcomes is difficult to do.</li><li style="text-align: justify;"><u>Minuses</u>: Estimating the probability of the catastrophe may require specific skills that you do not have, but consulting those who do have those skills can help, drawing on meteorologists for hurricane prediction and on seismologists for earthquakes. In addition, working through the effect on value of the business, if the catastrophe occurs, will stretch your estimation skills, but what options do you have?</li><li style="text-align: justify;"><u>Applications</u>: This approach comes into play for many different catastrophic risks that businesses face, including the loss of a key employee, in a personal-service business, and I used it in <a href="https://aswathdamodaran.blogspot.com/2023/12/the-difference-makers-key-persons.html">my post on valuing key persons in businesses</a>. You can also use it to assess the effect on value of a loss of a big contract for a small company, where that contract accounts for a significant portion of total revenues. It can also be used to value a company whose business models is built upon the presence or absence of a regulation or law, in which case a change in that regulation or law can change value. </li></ul><p></p><div><div style="text-align: justify;"><i><b>3. Uninsurable Risk. Failure Risk, Company-specific</b></i>: When a risk is uninsurable and its manifestation can cause a company to fail, it poses a challenge for intrinsic value, which is, at its core, designed to value going concerns. Attempts to increase the discount rate, to bring in catastrophic risk, or applying an arbitrary discount on value almost never work.</div><ul style="text-align: left;"><li><div style="text-align: justify;"><u>Intrinsic Value Effect</u>: If the catastrophic risk is not insurable, and the business will not survive, if the risk unfolds, the approach parallels the previous one, with the difference being that that the failure value of the business, i.e, what you will generate in cash flows, if it fails, replaces the intrinsic valuation, with catastrophic risk built in:</div><i><div style="text-align: justify;"><i>Expected Value with Catastrophe = Value without Catastrophe (1 – Probability of Catastrophe) + Failure Value (Probability of Catastrophe)</i></div></i><div style="text-align: justify;">The failure value will come from liquidation the assets, or what is left of them, after the catastrophe.</div></li></ul></div><div><ul style="text-align: left;"><li style="text-align: justify;"><u>Pluses</u>: As with the previous approach, separating the going concern from the failure values can help in the estimation process. Trying to estimate cash flows, growth rates and cost of capital for a company across both scenarios (going concern and failure) is difficult to do, and it is easy to double count risk or miscount it. It is fanciful to assume that you can leave the expected cash flows as is, and then adjust the cost of capital upwards to reflect the default risk, because discount rates are blunt instruments, designed more to capture going-concern risk than failure risk. </li><li style="text-align: justify;"><u>Minuses</u>: As in the last approach, you still have to estimate a probability that a catastrophe will occur, and in addition, and there can be challenges in estimating the value of a business, if the company fails in the face of catastrophic risk.</li><li style="text-align: justify;"><u>Applications</u>: This is the approach that I use to value highly levered., cyclical or commodity companies, that can deliver solid operating and equity values in periods where they operate as going concerns, but face distress or bankruptcy, in the face of a severe recession. And for a business like the Blue Lagoon, it may be the only pathway left to estimate the value, with the volcano active, and erupting, and it may very well be true that the failure value can be zero.</li></ul><div style="text-align: justify;"><i><b><span>4 & 5 Uninsurable Risk. Going Concern or Failure, Market or Sector wide</span>:</b></i><u> </u>If a risk can affect many or most firms, it does have a secondary impact on the returns investors expect to make, pushing up costs of capital.</div></div><div><ul style="text-align: left;"><li style="text-align: justify;"><u>Intrinsic Value Effect</u>: The calculations for cashflows are identical to those done when the risks are company-specific, with cash flows estimated with and without the catastrophic risk, but since these risks are sector-wide or market-wide, there will also be an effect on discount rates. Investors will either see more relative risk (or beta) in these companies, if the risks affect an entire sector, or in equity risk premiums, if they are market-wide. Note that these higher discount rates apply in both scenarios.</li><li style="text-align: justify;"><u>Pluses</u>: The risk that is being built into costs of equity is the risk that cannot be diversified away and there are pathways to estimating changes in relative risk or equity risk premiums. </li><li style="text-align: justify;"><u>Minuses</u>: The conventional approaches to estimating betas, where you run a regression of past stock returns against the market, and equity risk premiums, where you trust in historical risk premiums and history, will not work at delivering the adjustments that you need to make.</li><li style="text-align: justify;"><u>Applications</u>: My argument for using implied equity risk premiums is that they are dynamic and forward-looking. Thus, during COVID, when the entire market was exposed to the economic effects of the pandemic, the implied ERP for the market jumped in the first six weeks of the pandemic, when the concerns about the after effects were greatest, and then subsided in the months after, as the fear waned:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiW8LCOzNwT6lEVUaLv-MffUG5KtobFmUD3l0wfV0RI-k35sbMFrBJLi6GqchCXaefO5FM6xRZ6e1ZkyPOVggAcTeTDIr25Yp6CS5yiTWfMhA33jTmYF1I20Ndx1gAleJYMala-huQCPuFESnodyTLhEcy5zzlxmyE-4zT705TJZrnQ005kvdFoq_cuXcI/s2475/COVIDERP.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1479" data-original-width="2475" height="239" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiW8LCOzNwT6lEVUaLv-MffUG5KtobFmUD3l0wfV0RI-k35sbMFrBJLi6GqchCXaefO5FM6xRZ6e1ZkyPOVggAcTeTDIr25Yp6CS5yiTWfMhA33jTmYF1I20Ndx1gAleJYMala-huQCPuFESnodyTLhEcy5zzlxmyE-4zT705TJZrnQ005kvdFoq_cuXcI/w400-h239/COVIDERP.jpg" width="400" /></a></div><br /> In a different vein, one reason that I compute betas by industry grouping, and update them every year, is in the hope that risks that cut across a sector show up as changes in the industry averages. In 2009, for instance, when banks were faced with significant regulatory changes brought about in response to the 2008 crisis, the average beta for banks jumped from 0.71 at the end of 2007 to 0.85 two years later.</li></ul></div><div><i>Catastrophic Risk and Pricing</i><br /> <span> </span>The intrinsic value approach assumes that we, as business owners and investors, look at catastrophic risk rationally, and make our assessments based upon how it will play out in cashflows, growth and risk. In truth, is worth remembering key insights from psychology, on how we, as human beings, deal with threats (financial and physical) that we view as existential. <br /><ul style="text-align: left;"><li>The first response is <i>denial</i>, an unwillingness to think about catastrophic risks. As someone who lives in a home close to one of California's big earthquake faults, and two blocks from the Pacific Ocean, I can attest to this response, and offer the defense that in its absence, I would wither away from anxiety and fear. </li><li>The second is <i>panic</i>, when the catastrophic risk becomes imminent, where the response is to flee, leaving much of what you have behind. </li></ul><div style="text-align: justify;">When looking at how the market prices in the expectation of a catstrophe occurring and its consequences, both these human emotions play out, as the overpricing of businesses that face catastrophic risk, when it is low probability and distant, and the underpricing of these same businesses when catastrophic risk looms large. </div><br /> <span> </span>To see this process at work, consider again how the market initially reacted to the COVID crisis in terms of repricing companies that were at the heart of the crisis. Between February 14, 2020 and March 23, 2020, when fear peaked, the sectors most exposed to the pandemic (hospitality, airlines) saw a decimation in their market prices, during that period:</div><div><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgsm8G6rwijvD_7LSuOeDkIEL2z5KmGi2mOUOWd9_V4e4CKjvt6nIAEgcuvOmWmM5-45uijvUFUtcvJOdiMHKae722t-WxfXySWLWt5wdWOCsIeZ3DZoJtyJqsDhJ-8EvZegL2mCfx0GoKxxGF24aGfx14rZasfUbz2lZb00o-XOBqO0nIZd5srUkba4To/s1444/Industrybest&worst.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1052" data-original-width="1444" height="291" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgsm8G6rwijvD_7LSuOeDkIEL2z5KmGi2mOUOWd9_V4e4CKjvt6nIAEgcuvOmWmM5-45uijvUFUtcvJOdiMHKae722t-WxfXySWLWt5wdWOCsIeZ3DZoJtyJqsDhJ-8EvZegL2mCfx0GoKxxGF24aGfx14rZasfUbz2lZb00o-XOBqO0nIZd5srUkba4To/w400-h291/Industrybest&worst.jpg" width="400" /></a></div><div><br /></div><div><div style="text-align: justify;">With catastrophic risk that are company-specific, you see the same phenomenon play out. The market capitalization of many young pharmaceutical company have been wiped out by the failure of blockbuster drug, in trials. PG&E, the utility company that provides power to large portions of California saw its stock price halved after wildfires swept through California, and investors worried about the culpability of the company in starting them. </div><div style="text-align: justify;"> The most fascinating twist on how markets deal with risks that are existential is their pricing of fossil fuel companies over the last two decades, as concerns about climate change have taken center stage, with fossil fuels becoming the arch villain. The expectation that many impact investors had, at least early in this game, was that relentless pressure from regulators and backlash from consumers and investors would reduce the demand for oil, reducing the profitability and expected lives of fossil fuel companies. To examine whether markets reflect this view, I looked at the pricing of fossil fuel stocks in the aggregate, starting in 2000 and going through 2023:</div></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhc8ldRLTcd5ppeX7DwWdEWsry72ophHWO27EB2qzAM60ep42njywMMky16VIlLvXxfxqht99H517eqndbUBANbhPvL5bClmNBmKHk-oJfaEkr3iNLbu-nIZlItoBvOTfcfgg_2AHfPUQMslRJZ6batTCP-B1Rz9Y6lt1Yw-hL8Ez-76c97fg549H0CDNI/s1791/FossiFuelMarketPricing.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="700" data-original-width="1791" height="156" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhc8ldRLTcd5ppeX7DwWdEWsry72ophHWO27EB2qzAM60ep42njywMMky16VIlLvXxfxqht99H517eqndbUBANbhPvL5bClmNBmKHk-oJfaEkr3iNLbu-nIZlItoBvOTfcfgg_2AHfPUQMslRJZ6batTCP-B1Rz9Y6lt1Yw-hL8Ez-76c97fg549H0CDNI/w400-h156/FossiFuelMarketPricing.jpg" width="400" /></a></div><br /><div style="text-align: justify;">In the graph to the left, I chart out the total market value for all fossil fuel companies, and note a not unsurprising link to oil prices. In fact, the one surprise is that fossil fuel stocks did not see surges in market capitalization between 2011 and 2014, even as oil prices surged. While fossil fuel pricing multiples have gone up and down, I have computed the average on both in the 2000-2010 period and again in the 2011-2023 period. If the latter period is the one of enlightenment, at least on climate change, with warnings of climate change accompanied by trillions of dollars invested in combating it, it is striking how little impact it has had on how markets, and investors in the aggregate, view fossil fuel companies. In fact, there is evidence that the business pressure on fossil fuel companies has become less over time, with fossil fuel stocks rebounding in the last three years, and fossil fuel companies increasing investments and acquisitions in the fossil fuel space. </div><div style="text-align: justify;"><span> </span>Impact investors would point to this as evidence of the market being in denial, and they may be right, but market participants may point back at impact investing, and argue that the markets may be reflecting an unpleasant reality which is that despite all of the talk of climate change being an existential problem, we are just as dependent on fossil fuels today, as we were a decade or two decades ago:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiuQa4zAtZKyt5tMJSH0mYHhH6J54Yx9QukLm7ZStWEzxJSiRFl8KXAm9eAEOs-3vYBZ3Tyy5g1Hf_-YzbJMrvxjpTiC5sAP1FncnrsHa1i_BkGA_fYiXO97c96Zz3Tg0blUthcQxRP8CHusg1F1tq-Uchx8o-_FZ68Bgu-orn_Z42roiN0H02pEjLhA9E/s752/EnergyBreakdown.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="554" data-original-width="752" height="295" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiuQa4zAtZKyt5tMJSH0mYHhH6J54Yx9QukLm7ZStWEzxJSiRFl8KXAm9eAEOs-3vYBZ3Tyy5g1Hf_-YzbJMrvxjpTiC5sAP1FncnrsHa1i_BkGA_fYiXO97c96Zz3Tg0blUthcQxRP8CHusg1F1tq-Uchx8o-_FZ68Bgu-orn_Z42roiN0H02pEjLhA9E/w400-h295/EnergyBreakdown.jpg" width="400" /></a></div><div><br /></div><div style="text-align: justify;">Don’t get me wrong! It is possible, perhaps even likely, that investors are not pricing in climate change not just in fossil fuel stocks, and that there is pain awaiting them down the road. It is also possible that at least in this case, that the market's assessment that doomsday is not imminent and that humanity will survive climate change, as it has other existential crises in the past. </div><div style="text-align: justify;"><span> </span></div><div style="text-align: justify;"><b>Mr. Market versus Mad Max Thunderdome</b></div><div><span> The question posed about fossil fuel investors and whether they are pricing in the risks of gclimated change can be generalized to a whole host of other questions about investor behavior. </span>Should buyers be paying hundreds of millions of dollars for a Manhattan office building, when all of New York may be underwater in a few decades? Lest I be accused of pointing fingers, what will happen to the value of my house that is currently two blocks from the beach, given the prediction of rising oceans. The painful truth is that if doomsday events (nuclear war, mega asteroid hitting the earth, the earth getting too hot for human existence) manifest, it is survival that becomes front and center, not how much money you have in your portfolio. Thus, ignoring Armageddon scenarios when valuing businesses and assets may be completely rational, and taking investors to task for not pricing assets correctly will do little to alter their trajectory! There is a lesson here for policy makers and advocates, which is that preaching that the planet is headed for the apocalypse, even if you believe it is true, will induce behavior that will make it more likely to happen, not less.</div><div style="text-align: justify;"><span> On a different note, you probably know that I am deeply skeptical about sustainability, at least as preached from the Harvard Business School pulpit. It remains ill-defined, morphing into whatever its proponents want it to mean. The catastrophic risk discussion presents perhaps a version of sustainability that is defensible. To the extent that all businesses are exposed to catastrophic risks, some company-level and some having broader effects, there are actions that businesses can take to, if not protect to themselves, at least cushion the impact of these risks. A personal-service business, headed by an aging key person, will be well served designing a succession plan for someone to step in when the key person leaves (by his or her choice or an act of God). No global company was ready for COVID in 2020, but some were able to adapt much faster than others because they were built to be adaptable. Embedded in this discussion are also the limits to sustainability, since the notion of sustaining a business at any cost is absurd. Building in adaptability and safeguards against catastrophic risk makes sense only if the costs of doing so are less than the potential benefits, a simple but powerful lesson that many sustainability advocates seem to ignore, when they make grandiose prescriptions for what businesses should and should not do to avoid the apocalypse.</span></div><div style="text-align: justify;"><span><br /></span></div><div style="text-align: justify;"><b>YouTube</b></div><div style="text-align: justify;"><br /><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/m_wVCnkLn-U?si=TheSg-7MjddvlIUa" title="YouTube video player" width="560"></iframe></div><div style="text-align: justify;"><br /></div><div class="separator" style="clear: both; text-align: center;"><br /></div>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-90197432680281005692024-02-08T19:15:00.004-05:002024-02-14T10:09:37.727-05:00The Seven Samurai: How Big Tech Rescued the Market in 2023!<p style="text-align: justify;">I was planning to finish my last two data updates for 2024, but decided to take a break and look at the seven stocks (Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia and Tesla) which carried the market in 2023. While I will use the "Magnificent Seven" moniker attached by these companies by investors and the media, my preference would have been to call them the Seven Samurai. After all, like their namesakes in that <a href="https://www.imdb.com/title/tt0047478/">legendary Kurosawa movie</a>, who saved a village and its inhabitants from destruction, these seven stocks saved investors from having back-to-back disastrous years in the stock market.</p><p><b>The What?</b></p><p style="text-align: justify;"><b> </b>It is worth remembering that the Magnificent Seven (Mag Seven) had their beginnings in the FANG (Facebook, Amazon, Netflix and Google) stocks, in the middle of the last decade, which morphed into the FANGAM (with the addition of Apple and Microsoft to the group) and then to the Mag Seven, with the removal of Netflix from the mix, and the addition of Tesla and Nvidia to the group. There is clearly hindsight bias in play here, since bringing in the best performing stocks of a period into a group can always create groups that have supernormal historical returns. That bias notwithstanding, these seven companies have been extraordinary investments, not just in 2023, but over the last decade, and there are lessons that we can learn from looking at the past.</p><p style="text-align: justify;"><span> First, let's look at the performance of these seven stocks in 2023, when their collective market capitalization increased by a staggering $5.1 trillion during the course of the year. In a group of standout stocks, </span>Nvidia and Meta were the best performers, with the former more than and the later almost tripling in value over the period. In terms of dollar value added, Microsoft and Apple each added a trillion dollars to their market capitalizations, during the year.</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhPqVJvWI8xuYSEkNwQ0H0JbPBJocK7g3iMGfDrFHlydmlltOCOX0JZ_S6X5ykHT1F9If3u6w3IInwqkUMJlxIpHnBmDBm_6Db-9R7gE6MG-LkOnYUH_Qs1w80qteB_B8VGldVkU4lcV6UNSUu2Qah2g8iJ8u0vQRG8WUVict91dFVV8VuYG5DIt4BdEP0/s753/MAG7in2023.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="227" data-original-width="753" height="120" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhPqVJvWI8xuYSEkNwQ0H0JbPBJocK7g3iMGfDrFHlydmlltOCOX0JZ_S6X5ykHT1F9If3u6w3IInwqkUMJlxIpHnBmDBm_6Db-9R7gE6MG-LkOnYUH_Qs1w80qteB_B8VGldVkU4lcV6UNSUu2Qah2g8iJ8u0vQRG8WUVict91dFVV8VuYG5DIt4BdEP0/w400-h120/MAG7in2023.jpg" width="400" /></a></div><div><br /></div><div style="text-align: justify;">To understand how much these stocks meant for overall market performance, recognize that these seven companies accounted for more than 50% of the increase in market capitalization of the the entire US equity market (which included 6658 listed companies in 2023). With them, US equities had price appreciation of 23.25% for the year, but without them, the year would have been an average one, with returns on 12.6%.</div><p><span> While these seven stocks had an exceptional year in 2023, their outperformance stretches back for a much longer period. In the graph below, I look at the cumulated market capitalization of the Mag Seven stocks, and the market capitalization of all of the remaining US stocks from 2012 to 2023:</span></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjpCusuLh2aIYriPdM-Dsw_gqPWDW3dapjnYWJiQ7WmdR4Z9Z88TAhrZEm43fEhowQuKm_p7jxbtYibgha0FoYAZJdO-5xxQONld4CvtLr4vd5jEhA2ymS_JF0O3Kb3FlB-bvDI12bnbdu6AiAYSK86xTX7qEFaf-Xjhd9UMMHiXE-vMHxf9vag61d8OOA/s1175/MAg7inLastDecade.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="853" data-original-width="1175" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjpCusuLh2aIYriPdM-Dsw_gqPWDW3dapjnYWJiQ7WmdR4Z9Z88TAhrZEm43fEhowQuKm_p7jxbtYibgha0FoYAZJdO-5xxQONld4CvtLr4vd5jEhA2ymS_JF0O3Kb3FlB-bvDI12bnbdu6AiAYSK86xTX7qEFaf-Xjhd9UMMHiXE-vMHxf9vag61d8OOA/w400-h290/MAg7inLastDecade.jpg" width="400" /></a></div><span><br /></span><p></p><p style="text-align: justify;">Over the eleven-year period, <i>the cumulative market capitalization of the seven companies has risen from $1.1 trillion in 2012 to $12 trillion in 2023</i>, rising from 7.97% of overall US market cap in 2012 to 24.51% of overall market cap at the end of 2023. To put these numbers in perspective, the Mag Seven companies now have a market capitalization larger than that of all listed stocks in China, the second largest market in the world in market capitalization terms.</p><p><span> </span>Another way to see how much owning or not owning these stocks meant for investors, I estimated the cumulated value of $100 invested in December 2012 in a market-cap weighted index of US stocks at the end of 2023, first in US equities , and then in US equities, without the Mag Seven stocks:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEisICnwiRYeryCHUG3jQXjfZkSIZ1L1vPsQads4-DsUFY5ZDXWrYlI14Wrbi-fXprApvyiPryOPOYAnHlheA3LRb6DTT0iNqHo0MfaP8SZIfpPP0bCAb7J7miJZJNh3PS3X8pmJr5cfBaGODjOM9FjxePNplHFYwKgcSBBzQmOMdLZGNPU3VFYSY0JrIhc/s1113/MAGSevenCumValue.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="775" data-original-width="1113" height="279" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEisICnwiRYeryCHUG3jQXjfZkSIZ1L1vPsQads4-DsUFY5ZDXWrYlI14Wrbi-fXprApvyiPryOPOYAnHlheA3LRb6DTT0iNqHo0MfaP8SZIfpPP0bCAb7J7miJZJNh3PS3X8pmJr5cfBaGODjOM9FjxePNplHFYwKgcSBBzQmOMdLZGNPU3VFYSY0JrIhc/w400-h279/MAGSevenCumValue.jpg" width="400" /></a></div><div style="text-align: justify;">It is striking that removing seven stocks from a portfolio of 6658 US stocks, investing between 2012 and 2023, creates a 17.97% shortfall in the end value. In effect, this would suggest that any portfolio that did not include any of these seven stocks during the last decade would have faced a very steep, perhaps even insurmountable, climb to beat the market. That may go a long way in explaining why both value and small cap premium have essentially disappeared over this period.</div><div style="text-align: justify;"><span> In all of the breathless coverage of the Mag Seven (and FANG and FANGAM) before it, there seems to be the implicit belief that their market dominance is unprecedented, but it is not. In fact, equity </span><span style="text-align: left;">markets have almost always owed their success to their biggest winners, and Henrik Bessimbinder highlighted this reality by documenting that of the $47 trillion in increase in market capitalization between 1926 and 2019, five companies accounted for 22% of the increase in market value. I will wager that at the end of the next decade, looking back, we will find that a few companies accounted for the bulk of the rise in market capitalization during the decade, and another acronym will be created. </span></div><div><p><b>The Why?</b></p><p style="text-align: justify;"><b> </b>When stocks soar as much as the Mag Seven stocks have in recent years, they evoke two responses. One is obviously regret on the part of those who did not partake in the rise, or sold too soon. The other is skepticism, and a sense that a correction is overdue, leading to what I call knee-jerk contrarianism, where your argument that these stocks are over priced is that they have gone up too much in the past. With these stocks, in particular, that reaction would have been costly over much of the last decade, since other than in 2022, these stocks have found ways to deliver positive surprises. In this section, we will look at the plausible explanations for the Mag Seven outperformance in 2023, starting with a correction/momentum story, where 2023 just represented a reversal of the losses in 2022, moving on to a profitability narrative, where the market performance of these companies can be related to superior profitability and operating performance, and concluding with an examination of whether the top-heavy performance (where a few large companies account for the bulk of market performance can explained by winner-take-all economics,</p><p style="text-align: justify;"><u>1. Correction/Momentum Story</u>: One explanation for the Mag Seven's market performance in 2023 is that they were coming off a catastrophic year in 2022, where they collectively lost $4.8 trillion in market cap, and that 2023 represented a correction back to a level only slightly above the value at the end of 2021. There is some truth to this statement, but to see whether it alone can explain the Mag Seven 2023 performance, I broke all US stocks into deciles, based upon 2022 stock price performance, with the bottom decile including the stocks that went down the most in 2022 and the top decile the stocks that went up the most in 2022, and looked at returns in 2023:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhqEPYcnwTt2uBxehVbsWkw9E-GjooqnN7acBFYErMdLOgidIJIbvYbDqnKV25iiecifTLEZLpTvhpSZqR_VSRyho5iOxD-Od5Q9MbEA-x3omv7wD4qoAUETGxsR3FpxBGBDss-ltIHW5IkPr0cft3tAOA7LcA65AI4t8iDRfjtpTtrp4e7MmDIKpQAwcA/s641/MomentumCheck.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="199" data-original-width="641" height="124" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhqEPYcnwTt2uBxehVbsWkw9E-GjooqnN7acBFYErMdLOgidIJIbvYbDqnKV25iiecifTLEZLpTvhpSZqR_VSRyho5iOxD-Od5Q9MbEA-x3omv7wD4qoAUETGxsR3FpxBGBDss-ltIHW5IkPr0cft3tAOA7LcA65AI4t8iDRfjtpTtrp4e7MmDIKpQAwcA/w400-h124/MomentumCheck.jpg" width="400" /></a></div><div style="text-align: justify;">As you can see in the first comparison, the worst performing stocks in 2022 saw their market capitalizations increase by 35% in 2023, while the best performing stocks saw little change in market capitalization. Since all of the MAG 7 stocks fell into the bottom decile, I compared the performance of those stocks against the rest of the stocks in that decile, and th difference is start. While Mag Seven stocks saw their market capitalizations increase by 74%, the rest of the stocks in the bottom decile had only a 19% increase in market cap. In short, a portion of the Mag Seven stock performance in 2023 can be explained by a correction story, aided and abetted by strong momentum, but it is not the whole story.</div></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><u>2. Operating Performance/Profitability Narrative</u>: While it is easy to attribute rising stock prices entirely to mood and momentum, the truth is that momentum has its roots in truth. Put differently, there are some good business reasons why the Mag Seven dominated markets in 2023:</div><div><ul style="text-align: left;"><li style="text-align: justify;"><u>Pricing power and Economic Resilience</u>: Coming into 2023, market and the Mag Seven stocks were battered, down sharply in 2022, largely because of rising inflation and concerns about an economic downturn. There were real concerns about whether the big tech companies that had dominated markets for the prior decade had pricing power and how well they would weather a recession. During the course of 2023, the Mag Seven set those fears to rest at least for the moment on both dimensions, increasing prices (with the exception of Tesla) on their products/services and delivering growth. In fact, if you are a Netflix subscriber or Amazon Prime member (and I would be surprised if any reader has neither, indicating their ubiquity), you saw prices increase on both services, and my guess is that you did not cancel your subscription/membership. With Alphabet and Meta, which make their money on online advertising, the rates for that advertising, measures in costs per click, rose through much of the year, and as an active Apple customer, I can guarantee that Apple has been passing through inflation into their prices all year.</li><li style="text-align: justify;"><u>Money Machines</u>: The pricing power and product demand resilience exhibited by these companies have manifested as strong earnings for the companies. In fact, both Alphabet and Meta have laid off thousands of employees, without denting revenues, and their profits in 2023 reflect the cost savings: <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgbPNqh8BU18W1cXdXrvwqqQF9XLVZ8i1v9iTeoyDONDHCGhY-hh7p2pkGoSGR6-pU5-nRdvV2YjW_le1BNniCtb-azFpaP1NLqxKIoJ98bVvb9le2sY38GcZpx7gQk_MG8E3jebad7MhRf-585Q7ql96sOia2ZG6chiyY0LrYQgKXpObvUFLA6i1DzbUY/s897/Mag7Profitability.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="217" data-original-width="897" height="96" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgbPNqh8BU18W1cXdXrvwqqQF9XLVZ8i1v9iTeoyDONDHCGhY-hh7p2pkGoSGR6-pU5-nRdvV2YjW_le1BNniCtb-azFpaP1NLqxKIoJ98bVvb9le2sY38GcZpx7gQk_MG8E3jebad7MhRf-585Q7ql96sOia2ZG6chiyY0LrYQgKXpObvUFLA6i1DzbUY/w400-h96/Mag7Profitability.jpg" width="400" /></a></div><br /></li><li style="text-align: justify;"><u>Safety Buffers</u>: As interest rates, for both governments and corporates, has risen sharply over the last two years, it is prudent for investors to worry about companies with large debt burdens, since old debt on the books, at low rates, will have to get refinanced at higher rates. With the Mag Seven, those concerns are on the back burner, because these companies have debt loads so low that they are almost non-existent. In fact, six of the seven firms in the Mag Seven grouping have cash balances that exceed their debt loads, giving them negative net debt levels.<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi5Gi-G5aPGa5NTCgvWUqOwkXUAhZ8JCQVQp8Ynt0GTwP3MKD2yY5C27sfl1qLh08ZZmp8ShDbxPpcxF8QWim9rFhVvsP32m-IGSHBf0g6HihEnRmXTZs9AtkUK7IMmleT0lnvSN9UXLbMjmSoQgLSiCP7D6LQQGg8N1faImLJ6xZemcUFIx6HFoXxOYks/s816/MAg7Debtload.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="114" data-original-width="816" height="56" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi5Gi-G5aPGa5NTCgvWUqOwkXUAhZ8JCQVQp8Ynt0GTwP3MKD2yY5C27sfl1qLh08ZZmp8ShDbxPpcxF8QWim9rFhVvsP32m-IGSHBf0g6HihEnRmXTZs9AtkUK7IMmleT0lnvSN9UXLbMjmSoQgLSiCP7D6LQQGg8N1faImLJ6xZemcUFIx6HFoXxOYks/w400-h56/MAg7Debtload.jpg" width="400" /></a></div></li></ul></div><div><p style="text-align: justify;">Put simply, there are good business reasons for why the seven companies in the Mag Seven have been elevated to superstar status. </p><p style="text-align: justify;"><u>3. Winner take all economics</u>: It is undeniable that as the global economy has shifted away from its manufacturing base in the last century to a technology base, it has unleashed more "winner-take-all (or most" dynamics in many industries. In advertising, which was a splintered business where even the biggest players (newspapers, broadcasting companies) commanded small market shares of the overall market, Alphabet and Meta have acquired dominant market shares of online advertising, driven by easy scaling and network benefits (where advertising flows to the platforms with the most customers). Over the last two decades, Amazon has set in motion similar dynamics in retail and Microsoft's stranglehold on application and business software has been in existence even longer. In fact, it is the two newcomers into this group, Nvidia and Tesla, where questions remain about what the end game will look like, in terms of market share. Historically, neither the chip nor car businesses have been winner-take-all businesses, but investors are clearly pricing in the possibility that the changing economics of AI chips and electric cars could alter these businesses. </p><p style="text-align: justify;">This may seem like a cop out, but I think all three factors contributed to the success of the Mag Seven stocks in 2023. There was clearly a bounce back effect, as these firms recovered from a savage beatdown in 2022, but that bounce back occurred only because they were able to deliver strong profits and solid cash flows. And looking across the decade, I don't think it is debatable that investors have not only bought into the dominant player story (coming from the winner-take-all economics), but have also anointed these seven companies as leaders in the race to dominance in each of their businesses.</p><p><b>The What Next?</b></p><p style="text-align: justify;"><b> </b>At the risk of stating the obvious, investing is always about the future, and a company's past market history, no matter how glorious, has little or no effect on whether it is a good investment today. I have long argued that investors need to separate what they think about the quality of a company (great, good or awful) from its quality as an investment (cheap or expensive). In fact, investing is about finding mismatches between what you think of a company and what investors have already priced in:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhEhY2Z4WVXlCzvYQN0RC46HK0Gz-nbK6qrfvVV0pMAXuDdxuSMdvmlGZLSYYW7A0ZvP3LQ21bJEEsU_94yo6Bc8Ii9RrpW0AXqR1oqXLG2Q0TyuQZ9Q83kaSIKRjOxSXqdrRnRf-Jern_uONJopQld_rut6PgUd3KQIlF2O4w3ql34p7Rt2dOz7O_KESU/s1310/InvestmentMismatch.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="808" data-original-width="1310" height="246" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhEhY2Z4WVXlCzvYQN0RC46HK0Gz-nbK6qrfvVV0pMAXuDdxuSMdvmlGZLSYYW7A0ZvP3LQ21bJEEsU_94yo6Bc8Ii9RrpW0AXqR1oqXLG2Q0TyuQZ9Q83kaSIKRjOxSXqdrRnRf-Jern_uONJopQld_rut6PgUd3KQIlF2O4w3ql34p7Rt2dOz7O_KESU/w400-h246/InvestmentMismatch.jpg" width="400" /></a></div><p style="text-align: justify;">I think that most of you will agree that the seven companies in the Mag Seven all qualify as very good to awesome, as businesses, and the last section provides backing, but the question that remains is whether our perceptions are shared by other investors, and already priced in.</p><p style="text-align: justify;"><span> The tool that most investors use in making this assessment is pricing, and specifically, pricing multiples. In the table below, I compute pricing metrics for the Mag Seven, and compare them to that of the S&P 500:</span><br /></p><p style="text-align: justify;"></p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhpR_-W-qUcCl8e_-_Gd59o_nNdiF6QfbTyWd9sQVdxw2yOr06WlWH5k-6VOR0NJF6bkNW6LL9GHUAVURJL1QGKyUfsA715m-XbHgkYtqpNCCEpqpLdikkSimrLoeRwUSv2nqwCgxraRLd6nrrh3nIlwaPImhWuwp8z_HS6AAMywSXFj4ruXf9YSM7oFHw/s899/PricingMetricsMag&.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="282" data-original-width="899" height="125" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhpR_-W-qUcCl8e_-_Gd59o_nNdiF6QfbTyWd9sQVdxw2yOr06WlWH5k-6VOR0NJF6bkNW6LL9GHUAVURJL1QGKyUfsA715m-XbHgkYtqpNCCEpqpLdikkSimrLoeRwUSv2nqwCgxraRLd6nrrh3nIlwaPImhWuwp8z_HS6AAMywSXFj4ruXf9YSM7oFHw/w400-h125/PricingMetricsMag&.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;">Trailing 12-month operating metrics used</span></i></td></tr></tbody></table>On every pricing metric, the Mag Seven stocks trade at a premium over the rest of the stocks in the S&P 500, and therein lies the weakest link in pricing. That premium can be justified by pointing to higher growth and margins at the Mag Seven stocks, but that is followed by a great deal of hand waving, since how much of a premium is up for grabs. Concocting growth-adjusted pricing multiples like PEG ratios is one solution, but the PEG ratio is an absolutely abysmal measuring of pricing, making assumptions about PE and growth that are untenable. The pricing game becomes even more unstable, when analysts replace current with forward earnings, with bias entering at every step.<span><br /></span><p></p><p style="text-align: justify;"><span> I know that some of you don't buy into intrinsic valuation and note quite correctly that there are lots of assumptions that you have to make about growth, profitability and risk to arrive at a value and that no matter how hard you try, you will be wrong. I agree, but I remain a </span>believer that intrinsic valuation is the only tool that I have for assessing whether the market is incorporating what I see in a company (awful to awesome). I have valued every company in the Mag Seven multiple times over the last decade, and based my judgments on investing in these companies on a comparison of my value estimates and price. With the operating numbers (revenues, earnings) coming in for the 2023 calendar year, I have updated my valuations, and here are my summary estimates:</p></div>
<table class="tableizer-table">
<thead><tr class="tableizer-firstrow"><th><span style="font-size: x-small;">Input</span></th><th><span style="font-size: x-small;">Alphabet</span></th><th><span style="font-size: x-small;">Amazon</span></th><th><span style="font-size: x-small;">Apple</span></th><th><span style="font-size: x-small;">Microsoft</span></th><th><span style="font-size: x-small;">Meta</span></th><th><span style="font-size: x-small;">Nvidia</span></th><th><span style="font-size: x-small;">Tesla</span></th></tr></thead><tbody>
<tr><td><span style="font-size: x-small;">Expected CAGR Revenue (next 5 years)</span></td><td><span style="font-size: x-small;">8.00%</span></td><td><span style="font-size: x-small;">12.00%</span></td><td><span style="font-size: x-small;">7.50%</span></td><td><span style="font-size: x-small;">15.00%</span></td><td><span style="font-size: x-small;">12.00%</span></td><td><span style="font-size: x-small;">32.20%</span></td><td><span style="font-size: x-small;">31.10%</span></td></tr>
<tr><td><span style="font-size: x-small;">Target Operating Margin</span></td><td><span style="font-size: x-small;">30.00%</span></td><td><span style="font-size: x-small;">14.00%</span></td><td><span style="font-size: x-small;">36.00%</span></td><td><span style="font-size: x-small;">45.00%</span></td><td><span style="font-size: x-small;">40.00%</span></td><td><span style="font-size: x-small;">40.00%</span></td><td><span style="font-size: x-small;">13.07%</span></td></tr>
<tr><td><span style="font-size: x-small;">Cost of Capital</span></td><td><span style="font-size: x-small;">8.84%</span></td><td><span style="font-size: x-small;">8.60%</span></td><td><span style="font-size: x-small;">8.64%</span></td><td><span style="font-size: x-small;">9.23%</span></td><td><span style="font-size: x-small;">8.83%</span></td><td><span style="font-size: x-small;">8.84%</span></td><td><span style="font-size: x-small;">9.17%</span></td></tr>
<tr><td><span style="font-size: x-small;">Value per share</span></td><td><span style="font-size: x-small;">$138.14</span></td><td><span style="font-size: x-small;">$155.72</span></td><td><span style="font-size: x-small;">$176.79</span></td><td><span style="font-size: x-small;">$355.88</span></td><td><span style="font-size: x-small;">$445.10</span></td><td><span style="font-size: x-small;">$436.34</span></td><td><span style="font-size: x-small;">$183.75</span></td></tr>
<tr><td><span style="font-size: x-small;">Price per share</span></td><td><span style="font-size: x-small;">$145.00</span></td><td><span style="font-size: x-small;">$169.15</span></td><td><span style="font-size: x-small;">$188.00</span></td><td><span style="font-size: x-small;">$405.49</span></td><td><span style="font-size: x-small;">$456.08</span></td><td><span style="font-size: x-small;">$680.00</span></td><td><span style="font-size: x-small;">$185.07</span></td></tr>
<tr><td><span style="font-size: x-small;">% Under or Over Valued</span></td><td><span style="font-size: x-small;">4.97%</span></td><td><span style="font-size: x-small;">8.62%</span></td><td><span style="font-size: x-small;">6.34%</span></td><td><span style="font-size: x-small;">13.94%</span></td><td><span style="font-size: x-small;">2.47%</span></td><td><span style="font-size: x-small;">55.84%</span></td><td><span style="font-size: x-small;">0.72%</span></td></tr>
<tr><td><span style="font-size: x-small;">Internal Rate of Return</span></td><td><span style="font-size: x-small;">8.41%</span></td><td><span style="font-size: x-small;">7.85%</span></td><td><span style="font-size: x-small;">7.89%</span></td><td><span style="font-size: x-small;">8.06%</span></td><td><span style="font-size: x-small;">8.53%</span></td><td><span style="font-size: x-small;">7.18%</span></td><td><span style="font-size: x-small;">9.16%</span></td></tr>
<tr><td><span style="font-size: x-small;">Full Valuation (Excel)</span></td><td><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Google2024.xlsx"><span style="font-size: x-small;">Link</span></a></td><td><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Amazon2024.xlsx"><span style="font-size: x-small;">Link</span></a></td><td><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Apple2024.xlsx"><span style="font-size: x-small;">Link</span></a></td><td><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/MSFT2024.xlsx"><span style="font-size: x-small;">Link</span></a></td><td><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Meta2024.xlsx"><span style="font-size: x-small;">Link</span></a></td><td><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/NVIDIA2024.xlsx"><span style="font-size: x-small;">Link</span></a></td><td><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/TeslaJan2024DIY.xlsx"><span style="font-size: x-small;">Link</span></a></td></tr>
</tbody></table><p style="text-align: justify;">* <i><span style="font-size: x-small;">NVidia and Tesla were valued as the sum of the valuations of their different businesses. The growth and margins reported are for the consolidated company.</span></i></p><p style="text-align: justify;">First, while all of the companies in the Mag Seven have values that exceed their prices, Tesla and Meta look close to fairly valued, at current prices, Alphabet, Apple and Amazon are within striking distance of value, and Microsoft and Nvidia look over valued, with the latter especially so. It may be coincidence, but these are the two companies that have benefited most directly from the AI buzz, and my findings of over valuation may just reflect my lack of imagination on how big AI can get as a business. Just to be clear, though, I have built in substantial value from AI in my valuation of Nvidia, and given Microsoft significantly higher growth because of it, but it is plausible that I have not done enough. If intrinsic value is not your cup of tea, you can look at the internal rates of return that you would earn on these companies, at current market prices, and with my expected cash flows. For perspective, the median cost of capital for a US company at the start of 2024 was 8.60%, and while only Tesla delivers an expected return higher than that number, the test, with the exception of Nvidia, are close.</p><p style="text-align: justify;"><span> </span>I own all seven of these companies, which may strike you as contradictory, but with the exception of Tesla that I bought just last week, my acquisitions of the other seven companies occurred well in the past, and reflected my judgments that they were undervalued (at the time). To the question of whether I should be selling, which would be consistent with my current assessment that these stocks are overvalued, I hesitate for three reasons: The first is that my assessments of value come with error, and for at least five of the companies, the price is well within my range of value. The second is that I will have to pay a capital gains tax that will amount to close to 30%, with state taxes included. The third is psychological, since selling everything or nothing would leave me with regrets either way. Last summer, when I valued Nvidia in this post, I found it over valued at a price of $450, and sold half my holdings, choosing to hold the other half. Now that the price has hit $680, I plan to repeat that process, and sell half of my remaining holdings.</p><p><b>Conclusion</b></p><p style="text-align: justify;"><b> </b>As I noted at the start of this post, the benefit of hindsight allows us to pick the biggest winners in the market, bundle them together in a group and then argue that the market would be lost without them. That is true, but it is neither original nor unique to this market. The Mag Seven stocks have had a great run, but their pricing now reflects, in my view, the fact that they are great companies, with business models that deliver growth, at scale, with profitability. If you have never owned any of these companies, your portfolio will reflect that choice, and jumping on to the bandwagon now will not bring back lost gains. You should bide your time, since in my experience, even the very best companies deliver disappointments, and that markets over react to these disappointments, simply because expectations have been set so high. It is at those times that you will find that the price is right!</p><p><b>YouTube Video</b></p><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/XJnr8qHqoLQ?si=j5w_4WVEbcPY44q7" title="YouTube video player" width="560"></iframe><p><b>Intrinsic Valuations</b></p><p></p><div></div><p></p><table class="tableizer-table"><tbody><tr><td><ol><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Google2024.xlsx">Alphabet in February 2024</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Amazon2024.xlsx">Amazon in February 2024</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Apple2024.xlsx">Apple in February 2024</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/MSFT2024.xlsx">Microsoft in February 2024</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Meta2024.xlsx">Meta in February 2024</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/NVIDIA2024.xlsx">NVidia in February 2024</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/TeslaJan2024DIY.xlsx">Tesla in February 2024</a></li></ol></td></tr></tbody></table>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-74182929758615300982024-01-31T12:20:00.004-05:002024-01-31T12:26:35.942-05:00Data Update 5 for 2024: Profitability - The End Game for Business?<p style="text-align: justify;">In my last three posts, I looked at the macro (equity risk premiums, default spreads, risk free rates) and micro (company risk measures) that feed into the expected returns we demand on investments, and argued that these expected returns become hurdle rates for businesses, in the form of costs of equity and capital. Since businesses invest that capital in their operations, generally, and in individual projects (or assets), specifically, the big question is whether they generate enough in profits to meet these hurdle rate requirements. In this post, I start by looking at the end game for businesses, and how that choice plays out in investment rules for these businesses, and then examine how much businesses generated in profits in 2023, scaled to both revenues and invested capital. </p><p><b>The End Game in Business</b></p><p style="text-align: justify;"><span> </span>If you start a business, what is your end game? Your answer to that question will determine not just how you approach running the business, but also the details of how you pick investments, choose a financing mix and decide how much to return to shareholders, as dividend or buybacks. While private businesses are often described as profit maximizers, the truth is that if they should be value maximizers. In fact, that objective of value maximization drives every aspect of the business, as can be seen in this big picture perspective in corporate finance:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjzQ-rG24bpHavJknm3KZfYe0h9MfyHNwOQB19PibM8CATH-lrlDPpZ7YEdTb0AkqCxBBfqS2IG6fr5BzL9yzq9piW9F_yfsXCtc1XJmTmiuf5XqcU7ocuNd-OD-Z9ac1SydnZ7zCSBRo8lIDnX6oIGxFOoh7CjfAWq4X6K_Gg7MNvJ15FRe2inGUQ4n1w/s2941/CFBigPicture.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1641" data-original-width="2941" height="224" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjzQ-rG24bpHavJknm3KZfYe0h9MfyHNwOQB19PibM8CATH-lrlDPpZ7YEdTb0AkqCxBBfqS2IG6fr5BzL9yzq9piW9F_yfsXCtc1XJmTmiuf5XqcU7ocuNd-OD-Z9ac1SydnZ7zCSBRo8lIDnX6oIGxFOoh7CjfAWq4X6K_Gg7MNvJ15FRe2inGUQ4n1w/w400-h224/CFBigPicture.jpg" width="400" /></a></div><p style="text-align: justify;">For some companies, especially mature ones, value and profit maximization may converge, but for most, they will not. Thus, a company with growth potential may be willing to generate less in profits now, or even make losses, to advance its growth prospects. In fact, the biggest critique of the companies that have emerged in this century, many in social media, tech and green energy, is that they have prioritized scaling up and growth so much that they have failed to pay enough attention to their business models and profitability.</p><p style="text-align: justify;"><span> </span>For decades, the notion of maximizing value has been central to corporate finance, though there have been disagreements about whether maximizing stock prices would get you the same outcome, since that latter requires assumptions about market efficiency. In the last two decades, though, there are many who have argued that maximizing value and stockholder wealth is far too narrow an objective, for businesses, because it puts shareholders ahead of the other stakeholders in enterprises:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjh83rn7B8nNskiHBoKSuX6hd2X1Q_JXatQwAgGZs7Y1A3iq-LB6QtKM8rpfcGUbuobhyphenhypheniymzEvnDoW8MSi92LwTujVA1Lnwca_AjyfEQCcuJHLeYj-A01p-Rxpm8RqZD2SJPZJ2lXL7OiismfEnCkQftJ7Zl62Du7oQwMBqCEW7EGLXWhHXSer6qCpXbQ/s741/stakeholders.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="369" data-original-width="741" height="199" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjh83rn7B8nNskiHBoKSuX6hd2X1Q_JXatQwAgGZs7Y1A3iq-LB6QtKM8rpfcGUbuobhyphenhypheniymzEvnDoW8MSi92LwTujVA1Lnwca_AjyfEQCcuJHLeYj-A01p-Rxpm8RqZD2SJPZJ2lXL7OiismfEnCkQftJ7Zl62Du7oQwMBqCEW7EGLXWhHXSer6qCpXbQ/w400-h199/stakeholders.jpg" width="400" /></a></div><br /><p style="text-align: justify;">It is the belief that stockholder wealth maximization shortchanges other stakeholders that has given rise to <i>stakeholder wealth maximization</i>, a misguided concept where the end game for businesses is redefined to maximize the interests of all stakeholders. In addition to being impractical, it misses the fact that shareholders are given primacy in businesses because they are the only claim holders that have no contractual claims against the business, accepting residual cash flows, If stakeholder wealth maximization is allowed to play out, it will result in confused corporatism, good for top managers who use stakeholder interests to become accountable to none of the stakeholders:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi2A0hDUDLknihzM1jFW4-mGApstdH4BqjTBt9LHpH4nPE4jPnUWeHLmZX5NcxqnrnihbdtvhXsmPXydUhnjjuuznBOowf908l2Tt-JKFTfLy_hjeplP240eMdKcFEXOo0lXYMrMUGI6Bqn93gO59DOoYPhjnT4y0BT7XpKOyqzl1-eKLzvD6KXA_-R6ZY/s738/ConfusedCorporatism.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="451" data-original-width="738" height="245" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi2A0hDUDLknihzM1jFW4-mGApstdH4BqjTBt9LHpH4nPE4jPnUWeHLmZX5NcxqnrnihbdtvhXsmPXydUhnjjuuznBOowf908l2Tt-JKFTfLy_hjeplP240eMdKcFEXOo0lXYMrMUGI6Bqn93gO59DOoYPhjnT4y0BT7XpKOyqzl1-eKLzvD6KXA_-R6ZY/w400-h245/ConfusedCorporatism.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><p style="text-align: justify;">As you can see, I am not a fan of confused corporatism, arguing that giving a business multiple objectives will mangle decision making, leaving businesses looking like government companies and universities, wasteful entities unsure about their missions. In fact, it is that skepticism that has made me a critic of ESG and sustainability, offshoots of stakeholder wealth maximization, suffering from all of its faults, with greed and messy scoring making them worse. </p><p style="text-align: justify;"><span> It may seem odd to you that I am spending so much time defending the centrality of profitability to a business, but it is a sign of how distorted this discussion has become that it is even necessary. In fact, you may</span> find my full-throated defense of generating profits and creating value to be distasteful, but if you are an advocate for the point of view that businesses have broader social purposes, the reality is that for businesses to do good, they have to be financial healthy and profitable. Consequently, you should be just as interested, as I am, in the profitability of companies around the world, albeit for different reasons. My interest is in judging them on their capacity to generate value, and yours would be to see if they are generating enough as surplus so that they can do good for the world. </p><p><b>Profitability: Measures and Scalars</b></p><p style="text-align: justify;"><span> Measuring profitability at a business is messier than you may think, since it is not just enough for a business to make money, but it has to make enough money to justify the capital invested in it. The first step is understanding profitability is recognizing that there are multiple measures of profit, and that each measure they captures a different aspect of a business:</span></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjr_b0icGlWyx8Ok67EAa_Aq96N0QtTRQgKIfG1ZrXOuNI1zJU1w0GG8E5yeSDYxrAs7rsg71W3F3UsS8Se6Uz411jhaJuHAPJzCK_tfztLYmsnMMNJXTxwTsFBDQPhoTUcJ2osIJ5U_H5aGsY9WiQXXbph_svk4X36On1HhVCVDf2f5dAcIkYs1-Bhx-0/s627/ProfitMeasures.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="346" data-original-width="627" height="221" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjr_b0icGlWyx8Ok67EAa_Aq96N0QtTRQgKIfG1ZrXOuNI1zJU1w0GG8E5yeSDYxrAs7rsg71W3F3UsS8Se6Uz411jhaJuHAPJzCK_tfztLYmsnMMNJXTxwTsFBDQPhoTUcJ2osIJ5U_H5aGsY9WiQXXbph_svk4X36On1HhVCVDf2f5dAcIkYs1-Bhx-0/w400-h221/ProfitMeasures.jpg" width="400" /></a></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">It is worth emphasizing that these profit numbers reflect two influences, both of which can skew the numbers. The first is the <i>explicit role of accountants</i> in measuring profits implies that inconsistent accounting rules will lead to profits being systematically mis-measured, a point I have made <a href="https://aswathdamodaran.blogspot.com/2022/11/meta-lesson-2-accounting.html">in my posts </a>on how R&D is routinely mis-categorized by accountants. The other is the <i>implicit effect of tax laws</i>, since taxes are based upon earnings, creating an incentive to understate earnings or even report losses, on the part of some businesses. That said, global (US) companies collectively generated $5.3 trillion ($1.8 trillion) in net income in 2023, and the pie charts below provide the sector breakdowns for global and US companies:</div><div style="text-align: justify;"><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjXHdCJiQnKNp16SFqXXteJUfjuxykEYN59mWzPt0Dzswmw2rtkEvh9UEcm9PLopawuJRl7Ql6XrmZOo2GujHBn8WlQ860rfT81H7qs3xSNaUQLWYRF7KPYrm69g9bU_P_4TcwK1s70uUAibGa4XzwcMNYT8f5YTpmrv3R-VNv08G9ACY8ni99QIIFpoTU/s1521/IncomePiein2023.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="788" data-original-width="1521" height="208" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjXHdCJiQnKNp16SFqXXteJUfjuxykEYN59mWzPt0Dzswmw2rtkEvh9UEcm9PLopawuJRl7Ql6XrmZOo2GujHBn8WlQ860rfT81H7qs3xSNaUQLWYRF7KPYrm69g9bU_P_4TcwK1s70uUAibGa4XzwcMNYT8f5YTpmrv3R-VNv08G9ACY8ni99QIIFpoTU/w400-h208/IncomePiein2023.jpg" width="400" /></a></div><br /><div style="text-align: justify;">Notwithstanding their trials and tribulations since 2008, financial service firms (banks, insurance companies, investment banks and brokerage firms) account for the largest slice of the income pie, for both US and global companies, with energy and technology next on the list.</div><p></p><p><i>Profit Margins</i></p><p><i> </i>While aggregate income earned is an important number, it is an inadequate measure of profitability, especially when comparisons across firms, when it is not scaled to something that companies share. As as a first scalar, I look at <i>profits, relative to revenues, which yields margin</i>s, with multiple measures, depending upon the profit measure used:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhrrzkwE20o9mUnnLQpdkkWyq9hZ6UzXLYhMO2jSuua-EYzbwFV4WA_S2sfHgNKqVR15uINPb1Ehjud_1q9g14dNeyrHVjoARWh_jXN5-QDXP1reKmHpy2wrcUH8UpYbYM0yZBXJqjW1pghA7aD5nvAfNhtFEUaBm4clee9DOhAM9Tt_FRoXEKKCuvymcs/s596/ProfitMargins.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="324" data-original-width="596" height="217" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhrrzkwE20o9mUnnLQpdkkWyq9hZ6UzXLYhMO2jSuua-EYzbwFV4WA_S2sfHgNKqVR15uINPb1Ehjud_1q9g14dNeyrHVjoARWh_jXN5-QDXP1reKmHpy2wrcUH8UpYbYM0yZBXJqjW1pghA7aD5nvAfNhtFEUaBm4clee9DOhAM9Tt_FRoXEKKCuvymcs/w400-h217/ProfitMargins.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: justify;">Looking across US and global companies, broken down by sector, I look at profit margins in 2023:</div><div style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgyBILQHQAvZ8V9rLuGOJGQ8jJ-y0e1s3YZVH6S1_OKupOdiICcgGKvlo-PSqf8H-yu5QTzXGQldH7xqKkNd18bgO-mR6VUbCdzvItB3i2SdYXhc8V6rognGtipNn8gh0S49glnjIPjIFGa-AeVa8-9KWswJ8CuHMrZLD3mntEiDiWTH0K0fKJH4jx5GLs/s712/SectorMargin.jpg"><img border="0" data-original-height="528" data-original-width="712" height="296" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgyBILQHQAvZ8V9rLuGOJGQ8jJ-y0e1s3YZVH6S1_OKupOdiICcgGKvlo-PSqf8H-yu5QTzXGQldH7xqKkNd18bgO-mR6VUbCdzvItB3i2SdYXhc8V6rognGtipNn8gh0S49glnjIPjIFGa-AeVa8-9KWswJ8CuHMrZLD3mntEiDiWTH0K0fKJH4jx5GLs/w400-h296/SectorMargin.jpg" width="400" /></a></div><br /><div class="separator" style="clear: both; text-align: justify;">Note that financial service companies are conspicuously absent from the margin list, for a simple reason. Most financial service firms have no revenues, though they have their analogs - loans for banks, insurance premiums for insurance companies etc. Among the sectors, energy stands out, generating the highest margins globally, and the second highest, after technology firms in the United States. Before the sector gets targeted as being excessively profitable, it is also one that is subject to volatility, caused by swings in oil prices; in 2020, the sector was the worst performing on profitability, as oil prices plummeted that year.</div><div class="separator" style="clear: both; text-align: justify;"><span> Does profitability vary across the </span>globe? To answer that question, I look at differences in margins across sub-regions of the world:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiJeHxBg858IAKaAWTcKrARTKg0RN45tvJp8czfpu8tIY3dknpeZrmeTYiLRcaFJ_2Ce2Vn-K47sM0KDHUPv8in5J2Breuw0ZG4R14TJYajhNXr06eCDlRpm8h0TjQFK2NeijObvnZyoFEhddekBEEp6PkeS5W64H4_qgd_AEPFK8EISqgy7Pq0BMhNnLQ/s710/RegionMargin.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="255" data-original-width="710" height="144" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiJeHxBg858IAKaAWTcKrARTKg0RN45tvJp8czfpu8tIY3dknpeZrmeTYiLRcaFJ_2Ce2Vn-K47sM0KDHUPv8in5J2Breuw0ZG4R14TJYajhNXr06eCDlRpm8h0TjQFK2NeijObvnZyoFEhddekBEEp6PkeS5W64H4_qgd_AEPFK8EISqgy7Pq0BMhNnLQ/w400-h144/RegionMargin.jpg" width="400" /></a></div><br /><div class="separator" style="clear: both; text-align: justify;">You may be surprised to see Eastern European and Russian companies with the highest margins in the world, but that can be explained by two phenomena. The first is the preponderance of natural resource companies in this region, and energy companies had a profitable year in 2023. The second is that the sanctions imposed after 2021 on doing business in Russia drove foreign competitors out of the market, leaving the market almost entirely to domestic companies. At the other end of the spectrum, Chinese and Southeast Asian companies have the lowest net margins, highlighting the reality that big markets are not always profitable ones.</div><div class="separator" style="clear: both; text-align: justify;"><span> </span><span style="text-align: left;">Finally, there is a relationship between corporate age and profitability, with younger companies often struggling more to deliver profits, with business models still in flux and no economies of scale. In the fact, the pathway of a company through the life cycle can be seen through the lens of profit margins:</span></div><div class="separator" style="clear: both; text-align: justify;"><br /></div><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjkCk4HDTx16D2I0RDeh-CAwsLXtfkPKqihDiLu9oUtFQ8f7skkZKwNgpJidA_m7TCpFrVdJ7KUtq1E5OZNK74ZaySuBV8BrpdIRIYd1EmFKFrqEGIq7k6tN7YYsoYweODmK36ZQQoiKuxSRgiMum5TsN8p_PgtqigN1YYTiCfxk9HOiyUVh1Sz9vbXgG8/s713/LifeCycleMrgins.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="469" data-original-width="713" height="263" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjkCk4HDTx16D2I0RDeh-CAwsLXtfkPKqihDiLu9oUtFQ8f7skkZKwNgpJidA_m7TCpFrVdJ7KUtq1E5OZNK74ZaySuBV8BrpdIRIYd1EmFKFrqEGIq7k6tN7YYsoYweODmK36ZQQoiKuxSRgiMum5TsN8p_PgtqigN1YYTiCfxk9HOiyUVh1Sz9vbXgG8/w400-h263/LifeCycleMrgins.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: justify;">Early in the life cycle, the focus will be on gross margins, partly because there are losses on almost every other earnings measure. As companies enter growth, the focus will shift to operating margins, albeit before taxes, as companies still are sheltered from paying taxes by past losses. In maturity, with debt entering the financing mix, net margins become good measures of profitability, and in decline, as earnings decline and capital expenditures ease, EBITDA margins dominate. In the table below, I look at global companies, broken down into decals, based upon corporate age, and compute profit margins across the deciles:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjWJFOwbDLNjSv3lKnTGhHqihGlKawkDKPAJ3-r3lR3N6SwWU6guh3ud6KDECShny4TvaDtatewQctoSrD8o3IiE4htBRUlM56PsDhIAhgYI2rz8N5Lrhz-cb6f-FDEAyPkrWNnp_J3rbbgXEpoI_KfV1aXmO6iF3UST1OUw6T14BKbNJMIDoO8846KuEk/s714/AgeDecile.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="202" data-original-width="714" height="114" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjWJFOwbDLNjSv3lKnTGhHqihGlKawkDKPAJ3-r3lR3N6SwWU6guh3ud6KDECShny4TvaDtatewQctoSrD8o3IiE4htBRUlM56PsDhIAhgYI2rz8N5Lrhz-cb6f-FDEAyPkrWNnp_J3rbbgXEpoI_KfV1aXmO6iF3UST1OUw6T14BKbNJMIDoO8846KuEk/w400-h114/AgeDecile.jpg" width="400" /></a></div><br /><div class="separator" style="clear: both; text-align: justify;">The youngest companies hold their own on gross and EBITDA margins, but they drop off as you move to operating nnd net margins.</div><div class="separator" style="clear: both; text-align: justify;"><span> In summary, profit margins are a useful measure of profitability, but they vary across sectors for many reasons, and you can have great companies with low margins and below-average companies that have higher margins. Costco has sub-par operating margins, barely hitting 5%, but makes up for it with high sales volume, whereas there are luxury retailers with two or three times higher margins that struggle to create value.</span><br /></div><p><i>Return on Investment</i></p><p style="text-align: justify;"><i> </i>The second scalar for profits is the capital invested in the assets that generate these profits. Here again, there are two paths to measuring returns on investment, and the best way to differentiate them is to think of them in the context of a financial balance sheet:<br /></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjVHIbiJWolDmMI3lPSi_AgWSSWp5S7tHIMRkSUolqps8wAEQLsWD9RgfY7gU07b_hEXDJ9eKr7akwJbh6OlkGek9CK5KVj0JpRziat1wRwV63RBNNENzGdA-9Kb5mb4-HAh2iH03wegKujhNI78qbCXNuirMyzib-uu2hMUcfXUkCrQuioz-ub90okVmk/s834/AccReturnBS.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="333" data-original-width="834" height="160" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjVHIbiJWolDmMI3lPSi_AgWSSWp5S7tHIMRkSUolqps8wAEQLsWD9RgfY7gU07b_hEXDJ9eKr7akwJbh6OlkGek9CK5KVj0JpRziat1wRwV63RBNNENzGdA-9Kb5mb4-HAh2iH03wegKujhNI78qbCXNuirMyzib-uu2hMUcfXUkCrQuioz-ub90okVmk/w400-h160/AccReturnBS.jpg" width="400" /></a></div><br /><div style="text-align: justify;">The accounting return on equity is computed by dividing the net income, the equity investor's income measure, by the book value of equity and the return on invested capital is computed, relative to the book value of invested capital, the cumulative values of book values of equity and debt, with cash netted out. Looking at accounting returns, broken down by sector, for US and global companies, here is what 2023 delivered:</div><p></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiR16B_kpno9ZKLA1Nl6DDT6daz4_L9HVzj0ISlubsZG3aBVgx_7_IFSt4TpM2k-4r-aRUaDy0mKZA7MRpH2f-YtNjagNCrB8ZjWMct3DUy2hyphenhyphen_JO5h3DDWNZW2UpYHY7r4PZBYlkgW7FxMXyCwJ3cQIW6jEHCRaxhLXCQDbdDR5vCog_sNoCGA6yyDSZU/s592/SectorROCTable.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="505" data-original-width="592" height="341" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiR16B_kpno9ZKLA1Nl6DDT6daz4_L9HVzj0ISlubsZG3aBVgx_7_IFSt4TpM2k-4r-aRUaDy0mKZA7MRpH2f-YtNjagNCrB8ZjWMct3DUy2hyphenhyphen_JO5h3DDWNZW2UpYHY7r4PZBYlkgW7FxMXyCwJ3cQIW6jEHCRaxhLXCQDbdDR5vCog_sNoCGA6yyDSZU/w400-h341/SectorROCTable.jpg" width="400" /></a></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">In both the US and globally, <i>technology companies deliver the highest accounting returns</i>, but these returns are skewed by the accounting inconsistencies in capitalizing R&D expenses. While I partially correct for this by capitalizing R&D expenses, it is only a partial correction, and the returns are still overstated. The worst accounting returns are delivered by real estate companies, though they too are skewed by tax considerations, with expensing to reduce taxes paid, rather than getting earnings right.</div><p></p><p><i>Excess Returns</i></p><p><i> </i>In the final assessment, I bring together the costs of equity and capital estimated <a href="https://aswathdamodaran.blogspot.com/2024/01/data-update-4-for-2024-danger-and.html">in the last post</a> and the accounting returns in this one, to answer a critical question that every business faces, i.e,, <i>whether the returns earned on its investment exceed its hurdle rate</i>. As with the measurement of returns, excess returns require consistent comparisons, with accounting returns on equity compared to costs of equity, and returns on capital to costs of capital:</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjApsqMIV7xaFCJ71g5THd0Bzqc0nQp-NOSbbL6AcR2LoAMZ-rwPk-_SDxrl1qjrGui2h7nsK3zkS9yAUFZMgOnWzbJxsAM_Bm1a7TaWZQUn0a0VrNAV-LIrT7FqDcM8IVwU-fHsM11RRfjr-NIUT0Tv1fokssWZM2Wn9nEEcVn1CY-GWCmt9ZTFVjNcy8/s746/ExcessREturns.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="323" data-original-width="746" height="174" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjApsqMIV7xaFCJ71g5THd0Bzqc0nQp-NOSbbL6AcR2LoAMZ-rwPk-_SDxrl1qjrGui2h7nsK3zkS9yAUFZMgOnWzbJxsAM_Bm1a7TaWZQUn0a0VrNAV-LIrT7FqDcM8IVwU-fHsM11RRfjr-NIUT0Tv1fokssWZM2Wn9nEEcVn1CY-GWCmt9ZTFVjNcy8/w400-h174/ExcessREturns.jpg" width="400" /></a></div><div style="text-align: justify;">These excess returns are not perfect or precise, by any stretch of the imagination, with mistakes made in assessing risk parameters (betas and ratings) causing errors in the cost of capital and accounting choices and inconsistencies affecting accounting returns. That said, they remain noisy estimates of a company's competitive advantages and moats, with strong moats going with positive excess returns, no moats translating into excess returns close to zero and bad businesses generating negative excess returns.</div><div><span> I start again by looking at the sector breakdown, both US and global, of excess </span>returns in 2023, in the table below:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgLphhyuBuGkTJSAjo3AncsJJgqlY9p9bgFp659ZpT8BAiOlfb5KcNxIIoB3GUL65PGPmJl0Q0HXCYLB-x8_rhhyphenhyphen6DIP_dBcTgZC7Mc7_boq_djhrGsSBaEkdx2j-p5ZtAUwJu5BpqqbEVbIAtFNLnm7ahaaXOUQYK3B4YyOuKO7wPrghLvbp9D3B0OFo0/s971/SectorXRet.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="549" data-original-width="971" height="226" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgLphhyuBuGkTJSAjo3AncsJJgqlY9p9bgFp659ZpT8BAiOlfb5KcNxIIoB3GUL65PGPmJl0Q0HXCYLB-x8_rhhyphenhyphen6DIP_dBcTgZC7Mc7_boq_djhrGsSBaEkdx2j-p5ZtAUwJu5BpqqbEVbIAtFNLnm7ahaaXOUQYK3B4YyOuKO7wPrghLvbp9D3B0OFo0/w400-h226/SectorXRet.jpg" width="400" /></a></div><br /><div style="text-align: justify;">In computing excess returns, I did add a qualifier, which is that I would do the comparison only among money making companies; after all, money losing companies will have accounting returns that are negative and less than hurdle rates. With each sector, to assess profitability, you have to look at the percentage of companies that make money and then at the percent of these money making firms that earn more than the hurdle rate. With financial service firms, where only the return on equity is meaningful, 57% (64%) of US (global) firms have positive net income, and of these firms, 82% (60%) generated returns on equity that exceeded their cost of equity. In contrast, with health care firms, only 13% (35%) of US (global) firms have positive net income, and about 68% (53%) of these firms earn returns on equity that exceed the cost of equity. </div><div style="text-align: justify;"><span> In a final cut, I looked at excess returns by region of the world, again looking at only money-making companies in each region:</span></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgsuCRY7PHJshpXNO2vVPhYdmj_waPYtljPYhCVKDVXXkDWK0MZsu4I3w5Anpzy0ndHc7BgLsreHhCiOlcqvvdLkumoa-5XV6EN3XRVS9028i-JEorZ5nGHsL1U-9lfTegBM5YAQ4MEk-0OCP1j8CrnCI0dOHQIxf74BtRq9OCi0qMbernATiAV7pr_rsU/s946/RegionXret.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="276" data-original-width="946" height="116" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgsuCRY7PHJshpXNO2vVPhYdmj_waPYtljPYhCVKDVXXkDWK0MZsu4I3w5Anpzy0ndHc7BgLsreHhCiOlcqvvdLkumoa-5XV6EN3XRVS9028i-JEorZ5nGHsL1U-9lfTegBM5YAQ4MEk-0OCP1j8CrnCI0dOHQIxf74BtRq9OCi0qMbernATiAV7pr_rsU/w400-h116/RegionXret.jpg" width="400" /></a></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">To assess the profitability of companies in each region, I again look at t the percent of companies that are money-making, and then at the percent of these money-making companies that generate accounting returns that exceed the cost of capital. To provide an example, 82% of Japanese companies make money, the highest percentage of money-makers in the world, but only 40% of these money-making companies earn returns that exceed the hurdle rate, second only to China on that statistic. The US has the highest percentage (73%) of money-making companies that generate returns on equity that exceed their hurdle rates, but only 37% of US companies have positive net income. Australian and Canadian companies stand out again, in terms of percentages of companies that are money losers, and out of curiosity, I did take a closer look at the individual companies in these markets. It turns out that the money-losing is endemic among smaller publicly traded companies in these markets, with many operating in materials and mining, and the losses reflect both company health and life cycle, as well as the tax code (which allows generous depreciation of assets). In fact, the largest companies in Australia and Canada deliver enough profits to carry the aggregated accounting returns (estimated by dividing the total earnings across all companies by the total invested capital) to respectable levels.</div><div style="text-align: justify;"><span> In the most sobering statistic, if you aggregate </span>money-losers with the companies that earn less than their hurdle rates, as you should, <i>there is not a single sector or region of the world, where a majority of firms earn more than their hurdle rates</i>. </div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgTqcXjBSAo-TgjI1lHvWbQ1V00D-dHtWphhG_pmY4L4cSoz6-cOKcLhA0dXee7hyphenhyphenDfZVq8QxxHSPpncH3o51aX33-cKzxmIsqpsJWtWiNImXrgiU6EDsJuSAY1n_RrWL_dJwOhR5JCiFLT1eZcK-LNN4Y_-lnlwyPxcKSUilv1RllU0lloJJLfzLiNupo/s2675/XRetAllfirms.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="925" data-original-width="2675" height="139" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgTqcXjBSAo-TgjI1lHvWbQ1V00D-dHtWphhG_pmY4L4cSoz6-cOKcLhA0dXee7hyphenhyphenDfZVq8QxxHSPpncH3o51aX33-cKzxmIsqpsJWtWiNImXrgiU6EDsJuSAY1n_RrWL_dJwOhR5JCiFLT1eZcK-LNN4Y_-lnlwyPxcKSUilv1RllU0lloJJLfzLiNupo/w400-h139/XRetAllfirms.jpg" width="400" /></a></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">In 2023, close to 80% of all firms globally earned returns on capital that lagged their costs of capital. Creating value is clearly far more difficult in practice than on paper or in case studies!</div><div><p><b>A Wrap!</b></p><div style="text-align: justify;">I started this post by talking about the end game in business, arguing for profitability as a starting point and value as the end goal. The critics of that view, who want to expand the end game to include more stakeholders and a broader mission (ESG, Sustainability) seem to be operating on the presumption that shareholders are getting a much larger slice of the pie than they deserve. That may be true, if you look at the biggest winners in the economy and markets, but in the aggregate, the game of business has only become harder to play over time, as globalization has left companies scrabbling to earn their costs of capital. In fact, a decade of low interest rates and inflation have only made things worse, by making risk capital accessible to young companies, eager to disrupt the status quo.</div><p style="text-align: justify;"><b>YouTube Video</b></p><p><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/GjCPRQfT_xM?si=GznHgGeNaTur-ErR" title="YouTube video player" width="560"></iframe><b><br /></b></p><p><b>Datasets</b></p><p></p><ol style="text-align: left;"><li>Profit Margins, by Industry (<a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/margin.xls">US</a>, <a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/marginGlobal.xls">Global)</a></li><li>Accounting Returns and Excess Returns, by Industry (<a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/EVA.xls">US</a>, <a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/EVAGlobal.xls">Global</a>)</li></ol><div><div style="text-align: justify;"><b>Data Update Posts for 2024</b></div><div style="text-align: justify;"><ol><li><a href="https://aswathdamodaran.blogspot.com/2024/01/data-update-1-for-2024-data-speaks-but.html">Data Update 1 for 2024: The Data Speaks, but what is it saying?</a></li><li><a href="https://aswathdamodaran.blogspot.com/2024/01/data-update-2-for-2024-stock-comeback.html">Data Update 2 for 2024: A Stock Comeback - Winning the Expectations Game!</a></li><li><a href="https://aswathdamodaran.blogspot.com/2024/01/data-update-3-for-2024-interest-rates.html">Data Update 3 for 2024: Interest Rates in 2023 - A Rule-breaking Year</a></li><li><a href="https://aswathdamodaran.blogspot.com/2024/01/data-update-4-for-2024-danger-and.html">Data Update 4 for 2024: Danger and Opportunity - Bringing Risk into the Equation</a></li><li><a href="https://aswathdamodaran.blogspot.com/2024/01/data-update-5-for-2024-profitability.html">Data Update 5 for 2024: Profitability - The End Game for Business?</a></li></ol></div></div><p></p></div>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-17043121211882201902024-01-28T11:18:00.005-05:002024-02-10T11:31:40.687-05:00Data Update 4 for 2024: Danger and Opportunity - Bringing Risk into the Equation!<p style="text-align: justify;">In my last data updates for this year, I looked first at <a href="https://aswathdamodaran.blogspot.com/2024/01/data-update-2-for-2024-stock-comeback.html">how equity markets rebounded in 2023</a>, driven by a stronger-than-expected economy and inflation coming down, and then <a href="https://aswathdamodaran.blogspot.com/2024/01/data-update-3-for-2024-interest-rates.html">at how interest rates mirrored this rebound</a>. In this post, I look at risk, a central theme in finance and investing, but one that is surprisingly misunderstood and misconstrued. In particular, there are wide variations in how risk is measured, and once measured, across companies and countries, and those variations can lead to differences in expected returns and hurdle rates, central to both corporate finance and investing judgments.</p><p><b>Risk Measures</b></p><p style="text-align: justify;"><b> </b>There is almost no conversation or discussion that you can have about business or investing, where risk is not a part of that discussion. That said, and notwithstanding decades of research and debate on the topic, there are still wide differences in how risk is defined and measured.<br /></p><p><i>What is risk?</i></p><p style="text-align: justify;"> I do believe that, in finance, we have significant advances in understanding what risk, I also think that as a discipline, finance has missed the mark on risk, in three ways. First, it has put <u>too much emphasis on market-price driven measures of risk</u>, where price volatility has become the default measure of risk, in spite of evidence indicating that a great deal of this volatility has nothing to do with fundamentals. Second, in our zeal to measure risk with numbers, we have <u>lost sight of the reality that the effects of risk are as much on human psyche,</u> as they are on economics. Third, by making investing a choice between good (higher returns) and bad (higher risk), a message is sent, perhaps unwittingly, <u>that risk is something to be avoided or hedged</u>. It is perhaps to counter all of these that I start my session on risk with the Chinese symbol for crisis:</p><p style="text-align: center;">Chinese symbol for crisis = 危機 = Danger + Opportunity</p><p style="text-align: justify;">I have been taken to task for using this symbol by native Chinese speakers pointing out mistakes in my symbols (and I have corrected them multiple times in response), but thinking of risk as a combination of danger and opportunity is, in my view, a perfect pairing, and this perspective offers two benefits. First, by linking the two at the hip, it sends the clear and very important signal that you cannot have one (opportunity), without exposing yourself to the other (danger), and that understanding alone would immunize individuals from financial scams that offer the best of both worlds - high returns with no risk. Second, it removes the negativity associated to risk, and brings home the truth that you build a great business, not by avoiding danger (risk), but by seeking out the right risks (where you have an advantage), and getting more than your share of opportunities. </p><p><i>Breaking down risk</i></p><div class="separator" style="clear: both; text-align: justify;"><span> One reason that we have trouble wrapping our heads around risk is that it has so many sources, and our capacity to deal with varies, as a consequence. When assessing risk in a project or a company, I find it useful to make a list of every risk that I see in the investment, big and small, but I then classify these risks into buckets, based upon type, with very different ways of dealing with and incorporating that risk into investment analysis. The table below provides a breakdown of those buckets, with economic uncertainty contrasted with estimation uncertainty, micro risk separated from macro risks and discrete risks distinguished from continuous risks:</span></div><div class="separator" style="clear: both; text-align: justify;"><span><br /></span></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiCU0mIb6Cwcqhl0hTiqBpvBR4EC81KnclDJIFx1C8jFlaZDFbtnWc2RkqFZrs18fSJeBQ3XSvpCyJWNqTtI9PvKB1pKBWwe6PRIf5StWpLIWcgObWNBxy4XGWAl3iYC1g2ymFiufUo0W5f-e6IVH19NU0WgOkENSZb603qkqpEjGGoNjkc816v33Y6xTc/s663/RiskTypes.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="319" data-original-width="663" height="193" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiCU0mIb6Cwcqhl0hTiqBpvBR4EC81KnclDJIFx1C8jFlaZDFbtnWc2RkqFZrs18fSJeBQ3XSvpCyJWNqTtI9PvKB1pKBWwe6PRIf5StWpLIWcgObWNBxy4XGWAl3iYC1g2ymFiufUo0W5f-e6IVH19NU0WgOkENSZb603qkqpEjGGoNjkc816v33Y6xTc/w400-h193/RiskTypes.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: justify;">While risk breakdowns may seem like an abstraction, they do open the door to healthier practices in risk analysis, including the following:</div><div class="separator" style="clear: both; text-align: justify;"><ol><li><u>Know when to stop</u>: In a world, where data is plentiful and analytical tools are accessible, it is easy to put off a decision or a final analysis, with the excuse that you need to collect more information. That is understandable, but digger deeper into the data and doing more analysis will lead to better estimates, <u>only if the risk that you are looking at is estimation risk</u>. In my experience, much of the risk that we face when valuing companies or analyzing investments is <u>economic uncertainty, impervious to more data and analysis</u>. It is therefore healthy to know when to stop researching, accepting that your analysis is always a work-in-progress and that decisions have to be made in the face of uncertainty.</li><li><u>Don't overthink the discount rate</u>: One of my contentions of discount rates is that they cannot become receptacles for all your hopes and fears. Analysts often try to bring company-specific components, i.e, micro uncertainties, into discount rates, and in the process, they end up incorporating risk that investors can eliminate, often at no cost. Separating the risks that do affect discount rates from the risks that do not, make the discount rate estimation simpler and more precise.</li><li><u>Use more probabilistic & statistical tools</u>: The best tools for bringing in discrete risk are probabilistic, i.e., decision trees and scenario analysis, and using them in that context may open the door to other statistical tools, many of which are tailor-made for the problems that we face routinely in finance, and are underutilized.</li></ol></div><p><i>Measuring risk</i></p><p style="text-align: justify;"><i> </i>The financial thinking on risk, at least in its current form, had its origins in the 1950s, when Harry Markowitz uncovered the simple truth that the risk of an investment is not the risk of it standing alone, but the risk it adds to an investor's portfolio. He followed up by showing that holding diversified portfolios can deliver much higher returns, for given levels of risk, for all investors. That insight gave rise not only to modern portfolio theory, but it also laid the foundations for how we measure and deal with risk in finance. In fact, almost every risk and return model in finance is built on pairing two assumptions, the first being that the <u>marginal investors in a company or business are diversified </u>and the second being that investors <u>convey their risk concerns through market prices</u>:</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjeu_LzRB-MDjNn_0G1l5q-ViD_CORa_e3MbHppNyXitbeUHNPzvnQhJp5NQdqPun6gQtsub0K7OAWDfI-hbZhnmeA93-twF5axJ2_OYcrB_4EFaSO6_tucxpTg34WpvSJn1bp7RPbRTkMgEQ4hiW6x4uT7cjCwteII1XEwqt0hyphenhyphenF5MRKZFTQicf52R54g/s653/MPTRiskMeasure.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="305" data-original-width="653" height="186" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjeu_LzRB-MDjNn_0G1l5q-ViD_CORa_e3MbHppNyXitbeUHNPzvnQhJp5NQdqPun6gQtsub0K7OAWDfI-hbZhnmeA93-twF5axJ2_OYcrB_4EFaSO6_tucxpTg34WpvSJn1bp7RPbRTkMgEQ4hiW6x4uT7cjCwteII1XEwqt0hyphenhyphenF5MRKZFTQicf52R54g/w400-h186/MPTRiskMeasure.jpg" width="400" /></a></div><div style="text-align: justify;">By building on the assumptions that the investors pricing a business are diversified, and make prices capture that risk, modern portfolio theory has exposed itself to criticism from those who disagree with one or both of these assumptions. Thus, there are value investors, whose primary disagreement is on the use of pricing measures for risk, arguing that risk has to come from numbers that drive intrinsic value - earnings and cash flows. There are other investors who are at peace with price-based risk measures , but disagree with the "diversified marginal investor" assumption, and they are more intent on finding risk measures that incorporate total risk, not just risk that cannot be diversified away. I do believe that the critiques of both groups have legitimate basis, and while I don't feel as strongly as they do, I can offer modifications of risk measures to counter the critiques;</div><p></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjixQ6aAoptBGZI_AsISInfrPTowhOeo5S_p9XYnqULgyqFcGLcCMGnUDxylp6z6P211_htwFRODfkBs6GktKIRpD-4i5Ctt2x_l6H2KLo8s6Bp5zO4kDqMBy0sO9cI85obzLAtyXbxAIl1rJwpONGCZEss6TLlpjXhT1M698NWZ5mfPcFSDQ_fsqG6tOk/s653/RiskMeasureModels.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="341" data-original-width="653" height="209" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjixQ6aAoptBGZI_AsISInfrPTowhOeo5S_p9XYnqULgyqFcGLcCMGnUDxylp6z6P211_htwFRODfkBs6GktKIRpD-4i5Ctt2x_l6H2KLo8s6Bp5zO4kDqMBy0sO9cI85obzLAtyXbxAIl1rJwpONGCZEss6TLlpjXhT1M698NWZ5mfPcFSDQ_fsqG6tOk/w400-h209/RiskMeasureModels.jpg" width="400" /></a></div><br /><div style="text-align: justify;">For investors who do not trust market prices, you can create risk analogs that look at accounting earnings or cash flows, and for those who believe that the diversified investor assumption is an overreach, you can adapt risk measures to capture all risk, not just market risk. In short, if you don't like betas and have disdain for modern portfolio theory, your choice should not be to abandon risk measurement all together, but to come up with an alternative risk measure that is more in sync with your view of the world. </div><p></p><p><b>Risk Differences across Companies</b></p><p style="text-align: justify;"> With that long lead-in on risk, we are positioned to take a look at how risk played out, at the company level, in 2024. Using the construct from the last section, I will start by looking at price-based risk measures and then move on to intrinsic risk measures in the second section.<br /></p><p><i>a. Price-based Risk Measures</i></p><p style="text-align: justify;"><i> </i>My data universe includes all publicly traded companies, and since they are publicly traded, computing price-based risk measures is straight forward. That said, it should be noted that liquidity varies widely across these companies, with some located in markets where trading is rare and others in markets, with huge trading volumes. With that caveat in mind, I computed three risk-based measures - <i>a simplistic measure of range</i>, where I look at the distance between the high and low prices, and scale it to the mid-point, the <i>standard deviation in stock prices</i>, a conventional measure of volatility and <i>beta</i>, a measure of that portion of a company's risk that is market-driven. </p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhcdOZQBO56XI2bbUI85XXMWwymoxM6RsEe3yh67LF1gsLfQWbHXVK6AtzCBea8tsXdv7raZ1Zx1hK3D3iBI7jS3U-b-cAjnIXgcytsIUCjjNCEghfsETi0XBGusM1dHbZPAwPjqt2UE4c42hAAkjs2RvBeINe4oBtH89NXT6O-9TtzhJWyxWS4iTbty7c/s1368/PriceBasedRisk.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="536" data-original-width="1368" height="156" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhcdOZQBO56XI2bbUI85XXMWwymoxM6RsEe3yh67LF1gsLfQWbHXVK6AtzCBea8tsXdv7raZ1Zx1hK3D3iBI7jS3U-b-cAjnIXgcytsIUCjjNCEghfsETi0XBGusM1dHbZPAwPjqt2UE4c42hAAkjs2RvBeINe4oBtH89NXT6O-9TtzhJWyxWS4iTbty7c/w400-h156/PriceBasedRisk.jpg" width="400" /></a></div><p style="text-align: justify;">I use the data through the end of 2023 to compute all three measures for every company, and in my first breakdown, I look at these risk measures, by sector (globally):</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiDaUX4PpoiE5dYhfM-yGDrBsqdacMBHMB87szQOWa-5asSfPIWEuBlXATf6es2y4vZtJ200WSm3eWJ21_czQ4ovTTTt_QGNIZ6_CLlmwykHmos6n3WuRow4GiYAf3HN-NVVD2nrTFWY__7n_pmRFHZtZFRr5l1bwC1r3c7903JOBOdXFOjYTbny7UJV1s/s1447/SectorPriceRisk.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="366" data-original-width="1447" height="101" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiDaUX4PpoiE5dYhfM-yGDrBsqdacMBHMB87szQOWa-5asSfPIWEuBlXATf6es2y4vZtJ200WSm3eWJ21_czQ4ovTTTt_QGNIZ6_CLlmwykHmos6n3WuRow4GiYAf3HN-NVVD2nrTFWY__7n_pmRFHZtZFRr5l1bwC1r3c7903JOBOdXFOjYTbny7UJV1s/w400-h101/SectorPriceRisk.jpg" width="400" /></a></div><p style="text-align: justify;">Utilities are the safest or close to the safest , on all three price-based measures, but there are divergences on the other risk measures. Technology companies have the highest betas, but health care has the riskiest companies, on standard deviation and the price range measure. Looking across geographies, you can see the variations in price-based risk measures across the world:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhQCSl2qO26RJ3wffV2bzB0eIzOxDFWTCuSciEMfegg00uVtnwcietKb5LdvFdyngP1xwPbV3cwBhdeSiKbiFKTVpblSr2b6gcLH-mQhtnqwnxDWGqvOnhfy4eppmsWhaSgSyLS9cQir4xAxOb-eSoA6gg7zHi0CC3ZM8czLPlNr1gv1QUwE7aBgSAip8I/s1471/RegionPriceRisk.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="373" data-original-width="1471" height="101" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhQCSl2qO26RJ3wffV2bzB0eIzOxDFWTCuSciEMfegg00uVtnwcietKb5LdvFdyngP1xwPbV3cwBhdeSiKbiFKTVpblSr2b6gcLH-mQhtnqwnxDWGqvOnhfy4eppmsWhaSgSyLS9cQir4xAxOb-eSoA6gg7zHi0CC3ZM8czLPlNr1gv1QUwE7aBgSAip8I/w400-h101/RegionPriceRisk.jpg" width="400" /></a></div><div style="text-align: justify;">There are two effects at play here. The first is liquidity, with markets with less trading and liquidity exhibiting low price-based risk scores across the board. The second is that some geographies have sector concentrations that affect their pricing risk scores; the preponderance of natural resource and mining companies in Australia and Canada, for instance, explain the high standard deviations in 2023.</div><div style="text-align: justify;"><span> </span>Finally, I brought in my corporate life cycle perspective to the risk question, and looked at price-based risk measures by corporate age, with the youngest companies in the first decile and the oldest ones in the top decile (with a separate grouping for companies that don't have a founding year in the database):</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEho3_eWkvwupj3lwQhy97kdrew1HksIrEj1WXelsuDN3XPNqqWO-ZPn8QYnbGrifXAksDnLZQCQnbKLD_rFNOOn9wOG3OkwGSgGQh_ZwmDxBnrygxQthK6hfjOTHn5rcH8-A75VYbUPo4sY8wV1T2PF-tLiJcMwAjGgs0YAnFH9hOn6ub7Z2r5UpUU6DwI/s1469/AgePriceRisk.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="368" data-original-width="1469" height="100" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEho3_eWkvwupj3lwQhy97kdrew1HksIrEj1WXelsuDN3XPNqqWO-ZPn8QYnbGrifXAksDnLZQCQnbKLD_rFNOOn9wOG3OkwGSgGQh_ZwmDxBnrygxQthK6hfjOTHn5rcH8-A75VYbUPo4sY8wV1T2PF-tLiJcMwAjGgs0YAnFH9hOn6ub7Z2r5UpUU6DwI/w400-h100/AgePriceRisk.jpg" width="400" /></a></div><div style="text-align: justify;">On both the price range and standard deviation measures, not surprisingly, <u>younger firms are riskier than older ones, but on the beta measure, there is no relationship</u>. That may sound like a contradiction, but it does reflect the divide between measures of total risk (like the price range and standard deviation) and measures of just market risk (like the beta). Much of the risk in young companies is company-specific, and for those investors who hold concentrated portfolios of these companies, that risk will translate into higher risk-adjusted required returns, but for investors who hold broader and more diversified portfolios, younger companies are similar to older companies, in terms of risk.</div><p><i>b. Intrinsic Risk Measures</i></p><p style="text-align: justify;"><i> </i>As you can see in the last section, price-based risk measures have their advantages, including being constantly updated, but they do have their limits, especially when liquidity is low or when market prices are not trustworthy. In this section, I will look at three measures of intrinsic risk - w<i>hether a company is making or losing money</i>, with the latter being riskier, the <i>variability in earnings</i>, with less stable earnings translating to higher risk, and <i>the debt load of companies</i>, with more debt and debt charges conferring more risk on companies. </p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiUWLVCXljyPduaPdrfHmV2wfRt3UC7ANeE2kywmvlZh8EJV6E-8Iy8ceSFY4PEzqFt5m7n1Ul-NLE5ftzk6dy1hef-2T5L2Gm_9aqtygKOeOkXGNqNyxcQP_B8VchRKQ4e-dQNX7kRyxtzfWp8LO4tEOksLVR3buZD7OBUDHgMLLv7leAMooad48hZwe0/s1342/IntrinsicRiskMeasures.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="540" data-original-width="1342" height="161" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiUWLVCXljyPduaPdrfHmV2wfRt3UC7ANeE2kywmvlZh8EJV6E-8Iy8ceSFY4PEzqFt5m7n1Ul-NLE5ftzk6dy1hef-2T5L2Gm_9aqtygKOeOkXGNqNyxcQP_B8VchRKQ4e-dQNX7kRyxtzfWp8LO4tEOksLVR3buZD7OBUDHgMLLv7leAMooad48hZwe0/w400-h161/IntrinsicRiskMeasures.jpg" width="400" /></a></div><p style="text-align: justify;"><i> </i>I begin by computing these intrinsic risk measures across sectors, with the coefficient of variation on both net income and operating income standing in for earnings variability; the coefficient of variation is computed by dividing the standard deviation in earnings over the last ten years, divided by the average earnings over those ten years. </p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiOCOCC1dGoT5LVkm5J0SqsbARuConqP1Tcz66UsM3Boez7TUFjb1JJZK0M2LM1CAnpePX55OaCi3dKQ4jjuJWmm6eTxlhxQiKyE8WVe6iDOJqGVXcdiLE5rFLNh72OuFYjCibGek_usDWKTpnJlfLvAEJA3mexOlh0RdPXK6OzmprvBDJi0THt6VVCvVw/s1884/SectorIntrinsicRisk.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="448" data-original-width="1884" height="95" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiOCOCC1dGoT5LVkm5J0SqsbARuConqP1Tcz66UsM3Boez7TUFjb1JJZK0M2LM1CAnpePX55OaCi3dKQ4jjuJWmm6eTxlhxQiKyE8WVe6iDOJqGVXcdiLE5rFLNh72OuFYjCibGek_usDWKTpnJlfLvAEJA3mexOlh0RdPXK6OzmprvBDJi0THt6VVCvVw/w400-h95/SectorIntrinsicRisk.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: justify;">Globally, <i>health care has the highest percentage of money-losing companies</i> and <i>utilities have the lowest</i>. In 2023, energy companies have the most volatile earnings (net income and operating income) and real estate companies have the most onerous debt loads. Looking at the intrinsic risk measures for sub-regions across the world, here is what I see:</div><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhf1ugw9J1nEfhrrLPH9qkp91eCCBeog7LYrTkjT6oObDv3UBoeZNusJjykzxITs7jTZtgbqgWulwp7e7W40XY7V3WzhRLaFdQYXiAss0Qesz1vJJ28h9s3QGD4jBZwim-jASNxrdR0WTtSAykC4CpISGCOyCeYEmGhWrNXUIN6PWWVYq-KxsQYm-bzcZc/s1880/RegionIntrinsicRisk.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="484" data-original-width="1880" height="103" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhf1ugw9J1nEfhrrLPH9qkp91eCCBeog7LYrTkjT6oObDv3UBoeZNusJjykzxITs7jTZtgbqgWulwp7e7W40XY7V3WzhRLaFdQYXiAss0Qesz1vJJ28h9s3QGD4jBZwim-jASNxrdR0WTtSAykC4CpISGCOyCeYEmGhWrNXUIN6PWWVYq-KxsQYm-bzcZc/w400-h103/RegionIntrinsicRisk.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: justify;">Again, Australia and Canada have the highest percentage of money losing companies in the world and Japan has the lowest, Indian companies have the highest earnings variability and Chinese companies carry the largest debt load, in terms of debt as a multiple of EBITDA. In the last table, I look at the intrinsic risk measures, broken down by company age:</div><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgo5nuBxWp8owW2HUKOCUKHtY-xS512ALDixqwgJ8BEcp8RqcYjbCNg4guxwibAmDd1uFgp-dqByNb7CArKL2Ym1-7EzRlyLF6JPoY2S7gmZwd0tBYIG_r-6mjBPFEM6bik4_qhIE4NItJlRIsCLaGLNGCd2Y5Rvh57yZy1XPEcWL0RFbQQQFkDuu1maSA/s1882/AgeIntrinsicRisk.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="458" data-original-width="1882" height="98" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgo5nuBxWp8owW2HUKOCUKHtY-xS512ALDixqwgJ8BEcp8RqcYjbCNg4guxwibAmDd1uFgp-dqByNb7CArKL2Ym1-7EzRlyLF6JPoY2S7gmZwd0tBYIG_r-6mjBPFEM6bik4_qhIE4NItJlRIsCLaGLNGCd2Y5Rvh57yZy1XPEcWL0RFbQQQFkDuu1maSA/w400-h98/AgeIntrinsicRisk.jpg" width="400" /></a></div><p style="text-align: justify;">Not surprisingly, there are <i>more money losing young companies</i> than older ones, and these young companies also have <i>more volatile earnings</i>. On debt load, though, there is no discernible pattern in debt load across age deciles, though the youngest companies do have the lowest interest coverage ratios (and thus are exposed to the most danger, if earnings drop).</p><p><b>Risk Differences across Countries</b></p><p style="text-align: justify;"><span> In this final section, I will look risk differences across countries, both in terms of why risk varies across, as well as how these variations play out as equity risk premiums. There are many reasons why risk exposures vary across countries, but I have tried to capture them all in the picture below (which I have used before in my country risk posts and in <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4509578">my paper on country risk</a>):</span></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhHPCxTQ9HJVgi6wRNTW-NFtBKQBksNPPJy468Bi5Aq8vGxK_k5a-KpnQmEBH0rqqK7z7nOwregWd231tvT10w8dpU1Z4DPYqD4ykKgwK_BjToSkN4n1O8VW7a8gBoVll2jRsyVS9JP0FyMn5BG7BTH-NJTgT-WL5nEtGkxxhWvBgU-sA8JCMr4ETlvvfE/s1392/CountryRiskDrivers.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1000" data-original-width="1392" height="288" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhHPCxTQ9HJVgi6wRNTW-NFtBKQBksNPPJy468Bi5Aq8vGxK_k5a-KpnQmEBH0rqqK7z7nOwregWd231tvT10w8dpU1Z4DPYqD4ykKgwK_BjToSkN4n1O8VW7a8gBoVll2jRsyVS9JP0FyMn5BG7BTH-NJTgT-WL5nEtGkxxhWvBgU-sA8JCMr4ETlvvfE/w400-h288/CountryRiskDrivers.jpg" width="400" /></a></div><br /><p style="text-align: justify;">Put simply, there are four broad groups of risks that lead to divergent country risk exposures; <i>political structure</i>, which can cause public policy volatility, <i>corruption</i>, which operates as an unofficial tax on income, <i>war and violence</i>, which can create physical risks that have economic consequences and <i>protections for legal and property rights</i>, without which businesses quickly lose value. </p><p style="text-align: justify;"><span> While it is easy to understand why risk varies across countries, it is more difficult to measure that risk, and even more so, to convert those risk differences into risk premiums. Ratings agencies like Moody's and S&P provide a measure of the default risk in countries with sovereign ratings, and I build on those ratings to estimate country and equity risk premiums, by country. The figure below summarizes the numbers used to compute these numbers at the start of 2024:</span><br /></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi4Nqg9OLahG6VQOqTrEY5YcB_x3vgaJCy2ZbCBhTmaB2puqRqxFibrAONr87nQWnUBqYmNLECv17zpt1Ei1ulDORNC8eV7e7rfDufxXxPmFCs-uw3CSwkAaAFRY-fNFYUK0oom6KR6sn5g_c1ASxuj-VmE_4PCSyDj_QljhW0xjqtKldHq86S_YR1WRVk/s746/ERPComputationforCountries.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="485" data-original-width="746" height="260" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi4Nqg9OLahG6VQOqTrEY5YcB_x3vgaJCy2ZbCBhTmaB2puqRqxFibrAONr87nQWnUBqYmNLECv17zpt1Ei1ulDORNC8eV7e7rfDufxXxPmFCs-uw3CSwkAaAFRY-fNFYUK0oom6KR6sn5g_c1ASxuj-VmE_4PCSyDj_QljhW0xjqtKldHq86S_YR1WRVk/w400-h260/ERPComputationforCountries.jpg" width="400" /></a></div><br /><div style="text-align: justify;">The starting point for estimating equity risk premiums, for all of the countries, is the implied equity risk premium of 4.60% that I computed at the start of 2024, and talked about in <a href="https://aswathdamodaran.blogspot.com/2024/01/data-update-2-for-2024-stock-comeback.html">my second data post this year</a>. All countries that are rated Aaa (Moody's) are assigned 4.60% as equity risk premiums, but for lower-rated countries, there is an additional premium, reflecting their higher risk:</div><p></p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiFMiLlQJkIAqcClGTlzxtJLJ1gI92NE6potZeCVlcwRlEctxK0lhEWCcSZUxVdoZgPMoYffPkLJ2YW5WK2KhFEtIEVDcFBAa1gJ64sekU_ne15vMyC43NxAZoCPyUz0z0-IL23_qMPO5O9QGRlqZkoQz4IqOmo5KErPnAff6xvbHrp1VupCQ0s8gg5kT0/s1541/CountryERP.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1541" data-original-width="1446" height="400" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiFMiLlQJkIAqcClGTlzxtJLJ1gI92NE6potZeCVlcwRlEctxK0lhEWCcSZUxVdoZgPMoYffPkLJ2YW5WK2KhFEtIEVDcFBAa1gJ64sekU_ne15vMyC43NxAZoCPyUz0z0-IL23_qMPO5O9QGRlqZkoQz4IqOmo5KErPnAff6xvbHrp1VupCQ0s8gg5kT0/w467-h400/CountryERP.jpg" width="467" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/ctryprem.xlsx">Download data</a></td></tr></tbody></table><br /><div class="separator" style="clear: both; text-align: justify;">You will notice that there are countries, like North Korea, Russia and Syria, that are unrated but still have equity risk premiums, and for these countries, the equity risk premiums estimate is based upon a country risk score from <a href="https://www.prsgroup.com">Political Risk Services</a>. If you are interested, you can review the process that I use in far more detail <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4509578">in this paper</a> that I update every year on country risk.</div><p><b>Risk and Investing</b></p><p style="text-align: justify;"><span> The discussion in the last few posts, starting with equity risk premium in <a href="https://aswathdamodaran.blogspot.com/2024/01/data-update-2-for-2024-stock-comeback.html">my second data update</a>, and interest rates and default spreads in <a href="https://aswathdamodaran.blogspot.com/2024/01/data-update-3-for-2024-interest-rates.html">my third data update</a>, leading into risk measures that differrentiate across companies and countries in this one, all lead in to a final computation of the costs of equity and capital for companies. That may sound like a corporate finance abstraction, but the cost of capital is a pivotal number that can alter whether and how much companies invest, as well as in what they invest, how they fund their investments (debt or equity) and how much they return to owners as dividends or buybacks. For investors looking at these companies, it becomes a number that they use to estimate intrinsic values and make judgments on whether to buy or sell stocks:</span></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEicPkKAly7JXoB4L23AQCpvPI8qqEZYEhGo1P41MJVkmkGOf-X_haGcVWNYMrPSexQYlT-rC1olq3Wj8Vnnwybh8Lf6FPgfY5XPdMRNiYDohTMIsi7FAOK7V2OXxAAPbg06v8HgARDq7lGn0VwAwfei4X88n9B8UHZ5zT3jKUExrznufTtRhPdQs8A2NWU/s614/WACCUses.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="416" data-original-width="614" height="271" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEicPkKAly7JXoB4L23AQCpvPI8qqEZYEhGo1P41MJVkmkGOf-X_haGcVWNYMrPSexQYlT-rC1olq3Wj8Vnnwybh8Lf6FPgfY5XPdMRNiYDohTMIsi7FAOK7V2OXxAAPbg06v8HgARDq7lGn0VwAwfei4X88n9B8UHZ5zT3jKUExrznufTtRhPdQs8A2NWU/w400-h271/WACCUses.jpg" width="400" /></a></div><div style="text-align: justify;">The multiple uses for the cost of capital are what led me to label it "the Swiss Army knife of finance" and if you are interested, you can keep a get a deeper assessment by <a href="https://pages.stern.nyu.edu/~adamodar/pdfiles/papers/costofcapital.pdf">reading this paper.</a></div><p></p><p style="text-align: justify;"><span><span> Using the updated numbers for the risk free rate (in US dollars), the equity risk premiums (for the US and the rest of the world) and the default spreads for debt in different ratings classes, I computed the cost of capital for the 47,698 companies in my data universe, at the start of 2024. In the graph below, I provide a distribution of corporate costs of capital, for US and global companies, in US dollars:</span> </span><br /></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEijA2C3LxA0CATMouwllT0q-uGDB-XDapW-jfcg7jJF-VugpoV-3HN1EbHBHG5Tp2PcH3QSPTln-oZMidUJAXxeuNkVhYoaCA6QjvRldv3YdavVW9977bQK0NwkLnVRsWQ1zeD09ULe8STAFdYNnWDSnWCFJxfJIlTSPdCkY9EnNCH-3bWH8b0zpwJUkz4/s919/WACC2024.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="672" data-original-width="919" height="293" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEijA2C3LxA0CATMouwllT0q-uGDB-XDapW-jfcg7jJF-VugpoV-3HN1EbHBHG5Tp2PcH3QSPTln-oZMidUJAXxeuNkVhYoaCA6QjvRldv3YdavVW9977bQK0NwkLnVRsWQ1zeD09ULe8STAFdYNnWDSnWCFJxfJIlTSPdCkY9EnNCH-3bWH8b0zpwJUkz4/w400-h293/WACC2024.jpg" width="400" /></a></div><div style="text-align: justify;">If your frame of reference is another currency, be it the Euro or the Indian rupee, adding the differential inflation to these numbers will give you the ranges in that currency. At the start of 2024, <i>the median cost of capital, in US dollars, is 7.9% (8.7%) for a US (global) company</i>, lower than the 9.6 (10.6%) at the start of 2023, for US (global) stocks, entirely because of declines in the price of risk (equity risk premiums and default spreads), but the 2024 costs of capital are higher than the historic lows of 5.8% (6.3%) for US (Global) stocks at the start of 2022. In short, if you are a company or an investor who works with fixed hurdle rates over time, you may be using a rationale that you are just normalizing, but you have about as much chance of being right as a broken clock.</div><p></p><p><b>What's coming?</b></p><p style="text-align: justify;"><b> </b>Since this post has been about risk, it is a given that things will change over the course of the year. If your question is how you prepare for that change, one answer is to be dynamic and adaptable, not only reworking hurdle rates as you go through the year, but also building in escape hatches and reversibility even into long term decisions. In case things don't go the way you expected them to, and you feel the urge to complain about uncertainty, I urge you to revisit the Chinese symbol for risk. We live in dangerous times, but embedded in those dangers are opportunities. If you can gain an edge on the rest of the market in assessing and dealing with some of these dangers, you have a pathway to success. I am not suggesting that this is easy to do, or that success is guaranteed, but if investment is a game of odds, this can help tilt them in your favor.</p><p><b>YouTube Video</b></p><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/ouVQJVGs9lI?si=vk_SDMZvg2ip2FyN" title="YouTube video player" width="560"></iframe><p><b>Datasets</b></p><p></p><ol style="text-align: left;"><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/IndustryRisk2024.xlsx">Risk Measures, by Industry - Start of 2024</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/CountryRisk2024.xlsx">Risk Measures, by Country - Start of 2024</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/ctryprem.xlsx">Equity Risk Premiums, by Country - Start of 2024</a></li><li>Cost of Capital, by Industry - Start of 2024 (<a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/wacc.xls">US</a> & <a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/waccGlobal.xls">Global</a>)</li></ol><div><div style="text-align: justify;"><b>Data Update Posts for 2024</b></div><div style="text-align: justify;"><ol><li><a href="https://aswathdamodaran.blogspot.com/2024/01/data-update-1-for-2024-data-speaks-but.html">Data Update 1 for 2024: The Data Speaks, but what is it saying?</a></li><li><a href="https://aswathdamodaran.blogspot.com/2024/01/data-update-2-for-2024-stock-comeback.html">Data Update 2 for 2024: A Stock Comeback - Winning the Expectations Game!</a></li><li><a href="https://aswathdamodaran.blogspot.com/2024/01/data-update-3-for-2024-interest-rates.html">Data Update 3 for 2024: Interest Rates in 2023 - A Rule-breaking Year</a></li><li><a href="https://aswathdamodaran.blogspot.com/2024/01/data-update-4-for-2024-danger-and.html">Data Update 4 for 2024: Danger and Opportunity - Bringing Risk into the Equation</a></li></ol></div></div>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-46354620442658266962024-01-24T21:56:00.004-05:002024-01-24T22:01:40.658-05:00Data Update 3 for 2024: Interest Rates in 2023 - A Rule-breaking Year!<p style="text-align: justify;">In my last post, I looked at equities in 2023, and argued that while they did well during 2023, the bounce back were uneven, with a few big winning companies and sectors, and a significant number of companies not partaking in the recovery. In this post, I look at interest rates, both in the government and corporate markets, and note that while there was little change in levels, especially at the long end of the maturity spectrum, that lack of change called into question conventional market wisdom about interest rates, and in particular, the notions that the Fed sets interest rates and that an inverted yield curve is a surefire predictor of a recession. As we start 2024, the interest rate prognosticators who misread the bond markets so badly in 2023 are back to making their 2024 forecasts, and they show no evidence of having learned any lessons from the last year.</p><p style="text-align: justify;"><b>Government Bond/Bill Rates in 2023</b></p><p style="text-align: justify;"><span> I will start by looking at government bond rates across the world, with the emphasis on US treasuries, which suffered their worst year in history in 2022, down close to 20% for the year, as interest rates surged. That same phenomenon played out in other currencies, as government bond rates rose in Europe and Asia during the year, ravaging bond markets globally.</span><br /></p><p style="text-align: justify;"><i><b>US Treasuries </b></i></p><p style="text-align: justify;"><i> </i>Investors in US treasuries, especially in the longer maturities, came into 2023, bruised and beaten rising inflation and interest rates. The consensus view at the start of the year was that US treasury rates would continue to rise, with the rationale being that the Federal Reserve was still focused on knocking inflation down, and would raise rates during the yearl. Implicit in this view was the belief that it was the Fed that had created bond market carnage in 2022, and in <a href="https://aswathdamodaran.blogspot.com/2023/01/data-update-3-for-2023-inflation-and.html">my post on interest rates at the start of 2023</a>, I took issue with this contention, arguing that it was inflation that was the culprit.<br /></p><p style="text-align: justify;"><i>1. A Ride to Nowhere - US Treasury Rates in 2023</i></p><p style="text-align: justify;"><span> It was undoubtedly a relief for bond market investors to see US treasury markets </span>settle down in 2023, though there were bouts of volatility, during the course of the year. The graph below looks at US treasury rates, for maturities ranging from 3 months to 30 years, during the course of 2022 and 2023:</p><p></p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEheVs_WbzIhHTq5RLuN2wGSxT6PCgtAuzBRF7uHbPObKdcDKS3ShE_p_dVIYcaeJrHf-S__wcgdlcICQMzYDa5_sd-NdLwtjvczwLhbfIotVObdtYnjjHn4eZIZqUxo3hQwaEMH_8yiLtiCUxk8me80sDbi5tcokUFB2qdt22t6ARy99jSmamrevpO4RnA/s925/USTreasuryChart.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="671" data-original-width="925" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEheVs_WbzIhHTq5RLuN2wGSxT6PCgtAuzBRF7uHbPObKdcDKS3ShE_p_dVIYcaeJrHf-S__wcgdlcICQMzYDa5_sd-NdLwtjvczwLhbfIotVObdtYnjjHn4eZIZqUxo3hQwaEMH_8yiLtiCUxk8me80sDbi5tcokUFB2qdt22t6ARy99jSmamrevpO4RnA/w400-h290/USTreasuryChart.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/USTreasuriesin2023.xlsx">Download data</a></i></td></tr></tbody></table><div style="text-align: justify;">As you can see, while treasury rates, across maturities, jumped dramatically in 2022, their behavior diverged in 2023. At the short end of the spectrum, the three-month treasury bill rate rose from 4.42% to 5.40% during the year, but the 2-year rate decreased slightly from 4.41% to 4.23%, the ten-year rate stayed unchanged at 3.88% and the thirty-year rate barely budged, going from 3.76% to 4.03%. The fact that the treasury bond rate was 3.88% at both the start and the end of the year effectively also meant that the return on a ten-year treasury bond during 2023 was just the coupon rate of 3.88% (and no price change). </div><p></p><p style="text-align: justify;"><i>2. The Fed Effect: Where's the beef?</i></p><p style="text-align: justify;"><i> </i>I noted at the start of this post that the stock answer than most analysts and investors, when asked why treasury rates rose or fell during much of the last decade has been "The Fed did it". Not only is that lazy rationalization, but it is just not true, and for many reasons. First, the only rate that the Fed actually controls is the Fed funds rate, and it is true that the Fed has been actively raising that rate in the last two years, as you can see in the graph below:<i> </i></p><p style="text-align: justify;"><i><br /></i></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhi9RGnjnqrDiHwQMOwpNwn1Hk19-1qdPebrjKrQ_EEL66y-dFLDj2l9l0ewsZHhdz8k80J4dsuNxIrtLroxYnHizd9NB5hRL-ytYH_1GV4Zm01DEdbP4xXJwaHdOypR5002sck9R0jgFwSzpKgub7Ksma-OS8DCeaz-kr8dDFkT6A_U-wlpRbKJqI6K_g/s1068/FedFundsChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="780" data-original-width="1068" height="293" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhi9RGnjnqrDiHwQMOwpNwn1Hk19-1qdPebrjKrQ_EEL66y-dFLDj2l9l0ewsZHhdz8k80J4dsuNxIrtLroxYnHizd9NB5hRL-ytYH_1GV4Zm01DEdbP4xXJwaHdOypR5002sck9R0jgFwSzpKgub7Ksma-OS8DCeaz-kr8dDFkT6A_U-wlpRbKJqI6K_g/w400-h293/FedFundsChart.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: justify;"><br /></div><div class="separator" style="clear: both; text-align: justify;">In 2022, the Fed raised the Fed funds rate seven times, with the rate rising from close to zero (lower limit of zero and an upper limit of 0.25%) to 4.25-4.50%, by the end of the year. During 2023, the Fed continued to raise rates, albeit at a slower rate, with four 0.25% raises.</div><div class="separator" style="clear: both; text-align: justify;"><span> </span>Second, the argument that the Fed's Fed Funds rate actions have triggered increases in interest rates in the last two years becomes shaky, when you take a closer look at the data. In the table below, I look at all of the Fed Fund hikes in the last two years, looking at the changes in 3-month, 2-year and 10-year rates leading into the Fed actions. Thus, the Fed raised the Fed Funds rate on June 16, 2022 by 0.75%, to 1.75%, but the 3-month treasury bill rate had already risen by 0.74% in the weeks prior to the Fed hike, to 1.59%. </div><div style="text-align: justify;"><br /></div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi5IHdX87AdaSt_tq7PYBXeBK_tAEriC8TQpjMPtaCU9VN-KKu7Whq1xyCsN9V9kV6bGeFmPZhXn4OjGpnoij0l2E37ZJ6v6SNEyL8mk0f-S1xENNsvuIywNkmsj5JESQQZtY-WSxyego4YQy1bup9xe282wB8JSvTLkdFngItJ5gBtCHnM1Yj5pWubLTM/s1896/FedActions&%20Rates.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="588" data-original-width="1896" height="124" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi5IHdX87AdaSt_tq7PYBXeBK_tAEriC8TQpjMPtaCU9VN-KKu7Whq1xyCsN9V9kV6bGeFmPZhXn4OjGpnoij0l2E37ZJ6v6SNEyL8mk0f-S1xENNsvuIywNkmsj5JESQQZtY-WSxyego4YQy1bup9xe282wB8JSvTLkdFngItJ5gBtCHnM1Yj5pWubLTM/w400-h124/FedActions&%20Rates.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><br /></td></tr></tbody></table><div style="text-align: justify;"><br /></div><div style="text-align: justify;">In fact, treasury bill rates consistently rise ahead of the Fed's actions over the two years. This may be my biases talking, but to me, it looks like it is the market that is leading the Fed, rather than the other way around. </div><div style="text-align: justify;"><span> Third, e</span><span>ven if you are a believer that the Fed has a strong influence on rates, that effect is strongest on the shortest term rates and decays as you get to longer maturities. In 2023, for instance, for all of the stories about FOMC meeting snd the Fed raising rates, the two-year treasury declined and the ten-year did not budge. </span>To understand what causes long term interest rates to move, I went back to my interest rate basics, and in particular, the Fisher equation breakdown of a nominal interest rate (like the US ten-year treasury rate) into expected inflation and an expected real interest rate:</div><p style="text-align: center;">Nominal Interest Rate = Expected Inflation + Expected real interest rate</p><p style="text-align: justify;">If you are willing to assume that the expected real interest rate should converge on the growth rate in the real economy in the long term, you can estimate what I call an intrinsic riskfree rate:</p><p style="text-align: center;">Intrinsic Riskfree Rate = Expected Inflation + Expected real growth rate in economy</p><p style="text-align: justify;">In the graph below, I take first shot at estimating this intrinsic riskfree rate, by adding the actual inflation rate each year to the real GDP growth rate in that year, for the US:</p><p></p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEizBipFwzV4GoKOZ7JyXuMmCKh9hxlEy_6Xf_XHXJUXDCnQIjUQDmBlZJi1hMQUGL6R6Y5XGKmw0YUM-j_KJ-eM7lBZJvZ5Nkbaxnk1QfyOfj2NJCrW_dZPbvK9Cizg9sL4554Uno9mmxx06q4m1MkgwsCcg4ol6khzQfxeBurScRYqJdMwzsW5U5ul6NA/s842/IntrinsicRiskfreeChart.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="751" data-original-width="842" height="356" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEizBipFwzV4GoKOZ7JyXuMmCKh9hxlEy_6Xf_XHXJUXDCnQIjUQDmBlZJi1hMQUGL6R6Y5XGKmw0YUM-j_KJ-eM7lBZJvZ5Nkbaxnk1QfyOfj2NJCrW_dZPbvK9Cizg9sL4554Uno9mmxx06q4m1MkgwsCcg4ol6khzQfxeBurScRYqJdMwzsW5U5ul6NA/w400-h356/IntrinsicRiskfreeChart.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/intrinsicvsactualrate24.xlsx"><i>Download data</i></a></td></tr></tbody></table><p style="text-align: justify;">I will not oversell this graph, since my assumption about real growth equating to real interest rates is up for debate, and I am using actual inflation and growth, rather than expectations. That said, it is remarkable how well the equation does at explaining the movements in the ten-year US treasury bond rate over time. The rise treasury bond rates in the 1970s can be clearly traced to higher inflation, and the low treasury bond rates of the last decade had far more to do with low inflation and growth, than with the Fed. In 2023, the story of the year was that inflation tapered off during the course of the year, setting to rest fears that it would stay at the elevated levels of 2022. That explains why US treasury rates stayed unchanged, even when the Fed raised the Fed Funds rate, though the 3-month rate remains a testimonial to the Fed's power to affect short term rates. </p><p></p><p style="text-align: justify;"><i>3. Yield Curves and Economic Growth</i></p><p style="text-align: justify;"><span> </span>It is undeniable that the slope of the yield curve, in the US, has been correlated with economic growth, with more upward sloping yield curves presaging higher real growth, for much of the last century. In an extension of this empirical reality, an inversion of the yield curve, with short term rates exceed long term rates, has become a sign of an impending recession. In a <a href="https://aswathdamodaran.blogspot.com/2018/12/is-there-signal-in-noise-yield-curves.html">post a few years ago</a>, I argued that if the slope of the yield curve is a signal, it is one with a great deal of noise (error in prediction). If you are a skeptic about the inverted yield curves as a recession-predictor, that skepticism was strengthened in 2022 and 2023:</p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgzn_x7feFPJw5b01yWlafCh0laFNf2ozk6RTMOokABNPOpqXeSFxOhFJ-G1AlBJYXc586ZHKXR_WuPsQ6SX2QEZwj40poU10l-G9yZSqcGKZ5DYKF5_VX1f-ec8ZyyuEfUZiz_BooAgNB1FJznS0iLG55kGCbbNmJmtR3PQXt7cak-Nje9ufCvohYzu3c/s953/YldCurveChart.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="700" data-original-width="953" height="294" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgzn_x7feFPJw5b01yWlafCh0laFNf2ozk6RTMOokABNPOpqXeSFxOhFJ-G1AlBJYXc586ZHKXR_WuPsQ6SX2QEZwj40poU10l-G9yZSqcGKZ5DYKF5_VX1f-ec8ZyyuEfUZiz_BooAgNB1FJznS0iLG55kGCbbNmJmtR3PQXt7cak-Nje9ufCvohYzu3c/w400-h294/YldCurveChart.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/USTreasuriesin2023.xlsx">Download data</a></i></td></tr></tbody></table><div style="text-align: justify;"><br /></div><p style="text-align: justify;">As you can see, the yield curve has been inverted for all of 2023, in all of its variations (the difference between the ten-year and two-year rates, the difference between the two-year rate and the 3-month rate and the difference between the ten-year rate and the 3-month T.Bill rate). At the same time, not only has a recession not made its presence felt, but the economy showed signs of strengthening towards the end of the year. It is entirely possible that there will be a recession in 2024 or even in 2025, but what good is a signal that is two or three years ahead of what it is signaling? </p><p style="text-align: justify;"><b><i>Other Currencies</i></b></p><p style="text-align: justify;"><i style="font-weight: bold;"> </i>The rise in interest rates that I chronicled for the United States played out in other currencies, as well. While not all governments issue local-currency bonds, and only a subset of these are widely traded, there is information nevertheless in a comparison of these traded government bond rates across time:<br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgILYF9VL8ms8HMndbdw7BQJ9w4C7sx2Al7qvEYlL1nu8DnAg8vr-dHMlaZJtdDM97Q6AduRgivAFU3tsWCau7yUsyrYugnkrqkrctXl7jzJD9mDFItvvBsY751Iw55FLtXgKf5khuIeCqlzAoVBdUtqaQQJ_bVdfYGWLh12MPIyInipOfjlMc6Og0DoVk/s991/10-yrGovtChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="451" data-original-width="991" height="183" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgILYF9VL8ms8HMndbdw7BQJ9w4C7sx2Al7qvEYlL1nu8DnAg8vr-dHMlaZJtdDM97Q6AduRgivAFU3tsWCau7yUsyrYugnkrqkrctXl7jzJD9mDFItvvBsY751Iw55FLtXgKf5khuIeCqlzAoVBdUtqaQQJ_bVdfYGWLh12MPIyInipOfjlMc6Og0DoVk/w400-h183/10-yrGovtChart.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div style="text-align: justify;">Note that these are all local-currency ten-year bonds issued by the governments in question, with the German Euro bond rate standing in as the Euro government bond rate. Note also that during 2022 and 2023, the movements in these government bond rates mimic the US treasuries, rising strongly in 2022 and declining or staying stable in 2023.</div><div><div style="text-align: justify;"> These government bond rates become the basis for estimating risk-free rates in these currencies, essential inputs if you are valuing your company or doing a local-currency project analysis; to value a company in Indian rupees, you need a rupee riskfree rate, and to do a project analysis in Japanese yen, a riskfree rate in yen is necessary. While there are some who use these government bond rates as riskfree rates, it is worth remembering that governments can and sometimes do default, even on local currency bonds, and that these government bond rates contain a spread for default risk. I use the sovereign ratings for countries to estimate and clean up for that default risk, and estimate the riskfree rates in different currencies at the start of 2024:</div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiT_jvF9KrZx2OoDXWWMk-ccZKYvl7X8h-Ov668_CH-RStsIZ1uoCiTeqX_QtrjiUfjvc1bSH1aht63T8jyHn_6Fr7fZerNN-xUnLkclC24YF5cPY61GDvcjykPYm2HDDSNvBrvqL0BR-CQyIz2CwyQhQz6ytCPOpKnDE4ohitCkgAzXZHkC_DXoEQRBC0/s513/CurrencyRiskfreeRates.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="350" data-original-width="513" height="272" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiT_jvF9KrZx2OoDXWWMk-ccZKYvl7X8h-Ov668_CH-RStsIZ1uoCiTeqX_QtrjiUfjvc1bSH1aht63T8jyHn_6Fr7fZerNN-xUnLkclC24YF5cPY61GDvcjykPYm2HDDSNvBrvqL0BR-CQyIz2CwyQhQz6ytCPOpKnDE4ohitCkgAzXZHkC_DXoEQRBC0/w400-h272/CurrencyRiskfreeRates.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/currencyriskfree2024.xls">Download data</a></td></tr></tbody></table><div style="text-align: justify;"><br /></div><p style="text-align: justify;">Unlike the start of 2022, when five currencies (including the Euro) had negative riskfree rates, there are only two currencies in that column at the start of 2024; the Japanese yen, a habitual member of the low or negative interest rate club, and the Vietnamese Dong, where the result may be an artifact of an artificially low government bond rate (lightly traded). Understanding that riskfree rates vary across currencies primarily because of difference in inflation expectations is the first step to sanity in dealing with currencies in corporate finance and valuation.</p><p><b>Corporate Borrowing</b></p><p style="text-align: justify;"><span> As riskfree rates fluctuate, they affect the rates at which private businesses can borrow money. Since no company or business can print money to pay off its debt, there is always default risk, when you lend to a company, and to protect yourself as a lender, it behooves you to charge a default or credit </span>spread to cover that risk:</p><p style="text-align: center;">Cost of borrowing for a company = Risk free Rate + Default Spread</p><p style="text-align: justify;">The question, when faced with estimating the cost of debt or borrowing for a company, is working out what that spread should be for the company in question. Many US companies have their default risk assessed by ratings agencies (Moody's, S&P, Fitch), and this practice is spreading to other markets as well. The bond rating for a company then becomes a proxy for its default risk, and the default spread then becomes the typical spread that investors are charging for bonds with that rating. In the graph below, I look at the path followed by bonds in different ratings classes - AAA, AA, A, BBB, BB, B and CCC & below - in 2022 and 2023:</p><p></p><div class="separator" style="clear: both; font-weight: bold; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgpHVT6r55QBc-MvE7a8eOtRzyJZ63ucoESmjt5kGRcVtzdY47ol6RWUGH4tIMzkEYpkYlU6bSJwuMrElaaWw2JmTUgw2t0xDwc_kB_LiayhSHenMho8vqgU5GkAipWGARFrffXa1i_uLG2DUE04ANR8bcqjJ1ovQo0O0imhyphenhyphenuljrw3WV04R46vmALFOZM/s1076/DefSpreadChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="939" data-original-width="1076" height="349" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgpHVT6r55QBc-MvE7a8eOtRzyJZ63ucoESmjt5kGRcVtzdY47ol6RWUGH4tIMzkEYpkYlU6bSJwuMrElaaWw2JmTUgw2t0xDwc_kB_LiayhSHenMho8vqgU5GkAipWGARFrffXa1i_uLG2DUE04ANR8bcqjJ1ovQo0O0imhyphenhyphenuljrw3WV04R46vmALFOZM/w400-h349/DefSpreadChart.jpg" width="400" /></a></div><div class="separator" style="clear: both; font-weight: bold; text-align: center;"><br /></div><div style="text-align: justify;">As with US treasuries, the default spread behaved very differently in 2023, as opposed to 2022. In 2022, the spreads rose strongly across ratings classes, and more so for the lowest ratings, over the course of the year. During 2023, default spreads reversed course, declining across the ratings classes, with larger drops again in the lowest ratings classes.</div><div style="text-align: justify;"><b> </b> One perspective that may help make sense of default spread changes over time is to think of the default spread as the price of risk in the bond market, with changes reflecting the ebbs and flows in fear in the market. In my last data update, I measured the price of risk in the equity market in the form on an implied equity risk premium, and chronicled how it rose sharply in 2022 and dropped in 2023, paralleling the movements in default spreads. The fact that fear and risk premiums in equity and bond markets move in tandem should come as no surprise, and the graph below looks at the equity risk premiums and default spreads on one rating (Baa) between 1928 and 2023:</div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj9lUHN0-wney7KUz714DKfJxeOcOztJuwF8XjmTWhI0HrNmvieB7lUkAbmH2DgoqtTPe1iokrMvjbDe1nSFEEppeT_khJYnfoNXhIp3XZZ3cQA6zejpRzhdTzRh0QX-ncKWsiOJRfBRydvLfxC9-_4VIFTLYa2JcMAk5P0K_yWLffrD0urCBnIZF2ykCs/s851/ERPvsSpread.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="591" data-original-width="851" height="278" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj9lUHN0-wney7KUz714DKfJxeOcOztJuwF8XjmTWhI0HrNmvieB7lUkAbmH2DgoqtTPe1iokrMvjbDe1nSFEEppeT_khJYnfoNXhIp3XZZ3cQA6zejpRzhdTzRh0QX-ncKWsiOJRfBRydvLfxC9-_4VIFTLYa2JcMAk5P0K_yWLffrD0urCBnIZF2ykCs/w400-h278/ERPvsSpread.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/baayldvsERP.xls">Download data</a></i></td></tr></tbody></table><div style="text-align: justify;">For the most part, equity risk premiums and default spreads move together, but there have been periods where the two have diverged; the late 1990s, where equity risk premiums plummeted while default spreads stayed high, preceding the dot-com crash in 2001, and the the 2003-2007 time periods, where default spreads dropped but equity risk premiums stayed elevated, ahead of the 2008 market crisis. Consequently, it is comforting that the relationship between the equity risk premium and the default spread at the start of 2024 is close to historic norms and that they have moved largely together for the last two years.</div><p></p><p><b>Looking to 2024</b></p><p style="text-align: justify;"><span> If there are lessons that can be learned from interest rate movements in 2022 and 2023, it is that notwithstanding all of the happy talk of the Fed cutting rates in the year to come, it is inflation that will again determine what will happen to interest rates, especially at the longer maturities, in 2024. </span>If inflation continues its downward path, it is likely that we will see longer-term rates drift downwards, though it would have to be accompanied by significant weakening in the economy for rates to approach levels that we became used to, during the last decade. If inflation persists or rises, interest rates will rise, no matter what the Fed does. </p><p></p><div style="text-align: justify;"><b>YouTube Video</b></div><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/r8Dlnp1dX5Q?si=nRUTTvIgTADjnPOp" title="YouTube video player" width="560"></iframe><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Data</b></div><div style="text-align: justify;"><ol><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/USTreasuriesin2023.xlsx">US Treasury Rates in 2022 and 2023</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/intrinsicvsactualrate24.xlsx">Intrinsic Riskfree Rates and T.Bond Rates - 1954 to 2023</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/baayldvsERP.xls">ERP and Default Spreads: 1960 - 2023</a></li></ol></div><div style="text-align: justify;"><b>Data Update Posts for 2024</b></div><div style="text-align: justify;"><ol><li><a href="https://aswathdamodaran.blogspot.com/2024/01/data-update-1-for-2024-data-speaks-but.html">Data Update 1 for 2024: The Data Speaks, but what is it saying?</a></li><li><a href="https://aswathdamodaran.blogspot.com/2024/01/data-update-2-for-2024-stock-comeback.html">Data Update 2 for 2024: A Stock Comeback - Winning the Expectations Game!</a></li><li><a href="https://aswathdamodaran.blogspot.com/2024/01/data-update-3-for-2024-interest-rates.html">Data Update 3 for 2024: Interest Rates in 2023 - A Rule-breaking Year</a></li></ol></div><p></p></div>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-81373954258248619172024-01-17T13:06:00.008-05:002024-01-17T13:40:21.651-05:00Data Update 2 for 2024: A Stock Comeback - Winning the Expectations Game!<div style="text-align: justify;">Heading into 2023, US equities looked like they were heading into a sea of troubles, with inflation out of control and a recession on the horizon. While stocks had their ups and downs during the year, they ended the year strong, and recouped, at least in the aggregate, most of the losses from 2022. That positive result notwithstanding, the recovery was uneven, with a big chunk of the increase in market capitalization coming from seven companies (Facebook, Amazon, Apple, Microsoft, Alphabet, NVidia and Tesla) and wide divergences in performance across stocks, in performance. As we move into 2024, it looks like expectations have been reset, with most forecasters now expecting the economy to glide in for a soft landing and interest rates to decline, and while that may seem like good news, it will represent a challenge for equity market investors.</div><div><br /></div><div><b>Looking Back</b></div><div style="text-align: justify;"><b> </b>Almost a year ago, I <a href="https://aswathdamodaran.blogspot.com/2023/01/data-update-2-for-2023-rocky-year-for.html">wrote a post</a> about what 2023 held for stocks, and it reflected the dark mood in markets, and in the face of investor gloom, looked at how the expectations game would play out for equities. In that post, I noted that if inflation subsided quickly, and the economy stayed out of a recession, stocks had upside, and that is the scenario that played out in 2023. Stocks ended the year well, with November and December both delivering strong up movements, and while this left investors feeling good about the year, it was a rocky year. In the graph below, I look at the monthly levels on the index and price returns, by month:</div><div><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEitI0vf3WSzg3Tppe4gFKEYPkvIM-tEicwT4M7bLj-Hbq2fKhtdhhgtjSg7FIqijFPJon4v2dcjuxXbqHxuXz1POy9ORDHatZ5bEK2upIJzmVJPeaDmhtgk7wOAtPiUzxf7LVW6oo6ThbnZvDALDV4XpODgX5ISikCegDmG0kREV-bmF-4B4SeBSoZ4408/s1470/S&P%20500%20Monthly%20Chart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1062" data-original-width="1470" height="231" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEitI0vf3WSzg3Tppe4gFKEYPkvIM-tEicwT4M7bLj-Hbq2fKhtdhhgtjSg7FIqijFPJon4v2dcjuxXbqHxuXz1POy9ORDHatZ5bEK2upIJzmVJPeaDmhtgk7wOAtPiUzxf7LVW6oo6ThbnZvDALDV4XpODgX5ISikCegDmG0kREV-bmF-4B4SeBSoZ4408/s320/S&P%20500%20Monthly%20Chart.jpg" width="320" /></a></div><div class="separator" style="clear: both; text-align: justify;"><span style="text-align: start;">On a month-to-month basis, stocks started the year well and had a good first half, before entering a tough third quarter where they gave back most of those gains. Over the course of the year, the S&P 500 rose from 3840 to 4770, an increase of 24.23% for the year, which when added to the dividend yield of 1.83% translated into a return of 26.06% for the year:</span></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg0TidR6K3iR4lXxFu6JielRJbVczjjmbeiVMZb_kkJMcV3QxbDHEwJ3GUCqBybJUJFZw_hMw5ip9ITvmeWB2CYIeuia8vGjwNFtdH_Ube_LVFMERRAEcYcgsbqUqPVNNxUFh4ekn0cAtTDqH8QwNIrN6N6OJFPeLixvTF97nAdyGs37YylIh3oN_A5-jU/s1492/S&P%20in%202023.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="946" data-original-width="1492" height="254" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg0TidR6K3iR4lXxFu6JielRJbVczjjmbeiVMZb_kkJMcV3QxbDHEwJ3GUCqBybJUJFZw_hMw5ip9ITvmeWB2CYIeuia8vGjwNFtdH_Ube_LVFMERRAEcYcgsbqUqPVNNxUFh4ekn0cAtTDqH8QwNIrN6N6OJFPeLixvTF97nAdyGs37YylIh3oN_A5-jU/w400-h254/S&P%20in%202023.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: justify;">To get historical context, I compared the returns in 2023 to annual returns on the S&P 500 going back to 1928:</div><div class="separator" style="clear: both; text-align: center;"><br /></div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEir4nWQBYmJLWFUMYOH4-VRaBJuLnjnT5L5usyCbre4WLe2QNaq6YmCn_PqT9HlI34AYd9Ox_EaST5Oq-8AZjPRSO5R-TdL-LbZqK78kfSObJJBxVCLX3J4qicdESvXG9yXFzSIfvnils19rhKr3C1wXdOFyyJBXRMCES7_qv_jQLgR9Y9hN4YYh0HZ4Zk/s1848/HistoricalReturnContext.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1318" data-original-width="1848" height="228" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEir4nWQBYmJLWFUMYOH4-VRaBJuLnjnT5L5usyCbre4WLe2QNaq6YmCn_PqT9HlI34AYd9Ox_EaST5Oq-8AZjPRSO5R-TdL-LbZqK78kfSObJJBxVCLX3J4qicdESvXG9yXFzSIfvnils19rhKr3C1wXdOFyyJBXRMCES7_qv_jQLgR9Y9hN4YYh0HZ4Zk/s320/HistoricalReturnContext.jpg" width="320" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;"><a href="https://www.stern.nyu.edu/~adamodar/pc/datasets/histretSP.xlsx">Download historical return data</a></span></i></td></tr></tbody></table>It was a good year, ranking 24th out of the 95 years of data that I have in my dataset, a relief after the -18.04% return in 2022. <div><span> The solid comeback in stocks, though, came with caveats. The first is that it was an uneven recovery, if you break stocks down be sector, which I have, for both US and global stocks, in the table below:</span> <br /><div><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgJF-3F_OPd81zeoN2_AQ2GetnU5DldpD5IFNL4pwtmOcEGS0qfTRQX-6Hh2m2YjyAFDYQXgc2Fz7R9BozwGDxFh6LS8jRV3IBrIKHhyphenhyphenDbEl9IU8TCkpvn-FneqAE4DyW8iFaE2mjDbjJzD1E_rc93TQHKayZMyBBshhugUl8LLkG-Cj4gFNZCJr6cnTfA/s1934/SectorBreakdown.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1164" data-original-width="1934" height="241" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgJF-3F_OPd81zeoN2_AQ2GetnU5DldpD5IFNL4pwtmOcEGS0qfTRQX-6Hh2m2YjyAFDYQXgc2Fz7R9BozwGDxFh6LS8jRV3IBrIKHhyphenhyphenDbEl9IU8TCkpvn-FneqAE4DyW8iFaE2mjDbjJzD1E_rc93TQHKayZMyBBshhugUl8LLkG-Cj4gFNZCJr6cnTfA/w400-h241/SectorBreakdown.jpg" width="400" /></a></div><br /><div style="text-align: justify;">As you can see, technology was the biggest winner of the year, up almost 58% (44%) for US (global) stocks, with communication services and consumer discretionary as the next best performers. Energy, one of the few survivors of the 2022 market sell-off, had a bad year, as did utilities and consumer staples. <span style="text-align: left;">Breaking equities down by </span><span style="text-align: left;">sub-region, and looking across the globe, I computed the change in aggregate market capitalization, by region:</span></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiAJWBdaD5ASXtS2251ftC0UFKk-TB8P7u4GQYPZSO9cnXOllDRVSVSFWWfLnWlKg2dwrHK73ejIPNgDIxmcBWbgX-KN4lZr3x2C4JHxBFJ3zWjwnmVBwg11543ogy1b_wBuAZ_irVM5I3ObLVPqCtSpiHsVYKGzv4na_Ai1pw747BgqWrl4hoo-4jIXZc/s1988/RegiionBreakdown.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="598" data-original-width="1988" height="120" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiAJWBdaD5ASXtS2251ftC0UFKk-TB8P7u4GQYPZSO9cnXOllDRVSVSFWWfLnWlKg2dwrHK73ejIPNgDIxmcBWbgX-KN4lZr3x2C4JHxBFJ3zWjwnmVBwg11543ogy1b_wBuAZ_irVM5I3ObLVPqCtSpiHsVYKGzv4na_Ai1pw747BgqWrl4hoo-4jIXZc/w400-h120/RegiionBreakdown.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div style="text-align: justify;">While US stocks accounted for about $9.5 trillion of the $14 trillion increase in equity market capitalization across the world, two regions did even better, at least on a percentage basis. The first was Eastern Europe and Russia, coming back from a massive sell-off in the prior two years and the other was India, which saw an increase of $1 trillion in market cap, and a 31.3% increase in market capitalization.</div><div><b><br /></b></div><div><b>Looking forward</b></div><div style="text-align: justify;"><b> </b>While there is comfort in looking backwards, slicing and dicing data in the hope of getting clues for the future, investing is about the future. Much as we like to believe that history repeats itself, and find patterns even when they do not exist, the nature of markets makes them difficult to forecast, precisely because they are driven not by what actually happens to the economy, inflation and other fundamentals, but by how these results compare to expectations. Going into 2024, investors are clearly in a better mood about what is to come this year, than they were a year ago, but they are pricing in that better mood. To capture the market's mood, I back out the expected return (and equity risk premium) that investors are pricing in, through an implied equity risk premium:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgw0FHPU7e3-nsx4g07UASYY7Huk9K03Bgq5c6OvwuNe3MQjPftdkiHOM8meXDwJqka5d-kikcpS2Ps_TLAqLQzIq96Ro48ujWmq26o5785KzTkJ0x7sINVrSPz3jJyik4l7xXGtKI89NenZkvDlo5RsmKdZ389rRjYP9pPuTjvrz14SXhCGJpTtK9w0xo/s1116/ImpliedERPPicture.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="632" data-original-width="1116" height="226" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgw0FHPU7e3-nsx4g07UASYY7Huk9K03Bgq5c6OvwuNe3MQjPftdkiHOM8meXDwJqka5d-kikcpS2Ps_TLAqLQzIq96Ro48ujWmq26o5785KzTkJ0x7sINVrSPz3jJyik4l7xXGtKI89NenZkvDlo5RsmKdZ389rRjYP9pPuTjvrz14SXhCGJpTtK9w0xo/w400-h226/ImpliedERPPicture.jpg" width="400" /></a></div><div><br /></div><div>Put simply, the expected return is an internal rate of return derived from the pricing of stocks, and the expected cash flows from holding them, and is akin to a yield to maturity on bonds. </div><div><span> To see how expectations and pricing have changed over the course of the year, I compare the implied equity risk premium (ERP) from the start of 2023 with the same number at the start of 2024</span></div><ul style="text-align: left;"><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEguyzwKWt0AcECROpt-ixTR7HPCnJfzspGUzSe_LR1j27PWitSG6kAd-_8PRfnjmwPq8ThRW_EnnG9qb6OQS65Ku-uJ7HA_mVDLAkioRjVt4XYnbuxNGYw7mI1HLinaXLPHespSZfn7ecwAYb5SGU_KJFyky97HbAgQuh-xBY4pUMY29MpGALvSEVXbAA0/s3198/ERPO2023vs2024.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1086" data-original-width="3198" height="136" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEguyzwKWt0AcECROpt-ixTR7HPCnJfzspGUzSe_LR1j27PWitSG6kAd-_8PRfnjmwPq8ThRW_EnnG9qb6OQS65Ku-uJ7HA_mVDLAkioRjVt4XYnbuxNGYw7mI1HLinaXLPHespSZfn7ecwAYb5SGU_KJFyky97HbAgQuh-xBY4pUMY29MpGALvSEVXbAA0/w400-h136/ERPO2023vs2024.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/implprem/ERPJan23.xlsx">2023 ERP</a> & <a href="https://pages.stern.nyu.edu/~adamodar/pc/implprem/ERPJan24.xlsx">2024 ERP</a></span></i></td></tr></tbody></table></ul><div style="text-align: justify;">At the start of 2023, in the midst of the market's pessimism of what the coming years would deliver, stocks were priced to earn a 9.82% annual return and a 5.94% equity risk premium. In contrast, at the start of 2024, the lifting of fear has led to higher prices, a more upbeat forecast of earnings and an expected return of 8.48% and an equity risk premium of 4.60%. I do compute this expected return and the equity risk premium at the start of each month, and the last 24 months have been a roller coaster ride:</div><div style="text-align: justify;"><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj5gPYd9ZZX1wg9wWQaW8tYZ9teEdZ8pT62DTkh1xwBNJxGgIhb9sfzHWtXyuC5D8Stck-ssQr0CG_yWGrvoH0Huhky-rSPXFhz-WV-VwaHyycWHsObnKTNrF6UG7uFrlPzO3Ti1G9Kxr70yKjFpdFl-VSWPrc_dKJykmE_DJb1MWn28Lxoc6dS1h2LLCc/s2890/ERPin2022&2023.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="2104" data-original-width="2890" height="291" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj5gPYd9ZZX1wg9wWQaW8tYZ9teEdZ8pT62DTkh1xwBNJxGgIhb9sfzHWtXyuC5D8Stck-ssQr0CG_yWGrvoH0Huhky-rSPXFhz-WV-VwaHyycWHsObnKTNrF6UG7uFrlPzO3Ti1G9Kxr70yKjFpdFl-VSWPrc_dKJykmE_DJb1MWn28Lxoc6dS1h2LLCc/w400-h291/ERPin2022&2023.jpg" width="400" /></a></div><div><br /></div>While equity risk premiums and expected returns rose strongly in 2022, registering the largest single-year increase in history, they declined over 2023, as hope has gained an upper hand over fear.</div><div><div style="text-align: justify;"><span> To the question of whether 8.48% is a reasonable expectation for an annual return for US stocks, and 4.60% a sufficient equity risk </span>premium, I looked at the historical estimates for these numbers going back to 1960:</div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgxwmMNsTckT3Jr5Ihl9HhItbq1p_6dyZcKTdf9HWnsmx84XwBuA6t2rau9q50g4xmfAoc7TDLqvr9jDLBICCVhdOGCOWUT3J_waoiHOv0ctJ9Vjti-ci9KH4dSVzubNtwNJ6yqLmJ5TJJ8k7T88Yi2RpcbgZm7lZeSofYebxCNg_X-sr_ejTzx3cqqtVg/s1620/historicalERP.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1160" data-original-width="1620" height="286" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgxwmMNsTckT3Jr5Ihl9HhItbq1p_6dyZcKTdf9HWnsmx84XwBuA6t2rau9q50g4xmfAoc7TDLqvr9jDLBICCVhdOGCOWUT3J_waoiHOv0ctJ9Vjti-ci9KH4dSVzubNtwNJ6yqLmJ5TJJ8k7T88Yi2RpcbgZm7lZeSofYebxCNg_X-sr_ejTzx3cqqtVg/w400-h286/historicalERP.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/histimpl.xls"><i><span style="font-size: x-small;">Download historical ERP</span></i></a></td></tr></tbody></table><div class="separator" style="clear: both; text-align: justify;">While stocks had expected returns exceeding 10% for much of the 1970s and 1980s, the culprit was high interest rates, and as interest rates have declined in this century, expected returns have come down as well. The post-2008 time period also was a period of historically low interest rates, and expected returns bottomed out in 2021, before rising again in 2022. In the table below, I look at the expected returns and equity risk premiums at the start of 2022, 2023 and 2024 against the distribution of the corresponding variables between 1960 and 2024:</div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjzD0iWAwfGIlBIICcrcEwE89JUVMgPhp4cGILC4dIpyw_4xjYeB3cNQI4DKmWLMQGdZBVf13XQ4ZVT2AAH7SColPTdZa4quWnUeYbbMSR-qXqI4dki29gxSxm0c150yUCAQkqbSgvLW2gdoJ5gY5YA_GGrUu6dcC1-IxJaMIUXFWlmwiAbzAb_erNZ1_o/s758/ERPinPerspective.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="356" data-original-width="758" height="150" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjzD0iWAwfGIlBIICcrcEwE89JUVMgPhp4cGILC4dIpyw_4xjYeB3cNQI4DKmWLMQGdZBVf13XQ4ZVT2AAH7SColPTdZa4quWnUeYbbMSR-qXqI4dki29gxSxm0c150yUCAQkqbSgvLW2gdoJ5gY5YA_GGrUu6dcC1-IxJaMIUXFWlmwiAbzAb_erNZ1_o/s320/ERPinPerspective.jpg" width="320" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/histimpl.xls"><i><span style="font-size: x-small;">Download historical ERP</span></i></a></td></tr></tbody></table><br /><div class="separator" style="clear: both; text-align: justify;">It is comforting, if you are an equity investor, to see that the expected returns are only slightly lower than the median value over the longer period, and the equity risk premium is above historical norms.</div><div class="separator" style="clear: both; text-align: justify;"><span> Needless to say, there are other metrics, measuring the cheapness or expensiveness of equities, that investors may find more troubling. In particular, the earnings yield (the inverse of the PE ratio) for US equities will give investors pause:</span><br /></div><div><br /></div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgJYq1KPTr84rnXoiEBorNTDk91ygZfyJ41NnSdKR2HaKvTixgjFMbTH21Nh80EwmRRxELj0LvFpKWdzUAT2jDzGjVb2II1z97-rrgTnhxUQ2WIfWIbfzU1e62HlcS_d6v8bSMq_gpJtP3stzwG7JreYk0FYV0WBCXB6e5q4cH0XAnJbVb_mGWw6FMH998/s1846/EPChart.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1328" data-original-width="1846" height="288" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgJYq1KPTr84rnXoiEBorNTDk91ygZfyJ41NnSdKR2HaKvTixgjFMbTH21Nh80EwmRRxELj0LvFpKWdzUAT2jDzGjVb2II1z97-rrgTnhxUQ2WIfWIbfzU1e62HlcS_d6v8bSMq_gpJtP3stzwG7JreYk0FYV0WBCXB6e5q4cH0XAnJbVb_mGWw6FMH998/w400-h288/EPChart.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/histimpl.xls">Download historical EP</a></span></i></td></tr></tbody></table><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: justify;">Note that the EP ratio, after a surge last year, has dropped back towards 2022 levels, with the caveat being that treasury bond rates are much higher now than they were then, an attractive alternative to equities that did not exist two years ago.</div><br /><div><b>Taking a Stand</b></div><div><b> </b> I am not a market timer, but I do value the market at regular intervals, more to get a measure of what the market is pricing in, than to forecast future movements. In valuing the index, I follow the intrinsic value rulebook, where the value is determined by expectations of cash flows in the future, discounted back to adjust their risk. </div><ul style="text-align: left;"><li style="text-align: justify;">To get <b>expected cash flows</b>, I start with expectations of earnings from the equities that comprise the index. For the S&P 500, the most widely followed equity index, I use the consensus estimates of aggregate earnings for 2024 and 2025, from analysts. I know that mistrust of analysts runs high, and the perception that they are cheerleaders for individual companies is often well founded, but I will stick with these forecasts for a simple reason. Having tracked analyst forecasts for four decades,I have found that analyst estimates of aggregated earnings for the index are unbiased, with analysts under estimating earnings in almost as many years as they over estimate them. </li><li style="text-align: justify;">The<b> cash flows </b>to equity investors, especially in the United States, have increasingly taken the form of buybacks, not just supplementing but supplanting dividends. In 2023, dividends and buybacks on the S&P 500 index amounted to $1.367 trillion, 164.25 in index units, with 57.6% of these cash flows coming from buybacks. As a percent of earnings, the cumulative cash returned represented 74.8% of earnings in that year, representing a decline from payout ratios during this century (2000-2022); the median payout ratio for this period was 83%.</li></ul>With these earnings and cash flows as starting points, and assuming that the treasury bond rate of 3.88% is a fair interest rate, I value the S&P 500:</div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiZzfbMFZYBrG-7CGTxynIqwW441vMhWG_qwA5zqtxwKobtPuW3AwFkxnDrHwPlpn3BzBmJyVADKEpolnpzXnt7PBCnfnXM1-b8Nm7wKT7W02YDg3NRxt8j__BJbxCsq_KSqtTCvzvwiMGyBusWM_bXPUBUSF2GkF2mKcCvVteqrq2pEV-v2mjE1CEP6_s/s1496/S&PValJan2024.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="796" data-original-width="1496" height="213" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiZzfbMFZYBrG-7CGTxynIqwW441vMhWG_qwA5zqtxwKobtPuW3AwFkxnDrHwPlpn3BzBmJyVADKEpolnpzXnt7PBCnfnXM1-b8Nm7wKT7W02YDg3NRxt8j__BJbxCsq_KSqtTCvzvwiMGyBusWM_bXPUBUSF2GkF2mKcCvVteqrq2pEV-v2mjE1CEP6_s/w400-h213/S&PValJan2024.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/S&P500ValueJan2024.xlsx">Download valuation spreadsheet</a></span></i></td></tr></tbody></table><div><div style="text-align: justify;">Note that I forecast earnings beyond 2025, by assuming that growth scales down to the growth rate of the economy, estimated to be roughly equal to the riskfree rate. Unlike early in 2023, when stocks looked slightly under valued, with consensus earnings numbers and prevailing rates, stocks look over valued by about 9.2%, with a similar structure today.</div><div style="text-align: justify;"><span> As with any market valuation, there are risks embedded in this value. First, the consensus view that the economy will come in for a soft landing may be wrong, with a recession or a stronger recovery both in the cards; the earnings numbers will be lower than analyst estimates in a recession and higher with a stronger economy. Second, while the market is building in expectations of interest rates declining in 2024, a significant portion of that optimism comes from a delusion that the Fed can raise or lower rates at well. After all, the treasury bond rate, a much stronger driver of equity values than short term treasury rates, remained unchanged in 2023, even as the Fed repeatedly raised the Fed Fund rates, and it is very likely that the future path of the treasury bond rate will depend more on the vagaries of inflation than on the whims of Jerome Powell. In the graph below, I look at the fair index level as a function of assumptions about earnings surprises and interest rates:</span></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh5fRDVKwT0abtpWXCYKURP53VlQytYHUT5MD64Y1XRP8EGy2AnomyDOHj4u_Mm7J9gJZ6B4zLpPM-WKWmsXiNHMtbGLFvH_w_jH7bDmNUg16kzGeLYlKz4r_t5NDIFj1_7w-pHNpD8z6sOHx9CxLh_tAocyRx3FMq8nca0BPTUahZfDzus9CrfEPOSA18/s1448/IndexWhatifTable.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1448" data-original-width="1440" height="400" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh5fRDVKwT0abtpWXCYKURP53VlQytYHUT5MD64Y1XRP8EGy2AnomyDOHj4u_Mm7J9gJZ6B4zLpPM-WKWmsXiNHMtbGLFvH_w_jH7bDmNUg16kzGeLYlKz4r_t5NDIFj1_7w-pHNpD8z6sOHx9CxLh_tAocyRx3FMq8nca0BPTUahZfDzus9CrfEPOSA18/w398-h400/IndexWhatifTable.jpg" width="398" /></a></div><div class="separator" style="clear: both; text-align: justify;"><br /></div></div><div style="text-align: justify;">Note that I report the fair index values currently, and to convert them into target levels for the index a year from now, you have to take the future value of the index, using the expected return on stocks (net of dividend yield). For instance, to get the expected index level at the end of 2024, if rates stay at around 4% and earnings come in 10% above expectations, is as follows:</div></div><div style="text-align: justify;">Fair value of the index in current terms = 5202</div><div style="text-align: justify;">Expected annual return on equities = T.Bond rate + ERP = 4% + 5% = 9%</div><div style="text-align: justify;">Expected price appreciation on equities = Expected annual return - Dividend yield = 9% - 1.5% = 7.5%</div><div><div style="text-align: justify;">Expected index level on 12/31/2024 (r =4%, Earnings 10% above expected) = 5202 (1.075) = 5592</div><div style="text-align: justify;">As you can see, you would need earnings to come in above expectations, for the current index level (4750 on January 16) to be justified, with lower interest rates providing an assist. While what-if tables like the one above are useful tools for dealing with uncertainties, a more complete assessment of uncertainty requires that I be explicit about the uncertainties I face on each input, resulting in a simulation:</div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjciL3zd2tEpOwnu4QiRBlGo81szex2N9uLY9oKMuHTzY0VUUI_RGf0kiPUfujyIEz7jrpUpRHmYH1NITMZ8xBPrHkrFw9xFtdxfEo2QyC0-3xxLGchaHcO4IQ1qzZEuP156tgXfd5bfVbCNF73TDOFTJ2HJ37isU4xjWKzkUpI-Jha5s_36qASMTyaz_0/s1504/S&P500Simulation.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1146" data-original-width="1504" height="305" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjciL3zd2tEpOwnu4QiRBlGo81szex2N9uLY9oKMuHTzY0VUUI_RGf0kiPUfujyIEz7jrpUpRHmYH1NITMZ8xBPrHkrFw9xFtdxfEo2QyC0-3xxLGchaHcO4IQ1qzZEuP156tgXfd5bfVbCNF73TDOFTJ2HJ37isU4xjWKzkUpI-Jha5s_36qASMTyaz_0/w400-h305/S&P500Simulation.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><a href="https://www.oracle.com/applications/crystalball/">Simulation run with Crystal Ball, an Excel add-on</a><br /><br /></i></td></tr></tbody></table><div class="separator" style="clear: both; text-align: justify;">Not surprisingly, with uncertainties built in, the fair value of the index has a wide range, but using the first and ninth decile, a reasonable range for the fair value would 3670 - 5200, and at the January 16 closing level of 4750, there is about a 70% chance that the market is over valued.</div><div class="separator" style="clear: both; text-align: justify;"><span> I am sure that you will disagree with one or more of the inputs that I have used to value the index, and I welcome that disagreement. Rather than point out to me the error of my ways, please <a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/S&P500ValueJan2024.xlsx">download the spreadsheet containing the intrinsic valuation</a>, and you should be able to replace my assumptions about earnings, cash payout and interest rates, and arrive at your own estimates of index value. </span><br /></div><div class="separator" style="clear: both; text-align: justify;"><br /></div><div class="separator" style="clear: both; text-align: justify;"><b>Caveat emptor!</b></div><div class="separator" style="clear: both; text-align: justify;"><span> Before you take my market prognostications at face value, please consider my open disclosure that I am a terrible market timer and try to avoid it in my investing. In short, I do not plan to act on my market valuation by buying puts on the index, or scaling down by portfolio's equity exposure. If you are wondering why I bother valuing the index, there are two reasons. First, t</span><span>here are times in the past, when the overvaluation of the market is so large that it operates as a red flag on investing in equities, as an asset class, in general. That signal </span>worked in early 2000 but did not in early 2008, and it is thus a noisy one. Second, and more generally, though, valuing the market allows you to make sense of, and tolerance for, bullish and bearish views on the market that may diverge from your own views. Thus, investors and analysts who believe that rates will continue to decline, with a strong economy delivering higher-than-expected earnings, will see significant upside in this market, just as investors and analysts who believe that stubbornly higher inflation will cause rates to rise, and that earnings will come in well below expectations will be more likely to be part of the doomsday crowd. Just as in 2023, there will be times in 2024 when one side or the other will think that it has decisively won the argument, just to see a reversal in the next period.</div><div class="separator" style="clear: both; text-align: justify;"><div><br /></div></div><div class="separator" style="clear: both; text-align: left;"><b>YouTube Video</b></div><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/5u5Pom4gfKY?si=E5_tVVY0AwzfycrV" title="YouTube video player" width="560"></iframe><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;"><b>Datasets</b></div><div class="separator" style="clear: both; text-align: left;"><ol style="text-align: left;"><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/histretSP.xlsx">Historical Returns on Stocks, Bonds, Gold and Real Estate - 1928 -2023</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/histimpl.xlsx">Historical Implied Equity Risk Premiums and Expected Returns - 1960- 2023</a></li></ol><div><b>Spreadsheets</b></div><div><ol style="text-align: left;"><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/implprem/ERPJan24.xlsx">Implied ERP calculator - January 1, 2024</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/S&P500ValueJan2024.xlsx">Valuation of the S&P 500 on January 1, 2024</a></li></ol></div></div></div>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-44929704358339463782024-01-11T17:56:00.001-05:002024-01-12T09:50:36.719-05:00The School Bell Rings: Time for Class!<p style="text-align: justify;">Continuing an annual ritual of long standing, ahead of starting my spring teaching at NYU starting in a couple of weeks, I would like to invite you, if you are interested, to come along for the ride. I know! I know! Most of you are not enrolled at NYU, paying nosebleed prices, and that is prerequisite to be in the classroom, but thanks to technology and a loose reading of the rules that constrain me, you can get a close approximation of the classroom experience, wherever you are in the world, with broadband being your only constraint.</p><p style="text-align: justify;"><b>My Teaching Journey</b></p><p style="text-align: justify;"><span> I am a product of my life experiences, and at the risk of boring you, I would like to give you a short history of the lucky breaks and choices that have led me to where I am today. I came to the United States in 1979, and having lived here much of my life, I feel nothing but gratitude for the kindness and opportunities that this country has offered me. I started in the MBA program at University of California at Los Angeles (UCLA) in 1979, at the tail-end of its basketball glory days, fully expecting to move on to a career in consulting or investment banking, when I was done. To ease my financial constraints, I became a teaching assistant in the second year of my MBA program, and in what I can only describe as a moment of grace, I realized that teaching was what I wanted to do with the rest of my life. </span><br /></p><p style="text-align: justify;"><span><span> Recognizing the need for a doctorate as an entree into college teaching, I stayed on at UCLA to get my Phd. In 1984, I moved on to the University of California at Berkeley, as a visiting lecturer, teaching </span>anything that needed to be taught. The six classes that I prepped for in those two years ranged from banking to investments to corporate finance, and while I have never worked harder, much of what I teach today came out of those classes. </span><span><span>In 1986, I joined New York University's business school as an assistant professor, and asked to teach Security Analysis, a class made legendary by Ben Graham, who taught it at Columbia University in the 1950s. By 1986, </span>though, it was showing its age, more a collection of topics about institutions and types of securities, than a cohesive class. I balked at teaching this motley collection of </span>topics and wanted to teach a class on valuation, but I was told that there was not enough stuff in valuation to fill a class. I learned early in my academic life that if you want to get anything done in an academic setting, it is better to do it subversively than it is to ask (and get) official permission. In the fall of 1986, I taught a valuation class in my security analyst slot, and with no cameras in the classroom or complaints from students, no one was any wiser. In spring 2024, I will be teaching valuation again to the MBAS, for the 59th time, and I have an identical class that I will delivering to undergraduates during the semester. </p><p style="text-align: justify;"><span> The very first class that I taught at Berkeley in 1984 was an introductory corporate finance class (BA 130, for those who are from Berkeley and remember the class codes) and I have continued to teach that class as well to the MBAs at Stern, usually in the first year of the program. Since many MBAs consider taking both my corporate finance and valuation classes, I am asked what the difference is between the classes, and my explanation is that in corporate finance, we look at first principles in finance from the inside of </span>businesses, as owners or managers, whereas in valuation, you look at those same principles, as investors or potential investors in these companies, from the outside in. In the years that I have taught these two classes, I find myself using my corporate finance framework constantly, when valuing companies, and bringing my understanding of valuation into play, when examining how companies should make investing, financing and dividend decisions.</p><p style="text-align: justify;"><span> In the 1990s, I was asked to pinch hit for a colleague and manage a semester-long class of sessions with outside speakers, all of whom were successful investors and portfolio managers. As I watched these investors come in and pitch their ideas about how markets worked and the best way to beat these markets to the students in the class, I noticed that while the speakers all shared success, they had very different perspectives about markets and divergent investment philosophies. At the end of that class, I put together a class on investment philosophies, not with the intent of picking the best one, but instead offering the entire menu, so that students could decide for themselves whether they wanted to be technical analysts, momentum trades, value investors, venture capitalists of market timers. </span><br /></p><p><b>Pre-Season Prep</b></p><p><b> </b>If you are new to finance or valuation, and especially if you have a non-quantitative background (a liberal arts major, a job in strategy or marketing, for example), I don't blame you for feeling intimidated at the prospect of taking a corporate finance, valuation or investment philosophies class. Investment bankers, consultants and portfolio managers often speak in a language that is foreign to those not in the space, and create an aura of mystery and layers of complexity around what they do. In my view, much of this is smoke and mirrors, and there is nothing in finance that is beyond your reach, if you are willing to use common sense and commit to doing a little bit of work that is outside your comfort zone. In particular, there are three disciplines that can help you in any finance class or analysis, and the payoff to spending time on each of them is significant.<br /></p><p style="text-align: justify;"><span><u>1. The Language of Finance</u>: Much as I take issue with the rigidity of accounting rules and the incapacity of accounting to be imaginative, the data that we use in finance is expressed in accounting terms. If you really don't understand the difference between operating earnings and net income, or know what accounting balance sheets can (and cannot) measure, you will have trouble doing any type of corporate financial analysis or valuation. That said, accounting classes are not only overkill but they also actively create perspectives that can get in the way of sensible financial analysis. A few years ago, I created <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcastacctg.htm ">my own version of an accounting class</a>, reflecting my selfish interests in accounting data, and you can find this online, if your accounting is rusty:</span></p><p></p><div class="separator" style="clear: both; text-align: center;"><div class="separator" style="clear: both; font-weight: bold; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg11vLB_-ZHFyDjrADorWZe3vc0sQhicJkZMw-89KmXCQwP5ttNAomsXdi1BDOk0LP0apZHM7oZh4jC-QZ4Np99kEY0Q3S9jsWCMgUCBIuGQR2wBKrow92thBq_Dy5Uyr5YZvgExvCcD9yDANnPkINldkDuvCcB1Mgz3zeGcuaSybu0U4TLvknZiFm-Xvs/s1616/AcctgBigPicture.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1264" data-original-width="1616" height="313" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg11vLB_-ZHFyDjrADorWZe3vc0sQhicJkZMw-89KmXCQwP5ttNAomsXdi1BDOk0LP0apZHM7oZh4jC-QZ4Np99kEY0Q3S9jsWCMgUCBIuGQR2wBKrow92thBq_Dy5Uyr5YZvgExvCcD9yDANnPkINldkDuvCcB1Mgz3zeGcuaSybu0U4TLvknZiFm-Xvs/w400-h313/AcctgBigPicture.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: justify;">If you are an accountant or have an accounting degree, you may find my treatment of accounting rules to be sacrilegious, but I have a very different end game.</div><div class="separator" style="clear: both; font-weight: bold; text-align: justify;"><br /></div><div class="separator" style="clear: both; text-align: justify;"><u>2. The Building Blocks of Finance</u>: Over the decades, finance has become specialized, but it is astonishing how much of finance is still build around basic building blocks. Since many of the students in my NYU finance classes come in with a foundational class in finance already under their belt, I used to take it for granted that they had mastered those building blocks. Over time, I have learned that this is not always true, and I have a <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcastfoundationsonline.htm">short class on foundational finance</a>, which includes discussions of what risk is, and how to measure it, the time value of money and the basic macroeconomic drivers of interest rates and exchange rates.</div></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEio1RhnKdmOUPjcFednyorNMn7T7fY4qJI5m0QN3xviT8swInEqjc4gRHaw3DjcgllLkbd7u60E-kd10cH8fuRIm3dvgK2ZUfLJVbWYXGmQCb9cEoyigynjoJUOujHaN66MvuKOx-vAIUs7c-9DqsAZGZWPYLskohMlixIdgAt67SpG9XqylYQydKx71GU/s1360/Foundations.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="930" data-original-width="1360" height="274" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEio1RhnKdmOUPjcFednyorNMn7T7fY4qJI5m0QN3xviT8swInEqjc4gRHaw3DjcgllLkbd7u60E-kd10cH8fuRIm3dvgK2ZUfLJVbWYXGmQCb9cEoyigynjoJUOujHaN66MvuKOx-vAIUs7c-9DqsAZGZWPYLskohMlixIdgAt67SpG9XqylYQydKx71GU/w400-h274/Foundations.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: justify;">If you are well versed in these areas already, you should skip this class and move on, but it cannot hurt to refresh the basics.</div><div class="separator" style="clear: both; text-align: justify;"><br /></div><div class="separator" style="clear: both; text-align: justify;">3. <u>The Data Wranglers</u>: We live in the age of big data, and as I watch those marketing big data make tall claims about what it can do for businesses, It is worth remembering that finance discovered the power of data decades ago, and that its effects on practice have been mixed. In particular, we have discovered that having more financial data does not always lead to better decisions and that our behavioral quirks can lead us to skew and ignore data. It is for that reason that I find myself turning more and more to statistics, a discipline designed to take large amounts of contradictory data and make sense of that data. Again, I have a short course that I put together that <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcaststatistics.htm ">covers the statistical concepts</a> needed in finance, from summary statistics (averages, medians) to measures of relationships (correlations, covariances) to predictive and analytics tools (regressions, simulations):<i style="text-align: left;"> </i></div><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiDfZ1E9XxWvUkTw5SpLUiE0i5DrmSf4JUOMwnt8_xrK6uJcXrL0Inl5h3nDd9EPRHsRSeakbVKSzggTVgLJUASJwsG4RLBxVqQVx_dsOyp4I1nyJTjBp6sgSLf6ANNyB6K5DsXui-rtXEHdRCKsawKC4crxocGVgHt_UMqAy8db0la1K1lZ6IJec9jvaQ/s1194/StatisticsClass.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="790" data-original-width="1194" height="265" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiDfZ1E9XxWvUkTw5SpLUiE0i5DrmSf4JUOMwnt8_xrK6uJcXrL0Inl5h3nDd9EPRHsRSeakbVKSzggTVgLJUASJwsG4RLBxVqQVx_dsOyp4I1nyJTjBp6sgSLf6ANNyB6K5DsXui-rtXEHdRCKsawKC4crxocGVgHt_UMqAy8db0la1K1lZ6IJec9jvaQ/w400-h265/StatisticsClass.jpg" width="400" /></a></div><div style="text-align: justify;">If you are a statistics maven, you will undoubtedly find my discussion of statistical topics to be simplistic and naive, but if you are not, I hope that this revisiting of statistical concepts helps.</div><p><b>Learning Choices</b></p><p><span> If I have not already talked you out of taking my classes, and you are still interested, the classes exist in multiple formats, and you can make your choice, based upon time </span>available, preferences and end games.</p><p><i>The Classes</i></p><p style="text-align: justify;"><i> </i>In the first section of this post, I described the history of the three classes that I teach - the corporate finance class that I first taught at Berkeley in 1984 and have taught every year since, the valuation class that I sneaked in, as a replacement for security analysis, into my NYU classroom in 1986, and my investment philosophies class, born out of my experience listening to great investors talk about how they make money. <br /></p><p style="text-align: justify;"><span> I describe my corporate finance class as an applied, big-picture class. </span>It is a big-picture class because it is really a class about how to run a business, from a financial principles perspective, and every decision that a business makes is ultimately a corporate finance decision. The class tries to answer three core questions that every business, small or large, public or private, faces - the investment question (of whether and how much to invest in new projects/assets, the financing question of how much to borrow and in what form and the dividend question of how much cash to return to shareholders, if at all:</p><p style="text-align: justify;"><span> </span><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiMMr1aHN8R_FEw2Girx328w0MgZ7u24qx00pK9cLKOmLdq6BSeMlhiM6TYN8QcDgATGBuBQD308MNwAttUXaU_YlhtVEb0-BnZ5pbc9HSiZ0_sIgA4dh5E2A-kFlhhSWX9xvNWt8FD7_WeVW-cW9n0OSshTEWs2IMYxBcPG0JH7AglbK7ovU-66K_aQuQ/s1490/CFBigPicture.jpg" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="1020" data-original-width="1490" height="274" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiMMr1aHN8R_FEw2Girx328w0MgZ7u24qx00pK9cLKOmLdq6BSeMlhiM6TYN8QcDgATGBuBQD308MNwAttUXaU_YlhtVEb0-BnZ5pbc9HSiZ0_sIgA4dh5E2A-kFlhhSWX9xvNWt8FD7_WeVW-cW9n0OSshTEWs2IMYxBcPG0JH7AglbK7ovU-66K_aQuQ/w400-h274/CFBigPicture.jpg" width="400" /></a></p><p style="text-align: justify;">It is an applied class, because I answer each of these questions for a mix of companies that range the spectrum from large to small, developed to emerging market and from public to private - Disney, Vale, Tara Motors, Baidu, Deutsche Bank and a privately owned bookstore in New York Since these are real businesses exposed to changes in real time, there will be surprises that they deliver during the next few months that will become fodder for discussion. </p><p style="text-align: justify;"><span> </span>The corporate finance class ends with a valuation segment, where I link the decisions that companies make on the investing, financing and dividend dimension to value. I pick up on that segment in the valuation class, which I describe grandiosely as a class about valuing and pricing just about anything and from any perspective:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgIXFqvvNKysoFqM6rrhXdbHiME4MxS-kIG0z7Sq6ZCXBWaibJNBFl5LFFvRCMJ5eYAyrXq1Ei7DApxeb2pSgZlygxLDVsPXZO75nAiXjhyQTZaviBJSvhEcmPPV6PZIttx5GvTd6ZghFKa6Vlnpu7yBbXGJpxlW1bLNfb_nSsLbibt1dAg-hg2weyIWXM/s1452/ValPicture.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1112" data-original-width="1452" height="245" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgIXFqvvNKysoFqM6rrhXdbHiME4MxS-kIG0z7Sq6ZCXBWaibJNBFl5LFFvRCMJ5eYAyrXq1Ei7DApxeb2pSgZlygxLDVsPXZO75nAiXjhyQTZaviBJSvhEcmPPV6PZIttx5GvTd6ZghFKa6Vlnpu7yBbXGJpxlW1bLNfb_nSsLbibt1dAg-hg2weyIWXM/s320/ValPicture.jpg" width="320" /></a></div><div class="separator" style="clear: both; text-align: justify;">Rather than use case studies and abstractions, this class is built around valuing businesses in real time, and the companies that hit the news during the course of the next few months will find their way into my classroom versions of the valuation class. While it is offered to both undergraduates and MBAs, the class is identical in terms of content, and you can pick either to follow.</div><div class="separator" style="clear: both; text-align: justify;"><span> The investment philosophies class covers the spectrum of investment philosophies, and I have classified them in the picture below, based upon whether they are built around value or pricing. If you find that contrast mystifying, tune in to the class, and I will clarify:</span><br /></div><div class="separator" style="clear: both; text-align: justify;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhn7LAFZnVPswRwCGQsTeJeylTXotQalrb1kkDeFSLLujoFYCQV2fPEFvqJchoNnAwCRy16garJKtIPWPI1fuzZLkepoMoVMHsTGG_rvD4Ms4ZX-vcq5vrOKcInjoJo0wwbEqjGwrdvwcxvImqXjvw7a2KIR3PlCgSfHvyqpue69CLRD6oTu2dN7LrltkM/s1348/InvPhilChoices.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="774" data-original-width="1348" height="230" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhn7LAFZnVPswRwCGQsTeJeylTXotQalrb1kkDeFSLLujoFYCQV2fPEFvqJchoNnAwCRy16garJKtIPWPI1fuzZLkepoMoVMHsTGG_rvD4Ms4ZX-vcq5vrOKcInjoJo0wwbEqjGwrdvwcxvImqXjvw7a2KIR3PlCgSfHvyqpue69CLRD6oTu2dN7LrltkM/w400-h230/InvPhilChoices.jpg" width="400" /></a></div><p style="text-align: justify;">The end game with this class is not to sell you on the best investment philosophy, but the one that best fits you, based upon what you bring to the game.</p><p><i>Class Format</i></p><p style="text-align: justify;"><b> </b>My classes are available in three formats. The first is the <i>classroom format</i>, where you can watch recordings of my undergraduate and MBA classes at Stern this semesters, shortly after they are delivered in real time. In that format, you will also have access to all of the materials that I use in the classroom, including lectures notes and exams/quizzes, and if you really want to get close to classroom-experience, you can do the project that everyone in class is required to do. You will not get credit or a grade, and you are not enrolled the class, but you don't have to pay tuition. The second is a <i>free online version</i> that I have created for each class, with the lectures shrunk (in substance and time) to be more attuned to an online audience. You can <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/onlineclass.htm">access these online classes on my website</a>, and as with the classroom classes, be able to download lecture notes and quizzes. The third is an online and paid version offered by NYU, where there are professional recordings of the online lectures, administered and grades quizzes and exams and virtual office hours. You will get an official certificate of course completion with this class, but NYU will extract its (financial) pound of flesh in the form of a tuition payment.</p><style type="text/css">
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<thead><tr class="tableizer-firstrow"><th>Class Format</th><th>Cost</th><th>Credit</th><th>Timing</th><th>Sessions</th><th>Material</th><th>Personal Interaction</th></tr></thead><tbody>
<tr><td><a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/regularclass.htm">Classroom</a></td><td>$0 </td><td>None</td><td>Taught Jan - May 2024, but flexible on your part</td><td>Twenty six 80-minute recorded sessions (MBA) or twenty eight 75-minute sessons (Undergraduate)</td><td>Lecture notes, additional material, quizzes/exams and final project </td><td>None, unless you are an NYU student in the class</td></tr>
<tr><td><a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/onlineclass.htm">Onliine (Free)</a></td><td>$0 </td><td>None</td><td>Flexible</td><td>26-36 online 10-20 minutes recorded sessions</td><td>Lecture notes, post-class tests</td><td>None</td></tr>
<tr><td>Online (NYU Certificate)</td><td>$2,200 </td><td>Certification</td><td>Jan - May 2024</td><td>26-36 online 10-20 minutes recorded sessions</td><td>Lecture notes, post-class tests, quizzes/exams, project</td><td>One live virtual office hour every two weeks.</td></tr>
</tbody></table><p style="text-align: justify;">I want to emphasize that if you decide to follow the classroom or online versions of the class, it is entirely informal and that it has nothing to do with NYU. There is no registration, recording or access to NYU resources that come with taking these classes. If you take the certificate class, you will have a more formal relationship with NYU. </p><p><span> </span>In choosing between these alternatives (and I really am completely okay with any choice you make), here are some things to consider:<br /></p><p></p><ol style="text-align: left;"><li style="text-align: justify;"><u>Financial constraints</u>: If you are budget-constrained, your choice is a simple one. Since my NYU certificate classes are available, with almost nothing held back, for free on my webpage, why pay for these classes? The corollary to this proposition, however, is if you do choose to take the certificate class, please recognize that NYU sets the prices and complaining to me that the price is too high accomplishes nothing.</li><li style="text-align: justify;"><u>Time constraints</u>: You have lives to live, work to do and families that you want to spend time with, and adding one of my classes to the list of things to do will eat into your time. The NYU certificate classes run on a semester clock, and if it looks like you will be busy for the next few months, you may find yourself unable to finish the class. Unlike some university-offered certificate classes, I do require those who take these certificate classes show me through a project and exams that they understand the material, and I don't give free passes. The two free versions (classroom and free online) do not operate on a calendar. In short, you can start with the regular class in January 2024 and stretch out the class over 12 months or 18 months, if you want to.</li><li style="text-align: justify;"><u>End game</u>: Much as we all like to buy into the notion that learning is what matters, the truth is that some of you may want to use proof of that learning as a ticket to improve your standing in life (get a different job, move up in the ranks). With the free versions, you may very well learn just as much as those taking the class in the classroom, but you will get no credit for the class. Of course, you will get the certificate if you take the NYU certificate version, but NYU will extract its pound of flesh.</li><li style="text-align: justify;"><u>Updating</u>: You will be watching recorded lectures in all three versions of the class, but the timing of these recordings will be different. With the classroom format, you will get an updated 2024 version and in real time, but with the online versions (free and certificate), the sessions will reflect when they were recorded. While my framework and fundamentals remain the same, the examples I will be using will reflect this updating (or lack of it).</li><li style="text-align: justify;"><u>Personal preferences</u>: The online sessions (free and certificate) are shorter (10-20 minutes) and thus more easily amenable to online consumption. Watching an 80-minute session online is not easy, especially in a world of TikTok and short YouTube videos. You may want to try both formats, before you decide.</li></ol><div style="text-align: justify;">The links to all of the classes in their different formats is below:</div><style type="text/css">
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<tr><td><span style="font-size: x-small;">Accounting 101</span></td><td><a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcastacctg.htm"><span style="font-size: x-small;">https://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcastacctg.htm </span></a></td></tr>
<tr><td><span style="font-size: x-small;">Foundations of Finance</span></td><td><span style="font-size: x-small;"><a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcastfoundationsonline.htm">https://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcastfoundationsonline.htm</a> </span></td></tr>
<tr><td><span style="font-size: x-small;">Statistics</span></td><td><a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcaststatistics.htm"><span style="font-size: x-small;">https://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcaststatistics.htm </span></a></td></tr>
<tr><td><span style="font-size: x-small;">Corporate Finance (MBA)</span></td><td><a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcastcfspr24.htm"><span style="font-size: x-small;">https://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcastcfspr24.htm </span></a></td></tr>
<tr><td><span style="font-size: x-small;">Corporate Finance (Online Free)</span></td><td><a href="https://pages.stern.nyu.edu/adamodar/New_Home_Page/webcastcfonline.htm"><span style="font-size: x-small;">https://pages.stern.nyu.edu/adamodar/New_Home_Page/webcastcfonline.htm </span></a></td></tr>
<tr><td><span style="font-size: x-small;">Corporate Finance (NYU Certificate)</span></td><td><a href="https://execed.stern.nyu.edu/products/corporate-finance-with-aswath-damodaran"><span style="font-size: x-small;">https://execed.stern.nyu.edu/products/corporate-finance-with-aswath-damodaran </span></a></td></tr>
<tr><td><span style="font-size: x-small;">Valuation (MBA)</span></td><td><a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcasteqspr24.htm"><span style="font-size: x-small;">https://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcasteqspr24.htm</span></a></td></tr>
<tr><td><span style="font-size: x-small;">Valuation (Undergrads)</span></td><td><a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcasteqUGspr24.htm"><span style="font-size: x-small;">https://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcasteqUGspr24.htm</span></a></td></tr>
<tr><td><span style="font-size: x-small;">Valuation (Online Free)</span></td><td><span style="font-size: x-small;"><a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcastvalonline.htm">https://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcastvalonline.htm </a></span></td></tr>
<tr><td><span style="font-size: x-small;">Valuation (NYU Certificate)</span></td><td><a href="https://execed.stern.nyu.edu/products/advanced-valuation-with-aswath-damodaran"><span style="font-size: x-small;">https://execed.stern.nyu.edu/products/advanced-valuation-with-aswath-damodaran </span></a></td></tr>
<tr><td><span style="font-size: x-small;">Inv Philosophies(Online Free)</span></td><td><a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/invphil.htm"><span style="font-size: x-small;">https://pages.stern.nyu.edu/~adamodar/New_Home_Page/invphil.htm </span></a></td></tr>
<tr><td><span style="font-size: x-small;">Inv Philosophies (NYU Certificate)</span></td><td><span style="font-size: x-small;"><a href="https://execed.stern.nyu.edu/products/investment-philosophies-with-aswath-damodaran">https://execed.stern.nyu.edu/products/investment-philosophies-with-aswath-damodaran</a></span></td></tr></tbody></table><p></p><p style="text-align: justify;"><b>Note that the certificate classes for the spring 2024 will be open for enrollment only until Sunday, January 14, 2024</b>, and that the corporate finance certificate class is available only in the fall.</p><p><i>Sequencing</i></p><p style="text-align: justify;"><i> </i>I like all the classes I teach, and if you asked which one you should take, I would be unable to answer, partly because it depends on what you plan to do in the future. If your question is about sequence, i.e., which classes should be taken first, that too will depend on what your background is and your end game. To help you make these choices, I put together a flow chart:</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh6hIpa9FMBb7Kb4j7vNxnJG-44HJRwSbdKueFU2W0IBUruJJoGc2rE6FhW0kpHbQZB3O8Vn8CKMEQOMF4ijU8CjZ3pC5ogJsUtIOBSFiScBFuDjg2Gxefb-uc_ELF303zgJOJ_gNvw0FsgCxPw3V0j09nfucHxJGwAGUmFdenlbid-ucoBogVq50uu9tU/s1181/ClassGuide.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="783" data-original-width="1181" height="265" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh6hIpa9FMBb7Kb4j7vNxnJG-44HJRwSbdKueFU2W0IBUruJJoGc2rE6FhW0kpHbQZB3O8Vn8CKMEQOMF4ijU8CjZ3pC5ogJsUtIOBSFiScBFuDjg2Gxefb-uc_ELF303zgJOJ_gNvw0FsgCxPw3V0j09nfucHxJGwAGUmFdenlbid-ucoBogVq50uu9tU/w400-h265/ClassGuide.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: justify;">In fact, you may short circuit this sequencing and take only a portion of a class. Thus, if you are involved in banking or project financing, you may choose to take only the capital structure part of the corporate finance class, and if you are a trader, your focus may be on the pricing portion of the valuation class. </div><p></p><p><b>The Joy of Learning</b></p><p style="text-align: justify;"><span> As I </span>watch young children experience the joy of learning, it reinforces my belief that human beings love to learn and that the tragedy of education systems is that they seem to be designed to destroy that love. It would be hubris on my part to claim that I will make you rediscover that love, but I do know that one reason I teach is to expose people to how much I enjoy learning new things or relearning old lessons. I hope that you can see that joy and that some of it rubs off on you! </p><p><b>YouTube Video</b></p><p><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/7fXv-EO5mVg?si=NWUdVecbWqVLMZ-1" title="YouTube video player" width="560"></iframe><b><br /></b></p><p><br /></p>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-87640067750320083822024-01-05T18:36:00.002-05:002024-01-06T13:33:58.609-05:00 Data Update 1 for 2024: The data speaks, but what does it say?<p></p><div style="text-align: justify;"><span> </span>In January 1993, I was valuing a retail company, and I found myself wondering what a reasonable margin was for a firm operating in the retail business. In pursuit of an answer to that question, I used company-specific data from Value Line, one of the earliest entrants into the investment data business, to compute an industry average. The numbers that I computed opened my eyes to how much perspective on the high, low, and typical values, i.e., the distribution of margins, helped in valuing the company, and how little information there was available, at least at that time, on this dimension. That year, I computed these industry-level statistics for five variables that I found myself using repeatedly in my valuations, and once I had them, I could not think of a good reason to keep them secret. After all, I had no plans on becoming a data service, and making them available to others cost me absolutely nothing. In fact, that year, my sharing was limited to the students in my classes, but in the years following, as the internet became an integral part of our lives, I extended that sharing to anyone who happened to stumble upon my website. That process has become a start-of-the-year ritual, and as data has become more accessible and my data analysis tools more powerful, those five variables have expanded out to more than two hundred variables, and my reach has extended from the US stocks that Value Line followed to all publicly traded companies across the globe on much more wide-reaching databases. Along the way, more people than I ever imagined have found my data of use, and while I still have no desire to be a data service, I have an obligation to be transparent about my data analysis processes. I have also developed a practice in the last decade of spending much of January exploring what the data tells us, and does not tell us, about the investing, financing and dividend choices that companies made during the most recent year. In this, the first of the data posts for this year, I will describe my data, in terms of geographic spread and industrial breakdown, the variables that I estimate and report on, the choices I make when I analyze data, as well as caveats on best uses and biggest misuses of the data. </div><br /><b>The Sample</b><br /><div style="text-align: justify;"> While there are numerous services, including many free ones, that report data statistics, broken down by geography and industry, many look at only subsamples (companies in the most widely used indices, large market cap companies, only liquid markets), often with sensible rationale – that these companies carry the largest weight in markets or have the most reliable information on them. Early in my estimation life, I decided that while this rationale made sense, the sampling, no matter how well intentioned, created sampling bias. Thus, looking at only the companies in the S&P 500 may give you more reliable data, with fewer missing observations, but your results will reflect what large market cap companies in any sector or industry do, rather than what is typical for that industry.</div> <br /><div style="text-align: justify;"><span> </span>Since I am lucky enough to have access to databases that carry data on all publicly traded stocks, I choose all publicly traded companies, with a market price that exceeds zero, as my universe, for computing all statistics. In January 2024, that universe had 47,698 companies, spread out across all of the sectors in the numbers and market capitalizations that you see below:</div><div style="text-align: justify;"><br /></div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgEdCO_Bdoc7R3dN5Y7qismE-tJgkOnz8TXa7l2Nu5F-KqFKzztRVw4cq7kiIAne_v8jQgE6AxkGmbJCOVtSH1NxMCloIJgVqbmsB636Oy-ECecNDAHqkqMpkJkikRk-rIfLjOUAGGF2ElVVH-oyXNQ_qlZWXxoxRdXUvppAGv3OdTui1CNdTo0k0Ro_LY/s2262/SamplebySector.jpg" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="2136" data-original-width="2262" height="378" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgEdCO_Bdoc7R3dN5Y7qismE-tJgkOnz8TXa7l2Nu5F-KqFKzztRVw4cq7kiIAne_v8jQgE6AxkGmbJCOVtSH1NxMCloIJgVqbmsB636Oy-ECecNDAHqkqMpkJkikRk-rIfLjOUAGGF2ElVVH-oyXNQ_qlZWXxoxRdXUvppAGv3OdTui1CNdTo0k0Ro_LY/w400-h378/SamplebySector.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;"><a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/data.html">Data on Damodaran Online</a></span></i></td></tr></tbody></table><div style="text-align: justify;">Geographically, these companies are incorporated in 134 countries, and while you can download the number of companies listed, by country, in a dataset at the end of this post, I break the companies down by region into six broad groupings – United States, Europe (including both EU and non-EU countries, but with a few East European countries excluded), Asia excluding Japan, Japan, Australia & Canada (as a combined group) and Emerging Markets (which include all countries not in the other groupings), and the pie chart below provides a picture of the number of firms and market capitalizations of each grouping:</div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgCjaIf5S93Fkr-9o7NYUtQkBIfAy6OUaZIBb_wqJoQlmtMVMHsH7V238CjswiWhc4R8-N2rrlCUpBj-sy_mR4k5l6h0Y-h2QkrfUKQuk2qIgJ7ESHiGNDUZ4n2e9F23M-UpgbTi-dl8RY8OIhzahGttikvqtrkcAiMNtZOqrRRh6xlUxw1oIsUBZXahv8/s2560/SamplebyRegion.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="2190" data-original-width="2560" height="343" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgCjaIf5S93Fkr-9o7NYUtQkBIfAy6OUaZIBb_wqJoQlmtMVMHsH7V238CjswiWhc4R8-N2rrlCUpBj-sy_mR4k5l6h0Y-h2QkrfUKQuk2qIgJ7ESHiGNDUZ4n2e9F23M-UpgbTi-dl8RY8OIhzahGttikvqtrkcAiMNtZOqrRRh6xlUxw1oIsUBZXahv8/w400-h343/SamplebyRegion.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;"><a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/data.html">Data on Damodaran Online</a></span></i></td></tr></tbody></table><p></p><div style="text-align: justify;">Before you take issue with my categorization, and I am sure that there are countries or at least one country (your own) that I have miscategorized, I have three points to make, representing a combination of mea culpas and explanations. First, these categorizations were created close to twenty years ago, when I first started looking a global data, and many countries that were emerging markets then have developed into more mature markets now. Thus, while much of Eastern Europe was in the emerging market grouping when I started, I have moved those countries that have either adopted the Euro or grown their economies strongly into the Europe grouping. Second, I use these groupings to compute industry averages, by grouping, as well as global averages, and nothing stops you from using the average of a different grouping in your valuation. Thus, if you are from Malaysia, and you believe strongly that Malaysia is more developed than emerging market, you should look at the global averages, instead of the emerging market average. Third, the emerging market grouping is now a large and unwieldy one, including most of Asia (other than Japan), Africa, the Middle East, portions of Eastern Europe and Russia and Latin America. Consequently, I do report industry averages for the two fastest growing emerging markets in India and China.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>The Variables</b></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><span> </span>As I mentioned at the start of this post, this entire exercise of collecting and analyzing data is a selfish one, insofar as I compute the data variables that I find useful when doing corporate financial analysis, valuation, or investment analysis. I also have quirks in how I compute widely used statistics like accounting returns on capital or debt ratios, and I will stay with those quirks, no matter what the accounting rule writers say. Thus, I have treated leases as debt in computing debt ratios all through the decades that I have been computing this statistic, even though accounting rules did not do so until 2019, and capitalized R&D, even though accounting has not made that judgment yet. </div><div style="text-align: justify;"><span> </span>In my corporate finance class, I describe all decisions that companies make as falling into one of three buckets – investing decisions, financing decision and dividend decisions. My data breakdown reflects this structure, and here are some of the key variables that I compute industry averages for on my site:</div><div class="separator" style="clear: both; text-align: center;"><br /></div><div style="text-align: justify;"><style type="text/css">
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<thead><tr class="tableizer-firstrow"><th></th><th><span style="font-size: x-small;"> </span></th><th><span style="font-size: x-small;">Corporate Governance & Descriptive</span></th><th><span style="font-size: x-small;"> </span></th><th><span style="font-size: x-small;"> </span></th><th><span style="font-size: x-small;"> </span></th></tr></thead><tbody>
<tr><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;">1.<a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/inshold.html"> Insider, CEO & Institutional holdings</a></span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td></tr>
<tr><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;">2.<a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/DollarUS.html"> Aggregate operating numbers</a></span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td></tr>
<tr><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;">3. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Employee.html">Employee Count & Compensation</a></span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td></tr>
<tr><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td></tr>
<tr><td><span style="font-size: x-small;">I<b>nvesting Principle</b></span></td><td><span style="font-size: x-small;"><b> </b></span></td><td><span style="font-size: x-small;"><b>Financing Principle</b></span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"><b>Dividend Principle</b></span></td><td><span style="font-size: x-small;"> </span></td></tr>
<tr><td><span style="font-size: x-small;"><i>Hurdle Rate</i></span></td><td><span style="font-size: x-small;"><i>Project Returns</i></span></td><td><span style="font-size: x-small;"><i>Financing Mix</i></span></td><td><span style="font-size: x-small;"><i>Financing Type</i></span></td><td><span style="font-size: x-small;"><i>Cash Return</i></span></td><td><span style="font-size: x-small;"><i>Dividends/Buyback</i>s</span></td></tr>
<tr><td><span style="font-size: x-small;">1. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html">Beta & Risk</a></span></td><td><span style="font-size: x-small;">1. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/roe.html">Return on Equity</a></span></td><td><span style="font-size: x-small;">1. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/dbtfund.html">Debt Ratios & Fundamentals</a></span></td><td><span style="font-size: x-small;">1.<a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/debtdetails.html"> Debt Details</a></span></td><td><span style="font-size: x-small;">1. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/divfcfe.html">Dividends and Potential Dividends (FCFE)</a></span></td><td><span style="font-size: x-small;">1.<a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/divfcfe.html">Buybacks</a></span></td></tr>
<tr><td><span style="font-size: x-small;">2. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html">Equity Risk Premiums</a></span></td><td><span style="font-size: x-small;">2. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/fundgrEB.html">Return on (invested) capital</a></span></td><td><span style="font-size: x-small;">2. <a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/corpdefaultspreads2023.xlsx">Ratings & Spreads</a></span></td><td><span style="font-size: x-small;">2.<a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/leaseeffect.html"> Lease Effect</a></span></td><td><span style="font-size: x-small;">2. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/divfund.html">Dividend yield & payout</a></span></td><td><span style="font-size: x-small;"> </span></td></tr>
<tr><td><span style="font-size: x-small;">3. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ratings.html">Default Spreads</a></span></td><td><span style="font-size: x-small;">3. <a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/mgnroc.xls">Margins & ROC</a></span></td><td><span style="font-size: x-small;">3<a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/taxrate.html">. Tax rates</a></span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td></tr>
<tr><td><span style="font-size: x-small;">4. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/wacc.html">Costs of equity & capital</a></span></td><td><span style="font-size: x-small;">4. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/EVA.html">Excess Returns on investments</a></span></td><td><span style="font-size: x-small;"> 4. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/finflows.html">Financing Flows</a></span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td></tr>
<tr><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;">5. <a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/indreg.xls">Market alpha</a></span></td><td><span style="font-size: x-small;"> </span></td><td> </td><td> </td><td></td></tr>
</tbody></table>Many of these corporate finance variables, such as the costs of equity and capital, debt ratios and accounting returns also find their way into my valuations, but I add a few variables that are more attuned to my valuation and pricing data needs as well.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><style type="text/css">
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<thead><tr class="tableizer-firstrow"><th></th><th><span style="font-size: x-small;">Valuation</span></th><th><span style="font-size: x-small;"> </span></th><th><span style="font-size: x-small;">Pricing </span></th></tr></thead><tbody>
<tr><td><i><span style="font-size: x-small;">Growth & Reinvestment</span></i></td><td><i><span style="font-size: x-small;">Profitability</span></i></td><td><i><span style="font-size: x-small;">Risk</span></i></td><td><span style="font-size: x-small;"><i>Multiple</i>s</span></td></tr>
<tr><td><span style="font-size: x-small;">1.<a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histgr.html"> Historical Growth in Revenues & Earnings</a></span></td><td><span style="font-size: x-small;">1. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/margin.html">Profit Margins</a></span></td><td><span style="font-size: x-small;">1. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/wacc.html">Costs of equity & capital</a></span></td><td><span style="font-size: x-small;">1. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/pedata.html">Earnings Multiples</a></span></td></tr>
<tr><td><span style="font-size: x-small;">2. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/fundgr.html">Fundamental Growth in Equity Earnings</a></span></td><td><span style="font-size: x-small;">2. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/roe.html">Return on Equity</a></span></td><td><span style="font-size: x-small;">2. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/optvar.html">Standard Deviation in Equity/Firm Value</a></span></td><td><span style="font-size: x-small;">2. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/pbvdata.html">Book Value Multiples</a></span></td></tr>
<tr><td><span style="font-size: x-small;">3. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/fundgrEB.html">Fundamenal Growth in Operating Earnings</a></span></td><td><br /></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;">3.<a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/psdata.html"> Revenue Multiples</a></span></td></tr>
<tr><td><span style="font-size: x-small;">4.<a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/capex.html"> Long term Reinvestment (Cap Ex & Acquisitons)</a></span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;">4. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/vebitda.html">EBIT & EBITDA multiple</a>s</span></td></tr>
<tr><td><span style="font-size: x-small;">5. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/R&D.html">R&D</a></span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td><td><span style="font-size: x-small;"> </span></td></tr>
<tr><td><span style="font-size: x-small;">6. <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/wcdata.html">Working capital needs</a></span></td><td><span style="font-size: x-small;"> </span></td><td> </td><td></td></tr>
</tbody></table>Thus, I compute pricing multiples based on revenues (EV to Sales, Price to Sales), earnings (PE, PEG), book value (PBV, EV to Invested Capital) or cash flow proxies (EV to EBITDA). In recent years, I have also added employee statistics (number of employees and stock-based compensation) and measures of goodwill (not because it provides valuable information but because of its potential to cause damage to your analysis). </div><div style="text-align: justify;"><span> </span>My data is primarily micro-focused, since there are other services that are much better positioned to provide macro data (on inflation, interest rates, exchange rates etc.). My favorite remains the Federal Reserve data site in St. Louis (<a href="https://fred.stlouisfed.org">know as FRED</a>, and one of the great free data resources in the world), but there are a few macro data items that I estimate, primarily because they are not as easily available, or if available, are exposed to estimation choices. Thus, I report <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html">annual historical returns on asset classes (stocks, bonds, real estate, gold) going back to 1928</a>, mostly because data services seem to focus on individual asset classes and partly because I want to make sure that returns are computed the way I want them to be. I also have <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histimpl.html">implied equity risk premiums</a> (forward-looking and dynamic estimate of what investors are pricing stocks to earn in the future) for the S&P 500 going back annually to 1960 and monthly to 2008, and equity risk premiums for countries. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>The Industry Groupings</b></div><div style="text-align: justify;"><span> </span>I am aware that there are industry groupings that are widely used, including industry codes (SIC and NAICS), I have steered away from these in creating my industry groupings for a few reasons. First, I wanted to create industry groupings that were intuitive to use for analysts looking for peer groups, when analyzing companies. Second, I wanted to maintain a balance in the number of groupings - having too few will make it difficult to differentiate across businesses and having too many will create groupings with too few firms for some parts of the world. The sweet spot, as I see it, is around a hundred industry groupings, and I get pretty close with 95 industry groupings; the table below lists the number of firms within each in my data:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhjjy4tqbjhQUGgUheCZ1Fk2pVgnFcq2jEFme9XPRDch9EKj5ZhmYlm77xKFA2AtdgSgUwqQIRL-aqPpJ5rheyD26poGIRYX2YI8QxmJpsi6r6gRGMHTTR4sBGb7esvhsAjTXsBLqj_p9itm0Iwue8y_LJzEIFyPztUWjHQEPobMn_Q2cF0YGGwBHJDVfA/s2296/IndustryBreakdown.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1268" data-original-width="2296" height="221" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhjjy4tqbjhQUGgUheCZ1Fk2pVgnFcq2jEFme9XPRDch9EKj5ZhmYlm77xKFA2AtdgSgUwqQIRL-aqPpJ5rheyD26poGIRYX2YI8QxmJpsi6r6gRGMHTTR4sBGb7esvhsAjTXsBLqj_p9itm0Iwue8y_LJzEIFyPztUWjHQEPobMn_Q2cF0YGGwBHJDVfA/w400-h221/IndustryBreakdown.jpg" width="400" /></a></div><div style="text-align: justify;">No matter how carefully you create these groupings, you will still face questions about where individual companies fall, especially when each company can be assigned to one industry group. Is Apple a personal computer company, an entertainment company or wireless telecom company? While you can allow it to be in all three, when analyzing the companies, for purposes of computing industry averages, I had to assign each company to a single grouping. If you are interested in seeing which companies fall within each group, you can find it by clicking <a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/indname.xlsx">on this link</a>. (Be patient. This is a large dataset and can take a while to download) </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Data Timing & Currency Effects</b></div><div style="text-align: justify;"><span> </span>In computing the statistics for each of the variables, I have one overriding objective, which is to make sure that they reflect the most updated data that I have at the time that I compute them, which is usually the first week of January. That does lead to what some of you may view as timing contradictions, since any statistic based upon market data (costs of equity and capital, equity risk premiums, risk free rates) is updated to the date that I do the analysis (usually the values at the close of the last trading day of the prior year – Dec 31, 2023, for 2024 numbers), but any statistic that uses accounting numbers (revenues, earnings etc.) will reflect the most recent quarterly accounting filing. Thus, when computing my accounting return on equity in January 2024, I will be dividing the earnings from the four quarters ending in September 2023 (trailing twelve month) by the book value of equity at the end of September 2022. Since this is reflecting of what investors in the market have access to at the start of 2024, it fulfils my objective of being the most updated data, notwithstanding the timing mismatch.</div><div style="text-align: justify;"><span> </span>There are two perils with computing statistics across companies in different markets. The first is differences in accounting standards, and there is little that I can do about that other than point out that these differences have narrowed over time. The other is the presence of multiple currencies, with companies in different countries reporting their financials in different currencies. The global database that I use for my raw data, S&P Capital IQ, gives me the option of getting all of the data in US dollars, and that allows for aggregation across global companies. In addition, most of the statistics I report are ratios rather than absolute values, and are thus amenable to averaging across multiple countries.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Statistical Choices</b></div><div style="text-align: justify;"><span> </span>In the interests of transparency, it is worth noting that there are data items where the reporting standards either don’t require disclosure in some parts of the world (stock-based compensation) or disclosure is voluntary (employee numbers). When confronted with missing data, I do not throw the entire company out of my sample, but I report the statistics only across companies that report that data.</div><div style="text-align: justify;"><span> </span>In all the years that I have computed industry statistics, I have struggled with how best to estimate a number that is representative of the industry. As you will see, when we take a closer look at individual data items in later posts, the simple average, which is the workhorse statistic that most services report for variables, is often a poor measure of what is typical in an industry, either because the variable cannot be computed for many of the companies in the industry, or because, even when computed, it can take on outlier values. Consider the PE ratio, for example, and assume that you trying to measure a representative PE ratio for software companies. If you follow the averaging path, you will compute the PE ratio for each software company and then take a simple average. In doing so, you will run into two problems. </div><div style="text-align: justify;"><ul><li>First, when earnings are negative, the PE ratio is not meaningful, and if that happens for a large number of firms in your industry group, the average you estimate is biased, because it is only for the subset of money-making companies in the industry. </li><li>Second, since PE ratios cannot be lower than zero but are unconstrained on the upside, you will find the average that you compute to be skewed upwards by the outliers. </li></ul>Having toyed with alternative approaches, the one that I find offers the best balance is the aggregated ratio. In short, to compute the PE ratio for software companies, I add up the market capitalization of all software companies, including money-losers, and divide by the aggregated earnings across these companies, against including losses. The resulting value uses all of the companies in the sample, reducing sampling bias, and is closer to a weighted average, alleviating the outlier effect. For a few variables, I do report the conventional average and median, just for comparison. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Using the data</b></div><div style="text-align: justify;"><span> </span>As I noted earlier, the datasets that I report are designed for my use, in corporate financial analysis and valuation that I do in real time. Thus, I plan to use the 2024 data that you see, when I value companies or do corporate financial analysis during the year, and if you are a practitioner doing something similar, it should work for you. You can find this <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datacurrent.html">current data at this link</a>, organized to reflect the categories. </div><div style="text-align: justify;"><span> </span>That said, there are some of you who are not doing your analysis in real time, either because you are in the appraisal business and must value your company as of the start of 2020 or 2021, or a researcher looking at changes over time. I do maintain the <a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/dataarchived.html">archived versions of my datasets for prior years</a> on my webpage, and if you click on the relevant data, you can get the throwback data from prior years.</div><div style="text-align: justify;"><span> </span>There are two uses that my data is put to where you are on your own. The first is in<b> legal disputes</b>, where one or both sides of the dispute seem to latch on to data on my site to make their (opposing) cases. While I clearly cannot stop that from happening, please keep me out of those fights, since there is a reason I don’t do expert witness of legal appraisal work; courts are the graveyards for good sense in valuation. The other is in <b>advocacy work</b>, where data from my site is often selectively used to advance a political or business argument. My dataset on what companies pay as tax rates seems to be a favored destination, and I have seen statistics from it used to advance arguments that US companies pay too much or too little in taxes. </div><div style="text-align: justify;"><span> </span>Finally, my datasets do not carry company-specific data, since my raw data providers (fairly) constrain me from sharing that data. Thus, if you want to find the cost of capital for Unilever or a return on capital for Apple, you will not find it on my site, but that data is available online already, or can be computed from the financial releases from these companies.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>A Sharing Request</b></div><div style="text-align: justify;"><span> </span>I will end this post with words that I have used before in these introductory data posts. If you do use the data, you don’t have to thank me, or even acknowledge my contribution. Use it sensibly, take ownership of your analysis (don’t blame my data for your value being too high or low) and pass on knowledge. It is one of the few things that you can share freely and become richer as you share more. Also, as with any large data exercise, I am sure that there are mistakes that have found their way into the data, and if you find them, let me know, and I will fix them as quickly as I can!</div><br /><b>YouTube Video</b><div><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/8np1_fSeInc?si=7MqPdlEqIeWf8djf" title="YouTube video player" width="560"></iframe><b><br /></b><br /><b> Sample Breakdown</b><br /><ol style="text-align: left;"><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/countrystats.xls">Country Breakdown</a></li></ol><div><b><br /></b><div><b>Links to my data</b><div><ol style="text-align: left;"><li><a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datacurrent.html">Current Data</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/New_Home_Page/dataarchived.html">Archived Data</a></li></ol><div><b>Data Update Posts for 2024</b><p></p><style class="WebKit-mso-list-quirks-style">
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</style></div></div></div></div></div><div><ol style="text-align: left;"><li>Data Update 1 for 2024: The data speaks, but what does it say?</li></ol></div>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-13591711883761805602023-12-10T06:01:00.003-05:002023-12-10T18:57:25.308-05:00The Difference Makers: Key Person(s) Valuation<div style="text-align: justify;"><span> </span>Can one person make a difference to the value of a business? Of course, and with small businesses, especially those built around personal services (a doctor or plumber’s practice), it is part of the valuation process, where the key person is valued or at least priced and incorporated into valuation. While that effect tends to fade as businesses get larger, the tumult at Open AI, where the board dismissed Sam Altman as CEO, and then faced with an enterprise-wide meltdown, as capital providers and employees threatened to quit, illustrates that even at larger entities, a person or a few people can make a value difference. In fact, at Tesla, a company that I have valued at regular intervals over the last decade, the question of what Elon Musk adds or detracts from value has become more significant over time, rather than fading. Finally, Charlie Munger's passing at the age of ninety-nine brought to a close one of the most storied key person teams of all time at Berkshire Hathaway, and generations of investors who had attached a premium to the company because of that team's presence mourned.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Key Person: Who, what and why?</b></div><div style="text-align: justify;"><span> </span>While it is often assumed that key people, at least from a value perspective, are at the top of the organization, usually founders and top management, we will begin this section by expanding the key person definition to include anyone in an organization, and sometimes even outside it. We will then follow up with a framework for thinking about how key people can affect the value of a business, with practical suggestions on valuing and pricing key people. We will end with a discussion of how enterprises try, with mixed effects, to build protections against the loss of key personnel.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><i>Who is a key person?</i></div><div style="text-align: justify;"><span> </span>In the Open AI, Tesla and Berkshire Hathaway cases, it is persons at the top of the organization that have been identified as key value drivers, but the key people in an organization can be at every level, with differing value effects. </div><div style="text-align: justify;"><ul><li>It starts of course with <b>founders who create organizations</b> and lead them through their early years, partly because they represent their companies to the rest of the world, but more because they mold these companies, at least in their formative years. It is worth noting that while some reach legendary status, sharing their names with the organization (like Ford and HP), others are unceremoniously pushed aside, because they were viewed, rightly or wrongly, as unfit to lead their own creations. </li><li>Staying at the top, <b>CEOs for companies</b> often become entwined with their companies, especially as their tenure lengthens. From Alfred Sloan at General Motors to Jack Welch at General Electric to Steve Jobs at Apple, there is a history of CEOs being tagged as superstars (and indispensable to the organizations that they head), in successful companies. By the same token, as with founders, the failures of businesses often rub off on the people heading them, fairly or unfairly.</li><li>As you move down the organization, there can be <b>key players in almost every aspect of business</b>, with scientists at pharmaceutical companies who come up with pathbreaking discoveries that become the basis for blockbuster drugs or design specialists like Jon Ive at Apple, whose styling for Apple’s devices was viewed as a critical component of the company's success. The skills they bring can be unique, or at least very difficult to replace, making them indispensable to the organization's success.</li><li>In businesses driven by selling, a <b>master-salesperson or dealmaker</b> can become a central driver of its value, bringing in a clientele that is more attached to the sales personnel than they are to the organization providing the product or service. In businesses like banking, consulting or the law, rainmakers can represent a significant portion of value, and their departure can be not just damaging but catastrophic.</li><li>In people-oriented businesses, especially in service, a <b>manager or employee that cultivates strong relationships with customers, suppliers and other employees</b>, can be a key person, with the loss of that person leading to not just lost sales, as clients flee, but create ripple effects across the organization.</li><li>In some businesses, the <b>key person may not work for the organization</b> but contribute a significant amount to its value as a spokesperson or product brander. In sports and entertainment, for instance, business can gain value from having a celebrity representing them in a paid or unpaid capacity. In my valuation of Birkenstock for their IPO, just a few weeks ago, I noted the value added to the company by Kate Moss or Steve Jobs wearing their sandals. Over the decades, a significant part of Nike’s value has been gained and sometimes lost from the celebrities who have attached their names to its shoes.</li></ul></div><div style="text-align: justify;">In short, the key person or people in an organization can range the spectrum, with the only thing in common being a “significant effect” on value or price.</div> <div style="text-align: justify;"><br /></div><div style="text-align: justify;"><i>Key Person(s): Value effects</i></div><div style="text-align: justify;"><span> </span>Given my obsession with value, it should come as no surprise that my discussion of key people begins by looking at the many ways that they can affect value. As I identify the multiple key person value drives, note that not all key people affect all value drivers, and the value effects can also vary not only widely across key people, but for the same key person, across time. At the risk of being labeled as a one-trick pony, I will use my intrinsic value framework, and by extension, the <i>It Proposition</i>, where<i> if it does not affect cash flow or risk, it cannot affect value</i>, to lay out the different effects a key person can have on value:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhRejp1LV2CVMFLle57PDN8CEHxhNkuA4egF9Fb7U8Pw-Vo-7E7WoFpEHNobC0GOqBItUCgfvw3Bod9sLjIzBfvPRDc5CDHWDtZtIyOrkB-lFPYLU5zykoWgLmpHiU9x_-wKUDkvTouW_rSLGT0cWm61e6Un2t2Dkq1w_Jp15HfBLjOgZpWipXjmtDE6TI/s940/KeyPersonValueEffect.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="549" data-original-width="940" height="234" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhRejp1LV2CVMFLle57PDN8CEHxhNkuA4egF9Fb7U8Pw-Vo-7E7WoFpEHNobC0GOqBItUCgfvw3Bod9sLjIzBfvPRDc5CDHWDtZtIyOrkB-lFPYLU5zykoWgLmpHiU9x_-wKUDkvTouW_rSLGT0cWm61e6Un2t2Dkq1w_Jp15HfBLjOgZpWipXjmtDE6TI/w400-h234/KeyPersonValueEffect.jpg" width="400" /></a></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">For personnel at the top, and I include founders and CEOs, the effect on value comes from setting the business narrative, i.e., the story that animates the numbers (revenue growth, profit margins, capital intensity and risk) that drives value., and that effect, as I have noted in my earlier discussions of narrative and numbers, can be all encompassing. The effects of people lower down in the organization tend to be more focused on one or two inputs, rather than across the board, but that does not preclude the effect from being substantial. A salesperson who accounts for half the sales of a business and most of its new customers will influence value, through revenues and revenue growth, whereas an operations manager who is a supply chain wizard can have a large impact on profit margins. As someone who teaches corporate finance, I have always tried to pass on the message, especially to those who are headed to finance jobs at companies or investment banks, that of all of the players in an organization, finance people are among the most replaceable, and thus least likely to be key people. It is perhaps the reason that you are less likely to see a company’s value implode even when a well-regarded CFO leaves, though there are exceptions, especially with distressed or declining companies, where financial legerdemain can make the difference between survival and failure.</div><div style="text-align: justify;"><span> </span>With this framework, valuing a key person or persons becomes a simple exercise, albeit one that may require complex assumption. To estimate key person value, there are three general approaches:</div><div style="text-align: justify;"><u>1. Key person valuation</u>: You value the company twice, once with the key persons included, with all that they bring to it’s cash flows and value, and then again, without those key persons, reflecting the changes that will occur to value inputs:</div><div style="text-align: center;"><i>Value of key person(s) = Value of business with key person - Value of business without key person</i></div><div style="text-align: justify;">A key person whose effect on a business is identifiable and isolated to one of the dimensions of value will be easier to value than one whose effects are disparate and difficult to isolate. Thus, valuing a key salesperson is easier than valuing a key CEO, since the former's effects are only on sales and can be traced to that person's efforts, whereas the effect of a CEO can be on every dimension of value and difficult to separate from the efforts of others in the organization.<br /><u>2. Replacement Cost</u>: In some cases, the value of a key person can be computed by estimating the cost of replacing that person. Thus, key people with specific and replicable skills, such as skilled scientists or engineers, may be easier to value than key people, with fuzzier skill sets, such as strong connections and people skills. However, finding replacements for people with unique or blended skills can be more difficult, since they may not exist.</div><div style="text-align: justify;"><u>3. Insurance cos</u>t: Finally, there are some key people in an organization who can be insured, where insurance companies, in return for premium payments, will pay out an amount to compensate for the losses of these key people. For companies that buy insurance, the key person value then become monetized as a cost, reducing the value of these companies when the key person is present, while increasing its value, when it loses that person.</div><div style="text-align: justify;"><span> </span>The key person valuation approach, while general, can not only yield different values for key people, but also generate a value effect that is negative for a key person whose influence has become malignant. The framework can also help explain how the value of a key person can evolve over time, from a significant positive at one stage of an organization to neutral later or even a large negative, explaining why some key people get pushed out of organizations, including those that they may have founded. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><i>Key Person(s): Pricing effects</i></div><div style="text-align: justify;"><span> </span>It is true that markets are pricing mechanisms, not instruments for reflecting value, at least in the short term, and it should come as no surprise then that the effects of a key person are captured in pricing premiums or discounts, sometime arbitrary, and sometimes based upon data. In this section, I will start with the practices used by appraisers to try to adjust the pricing of businesses for the presence or potential loss of a key person and then move on to how markets react to the loss of key personnel at publicly traded companies.</div><div style="text-align: justify;"><span> </span>In appraisal practice, the effect of the potential loss of an owner, founder or other key person in a business that you are acquiring is usually captured with a <i>key person discount</i>, where you price the business first, based upon its existing financials, and then reduce that pricing by 15%, 20% or more to reflect the absence of the key person. Shannon Pratt, in his widely used work on valuing private companies, suggested a key person discount of between 10%-25%, though he left the number almost entirely to appraiser discretion. In addition, the nature of private company appraisal, where valuations are done for tax or legal purposes, has also meant that the acceptable levels of discount for key people have been determined more by courts, in their rulings on these valuations, than by first principles.</div><div style="text-align: justify;"><span> </span>In public companies, the market reaction to the loss of key personnel can be an indication of how much investors priced the presence of those personnel. Empirically, the research in this area is deepest on CEO departures, with the market reaction to those departures broken down by cause into Acts of God (death), firing or retirement. </div><div style="text-align: justify;"><ol><li><u>CEO Deaths</u>: In the <a href="https://www.ft.com/content/a7ce31e0-06f0-4986-9eb9-f4322a40ffc3">HBO hit series, Succession, the death of Logan Roy</a>, the imperious CEO of the company causes the stock price of Waystar Royco, his family-controlled company, to drop precipitously. While that was fiction, and perhaps exaggerated for dramatic effect, there is research that looks at the market reaction to the deaths of CEOs of publicly traded companies, albeit with mixed results. A <a href="http://onlinelibrary.wiley.com/doi/10.1002/smj.2504/abstract">study of CEO deaths at 240 publicly traded companies</a> between 1950 and 2009 finds that in almost half of all of these cases, the stock price increases on the death of a CEO, and unsurprisingly, the reactions tended to be positive with under-performing CEOs and negative with highly regarded ones. Interestingly, this study also finds that the impact of CEOs, both positive and negative, was greater in the later time periods, than in earlier periods. A<a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=819564"> different study</a> documented that the stock price reaction to CEO deaths was greater for longer-tenured CEOs in badly performing firms, strengthening the negative value effect argument.</li><li><u>CEO (forced) replacements</u>: CEOs are most likely to be replaced in companies, where their policies are at odds with those that their shareholders desire, but given the powers of incumbency, change may require the presence of a large and vocal shareholder (activist), pushing for change. To the extent that shareholders have good reasons to be disgruntled, the companies can be viewed as case studies for key-person negative value, where the top manager is reducing value with his or her actions. Research on what happens to stock prices and company performance after forced replacements <a href="https://centaur.reading.ac.uk/77085/1/2018-05-05%20CEO%20Forced%20Turnovers%20Editor%20changes.pdf">largely confirm this hypothesis,</a> with stock prices rising on the firing, and improved performance following, under a new CEO.</li><li><u>CEO retirements</u>: If CEO deaths represent unexpected losses of key people, and CEO dismissals represent the subset of firms where CEOs are more likely to be value-reducing key people, it stands to reason that CEO retirements should be more of a mixed bag. Research backs up this hypothesis, with the average stock price reaction to voluntary CEO departures being close to zero, with a mildly negative reaction to age-related departures. It is worth noting that market reactions tend to be much more positive, when CEOs are replaced by outsiders than by someone from within the firm, suggesting that shareholders see value in changing the way these businesses are run.</li></ol>The positive reaction, at least on average, to CEO firing is understandable since CEOs usually get replaced by boards only after extended periods of poor performance at companies or personal scandal, and investors are pricing in the expectation that change is likely to be positive. The positive reaction to some CEO deaths is macabre, but it does reflect the reality that they are more likely to occur in organizations that are badly in need of fresh insights. </div><div style="text-align: justify;"><span> There are a few case studies that look at how the market reacts to a company signing or losing a key celebrity spokesperson or product endorser, especially when that loss is unexpected. Thus, when Tiger Woods, who operated as a spokesperson or product endorser for five companies (</span>Accenture, Nike, Gillette, Electronic Arts and Gatorade), had personal troubles that were made public, <a href="https://www.moneylife.in/article/tiger-woods-sponsors-lose-5billion-12-billion-in-just-13-days/2986.html#:~:text=The%20study%20also%20finds%20that,equivalent%20to%20about%20%246%20billion.">these five companies collectively lost 2-3% of their market value (about $5-12 billion)</a>. That should come as little surprise, since Tiger Wood's product endorsements, prior to this incident, had added significant value to these companies, with o<a href="https://www.jstor.org/stable/24544945">ne study noting that Nike generated a 10% increase in profits in its golf ball division</a>, after the endorsement. In an earlier episode, Nike also lost billions in market capitalizations, when Michael Jordan, an NBA superstar whose name-branded footwear (Air Jordan) had become a game changer for Nike, <a href="https://www.essentiallysports.com/nba-news-nikes-designer-reveals-the-turmoil-and-panic-michael-jordan-caused-due-to-his-retirement-in-1993/">unexpectedly announced in 1993</a>, that he would be retiring from basketball, to play baseball. Finally, and this is perhaps a reach at this point, the biggest story coming out of the National Football League (NFL) this year has been the Taylor Swift-Travis Kielce romance, which in addition to creating tabloid headlines, has <a href="https://www.forbes.com/sites/bradadgate/2023/10/02/the-nfl-and-travis-kelce-is-benefitting-from-the-taylor-swift-effect/?sh=7c0607385f31">also increased NFL ratings</a>, especially among women. Is it possible that the person who adds the most value to the NFL this year is not Patrick Mahomes (its highest profile quarterback) or Roger Goodell (its commissioner), but a pop star? Time will tell, but it is not an implausible claim.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><i>Managing Key Person Value</i></div><div style="text-align: justify;">A business that has significant positive value exposure to a key person can try to mitigate that risk, albeit with limits. The actions taken can vary depending on the key person involved, with more effective protections against losses that are easily identifiable.</div><div style="text-align: justify;"><ol><li><u>Insurance</u>: Smaller businesses that are dependent on a person or persons for a significant portion of their revenues and profits can buy insurance against losing them, with the insurance premia reflecting the expected value loss. To the extent that the insurance actuaries who assess the premiums are good at their jobs, companies buying key person insurance even out their earnings, trading lower earnings (because of the premiums paid) in periods when the key person is still present for higher earnings, when they are absent. It is also true that key person insurance is easier to price and buy, when the effects of a key person are separable and identifiable, as is the case of a master salesperson with a track record, than when the effects are diffuse, as is the case for a star CEO who sets narrative.</li><li><u>No-compete clauses</u>: One of the concerns that businesses have with key people is not just the loss of value from their departure, but that these key people can take client lists, trade secrets or product ideas to a competitor. It is for this reason that companies put in no-compete clauses into employment contracts, but the degree of protection will depend on what the key person takes with them, when they leave. No-compete clauses can prevent a key person from taking a client list or soliciting clients at a direct competitor, but will offer little protection when the skills that the person possesses are more diffuse.</li><li><u>Overlapping tenure</u>: As we noted earlier, it is routine, when pricing smaller, personal service businesses to attach a significant discount to the pricing of those businesses, on the expectation that a portion of the client base is loyal to the old owner, not the business. Since this reduces the sales proceeds to the old owner, there is an incentive to reduce the key person discount, and one practice that may help is for the old owner to stay on in an official or unofficial capacity, even after the business has been sold, to smooth the transition.</li><li><u>Team building</u>: To the extent that key people can build teams that reflect and magnify their skills, they are reducing their key person value to the business. That team building includes hiring the “right’ people and not just offering them on-the-job training and guidance, but also the autonomy to make decisions on their own. In short, key people who refuse to delegate authority and insist on micro-management will not build teams that can do what they do.</li><li><u>Succession planning</u>: For key people at the top of organizations, the importance of succession planning is preached widely, but practiced infrequently. A good succession plan starts of course by finding the person with the qualities that you believe are necessary to replicate what the key person does, but being willing to share knowledge and power, ahead of the transfer of power.</li></ol></div><div style="text-align: justify;">As you can see, some of the actions that reduce key people value must come from those key people, and that may seem odd. After all, why would anyone want to make themselves less valuable to an organization? The truth is that from the organization's perspective, the most valuable key people find ways to make themselves more dispensable and less valuable over time by finding successors and building teams who can replicate what they can do. That may be at odds with the key person's interests, leading to a trade off a lower value added from being key people for a much higher value for the organization, and if they own a large enough stake in the latter, can end with being better off financially at the end. I have been open about my loyalty to Apple over the decades, but even as an Apple loyalists, I admire Bill Gates for building a management team that he trusted enough, at Microsoft, to step down as CEO in 2000, and while I cringe at Jeff Bezos becoming tabloid fodder, he too has built a company, in Amazon, that will outlast him. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Determinants of Key Person Value</b></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><span> </span>If key person value varies across businesses and across time, it is worth examining the forces that determine that value effect, looking for both management and investment lessons. In particular, key people will tend to matter more at smaller enterprises than at larger ones, more at younger firms than at mature businesses, more at businesses that are driven by micro factors than one driven by macro forces and more at firms with shifting and transitory moats than firms with long-standing competitive advantages.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><i>Company size</i></div><div style="text-align: justify;"><span> </span>In general, the value of a key person or persons should decrease as an organization increases in size. The value added by a superstar trader will be greater if he or she works at a ten-person trading group than if they work at a large investment bank. There are clearly exceptions to this rule, with Tesla being the most visible example, but at the largest companies, with hundreds or even thousands of employees, and multiple products and clients, it becomes more and more difficult for a single person or even a group of people to make a significant difference. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><i>Stage in Corporate Life Cycle</i></div><div style="text-align: justify;"><span> </span>I have written about how companies, like human beings, are born, mature, age and die, and have used the corporate life cycle as a framework to talk about corporate financial and investment choices. I also believe it provides insight into the key person value discussion:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhxXh83S1oLchmaa5e7d5y9Fa0rsElxnZOnl3ARh5CoOqs1EWNLnRsh5PJo-nau3IxFNx4Az6cjCoTQNeRUK_r3wbScaLcwe7HAjVf6joCJC5uhetX-3Y46XjRgoru6CUk36MtkHBZ9SDAk9E41dDN0mNxk3BLxTBs5CQ3mJ3EDNCXF9n-qi8c18i6nitc/s785/LifeycleKeyCEO.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="559" data-original-width="785" height="285" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhxXh83S1oLchmaa5e7d5y9Fa0rsElxnZOnl3ARh5CoOqs1EWNLnRsh5PJo-nau3IxFNx4Az6cjCoTQNeRUK_r3wbScaLcwe7HAjVf6joCJC5uhetX-3Y46XjRgoru6CUk36MtkHBZ9SDAk9E41dDN0mNxk3BLxTBs5CQ3mJ3EDNCXF9n-qi8c18i6nitc/w400-h285/LifeycleKeyCEO.jpg" width="400" /></a></div><div style="text-align: justify;">As you can see, early in the life cycle, where the corporate narrative drives value, a single person, usually a founder, can make or break the business, with his or her capacity to set narrative and inspire loyalty (from employees and investors). As a business ages, CEOs matter less, as the business takes form, and scales up, and less of its value comes from future growth. At mature companies, CEOs often are custodians of value in assets in place, playing defense against competitors, and while they have value, their potential for value-added becomes smaller. At a company facing decline, the value of a key person at the top ticks up again, partly in the hope that this person can resurrect the company and partly because a CEO for a declining company who doubles down on bad growth choices can destroy value over short periods. The research provides support, with evidence that CEO deaths at young companies more likely to evoke large negative stock price reactions. </div><div style="text-align: justify;"><span> </span>This life-cycle driven view of the value of to management may provide some perspective into the key person effects at both Open AI and Tesla.</div><div style="text-align: justify;"><ul><li>At OpenAI, for better or worse, it is Sam Altman who has been the face of the company, laying out the narrative for the future of AI, and Open AI remains a young company, notwithstanding its large estimated value. While the board of directors felt that Altman was on a dangerous path, the capital providers, which included not only venture capitalists, but Microsoft as a joint-venture investor, were clearly swayed not in agreement, and Open AI’s employees were loyal to him. In short, once Open AI decided to open the door to eventually being not just a money-making business, but one worth $80 billion or more, Altman became the key person at the company, as Open AI’s board discovered very quickly, and to its dismay.</li><li>With Tesla, the story is more complicated, but this company has always revolved around Elon Musk. As a young company, where investors and legacy auto companies viewed it as foolhardy in its pursuit of electric cars, Musk's vision and drive was indispensable to its growth and success. As Tesla has brought the rest of the auto business around to its narrative, and become not just a successful company, but one worth a trillion dollars or more at its peak, Musk has remained the center of the story, in good and bad ways. His vision continues to animate the company’s thinking on everything from the Cybertruck to robo-taxis, but his capacity for distraction has also sometimes hijacked that narrative. Thus, the debate of whether Musk, as a key person, is adding or detracting from Tesla’s value has been joined, and while I remain convinced that he remains a net positive, since I cannot imagine Tesla without him, there are many who disagree with me. At the same time, Musk is mortal and it remains an open question whether he is willing to make himself dispensable, by not only building a management teams that can run the company without him, but also a successor that he is willing to share power and the limelight.</li></ul></div><div style="text-align: justify;">In general, the life cycle framework explains why good venture capitalists often spend so much time assessing founder qualities and why public market investors, especially those who focus on mature companies, can base their investments on just financial track records.</div> <div style="text-align: justify;"><br /></div><div style="text-align: justify;"><i>Micro versus Macro</i></div><div style="text-align: justify;"><span> </span>There are some companies where value comes more from company-specific decisions on products/services to offer, markets to enter and pricing decisions, and others, where the value comes more from macro variables. A media company, like Disney, where movie or television offerings constantly have to adjust to reflect changing demand and in response to competition, would be an example of the former, whereas an oil company, where it is the oil price that is the key determinant of revenues and earnings, would be an example of the latter.</div><div style="text-align: justify;"><span> </span>In general, you are far more likely to find key people, who can add or take away from value at the former (micro companies) than at the latter (macro companies). Consider the heated arguments that you are hearing about Bob Iger and his return to the CEO position at Disney, with Nelson Peltz in the mix, arguing for change. While some of the forces affecting Disney are across entertainment companies, as I noted in this post, I also argued that whether Disney ends up as one of the winners in this space will depend on management decisions on which businesses to growth, which ones to shrink or spin off and how they are run. With Royal Dutch, it is true that canny management can add to oil reserves, by buying them when oil prices are low, but for the most part, much of what happens to it is impervious to who runs the company. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><i>Business Moats</i></div><div style="text-align: justify;"><span> </span>Business moats refer to competitive advantages that companies have over their competitors that allow them to not just grow and be profitable, but to create value by earning well above their cost of capital. That said, moats can range the spectrum, both in terms of sources (cheap raw material, brand names, patents) as well as sustainability (some last for decades and others are transitory). Some moats are inherited by management, and others are earned, and some are high maintenance and others require little care.</div><div style="text-align: justify;"><span> </span>In general, there will be less key person value at companies with inherited moats that are sustainable and need little care, and more key person value at companies where moats need to be recreated and maintained. To illustrate, consider two companies at opposite ends of the spectrum. At one end, Aramco, one of the most valuable companies in the world, derives almost all of its value from its control of the Saudi oil sands, allowing it to extract oil at a traction of the cost faced by other oil companies, and it is unlikely that there is any person or group of people in the organizational that could affect its value very much. At the other end, an entertainment software company like Take-Two Interactive is only as good as its latest game or product, and success can be fleeting. It should come as no surprise that there are far more key people, both value-adders and value-destroyers, in these businesses than in most others. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Implications</b></div><div style="text-align: justify;"><span><b> </b>The notion that a key person or persons can add or detract from the value of an organization is neither surprising nor unexpected, but having a structured framework for examining the value effects can yield interesting implications.</span><br /></div><div style="text-align: justify;"><b><br /></b></div><div style="text-align: justify;"><i>Aging of key person(s)</i></div><div style="text-align: justify;"><i> </i>There are many reasons that key persons leave companies, and while companies can try to stave them off by taking actions to protect key people, there is one reason - aging and death - which are inexorable and inevitable. As key people, especially at the top of an organization age, investors should start factoring in not just their eventual departures, but a decline in effectiveness, as they get older. Speaking of key people in large companies, Berkshire Hathaway has a had a special status, an insurance company with the best portfolio managers in the world in Warren Buffett and Charlie Munger. Well before Munger's passing, Buffett and Munger had bowed to advancing age and had passed the baton on to Ted Weschler and Todd Combs. While Buffett undoubtedly still has a say in investment choices, it is also clear that he has a far lesser role than he used ro, which may explain Berkshire's <a href="https://www.nasdaq.com/articles/1-artificial-intelligence-ai-stock-warren-buffett-owns-that-you-may-want-to-buy-hand-over">bet on a company like Snowflake</a>, a company that has a snowball's chance in hell of getting through a Buffett-Munger investment screening.<br /></div><div style="text-align: justify;"><span> Are markets building in the recognition that Berkshire Hathaway's future will be in the hands of someone other than the two legendary leaders? I think so, and one way to see how markets have adjusted expectations is by comparing the price to book ratio that Berkshire Hathaway trades at relative to a typical insurance company:</span><br /></div><div style="text-align: justify;"><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhsVyRcFV5bnyofm0DGcCMiRy-e5ezTC8uFSDI7uXoGhWC7tl1H2ScuzLMHaYPQ97E2gvT5AvzZSAP97X8k7oPYmUXh9fLCC1o0TCSWYPkndG40m1QuXu0Vo96XuwTUrcKYABOGdeX6tujDk70uspuiVVYUF4wOM9meYpS6lPRRgovAIqrsVuub0mRY5bU/s954/BHHistory.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="615" data-original-width="954" height="258" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhsVyRcFV5bnyofm0DGcCMiRy-e5ezTC8uFSDI7uXoGhWC7tl1H2ScuzLMHaYPQ97E2gvT5AvzZSAP97X8k7oPYmUXh9fLCC1o0TCSWYPkndG40m1QuXu0Vo96XuwTUrcKYABOGdeX6tujDk70uspuiVVYUF4wOM9meYpS6lPRRgovAIqrsVuub0mRY5bU/w400-h258/BHHistory.jpg" width="400" /></a></div></div><div style="text-align: justify;"><span><br /></span></div><div style="text-align: justify;"><span>In the last decade, as you can see, Berkshire Hathaway's price to book has drifted down, and relative to insurance companies in the aggregate, the Buffett-Munger premium has largely dissipated, suggesting that while Combs and Weschler are well-regarded stock pickers, they cannot replace Buffett and Munger. That may explain why Berkshire's stock price was unaffected by Munger's passing.</span></div><div style="text-align: justify;"><span><br /></span></div><div style="text-align: justify;"><div><i>Industry Structure</i></div><div> As we shift away from a twentieth century economy, where manufacturing and financial service companies dominated, to one where technology and service companies are atop the largest company list, we are also moving into a period where value will come as much from key people in the organization as it does from physical assets. It follows that companies will invest more in human capital to preserve their value, and here, as in much of the new economy, accounting is missing the boat. While there have been attempts to increase corporate disclosure about human capital, the impetus seems to be coming more from diversity advocates than from value appraisers. If human capital is to be treated as a source of value, what companies spend in recruitment, training and nurturing employee loyalty is more capital expenditure than operating expense, and as with any other investment, these expenses have to be judged by the consequences in terms of employee turnover and key person losses.</div></div><div style="text-align: justify;"><i><br /></i></div><div style="text-align: justify;"><i>Compensation</i></div><div style="text-align: justify;"><span> </span>To the extent that key people deliver more value to companies, it stands to reason that they will try to claim some or all of that added value for themselves. In organizations where they are valuable key people, you should expect to see much greater differences in compensation across employees, with the most valued key people being paid large multiples of what the typical employee earns. In addition, to encourage these key people to make themselves less key, by building teams and grooming successors, you would expect the pay to be more in the form on equity (restricted stock or options) than in cash.While that may strike you as inequitable or unfair, it reflects the economics of businesses, and legislating compensation limits will either cause key people to move on or to find loopholes in the laws. </div><div style="text-align: justify;"><span> </span>Lest I be viewed as an apologist for monstrously large top management compensation packages, the key person framework can be a useful in holding to account boards of directors that grant absurdly high compensation packages to top managers in companies, where their presence adds little value. Thus, I don’t see why you would pay tens of millions of dollars to the CEOs of Target (a mature to declining retail company, no matter who runs it), Royal Dutch (an almost pure oil play) or Coca Cola ( where the management is endowed with a brand name that they had little role in creating). This may be a bit unfair, but I would wager that an AI-generated CEO could replace the CEOs of half or more of the S&P 500 companies, and no one would notice the difference.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>In conclusion</b></div><div style="text-align: justify;"><span> There are many canards about intrinsic valuation that are in wide circulation, and one is that intrinsic valuations do not reflect the value of people in a company. That is not true, </span>since intrinsic valuations, done right, should incorporate the value of a key person or people in a business, reflecting that value in cash flows, growth or risk inputs. That said, intrinsic value is built, not on nostalgia or emotion, but on the cold realities that key people can sometimes destroy value, that a key person in a company can go from being a value creator to a value destroyer over time and that key people, in particular, and human capital, in general, will matter less in some companies (more mature, manufacturing and with long-standing competitive advantages) than in other companies (younger, service-oriented and with transitory and changing moats. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>YouTube Video</b></div><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/_cjUNmwvJD8?si=0Y8lLwbbN-tn9wPT" title="YouTube video player" width="560"></iframe><style class="WebKit-mso-list-quirks-style">
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</style>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-51564452738094749992023-11-01T13:01:00.003-04:002023-11-01T15:01:31.875-04:00Tesla in November 2023 : Story twists and turns, with value consequences!<p style="text-align: justify;">I was planning to start this post by telling you that Tesla was back in the news, but that would be misleading, since Tesla never leaves the news. Some of that attention comes from the company's products and innovations, but much of it comes from having Elon Musk as a CEO, a man who makes himself the center of every news cycle. That attention has worked in the company's favor over much of its lifetime, as it has gone from a start-up to one of the largest market cap companies in the world, disrupting multiple businesses in the process. At regular intervals, though, the company steps on its own story line, creating confusion and distractions, and during these periods, its stock price is quick to give up gains, and that has been the case for the last few weeks. As the price dropped below $200 today (October 30,2023), I decided that it was time for me to revisit and revalue the company, taking into account the news, financial and other, that has come out since my last valuation in January 2023, and to understand the dueling stories that are emerging about the company.</p><p><b>My Tesla History</b></p><p style="text-align: justify;"><b> </b>When I write and teach valuation, I describe it as a craft, and there are very few companies that I enjoy practicing that craft more than I do with Tesla. Along the way, I have been wrong often on the company, and if you are one of those who only reads valuations by people who get it right all the time, you should skip the rest of this post, because I will cheerfully admit that I will be wrong again, though I don't know in which direction. My <a href="https://aswathdamodaran.blogspot.com/2013/09/valuation-of-week-1-tesla-test.html">first valuation of Tesla was in 2013</a>, when it was a nascent automobile firm, selling less than 25,000 cars a year, and viewed by the rest of the automobile sector with a mix of disdain and curiosity. I valued it as a luxury automobile firm that would succeed in that mission, giving it Audi-level revenues in 2023 of about $65 billion, and operating margins of 12.50% that year (reflecting luxury auto margins). To deliver this growth, I did assume that Tesla would have to invest large amounts of capital in capacity, and that this would create a significant drag on value, resulting in a equity value of just under $10 billion.</p><p style="text-align: justify;"><span> In subsequent valuations, I modified and adapted this story to reflect lessons that I learned about Tesla, along the way. First, I learned that the company was capable of generating growth much more efficiently, and more flexibly, than other auto companies, reducing the capital investment needed for growth. Second, I noticed that Tesla customers </span>were almost fanatically attached to the company's products, and were willing to evangelize about it, yielding a brand loyalty that legacy auto companies could only dream about. Third, in a world where many companies are run by CEO who are, at best, operating automatons, and at worst, evidence of the Peter Principle at play, where incompetence rises to the top, Tesla had a CEO whose primary problem was too much vision, rather than too little. In valuation terms, that results in a company whose value shifts with narrative changes, creating not only wide swings in value, but vast divergences in opinion on value. In 2016, <a href="https://aswathdamodaran.blogspot.com/2016/07/tesla-story-meets-numbers-promise-meets.html">I looked at how Tesla's story would vary depending upon the narrative</a> you had for the company and listed some of the possible choices in a picture:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgLbdr4qyOinfbZo_dgKQzamnNTl2T_zApDDzLPj-RJj2JJ4lo0N9FMoOvwHWujx9QlovuF4Us8rKFQnhGwRn-BdmZYt8PDA28IyApYQDm-1GT6G6j_g8tr3QtGDz-50AG3ogTt3JhqgEW0chPpgA6tUeWNqv83d674Qaq6gXw3FqyG8AYtsUzG0Mi1HTs/s1426/TEslaoStoryin2016.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="776" data-original-width="1426" height="217" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgLbdr4qyOinfbZo_dgKQzamnNTl2T_zApDDzLPj-RJj2JJ4lo0N9FMoOvwHWujx9QlovuF4Us8rKFQnhGwRn-BdmZYt8PDA28IyApYQDm-1GT6G6j_g8tr3QtGDz-50AG3ogTt3JhqgEW0chPpgA6tUeWNqv83d674Qaq6gXw3FqyG8AYtsUzG0Mi1HTs/w400-h217/TEslaoStoryin2016.jpg" width="400" /></a></div><div style="text-align: justify;">I translated these stories into inputs on revenue growth, profit margins and reinvestment, to arrive at a template of values:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjxXDKrPVCK6YSjf6juQBsyc2tQf3SnmPvYdi7jObr3bOEOnFRSjDSA9ZqVb4hpo2itFSXJz4Til0ko9VlbEHQiDAHyvs2yShmyLdAE2oPEaO9iTSdiuS2YfCyEpSq8bFRtjkHMVufBEb4iRj6hwEM89ot9MFL2QEuux9cesGxAUd_9DUeL1QCjScWCIg8/s1468/TeslaValuesin2016.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="596" data-original-width="1468" height="163" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjxXDKrPVCK6YSjf6juQBsyc2tQf3SnmPvYdi7jObr3bOEOnFRSjDSA9ZqVb4hpo2itFSXJz4Til0ko9VlbEHQiDAHyvs2yShmyLdAE2oPEaO9iTSdiuS2YfCyEpSq8bFRtjkHMVufBEb4iRj6hwEM89ot9MFL2QEuux9cesGxAUd_9DUeL1QCjScWCIg8/w400-h163/TeslaValuesin2016.jpg" width="400" /></a></div>Note that is multiple stock splits ago, and the prices per share here are not comparable to the share price today, but the overall lessons contained in this table still apply. First, when you see significant disagreements about what Tesla is worth, those differences come from divergent stories, not disagreements about numbers. Second, every news story or financial disclosure about Tesla has to be used to evaluate how the company's narrative is changing, creating multiplier effects that create disproportionate value changes.<div style="text-align: justify;"> Along the way, Tesla (or more precisely, Elon Musk) has made choices that could be, at best, described as puzzling, and, at worst, as perilous for the company's long term health, from <a href="https://aswathdamodaran.blogspot.com/2017/08/a-tesla-2017-update-disruptive-force.html">borrowing money in 2017</a>, when equity would have been a much better choice, to setting arbitrary targets on production (remember the <a href="https://www.bloomberg.com/news/articles/2018-06-29/tesla-reaches-moment-of-truth-in-mad-dash-to-make-5-000-cars-per-week">5000 cars a week</a> for the company in 2018) and cash flows (<a href="https://twitter.com/elonmusk/status/984705630106673152">positive cash flows in 2018</a>) that pushed the company into a corner. If you add to that the self-inflicted wounds including Musk tweeting out that he had a deal to <a href="https://twitter.com/elonmusk/status/1026872652290379776?lang=en">sell the company at $420 a share, funding secured</a>, in 2018, it is not surprising that the stock has had periods of trauma. It was after one of these downturns in 2019, when the stock hit $180 (with a market cap of $32 billion), that <a href="https://aswathdamodaran.blogspot.com/2019/06/teslas-travails-curfew-for-corporate.html">I bought Tesla for the first time</a>, albeit labeling it as my corporate teenager, an investment that would frustrate me because it would get in the way of its own potential. </div><div style="text-align: justify;"> I profited mightily on that investment, but I <a href="https://aswathdamodaran.blogspot.com/2020/01/an-ode-to-luck-revisiting-my-tesla.html">sold too soon</a>, when Tesla's market capitalization hit $150 billion, and just before COVID put the company on a new price orbit. In fact, I<a href="https://aswathdamodaran.blogspot.com/2021/11/teslas-trillion-dollar-moment-valuation.html"> revisited the company's value in November 2021</a>, when its market capitalization hit a trillion, marveling at its rise, but also noting that it was priced to deliver such wondrous results ($600-$800 billion in revenues, with 20%+ margins) that I was uncomfortable going along:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh_9Tgxa51eX8K2Yd4ii8ODtzwpeb5tqZbMwtcgkkgr08Bl1mA24QQzJknEKun_9OScOx0hiDBavrdut927AWPSYGFGCT6F7cPt5h02gFy8rrtkAMXlRhYf5WATAXF0Bz8nrVKiwBPhxjEu1V993JWLmQBM6kYIjs2-q4W_sIs6KZFGVCbTV9DcE67KcXc/s1510/TeslaWhatifTable.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="406" data-original-width="1510" height="108" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh_9Tgxa51eX8K2Yd4ii8ODtzwpeb5tqZbMwtcgkkgr08Bl1mA24QQzJknEKun_9OScOx0hiDBavrdut927AWPSYGFGCT6F7cPt5h02gFy8rrtkAMXlRhYf5WATAXF0Bz8nrVKiwBPhxjEu1V993JWLmQBM6kYIjs2-q4W_sIs6KZFGVCbTV9DcE67KcXc/w400-h108/TeslaWhatifTable.jpg" width="400" /></a></div><div><br /></div><div style="text-align: justify;">In 2022, the stock came back to earth with a vengeance, losing more than 65% of its equity value, leaving the stock (on a post-split basis) trading at close to $100 a share at the end of the year. Three weeks later, i.e., at the start of 2023, <a href="https://aswathdamodaran.blogspot.com/2023/01/tesla-in-2023-return-to-reality-start.html">I revalued the stock</a>, allowing for uncertainties in my estimate of revenues and margins to deliver a median value per share of $153, with significant variation in potential outcomes:</div><div class="separator" style="clear: both; text-align: center;"><br /></div><div><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi-iTHZ946LWKJqszJcE7fI6rxS3IMk43nkMBUsD7fRmgvCt1HxXZJN1HJo69K-ljGkwtq9N-HaUquUSUPUncXjJosH4PhiX6vIXfOBSnV-02X0BVOK7N1LE2kg-Mmt-TD3LYoVNGrKKeBY79k4aVXqj3ky7wV4Oh7rn2-oSGYZNAgPzi0Nr8QyJLmcIgI/s1454/TeslaSimulation.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1130" data-original-width="1454" height="311" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi-iTHZ946LWKJqszJcE7fI6rxS3IMk43nkMBUsD7fRmgvCt1HxXZJN1HJo69K-ljGkwtq9N-HaUquUSUPUncXjJosH4PhiX6vIXfOBSnV-02X0BVOK7N1LE2kg-Mmt-TD3LYoVNGrKKeBY79k4aVXqj3ky7wV4Oh7rn2-oSGYZNAgPzi0Nr8QyJLmcIgI/w400-h311/TeslaSimulation.jpg" width="400" /></a></div>I was about a week late on my valuation, since the stock price had already broken through this value by the time I finished it, leaving my portfolio Tesla-free, in 2023.<div><p><b>Tesla Update</b></p><p style="text-align: justify;"><b> </b>My last Tesla valuation is less than ten months old, and while that is not long in calendar time, with Tesla, it feels like an eternity, with this stock. As a lead in to updating the company’s valuation, it makes sense to start with the stock price, the market’s barometer for the company's health. The stock, which started the year in a swoon, recovered quickly in the first half of the year, peaking around mid-year at close to $300 a share. </p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhMX3yHfTo2ftoG0iR-5mUwAp-XP-suzLqJvIZwmGTLbs6kk6fdLTddCnIANzSj3vNiBn7X-voKPU2jHSR7fIFqqPDMv_ScMATd3YvA3ARW3gdafQ79m5Lrt2_eizvlT0tW66SBGZ1ntp13EoaW33BMTku6jx1CaCdLx6nPt1E9nmFK3ySxGps8-p2Boaw/s1172/TSLAstockpriceChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="860" data-original-width="1172" height="294" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhMX3yHfTo2ftoG0iR-5mUwAp-XP-suzLqJvIZwmGTLbs6kk6fdLTddCnIANzSj3vNiBn7X-voKPU2jHSR7fIFqqPDMv_ScMATd3YvA3ARW3gdafQ79m5Lrt2_eizvlT0tW66SBGZ1ntp13EoaW33BMTku6jx1CaCdLx6nPt1E9nmFK3ySxGps8-p2Boaw/w400-h294/TSLAstockpriceChart.jpg" width="400" /></a></div><p style="text-align: justify;">The last four months have tested the stock, and it has given back a significant portion of its gains this year, with the stock dropping below $200 on October 30, 2023. Since earnings reports are often viewed as the catalysts for momentum shifts, I have highlighted the four earnings reports during the course of 2023, with a comparison of earnings per share reported, relative to expectations. The first earnings report, in January 2023, has been the only one where the company beat expectations, and it matched expectations in the April report, and fallen behind in the July and October reports. </p><p><span> The earnings per share focus misses much of Tesla’s story, and it is instructive to dig deeper into the income statement and examine how the company has performed on broader operating metrics:</span></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgHgJt8H4l-2UYpvnyJtDQ-WWPICqnzJeGjnBQs-2_bEKlU80gFMtCI_vQCGEy12z9CW_U2eBWbxOiaWX2WXahuFJ3JUy5itd10hk5St2zgti7px_lvHa9EwqgxNfkKwIrvDeBsudOrVCa3ddt8Ak13xQePqoETOyFH6rxlrSK61yDpV76jE9E3NenZX00/s1740/TeslaQtrlyHistory.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1676" data-original-width="1740" height="385" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgHgJt8H4l-2UYpvnyJtDQ-WWPICqnzJeGjnBQs-2_bEKlU80gFMtCI_vQCGEy12z9CW_U2eBWbxOiaWX2WXahuFJ3JUy5itd10hk5St2zgti7px_lvHa9EwqgxNfkKwIrvDeBsudOrVCa3ddt8Ak13xQePqoETOyFH6rxlrSK61yDpV76jE9E3NenZX00/w400-h385/TeslaQtrlyHistory.jpg" width="400" /></a></div><p style="text-align: justify;">In the twelve months, ending September 2023, Tesla <u>reported operating income of $10.7 billion on revenues of $95.9 billion</u>; that puts their revenues well ahead of my 2013 projection of $65 billion, albeit with an operating margin of 11.18%, lagging my estimate of 12.5%. That makes Tesla the eleventh largest automobile company in the world, in revenue terms, and the seventh most profitable on the list, making it more and more difficult for naysayers to argue that it is a fad that will pass. Breaking down the news in the financials by business grouping, here is what the reports reveal:</p><ul style="text-align: left;"><li style="text-align: justify;"><u>Auto business</u>: Tesla's auto business saw revenue growth slow down from the torrid pace that it posted between 2020 and 2022, with third quarter year-on-year revenue growth dropping to single digits, but given the flat sales in the auto sector and a sluggish electric car market, it remains a stand-out. The more disappointing number, at least for those who were expecting pathways to software-company like margins for the company, was the decline in profit margins on automobiles from 2022 levels, though the 17.42% gross margin in the third quarter, while disappointing for Tesla, would have been cause for celebration at almost any of its competitors.</li><li style="text-align: justify;"><u>Energy business</u>: Tesla's energy business, which was grounded by its acquisition of Solar City in 2016, has had a strong year, rising from 4.8% of the company's revenues in 2022 to 6.2% in the twelve months ending September 2023. In conjunction, the profitability of the business also surged in the last twelve months, and while some of this increase will average out, some of it can be attributed to a shift in emphasis to storage solutions (battery packs and other) from energy generation.</li></ul><div style="text-align: justify;">In short, Tesla's financial reports, are an illustration of how much expectations can play a role in how markets react to the news in them. The post-COVID surge in Tesla's revenues and profitability led to unrealistically high expectations of what the company can do in this decade, and the numbers, especially in the last two quarters, have acted as a reality check.</div><div style="text-align: justify;"><span> As a story stock, Tesla is affected as much by news stories about the company and its CEO, as it is by financials, and there are three big story lines about the company that bear on its value today:</span><br /></div><div><ol style="text-align: left;"><li style="text-align: justify;"><u>Price Cuts</u>: During the course of 2023, Tesla has repeatedly <a href="https://www.reuters.com/business/autos-transportation/tesla-slashes-prices-model-3-models-y-vehicles-us-2023-10-06/">cut prices on its offerings</a>, with the most recent ones coming earlier this month, The $1,250 reduction in the Model 3 should see its price drop to about $39,000, making it competitive, even on a purely price basis, in the mass auto market in the United States. Some of this price cutting is tactical and in response to competition, current or forecast, but some of it may reflect a shift in the company's business model.</li><li style="text-align: justify;"><u>Full Self Driving (FSD)</u>: Tesla, as a company, has <a href="https://www.bloomberg.com/news/articles/2022-11-24/tesla-opens-floodgates-for-owners-to-test-out-automated-driving?utm_medium=cpc_search&utm_campaign=NB_ENG_DSAXX_DSAXXXXXXXXXX_EVG_XXXX_XXX_COUSA_EN_EN_X_BLOM_GO_SE_XXX_XXXXXXXXXX&gclid=EAIaIQobChMIrZHUnPOeggMV6QKtBh2EEwF1EAMYASAAEgIcK_D_BwE&gclsrc=aw.ds&embedded-checkout=true">pushed its work on full self driving</a> to the forefront of its story, though there remains a divide in how far ahead Tesla is of its competition, and the long term prospects for automated driving. Its novelty and news value has made it a central theme of debate, with Tesla fans and critics using its successes and failures as grist for their social media postings. While an autopilot feature is packaged as a standard feature with Teslas, it offers FSD software, which is still <a href="https://www.notateslaapp.com/news/1625/tesla-starts-public-release-of-fsd-beta-11-4-7-1-with-over-50-new-features">in beta version</a>, offers an enhanced autopilot model, albeit at a price of $12,000. The FSD news stories have also reignited talk of a robotaxi business for Tesla, with leaks from the company of a $25,000 vehicle specifically aimed at that business.</li><li style="text-align: justify;"><u>Cybertruck</u>: After years of waiting, the Tesla Cybertruck is here, and it too has garnered outsized attention, partly because of its<u><a href="https://www.axios.com/2019/11/22/tesla-debuts-first-electric-pickup-truck"> unique design </a></u>and partly because it is Tesla's entree into a market, where traditional auto companies still dominate. While there is still debate about whether this product will be a niche offering or one that changes the trucking market, it has undoubtedly drawn attention to the company. In fact, the company's<a href="https://docs.google.com/spreadsheets/d/1--6OR9ECwSwZdkOtWkuslJVCyAAfQv1eJal1fdngfsk/edit#gid=982860347"> reservation tracker </a>records more than two millions reservations (with deposits), though if history is a guide, the actual sales will fall well short of these numbers.</li></ol><div style="text-align: justify;">This being Tesla, there are dozens of other stories about the company, but that is par for the course. We will focus on these three stories because they have the potential to upend or alter the Tesla narrative, and by extension, its value.</div></div><p><b>Story and Valuation: Revisit and Revaluation</b></p><p style="text-align: justify;"><b> </b>In my Tesla valuations through the start of 2023, I have valued Tesla as an automobile company, with the other businesses captured in top line numbers, rather than broken out individually. That does not mean that they are adding significantly to value, but that the value addition is buried in an input to value, rather than estimated standing alone. In my early 2023 valuation, I estimated an operating margin of 16% for Tesla, well above auto industry averages, because I believed that software and or the robotaxi businesses, in addition to delivering additional revenues, would augment operating margins, since they are high-margin businesses. <span> </span></p><p style="text-align: justify;"><span> </span>The news stories about Tesla this year have made me reassess that point of view, since they feed into the narrative that Tesla not only believes that the software and robotaxi businesses have significant value potential as stand-alone businesses, but it is acting accordingly. To see why, let me take each of the three news story lines and work them into my Tesla narrative:</p><p style="text-align: justify;"></p><ol><li><span><u style="text-align: left;">Cybertrucks</u>: The easiest news items to weave into the Tesla narrative is the Cybertruck effect. If the advance orders are an indication of pent-up demand and the Cybertruck represents an extension into a hitherto untapped market, it does increase Tesla's revenue growth potential. There are two potential negatives to consider, and Musk referenced them during the course of the most recent earnings call. The first is that, even with clever design choices, at their rumored pricing, the margins on these trucks will be lower than on higher-end offerings. The other is that the Cybertruck </span>may very well require dedicated production facilities, pushing up reinvestment needs. <span>If Cybertruck sales are brisk, and the demand is strong, the positives will outweigh the negatives, but if the buzz fades, and it becomes a niche product, it may very well prove a distraction that reduces value. The value added by Cybertrucks will also depend, in part, on who buys them, with Tesla gaining more if the sales comes from truck buyers, coming from other companies, than it will if the sales comes from Tesla car buyers, which will cannibalize their own sales.</span></li><li><span style="text-align: left;"><u>FSD</u>: As I look at the competing arguments about Tesla's FSD research, it seems clear to me that both sides have a point. On the plus side, Tesla is clearly further along this road than any other company, not only from a technological standpoint, but also from business model and marketing </span>standpoints. While I do not believe that charging $12,000 for FSD as an add-on will create a big market, lowering that price will open the door not only to software sales to Tesla drivers, but perhaps even to other carmakers. In addition, it seems clear to me that the Tesla robotaxi business has now moved from possible to plausible on my scale, and thus merits being taken seriously. On the minus side, I do agree that the world is not quite ready for driverless cars, on scale, and that rushing the product to market can be catastrophic. </li><li><span style="text-align: left;"><u>Price cuts</u>: The Tesla price cuts have led to a divide among Tesla bulls, with some pointing to it as the reason for Tesla's recent pricing travails and others viewing it as a masterstroke advancing it on its mission of global domination. To decide which side has the more realistic perspective, I decided to take a look at how price cuts play out in value for a generic company. The first order effect of a price cut is negative, since lowering prices will lower margins and profits, and it is easy to compute. It is the second order effects that are tricky, and I list the possibilities in the figure below, with value consequences: <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiJSu7Y9sxu1c5iN_CsKoaJasJXuJ9V2rfXsC00oNhBkoLZXnnirqpwgVRa8M5Sp1IBON79QOOaoeiaijLyalZni4kbSDyTe-SCjkdJGqt-7SnquWfUhWBG1sWwvevX1ZfJbUAFY12Q0a-fQ9ilGQoB7JZtRy3S2xT4oYJw5ZRCbWFI1nOF3LEZEsYDOyY/s1778/Price%20utsValue.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1188" data-original-width="1778" height="268" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiJSu7Y9sxu1c5iN_CsKoaJasJXuJ9V2rfXsC00oNhBkoLZXnnirqpwgVRa8M5Sp1IBON79QOOaoeiaijLyalZni4kbSDyTe-SCjkdJGqt-7SnquWfUhWBG1sWwvevX1ZfJbUAFY12Q0a-fQ9ilGQoB7JZtRy3S2xT4oYJw5ZRCbWFI1nOF3LEZEsYDOyY/w400-h268/Price%20utsValue.jpg" width="400" /></a></div><br />In short, price cuts can, and often will, change the number of units sold, perhaps offsetting some of the downside to price cut (tactical), make it more difficult for competitors to keep up or enter your business (strategic) and expand the potential for side or supplemental businesses to thrive (synergistic). This figure explains the divide on the Tesla price cuts, with the pessimists arguing that electric car demand is too inelastic for volume increases that will compensate for the lower margins, and the optimists arguing that the value losses from lower margins will be more than offset by a long-term increase in Tesla's market share, and increase the value from their software and robotaxi businesses.</span></li></ol><p></p><p>To bring these stories into play, I break Tesla down into four businesses - the auto business, the energy business, the software business and the robotaxi business. I do know that there will be Tesla optimists who will argue that there are other businesses that Tesla can enter, including insurance and robots, but for the moment, I think that the company has its hands full. I look out the landscape for these businesses in the picture below, looking at the potential size and profitability of the market for each of these businesses, as well as Tesla's standing in each.</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgKjLBoi41FDi8IVGjmza9jOI8PLVyPnH-BERS7sYXTls-LhyK1X3Z6-MfM8HLgM4_TLY5y3eHLfhAfoV2x0IuP9AQw-fhmoiPPd5BAesVh8bmIQ8oEytEZ7q_56d7QsV-nl_IEXuGvXzA_Ij5Yl2VlhVPiJNA1XEt6htRhxYASNZR3gwUczBtGg1B6iuI/s1420/TeslaBusinesses.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="962" data-original-width="1420" height="303" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgKjLBoi41FDi8IVGjmza9jOI8PLVyPnH-BERS7sYXTls-LhyK1X3Z6-MfM8HLgM4_TLY5y3eHLfhAfoV2x0IuP9AQw-fhmoiPPd5BAesVh8bmIQ8oEytEZ7q_56d7QsV-nl_IEXuGvXzA_Ij5Yl2VlhVPiJNA1XEt6htRhxYASNZR3gwUczBtGg1B6iuI/w447-h303/TeslaBusinesses.jpg" width="447" /></a></div><p>Note that the auto business is, by far, the largest in terms of revenue potential, but it lags the other business in profitability, especially the software and robotaxi businesses, where unit economics are favorable and margins much higher. Note also that estimates for the future in the robotaxi and auto software businesses are squishy, insofar as they are till nascent, and there is much that we do not know.<u>My</u> Tesla story for each of these businesses is below, with revenue and profitability assumption, broken down by business:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhMYqGHcxWkOIKksZTEID-XAXNRaEVhH0S4I3O8pW0pbdYM_4Foyp2YA3H_3jHlatoPn9M61cuKPVETsR1YEHigB9rKcXkUAO_Iv4k5H0v6iF3rDW9U_NV8s_szpSoxPxX_OPv0BWTGAbsUTeEmXggOifNC5i9u0hIKdaWwTRrNN13msmsadRv1_-QrA6U/s1632/TeslaBusinessesStories.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1144" data-original-width="1632" height="280" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhMYqGHcxWkOIKksZTEID-XAXNRaEVhH0S4I3O8pW0pbdYM_4Foyp2YA3H_3jHlatoPn9M61cuKPVETsR1YEHigB9rKcXkUAO_Iv4k5H0v6iF3rDW9U_NV8s_szpSoxPxX_OPv0BWTGAbsUTeEmXggOifNC5i9u0hIKdaWwTRrNN13msmsadRv1_-QrA6U/w400-h280/TeslaBusinessesStories.jpg" width="400" /></a></div><div><br /></div><div>With these stories in place, I estimate revenues, earnings and cash flows for the businesses, and in sum, for the company, and use these cash flows to estimate a value per share for the company:</div><div><br /></div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEicURRl_4w-IPD9egal5d3H9_iJ9BhOQUllP1WTluHwlfM5p2o9Pi1LZc0BPzzJHQuem5bHpq-My_WHnKkjLOj4zZ5nzkFdQvFjcUQlc36xtZEUGj5BmFlnmec8gMNpmUkykNkJ2DqudSwBIv9j8HMaLDdkbv9FyEO25d5Dp-z3o8QdrtqETecJaW6VGi4/s2156/TEslaValOct23Picture.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="2026" data-original-width="2156" height="376" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEicURRl_4w-IPD9egal5d3H9_iJ9BhOQUllP1WTluHwlfM5p2o9Pi1LZc0BPzzJHQuem5bHpq-My_WHnKkjLOj4zZ5nzkFdQvFjcUQlc36xtZEUGj5BmFlnmec8gMNpmUkykNkJ2DqudSwBIv9j8HMaLDdkbv9FyEO25d5Dp-z3o8QdrtqETecJaW6VGi4/w400-h376/TEslaValOct23Picture.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Tesla2023OctDIY.xlsx">Download spreadsheet</a></td></tr></tbody></table><div style="text-align: justify;"><br /></div><div style="text-align: justify;">In sum, the value per share that I get with Tesla's businesses broken down and allowing for divergent growth and profitability across businesses, is about $180 a share. That is higher than my estimate at the start of the year, with part of that increase coming from the higher profit potential in the side businesses, and expectations of a much larger end game in each one. </div><div style="text-align: justify;"><span> Given that this value comes from four businesses, you can break down the value into each of those businesses, and I do so below:</span><br /></div><div style="text-align: justify;"><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgxOZzC-r_jtfbmZUfPIYtTblQvOxi3uF921HErQjx7C_eulUk3mv1a5pw9n4k_ktDYiumV-J-oe_gTl1qO-WSGZwakny4zG7iEREEYQOZvXROp4zbMR-caZAn2ixaXS7R5lBGF3VvlcfjQOLeLg8kzawkLOqdy2pI_macLeEK-gyRgXATPDikdK-6SqoM/s3656/TeslaValueBreakdown.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="2652" data-original-width="3656" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgxOZzC-r_jtfbmZUfPIYtTblQvOxi3uF921HErQjx7C_eulUk3mv1a5pw9n4k_ktDYiumV-J-oe_gTl1qO-WSGZwakny4zG7iEREEYQOZvXROp4zbMR-caZAn2ixaXS7R5lBGF3VvlcfjQOLeLg8kzawkLOqdy2pI_macLeEK-gyRgXATPDikdK-6SqoM/w400-h290/TeslaValueBreakdown.jpg" width="400" /></a></div>Just as a note of caution, these businesses are all linked together, since the battery technology that drives the auto and energy businesses are shared, and FSD software sales will be tied to car sales. Consequently, you would not be able to spin off or sell these businesses, at least as these estimated values, but it does provide a sense of investors should watch for in this company. Thus, with a chunk of value tied to FSD, from software and robotaxis, any signs of progress (failure) on the FSD front will have consequences for value.<span><br /></span></div><div style="text-align: justify;"><b><br /></b></div><div style="text-align: justify;"><b>An Action Plan</b></div><div style="text-align: justify;"><span> </span>As you review my story and numbers, you will undoubtedly have very different views about Tesla going forward, and rather than tell me that you disagree with my views, which serves neither of us, please download the spreadsheet and make your own projections, by business. So, if you believe that I am massively underestimating the size of the robotaxi business, please do make your own judgment on how big it can get, with the caveat that making that business bigger will make your auto and software businesses smaller. After all, if everyone is taking robotaxis, the number of cars sold should drop off and existing car owners may be less likely to pay extra for a FSD package. </div></div><div style="text-align: justify;"><span> At $197 a share, Tesla remains over valued, at least based on my story, but a stock that has dropped $54 in price in the last few weeks could very well drop another $20 in the next few. To capture that possibility, I have a limit buy at my estimated value of $180, with the acceptance that it may never hit that price in this iteration. For those of you who wonder why I don't have a margin of safety (MOS), I have argued that the MOS is a blunt instrument that is most useful when <u>you are valuing mature companies where you face a luxury of riches (lots of under valued companies)</u>. Furthermore, as my January 2023 simulation of Tesla value reveals, this is a company with more upside than downside, and that make a fair-value investment one that I can live with. Put simply, the possibility of other businesses that Tesla can enter into adds optionality that I have not incorporated into my value, and that acts as icing on the cake.</span></div><div style="text-align: justify;"><span><span> </span>Obviously, and this will sound like the postscript from an email that you get from your investment banking friends, I am not offering this as investment advice. Unlike those investment banking email postscripts, I mean that from the heart and am not required by either regulators or lawyer to say it. I believe that investors have to take ownership of their investment decisions, and I would suggest that the only way for you to make your own judgment on Tesla is to frame your story, and value it based on that story. Of course, you are welcome to use, adapt or just ignore my spreadsheet in that process.</span><br /></div><div style="text-align: justify;"><span><br /></span></div><div style="text-align: justify;"><span><b>YouTube Video</b></span></div><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/iqyfByXmZHI?si=pfxneOkkLQBXvnzB" title="YouTube video player" width="560"></iframe><div style="text-align: justify;"><span><b><br /></b></span></div><div style="text-align: justify;"><span><br /></span></div><div style="text-align: justify;"><b>Data and Spreadsheets</b></div><div style="text-align: justify;"><ol><li><a href="https://www.sec.gov/Archives/edgar/data/1318605/000162828023034847/tsla-20230930.htm">Tesla 10Q (third quarter of 2023)</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Tesla2023OctDIY.xlsx">My Tesla Valuation (October 30, 2023)</a></li></ol></div>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-58053175281104559362023-10-12T14:10:00.082-04:002023-10-12T16:14:00.922-04:00Good Intentions, Perverse Outcomes: The Impact of Impact Investing!<p style="text-align: justify;"> <span> I have made no secret of my disdain for ESG, an <a href="https://aswathdamodaran.blogspot.com/2020/09/sounding-good-or-doing-good-skeptical.html">over-hyped and over-sold acronym</a>, that has been a <a href="https://aswathdamodaran.blogspot.com/2021/09/the-esg-movement-goodness-gravy-train.html">gravy train for a whole host of players</a>, including fund managers, consultants and academics. In response, I have been told that the problem is not with the idea of ESG, but in its measurement and application, and that impact investing is the solution to both market and society's problems. Impact investing, of course, is investing in businesses and assets based on the expectation of not just earning financial returns, but also creating positive change in society. </span></p><p style="text-align: justify;"><span><span> </span>It is human nature to want to make the world a better place, but does impact investing have the impact that it aims to create? That is the question that I hope to address in this post. In the course of the post, I will work with two presumptions. The first is that the problems for society that impact investing are aiming to address are real, whether it be climate change, poverty or wealth inequality. The second is that impact investors have good intentions, aiming to make a positive difference in the world. I understand that there will be some who feel that these presumptions are conceding too much, but I want to keep my focus on the mechanics and consequences of impact investing, rather than indulge in debates about society's problems or question investor motives.</span></p><p style="text-align: justify;"><b>Impact Investing: The What, The Why and the How!</b></p><span><div style="text-align: justify;"><span> Impact</span> investments are investments made with the intent of generating benefits for society, alongside a financial return. That generic definition is not only broad enough to cover a wide range of impact investing actions and motives, but has also been with us since the beginning of time. Investors and business people have often considered social payoffs when making investments, though they have differed on the social outcomes that they seek, and the degree to which they are willing to sacrifice the bottom line to achieve those outcomes. </div><div style="text-align: justify;"><span> </span>In the last two decades, this age-old investing behavior has come under the umbrella of impact investing, with several books on how to do it right, academic research on how it is working (or not), and organizations dedicated to advancing its mission. The Global Impact Investing Network (GIIN), a non-profit that tracks the growth of this investing movement, estimated that more than $1.16 trillion was invested by impact investors in 2021, with a diverse range of investors:</div><table cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEje5YI-lrjFf3p33GdLWAQdrCYuPJd1v0OkecTDAMa7YCFfd_W6SsccVrr8jycsE5EHH9sB0DHKIGVyMU9fyoXvHNCCaCFLvGKY1Yf2z-uUPhAbs6QxbMJmnVG0i_4eoAzMM77hvmZHG0ObtArOzMhg8-4R0z1j0wtrFMET8p8rO0LHcEFbWGqegoSJpNc/s1130/ImpactInvestorsMakeUpChart.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="920" data-original-width="1130" height="326" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEje5YI-lrjFf3p33GdLWAQdrCYuPJd1v0OkecTDAMa7YCFfd_W6SsccVrr8jycsE5EHH9sB0DHKIGVyMU9fyoXvHNCCaCFLvGKY1Yf2z-uUPhAbs6QxbMJmnVG0i_4eoAzMM77hvmZHG0ObtArOzMhg8-4R0z1j0wtrFMET8p8rO0LHcEFbWGqegoSJpNc/w400-h326/ImpactInvestorsMakeUpChart.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><span style="font-size: x-small;"><i>Global Impact Investing Network, 2022 Report</i></span></td></tr></tbody></table><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Not surprisingly, the balance between social impact and financial return desired by investors, varies across investor groups, with some more focused on the former and others the latter. In a survey of impact investors, GIIN elicited these responses on what types of returns investors expected to earn on their impact investments, broken down by groups:</div><div style="text-align: justify;"><br /></div><table cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhI3QmqoPTkqHbFfP1l7Z97s5CJNGRx5y7blipC93ph5GBEsr8z-Qy9FiJekNYVARjOm-5OujKW3xN_eJ7ewDTM2TVhzZS8rkGcA4Hh-ONQqmBZg9e0m_QaaHtvFamvnEINH7wTcVlZM8vZiJkbFmjWFfBDwf4gq_XpangCyiz6XUER9alxyfcNhdLdDzM/s1258/InvestorMotiveChart.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="942" data-original-width="1258" height="300" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhI3QmqoPTkqHbFfP1l7Z97s5CJNGRx5y7blipC93ph5GBEsr8z-Qy9FiJekNYVARjOm-5OujKW3xN_eJ7ewDTM2TVhzZS8rkGcA4Hh-ONQqmBZg9e0m_QaaHtvFamvnEINH7wTcVlZM8vZiJkbFmjWFfBDwf4gq_XpangCyiz6XUER9alxyfcNhdLdDzM/w400-h300/InvestorMotiveChart.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i>Global Impact Investing Network, 2020 Report</i></td></tr></tbody></table><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Almost two thirds of impact investors believe that they can eat their cake and have it too, expecting to earn as much or more than a risk-adjusted return, even as they do good. That delusion running deepest among pension funds, insurance companies, for-profit fund managers and diversified financial investors, who also happen to account for 78% of all impact investing funds.</div><div style="text-align: justify;"><span> </span>If having a positive impact on society, while earning financial returns, is what characterizes impact investing, it can take one of three forms:</div></span><div><ol style="text-align: left;"><li style="text-align: justify;"><u>Inclusionary Impact Investing</u>: On the inclusionary path, impact investors seek out businesses or companies that are most likely to have a positive impact on whatever societal problem they are seeking to solve, and invest in these companies, often willing to pay higher prices than justified by the financial payoffs on the business. </li><li style="text-align: justify;"><u>Exclusionary Impact Investing</u>: In the exclusionary segue, impact investors sell shares in businesses that they own, or refuse to buy shares in these businesses, if they are viewed as worsening the targeted societal problem.</li><li style="text-align: justify;"><u>Evangelist Impact Investing</u>: In the activist variant, impact investors buy stakes in businesses that they view as contributing to the societal problem, and then use that ownership stake to push for changes in operations and behavior, to reduce the negative social or environmental impact.</li></ol></div><div style="text-align: justify;">The effect of impact investing in the inclusionary and exclusionary paths is <u>through the stock price</u>, with the buying (selling) in inclusionary (exclusionary) investing pushing stock prices up (down), which, in turn, decreases (increases) the costs of equity and capital at these firms. The changes in costs of funding then show up in investing decisions and growth choices at these companies, with good companies expanding and bad companies shrinking. </div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgcuACWphhHVi76c1M78vFpgorao8kuYph1I1NCrtzHO-Xp46tB1rIlklVKj_E3Tjx8K6wYEOWHhUwQ6KXgpNpcLUkSHmSGEw9S0rGhwHvGwIG4-rDg2OZQDyuGpk6DldiBs0D3g9JxX-s9QHj0UL6MTytqwM6n48HhyvzD2k63mAO3lr2fU-dqXfb5-Kk/s1422/ImpactInestingEffect.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="456" data-original-width="1422" height="103" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgcuACWphhHVi76c1M78vFpgorao8kuYph1I1NCrtzHO-Xp46tB1rIlklVKj_E3Tjx8K6wYEOWHhUwQ6KXgpNpcLUkSHmSGEw9S0rGhwHvGwIG4-rDg2OZQDyuGpk6DldiBs0D3g9JxX-s9QHj0UL6MTytqwM6n48HhyvzD2k63mAO3lr2fU-dqXfb5-Kk/s320/ImpactInestingEffect.jpg" width="320" /></a></div><div style="text-align: justify;">With evangelist impact investing, impact investors aim to get a critical mass of shareholders as allies in pushing for changes in how companies operate, shifting the company away from actions that create bad consequences for society to those that have neutral or good consequences.</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgkpqn_8MJgKSL27A_jH3q8qAf9zHO0UXcMn9JDQH-jsAiwetXrzt-E4JqP8UnTXNB27jbTbvsecU6IrMsi9nTqHlR1sLvMtapq6yXpNrvNvNCxOzXbUqInn4ft6cbfONsLQ-FbjiCo0G_BY_tvQM11ap-7fsLP6iggn2yVn_4LV38ZdSF3t3Fo79muEgY/s1436/ActivistImpact.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="184" data-original-width="1436" height="51" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgkpqn_8MJgKSL27A_jH3q8qAf9zHO0UXcMn9JDQH-jsAiwetXrzt-E4JqP8UnTXNB27jbTbvsecU6IrMsi9nTqHlR1sLvMtapq6yXpNrvNvNCxOzXbUqInn4ft6cbfONsLQ-FbjiCo0G_BY_tvQM11ap-7fsLP6iggn2yVn_4LV38ZdSF3t3Fo79muEgY/w400-h51/ActivistImpact.jpg" width="400" /></a></div><div style="text-align: justify;"><span><br /></span></div><div style="text-align: justify;"><span>As you can see, for impact investing to have an impact on society, a series of links have to work, and if any or all of them fail, there is the very real potential that impact investing can have perverse consequences.</span></div><div><ul style="text-align: left;"><li style="text-align: justify;">With inclusionary investing, there is the danger that you <u>mis-identify the companies capable of doing good</u>, and flood these companies with too much capital. Not only is capital invested in these companies wasted, but increases the barriers to better alternatives to doing good. </li><li style="text-align: justify;">With exclusionary investing, pushing prices down below their "fair" values will a<u>llow investors who don’t care about impact to earn higher returns</u>, from owning these companies. More importantly, if it works at reducing investment from public companies in a "bad" business, it will o<u>pen the door to private investors to fill the business void</u>. </li><li style="text-align: justify;">With evangelist investing, <u>an absence of allies among other shareholders</u> will mean that your attempts to change the course of businesses will be largely unsuccessful. Even when you are successful in dissuading these companies from "bad" investments, but may not be able to stop them from returning the cash to shareholders as dividends and buybacks, rather than making "good" investments.</li></ul></div><div style="text-align: justify;"><span>In the table below, I look at the potential for perverse outcomes under each of three impact investing approaches, using climate change impact investing as my illustrative example:</span></div><div><br /><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgl8nHN7cTFvuQuqik-VNJUVAWxsRh69YrY8IWZW7EamtpOGEkpTCajnh9_SZ4fX8Tw2jToaVBdhcUSnyfAOslvgL4j5m4_aKitSzvcIdfGudnJaz9Js46ixzZkgoxk4kmViT352jWOpBwHPYISUk6N137j5XxSsK3R_qeYR7nC6odg-k4EOLeN2DIJFLE/s1494/impactgoodvsperverseimpacts.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1110" data-original-width="1494" height="297" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgl8nHN7cTFvuQuqik-VNJUVAWxsRh69YrY8IWZW7EamtpOGEkpTCajnh9_SZ4fX8Tw2jToaVBdhcUSnyfAOslvgL4j5m4_aKitSzvcIdfGudnJaz9Js46ixzZkgoxk4kmViT352jWOpBwHPYISUk6N137j5XxSsK3R_qeYR7nC6odg-k4EOLeN2DIJFLE/w400-h297/impactgoodvsperverseimpacts.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><i><br /></i></div><div class="separator" style="clear: both; text-align: left;">The question of whether impact investing has beneficial or perverse effects is an empirical question, not a theoretical one, since your assumptions about market depth, investor behavior and business responses can lead you to different conclusion.</div><div class="separator" style="clear: both; text-align: justify;"><span> It is worth noting that impact investing may have no effect on stock prices or on corporate behavior, either because there is too little money behind it, or because there is offsetting investing in the other direction. In those cases, impact investing is less about impacting society and more about alleviating the guilt and cleansing the consciences of the impact investors, and the only real impact will be on the returns that they earn on their portfolios. </span><br /></div><p><b>The Impact of Impact Investing: Climate Change</b></p><p style="text-align: justify;"><b> </b>While impact investing can be directed at any of society's ills, it is undeniable that its biggest focus in recent years has been on climate change, with hundreds of billions of dollars directed at reversing its effects. Climate change, in many ways, is also tailored to impact investing, since concerns about climate change are widely held and many of the businesses that are viewed as good or bad, from a climate change perspective, are publicly traded. As an empirical question, it is worth examining how impact investing has affected the market perceptions and pricing of green energy and fossil fuel companies, the operating decisions at these companies, and most critically, on the how we produce and consume energy.<br /></p><p><b><i>Fund Flows</i></b></p><p style="text-align: justify;"><b><i><span> </span></i></b> The biggest successes of climate change impact investing have been on the funding side. Not only has impact investing directed large amounts of capital towards green and alternative energy investments, but the movement has also succeeded in convincing many fund managers and endowments to divest themselves of their investments in fossil fuel companies. </p><p style="text-align: justify;"></p><ul><li>As concerns about climate change have risen, the money invested in alternative energy companies has expanded, with $5.4 trillion cumulatively invested in the last decade:</li></ul><p></p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh6FVFXd6D8DzK4g9v2MQn-uQzH7rJaP5xevS7HRDaj2HdcqhZ8UMoj6KbdBy-EGtHQnojtIwq29yLXgJLdRRMc0f1A1jO19q5EtHiWyzYnrKpyqDaGDaIOnhz9kCdbBOh3DGeyZT97TdIGB1JKer7T0FzsbdN3oD-J-0fwdTd6VMeEh_1dVHiJACAtsEo/s1758/FundFlowGreen.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1282" data-original-width="1758" height="291" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh6FVFXd6D8DzK4g9v2MQn-uQzH7rJaP5xevS7HRDaj2HdcqhZ8UMoj6KbdBy-EGtHQnojtIwq29yLXgJLdRRMc0f1A1jO19q5EtHiWyzYnrKpyqDaGDaIOnhz9kCdbBOh3DGeyZT97TdIGB1JKer7T0FzsbdN3oD-J-0fwdTd6VMeEh_1dVHiJACAtsEo/w400-h291/FundFlowGreen.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;">Source: BloombergNEF</span></i></td></tr></tbody></table></div></div><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;"><div><div><p style="text-align: justify;">Almost half of this investment in alternative energy sources has been in renewable energy, with electrified transport and electrified heat accounting for a large portion of the remaining investments. </p></div></div></blockquote><div><p style="text-align: justify;"></p><ul><li>On the divestment side, the drumbeat against fossil fuel investing has had an effect, with many investment fund managers and endowments joining the divestiture movement:</li></ul><p></p><p><b></b></p><div class="separator" style="clear: both; text-align: center;"><b><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgWJOY8K5syqF40i0VwycjDhakAyowCMLuCuz2tqbEIxe4IkqiTmhwcWPDSszD60tNsZXjL913XVjdfSHugXZBYs7eShmCGI0uoO2oWPPYS9GfxjnM2OC1DKhpciS2eDMoGZ_iKTAMKo4EvJDzZ9qTIKKTcbVGybVeEhiAx_xpfZo16fA5HQ2d4yjWoC_E/s1752/FossilFuelDivestChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1286" data-original-width="1752" height="294" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgWJOY8K5syqF40i0VwycjDhakAyowCMLuCuz2tqbEIxe4IkqiTmhwcWPDSszD60tNsZXjL913XVjdfSHugXZBYs7eShmCGI0uoO2oWPPYS9GfxjnM2OC1DKhpciS2eDMoGZ_iKTAMKo4EvJDzZ9qTIKKTcbVGybVeEhiAx_xpfZo16fA5HQ2d4yjWoC_E/w400-h294/FossilFuelDivestChart.jpg" width="400" /></a></b></div><br /></div><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;"><div style="text-align: left;">By 2023, close to 1600 institutions, with more than $40 trillion of funds under their management, had announced or concluded their divestitures of investments in fossil fuel companies.</div></blockquote><p>If impact investing were measured entirely on fund flows into green energy companies and out of fossil fuel companies, it has clearly succeeded.</p><div><p></p><p><b><i>Market Price (and Capitalization)</i></b></p><p><i style="font-weight: bold;"> </i>It is undeniable that fund flows into or out of companies affects their stock prices, and if the numbers in the last section are even close to reality, you should have expected to see a surge in market prices at alternative energy companies, as a result of funds flowing into them, and a decline in market prices of fossil fuel companies, as fossil fuel divestment gathers steam. </p><p></p><ul style="text-align: left;"><li>On the alternative energy front, as money has flowed into these companies, there has been a surge in enterprise value (equity and net debt) and market capitalization (equity value); I report both because impact investing can also take the form of green bonds, or debt, at these companies. The enterprise value of publicly traded alternative energy companies has risen from close to zero two decades ago to more than $700 billion in 2020, before losing steam in the last three years:</li></ul><p></p><p></p><div class="separator" style="clear: both; text-align: center;"><br /></div><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj3rjygwjJ_Aht8vM34fEJAPG3sWvNdGs4WTnxSI5ROKlhRx3NncUqb9FJ84My7f-4YXeWkI7Sd_NiYUwLbG1IvbabklQdLFod9iHRRm6ubYEsvRbsr8dquoMKSeayrwIenvpMiZibNPr6MCN6h4saKEuJJuXvRJd08Y3JRbtv7jTKxyxpobpHoyamf2hs/s1254/GreenEnergyMktCap.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="906" data-original-width="1254" height="289" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj3rjygwjJ_Aht8vM34fEJAPG3sWvNdGs4WTnxSI5ROKlhRx3NncUqb9FJ84My7f-4YXeWkI7Sd_NiYUwLbG1IvbabklQdLFod9iHRRm6ubYEsvRbsr8dquoMKSeayrwIenvpMiZibNPr6MCN6h4saKEuJJuXvRJd08Y3JRbtv7jTKxyxpobpHoyamf2hs/w400-h289/GreenEnergyMktCap.jpg" width="400" /></a></div><div class="separator" style="clear: both; font-weight: bold; text-align: center;"><br /></div></div><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;"><div style="text-align: justify;">Adding in the value of private companies and start-ups in this space would undoubtedly push up the number further. </div></blockquote><div><p></p><p></p><ul style="text-align: left;"><li>On the fossil fuel front, the fossil fuel divestments have had an impact on market capitalizations, though there are signs that the effect is weakening:</li></ul><p></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgRmeshh44WHL8uI1t1jcJRbHeHOs_JFCHbvobfX3VKGYjj0jcrQ1f__khl2gM26OATEvbTuoBWKXMycBvBTqWvQFNcLW44NTUr9pQggMmjSMb63UbUyyzpVQdyMhRhGZ83CN2V9OA5ONAEHOzXoN5GTEUHhjas9umB4orcYHglrcwQXk0TlB1ebokUbOs/s2172/FossilFuelMktCap.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="2172" data-original-width="1938" height="400" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgRmeshh44WHL8uI1t1jcJRbHeHOs_JFCHbvobfX3VKGYjj0jcrQ1f__khl2gM26OATEvbTuoBWKXMycBvBTqWvQFNcLW44NTUr9pQggMmjSMb63UbUyyzpVQdyMhRhGZ83CN2V9OA5ONAEHOzXoN5GTEUHhjas9umB4orcYHglrcwQXk0TlB1ebokUbOs/w358-h400/FossilFuelMktCap.jpg" width="358" /></a></div><br /></div><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;"><div style="text-align: justify;"><span>In the last decade, when fossil fuel divestment surged, the percentage changes in market capitalization at fossil fuel companies lagged returns on the market, with fossil fuel companies reporting a compounded annual percentage increase of 4.49% a year..</span><span style="text-align: left;"> The negative effect was strongest in the middle of the last decade, but market prices for fossil fuel companies have recovered strongly between 2020 and 2023.</span></div></blockquote><p>It is worth noting that even after their surge in market cap in the last decade, alternative energy companies have a cumulated enterprise value of about $600 billion in September 2023, a fraction of the $8.5 trillion of cumulated enterprise value at fossil fuel companies.</p><p><i><b>Investor perceptions</b></i></p><p><span><span> </span>Impact investing has always been about changing investor perceptions of energy companies, more than just prices. In fact, some impact investors have argued that their presence in the market and advocacy for alternative energy has led investors to change their views about fossil fuel companies, shifting from viewing them as profitable, cash-rich businesses with extended lives, to companies living on borrowed time, looking at decline and even demise. In intrinsic valuation terms, that shift should show up in the pricing, with lower value attached to the latter scenario than the former:</span></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgaWOVLJh5TCRXjWlit5T9Jbex_gjeOaMMWBLmx6RqJRS-LK94AKqmMuv3YyGq5lRKheS2l2qmlxAIQ-8IuuF5CSatp8RgU_H-x_2BZJ6OfvXunUjf-vpFNoEpZ4UnZlyzOOM3eFsQVrNTZCGq673YzeGzdXeWn8w204m7rLz5dyZPVFFJYoNQv9OQVCEM/s1342/Perception.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="578" data-original-width="1342" height="173" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgaWOVLJh5TCRXjWlit5T9Jbex_gjeOaMMWBLmx6RqJRS-LK94AKqmMuv3YyGq5lRKheS2l2qmlxAIQ-8IuuF5CSatp8RgU_H-x_2BZJ6OfvXunUjf-vpFNoEpZ4UnZlyzOOM3eFsQVrNTZCGq673YzeGzdXeWn8w204m7rLz5dyZPVFFJYoNQv9OQVCEM/w400-h173/Perception.jpg" width="400" /></a></div><p><span> On the green energy front, to see if investors perceptions of these companies have changed, I look at two the pricing metrics for green energy companies - the enterprise value to EBITDA and enterprise value to revenue multiples:</span><br /></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgeS-Kah1WhfpKRvYNCpDeRNjtX-R-sbMY08E0frBZHXdFjVDEqQ73iwvEHt2W5vXXh9wp0MHIb8jMiSdixw6tIoGOTR_KHNqqCsc4c0Z8cDObSyewJ3YfnmWr7vJ-QEnxyVkYSXVgheOP2lj6Cns8oyBjoQNwJ5GXKQeGQrnkLcP50JbO0vFxVgx2g2oY/s1684/GreenPricingMetrics.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1220" data-original-width="1684" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgeS-Kah1WhfpKRvYNCpDeRNjtX-R-sbMY08E0frBZHXdFjVDEqQ73iwvEHt2W5vXXh9wp0MHIb8jMiSdixw6tIoGOTR_KHNqqCsc4c0Z8cDObSyewJ3YfnmWr7vJ-QEnxyVkYSXVgheOP2lj6Cns8oyBjoQNwJ5GXKQeGQrnkLcP50JbO0vFxVgx2g2oY/w400-h290/GreenPricingMetrics.jpg" width="400" /></a></div>The numbers offer a mixed message on whether impact investing has changed investor perceptions, with EV to EBITDA multiples staying unchanged, between the 1998-2010 and 2011-2023 time periods, but EV as a multiple of revenues soaring from 2.62 in the 1998-2010 time period to 5.95 in the 2011-2023 time period. The fund flows into green energy are affecting pricing, though it remains an open question as to whether the pricing is getting too rich, as too much money chases too few opportunities.<p></p><p><span> </span>Looking at fossil fuel firms, the poor performance in the last decade seems to support the notion that impact investing has changed how investors perceive fossil fuel companies, but there are some checks that need to be run to come that conclusion. </p><p></p><ul style="text-align: left;"><li style="text-align: left;"><span style="text-align: justify;"><u>Oil Price Effect</u>: The market capitalization of oil companies is dependent on oil prices, </span><span style="text-align: justify;">as you can see in the figure below, where the collective market </span><span style="text-align: justify;">capitalization of fossil fuel companies is graphed against the average oil price each year from 1970 to 2022; almost 70% of the variation in market capitalization over time explained by oil price movements.</span></li></ul><p></p><div><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEilrSh72PbHUsBWQnCk98XJLx-iRfXH8LJli49s-ZL059TbRrtU0aqPNx6hVY4eMipQ06w9ijs75IVyKEmspt6Js6eErAquptXjrhTY1nnv08KAuf55xrfBMaWpqTGrprL5XSc3zlE7O44RgcGjN7iN4_-LPVffK5t_ukrtDGvouWUNzmPm8kPIhpgbNMs/s1658/Oil%20prices%20vs%20Mkt%20Cap%2050%20years.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1200" data-original-width="1658" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEilrSh72PbHUsBWQnCk98XJLx-iRfXH8LJli49s-ZL059TbRrtU0aqPNx6hVY4eMipQ06w9ijs75IVyKEmspt6Js6eErAquptXjrhTY1nnv08KAuf55xrfBMaWpqTGrprL5XSc3zlE7O44RgcGjN7iN4_-LPVffK5t_ukrtDGvouWUNzmPm8kPIhpgbNMs/w400-h290/Oil%20prices%20vs%20Mkt%20Cap%2050%20years.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div></div><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;"><div><div class="separator" style="clear: both; text-align: justify;">To separate impact investing divestment effects from oil price effects, I estimated the predicted market capitalization of fossil fuel companies, given the oil price each year, using the statistical relationship between market cap and oil prices in the twenty five years leading into the forecast year. (I regress market capitalization against average oil price from 1973 to 1997 to estimate the expected market cap in 1998, given the oil price in 1998, and so on, for every year from 1998 to 2023. Note that the only thing you can read these regressions is that market capitalization and oil prices move together, and that there is no way to draw conclusions about causation):</div></div></blockquote><div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiSIOo0XELiY3RbN57YkpC6Yd4xNP5EMXm-lrzmfoQtkUQz0_YcgZ80O6-pWWWJkcCRGWLxXOWyVWeFJEGwgdoe_ZBBL0BTvzsAYOjD1LaNFs5fGBzC-IscHDsJfHgkslE2By3ftQMiT6WU4dlGpfFKBmvZ_tLlp5jFRLaVzmAMF6-KBwp9sZvn1e5AIrU/s3158/OilExpvsExpMktCap.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="2294" data-original-width="3158" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiSIOo0XELiY3RbN57YkpC6Yd4xNP5EMXm-lrzmfoQtkUQz0_YcgZ80O6-pWWWJkcCRGWLxXOWyVWeFJEGwgdoe_ZBBL0BTvzsAYOjD1LaNFs5fGBzC-IscHDsJfHgkslE2By3ftQMiT6WU4dlGpfFKBmvZ_tLlp5jFRLaVzmAMF6-KBwp9sZvn1e5AIrU/w400-h290/OilExpvsExpMktCap.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div></div><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;"><div><div class="separator" style="clear: both; text-align: justify;">If divestitures are having a systematic effect on how markets are pricing fossil fuel companies, you should expect to see the actual market capitalizations trailing the expected market capitalization, based on the oil price. That seems to be the case, albeit marginally, between 2011 and 2014, but not since then. In short, the divestiture effect on fossil fuel companies has faded over time, with other investors stepping in and buying shares in their companies, drawn by their earnings power. </div></div></blockquote><p style="text-align: left;"></p><ul style="text-align: left;"><li><u>Pricing</u>: If impact investing is changing investor perceptions about the future growth and termination risk at fossil fuel companies, it should show up in how these companies are priced, lowering the multiples of revenues or earnings that investors are willing to pay. In the chart below, I look at the pricing of fossil fuel companies over time, using EV to sales and EV to EBITDA as pricing metrics: <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjNSacodTH2CsAlxhjx0M4bwQxvtEJlomVNBJQ8frSeCaT2eXfLLPyAds1gfPVwB0hZZYK8uYZfaTgNIpNacpMxUKoRdJ3hyphenhyphenZTQXpX3WiHUQJIJR5klQe7FZKQzuXnr_KFkxIPgKdGTBltX1OSt8HfuWVCuqNqapuBRAtXY6_I25La7gVWPLHZx67tu9H4/s1762/PricingChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1276" data-original-width="1762" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjNSacodTH2CsAlxhjx0M4bwQxvtEJlomVNBJQ8frSeCaT2eXfLLPyAds1gfPVwB0hZZYK8uYZfaTgNIpNacpMxUKoRdJ3hyphenhyphenZTQXpX3WiHUQJIJR5klQe7FZKQzuXnr_KFkxIPgKdGTBltX1OSt8HfuWVCuqNqapuBRAtXY6_I25La7gVWPLHZx67tu9H4/w400-h290/PricingChart.jpg" width="400" /></a></div>While the pricing metrics swing from year to year, that has always been true at oil companies, since earnings and revenues vary, with oil prices. However, if impact investing is having a systematic effect on how investors are pricing companies, there is little evidence of that in this chart.</li></ul><div style="text-align: justify;">In sum, while it is possible to find individual investors who have become skeptical about the future for fossil fuel companies, that view is not reflective of the market consensus. I do believe that investors are pricing fossil fuel companies now, with the expectation of much lower growth in the future, than they used to, but that is coming as much from these companies returning more of their earnings as cash and reinvesting less than they used to, as it is from an expectation that the days of fossil fuel are numbered. Some impact investors will argue that this is because investors are short-term, but that is a double-edged sword, since it undercuts the very idea of using investing as the vehicle to create social and environmental change.</div><p></p><div><div class="separator" style="clear: both; text-align: left;"><b><i>Operating Impact</i></b></div><div class="separator" style="clear: both; text-align: justify;"><i style="font-weight: bold;"> </i>Impact investing, in addition to affecting pricing of green energy and fossil fuel companies, can also have effects on how fossil fuel companies perform and operate. On the profitability front, fossil fuel companies seem to have weathered the onslaught of climate change critics, <i>with revenues and profit margins (EBITDA and operating) bouncing bac</i>k from a slump between 2014 and 2018 to reach historic highs in 2022. </div><div class="separator" style="clear: both; text-align: left;"><b><i><br /></i></b></div><div class="separator" style="clear: both; text-align: left;"><b><i><br /></i></b></div><div class="separator" style="clear: both; text-align: left;"><div class="separator" style="clear: both; font-weight: bold; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj_ulXv5Jv77gUiBF_zE7u_cAiu2shzmtQhD_L79t3zRe23ySwtiB1eG9UhKB3v9RebJywYFrfFL6b5JvRzDR23O-kUeLtCQCvQiJkWydYdq9Zijt4tg1QJZrw1KI1HiRdgdaYw2PB7-7BSjkl5ketRZ9DyLjGa7pVA0stHqE9pi5pR_lrQ9qxfUILgHoA/s1760/Fossil%20Opeating%20History%20Chart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1274" data-original-width="1760" height="232" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj_ulXv5Jv77gUiBF_zE7u_cAiu2shzmtQhD_L79t3zRe23ySwtiB1eG9UhKB3v9RebJywYFrfFL6b5JvRzDR23O-kUeLtCQCvQiJkWydYdq9Zijt4tg1QJZrw1KI1HiRdgdaYw2PB7-7BSjkl5ketRZ9DyLjGa7pVA0stHqE9pi5pR_lrQ9qxfUILgHoA/s320/Fossil%20Opeating%20History%20Chart.jpg" width="320" /></a></div><div class="separator" style="clear: both; text-align: justify;">A key development over the last decade, as profits have returned, is that fossil fuel companies are <i>returning much of cash flows that they are generating to their shareholders</i> in the form of dividends and buybacks, notwithstanding the pressure from activist impact investors that they reinvest that money in green energy projects:</div><div class="separator" style="clear: both; font-weight: bold; text-align: center;"><br /></div><div class="separator" style="clear: both; font-weight: bold; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiI4QrVLIbvt4xjunCgUuuPLT8LlZ7ub6bvVGRtqrSa297uh4KpcT5446YfAOPV1EfnnCxMgnjC9LYzEBFUpa7qrvjooHwcaHdnyKjTdvuHD-nKGVVU4CovsSclLHS9pCqXD79rmhOdxGME6dJjuSYkL3_7W3GHPaC-7JkgNnYyooUy7Q3qCm3ldonBSTc/s1766/FoxxilFuelCashReturnChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1284" data-original-width="1766" height="233" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiI4QrVLIbvt4xjunCgUuuPLT8LlZ7ub6bvVGRtqrSa297uh4KpcT5446YfAOPV1EfnnCxMgnjC9LYzEBFUpa7qrvjooHwcaHdnyKjTdvuHD-nKGVVU4CovsSclLHS9pCqXD79rmhOdxGME6dJjuSYkL3_7W3GHPaC-7JkgNnYyooUy7Q3qCm3ldonBSTc/s320/FoxxilFuelCashReturnChart.jpg" width="320" /></a></div><div class="separator" style="clear: both; text-align: left;">In one development that impact investors may welcome, fossil fuel companies are c<i>ollectively investing less in exploration for new fossil fuel reserves</i> in the last decade than they did in prior ones:</div><div class="separator" style="clear: both; font-weight: bold; text-align: center;"><br /></div><div class="separator" style="clear: both; font-weight: bold; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhhrzXSetK0JFSp9b3YyiHSBhZXLwIE_Gz72XMExCqbX245xHNQkAEuWQg9BVijDrLslR9TwpbmMe7JRY4rloMtB9FSX16teX6I-01dtUGHh1_P8-d5UYejbSYzX6ONcB_Gdik31R47Emd_mOtswSkqPyx0mg3Hdr1cdZI9yOoOuTpoM_p48JjuouZdXR8/s1750/FissilExplorationChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1310" data-original-width="1750" height="240" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhhrzXSetK0JFSp9b3YyiHSBhZXLwIE_Gz72XMExCqbX245xHNQkAEuWQg9BVijDrLslR9TwpbmMe7JRY4rloMtB9FSX16teX6I-01dtUGHh1_P8-d5UYejbSYzX6ONcB_Gdik31R47Emd_mOtswSkqPyx0mg3Hdr1cdZI9yOoOuTpoM_p48JjuouZdXR8/s320/FissilExplorationChart.jpg" width="320" /></a></div><div class="separator" style="clear: both; text-align: justify;">If you couple this trend of exploring less with the divestitures of fossil fuel reserves, over the last decade, there is a basis for the argument that fossil fuel companies are reducing their fossil fuel presence, and some impact investing advocates may be tempted to declare victory. After all, if the objective is to reduce fossil fuel production, does it not advance your cause if less money is being spent exploring for coal, oil and gas? </div><div class="separator" style="clear: both; text-align: justify;"><span> </span>Before claiming a win, though, there is a dark side to this retreat by public fossil-fuel companies, and that comes from private equity investors and privately-owned (or government-owned) oil companies stepping into the breach; many of the divestitures and sales of fossil fuel assets by publicly traded companies have been to private buyers, and the assets being divested are often among the dirtiest (from a climate-change perspective) of their holdings.. Over the last decade, some of private equity’s biggest players <a href="https://www.nytimes.com/2021/10/13/climate/private-equity-funds-oil-gas-fossil-fuels.html#:~:text=226-,Private%20Equity%20Funds%2C%20Sensing%20Profit%20in%20Tumult%2C%20Are%20Propping%20Up,lifelines%20to%20coal%20power%20plants.">have invested well over $1.1 trillion in fossil fuel</a>, with the investments ranging the spectrum. </div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgy3Tya7lvn7EvWofWD_440BBoGtcYOzI6Ej9vxKYwaDOhc6ISHo6eOV2NFO4rT37az6Gbx3mB9ijA_piA8uRBf6dG7or2UPTIfvRoEaOOgv-1ATxAxflzDqEW-JP-C_iWgqdDsGYmx5bAzZXFyHBZTJ-JvTSldG6sJAGtgPjEBbXvX4ZbVciQO3gF1Rw0/s1582/PEEnergyInvestments.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1158" data-original-width="1582" height="293" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgy3Tya7lvn7EvWofWD_440BBoGtcYOzI6Ej9vxKYwaDOhc6ISHo6eOV2NFO4rT37az6Gbx3mB9ijA_piA8uRBf6dG7or2UPTIfvRoEaOOgv-1ATxAxflzDqEW-JP-C_iWgqdDsGYmx5bAzZXFyHBZTJ-JvTSldG6sJAGtgPjEBbXvX4ZbVciQO3gF1Rw0/w400-h293/PEEnergyInvestments.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i>Source: Pitchbook</i></td></tr></tbody></table><br /><div class="separator" style="clear: both; text-align: justify;">While there was an uptick in investments in renewables in 2019 and 2020, the overwhelming majority of private equity investments during the decade were in fossil fuels. In the process, private equity firms like the Carlyle Group and KKR have become major holders of fossil fuel reserves, and there <a href="https://www.wsj.com/articles/wealthiest-oilman-houston-hildebrand-climate-activism-32bb8aec">are a few private buyers who have profited</a> from buying abandoned and castoff oil wells from oil companies, pressured to sell by impact investors. While climate change advocates are quick to point to this public-to-private transition of fossil fuel assets as a flaw, they fail to recognize that it is is a natural side-effect of an approach that paints publicly traded fossil fuel firms as villains and shuns their investments, while continuing to be dependent on fossil fuels for meeting energy needs. </div><div class="separator" style="clear: both; text-align: justify;"><span> On the activist front, there is evidence that impact investing's capacity to change oil company behavior is losing its potency. While fossil fuel companies were quick to give in to pressure </span>from impact investors<span> to de-carbonize, for much of the last decade, the Russian invasion of Ukraine seems to have been <a href="https://aswathdamodaran.blogspot.com/2022/03/esgs-russia-test-moment-to-shine-or.html">an "emperor-has-no-clothes" moment for green energy advocates</a>, laying bare how reliant the globe still is on fossil fuels for its energy needs. In the aftermath, the biggest fossil fuel companies have become bolder about their plans to stay in and grow their fossil fuel </span>investments, with <a href="https://www.aljazeera.com/economy/2022/7/5/shell-buys-stake-in-qatari-gas-field-expansion-project-2" style="text-align: left;">Royal Dutch taking a stake in Qatari gas field</a>, <a href="https://www.nytimes.com/2023/02/07/business/bp-oil-gas-profits.html" style="text-align: left;">BP announcing it will produce more oil and gas</a>, <a href="https://www.wsj.com/business/deals/exxon-mobil-closing-in-on-megadeal-with-shale-driller-pioneer-31b4092e" style="text-align: left;">Exxon Mobil buying Pioneer Natural Resources, a shale driller for $60 billion</a>, and <a href="https://www.nasdaq.com/articles/brazils-petrobras-ends-divestment-processes">Petrobras reversing course on divestitures</a>. </div><div class="separator" style="clear: both; font-weight: bold; text-align: center;"><br /></div></div><div class="separator" style="clear: both; text-align: left;"><b><i>Macro Impact</i></b></div><div class="separator" style="clear: both; text-align: left;"><i style="font-weight: bold;"> </i>The success or failure of impact investing, when it relates to climate change, ultimately comes from the changes it creates in how energy is produce and consumed, and it is on this front that the futility of the movement is most visible. While alternative energy sources have expanded their production, it has not been at the expense of oil consumption, which has barely budged over the last decade.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg50cU0CdgOLG3eOJwjcG0qEUOX9LvcNT3DMi9g1a-uzRSFr7LUl9GSURK7IuT3e4xjokXH6MOuo8Ik_husDQK5mkKruwyWglrn_BcQn8a31xM4UQ4Iix6xd1TlhXJ4g7p-d3M909orYbitabsEJ9E-oqe2xSTdmxVOL07p3sMasB2VLHi8NM5NrBL5Am8/s1558/Oil%20Consumption.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1120" data-original-width="1558" height="288" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg50cU0CdgOLG3eOJwjcG0qEUOX9LvcNT3DMi9g1a-uzRSFr7LUl9GSURK7IuT3e4xjokXH6MOuo8Ik_husDQK5mkKruwyWglrn_BcQn8a31xM4UQ4Iix6xd1TlhXJ4g7p-d3M909orYbitabsEJ9E-oqe2xSTdmxVOL07p3sMasB2VLHi8NM5NrBL5Am8/w400-h288/Oil%20Consumption.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://www.eia.gov/outlooks/steo/data/browser/#/?v=30&f=A&s=&start=1997&end=2024&id=&linechart=PATC_R01&ctype=linechart&maptype=0"><i><span style="font-size: x-small;">EIA: World Oil Consumption</span></i></a></td></tr></tbody></table><div class="separator" style="clear: both; text-align: justify;">Fairly or unfairly, the pandemic seems to have done more to curb oil consumption than all of impact investing's efforts over the last decade, but the COVID effect, which saw oil consumption drop in 2020 has largely faded.</div><div class="separator" style="clear: both; text-align: justify;"><span> T</span>aking a global and big-picture perspective of where we get our energy, a comparison of energy sources in 1971 and 2019 yields a picture of how little things have changed:</div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjfod-YxscHmI8KB63WxjtnMYoTckqkQoSI0FI1U8bjvhc0MFRyC0f_mBf22sc1it_5ZdiKmSR70geTRX1v3FSqLqCacRDDCYWYTVaBH4bNso2__1_J21elm6CWTBat6mC0quWujYD3dvFhiIrT-oryxfjnsJXjdqwRgwPKXJ_Rkb0Z5Fa_bI3CujQo-Uk/s1228/GlobalEnergySourcesChart.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="954" data-original-width="1228" height="311" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjfod-YxscHmI8KB63WxjtnMYoTckqkQoSI0FI1U8bjvhc0MFRyC0f_mBf22sc1it_5ZdiKmSR70geTRX1v3FSqLqCacRDDCYWYTVaBH4bNso2__1_J21elm6CWTBat6mC0quWujYD3dvFhiIrT-oryxfjnsJXjdqwRgwPKXJ_Rkb0Z5Fa_bI3CujQo-Uk/w400-h311/GlobalEnergySourcesChart.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;"><a href="https://www.iea.org/reports/world-energy-balances-overview/world#">IEA: World Energy Balances Overview</a></span></i></td></tr></tbody></table><div class="separator" style="clear: both; text-align: justify;"><br /></div><div class="separator" style="clear: both; text-align: left;">Fossil fuel, which accounted for 86.6% of energy production in 1971, was responsible for 80.9% of production in 2019, with almost all of that gain from coming from nuclear energy, which many impact investors viewed as an undesirable alternative energy source for much of the last decade. Focusing on energy production just in the US, the failure of impact investing to move the needle on energy production can be seen in stark terms:</div><div class="separator" style="clear: both; text-align: center;"><br /></div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhGTZ4VzEu9Y7Z7b4p7yCS14ty9mhIxotGnsiqTrMAvzURl2i0waRNER7ChSsqXO7x6BLTeLbkdRb6CdWOwWcjttU-NusEsuMIWJf5UF_tTQTW3sZR9m4tsV_OugG2kMvpcfrLtkrR9LgvqrxBzkABV535mcJDbH7bnxPl1VSC2a1xVvLYgn7t69ee-TD4/s1842/EnergySourcesUS.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1348" data-original-width="1842" height="293" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhGTZ4VzEu9Y7Z7b4p7yCS14ty9mhIxotGnsiqTrMAvzURl2i0waRNER7ChSsqXO7x6BLTeLbkdRb6CdWOwWcjttU-NusEsuMIWJf5UF_tTQTW3sZR9m4tsV_OugG2kMvpcfrLtkrR9LgvqrxBzkABV535mcJDbH7bnxPl1VSC2a1xVvLYgn7t69ee-TD4/w400-h293/EnergySourcesUS.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;"><a href="https://www.eia.gov/beta/states/data/dashboard/total-energy">Source: U.S. Energy Information Administration</a></span></i></td></tr></tbody></table><div class="separator" style="clear: both; text-align: justify;">Fossil fuels account for a higher percent of overall energy produced in the United States today than they did ten or fifteen years ago, with gains in solar, wind and hydropower being largely offset by reductions in nuclear energy. <span style="text-align: left;">If this is what passes for winning in impact investing, I would hate to see what losing looks like. </span></div><div class="separator" style="clear: both; text-align: left;"><span> I have tried out variants of this post with impact investing acquaintances, and there are three broad responses that they have to its findings (and three defenses for why we should keep trying):</span><br /></div><div class="separator" style="clear: both; text-align: left;"><ol style="text-align: left;"><li style="text-align: justify;"><u>Things would be worse without impact investing</u>: It is impossible to test this hypothetical, but is it possible that our dependence on fossil fuels would be even greater, without impact investing making a difference? Of course, but that argument would be easier to make, if the trend lines were towards fossil fuels before impact investing, and moved away from fossil fuels after its rise. The data, though, suggests that the biggest shift away from fossil fuels occurred decades ago, well before impact investing was around, primarily from the rise of nuclear energy, and that impact investing's tunnel vision on alternative energy has actually made things worse.</li><li style="text-align: justify;"><u>It takes time to create change</u>: It is true that the energy business is an infrastructure business, requiring large investments up front and long gestation periods. It is possible that the effects of impact investing are just not being felt yet, and that they are likely to show up later this decade. This would undercut the urgency argument that impact investors have used to induce their clients to invest large amounts and doing it now, and if they had been more open about the time lag from the beginning, this argument would have more credibility today.</li><li style="text-align: justify;"><u>Investing cannot offset consumption choices</u>: If the argument is that impact investing cannot stymie climate change on its own, without changes in consumer behavior, I could not agree more, but changing behavior will be painful, both politically and economically. I would argue that impact investing, by offering the false promise of change on the cheap, has actually reduced the pressure on politicians and rule-makers to make hard decisions on taxes and production.</li></ol><div><span>Even conceding some truth in all three arguments, what</span><span> I see in the data is the essence of insanity, where impact investors keep throwing in more cash into green energy and more vitriol at fossil fuels, while the global dependence on fossil fuels increases.</span></div></div><div><br /></div><div style="text-align: justify;"><b>Impact Investing: Investing for change</b></div><div style="text-align: justify;"><span> </span>Much of what I have said about impact investing's quest to fight climate change can be said about the other societal problems that impact investors try to address. Poverty, sexism, racism and inequality have had impact investing dollars directed at them, albeit not on the same scale as climate change, but are we better off as a society on any of these dimensions? To the response that doing something is better than being doing nothing, I beg to differ, since acting in ways that create perverse outcomes can be worse than sitting still. <span> </span>To end this post on a hopeful note, I believe that impact investing can be rescued, albeit in a humbler, more modest form. </div><div><ol style="text-align: left;"><li style="text-align: justify;"><u>With your own money, pass the sleep test</u>: If you are investing your own money, your investing should reflect your pocketbook as well as your conscience. After all, investors, when choosing what to invest in, and how much, have to pass the <i>sleep tes</i>t. If investing in Exxon Mobil or Altria leads you to lose sleep, because of guilt, you should avoid investing in these companies, no matter how good they look on a financial return basis.</li><li style="text-align: justify;"><u>With other people's money, be transparent and accountable about impact</u>: If you are investing other people’s money, and aiming for impact, you need to be explicit on what the problem is that you are trying to solve, and <i>get buy in from those who are investing with you</i>. In addition, you should specify measurement metrics that you will use to evaluate whether you are having the impact that you promised.</li><li style="text-align: justify;"><u>Be honest about trade offs</u>: When investing your own or other people's money, you have to be honest with yourself not only about the impact that you are having, but about the trade offs implicit in impact investing. As someone who teaches at NYU, I believe that <a href="https://www.theguardian.com/us-news/2023/sep/12/new-york-university-fossil-fuel-divestment">NYU's recent decision to divest itself of fossil fuels</a> will not only have no effect on climate change, but coming from an institution that has established a <a href="https://nyuad.nyu.edu/en/">significant presence in Abu Dhabi</a>, it is an act of rank hypocrisy. It is also critical that those impact investors who expect to make risk-adjusted market returns or more, while advancing social good, recognize that being good comes with a cost.</li><li style="text-align: justify;"><u>Less absolutism, more pragmatism</u>: For those impact investors who cloak themselves in virtue, and act as if they command the moral high ground, just stop! Not only do you alienate the rest of the world, with your I-care-about-the-world-more-than-you attitude, but you eliminate any chances of learning from your own mistakes, and changing course, when your actions don't work.</li><li style="text-align: justify;"><u>Harness the profit motive</u>: I know that for some impact investors, the profit motive is a dirty concept, and the root reason for the social problems that impact investing is trying to address. While it is true that the pursuit of profits may underlie the problem that you are trying to solve, the power from harnessing the profit motive to solve problems is immense. Agree with his methods or not, Elon Musk, driven less by social change and more by the desire to create the most valuable company in the world, has done more to address climate change than all of impact investing put together. </li></ol><div style="text-align: justify;">I started this post with two presumptions, that the social problems being addressed by impact investors are real and that impact investors have good intentions, and if that is indeed the case, I think it is time that impact investors face the truth. After 15 years, and trillions invested in its name, impact investing, as practiced now, has made little progress on the social and environmental problems that it purports to solve. Is it not time to try something different?</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>YouTube Video</b></div><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/kmAVbmDYMtQ?si=hQyt8CLu6kBtkS9l" title="YouTube video player" width="560"></iframe><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>ESG Posts</b></div><div style="text-align: justify;"><ol><li><a href="https://aswathdamodaran.blogspot.com/2020/09/sounding-good-or-doing-good-skeptical.html">Sounding Good or Doing Good: A Skeptical Look at ESG</a></li><li><a href="https://aswathdamodaran.blogspot.com/2021/09/the-esg-movement-goodness-gravy-train.html">The ESG Movement: The Goodness Gravy Train rolls on!</a></li><li><a href="https://aswathdamodaran.blogspot.com/2022/03/esgs-russia-test-moment-to-shine-or.html">ESG's Russia Test: Trial by Fire or Crash and Burn?</a></li></ol></div></div><div><div class="separator" style="clear: both; text-align: center;"><br /></div><br /></div></div>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-66613659085104217732023-10-06T17:46:00.007-04:002023-10-06T20:39:49.875-04:00Invisible, yet Invaluable: Valuing Intangibles in the Birkenstock IPO!<p style="text-align: justify;">A few days ago, I <a href="https://aswathdamodaran.blogspot.com/2023/09/putting-instacart-before-grocery-horse.html">valued Instacart ahead of its initial public offering</a>, and noted that the reception that the stock gets will be a good barometer of where risk capital stands in the market, right now. After a buzzy open, when the stock jumped from its offering price of $30 a share to $42, the stock has quickly given up those gains and now trades at below to its offer price. In this post, I will look at another initial public offering, Birkenstock, that is likely to get more attention in the next few weeks, given that it is targeting to go public at a pricing of about €8 billion, for its equity, in a few weeks. Rather than make this post all about valuing Birkenstock, and comparing that value to the proposed pricing, I would like to use the company to discuss how intangible assets get valued in an intrinsic valuation, and why much of the discussion of intangible valuation in accounting circles is a reflection of a mind-set on valuation that often misses its essence.</p><p style="text-align: justify;"><b>The Value of Intangible Assets</b></p><p style="text-align: justify;"><span><b> </b>Accounting has historically done a poor job dealing with intangible assets, and as the economy has transitioned away from a manufacturing-dominated twentieth century to the technology and services focused economy of the twenty first century, that failure has become more apparent. The resulting debate among accountants about how to bring intangibles on to the books has spilled over into valuation practice, and many appraisers and analysts are wrongly, in my view, letting the accounting debate affect how they value companies.</span><b> </b></p><p style="text-align: justify;"><i>The Rise of Intangibles</i></p><p style="text-align: justify;"><i> </i>While the debate about intangibles, and how best to value them, is relatively recent, it is unquestionable that intangibles have been a part of valuation, and the investment process, through history. An analyst valuing General Motors in the 1920s was probably attaching a premium to the company, because it was headed by Alfred Sloan, viewed then a visionary leader, just as an investor pricing GE in the 1980s was arguing for a higher pricing, because Jack Welch was engineering a rebirth of the company. Even a cursory examination of the the <a href="https://en.wikipedia.org/wiki/Nifty_Fifty">Nifty Fifty</a>, the stocks that drove US equities upwards in the early 1970s, reveals companies like Coca Cola and Gilette, where brand name was a significant contributor to value, as well as pharmaceutical companies like Bristol-Myers and Pfizer, which derived a large portion of their value from patents. In fact, IBM and Hewlett Packard, pioneers of the tech sector, were priced higher during that period, because of their technological strengths and other intangibles. Within the investment community, there has always been a clear recognition of the importance of intangibles in driving investment value. In fact, among old-time value investors, especially in the Warren Buffet camp, the importance of having "good management' and <u>moats </u>(competitive advantages, many of which are intangible) represented an acceptance of to how critical it is that we incorporate these intangible benefits into investment decisions.</p><p style="text-align: justify;"><span> With that said, it is clear that the debate about intangibles has become more intense in the last two decades. One reason is the perception that intangibles now represent a greater percent of value at companies and are a significant factor in more of the companies </span>that we invest in, than in the past. While I have seen claims that intangibles now account for sixty, seventy or even ninety percent of value, I take these contentions with a grain of salt, since the definition of "intangible" is elastic, and some stretch it to breaking point, and the measures of value used are questionable. A more tangible way to see why intangibles have become a hot topic of discussion is to <span style="text-align: left;">look at the evolution of the top ten companies in the world, in market capitalization, over time:</span></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiTvO-mKmuZGh3jnKYchpHpUjGHait6tFHEvRgc4svX7gg_V-74xCyw7YH-JE_NNgTKiAUMsu4uACihvs5EMaaGo2KkcPtqGASZTz0UIZSz6F29jQhjayMzCAq9U5QAPYFdJT8aE7qdLF-hOd2Ux7OBRfPezqfax-NANSv2cPO80zPcKhA7FebWNnZcnRw/s1920/TopTenoverTime.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="424" data-original-width="1920" height="124" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiTvO-mKmuZGh3jnKYchpHpUjGHait6tFHEvRgc4svX7gg_V-74xCyw7YH-JE_NNgTKiAUMsu4uACihvs5EMaaGo2KkcPtqGASZTz0UIZSz6F29jQhjayMzCAq9U5QAPYFdJT8aE7qdLF-hOd2Ux7OBRfPezqfax-NANSv2cPO80zPcKhA7FebWNnZcnRw/w557-h124/TopTenoverTime.jpg" width="557" /></a></div><div class="separator" style="clear: both; text-align: justify;"><span style="text-align: left;"><br /></span></div><div class="separator" style="clear: both; text-align: justify;">In 1980, IBM was the largest market cap company in the world, but eight of the top ten companies were oil or manufacturing companies. With each decade, you can see the effect of regional and sector performance in the previous decade; the 1990 list is dominated by Japanese stocks, reflecting the rise of Japanese equities in the 1980s, and the 2000 list by technology and communication companies, benefiting from the dot-com boom. Looking at the top ten companies in 2020 and 2023, you see the dominance of technology companies, many of which sell products that you cannot see, often in production facilities that are just as invisible.</div><div class="separator" style="clear: both; text-align: justify;"><span> The other development that has pushed the intangible discussion to the forefront is a sea change in the characteristics of companies entering public markets. While companies that were listed for much of the twentieth century waited until they had established business models to go public, the dot-com boom saw the listing of young companies with growth potential but unformed business models (translating into operating </span>losses), and that trend has continued and accelerated in this century. The graph below looks at the revenues and profitability of companies that go public each year, from 1980 to 2020:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjhuFB0shKUMQNRdfyQYV2aAr5_Wuzsf4ESKR2CykG7bG_pFCC1aI6o8eme3Eiy-ROoShyphenhyphenw1qgdN5DKYV2GWb8vPDaH53ObVf0H1oH-7ajH7ad9hmgNAstE8TBFvsLjMy5pxQAkk6RCYuHo5gO8xedWZch6_j8AIpSN7DYxr8yXwMvpFwShj_7dDT_10Ag/s1662/IPOCharacteristics.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1210" data-original-width="1662" height="324" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjhuFB0shKUMQNRdfyQYV2aAr5_Wuzsf4ESKR2CykG7bG_pFCC1aI6o8eme3Eiy-ROoShyphenhyphenw1qgdN5DKYV2GWb8vPDaH53ObVf0H1oH-7ajH7ad9hmgNAstE8TBFvsLjMy5pxQAkk6RCYuHo5gO8xedWZch6_j8AIpSN7DYxr8yXwMvpFwShj_7dDT_10Ag/w445-h324/IPOCharacteristics.jpg" width="445" /></a></div><div style="text-align: justify;"><br /></div><p style="text-align: justify;">As you can see, the percent of money-making companies going public has dropped from more than 90% in the 1980s to less than 20% in 2020, but at the same time, while also reporting much higher revenues, reporting the push by private companies to scale up quickly. In valuing these companies, investors and analysts face a challenge, insofar as much of the values of these firms came from expectations of what they would do in the future, rather than investments that they have already made. I capture this effect in what I call a financial balance sheet:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgA02LUIJTBllHA1PbuEodtaQm-Imj9cZIyjIDslmSzM6dUhxq61a60uF3ZqRjXhPSaNoJrxaobSN0TXqs4SNiz9DBi5h9Zi9vxAoYv-M4mGTpO4eHf66uDtqYNkAnQplMNsBCS7ohQn84sjt5SwG_2eQUfKmqsdpFM5ELmxOJ5qvRG8VGsnou6d_o3Cpk/s1538/FinBalSheet.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="714" data-original-width="1538" height="186" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgA02LUIJTBllHA1PbuEodtaQm-Imj9cZIyjIDslmSzM6dUhxq61a60uF3ZqRjXhPSaNoJrxaobSN0TXqs4SNiz9DBi5h9Zi9vxAoYv-M4mGTpO4eHf66uDtqYNkAnQplMNsBCS7ohQn84sjt5SwG_2eQUfKmqsdpFM5ELmxOJ5qvRG8VGsnou6d_o3Cpk/w400-h186/FinBalSheet.jpg" width="400" /></a></div><p style="text-align: justify;">While you can value assets-in-place, using historical data and the information in financial statements, in assessing the value of growth assets, you are making your best assessments of investments that these companies will make in the future, and these investments are formless, at least at the moment. </p><p style="text-align: justify;"><i>The Accounting Challenge with Intangibles</i></p><p style="text-align: justify;"><i> </i>The intangible debate is most intense in the accounting community, with both practitioners and academics arguing about whether intangibles should be "valued", and if so, how to bring that value into financial statements. To see why the accounting consequences are likely to be dramatic, consider how these choices will play out in the balance sheet, the accountants' attempt to encapsulate what a business owns, what it owes and how much its equity is worth. </p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgc4VPx8iH2Ah2HGalgMTWEg7GbNap5wEtyHqeRH0gOhnK5w95F8UQE4DQyQoIV-72Iw_cOo6FHFBsAAWYdiOa-vpMDMAHH4JRZjjGaIUGAlsltDjyx196La9l_mr17EWdQP_CdUeAS2PSKlan7JngpP_nhVsruWh_iy1wkybav7JsJs65zwI7_cEtgMgM/s1258/BalSheet.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="544" data-original-width="1258" height="201" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgc4VPx8iH2Ah2HGalgMTWEg7GbNap5wEtyHqeRH0gOhnK5w95F8UQE4DQyQoIV-72Iw_cOo6FHFBsAAWYdiOa-vpMDMAHH4JRZjjGaIUGAlsltDjyx196La9l_mr17EWdQP_CdUeAS2PSKlan7JngpP_nhVsruWh_iy1wkybav7JsJs65zwI7_cEtgMgM/w465-h201/BalSheet.jpg" width="465" /></a></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">There are inconsistencies in how accountants measure different classes of assets, and I incorporate them into my picture above, leaving the intangible assets section as the unknown: Any changes in accounting rules on measuring the value of intangibles, and bringing them on the balance sheet, will also play out as changes on the other side of the balance sheet, primarily as changes in the value of assessed or book equity. Put simply, if accountants decide to bring intangible assets like brand name, management quality and patent protection into asset value will increase the value of book equity, at least as accountants measure it, in that company.</div><div><div style="text-align: justify;"> In their attempt to bring intangible assets on to balance sheets, accountants face a barrier of their own creation, emanating from how they treat the expenditures incurred in building up these assets. To understand why, consider how fixed assets (such as plant and equipment and equipment) become part of the balance sheet. The expenditures associated with acquiring these fixed assets are treated as capital expenditures, separate from operating expenses, and only the portion of that expenditure (depreciation or amortization) that is assumed to be related to the current year's operations is treated as an operating expense. The unamortized or un-depreciated portions of these capital expenses are what we see as assets on balance sheets. The expenses that result in intangible asset acquisitions are, for the most part, not treated consistently, with brand name advertising, R&D expenses and investments in recruiting/training, the expenses associated with building up brand name, patent protection and human capital, respectively, being treated as operating, rather than capital, expenses. As a consequence of this mistreatment, I have argued that not only are the biggest assets, mostly intangible, at some companies kept off the balance sheet, but their earnings are misstated:</div><p></p><div class="separator" style="clear: both; text-align: justify;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh3iky3lncwoTV5Dga7tf0rUK0SJD76LtUudUCH4m8fT8pV1ikd4Y0iZz5MnOawOn3f1TpDtf17fJGhBsAbsuuRxIoZ7M0HLt3Tnw-mo-8NEWHfLbQtI_6fDSUkRbvCVUA9Xwfb_wSRCjwyq0Ex9t4WhTwSRO9fih9EnOm-kW_mLESsvTpQk1_cKcBIz6U/s1652/capExmiscategorization.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1248" data-original-width="1652" height="390" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh3iky3lncwoTV5Dga7tf0rUK0SJD76LtUudUCH4m8fT8pV1ikd4Y0iZz5MnOawOn3f1TpDtf17fJGhBsAbsuuRxIoZ7M0HLt3Tnw-mo-8NEWHfLbQtI_6fDSUkRbvCVUA9Xwfb_wSRCjwyq0Ex9t4WhTwSRO9fih9EnOm-kW_mLESsvTpQk1_cKcBIz6U/w515-h390/capExmiscategorization.jpg" width="515" /></a></div><div style="text-align: justify;">There are ways in which accounting can fix this inconsistency, but it will result in an overhaul of all of the financial statements, and companies and investors balk at wholesale revamping of accounting numbers (EBITDA, earnings per share, book value) that they have relied on to price these firms.</div></div><div><div style="text-align: justify;"> So, how far has accounting come in bringing intangible assets on to balance sheets? One way to measure progress on this issue is to look at the portion of the book value of equity at US companies that comes from tangible assets, in the chart below:</div><i><div style="text-align: justify;"><br /></div></i><p></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi3hWD2Uy1HSpQ6uGiFiJIcAAfNuYc9oeKCzMO4odd8jsx0VKLHGEDCqwvg9SPhVTDYP6_TOC-OMPC6Xsif3GdTp_T_LC6GlvA50PyNwMi8rzhnEzEbyFQ8tyxIR_CYzxg-goJcP5Ur68-DWm5zDGrAKzfBJEfDqTJYd8hSunkMNmeEwN5dX_xb5vFfyTM/s1816/BV&TangibleBV.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1334" data-original-width="1816" height="343" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi3hWD2Uy1HSpQ6uGiFiJIcAAfNuYc9oeKCzMO4odd8jsx0VKLHGEDCqwvg9SPhVTDYP6_TOC-OMPC6Xsif3GdTp_T_LC6GlvA50PyNwMi8rzhnEzEbyFQ8tyxIR_CYzxg-goJcP5Ur68-DWm5zDGrAKzfBJEfDqTJYd8hSunkMNmeEwN5dX_xb5vFfyTM/w466-h343/BV&TangibleBV.jpg" width="466" /></a></div><div style="text-align: justify;">Looking across all US firms from 1980 to 2022, <i>the portion of book value of equity that comes tangible assets has dropped from more than 70% in 1998 to about 30% in 2022</i>. That would suggest that intangible assets are being valued and incorporated into balance sheets much more now than in the past. Before you come to that conclusion, though, you may want to consider the breakdown of the intangible assets on accounting balance sheets, which I do in the graph below:</div><i><div style="text-align: justify;"><br /></div></i><p></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjNzMzv5QBq8iKXm5lIhrKApHx-VCvx_Wvia3vVWZz9OqeLe6zOHvHWt2k5-IFcpc9mrjHSSaXJXAszqOVSlP_qOLXVnZG1WdQBYRfeXkxBBQl1E8TSRAmfB2mHs1bTv7j8V7f7nvS3tpjxr3n57uneCWcnd4MgOyFGUT-MEV52j0yT5KoeeznZOJnJBbw/s1838/GoodwillChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1332" data-original-width="1838" height="318" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjNzMzv5QBq8iKXm5lIhrKApHx-VCvx_Wvia3vVWZz9OqeLe6zOHvHWt2k5-IFcpc9mrjHSSaXJXAszqOVSlP_qOLXVnZG1WdQBYRfeXkxBBQl1E8TSRAmfB2mHs1bTv7j8V7f7nvS3tpjxr3n57uneCWcnd4MgOyFGUT-MEV52j0yT5KoeeznZOJnJBbw/w439-h318/GoodwillChart.jpg" width="439" /></a></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Over the last 25 years, as intangible assets have risen in value, goodwill has been, by far, the biggest single component of that value, accounting for about 60% of all intangibles on US corporate balance sheets; the jump in 2001 came from a change in accounting rules on acquisitions, when pooling was banned and companies were forced to recognize goodwill on all acquisitions. So what?<a href="https://aswathdamodaran.blogspot.com/2012/12/acquisition-accounting-ii-goodwill-more.html"> I have long argued that goodwill is not an asse</a>t, intangible or not, but more a plug variable, signifying the difference between the price paid to acquire a target company and its book value, with adjustments for fairness, and designed to make balance sheets balance. Thus, much of the talk about intangibles in accounting has been just that, talk, with little of real consequence for balance sheets. </div></div><div><div style="text-align: justify;"> There is another measure that you can use to see the futility, at least so far, of accounting attempts to value intangibles. In the graph below, I look at the aggregated market capitalization of companies, in 2022, which should incorporate the pricing of intangibles by the market, and compare that value to book value (tangible and intangible), by sector, reflecting accounting attempts to value these same intangibles.</div><p></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhvr7P49aRgdBYyqBSOn7cqymhLJ_MA6q9WiBeXYS85pWS47wNIjFjWxRuuXmElqz7N2dLcqe_7mJWc1r_UcWGN-1pGrjhpzllhQnnv9-Z2DAbiSsm5oV_90HhJfBepkXAUKRTbtKCSypM8rshF_M-n0Yvc1a0g_x9pNB-Y53TP_Db3nipCwAyrnxM6Wdg/s1362/SectorValueBreakdown.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1002" data-original-width="1362" height="335" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhvr7P49aRgdBYyqBSOn7cqymhLJ_MA6q9WiBeXYS85pWS47wNIjFjWxRuuXmElqz7N2dLcqe_7mJWc1r_UcWGN-1pGrjhpzllhQnnv9-Z2DAbiSsm5oV_90HhJfBepkXAUKRTbtKCSypM8rshF_M-n0Yvc1a0g_x9pNB-Y53TP_Db3nipCwAyrnxM6Wdg/w455-h335/SectorValueBreakdown.jpg" width="455" /></a></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The sectors where you would expect intangible assets to be the largest portion of value are consumer products (brand name) and technology (R&D and patents). These are also the sectors with the lowest book values, relative to market value, suggesting that whatever accountants are doing to bring in intangibles in these companies into book value is not having a tangible effect on the numbers. </div></div><div style="text-align: justify;"><span> In sum, the accounting obsession with intangibles, and how best to deal with them, has not translated into material changes on balance sheets, at least with GAAP in the United States. It is true that IFRS has moved faster in bringing intangible assets on to balance sheets, albeit not always in the most sensible ways, but even with those rules in place, progress on bringing </span>intangible assets onto balance sheets has been slow. To be frank, I don't think accounting rule writers will be able to handle intangibles in a sensible way, and the barriers lie not in rules or models, but in the accounting mindset. Accounting is backward-looking and rule-driven, making it ill equipped to value intangibles, where you have no choice, but to be forward looking, and principle-driven. </div><div><p></p><p style="text-align: justify;"><i>The Intrinsic Value of Intangibles</i></p><p style="text-align: justify;"><i> </i>I have been teaching and writing about valuation for close to four decades now, and I have often been accused of giving short shrift to intangible assets, because I don't have a session dedicated to valuing intangibles, in my valuation class, and I don't have entire books, or even chapters of my books, on the topic. While it may seem like I am in denial, given how much value companies derive from assets you cannot see, I have never felt the need to create new models, or even modify existing models, to bring in intangibles. In this section, I will explain why and make the argument that if you do intrinsic valuation right, intangibles should be, with imagination and very little modification of existing models, already in your intrinsic value.</p><p style="text-align: justify;"><span><span> </span>To understand intrinsic value, it is worth starting with the simple equation that animates the estimation of value, for an asset with n years of cash flows:</span><br /></p><p></p><div class="separator" style="clear: both; text-align: justify;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjmCPQAFGVwyHc3iJMi4yHPQh3hypa5AtaCOK-HmGlaa0C3XQHno_XgLYeV_SmMrwDRHR2lqt35axQHheSJNMySuLPKmNIN-5K07fP8ntIdF5J_ASTP2NQTncgDg5YMyRc-2Bq8nv72eAPdbLozXjRuFJA9jEnQVq-phV3LPaHORVMsA5EnEsv2avNCHj0/s934/DCFgeneral.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="110" data-original-width="934" height="48" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjmCPQAFGVwyHc3iJMi4yHPQh3hypa5AtaCOK-HmGlaa0C3XQHno_XgLYeV_SmMrwDRHR2lqt35axQHheSJNMySuLPKmNIN-5K07fP8ntIdF5J_ASTP2NQTncgDg5YMyRc-2Bq8nv72eAPdbLozXjRuFJA9jEnQVq-phV3LPaHORVMsA5EnEsv2avNCHj0/w400-h48/DCFgeneral.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: justify;"><br /></div><div style="text-align: justify;">Thus, the intrinsic value of an asset is the present value of the expected cash flows on it, over its lifetime. When valuing a business, where cash flows could last for much longer (perhaps even forever), this equation can be adapted:</div><p></p><div class="separator" style="clear: both; text-align: justify;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjUJzYAbAJrGqiy_bpkByusa9XC1lpFgf-TAZ8XLqWnMmKgpiyo7LnlbzCzZoZx24rvqXOVyJGV09xXt59RDmsWuWRqZcoBM3SxTmhsOpLOh7FxFpWcYmumplc0ssOnkS4R8mXd7yh1-z5Gg8VQSYoC8T_fbu73mZEOZT97kZGbXgfX0HIPs67_ffyoV0U/s854/DCFBusiness.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="94" data-original-width="854" height="44" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjUJzYAbAJrGqiy_bpkByusa9XC1lpFgf-TAZ8XLqWnMmKgpiyo7LnlbzCzZoZx24rvqXOVyJGV09xXt59RDmsWuWRqZcoBM3SxTmhsOpLOh7FxFpWcYmumplc0ssOnkS4R8mXd7yh1-z5Gg8VQSYoC8T_fbu73mZEOZT97kZGbXgfX0HIPs67_ffyoV0U/w400-h44/DCFBusiness.jpg" width="400" /></a></div><div style="text-align: justify;"><br /></div><p style="text-align: justify;"><span><i>In this equation, for anything, tangible or not, has to show up in either the expected cash flows or in the risk (and the resulting discount rate); </i>that is <u>my "IT" proposition</u>. This proposition has stood me in good stead, in assessing the effect on value of just about everything, from macro variables like <a href="https://aswathdamodaran.blogspot.com/2022/05/a-follow-up-on-inflation-disparate.html">inflation</a> to buzzwords like <a href="https://aswathdamodaran.blogspot.com/2020/09/sounding-good-or-doing-good-skeptical.html">ESG</a>. </span></p><div class="separator" style="clear: both; text-align: justify;"><span> </span>Using this framework for assessing intangible assets, from brand name to quality management, you can see that their effect on value has to come from either higher expected cash flows or lower risk (discount rates).<span> </span>To provide more structure to this discussion, I reframe the value equation in terms of inputs that valuation analysts should be familiar with - revenue growth, operating margins and reinvestment, driving cash flows, and equity and debt risk, determining discount rates and failure risk. </div></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj7BnWCnMbBenfaELmAsyRP7GBffgMXfZ2hzc87AA0Ck5xwJLh9E2LmcX1vaGU9ra1XbGO-U1cXloetRtiRkJsFdjq4AJH79rbLOnIwF07oqr0GNQluEVkrYgGNUU2Mnm8HHrGM6LHw4tMCyCtBZ_kbeI9uY9Biy_cEPawjHjv8RkxyWoSy9sJb2tqgyNo/s1476/IntangibleValueEffectPicture.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1122" data-original-width="1476" height="304" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj7BnWCnMbBenfaELmAsyRP7GBffgMXfZ2hzc87AA0Ck5xwJLh9E2LmcX1vaGU9ra1XbGO-U1cXloetRtiRkJsFdjq4AJH79rbLOnIwF07oqr0GNQluEVkrYgGNUU2Mnm8HHrGM6LHw4tMCyCtBZ_kbeI9uY9Biy_cEPawjHjv8RkxyWoSy9sJb2tqgyNo/w400-h304/IntangibleValueEffectPicture.jpg" width="400" /></a></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">In the picture, I have highlight some of the key intangibles and which inputs are mostly likely to be affected by their presence. </div><div style="text-align: justify;"><ul><li>It is the operating margin where <i>brand name,</i> and the associated pricing power, is likely have its biggest effect, though it can have secondary effects on revenue growth and even the cost of capital. </li><li><i>Good management</i>, another highly touted intangible, will manifest in a business being able to deliver higher revenue growth, but also show up in margins and reinvestment; the essence of superior management is being able to find growth, when it is scarce, while maintaining profitability and not reinvesting too much. </li><li><i>Connections to governments and regulators</i>, an intangible that is seldom made explicit, can affect value by reducing failure risk and the cost of debt, while increasing growth and or profitability, as the company gets favorable treatment on bids for contracts.</li></ul><div>This is not a comprehensive list, but the framework applies to any intangible that you believe may have an effect on value. This approach to intangibles also allows you to separate valuable intangibles from wannabe intangibles, with the latter, no matter how widely sold, having little or no effect on value. Thus, a company that claims that it has a valuable brand name, while delivering operating margins well below the industry average, really does not, and the effect of ESG on value, no matter what its advocates claim, is non-existent.</div></div></div><div style="text-align: justify;"><span> It is true that this approach to valuing intangibles works best for a company with a single intangible, whether it be brand name or customer loyalty, where the effect is isolated to one of the value drivers. It becomes more difficult to use for companies, like Apple, with multiple intangibles (brand name, styling, operating system, user platform). While you can still value Apple in the aggregate, breaking out how much of that value comes from each of the intangibles will be difficult, but as an investor, why does it matter? </span><br /></div><div><p style="text-align: justify;"><b>The Birkenstock IPO: A Footwear company with intangibles</b></p><p style="text-align: justify;"><span> If you have found this discussion of intangibles abstract, I don't blame you, and I will try to remedy that by applying my intrinsic value framework to value Birkenstock, just ahead of its initial public offering. As a </span>company with multiple intangible components in its story, it is well suited to the exercise, and I will try to not only estimate the value of the company with the intangibles incorporated into the numbers, but also break down the value of each of its intangibles.</p><p style="text-align: justify;"><i>The Lead In</i></p><p style="text-align: justify;"><i> </i>Birkenstock is primarily a footwear company, and to get perspective on growth, profitability and reinvestment in the sector, I looked at all publicly traded footwear companies across the globe. the table below summarizes key valuation metrics for the 86 listed footwear companies that were listed as of September 2023.</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgCgnuXcaFUi89FwWSN3rOvn79YO3Fz-Fd9MixiwkZOh1BOtHLXm97DoldA1E7AoFQYS-qqChLACX-k6a_2YQdwpbw1BumBYjcLwXXgIpEvXsRMlg5wC6Xc4kTbC_J9H8iLQ2TCxKegGsfn1z0vDrDqrd1UEXCJAglUefiIFbefFnsyRyQM_PFnRucS38U/s1528/FootwearIndustryStats.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="266" data-original-width="1528" height="96" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgCgnuXcaFUi89FwWSN3rOvn79YO3Fz-Fd9MixiwkZOh1BOtHLXm97DoldA1E7AoFQYS-qqChLACX-k6a_2YQdwpbw1BumBYjcLwXXgIpEvXsRMlg5wC6Xc4kTbC_J9H8iLQ2TCxKegGsfn1z0vDrDqrd1UEXCJAglUefiIFbefFnsyRyQM_PFnRucS38U/w549-h96/FootwearIndustryStats.jpg" width="549" /></a></div><p style="text-align: justify;">In the aggregate, the metrics for footwear companies are <i>indicative of an unattractive business</i>, with more than half the listed companies seeing revenues shrink in the decade, leading into 2022 and more than quarter reporting operating losses. However, many of these companies are small companies, with a median revenue at $170 million, struggling to stay afloat in a competitive product market. Since Birkenstock generated revenues of $1.4 billion in the twelve months leading into its initial public offering, with an expectation of more growth in the future, I zeroed in on the twelve largest companies in the apparel and footwear sector, in market capitalization, and looked at their operating metrics:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjB-fvKKfgL9YQSzcV43A9PCzwVUqPZbGvXSPo3HkAhZvGRBHRD1WWorje4V8g_ee79T7T3Q0RDU54n0lVgYz_gMCOvmnXXl9B__nUE4NQrc39BYM-5bKbKDPjyUUY7YN9kEkdrwJlDzVLKoVgqmZxoKhTVGCUd-VgKi_UZaFiVaCxMnLasX7umnBP_l4k/s2146/BigApparelCos.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="688" data-original-width="2146" height="147" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjB-fvKKfgL9YQSzcV43A9PCzwVUqPZbGvXSPo3HkAhZvGRBHRD1WWorje4V8g_ee79T7T3Q0RDU54n0lVgYz_gMCOvmnXXl9B__nUE4NQrc39BYM-5bKbKDPjyUUY7YN9kEkdrwJlDzVLKoVgqmZxoKhTVGCUd-VgKi_UZaFiVaCxMnLasX7umnBP_l4k/w455-h147/BigApparelCos.jpg" width="455" /></a></div><p style="text-align: justify;">As you can see, these companies look very different from the sector aggregates, with solid revenue growth (median compounded growth rate of 8.66% a year, for the last decade) and exceptional operating margins (gross margins close to 70% and operating margins of 24%). Each of the companies also has a recognizable or many recognizable brand names, with LVMH and Hermes topping the list. In this business, at least, brand name seems to be dividing line between success and mediocrity, and having a well-recognized brand name contributes to growth and profitability. It is this grouping that I will draw on more, as I look valuing Birkenstock.</p><p style="text-align: justify;"><i>Birkenstock's History</i></p><p style="text-align: justify;"><i> </i>In my work on corporate life cycles, I talk about how companies age, and how importance it is that they act accordingly. Generally, as a company moves across the life cycle, revenue growth eases, margins level off and there is less reinvestment. As a business that has been around for almost 250 years, Birkenstock should be a mature or even old company, but it has found a new lease on life in the last decade. </p><p style="text-align: justify;"><span><span> </span>Birkenstock was founded in 1774 by Johann Adam Birkenstock, </span>a Germany cobbler, and it stayed a family business for much of its life. In the decades following its founding, the company modified and adapted its footwear offerings, catering to wealthy Europeans in the growing German spa culture in the 1800s, and modifying its product line, adding flexible insoles in 1896 and pioneering arch supports in 1902. During the 1920s and 1930s, the company carved out a market around comfort and foot care, partnering with physicians and podiatrists, offering solutions for customers with foot pain. In 1963, the company introduced its first fitness sandal, the Madrid, and sandals now represent the heart of Birkenstock's product line. </p><p style="text-align: justify;"><span> </span>Along the way, serendipity played a role in the company's expansion. In 1966, a Californian named Margot Fraser, when visiting her native Germany, discovered that Birkenstocks helped her tired and hurting feet, and she convinced Karl Birkenstock to try selling the company's sandals in California. It is said that Karl advanced her credit, and helped her persuade reluctant California retailers to carry the company’s unconventional footwear in their stores. That proved timely, since people protesting against the war and society's ills latched on to these sandals, making them them symbolic footwear for the rebellious. in the 1990s, the brand had a rebirth, when a very young Kate Moss wore it for a cover story, and it became a hot brand, especially on college campuses. Today, Birkenstock gets more than 50% of its revenues in the United States, with multiple celebrities among its customers. The company's prospectus does a good job painting a picture of both the product offerings and customer base, leading into the IPO, and I have captured those statistics in the picture below:</p><p style="text-align: justify;"></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjB8hP4XRj_uae9grLSKo4yIv_7e4GESSSzyP0Fs-D2sr_4WI85zrFzhVwWEJkzOb6o7ha9aGGmkv4X7zpU4QK9aZtveKk_spE01XmVtml3iK6hX0lAncJ3J6t0p-jmh6GSpiFPyzn3jjiBCawpLqJ_9AzmpruRbyxyJ8YLLFIrMJMqUHXefcwDHxZ3hJw/s1676/BirkentstockMktDescription.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="624" data-original-width="1676" height="149" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjB8hP4XRj_uae9grLSKo4yIv_7e4GESSSzyP0Fs-D2sr_4WI85zrFzhVwWEJkzOb6o7ha9aGGmkv4X7zpU4QK9aZtveKk_spE01XmVtml3iK6hX0lAncJ3J6t0p-jmh6GSpiFPyzn3jjiBCawpLqJ_9AzmpruRbyxyJ8YLLFIrMJMqUHXefcwDHxZ3hJw/w400-h149/BirkentstockMktDescription.jpg" width="400" /></a></div><p></p><p style="text-align: justify;">Unlike some in its designer and brand name peers, the company’s products are not exorbitantly over priced and the company’s best seller, the Arizona, sells for close to $100. While the company sells more shoes to <u>women than men</u>, it sells footwear to a <u>surprisingly diverse customer base</u>, in terms of income, with 20% of its sales coming from customers who earn less than $50,000 a year, and in terms of age, with almost 40% of its revenues coming from Gen X and Gen Z members.</p><p style="text-align: justify;"><span> </span>For much of its history, Birkenstock was run as a family business, capital constrained and with limited growth ambitions, perhaps explaining its long life. The turning point for the company, to get to its current form, occurred in 2012, when the family, facing internal strife, turned control of the company over to outside managers, choosing Markus Bensberg, a company veteran, and Oliver Reichert, a consultant, as co-CEOs of the company. Reichert, in particular, was a controversial pick since he was not only an outsider, but one with little experience in the shoe business, but the choice proved to be inspired. With an assist again from serendipity, when Phoebe Philo exhibited a black mink-lined Arizona on a Paris catwalk in 2012, leading to collaborations with high-end designers like Dior, the company has found a new life as a growth company, with revenues rising from €200 million in 2012 to more than <span style="text-align: left;">€</span>1.4 billion in the twelve months leading into the IPO, representing an 18.2% compounded annual growth rate over the decade:</p><table cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEglU_9Mgu8diK4QljrAyCn0UCCA9u724p-wgYQJUTnC2ew6bXTNCrbDXZAkg0ff1FV1GbYOsIIHo-iGus4EqInEXvYoDsD6_ZdX37xby9AyemTk_HT72utxjaM1YC7_AOZcC6q3onsCyjaSjdhSsJK6EBcOcl0WmT2e8uqusRxG6RXsNvYBPksFBwa0xmc/s1222/BirkenstockGrowthChart.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="902" data-original-width="1222" height="295" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEglU_9Mgu8diK4QljrAyCn0UCCA9u724p-wgYQJUTnC2ew6bXTNCrbDXZAkg0ff1FV1GbYOsIIHo-iGus4EqInEXvYoDsD6_ZdX37xby9AyemTk_HT72utxjaM1YC7_AOZcC6q3onsCyjaSjdhSsJK6EBcOcl0WmT2e8uqusRxG6RXsNvYBPksFBwa0xmc/w400-h295/BirkenstockGrowthChart.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;"><a href="https://www.sec.gov/Archives/edgar/data/1977102/000119312523250555/d507917df1a.htm">Birkenstock Prospectus 2023</a> (October 4 filing)</span></i></td></tr></tbody></table><p style="text-align: justify;">The surge in revenues has been particularly pronounced since 2020, the COVID year, with different theories on why the pandemic increased demand for the product; one is that people working from home chose the comfort of Birkenstocks over uncomfortable work shoes. <span>The company's growth has come with solid profitability, and the table below shows key profit metrics over the last three </span>years:</p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhZ4MOCbkskczs-Nfr2eClt0v9Cy5Dp3yemMbzcPiacyvH-KOGfb8p4-NEKCbirIPDs0UBdKVGV2NZO8zU3Ds3276hgpqLk65OMhg_r7J6ASqnZHPcap0LRw2e15vN-jUJHujGOF9OWLI1rWFdIkIkSRhh6WTI9g9wREckBfxIBGqivJkDr8CrG9F5HhYo/s1008/BirkenstockFinancials.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="350" data-original-width="1008" height="140" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhZ4MOCbkskczs-Nfr2eClt0v9Cy5Dp3yemMbzcPiacyvH-KOGfb8p4-NEKCbirIPDs0UBdKVGV2NZO8zU3Ds3276hgpqLk65OMhg_r7J6ASqnZHPcap0LRw2e15vN-jUJHujGOF9OWLI1rWFdIkIkSRhh6WTI9g9wREckBfxIBGqivJkDr8CrG9F5HhYo/w400-h140/BirkenstockFinancials.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><table cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody><tr><td class="tr-caption"><i><span style="font-size: x-small;"><a href="https://www.sec.gov/Archives/edgar/data/1977102/000119312523250555/d507917df1a.htm">Birkenstock Prospectus 2023</a> (October 4 filing)</span></i></td></tr></tbody></table></td></tr></tbody></table><p style="text-align: justify;">Note that the company's operating and gross margins, at least in the last two years, match up well with the operating margins of the large, brand name apparel & footwear companies that we highlighted in the last section. It may be early to value brand name, but the company certainly has been delivering margins that put it in the brand name group.</p><p> The strong growth since 2020 provide a strong basis for why the company is planning its public offering now, but there is another factor that may explain the timing. In 2021, the family sold a majority stake in the firm to L. Catterton, an LVMH-backed private equity firm, at an estimated value in excess of €<a href="#">4</a><a href="https://www.reuters.com/article/birkenstock-ma-catterton/birkenstocksells-majority-stake-to-l-catterton-idUSS8N2KN0CO"> billion Euros</a>. That deal was funded substantially with debt, leaving a debt overhang of close to €2 billion, in 2023; the prospectus states that all of of the company's proceeds from the offering will be used to pay down this debt. That said, the pricing for the offering has increased since news of it was first floated in July, with <span style="font-family: Helvetica; font-size: 13.333333px; text-align: left;">€</span><a href="https://fortune.com/2023/07/07/birkenstock-ipo-fashion-goldman-bernard-arnault/">6 billion plus pricing in initial reports</a> increasing to €<a href="https://fortune.com/2023/09/12/birkenstock-files-for-ipo/">8 billion in early September</a> and to<a href="https://www.wsj.com/business/retail/birkenstock-to-sell-10-8-million-shares-at-44-49-each-in-ipo-1e1c6879#"> €9.2 billion in the most recent news stories</a>. The company has picked up anchor investors along the way, with the Norwegian sovereign fund planning to buy €300 million of the initial offering.</p><p style="text-align: justify;"><i>Birkenstock's Intangibles</i></p><p style="text-align: justify;"><i> </i>Birkenstock is a good vehicle for identifying and valuing intangibles, since it has so many of them, with some more sustainable and more valuable than others:<i> </i><br /></p><p></p><ol style="text-align: left;"><li style="text-align: justify;"><u>Brand Name</u>: It is undeniable that Birkenstock not only has a brand name, in terms of recognition and visibility, but has the pricing power and operating margins to back up that brand name. However, as is often the case, the building blocks that gave rise to the brand name are complex and varied. The first is the uniqueness of the footwear makes the company stand out, with people people either hating its offerings (ugly, clunky, clog) or loving it. Unlike many footwear companies that attempt to copy the hottest styles, Birkenstock marches to its own drummer. The second is that the company's focus on comfort and foot health, in designing footwear, as well as the use of quality ingredients, is matched by actions. In fact, one reason that the company makes almost all of its shoes still in Germany, rather than offshoring or outsourcing, is to preserve quality, and sticks with time-tested and quality ingredients, is to preserve this reputation. The third is that unlike some of the companies on the big brand name list, Birkenstock's are not exorbitantly over priced, and has a diverse (in terms of income and age) customer base. In short, its brand name seems to have held up well over the generations.</li><li style="text-align: justify;"><u>Celebrity Customer Base</u>: As I noted earlier, especially as Birkenstocks entered the US market, they attracted a celebrity clientele, and that has continued through today. Birkenstock attracts celebrities in different age groups, from Gwyneth Paltrow & Heidi Klum to Paris Jackson & Kendall Jenner, and more impressively, it does so without paying them sponsorship fees. If the best advertising is unsolicited, Birkenstock clearly has mastered the game. </li><li style="text-align: justify;"><u>Good Management</u>: I tend be skeptical about claims of management genius, having discovered that even the most highly regarded CEOs come with blind spots, but Birkenstock seems to have struck gold with Oliver Reichert. Not only has he steered the company towards high growth, but he has done so without upsetting the balance that lies behind its brand name. In fact, while Birkenstock has entered into collaborative arrangements with other high profile brand names like Dior and Manolo Blank, Reichert has also turned down lucrative offers to collaborate with designers that he feels undermine Birkenstock's image. </li><li style="text-align: justify;"><u>The Barbie Buzz</u>: For a company that has benefited from serendipitous events, from Margot Fraser's introduction of its footwear to Americans in 1966 to Phoebe Philo's sandals on the Paris catwalk in 2012, the most serendipitous event, at least in terms of its IPO, may have been the release of the Barbie movie, this summer. Margot Robbie's<a href="https://pagesix.com/2023/07/27/shop-the-pink-birkenstocks-margot-robbie-wears-in-barbie/"> pink Birkenstock sandals in that movie,</a> which has been the blockbuster hit of the year, hyper charged the demand for the company's footwear. It is true that buzzes fade, but not before they create a revenue bump and perhaps even increase the customer base for the long term.</li></ol><div style="text-align: justify;">For the moment, these intangibles are qualitative and fuzzy, but in the next section, I will try to bring them into my valuation inputs.</div><p></p><p style="text-align: justify;"><i>Birkenstock Valuation</i></p><p style="text-align: justify;"><i> My </i>Birkenstock valuation is built around an upbeat story of continued high growth and sustained operating margins, with the details below:<br /></p><p></p><ol style="text-align: left;"><li><u>Revenue Growth</u>: The company is coming into the IPO, with the wind at its back, having delivered a compounded annual growth rate of 18.2% in revenues in the decade leading into the offering. That said, its revenues now are €1.4 billion, rather than the <span style="font-family: Helvetica; font-size: 13.333333px; text-align: left;">€</span>200 million they were in 2012, and growth rates will come down to reflect the larger scale. While the average CAGR in revenues for big brand apparel & footwear firms has been 8.66%, I believe that <b><i>Oliver Reichert and the management team</i></b> that runs Birkenstock will continue their successful history of opportunistic growth, and be able to triple revenues over the next decade. This will be accomplished with an assist from the <i><b>Barbie Buzz</b></i> in year 1 (pushing the growth rate to 25% over the next year) and a compounded growth rate of 15% a year in the following four years.</li><li style="text-align: justify;"><u>Profitability</u>: Birkenstock has had a history of strong operating margins, driven by its brand name and visibility. In the twelve months leading into the IPO, the company reported a pre-tax operating margin of 22.3%, and its margins over the last decade have hovered around 20%. I believe that the <i><b>strength of the brand name</b></i> will sustain and perhaps even slightly increase operating margins for the company, with the margin increasing to 23%, over the next year, and to 25% over the following four years.</li><li style="text-align: justify;"><u>Reinvestment</u>: Birkenstock has been circumspect in investing for growth, over its history, showing reluctance to move away from its reliance on its German workforce, and in making acquisitions. It has also not been a big spender on brand advertising, using its celebrity clientele as a key component of building and growing its brand I believe that the<i><b> celebrity clientele effect </b></i>will allow the company to continue on its path of efficient growth, delivering €2.62 for every euro invested, matching the third quartile of big brand apparel firms.</li><li style="text-align: justify;"><u>Risk</u>: The Catterton acquisition of a majority stake in Birkenstock in 2021 was funded with a significant amount of debt, but the proceeds from the offering are expected to be utilized in paying down debt. The company should emerge from the offering with a debt load on par with other brand name apparel & footwear companies, and the concentration of its production in Germany will reduce exposure to supply chain and country risk.</li><li style="text-align: justify;"><u>IPO Proceeds</u>: News stories suggest that Birkenstock is planning to offer about 21.5 million shares to the public, and use the proceeds (estimated to be €1 billion, at the <span style="font-family: Helvetica; font-size: 13.333333px; text-align: left;">€</span>45 offering price) to pay down debt. In conjunction, Catterton plans to sell about the same number of shares at the offering as well, reducing its stake in the company, and cashing out on what should be a big win for the private equity player.</li></ol><div style="text-align: justify;">To see how these inputs play out in value, I have brought them together in the (dense) valuation picture below. With each of the inputs, I have highlighted both the numbers that I am using, as well as highlighting how much intangibles contribute to each input:</div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj6sl05rInUaH6XZqvPc6GgRv9z2G6WvmFU6AINrT8pJM5p6JN6TNSXhbymWMfdusdIl5k6r-WQqy9SVKm-33p6O8kaerpQ69NEVZfQdbmRcbj_4HTIOPS5Y5x5CtWysQFej4hgmlk789rLCLFarUARDP3myYmp96ZONrQyf5EmrGTjJeRDyM1DFLE04Go/s3068/BirkenstockValuationPicture.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1198" data-original-width="3068" height="214" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj6sl05rInUaH6XZqvPc6GgRv9z2G6WvmFU6AINrT8pJM5p6JN6TNSXhbymWMfdusdIl5k6r-WQqy9SVKm-33p6O8kaerpQ69NEVZfQdbmRcbj_4HTIOPS5Y5x5CtWysQFej4hgmlk789rLCLFarUARDP3myYmp96ZONrQyf5EmrGTjJeRDyM1DFLE04Go/w550-h214/BirkenstockValuationPicture.jpg" width="550" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/BirkenstockIPO2023.xlsx"><span style="font-size: x-small;">Download spreadsheet</span></a></td></tr></tbody></table><p></p><p>The value that I estimate for Birkenstock, with my inputs on growth, profitability and risk, is about €8.38 billion, about 10% less than the rumored offering pricing, but still well within shouting distance of that number. In case you are tempted to use the company's many intangibles as the explanation for the difference, note that I have already incorporated them into my inputs and value. To make explicit that effect, I have isolated each intangible and its effect on value in the table below:</p><div class="separator" style="clear: both; text-align: justify;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEipahvRaOUNoXi614wqZMMevA6TDWiDR0d39kvL3I-vxPn0UeuC7QoRZKAYJeR56SjDaJhBdrTTkufleiG-mjy4srl4V8mqtWmlnrjt-6PAjmRMQRQRVHV3OUJUyGJWFbxj8UGcIcLW64BhyaLOW8oueBalRYIE9QnR0ffTeYfqUgGtR7dmsql9OFl93S0/s1692/IntangibleValueEffect.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="500" data-original-width="1692" height="119" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEipahvRaOUNoXi614wqZMMevA6TDWiDR0d39kvL3I-vxPn0UeuC7QoRZKAYJeR56SjDaJhBdrTTkufleiG-mjy4srl4V8mqtWmlnrjt-6PAjmRMQRQRVHV3OUJUyGJWFbxj8UGcIcLW64BhyaLOW8oueBalRYIE9QnR0ffTeYfqUgGtR7dmsql9OFl93S0/w400-h119/IntangibleValueEffect.jpg" width="400" /></a></div><p style="text-align: justify;">To value each intangible, I toggle the input that reflects the intangible on and off to determine how much it changes value. The intangible that has the biggest effect on value is brand name, followed by the strength of the management team, with the Barbie Buzz and Celebrity Effects lagging. Another way of visualizing how these intangibles play into value is to build up to estimated value of equity of €8.38 billion in pieces:</p><div class="separator" style="clear: both; text-align: justify;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi74MeiMfQIHD3M6sKBcIJmqGc_UJk4FU4voqrifOCMpFPByD1U01QJ8SBcUZgk8OvumOBs7cXFrQhqpbvcWg7EibSuIrYusuXAs_OVYrhNSNkiiaS6t0HQiXiJkrv01rYHuOfC99-qr8mqscAOriNlRsQtKhAOPE3tnZaAuEgLxaGhoVJxM2Lo969titQ/s3754/IntangibleValueChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="2734" data-original-width="3754" height="291" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi74MeiMfQIHD3M6sKBcIJmqGc_UJk4FU4voqrifOCMpFPByD1U01QJ8SBcUZgk8OvumOBs7cXFrQhqpbvcWg7EibSuIrYusuXAs_OVYrhNSNkiiaS6t0HQiXiJkrv01rYHuOfC99-qr8mqscAOriNlRsQtKhAOPE3tnZaAuEgLxaGhoVJxM2Lo969titQ/w400-h291/IntangibleValueChart.jpg" width="400" /></a></div><p style="text-align: justify;">These value judgments are based upon my estimates, and they are, of course, open for debate. For instance, you might argue that the effect of good management on revenue growth is more or less than my estimate, or even that the effects spill over into other inputs (cost of capital, margins and reinvestment), but that is a healthy debate to have. </p><p style="text-align: justify;"><i>Pricing Factors</i></p><p style="text-align: justify;"><b> </b>It is undeniable that the Birkenstock IPO will be priced, not valued, and the question of how the stock will do is just as much dependent, perhaps more so, on market mood and momentum, as it is on the fundamentals highlighted in the valuation. </p><p></p><ul style="text-align: left;"><li style="text-align: justify;">Looking at news about the company, the timing works well, since the company is coming into the market on a wave of good publicity. Almost every news story that I have read about the company paints a positive picture of it, with laudatory mentions of Oliver Reichert and the company's products, intermixed with pictures of not only Barbie's pink Birkenstock but a host of other celebrities.</li><li style="text-align: justify;">It is the market mood that is working against the company, at least at the moment that I am writing this post (October 6, 2023). As I wrote in <a href="https://aswathdamodaran.blogspot.com/2023/10/market-bipolarit-exuberance-versus.html">my post on bipolar markets</a> just a few days ago, the market mood has soured, with the optimism that we had dodged the bullet that was so widely prevalent just a few weeks ago replaced with the pessimism that dark days lie ahead for the global economy and markets.</li></ul><div>At its offering pricing of €9.2 billion (€45 to €50 per share), the company and its bankers seem to be betting that the good vibes about the company will outweigh the bad vibes in the market, but that is gamble. As someone who has tried and rejected the Arizona sandal, I am unlikely to be a customer for Birkenstock footwear, but this is a company with a truly unique brand name and a management team that understands the delicate balance between utilizing a brand name well and overdoing it. It is, in my view, a reach at €45 or €50 per share, but if the market turns sour, and the stock drops to below €40, I would be a buyer.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>YouTube Video</b></div><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/7vIsyP9pROM?si=NH6efG3cBrMMqLv_" title="YouTube video player" width="560"></iframe><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Attachments</b></div><div style="text-align: justify;"><ol><li><a href="https://www.sec.gov/Archives/edgar/data/1977102/000119312523250555/d507917df1a.htm">Birkenstock Prospectus (October 4 filing)</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/BirkenstockIPO2023.xlsx">My valuation of Birkenstock with intangibles breakdown</a></li></ol></div><p></p></div>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-32627039555953750272023-10-04T14:29:00.006-04:002023-10-05T10:23:38.589-04:00Market Bipolarity: Exuberance versus Exhaustion!<p style="text-align: justify;">As we enter the last quarter of 2023, it has been a roller coaster of a year. We started the year with significant uncertainty about whether the surge in inflation seen in 2022 would persist as well as about whether the economy was headed into a recession. In the first half of the year, we had positive surprises on both fronts, as inflation dropped after than expected and the economy stayed resilient, allowing for a comeback on stocks, which I wrote about <a href="https://aswathdamodaran.blogspot.com/2023/07/market-resilience-or-investors-in.html">in a post in July 2023</a>. That recovery notwithstanding, uncertainties about inflation and the economy remained unresolved, and those uncertainties became part of the market story in the third quarter of 2023. In July and the first half of August of 2023, it looked like the market consensus was solidifying around a soft-landing story, with no recession and inflation under control, but that narrative developed cracks in the second half of the quarter, with markets giving back gains. In this post, I will look at how markets did during the third quarter of 2023, and use that performance as the basis for examining risk capital's presence (or absence) in markets. </p><p><b>The Markets in the Third Quarter</b></p><p><span> Coming off a year of rising rates in 2022, interest rates have continued to command center stage in 2023. While the rise in treasury rates has been less dramatic this year, rates have continued to rise across the term structure:</span></p><div class="separator" style="clear: both; text-align: center;"><br /><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhEJNaOW9Acy0xn3Tw_iwReX_R4Dt51SGLzqhy3bjtes7HmQrcm0sBJpLLSFkBBhV2863PrWmmK_bS_Px5a0E0bh7UBGaj0EP0FJZpZm8aRML0U6dsabZ8WEp3_lfGZukE_BylQifH5Ow5Y19e57RbKwuozB6JlFcIM0d6BIBZt_S2MMpMVu9cLcZ0m7C0/s1534/TreasuryRates.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1504" data-original-width="1534" height="426" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhEJNaOW9Acy0xn3Tw_iwReX_R4Dt51SGLzqhy3bjtes7HmQrcm0sBJpLLSFkBBhV2863PrWmmK_bS_Px5a0E0bh7UBGaj0EP0FJZpZm8aRML0U6dsabZ8WEp3_lfGZukE_BylQifH5Ow5Y19e57RbKwuozB6JlFcIM0d6BIBZt_S2MMpMVu9cLcZ0m7C0/w433-h426/TreasuryRates.jpg" width="433" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;">US Treasury</td></tr></tbody></table></div><br /><div class="separator" style="clear: both; text-align: justify;">While short term rates rose sharply in the first half of the year, and long term rates stabilized, <u>the third quarter has sen a reversal, with short term rates now stabilizing and long term rates rising</u>. At the start of October, the ten-year and thirty-year rates were both approaching 15-year highs, with the 10-year treasury at 4.59% and the 30-year treasury rate at 4.73%. As a consequence, the yield curve which has been downward sloping for all of the last year, became less so, which may have significance for those who view this metric as an impeccable predictor of recessions, but I am not one of those.</div><div class="separator" style="clear: both; text-align: justify;"><span> Moving on to stocks, the strength that stocks exhibited in the first half of this year, continued for the first few weeks of the third quarter, with stocks peaking in mid-August, but giving back all of those gains and more in the last few weeks of the third quarter of 2023:</span></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgjuEB2yKi3RRuxrkyuvtIYLJgg91lPO9zJvPKu3EdG3ZonqxgeVQIybIaYhFRAx2WBNWxTasE0qZMTzEASeWr6xFWVRSxsig21mkI5XyxAwfVeZi22Rsar59m1c-wk9g-i2zvKtKMDvaq4lH_1wxNfIqzvUF-KXzqu8wCz3ABDABvbxK8wNsjnTtMts4A/s1658/USEquities3rdQtr.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1658" data-original-width="1604" height="460" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgjuEB2yKi3RRuxrkyuvtIYLJgg91lPO9zJvPKu3EdG3ZonqxgeVQIybIaYhFRAx2WBNWxTasE0qZMTzEASeWr6xFWVRSxsig21mkI5XyxAwfVeZi22Rsar59m1c-wk9g-i2zvKtKMDvaq4lH_1wxNfIqzvUF-KXzqu8wCz3ABDABvbxK8wNsjnTtMts4A/w446-h460/USEquities3rdQtr.jpg" width="446" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div style="text-align: justify;">As you can see, <u>it has been a divergent market</u>, looking at performance during 2023. In spite of losing 3.65% of their value in the third quarter of 2023, large cap stocks are still ahead 12.13% for the year, but <u>small cap stocks are now back to where they were at the start of 2023</u>. The NASDAQ also gave back gains in the third quarter, but is up 27.27% for the year, but those gaudy numbers obscure a sobering reality. Seven companies (NVIDIA, Apple, Microsoft, Alphabet, Meta, Amazon and Tesla) account for $3.7 trillion of the increase in market cap in 2023, and removing them from the S&P 500 and NASDAQ removes much of the increase in value you see in both indices. </div><div><span> Breaking global equities down by sector, and looking at the changes in 2023, both for the entire year as well as just the third quarter, we arrive at the following:</span><br /><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEifK3KbtD3AorXFhhUoolVgDrwNtR7ndvs-9_ePJFFq6VjD2UTmkR6kTB4E5DTvDfvdYNDZPlD2v_otZoKqzBSBfKT-RTJGOHovSYKaeWSq-9BZUkxjS4IivSHVY8FQLrl3XIO40x3Daq4fORcDRMckapsl5niuWt3NHd0MBQjJhrTdwtUgDdkf1z0LyZE/s1364/SectorBreakdown.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="514" data-original-width="1364" height="191" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEifK3KbtD3AorXFhhUoolVgDrwNtR7ndvs-9_ePJFFq6VjD2UTmkR6kTB4E5DTvDfvdYNDZPlD2v_otZoKqzBSBfKT-RTJGOHovSYKaeWSq-9BZUkxjS4IivSHVY8FQLrl3XIO40x3Daq4fORcDRMckapsl5niuWt3NHd0MBQjJhrTdwtUgDdkf1z0LyZE/w506-h191/SectorBreakdown.jpg" width="506" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><br /><div style="text-align: justify;"> <span style="text-align: justify;">In keeping with our findings from contrasting the NASDAQ to other US indices, <u>technology has been the best performing sector for 2023, followed by consumer discretionary and communication services</u>. However, also in keeping with our findings on divergence across stocks, five of the eleven sectors have decreased in value in 2023, with real estate and utilities the worst performing sectors. Some of these differences across sectors reflect reversals from the damage done in 2022, but some of it is reflective of the disparate impact of inflation and higher rates across companies</span></div></td></tr></tbody></table><p style="text-align: justify;"><span> Finally. I looked at global equities, broken down by region of the world, and in US dollars, to allow for direct comparison:</span><br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgurBJP_LvoM9zUtFgVr6gAqpNABsa6jkspr99fgVZs8CJ1J_cJmtYaNu-z_Munr7U4JxInxNJMCOGFINkvxmRIJr3F_tfN5-eXBDMGfmrx644uOr947lTRv64dqDccc54xvCJKdv2gtpAGhnR4ATAQrYL1jD6z_WHpZybT0dgxyRrS0qzBhoRfFlEj0Y8/s1366/RegiionBreakdown.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="548" data-original-width="1366" height="189" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgurBJP_LvoM9zUtFgVr6gAqpNABsa6jkspr99fgVZs8CJ1J_cJmtYaNu-z_Munr7U4JxInxNJMCOGFINkvxmRIJr3F_tfN5-eXBDMGfmrx644uOr947lTRv64dqDccc54xvCJKdv2gtpAGhnR4ATAQrYL1jD6z_WHpZybT0dgxyRrS0qzBhoRfFlEj0Y8/w473-h189/RegiionBreakdown.jpg" width="473" /></a></div><p style="text-align: justify;"><u>India is the only region of the world to post positive returns, in US dollar terms, in the third quarter,</u> and is the best performing market of the year, running just ahead of the US; note again that of the $5.2 trillion increase in value US equities, the seven companies that we listed earlier accounted for $3.7 trillion. <u>Latin America had a brutal third quarter, and is the worst performing region in the world</u>, for the year-to-date, followed by China. If you are an equity investor, your portfolio standing at this point of 2023 and your returns for the year will be largely determined by whether you had any money invested in the "soaring seven" stocks, as well as the sector and regional skews in your investments.</p><p><b>Price of Risk</b></p><p style="text-align: justify;"><b> </b>The drop in stock and bond prices in the third quarter of 2023 can partly be attributed to rising interest rates, but how much of that drop is due to the price of risk changing? Put simply, higher risk premiums translate into lower asset prices, and it is conceivable that political and macroeconomic factors have contributed to more risk in markets. To answer this question, I started with the corporate bond market, where <u>default spreads capture the price of risk</u>, and looked at the movement of default spreads across ratings classes in 2023:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhGkI4Pn6T23h24uJVaKeRjS7K36XXnFL1SwDKaoArSRIg7EMjEoVBcZsRevCBf19b39TG0SqYbFwF78rC2Gp-BmndBJiFN4cFPkopFlOVsXMgUw4IOtApy4s5zNtONmP9mq53CvXQ1cSFs2UkrDEjS6sOrSplAEkHG_schvM2z3CgBd6FfLwjcMmnbmXk/s1646/DefSpreadChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1450" data-original-width="1646" height="353" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhGkI4Pn6T23h24uJVaKeRjS7K36XXnFL1SwDKaoArSRIg7EMjEoVBcZsRevCBf19b39TG0SqYbFwF78rC2Gp-BmndBJiFN4cFPkopFlOVsXMgUw4IOtApy4s5zNtONmP9mq53CvXQ1cSFs2UkrDEjS6sOrSplAEkHG_schvM2z3CgBd6FfLwjcMmnbmXk/w400-h353/DefSpreadChart.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: justify;"><br /></div><div class="separator" style="clear: both; text-align: justify;">As you can see, bond default spreads, after surging in 2022, had a quiet third quarter, decreasing slightly across all ratings classes. Looking across the year to date, there has been little movement in the higher ratings classes, but default spreads have dropped substantially during2023, for lower rated bonds.</div><div class="separator" style="clear: both; text-align: justify;"><span> In the equity market, I fall back on my estimates of implied equity risk premiums, which I report at the <a href="http://damodaran.com">start of every month on my website</a>, and you can see the path that these premiums have taken during the course of the last two years below:</span><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgJ9ngBfaxDat9Kz_ejGP0VIR4s-3yPVACFbcsri5MvxsOJiFfaHnwwkMpNdtxwmMbLC5hJruYS4ATMcCODIJK2vNRK5GnLc3mIRueYtGZ372uuHevtnxi6GlyfS4z2Hv253VBbBgCIRszKSEgsiBvkOEe9Krytkx_zlhICM5OOKEFr_10RJ9kQOEjbgpw/s2472/ERPin2023.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1798" data-original-width="2472" height="326" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgJ9ngBfaxDat9Kz_ejGP0VIR4s-3yPVACFbcsri5MvxsOJiFfaHnwwkMpNdtxwmMbLC5hJruYS4ATMcCODIJK2vNRK5GnLc3mIRueYtGZ372uuHevtnxi6GlyfS4z2Hv253VBbBgCIRszKSEgsiBvkOEe9Krytkx_zlhICM5OOKEFr_10RJ9kQOEjbgpw/w448-h326/ERPin2023.jpg" width="448" /></a></div><div class="separator" style="clear: both; text-align: justify;">The <u>equity risk premium declined in the first half of the year, from 5.94% on January 1, 2023, to 5.00% on July 1, 2023</u>, but <u>have been relatively stable in the third quarter</u>, albeit on top of higher risk free rates. Thus, the equity risk premium of 4.84% on October 1, 2023, when added to the ten-year T.Bond rate of 4.58% on that day <u>yields an expected return on equity of 9.42%, up from 8.81% on July 1, 2023.</u> Put simply, notwithstanding the ups and downs in stock prices and interest rates in the third quarter of 2023, there is little evidence that changes in the pricing of risk had much to do with the volatility. Much of the change in stock and corporate bond prices in the third quarter has come from rising interest rates, not a heightened fear factor.</div></div><div><br /></div><div><b>Risk Capital</b><p style="text-align: justify;"><span> In a p<a href="https://aswathdamodaran.blogspot.com/2022/07/risk-capital-and-markets-temporary.html">ost in the middle of 2022</a>, I noted a dramatic shift in risk capital, i.e., the capital invested in the riskiest investments in every asset class - young, money-losing stocks in equities, high-yield bonds in the </span>corporate bond market and seed capital, in venture capital. After a decade of excess, where risk capital was not just abundant, but overly so, risk capital retreated to the sidelines, creating ripple effects in private and public equity markets. In making that case, I drew on three metrics for measuring risk capital - the <u>number of initial public offerings, the amount of venture capital investment and original issuances of high yield bonds</u>, and I decided that it is time to revisit those metrics, to see if risk capital is finding its way back into markets.</p><p style="text-align: justify;"><span> With IPOs, there have been positive developments in recent weeks, with a few high-profile IPOs (Instacart, ARM and Klaviyo) hitting the market, suggesting a loosening up of risk capital. To get a broader perspective, though, I took a look a the number of IPOs, as well as proceeds raised, in 2023, with the intent of detecting shifts:</span></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhtB5O1Vntp3BzTAYUW74G1bZwHDCkZzoq_FsMP70MGHx9Cseht-6q2gjq690tJfO32cOu1svDsImZLHbWrt5a-x92SkKTbMDNFXJYsbWVTrRxdCg-30TrZ3MUJsdmSyXtnnlYqjyDuROgukjazGU3ZJhifMGqc90wURXGlbFxSJa95tzTp1vJIgGKVW0A/s1768/IPOsin2023.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1276" data-original-width="1768" height="289" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhtB5O1Vntp3BzTAYUW74G1bZwHDCkZzoq_FsMP70MGHx9Cseht-6q2gjq690tJfO32cOu1svDsImZLHbWrt5a-x92SkKTbMDNFXJYsbWVTrRxdCg-30TrZ3MUJsdmSyXtnnlYqjyDuROgukjazGU3ZJhifMGqc90wURXGlbFxSJa95tzTp1vJIgGKVW0A/w400-h289/IPOsin2023.jpg" width="400" /></a></div><div style="text-align: justify;">The good news is that there has been some recovery from the last quarter of 2022, where there were almost no IPOs, but the bad news (for those in the IPO ecosystem) is that this is still a stilted recovery, with numbers well below what we observed for much of the last decade. In addition, it should be noted that the companies that have gone public in the last few weeks have had rough going, post-issuance, in spite of being priced conservatively (relative to what they would have been priced at two years ago).</div></div><div><span> Turning to venture capital financing, we look at both the dollar value of venture capital investing, as well as the breakdown into angel, early stage and late </span>stage funding:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhg8_MIMhOD8VtnHL7nSdN-sGZMJu3e8MOz8_dEF-W8Dw-Q8HXiG-9LNhQzmi1BbWlLiX_2vycRUNy9A5VCUXy2GBwV0DIG9iW1tvNJHcsr1BlM2shSMGUqbRgrmV6mIa3fZj1dv-tf8Rgt9MkeUpdM9ANhQpS92CrEKPawf8gx3_uraPE1hhu3YhmKqqs/s1758/VCInvesting2023.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1292" data-original-width="1758" height="294" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhg8_MIMhOD8VtnHL7nSdN-sGZMJu3e8MOz8_dEF-W8Dw-Q8HXiG-9LNhQzmi1BbWlLiX_2vycRUNy9A5VCUXy2GBwV0DIG9iW1tvNJHcsr1BlM2shSMGUqbRgrmV6mIa3fZj1dv-tf8Rgt9MkeUpdM9ANhQpS92CrEKPawf8gx3_uraPE1hhu3YhmKqqs/w400-h294/VCInvesting2023.jpg" width="400" /></a></div><div style="text-align: justify;">The drop off in venture capital investing that we saw in the second half of 2022 has clearly continued into 2023, with the second quarter funding down from the first. I have long argued that venture capital pricing is tied to IPO and young company pricing in public markets, and given that those are still languishing, venture capital is holding back. In short, if you are a venture capitalist or a company founder, battered by down rounds and withheld capital, the end is not in sight yet.</div></div><div><div style="text-align: justify;"><span> Finally, companies that have ratings below investment </span>grade need access to risk capital, to make original issuances of bonds. In the chart below, I look at corporate bond issuances in 2023:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiZljwu8vZVzzmZVFXryxsJRYnF5nBhCFAz8WeaxkryGypXg5zVNaAHyG5gi1HANzXq6Q_Rtqz8eLJ9q7vMN8JF4WZTO0lGDzYth8QWxbK5R49phyphenhyphenovoR6GG_tu0NEnmk2m6xLLTCJ1ZmPl0a1yFnR9TvT2Y3qxuPslm6qSHLypkEHtcXWAmAyMHCCWX8s/s1776/BondIssuancesin2023.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1296" data-original-width="1776" height="293" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiZljwu8vZVzzmZVFXryxsJRYnF5nBhCFAz8WeaxkryGypXg5zVNaAHyG5gi1HANzXq6Q_Rtqz8eLJ9q7vMN8JF4WZTO0lGDzYth8QWxbK5R49phyphenhyphenovoR6GG_tu0NEnmk2m6xLLTCJ1ZmPl0a1yFnR9TvT2Y3qxuPslm6qSHLypkEHtcXWAmAyMHCCWX8s/w400-h293/BondIssuancesin2023.jpg" width="400" /></a></div><div><br /></div><div>The good news is that corporations are back to issuing bonds, perhaps recognizing that waiting for rates to come down is futile. However, the portion of these issuances that are high-yield bonds has stayed low for the last six quarters, suggesting that the market for these bonds is still sluggish. </div><div style="text-align: justify;"><span> Looking across the risk capital metrics, notwithstanding the recovery we have seen in equities this year, it looks like risk capital is still on the side lines, perhaps because that recovery is concentrated in large and money-making companies. Until you start see stock market gains widen and include smaller, money-losing companies, it is unlikely that we will see bounce backs in the venture capital and high-yield bond markets. Even when that recovery comes, I believe that we will not return to the excesses of the last decade, and that is, in my view, a good development.</span></div><p><b>What now?</b></p><p style="text-align: justify;"><b> </b>Entering the last quarter of 2023, it is striking how little the terrain has shifted over the last nine months. The two big uncertainties that I highlighted at the start of the year - whether inflation would persist or subside and whether there would be a recession - remain unresolved. If anything, the failed prognostications of economists and market gurus on both of these macro questions has left us with even less faith in their forecasts, and more adrift about what's coming down the pike. On the economy, the consensus view at the start of 2023 was that we were heading into a recession, with the only questions being when it would kick in, and how deep it would be. One reason for market outperformance this year has been the performance of the economy, which has managed to not only avoid a recession but also deliver strong employment numbers:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgYoJe2YqlBSvDOchbW4bbecsC_tA1GDyiyfGmOwK50jswb_o7pd4MUkzHaXp4-Z_520fkVlf1jR7FWFbjwRKBNSdOx3lWo3eGyciWrCNGYLVAsBLYD9M6hdCwl-RVAFt0WymMnl7WcyBx68GNJhJV-BpNTO-vH7HVe-3CtSkxuyZApDIoL3k_3TJiQVxM/s2426/Economyin2023.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1760" data-original-width="2426" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgYoJe2YqlBSvDOchbW4bbecsC_tA1GDyiyfGmOwK50jswb_o7pd4MUkzHaXp4-Z_520fkVlf1jR7FWFbjwRKBNSdOx3lWo3eGyciWrCNGYLVAsBLYD9M6hdCwl-RVAFt0WymMnl7WcyBx68GNJhJV-BpNTO-vH7HVe-3CtSkxuyZApDIoL3k_3TJiQVxM/w400-h290/Economyin2023.jpg" width="400" /></a></div><br /><p style="text-align: justify;">It is true that if you squint at this graph long enough, you may see signs of slowing down, but there are few indicators of a recession. This data may explain why economists have become more optimistic about the future, over the course of 2023, as can be seen in their estimates of the probability of a recession: </p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhnrV4apPnnNgo5Shzkrd5WfPXeVlV4ErMeU0kXXIn9Avv_ZbKHwqPjDuJP0SbMuh1PcqGVPSr5f2Bl_D9JNGZ58x1WtAEy3PhhIX1y-q60gb-jSPyA4qPVnhXyx-eFK06qckwzwwNdDEkQabYkXJFAI1JPAanXeOb3Aq1haaHg-W3e2mwY-IVtVOfEvrE/s1426/REcessionProbEconSurvey.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1020" data-original-width="1426" height="286" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhnrV4apPnnNgo5Shzkrd5WfPXeVlV4ErMeU0kXXIn9Avv_ZbKHwqPjDuJP0SbMuh1PcqGVPSr5f2Bl_D9JNGZ58x1WtAEy3PhhIX1y-q60gb-jSPyA4qPVnhXyx-eFK06qckwzwwNdDEkQabYkXJFAI1JPAanXeOb3Aq1haaHg-W3e2mwY-IVtVOfEvrE/w400-h286/REcessionProbEconSurvey.jpg" width="400" /></a></div><br /><p>The economists polled in this survey have reduced their likelihood of a recession from more than 60% to about 40%, with the steepest drop off occurring in the last two months. </p><p><span> </span>On inflation, we started the year with the consensus view that inflation would come down, but only because of economic weakness. The positive surprise for markets in 2023 is that inflation has come down, without a recession yet in sight:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhWG58lSkDgUIYwmqg2p7sM9w6U5lH_pWFAawAc2Bx-r-6sZwCS0zejkfng5MNnYT1kLj5RRLoSpUjpak4D8-Jte4_1rNLHpwTVIuvqzZlPwBwKBAu3ElZ0k6KBs2sudruyxgxGHF-CH5oCfJUd5IRjlLFLFXPAwZrFlAL-WQI7jPQktcb74OJ797Ixlxk/s1938/InflationExpectations.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1346" data-original-width="1938" height="222" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhWG58lSkDgUIYwmqg2p7sM9w6U5lH_pWFAawAc2Bx-r-6sZwCS0zejkfng5MNnYT1kLj5RRLoSpUjpak4D8-Jte4_1rNLHpwTVIuvqzZlPwBwKBAu3ElZ0k6KBs2sudruyxgxGHF-CH5oCfJUd5IRjlLFLFXPAwZrFlAL-WQI7jPQktcb74OJ797Ixlxk/s320/InflationExpectations.jpg" width="320" /></a></div><br /><p style="text-align: justify;">The drop off in inflation in the first half of 2023 was steep, both in actual numbers (CPI and PPI) and in expectations (from surveys of consumers and the treasury market). While the third quarter saw of leveling off in those gains, it is clear that inflation has dropped over the course of the year, albeit to levels that still remain about Fed targets. If you are one of those who argued that inflation was transitory, this year is not a vindication, since prices, even if they level off, will be about 20% higher than they were two years ago. There is work to be done on the inflation front, and declaring premature victory can be dangerous.</p><p><b>Valuing Equities</b></p><p style="text-align: justify;"><b> </b>In response to what this means for the market, I have to start with a confession, which is that I am not a market timer, making it very unlikely that I will find the market to be mis-valued by a large magnitude. In keeping with a practice that I have used before (see my start-of-the year and mid-year valuations), I valued the S&P 500, given current market interest rates and consensus estimates of earnings for the future:</p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhgF-OnS2RVkpxiXU2X2dj9V02IzX4wkTrAEkPGFU4U3M8JrNkxh-IJHMXH78HXr2vBc_M1D0OzUnvIz7EKGWHQfhI3cURPyxsZlDmdKiDjFlt3IvXDjDxt7UITQyZl_uscoGN_6MctJA3Sifiz11tNfFcnRDfSN3kO7iVkK6OFpi3nhVPsYY7aAeblVoM/s1496/IntrinsicIndexValue.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="732" data-original-width="1496" height="237" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhgF-OnS2RVkpxiXU2X2dj9V02IzX4wkTrAEkPGFU4U3M8JrNkxh-IJHMXH78HXr2vBc_M1D0OzUnvIz7EKGWHQfhI3cURPyxsZlDmdKiDjFlt3IvXDjDxt7UITQyZl_uscoGN_6MctJA3Sifiz11tNfFcnRDfSN3kO7iVkK6OFpi3nhVPsYY7aAeblVoM/w484-h237/IntrinsicIndexValue.jpg" width="484" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/S&P500ValueOct2023.xlsx">Download valuation spreadsheet</a></td></tr></tbody></table><br /><div class="separator" style="clear: both; text-align: justify;">As you can see, with the 10-year treasury bond rate at 4.58% and the earnings estimates from analysts for 2023, 2024 and 2025, <i>I estimate an intrinsic value of the index of 4147, about 3.4% below the actual index level of 4288, making it close to fairly valued</i>. </div><div class="separator" style="clear: both; text-align: justify;"><span> </span>My assessment is a bit of a cop-out, since they are built on current interest rate levels and consensus earnings estimates. To the extent that your views about inflation and the economy diverge from that consensus can cause you to arrive at a different value. I have tried to capture four scenarios in the picture below, with a contrast to the market consensus scenario above, and computed intrinsic value under each one:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjE6CDYv86xgqkck3vYE0SvXNeWUJVwBgHJgJK99-jRQbP6BvwpUcOyKiMQ0rh2SPoTL7OcfVDaxYaC9FKYzJ2ITxfXqbTig66MVDoLRI72gmlUz3Q3aPviASZCEHJFeUeVFMIeehvKfAphQdiUWWx9LK172cCVBUJVLPzIKqxeJIse9cOpT8q7-NC6P58/s1034/IntrinsicValueScenarios.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="786" data-original-width="1034" height="243" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjE6CDYv86xgqkck3vYE0SvXNeWUJVwBgHJgJK99-jRQbP6BvwpUcOyKiMQ0rh2SPoTL7OcfVDaxYaC9FKYzJ2ITxfXqbTig66MVDoLRI72gmlUz3Q3aPviASZCEHJFeUeVFMIeehvKfAphQdiUWWx9LK172cCVBUJVLPzIKqxeJIse9cOpT8q7-NC6P58/s320/IntrinsicValueScenarios.jpg" width="320" /></a></div><div class="separator" style="clear: both; text-align: justify;"><br /></div><div class="separator" style="clear: both; text-align: justify;">As you can see, your views on inflation (stubborn or subsides) and the economy (soft landing or recession) will lead you to very different estimates of intrinsic value, and judgments about under or over valuation. </div><div class="separator" style="clear: both; text-align: justify;"><span> </span>Since I am incapable of forecasting inflation and economic growth, I fall back on another tool in my arsenal, a Monte Carlo simulation, where I allow three key variables (risk free rate, equity risk premium, earnings in 2024 & 2025) to vary, and estimate the effect on index value:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh_qBEDZR83qixdth6FUTvCH9b9IGZNtiHOPfEX4l4C0uosdbUehtLJ2xul3slw9wJb6Q17htTzdIaIHPttQOy5HOzp2t2oPWsIGS2poW0b8kJDOpVsSDA4iTGduCOTar83jng04XoBOP7fsnowVzA3S0wyIRVTE4ThF6yk-M3pap7DacPi9tHd5lU7Rk4/s1512/S&PSimulation.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1138" data-original-width="1512" height="301" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh_qBEDZR83qixdth6FUTvCH9b9IGZNtiHOPfEX4l4C0uosdbUehtLJ2xul3slw9wJb6Q17htTzdIaIHPttQOy5HOzp2t2oPWsIGS2poW0b8kJDOpVsSDA4iTGduCOTar83jng04XoBOP7fsnowVzA3S0wyIRVTE4ThF6yk-M3pap7DacPi9tHd5lU7Rk4/w400-h301/S&PSimulation.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div style="text-align: justify;">The median value across 10,000 simulations is 4199. 2.1% below the index value of 4288, confirming my base case conclusion. If there is a concern here for equity investors, it is that there is more downside than upside, across the simulation, and that should be a factor in asset allocation decisions. It can also explain not only why there is reluctance on the part of investors to jump on the bandwagon, but also the presence of high-profile investors, short selling the entire equity market. </div></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b style="text-align: left;">Conclusion</b></div><div style="text-align: justify;"><span style="text-align: left;"><b> </b>As I was writing this post, I am reminded of one of my favorite movies, <i><a href="https://www.imdb.com/title/tt0107048/">Groundhog Day</a></i>, where Bill Murray is a weatherman who wakes up and relives the same day over and over again. We started the year, talking about inflation and a possible recession, and we keep returning to that conversation repeatedly. You may want to move on, but it is unlikely that either uncertainty will be resolved in the near future. In the meantime, the market will continue swinging between wild optimism (where inflation is no longer viewed as a threat and the economy has a soft landing) and extreme pessimism (where inflation comes back with a bang and the economy falls into a </span>recession). The truth, as is often the case, will fall somewhere in the middle, but it will not be easy to find.</div><div><br /></div><div><b>YouTube Video</b></div><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/YiZPIwbA-CU?si=5eRAluKlVsA4IH8t" title="YouTube video player" width="560"></iframe><div><br /></div><div><br /></div><div><b>Spreadsheets</b></div><div><ol style="text-align: left;"><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/S&P500ValueOct2023.xlsx">Intrinsic Valuation of the S&P 500 Spreadsheet</a></li></ol></div>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-44976627969732998382023-09-19T16:50:00.006-04:002023-09-20T10:00:29.060-04:00Putting the (Insta)cart before the (Grocery) horse: A COVID Favorite's Reality Check!<p style="text-align: justify;">After years of rumors of an imminent IPO, Instacart has finally filed for a public offering of it’s shares, aspiring to raise about $600 million from markets, at a pricing of about $9-$10 billion for its equity. Coming in the week after ARM, an AI chip designer, also filed to go public, but with an estimated pricing of $55-$60 billion, it is an indication of how much the ground has shifted under Instacart since the heady days of 2020, when Instacart was viewed by some Americans as the only thing that stood between them and starvation. At that time, there were some who were suggesting that the company could go public at $50 billion or more, and pricing it on that basis, but reality has caught up with both the company and investors, and this IPO represents vastly downgraded expectations for the company’s future.</p><p><b>The Back Story</b></p><p style="text-align: justify;"><span> To value Instacart, you have to start with an understanding of the business model that animates the company, as well the underlying business that it is intermediating. I start with this section with the Instacart business model, which is not complicated, but I will spend the rest of the section exploring the operating characteristics of the grocery business, and its online segment.</span><br /></p><p><i>The Instacart Business Model</i></p><p style="text-align: justify;"><i> </i>The Instacart business model extends online shopping, already common in other areas of retailing, into the grocery store space. That is not to say that there aren't logistical challenges, especially because grocery store carry thousands of items, and grocery shopping lists can run to dozens of these, with varying unit measures (by item, by weight) and substitution questions (when items are out of stock). Instacart operates as the intermediary between customers and grocery stores, where customers pick the grocery store that they would like to shop at and the items that they would like to buy at that store, and Instacart does the rest:<br /></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjh8vzGXVPKwrtZBwEubL8DxvXJUpaRWTpo3MAhMqSBerNPB8wDcC3vlU6BGI39DO3eV2YX_u7XTHjhDv_ZF4a6VRdNS9Gnri3Q4csKp3EOiWU6sORgCCm3VzpFDIddBanCaPGelnfDIcD7IRBldEhCnSNBqDRdAAt2eSpVHrpifswClVl4zd030azU9dE/s1500/InstacartBusinessModel.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1060" data-original-width="1500" height="283" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjh8vzGXVPKwrtZBwEubL8DxvXJUpaRWTpo3MAhMqSBerNPB8wDcC3vlU6BGI39DO3eV2YX_u7XTHjhDv_ZF4a6VRdNS9Gnri3Q4csKp3EOiWU6sORgCCm3VzpFDIddBanCaPGelnfDIcD7IRBldEhCnSNBqDRdAAt2eSpVHrpifswClVl4zd030azU9dE/w400-h283/InstacartBusinessModel.jpg" width="400" /></a></div><br /><div style="text-align: justify;">Instacart hires store shoppers who gather the items for the order, checking with the customer on substitutions, if needed, and for those customers who choose the pick-up option, have them ready for pick-up. If home delivery is chosen as the option, a driver (who, in many cases, is also the shopper) delivers the groceries to the customer's home. Customers get the time-savings and convenience from having grocery shopping (and delivery, if chosen) done for them, but they pay in the form on both delivery fees and a service charge of 5-10% of the bill, depending on the store picked and the number of items in the basket. Instacart also offers a subscription model, Instacart Express, where subscribers in return for paying a subscription fee (annual or monthly) get free deliveries from the service.</div><p></p><p style="text-align: justify;"><span> For grocery stores, Instacart is a mixed blessing. It does expand the customer base by bringing in those who could not or would not have shopped physically at the store, but stores often have to pay Instacart fulfillment fees, which they sometime pass through as higher prices on products. In addition, grocery stores lose direct relationships with customers as well as data on their shopping habits, which may be useful in making strategic and tactical decision on product mix and pricing.</span><br /></p><p style="text-align: justify;"><span><span> I will approach the analysis of the Instacart model's capacity for growth and value creation in four steps. In the first, I will look at the grocery business, both in terms of growth and profitability of grocery stores, since Instacart, as an </span>intermediary in the business, will be affected by grocery business fundamentals. In the second, I will examine the forces that are pushing consumers to online grocery shopping, and the ceiling for that growth is much lower than it is than in other areas of retailing. In the third, I will focus on how the competition to Instacart, within the online grocery retail space, is shaping up, and the consequences for its market share. In the final, I will examine the operating costs faced by Instacart, especially in the content of how the fee pie will be shared by the company with its shoppers and drivers.</span></p><p><i>1. The Grocery Business</i></p><p style="text-align: justify;"><span> When you are looking for an easy company to value, where you can safely extrapolate the past and not over indulge your imagination, you should try a grocery store. For decades, at least in the US and Europe, the grocery business has had a combination of low growth and low margins that, on the one hand, keep pricing in check and on the other, make the business an unlikely target for disruption. Let's start by looking at growth in aggregate revenues, across all grocery stores in the United States over the last three decades:</span><br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhkgOgfgLD7J-n1tPlDCYSQgVN0IlEtxsa9jfEXrppYU18cU31HgrlRCpDGbPdLrBuXRcWyCIx6GygQeBWUgTs0EDnbRON-0aoE-tjf9fMMBxXZokqQktuwqbD3F6jHzkGDxTaeeADS-3FOWrDk3qQt55zSTqqw1KKnN5DGtGOufrT3oqbMWghvgm1S3JA/s1850/GrocerySales.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1334" data-original-width="1850" height="289" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhkgOgfgLD7J-n1tPlDCYSQgVN0IlEtxsa9jfEXrppYU18cU31HgrlRCpDGbPdLrBuXRcWyCIx6GygQeBWUgTs0EDnbRON-0aoE-tjf9fMMBxXZokqQktuwqbD3F6jHzkGDxTaeeADS-3FOWrDk3qQt55zSTqqw1KKnN5DGtGOufrT3oqbMWghvgm1S3JA/w400-h289/GrocerySales.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: justify;">You will notice that revenue growth rate has been anemic for most of the thirty years covered in this analysis, and that even the spurts in growth you have seen in 2020 and 2022 have specific reasons, unlikely to be sustainable, with the COVID shutdown explaining the 2020 jump, and inflation in food prices explaining the 2022 increase.</div><div class="separator" style="clear: both; text-align: justify;"><span> On the profitability front, the grocery business operates on slim margins, at every level. The gross margin, measuring how much grocery stores clear after covering the costs of the goods sold, has risen slightly over time, perhaps because of growth in processed and packaged food sales, but is still less than 25%. The operating margin, which is after all operating expenses, and a more complete measure of operating profitability has been about 5% or less for almost the entire period.</span><br /></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhO83neY_NCVSS3OYE9pej_nyqdFlffg_kzfNERIyBFzlp7A8yHDqseaQPuTzU6wso-CHULDfPv7y9Mp4q59i6K-H-w68dY4P1trVLz5dgQ8OHk1JjUvx9Ay53FAuAFrstpwAuON28Zr_cZADLUbWXny--DTuWOizyMgGObea5H2A_9iIX0Dtl5y9YAIeM/s1586/GroceryProfitability.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1152" data-original-width="1586" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhO83neY_NCVSS3OYE9pej_nyqdFlffg_kzfNERIyBFzlp7A8yHDqseaQPuTzU6wso-CHULDfPv7y9Mp4q59i6K-H-w68dY4P1trVLz5dgQ8OHk1JjUvx9Ay53FAuAFrstpwAuON28Zr_cZADLUbWXny--DTuWOizyMgGObea5H2A_9iIX0Dtl5y9YAIeM/w400-h290/GroceryProfitability.jpg" width="400" /></a></div><div style="text-align: justify;">If you are an intermediary in a business with slim operating margins, as Instacart is, the low operating profitability of the grocery business will limit how much you can claim as a price for intermediation, in service fees.</div><div style="text-align: justify;"><span> To complete the grocery business story, it is also worth looking at the players in the business, and it should come as little surprise that it is dominated by a few big names. The biggest is Walmart, which derives close to 56% of its $400 billion in total revenues in the US, from groceries, but Target and Amazon (through Whole Foods and Amazon Fresh) are also big players. Krogers and Albertsons have emerged as the grocery store giants, by consolidating smaller grocery companies across the country:</span> </div><br /><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj-hJPPNbDrOy67SIyVAWEbkN-_nQkP6JxwZcf4JjkoxrxD167BEMySC9BzaRqWPrEPLkjwDIXd6uPkGiHu-ko9nQuFUkWbrDN6UHlqmbVaRkHQCh5LqhYQ5tt4QDqYCslCKV40ZW53Byne6xRFLVRr9VT5O2At3SqPJs105SsBoBIIQfKPSM1_TLgb_B4/s1472/GroceryMktShare.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="824" data-original-width="1472" height="224" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj-hJPPNbDrOy67SIyVAWEbkN-_nQkP6JxwZcf4JjkoxrxD167BEMySC9BzaRqWPrEPLkjwDIXd6uPkGiHu-ko9nQuFUkWbrDN6UHlqmbVaRkHQCh5LqhYQ5tt4QDqYCslCKV40ZW53Byne6xRFLVRr9VT5O2At3SqPJs105SsBoBIIQfKPSM1_TLgb_B4/w400-h224/GroceryMktShare.jpg" width="400" /></a></div><p style="text-align: justify;">The fact that the grocery business is dominated by a few big names will also play a role in the Instacart valuation story, by affecting the bargaining power that Instacart has, in negotiating for its share of the grocery pie. In sum, the overall grocery pie is growing slowly, and the slice of the pie that is profit for those in the grocery game is slim, effectively limiting the valuation stories (and values) for every player in that game.</p><p><i>2. The Online Option</i></p><p style="text-align: justify;"><i> </i>Grocery shopping is different from other shopping, for many reasons. First, customers tend to favor a specific grocery store (or at most, a couple of stores) for most of their grocery needs. One reason for that is familiarity with store layout, since knowing where to find the items that you are looking for can make the difference between a 20-minute trip to the store and a hour-long slog. Another is location, with customers tending to shop at neighborhood stores, for much of their needs, since groceries do not do well with long transportation times. Second, for non-processed food, especially meats and produce, being able to see and sometimes touch items before you buy them is part of the shopping experience, with online pictures of the same products operating as poor substitute. For these reasons, grocery retail remained almost immune from the disruption wrought on the rest of brick-and-mortar retail, at least in the United States. <span style="text-align: left;">Even so, there has always been always a segment of the population that has been open to online grocery shopping, sometimes because of physical constraints (homebound or unable to drive) and sometimes because of time and convenience (busy work and family schedules). That segment was viewed as a niche market, and until 2020, conventional players in the grocery business did not pay much attention to it, with the exception of Amazon. It was the COVID shutdown in 2020 that changed the dynamics, as online grocery shopping became not just an option, but sometimes the only option, for some. </span></p><p><span></span></p><div class="separator" style="clear: both; text-align: center;"><span><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgI2B1_h-6AKNqhFOdPDj6XhOcPLDYmnobFqp4NEg3aF1eVRPYTxo8KjS0RTwcDgODVZjamcYOJCaC5ZyUTA0Hy1XNXbl9hxFi10WIiHlFgwvaPz1kQrHmbK8FtbDry4AQeSo2Dds5D_-RN4SLkjyqcwwgR4CRtHUkABxD-JraL7MgSHMR7NmjqcJFFIFs/s1854/COVIDeffectonOnlineChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1354" data-original-width="1854" height="293" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgI2B1_h-6AKNqhFOdPDj6XhOcPLDYmnobFqp4NEg3aF1eVRPYTxo8KjS0RTwcDgODVZjamcYOJCaC5ZyUTA0Hy1XNXbl9hxFi10WIiHlFgwvaPz1kQrHmbK8FtbDry4AQeSo2Dds5D_-RN4SLkjyqcwwgR4CRtHUkABxD-JraL7MgSHMR7NmjqcJFFIFs/w400-h293/COVIDeffectonOnlineChart.jpg" width="400" /></a></span></div><p></p><p style="text-align: justify;"><span><span>As a company that was built exclusively for this purpose, Instacart had a first-move advantage and saw customers, order and revenues all soar during the year. Caught up in the mood of the moment, it is easy to see why so many extrapolated Instacart’s success in 2020 into the future, forecasting that the shift to online grocery shopping would be permanent, and that Instacart would dominate that business.</span></span></p><p style="text-align: justify;"><span><span><span> <span> As COVID has eased, though, many of those who shopped for groceries online have returned to physical shopping, but it is undeniable that there are some who have decided that the convenience of online shopping exceeds any disadvantages, and have continued with that practice. In fact, while there is uncertainty on this front, the projection is that the percent of grocery shopping that will be done online will increase over time:</span></span></span></span></p><p><span><span><span></span></span></span></p><div class="separator" style="clear: both; text-align: center;"><span><span><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiTImKfrGh-IODRi-sT8E6ja5waugLlCfUSvM6EEegUPIHlm5JIIrqsOkQjb2R4i9zj9XQePKaO7lZOEjDa8CoRIR7CD-i__JokhTxxg5ibBd4Q5i0qCfv5g-60Q3L-H1YIAdvQ0-bfULj9Tis-2hitNRhuK11Deis6YmzBt3gmSfLB5PmPGZBRnats04U/s1834/OnlineandTotalChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1340" data-original-width="1834" height="234" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiTImKfrGh-IODRi-sT8E6ja5waugLlCfUSvM6EEegUPIHlm5JIIrqsOkQjb2R4i9zj9XQePKaO7lZOEjDa8CoRIR7CD-i__JokhTxxg5ibBd4Q5i0qCfv5g-60Q3L-H1YIAdvQ0-bfULj9Tis-2hitNRhuK11Deis6YmzBt3gmSfLB5PmPGZBRnats04U/s320/OnlineandTotalChart.jpg" width="320" /></a></span></span></div><p></p><p style="text-align: justify;">There are two points worth making about the trend towards online shopping. The first is that the ceiling on online grocery retail will remain much lower than the ceiling on online shopping in other areas in retail, with even optimists capping the share at 20%. In short, the growth in online grocery sales will be higher than total grocery sales growth, but not overwhelmingly so. The second is that while some have persisted with online grocery shopping after 2020, it is less in deliveries and more in pick-ups, which will have implications for the market shares of competitors in the space.</p><p><i>3. The Competition</i></p><p><span> In the first few months of the COVID shutdown, Instacart was dominant, partly because its platform was designed for online shopping, and partly because in a grocery market, where many stores were out of stock, it offered shopping choices to shoppers. That dominance, though, was short lived, since the grocers woke up quickly, and started offering online shopping services to their customer, with the tilt towards pick-up over delivery. The cost savings to customers was significant, since most grocery stores dispensed with service fees and used employees as shoppers, for their online customers.</span><span> In the aftermath of COVID, the grocery stores have cemented their dominance of </span>online grocery market, as can be seen in the market shares of the biggest online grocery retailers:</p><p><span></span></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj3tS1wDr5UYZ9JS736Zs7hO5GhJ-3kqRb2hv7Z2DzwHt-qmPIccNHI4iBO1RWeT5n9kOndziRl3h98_mjtpOK_Od_8PugPxy1-AMJ3E5clJ-Lb9SkEqHPvaqo6kfPc7YfNtr4y8Swe7OK-w96XNw6P-hk3cktsY0UY8E65XIYiAcLhaZnrG622wFy19PI/s1848/OnlineMktShare.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1322" data-original-width="1848" height="286" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj3tS1wDr5UYZ9JS736Zs7hO5GhJ-3kqRb2hv7Z2DzwHt-qmPIccNHI4iBO1RWeT5n9kOndziRl3h98_mjtpOK_Od_8PugPxy1-AMJ3E5clJ-Lb9SkEqHPvaqo6kfPc7YfNtr4y8Swe7OK-w96XNw6P-hk3cktsY0UY8E65XIYiAcLhaZnrG622wFy19PI/w400-h286/OnlineMktShare.jpg" width="400" /></a></div><br /><div style="text-align: justify;">Walmart and Amazon are the two largest players in the online grocery market, and Instacart, while it has lost market share since 2020, is firmly in third place. Kroger's and Albertsons, the two largest grocery story chains, have also improved their standing. Instacart, as the only pure intermediary in this group, allows customers access to multiple grocery store options, and more choices when it comes to delivery, but even one that front, it is starting to face competition from Uber Eats, DoorDash and GrubHub. In short, Instacart will be lucky to hold on to its existing market share, even if it plays its cards right, leaving its growth at or below the growth in the overall online grocery shopping market.</div><div style="text-align: justify;"> On a personal note, and it qualifies purely as anecdotal evidence, we (in my household) have not used Instacart since the peak COVID days of 2020, as we have returned to physical grocery shopping for products where it matters, while preserving online shopping for products which are staples, but only for pick up, rather than delivery. Since we shop at Ralph's, a Kroger subsidiary, we use their <a href="https://www.ralphs.com/i/ways-to-shop/mobile-app">online shopping app</a>, since it costless, matches in-store discounts and comes with a Ralph employee as a shopper, that is familiar with what we usually buy. I know that there are others who have stayed with Instacart, perhaps because of the grocery store choices it offers or because of its delivery options, but we have little interest in either, and perhaps are closer to the norm than the exception.</div><p></p><p><i>4. Operating Economics</i></p><p style="text-align: justify;"><span> The revenues that Instacart collects from customers, either in service fees or in subscription revenues have multiple costs to cover. By far, the biggest is the cost that the company faces in hiring and paying thousands of shoppers and drivers to operate its system. Like ride-sharing companies, the question of how Instacart categorizes these workers, and the resulting costs, will determine what it will be able to generate as operating profits:</span><br /></p><p></p><ol style="text-align: left;"><li style="text-align: justify;"><u>Pay versus Commission</u>: Instacart has traditionally paid its shoppers based upon the batches of work done (with a batch including shopping, packing and loading a customer order) and payments for deliveries made, with tips from customers accruing as additional income. In effect, that makes almost all of these expenses into variable costs, rising and falling with revenues, reducing risk to the company but also limiting benefits from economies of scale, as it gets bigger.</li><li style="text-align: justify;"><u>Independent contractor </u><u>versus Employee</u>: Instacart has argued that the shoppers and drivers who work for it are independent contractors, rather than employees. That distinction matters because an employee categorization will open up Instacart not only to additional costs (social security, health care etc.) but also to legal liabilities, for employee actions. Many states are pushing Instacart (and others users of independent contractors, like Uber and Lyft) to reclassify their workers as employees, and in 2023, Instacart paid $46.5 million, to settle a California lawsuit on this count. </li></ol><p></p><p style="text-align: justify;">As a company built around a technology platform, Instacart also has significant spending on R&D, as well as on customer support services. <span>In many ways, the operating expense issues that Instacart faces parallel the issues that Uber and Lyft have faced in the last few years, and I do believe that, over time, Instacart will have no </span>choice but to deal with their shoppers as employees, with the accompanying costs. </p><p><b>The Instacart IPO</b></p><p><span> To value Instacart ahead of its IPO, I will start with a look at the prospectus filed by the company, which will give me a chance to unload on my pet peeves about how these disclosures have evolved over time, then look at the operating history and unit economics at the company, before settling in on a valuation story (and valuation) of the company.</span><br /></p><p><i>Prospectus Pet Peeves</i></p><p style="text-align: justify;"><i> </i>About two years ago, I <a href="https://aswathdamodaran.blogspot.com/2021/07/disclosure-dilemma-when-more-data-leads.html">wrote a post on what I called the disclosure dilemma</a>, where the more companies disclose, the less informative these disclosures become. As part of the post, I talked about trends in IPO prospectuses over time, and the Instacart prospectus gives me a chance to revisit some of those trends that I highlighted. </p><p></p><ol style="text-align: left;"><li style="text-align: justify;"><u>Disclosure Diarrhea</u>: Apple and Microsoft, when they filed for their initial public offerings in the 1980s, had prospectuses that were less than 100 pages apiece; Apple weighed in at 73 pages and Microsoft had only 52. In 1997, when Amazon filed for a public offering, its prospectus was 47 pages long. I noted that prospectuses have become more and more bulky over time, with Airbnb's 2020 listing including a prospectus that was 350 pages long. With appendices, Instacart's prospectus stretches on to 416 pages.</li><li style="text-align: justify;"><u>“Tech” and AI</u>: In common with many other companies that have gone public in the last decade, Instacart is quick to label itself a technology company, when the truth is that it is a grocery delivery company that uses technology to smooth the ride. In keeping with the times, the prospectus mentions AI multiple times, I counted 32 mentions of AI in the prospectus, and I remain skeptical that AI will (or should) alter grocery shopping in fundamental ways.</li><li style="text-align: justify;"><u>Adjusted EBITDA</u>: I have written about the absolute foolishness of adding back stock-based compensation to get to adjusted earnings, noting that stock-based compensation is not a neutral non-cash expense (like depreciation) but one that an expense-in-kind, where you give away equity in your company to employees, either as options or as restricted stock. Needless to say, Instacart plows right ahead and not only adds back stock-based compensation but makes a host of other adjustments (see page 126 of prospectus). Since Instacart makes money without these adjustments, they only draw attention away from that good news.</li><li style="text-align: justify;"><u>Share count shenanigans</u>: On page 19 of the prospectus, Instacart headlines that its share count will be 279.33 million shares, if the underwriters exercise their options, but two pages later (on page 21) the company discloses that it does not count restricted stock units, which are shares in existence that still have restrictions on trading or waiting to be vested, options and shares issuable on conversion of preferred shares. Adding these exception together, you get an ignored share count of 43.62 million, which brings the total share count to 322.94 million shares.</li></ol><div style="text-align: justify;">To give the company credit on useful disclosures, the company has followed the lead of other user-based companies in providing a cohort table (see page 111) on platform users (tracing how usage changes as users stay on the platform) and on unit economics (the size of an order, with the costs of filling it), but that good disclosure is hidden behind layers of flab.</div><p></p><p><i>An Operating History</i></p><p style="text-align: justify;"><span> For young companies, you learn less by browsing through financial history than with much more mature companies, but it in instructive to look at the pathway that Instacart has taken to arrive at its current position. </span> For close to seven years after its founding in 2012, Instacart struggled to find its footing with customers, as relatively few were willing to jump on the online grocery shopping bandwagon. Coming into 2020, the company had about 50 million subscribers and $215 million in revenues, and the $5.1 billion that customers spent on groceries on its platform was a tiny fraction of the $800 billion US grocery market. In a turn of fortune that I am sure that even Instacart did not see coming, the COVID shutdown changed the shopping dynamics. As homebound customers desperately looked for options to shop for and get groceries delivered at home, Instacart stepped into the fray, allowing user numbers, the value of gross transactions (GTV) and revenues to quadruple in 2020. </p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjcfPwnnwrD82BT2FMn4whBlkOiV3FGiRGTCozRwEm51Tys-OW5BZiIc7PNsFsxrbZHJvZMPGDHesk8vWkdkzeK4EdaHOfWppN0dxmtGVV3tj5qwUzp546RKhdbogT1r4-VT4baNjZHtpXs4yxeBhwrJDDCdm7cDv7dMEhzF1MH7FnzIqooEIV-5Nb5UKg/s1850/InstacartGrowth.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1330" data-original-width="1850" height="288" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjcfPwnnwrD82BT2FMn4whBlkOiV3FGiRGTCozRwEm51Tys-OW5BZiIc7PNsFsxrbZHJvZMPGDHesk8vWkdkzeK4EdaHOfWppN0dxmtGVV3tj5qwUzp546RKhdbogT1r4-VT4baNjZHtpXs4yxeBhwrJDDCdm7cDv7dMEhzF1MH7FnzIqooEIV-5Nb5UKg/w400-h288/InstacartGrowth.jpg" width="400" /></a></div>It is undeniable that Instacart, like Zoom and Peloton, was a COVID winner, but like those companies, it has struggled to build on those winnings and deliver on the resulting unrealistic expectations. The good news for Instacart is that many of the customers who joined its platform at the height of COVID have stayed on, but the bad news is that growth has leveled off in the years since, and especially so leading into the initial public offering.<div><span> As subscribers and grocery sales on the Instacart platform grew between 2019 and 2023, its business model has also been taking form, turning from losses to a measure of profitability in the twelve months leading into the offering:</span><p></p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg9MYsFk339ifuhu5Zkjdmtw--bqJiuUxTAKORzz2zF7sL4msuFqy7kkY4Hd4BaQ32ddKGhb9B0sCz2PzqqfWYBLo0M4_JZXw1isyCpWbo4Hr03vVgXiVeFsDxTYgbo8xLINWHZ3zRCA-RYvFXhYlk4rUHIOHUA7vH0ydgv6Nzq-Jv9dOkMKpudafi2BHI/s1164/InstacartFinHistory.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="296" data-original-width="1164" height="101" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg9MYsFk339ifuhu5Zkjdmtw--bqJiuUxTAKORzz2zF7sL4msuFqy7kkY4Hd4BaQ32ddKGhb9B0sCz2PzqqfWYBLo0M4_JZXw1isyCpWbo4Hr03vVgXiVeFsDxTYgbo8xLINWHZ3zRCA-RYvFXhYlk4rUHIOHUA7vH0ydgv6Nzq-Jv9dOkMKpudafi2BHI/w400-h101/InstacartFinHistory.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://www.sec.gov/Archives/edgar/data/1579091/000119312523221345/d55348ds1.htm" style="text-align: right;">Instacart Prospectus</a></td></tr></tbody></table><div style="text-align: justify;">Note again, though, that the bulk of the improvement in operating metrics occurred in 2020, and while the numbers have continued to improve since 2020, the change has been marginal. To understand the drivers of Instacart’s profitability over time, let us break down its components:</div></div><div><ol style="text-align: left;"><li><div style="text-align: justify;"><u>Take Rate</u>: When an grocery order is placed on the Instacart platform, the service fees that Instacart collects represent its revenues from transactions, and the take rate measures these revenues as a percentage of the transaction value. Instacart's take rate has improved over time, doubling from 2.86% in 2019 to 5.70% in 2020, before leveling off in 2021 and 2022, and then increasing again to 7.49% in the last twelve months of 2023.</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjO2lU8krMICPqbmD3FU-1Mx_yohQ6yJ_e6nEhRPWhbm5GcBrjWVbfv8PTxsqVTwF3POXJJrPXQnwu__VCh9eXjmSi8sN-Mj7e2O_-R_LaF75dgDXcpTMmTLuUiuPA4XIUieZ3LIh_9hlN_tYJiX46BzKxFptcJ8_V0MteslLKOwouTNsYcaq2qajNMXew/s1828/InstacartTakeRate.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1334" data-original-width="1828" height="293" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjO2lU8krMICPqbmD3FU-1Mx_yohQ6yJ_e6nEhRPWhbm5GcBrjWVbfv8PTxsqVTwF3POXJJrPXQnwu__VCh9eXjmSi8sN-Mj7e2O_-R_LaF75dgDXcpTMmTLuUiuPA4XIUieZ3LIh_9hlN_tYJiX46BzKxFptcJ8_V0MteslLKOwouTNsYcaq2qajNMXew/w400-h293/InstacartTakeRate.jpg" width="400" /></a></div><br />Just to provide a contrast, <i>Airbnb and Doordash, two other companies in the intermediary business have much higher take rates at 14% and 11.79% respectively</i>. Much of that difference, though, is unbridgeable for a simple reason: the grocery business has significantly lower operating margins (at 5%) than the hospitality (15% in 2022) or restaurant businesses (16% in 2022). Put simply, Instacart's take rate will be lower, even with full economies of scale at play, than its counterparts in businesses with more profit buffer.</li><li><u style="text-align: justify;">Operating expenses</u><span style="text-align: justify;">: The revenues that Instacart collects, from transactions and advertising, are used to cover its operating expenses, which are broken down into three categories: cost of goods sold, operations and support and G&A: <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi7RqVji-NnRgt7l0D3LQp8h9fmMd1l1DPlmmYhgJS9HSfx2gD3rVOT1YqD31OdQMht6MIfBGIWhYqtXdQK-Kuop_eq5ODCF6jqiexeLvS9vqtNlne_Yd3go7Jbm_1q1fIRm6R1BwEBLZTp4eLDch2rhlmYd8ZEagZUOV0INBNvHakugHYJQboQR5Bs410/s1818/InstacartOperExpAlone.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1332" data-original-width="1818" height="293" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi7RqVji-NnRgt7l0D3LQp8h9fmMd1l1DPlmmYhgJS9HSfx2gD3rVOT1YqD31OdQMht6MIfBGIWhYqtXdQK-Kuop_eq5ODCF6jqiexeLvS9vqtNlne_Yd3go7Jbm_1q1fIRm6R1BwEBLZTp4eLDch2rhlmYd8ZEagZUOV0INBNvHakugHYJQboQR5Bs410/w400-h293/InstacartOperExpAlone.jpg" width="400" /></a></div><br />There are economies of scale that kicked in, in 2020, and the good news is that those economies of scales continued to benefit the company in 2021 and 2022, as all three categories of expense decreased, as a percent of sales. </span></li><li><span style="text-align: justify;"><u>Customer Acquisition and Reinvestment</u>: Growth comes with reinvestment, and in the case of Instacart, as with many other tech companies, that reinvestment is embedded in its operating expenses (instead of capital expenses), since their two biggest capital expenditures are the costs of acquiring new subscribers (shown as part of sales and marketing) and investments in technology/platform (shown as R&D). <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhTweIbvBMiMZv5hcuNUFzyCMpg9HN0Im_KwMVFx4qlrGMR7jASiYCIMWaibI5mfy1uC6fbsNriAwfn7c_zOW8vxuTZcamJ9eAnhYW6CJ-JD4SSGjUu9QvmKRAhgDPXvhH72ETVFKjlWAav8RfAbGwFWxAk3y5hfheUwfYhO4gcKxPQbSyj-DPcHwwLcgs/s1830/InstacartGrowthSpending.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1352" data-original-width="1830" height="295" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhTweIbvBMiMZv5hcuNUFzyCMpg9HN0Im_KwMVFx4qlrGMR7jASiYCIMWaibI5mfy1uC6fbsNriAwfn7c_zOW8vxuTZcamJ9eAnhYW6CJ-JD4SSGjUu9QvmKRAhgDPXvhH72ETVFKjlWAav8RfAbGwFWxAk3y5hfheUwfYhO4gcKxPQbSyj-DPcHwwLcgs/w400-h295/InstacartGrowthSpending.jpg" width="400" /></a></div><br />Looking at the customer acquisition (selling) costs alone, there is evidence that these <span style="text-align: left;">costs, in dollar terms and as a percent of revenues, after the steep drop off in 2020, are rising over time, indicating that there are more competitors for new online grocery shoppers. </span> If you add to that the same trend in R&D spending, it does look like the company is working harder and spending more to deliver growth after the COVID boost in 2020.</span></li><li><u>Unit Economics</u>: With transaction-based businesses, like Instacart, understanding how the unit economies (on individual orders and platform users) are evolving over time can be useful in forecasting the future. Looking across Instacart's entire history, the typical order size has remained remarkably stable, at around $100, with the spurt in 2020 being the exception. <table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj-ckOPR-jGm7_0RKt4RKyC52C6MSCJd1B0S1g3Wyoggf4hgeTfPfoXlXvo61eIXcy_F-Z2QxJlAkktfb3uGqmrdYoWJihBVdXnJElepUsC0Ln6Rh-hB7WtLdmY-dWXGR8iHy26UzbrIDu1R8f-egFK2RYIlCsZm2-60LYDkgcK-eVit0aZoR8sz_FBq2c/s1834/InstacartOrder.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1334" data-original-width="1834" height="291" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj-ckOPR-jGm7_0RKt4RKyC52C6MSCJd1B0S1g3Wyoggf4hgeTfPfoXlXvo61eIXcy_F-Z2QxJlAkktfb3uGqmrdYoWJihBVdXnJElepUsC0Ln6Rh-hB7WtLdmY-dWXGR8iHy26UzbrIDu1R8f-egFK2RYIlCsZm2-60LYDkgcK-eVit0aZoR8sz_FBq2c/w400-h291/InstacartOrder.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://www.sec.gov/Archives/edgar/data/1579091/000119312523221345/d55348ds1.htm" style="text-align: right;">Instacart Prospectus</a></td></tr></tbody></table><br />On an inflation-adjusted basis, especially in 2021 and 2022, the average order size has decreased over time. That, by itself, may not be a problem, if Instacart customers are ordering more often, especially as they stay on the platform for longer, and to answer this, I look at Instacart's estimates of revenues, by cohort class: <table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhFRMU0O2Dn8V_vfn2rmnVyLqE-us3C0qCGh-c8GQTLPILaPdWVq0NGGL-t5f5R-XufUldQwBNUzR1DUIvtYl3y6NXwt94zaIgINiTUybLW3SYSZmKSz_sciUPQHUDgo4fpVa50R_4aA0uyGxdKn2O9T8Ltg9uQKrLVgmJBQvwoitoD0oD2HYqQBV7IqGs/s960/InstacartCohortTable.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="274" data-original-width="960" height="114" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhFRMU0O2Dn8V_vfn2rmnVyLqE-us3C0qCGh-c8GQTLPILaPdWVq0NGGL-t5f5R-XufUldQwBNUzR1DUIvtYl3y6NXwt94zaIgINiTUybLW3SYSZmKSz_sciUPQHUDgo4fpVa50R_4aA0uyGxdKn2O9T8Ltg9uQKrLVgmJBQvwoitoD0oD2HYqQBV7IqGs/w400-h114/InstacartCohortTable.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://www.sec.gov/Archives/edgar/data/1579091/000119312523221345/d55348ds1.htm" style="text-align: right;">Instacart Prospectus</a></td></tr></tbody></table></li></ol></div><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;"><div style="text-align: left;">The good news is that customers who joined the platform in 2017, 2018, 2019 and 2021 spend more on the platform, the longer they are on it. The bad news is that customers in joined in 2020, Instacart's biggest year of growth in users, are spending less on the platform in 2021 and 2022, indicating that some of the COVID gains are slipping away. That should not be surprising, since many customers who used Instacart in 2020 did so only because they had no alternatives, and once the shutdown ended, returned to old habits.</div></blockquote><p style="text-align: justify;"><span> </span>As the company has struggled, coming off its COVID high, there has been turnover in its management ranks. Apoorva Mehta, who founded the company and oversaw its COVID growth, stepped down as CEO of the company in 2022, and was replaced with Fido Simo, a Facebook executive, with the impetus for the change rumored to have come from Sequoia, the biggest single stockholder in the company. Before you instinctively jump to the defense of founders, like Mr. Mehta, it is worth noting that he owned only 10% of the outstanding shares in the company in 2022. In short, scaling up and high growth often require large capital infusions, and a side cost almost always will be a reduction in founder control of the company. </p><div><p><i>The Valuation Story & Intrinsic Value</i></p><p><span> With that long lead-in, I have the basis for my Instacart story, and it reflects both the good and bad news in the company's operating history. </span><br /></p><p></p><ol style="text-align: left;"><li style="text-align: justify;"><u>Growth</u>: To estimate revenue growth at Instacart, I think it makes sense to break down revenues into transaction revenues and advertising revenues, with the former coming from service fees and subscriptions, and the latter from ads. To estimate transaction revenues, I will assume that gross transaction value on the platform will track growth in online grocery retailing, which seems to have settled into a compounded annual growth rate of about 12%, for the next five years. I will assume that Instacart will maintain its market share of the online grocery market, in the face of competition, but only by cutting its fees and accepting a take rate of 6%, by year 5, down from 7.5% in the trailing 12 months. Advertising revenues, though, are assumed to keep track with gross transactions on the platform.</li><li style="text-align: justify;"><u>Profitability</u>: Drawing on the company's history of delivering economies of scale on cost of goods sold and operations support, I will assume that the company will be able to improve its operating margins over time to 25%. The tensions between Instacart and its shoppers, as well as push back from grocery stores, will keep a lid on these margins and prevent further improvement.</li><li style="text-align: justify;"><u>Reinvestment</u>: As user growth levels off, I expect the company to revert to its capital-light origins, and spend far less on customer acquisitions, as well as on acquisitions. This allows me to assume that the company will be able to deliver $3.13 in revenues, for every dollar invested, roughly matching the global industry average.</li></ol>With these assumptions in place, the value that I get for the company is shown below:<br /><br /></div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiMGtL8jJT7MFgvFCg3pHvRYophN6ScQtggFRVbAqLEryU6KM2LyCZVZiLxCoyUUFfklhLZJZO-vRFOQ2fEYGTgtt1CaOQsUPmaOVbnhjBXEleHLeTydNPzm-NVUXDe1ds-O_n0E-Z5YxN7lqTgMZ7OjQJ4-CK-hZh66ceHy85Mvk8cCAdbsPmjIO2G-bM/s1834/InstacartValPicture.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1368" data-original-width="1834" height="299" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiMGtL8jJT7MFgvFCg3pHvRYophN6ScQtggFRVbAqLEryU6KM2LyCZVZiLxCoyUUFfklhLZJZO-vRFOQ2fEYGTgtt1CaOQsUPmaOVbnhjBXEleHLeTydNPzm-NVUXDe1ds-O_n0E-Z5YxN7lqTgMZ7OjQJ4-CK-hZh66ceHy85Mvk8cCAdbsPmjIO2G-bM/w400-h299/InstacartValPicture.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/InstacartIPO.xlsx" style="text-align: left;">My Instacart Valuation</a></td></tr></tbody></table><br /><div>With my story and inputs, the value per share that I get for Instacart is about $29, close to the offer price being floated of $30 per share. <br /><div><span> There is, of course, the very real possibility that I could be wrong on my estimates (in either direction) of key inputs: the growth in GTV, the take rate, the operating margin and the cost of capital, and to account for this uncertainty, I fall back on a simulation:</span></div><div><span><br /></span></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjCdvXReVKnwmtFipzIJe_vXzRbmNgHZ2iR5moG5-OEA3FQ1ZjAaZqCwVFuQASI2syPDLw3CM75Dt7AricvXCjSMHMo7mevFfgbKrdteNmwPX7LM1Qo-m3UVDJtSWTdUoyiMDfmBox4Z_nGZ-ReYcPRWZ95FYvKKGFELlbh8PNtbs5Ia2WzBEeP-eTZuPc/s1506/InstacartSimulation.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1152" data-original-width="1506" height="306" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjCdvXReVKnwmtFipzIJe_vXzRbmNgHZ2iR5moG5-OEA3FQ1ZjAaZqCwVFuQASI2syPDLw3CM75Dt7AricvXCjSMHMo7mevFfgbKrdteNmwPX7LM1Qo-m3UVDJtSWTdUoyiMDfmBox4Z_nGZ-ReYcPRWZ95FYvKKGFELlbh8PNtbs5Ia2WzBEeP-eTZuPc/w400-h306/InstacartSimulation.jpg" width="400" /></a></div><br /><span>As you can see, at the offer price of $30/share, the company is priced close to its median value, and the distribution of values suggests that there is less upside in this company than in some of the other growth companies I have valued in recent years.</span></div><p><b>The Offering</b></p><p style="text-align: justify;"><span> Instacart was expected to hit the market on September 19, and the reception that it gets may tell us as much about the market, as it does about the company. In my posts on the market, starting mid-year last year and extending into this one, I <a href="https://aswathdamodaran.blogspot.com/2022/07/risk-capital-and-markets-temporary.html">noted that risk capital had retreated o the sidelines</a>, and one of the statistics that I used was the number of IPOs hitting the market. After hitting an all-time high in 2021, the IPO market has frozen, and the ARM, Instacart and Birkenstock IPOs hitting the market in September may be a sign of a thaw. That sign will become stronger, if the offerings are well received and there is a price pop on the offering. </span></p><p style="text-align: justify;"><i>Pricing versus Investing</i></p><p style="text-align: justify;"><span><span> </span>I have long argued that IPOs are priced, not valued, notwithstanding the lip service that everyone involved in the process, including VCs, founders and bankers, pays to valuation, The difference between valuing and pricing is that while the former requires that you grapple with business questions on growth, profitability and reinvestment, the latter is based on how much investors are paying for peer group companies, a subjective judgment, but one made nevertheless. In keeping with this theme, I compared the proposed pricing for Instacart against the pricing of its peer group. That peer group is not other grocery companies, since the Instacart model is very different, but other intermediary companies like Airbnb and Doordash, </span>which like Instacart, take a slice of transaction revenues in the markets they serve, and try to keep costs under control:</p><div class="separator" style="clear: both; text-align: justify;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgbOGIsz0vWS-1EiDJxsRiQx4ZOLdP9gw40PHppYlfTG5Y4BzY-kEAkoJByRjBSt4hPyZtq_4Kb7E-KOY09sBElYhP1FfC2vxfLQDn_3IDLbs_sFgybtLl-zDcjshSX91ATez-pD6NqPOkN2b4v_K2tYqvxdGYmxJXi4hCqbJ2_d_UnppmQVj1bOm8EsGQ/s1266/InstacartPricing.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="156" data-original-width="1266" height="49" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgbOGIsz0vWS-1EiDJxsRiQx4ZOLdP9gw40PHppYlfTG5Y4BzY-kEAkoJByRjBSt4hPyZtq_4Kb7E-KOY09sBElYhP1FfC2vxfLQDn_3IDLbs_sFgybtLl-zDcjshSX91ATez-pD6NqPOkN2b4v_K2tYqvxdGYmxJXi4hCqbJ2_d_UnppmQVj1bOm8EsGQ/w400-h49/InstacartPricing.jpg" width="400" /></a></div><p style="text-align: justify;">While Instacart looks cheap, relative to Doordash and Airbnb, this pricing is an illustration of the limits of the approach. Instacart trades at a much lower multiple of revenues, because its take rate (as a percent of gross transaction value) is much lower than the slices that Doordash and Airbnb keep. Airbnb keeps 14% of gross transaction value, Doordash keeps more than 11.79%, but Instacart keeps only 7.5%, if advertising revenues are excluded. Instacart and Doordash both trade at lower multiples of revenues than Airbnb, but that is because Airbnb has higher expected growth and higher operating margins in steady state.<i><span> </span><br /></i></p><p style="text-align: justify;"><i>Previewing the Offering</i></p><p style="text-align: justify;"><span><span> Since pricing is about mood and momentum, it is worth looking at the ARM IPO offering on September 14, which saw the company's stock price, which was offered at $51, open for trading at $56.10 and close the dat at $63.59. If that mood spills over into this week,</span></span> I expect Instacart's IPO to pop on its opening day as well, especially given the fact that the offering price seems to reflect a relatively conservative outlook for the company, and the pricing looks favorable. Even if it does not, I don't see much benefit to buying the stock at the offering price, not only because it looks fairly valued, but also because I don't see enough of an upside, even if things work out in the company's favor. </p><p style="text-align: justify;"><span> The question of what the market will do became moot, even as I was finishing this post, the stock started trading(September 19), and popped to $42 per share, before giving back some of its gains to settle at about $38 per share. At those prices, you would need more upbeat assumptions about online grocery growth and take rates than I am willing to make, but with this market, who knows? The stock may be trading at a discount on value, a week from now. </span><br /></p><p style="text-align: justify;"><span><i>The VC Game</i></span></p><p style="text-align: justify;"><i> </i>In the last decade, we have raised venture capital to "great investor" status, driven by stories of investments that have paid off in huge returns. In fact, good venture capitalists are often viewed as shrewd assessors of business potential, capable of separating the wheat from the chaff, when it comes to start-ups. That is true for some of them, but I believe that <a href="https://aswathdamodaran.blogspot.com/2016/10/venture-capital-it-is-pricing-not-value.html">venture capital is a pricing game</a>, with little heed paid to value, and that the most successful venture capitalists share more traits with great traders, than with great investors. Not only are the best venture capitalists good at pricing the businesses they invest in, honing in on to the traits that are being priced in (users, subscribers, downloads etc.), but are just as good at making sure that these business scale up these traits. Their success comes from timing skills, entering a business at the right time and just as critically, exiting before the momentum shifts.<br /></p><p style="text-align: justify;"><span><span> Instacart's multiple venture capital rounds illustrates this process well, and you can see the pricing of the company at each round below:</span><br /></span></p><p style="text-align: justify;"><span></span></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh_VO88k86RU4x1ntA8VT-4mzlDC7Xq5_-xAlx5gMG-swHohXO2pDwI23B5XbJmRhNICn2Fq1gpEe5uzVLDOgIgLl2WTd317t4r3JRSLZOnBBT0ooxXfO14Eqwh99fC0xaERdsrLvGZNneYRb-SX0nDY4XC7Zc1rVkZ2EG-_qZZL4W7H2Vp_ZShc1YkwT4/s1350/VCReturnTable.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="470" data-original-width="1350" height="139" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh_VO88k86RU4x1ntA8VT-4mzlDC7Xq5_-xAlx5gMG-swHohXO2pDwI23B5XbJmRhNICn2Fq1gpEe5uzVLDOgIgLl2WTd317t4r3JRSLZOnBBT0ooxXfO14Eqwh99fC0xaERdsrLvGZNneYRb-SX0nDY4XC7Zc1rVkZ2EG-_qZZL4W7H2Vp_ZShc1YkwT4/w400-h139/VCReturnTable.jpg" width="400" /></a></div><p></p><p style="text-align: justify;"><span><span>The earliest providers of capital to the company will walk away with substantial profits, even if the company's market cap ends up at $9 - $9.5 billion, as indicated by the offering price. The seed capital providers (Khosla, Canaan and Y Combinator) will have earned at 55% compounded annual return on their investment, at the IPO offering price, well in excess of the S&P 500 annual return of 13.04% over the same period. Every subsequent round earns a lower annual return, and all investments in Instacart made after 2015 have underperformed the S&P 500 significantly, and the NASDAQ by even more. </span></span><span><span><span> The biggest losers in this capital game have been those who provided capital in 2020 and 2021, when COVID pushed up both capital needs and company pricing to new highs. The Series I investment in 2021, when the company was priced at $39 billion,will see markdowns in excess of 60%. While there is no redeeming grace for Fidelity and T. Rowe Price, it is true that Sequoia</span></span></span> also invested earlier in the company, and will walk away with substantial returns on its total investment. Thus, the write down that Sequoia takes for its $300 million investment in 2021 will be more than offset by the gains it made on the $21 million that it invested in the company in 2013 and 2014. </p><p style="text-align: justify;"><span> The notion that there is smart money, i.e., that there is an investor group that is somehow wiser, more informed and less likely to act emotionally than the rest of us, and that it earns higher returns than the rest of us, is deeply held. In my view, it is a mirage, since every group that is anointed as smart money ultimately ends up looking average (in terms of behavior and returns), when all is said and done. It happened to mutual fund managers decades ago, and it has happened to hedge funds and private equity over the last two decades. For those who are holding on to the belief that venture capitalists are the last bastion of smart money, it is time to let go. While there are a few exceptions, venture capitalists for the most part are traders on steroids, riding the momentum train, and being ridden over by it, when it turns. </span></p><p style="text-align: justify;"><b>YouTube Video</b></p><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/4JHdt9Jy1Xg?si=2qlRsVCiUwTGwzi4" title="YouTube video player" width="560"></iframe><p style="text-align: justify;"><b>Instacart files</b></p><p style="text-align: justify;"></p><ol><li><a href="https://www.sec.gov/Archives/edgar/data/1579091/000119312523221345/d55348ds1.htm">Instacart Prospectus</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/InstacartIPO.xlsx">My Instacart Valuation</a></li></ol></div><br /><br /><br /><div class="separator" style="clear: both; text-align: center;"><br /></div><br /><div class="separator" style="clear: both; text-align: center;"><br /></div><br />Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-13200165021752054762023-09-11T19:09:00.010-04:002023-09-13T10:05:19.138-04:00A Business Upended: Streaming disrupts the Entertainment Business!<p style="text-align: justify;">It has been an unsettling summer for anyone with a stake in the movie, television and broadcasting businesses. The strike by screen actors and writers which started in July is now into almost into its third month, with no end in sight, putting at risk the pipeline of movies and shows that were expected to hit theaters and streaming platforms in the next few months. On August 31, Disney pulled its television channels from Spectrum (owned by Charter, the second largest cable company in the US, after Comcast) after a dispute about payments for carrying these channels. Tennis fans, getting ready to watch the US Open on ESPN, were apoplectic, as their televisions went blank in the middle of matches, and Disney, in addition to encouraging them to complain to Spectrum, offered them an option of switching to <a href="https://www.hulu.com/live-tv">Hulu+ Live TV</a>, a streaming service alternative to cable. While actors and writers have been on strike before, and contractual disputes between content makers and cable providers is par for the course, the news stories of this summer seem more consequential, perhaps because they reflect longer time shifts in the movie and broadcasting businesses.</p><p style="text-align: justify;">Speaking of Disney, a company that has found itself in the crosshairs of political and cultural disputes, the stock hit $80 on September 7, close to a ten-year low. To add to the angst, the threat of artificial intelligence (AI) overhangs almost every aspect of the business, and is one of the contested issues in the strike. The recent troubles in entertainment, though, reflect a longer term disruption that has occurred in the business, with the rise of streaming as an alternative to the traditional platforms for movies and television shows. In this post, I will focus on how streaming has not only changed the way we consume content, but has also modified the way that content gets made. In the process, it has altered the financial characteristics of the companies in the business in ways that the market is still trying to come to terms with, which may explain the market turmoil this year.</p><p style="text-align: justify;"><b>A Cautionary Tale: The Music Business and Streaming</b></p><p style="text-align: justify;"><span> If, as you watch the broadcasting business go through its struggles with streamers, you get a sense of deja vu, it is because the music business in the 1990s found itself similarly challenged, and its upending by streaming may offer lessons for the movie business.</span><span><span> In the twentieth century, the music business followed a well-honed script. It was composed of companies which scouted for music talent, signed these musicians to music label contracts and then worked with them in their studios to produce record albums that were sold in music stores across the country. The music companies provided marketing support, seeking out radio stations that would carry their music, and distributional backing to get albums to retailers. In many ways, it was impossible for a musician to break through, without studio backing, and that power imbalance allowed the latter to claim the lion’s share of the revenues. </span></span></p><p style="text-align: justify;"><span><span><span> </span>The disruptor who upset the music business was Napster, </span></span><span> a platform that delivered pirated streams of music to its customers, effectively undercutting the need to go into music stores and buy expensive albums. While Napster downloads left much to be desired in terms of audio quality, and the company walked to (and often beyond) the very edge of legality, it exposed the weaknesses in the music business, from how new artists were found and marketed, to how their music was packaged and finally, how that music was sold. When the music companies of the day were able to shut Napster down in 2001, citing digital piracy, they were undoubtedly relieved, but their weaknesses had been exposed. Apple created the iTunes </span>Store in 2001, allowing customers to buy individual songs, rather than entire albums, and the unbundling of the music business began. In the years that followed, music albums and music retailers became rarer, and the advent of the internet allowed musicians to bypass the gatekeepers at the music studios and go directly to customers. As smart phones and personal devices became more plentiful, Spotify and Pandora introduced the music streaming model, and the game was forever changed, and the consequences for the music business have been staggering:</p><p style="text-align: justify;"></p><ol><li><div style="text-align: justify;"><u>The music business shrank and the center of gravity shifted</u>: The entry of streaming companies changed the economics of music, since it largely removed the need to buy music, even in the single-song format. Spotifyand Pandora allowed subscribers access to immense music libraries, with high audio quality, and as they grew, revenues to existing music labels dropped:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjhZoJVta6VULdmc3dsKE99sqGhDqaL2O8dGdli8Rt-Uht4R3czWToXlMj-TNxOT0DUBTDI5KufuIXXv91-XDqFG76ss1EkA8bauS4_yEqkqPuWIjW80WT5G1mwd5JnY1bqVDXKuP40a4HGDfWFYpclbq726hOW_vKpTnz3INdZ6_9Yv8LdEweg-RLFMPQ/s1374/GlobalMusic.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1004" data-original-width="1374" height="293" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjhZoJVta6VULdmc3dsKE99sqGhDqaL2O8dGdli8Rt-Uht4R3czWToXlMj-TNxOT0DUBTDI5KufuIXXv91-XDqFG76ss1EkA8bauS4_yEqkqPuWIjW80WT5G1mwd5JnY1bqVDXKuP40a4HGDfWFYpclbq726hOW_vKpTnz3INdZ6_9Yv8LdEweg-RLFMPQ/w400-h293/GlobalMusic.jpg" width="400" /></a></div><br /><div style="text-align: justify;">As you can see, music revenues shifted (unsurprisingly) from studios to music streaming, but in a more troubling sign, the aggregate revenues of the music business dropped by almost 40% between 2000 and 2016. On a more optimistic note, the revenues are now back to pre-2000 levels, albeit not on inflation-adjusted basis, and 65% of all revenues in 2021 came from streaming. It is undeniable that streaming, by removing many of the intermediaries in the old music business model, has shrunk the business.</div></li><li style="text-align: justify;"><u>The status quo crumbled</u>: As revenues shrunk, and moved from the studios to the streamers, the companies that represented the status quo imploded. The music studio business, which had a dozen or more active players in the last century, has consolidated into a handful of firms, most of which are small parts of much bigger entertainment companies (Sony. Vivendi), and many of the biggest labels in music (<a href="https://www.independent.co.uk/arts-entertainment/music/news/emi-puts-abbey-road-studios-up-for-sale-ft-1901408.html">Abbey Roads</a>, <a href="https://www.upi.com/Entertainment_News/2004/04/01/EMI-buys-last-of-Motown-catalog/38351080832170/">Motown</a>) are historical artifacts that have sold their music rights to others. The music retail business was decimated, as music retailers like Tower Records shut down, and as artists looking to replace lost revenues from record sales with live performances and merchandising sales, companies like LiveNation stepped in to fill the need. </li><li style="text-align: justify;"><u>The divergence in musician take became larger</u>: As revenues shrunk and partially recovered, not all musicians have shared in the new pie equally. The top one percent of musicians account for <a href="https://www.rollingstone.com/pro/news/top-1-percent-streaming-1055005/">ninety percent of all music streams</a> and close to <a href="https://www.wsj.com/articles/music-superstars-are-the-new-one-percenters-11556962200">sixty percent of revenues from concerts</a>. A business that has always been top heavy in terms of rewarding success, has become even more so.</li><li style="text-align: justify;"><u>Personalities became bigger than music labels</u>: The advent of social media has allowed the highest profile performers to break free of most of the intermediaries in the music business. When you are Beyonce, and you have <a href="https://twitter.com/Beyonce">15.3 million followers on Twitter</a> and <a href="https://www.instagram.com/beyonce/">317 million followers in Instagram</a>, you have more reach and persuasive powers than any music company on the face of the earth. While it is true that social media has allowed a few musicians to break through and become successes, I think it is undeniable that social media is exacerbating the differences between big name musicians and unknowns more than it is helping close the gap.</li></ol><div style="text-align: justify;">You could see these the last two phenomena at play, this year, in the <a href="https://www.taylorswift.com/tour-us/">Taylor Swift Eras Tour</a>, where Taylor has effectively cut out most of the middlemen in the concert business and laid direct claim to the <a href="https://www.cnn.com/2023/08/17/business/taylor-swift-eras-tour-two-billion/index.html">hundreds of millions of dollars in revenues</a> from the tour.</div><div style="text-align: justify;"><span> As movie and broadcast business executives look over their shoulders at what streaming has in store for them, a few of them are undoubtedly looking at the implosion of the music business and wondering whether a similar fate awaits them. The more optimistic among them will point to differences between the music and movie businesses that will make the latter more resilient, but the more pessimistic will note the similarities. To put it in more existential terms, if the movie business resembles the music business in how it responds to streaming, there is a boatload of pain that is coming for the status quo, with the key difference being that a meltdown similar to the one seen in music will wipe out hundreds of billions of dollars in value, rather than the tens of billions in the music business.</span></div><p></p><p><b>Movie and Broadcasting - The Twentieth Century Lead In</b></p><p style="text-align: justify;"><b> </b>The movie business had its beginnings in the early 1900s, when the first movies were made and Hollywood became the destination of choice for movie makers, at least in the United States. In the years after, the great movie studios had their beginnings, with the precursor to Paramount being created by Cecil B. DeMille and others in 1915, followed soon by Metro Goldwyn Mayer (MGM), RKO, 20th Century Fox and Warner Bros (creating the Big Five), as well as by smaller players (Universal, United, Columbia), . In the golden age (at least for the studios), these five studios controlled almost every aspect of the movies, including content, distribution and exhibition, with movie actors effectively owned and controlled by the studios that discovered them. It took the US Supreme Court and use of the anti-trust law, in 1948, to first force studios out of the movie theater ownership business, and then to release movie stars from their bondage, and in the process, it ended the Studio Age.</p><p style="text-align: justify;"><span> Forced to divest themselves of movie theaters and of their control of movie stars, the studios </span>were able to offset the negatives with the positives from new technologies (Technicolor, stereo sound) and an almost unchallenged claim on American leisure time, with close to two-thirds of Americans going to the movies at least once a week in the 1950s. <span>In the 1970s, Hollywood discovered the payoff from blockbuster movies, and the movie business became increasingly dependent on the biggest blockbusters delivering enough revenues and profits to cover a whole host of movies that either lost money or broke even. While Jaws and the first three Star Wars movies (A New Hope, The Empire Strikes </span>Back, The Return of the Jedi) were not the first mega-hits in history, they accelerated the trend towards the blockbuster phenomenon that continues through today. In the 1980s, the birth of video players created ways for studios to supplement revenues at movie theaters with revenues from selling videos and DVDs, while opening the door to illegal copying and piracy. </p><p style="text-align: justify;"> <span> Through this period, t</span>he big studios still controlled a large share of the content business, but independent studies, often more daring in choice of topics and settings, took a share. That said, the movie business remained concentrated, with the biggest players dominating each segment of the business.</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj5CFUv8TZ91qRqzmh_x0AHtho4YbsYRBnsRbR9IAXRUDxz78g6pAdQ0mC8K-StM1wJXtQ2yfhWoBHHZyn6hJf669582BaYSKiSHlG6UvKJ5WRXuUdTMo42IvFQHu5hTWzdMMNVYZUXpULJX0sj8bTyHTB6m3hff1bisNHSG65K6Na40bwEnlCpmOIxOe4/s1500/MovieBusinesPictured.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1154" data-original-width="1500" height="308" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj5CFUv8TZ91qRqzmh_x0AHtho4YbsYRBnsRbR9IAXRUDxz78g6pAdQ0mC8K-StM1wJXtQ2yfhWoBHHZyn6hJf669582BaYSKiSHlG6UvKJ5WRXuUdTMo42IvFQHu5hTWzdMMNVYZUXpULJX0sj8bTyHTB6m3hff1bisNHSG65K6Na40bwEnlCpmOIxOe4/w400-h308/MovieBusinesPictured.jpg" width="400" /></a></div><p style="text-align: justify;">That movie business was built around box office receipts at movie theaters, split between the movie makers and the theater owners. The latter were capital intensive, since they occupied valuable real estate, owned or leased by the theater companies. Though the theater-owners were nominally independent, studios retained significant bargaining power with these exhibitors and the sharing of supplemental revenues. </p><p style="text-align: justify;"><span> </span><span> The broadcasting business lagged the movie business, in terms of development, because televisions did not start making their way into households in sufficient numbers until the 1950s, but it too was built around a system of content-production, distribution and exhibition, but with advertising at the heart of its revenue generation. The dominance of the three big networks (ABC, CBS and NBC) in television viewing meant that television shows had to reach the broadest possible audiences to be successful, and t</span>elevision show success was measured with (Nielsen) ratings, measuring how much they were watched, and an entire business was built around these measurements. That business was disrupted in the 1970s and 1980s with the arrival of cable television, and cable's capacity to carry hundreds of channels, some of which catered to niche markets, shaking the major network hold on viewers and changing content again. At the start of 2010, it was estimated that close to 75% of all US households received their television through a cable or satellite provider, setting the stage for the next big disruption in the business.</p><p><b>Movie and Broadcasting: The Streaming Era</b></p><p style="text-align: justify;"> Netflix, which is now synonymous with the streaming threat to movies, started its life as a video rental company, more of a threat to Blockbuster video, the lead player in that business, than to any of the larger players in the content business. It is worth remembering that Netflix entree into the business was initially on the US postal system, with the innovation being that you could have the videos you wanted to watch mailed to you, instead of going into a video rental store. As the capacity of the internet to send large files improved, Netflix shifted to digital distribution, <a href="https://sharpencx.com/blog/netflix-digital-transformation-case-study/">albeit with angst on the part of some existing customers</a>, but it still relied entirely on rented content (from the traditional studios). It was in response to being squeezed by the studios on payments for this content that Netflix decided to try its hand at original content, with <i>House of Cards</i> and <i>Orange is the new Black </i>representing their first major forays, and set in sequence the events that have led us to where we stand today.<br /></p><p><i>The Netflix Disruption</i></p><p><span> The rise of Netflix as a streaming giant has been meteoric, and it can be seen both in the growth in subscribers and revenues at the company, especially in the last decade.</span><br /></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjMp98rD2FtDFxKsSVnQfKA8V56RTnprV-UvZIAlLdVl09wPq7d9qb2bcq6a0ntDnA35XoyAeFkCOT-RaCGAOhqf_7i9tYJqfQb9EzzZjUonAI-0LDdaDHCbR2Z1qp57Mt2MLVCeDxFtPdnXk8Kg-hlDA2YI1Gc4fBICmVUAG9OPqw0_2zblqLCmOvsF3k/s1178/NetflixRise.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="874" data-original-width="1178" height="296" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjMp98rD2FtDFxKsSVnQfKA8V56RTnprV-UvZIAlLdVl09wPq7d9qb2bcq6a0ntDnA35XoyAeFkCOT-RaCGAOhqf_7i9tYJqfQb9EzzZjUonAI-0LDdaDHCbR2Z1qp57Mt2MLVCeDxFtPdnXk8Kg-hlDA2YI1Gc4fBICmVUAG9OPqw0_2zblqLCmOvsF3k/w400-h296/NetflixRise.jpg" width="400" /></a></div><div style="text-align: justify;">Embedded in these numbers are two other trends worth noting. The first is that the percent of content that Netflix produced (original content) increased from almost nothing in 2011 <u>to close to 50% of content in 2022</u>. The second is that growth in recent years, in subscribers and revenues, has come from outside the US, with US <i>declining from 52% of all subscribers in 2018 to 33.6% of subscribers</i> in 2022. </div><div><div style="text-align: justify;"><span><span> </span>As Netflix has grown, it has drawn competition not only from traditional content makers, with the largest studios offering their own streaming services (Disney -> Disney +, Paramount -> Paramount+ & Showtime, Warner -> (HBO) Max, Universal -:> Peacock, MGM -> MGM+), but also from large technology companies (Apple TV+ and Amazon Prime). While Netflix remains the most </span>watched streaming service, many customers subscribe to multiple streaming services, and as streaming choices proliferate, more and more US households have started weaning themselves away from cable TV. This cord cutting phenomenon's effects can be seen in the percent of households that have no cable or satellite TV:</div><div class="separator" style="clear: both; text-align: center;"><br /></div><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjQ_YdeRzLFULP294wBQYF0GDKryuGxUtmKpERx-WDyk3c3GZivzw5_TRbKo1GZyv4MtTUXpVhYZPcvNt2nGAFtVUOc8gJwyQF9xD25AFV_q4UBNQvRRM1it_L6cgGegDaoS76kJkeCMWzeTKsNgI1l4Smkp7gt3AcWoPxaygNIwdNGeVe3g1U-zmT87Ic/s1656/CordCutting.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1202" data-original-width="1656" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjQ_YdeRzLFULP294wBQYF0GDKryuGxUtmKpERx-WDyk3c3GZivzw5_TRbKo1GZyv4MtTUXpVhYZPcvNt2nGAFtVUOc8gJwyQF9xD25AFV_q4UBNQvRRM1it_L6cgGegDaoS76kJkeCMWzeTKsNgI1l4Smkp7gt3AcWoPxaygNIwdNGeVe3g1U-zmT87Ic/w400-h290/CordCutting.jpg" width="400" /></a></div><br /><div class="separator" style="clear: both; text-align: justify;">Between 2015 and 2021, about 20 percent of all US households dropped their cable or satellite television subscriptions, with the drop off being dramatic in younger households. In August 2022, for the first time in history, <a href="https://www.nbcnews.com/business/consumer/streaming-viewership-overtakes-cable-tv-first-time-rcna43704#">Nielsen reported that more people watched streaming</a> than cable or broadcast TV, and there is every reason to believe that this trend will only get stronger over time. As a final note, there are two reasons why cable and satellite television has not suffered an even steeper fall. The first is that <i>aging households continue to stick with their television </i>watching habits, and relatively few older Americans have cut their cable subscriptions. The second is <i>live sports,</i> especially (American) football, where cable continues to retain a foothold, though even that advantage is under threat, as sports franchises create their own streaming platforms (MLB) or find streaming venues (MLS soccer on Apple TV, the NFL on Amazon Prime). It is in this context that Disney's battle with Charter over ESPN takes on a larger relevance, since ESPN and cable TV have had a symbiotic relationship for more than two decades.</div><div class="separator" style="clear: both; text-align: justify;"> As streaming has breached the broadcasting business, you may wonder how it is affecting the movie business. In the early years, streaming allowed studios to augment the value of their content by renting it out to streamers (Netflix, in particular) for substantial revenues. As its subscription base grew, Netflix turned to making original movies, mostly for its own platform, and in 2019, it spent close to $15 billion on original content, rivaling the spending of large movie makers. </div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiS1M-N7Tb9f3MUiovpCBx9pkWPPUyP964sNSBONaUSrfAUR4W4PtXyO60xRwaXTirWhXfO4MLdllEd9Byq-24jjOXMwuKm-Bu3gHTGDNBFeL3ZLgw1gD8ClZCs9KhbmuuXgf1T5BEUgsvSmgIkilcTpDVfAq_21CiaLt1R0v1HLa2MXvvsIHfaIs0llps/s1332/OriginalContent2019.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="938" data-original-width="1332" height="281" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiS1M-N7Tb9f3MUiovpCBx9pkWPPUyP964sNSBONaUSrfAUR4W4PtXyO60xRwaXTirWhXfO4MLdllEd9Byq-24jjOXMwuKm-Bu3gHTGDNBFeL3ZLgw1gD8ClZCs9KhbmuuXgf1T5BEUgsvSmgIkilcTpDVfAq_21CiaLt1R0v1HLa2MXvvsIHfaIs0llps/w400-h281/OriginalContent2019.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: justify;"><br /></div><div class="separator" style="clear: both; text-align: justify;">The COVID shut down of 2020, in particular, changed the dynamic further, as traditional studios, faced with the shuttering of movie theaters, released their <a href="https://movieweb.com/good-direct-to-streaming-movies/">movies directly into streaming</a>. That phenomenon has outlasted COVID, and as it develops as a viable alternative for content distribution, it not only strikes at the heart of the traditional movie business but may also be changing consumer behavior.</div><div class="separator" style="clear: both; text-align: justify;"><i style="text-align: left;"><br /></i></div><div class="separator" style="clear: both; text-align: left;"><i>The Streaming Effect</i></div><p style="text-align: justify;"><i> </i>As streaming disrupts both the broadcasting and movie businesses, let us look at how it is changing these businesses from the inside, starting with content (types of movies, movie budgets, number of movies), moving on to talent (actor and writer demand and compensation) and then to customers (how much and how we watch content). <br /></p><p><i>Content</i></p><p style="text-align: justify;"><span> The growth of streaming platforms has altered content (movies and broadcasting) in significant ways., with the first being an<i> increase in the total volume of content</i><u>,</u> as streaming platforms try to fill their content libraries. With Netflix leading the way on original content, this has translated into a jump in movies being made, as can be seen in the graph below, from an annual average of 367 movies a year, in the United States, between 2000 and 2012 to 1200 movies a year between 2013 and 2023. <br /></span></p><p style="text-align: justify;"></p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiawSFf10SBqywpm7qL49SH8YlMlbxBpt9F0BL9GioIURp3NQw8VOewk55IJ1pthUe2vqvE9RSvwKtvL_6hop9JfqtBNHcpF-1Pfu00H8rd_BbaqnInr7QmFX--Sx4a0A2TEkprn8SDU-ClMg9llIRNBghjJFZJipfj7KnfLQ1Jz8HuoDLj_p4mXWt2OmM/s1768/MovieStats.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1284" data-original-width="1768" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiawSFf10SBqywpm7qL49SH8YlMlbxBpt9F0BL9GioIURp3NQw8VOewk55IJ1pthUe2vqvE9RSvwKtvL_6hop9JfqtBNHcpF-1Pfu00H8rd_BbaqnInr7QmFX--Sx4a0A2TEkprn8SDU-ClMg9llIRNBghjJFZJipfj7KnfLQ1Jz8HuoDLj_p4mXWt2OmM/w400-h290/MovieStats.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://www.the-numbers.com/United-States/movies#tab=year">Source</a></td></tr></tbody></table><span style="text-align: left;">That increase in demand for content has been accompanied by an <i>increase in costs of movie making</i>, with the average cost for making a movie increasing from $39.5 million between 2000 and 2012 to about $54.5 million between 2013 and 2023.</span><p></p><p><span><span> If you are wondering why you have not seen an explosion of movies at theaters, it is because <i>fewer of these movies are being made for movie theaters</i>, with big studios, reducing theater movie production by almost 30%, from 108 movies a year, on average from 2000 to 2012, to about 75 movies a year, from 2013 to 2023. While independent studies increased their production over the period, the overall number of movies reaching </span>movie theaters has seen a significant drop off. </span></p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh5CR7cA_unLdp8QZg9FuFW8losGofxL1S_yGQuyT_TDO_6T4SDpxQ6nZQEKmpPi72VVzI5KCktsjKDTsAeu-CjwGdHRu4iwq5RLxveVnkUD5kB-5_nOUVZHY63DQzKtuPAS3hsAAA_qTtnnA_S-Pv45WP-U_uqHK9t9OmpI5icGMpeSKiHcCprdOxnn4E/s1758/TheaterMoviechart.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1276" data-original-width="1758" height="232" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh5CR7cA_unLdp8QZg9FuFW8losGofxL1S_yGQuyT_TDO_6T4SDpxQ6nZQEKmpPi72VVzI5KCktsjKDTsAeu-CjwGdHRu4iwq5RLxveVnkUD5kB-5_nOUVZHY63DQzKtuPAS3hsAAA_qTtnnA_S-Pv45WP-U_uqHK9t9OmpI5icGMpeSKiHcCprdOxnn4E/s320/TheaterMoviechart.jpg" width="320" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://www.the-numbers.com/market/">Source</a></td></tr></tbody></table>While the 2020 drop can be attributed to the shut down, movie production has not bounced back in the years since.<br /><p style="text-align: justify;"><span> Finally, t</span>he most interesting effects of streaming may be occurring under the surface in terms of the content that is produced, and they can be traced to the very different economics of making movies for theaters (or shows for broadcasting) as opposed to creating content for streaming services. With the former, the question of whether to make content can be answered by forecasting the revenues that will be generated by that content, either as gate receipts and ancillary revenues (for movies) or in advertising revenues (for broadcasting). With streaming, the end game with new content (movies or shows) is to add new subscribers to the service, and/or induce existing subscribers to renew their subscriptions, and it is difficult to link either directly to individual shows. Even within streaming services, there seems to be no consensus on what strategy best delivers these results, perhaps because success is so difficult to measure. </p><p style="text-align: justify;"></p><ul><li style="text-align: justify;">Netflix has chosen what can be best described as the <i>shotgun approach to content</i>, producing vast amounts of content, often in the form of entire seasons, for shows, with the hope that some portion of that content would be a binge-watching hit. That approach has delivered results in terms of higher subscriber count, but at a huge content cost, with content costs growing at the same rate, or higher rates, than subscriber count, until very recently.</li><li style="text-align: justify;">HBO has used a more <i>curated approach to content</i>, making fewer shows, albeit with less divergence in quality, and releasing episodes on a weekly basis, hoping for more viral reach from successful shows (Game of Thrones and Succession qualify as big successes). The plus of this approach is lower content costs, but with much lower subscriber numbers than in the shotgun model.</li><li style="text-align: justify;">Disney Plus started with the premise that a <i>massive library of content </i>would allow the platform to draw and keep subscribers, but early on, the company discovered that to compete with Netflix on subscriber numbers, it needed new content, and much of that content has come <i>from high-profile, expensive shows from its Avengers and Star Wars franchises</i>. If success is measured in subscriber count, Disney Plus has succeeded, but the spending on content has exploded, dragging Disney’s profitability down with it. </li><li style="text-align: justify;">With Apple TV+ and Amazon Prime, the game is even more difficult to gauge. Both companies <i>spend large amounts in content and clearly lose money</i> on their streaming platforms, but their benefits may come from tying users more closely into their platforms. with benefits showing up other products and services they sell to those in their ecosystems.</li></ul><div style="text-align: justify;">Given that all of these approaches have had difficult delivering sustained profitability, it is fair to say that while streaming has succeeded in delivering subscriber growth and changing content watching habits, it has not developed a business model that can delivered sustained profitability.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><i style="text-align: left;">Talent</i></div><p style="text-align: justify;"> The angst that many actors and writers about the sharing of streaming revenues can be best understood by considering how how they have historically received residual payments on content. Built around a <a href="https://www.hollywoodreporter.com/business/business-news/sag-wga-1960-hollywood-strike-reagan-history-1235538551/">pay structure negotiated in 1960</a>, actors and writers are paid residuals each time a show runs on broadcast or cable TV, or when someone buys a DVD or videotape of the show. With streaming, that old structure has buckled, as the benefits from a show or movie are more difficult to measure, since subscription revenue or subscriber count cannot be directly connected to individual shows. (There are exceptions, where added subscriber numbers can be attributed to a hit show, say Game of Thrones at HBO, or even a high-profile individual, with <a href="https://www.wsj.com/business/media/messi-apple-mls-subscriptions-inter-miami-ee777c26">Lionel Messi pushing up MLS subscriptions on Apple TV+</a>.) To the counter that you can measure how many people watch a show or movie on Netflix or Disney+, note that streaming companies do not make money from viewers, but only from added subscription revenues. With the more diffuse link between viewership and revenues in streaming, the question of how to structure residuals to actors and writers has become a key point of contention, and one of the central elements of the current strike. </p><p style="text-align: justify;"><span> <span face="Figtree, sans-serif" style="color: #333333; font-size: medium;"><span style="caret-color: rgb(51, 51, 51);">I</span></span></span>n 2019, <a href="https://www.sagaftra.org/2019-netflix-agreement#:~:text=The%20agreement%20covers%20how%20to,Schedule%20B%20to%20Schedule%20C.">the Screen Actors Guild made an agreement with Netflix</a> that applied to any scripted projects produced and distributed by the platform where residuals were calculated based on the amount that a performer was originally paid and how many subscribers the streaming platform has. That agreement though has yielded wildly divergent payments to actors, with s<a href="https://www.npr.org/2023/07/27/1190336979/actors-strike-residuals-sag-aftra-wga">ome taking to social media to showcase how little they received</a>, even on widely watched shows, while <a href="https://www.celebritynetworth.com/articles/entertainment-articles/these-4-actors-made-insane-deals-with-netflix/">other bigger name stars are being well compensated</a>. One of the demands from strikers is that streaming services be more transparent about viewership on shows and that they tie compensation more closely to viewership, but this dispute will not be easily resolved. Given the stakes, an agreement will eventually be reached where actors and writers will receive more than what they are receiving now, but to the extent that streaming gets its value from adding and holding on to subscribers, I expect the divergence in pay between the stars of streaming shows and the rest of the content makers to get worse over time, just as it did in the music business.</p><p><i>Consumption</i></p><p><span> Has streaming changed the way that we watch </span>movies and broadcasting content? I think so, and here are a few generalizations about those viewing changes:</p><p></p><ol style="text-align: left;"><li style="text-align: justify;"><u>More choice, but less quality control: </u>The fact that Netflix has built its content production around the shotgun approach, and is being copied by other streamers, you and I as consumers will be spending far more time starting and abandoning shows, before finding ones to watch than we used to. Not surprisingly, quite a few us are overwhelmed by that search for watchable content, and choose to go with the familiar (explaining the success of old network shows like <a href="https://people.com/tv/the-office-beats-friends-most-watched-licensed-show-netflix/">The Office, Friends</a> and <a href="https://www.independent.co.uk/arts-entertainment/tv/news/suits-netflix-meghan-markle-release-date-b2407574.html">Suits</a> on Netflix) or with the herd, often watching what everyone else is watching (the ten most watched shows and movies that Netflix highlights every day create feedback loops that lead them to be watched more).</li><li style="text-align: justify;"><u>Copycat Productions</u>: The content business have never been shy about imitation and sequels, trying to remake successful content with slight variations or add sequels to hits, but that has notched up with streaming. Thus, the success of a show on Netflix gives rise not only to more seasons of that show, but to a whole host of imitations. If you add to this the reality that streaming platforms track what you watch, and have algorithms that feed you more of the same, you may very well have the misfortune of being caught in a version of Groundhog Day, where you watch the same movie, with mild variations, over and over again for the rest of your life.</li><li style="text-align: justify;"><u>YouTube and TikTok</u>: As the content on streaming platforms dilutes quality and shifts to reality shows, it should come as no surprise that viewers are spending less time on streaming platforms and more on Twitch, YouTube and TikTok, where you get to watch people put out reality shows of their own, sometimes in real time.</li></ol><p></p><p style="text-align: justify;">Finally, the early promise of streaming was that it would allow us to save money, by cutting the cable cord, but as with most things that technology has promised us, those financial savings have become a mirage. If you add together the cost of multiple streaming services to the higher price that you paid to get higher-spreed broadband, to watch your streaming shows, I am sure that many of you are paying more on your entertainment budget than you did in pre-streaming days.</p><p><b>The Streaming Effect: Business Models and Profitability</b></p><p style="text-align: justify;"><b> </b>The effects of streaming on movies and broadcasting content and distribution are showing up in the financial statements of these companies and in the market pricing of these companies. In this section, I will start by looking at how the operating metrics of entertainment companies, with the intent of detecting shifts in growth and profitability, and then turn my attention to how investors are pricing in these changes.</p><p><i>Operating Effects</i></p><p><span> </span>For those who are concerned about a music business-like implosion in movie business revenues, I will start with the good news. At least so far, the cumulative revenues across all entertainment companies c has held up to the streaming disruption, as can be seen in the graph below, where I look at the cumulative revenues of all movie and broadcasting related companies from 1998 to 2023:</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgIaQsMSCnnmVpMzOsE4UeCSXWnq3zU1HZ2mKz-76NR_8cBL-Ov6xh-xpBPRXTh-o8urkKbPF5wYldcJYciifw-1O-HGPrHLBeaBqxpgkz-IoX4TsdbVbYAPxw4HDQHCkBDczwQnWvaGLxDoOugjiDyR8wB-h5d5RxW1dHw7w0gT4d2xopGiuXQFgdY3GY/s1790/USRevenues.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1302" data-original-width="1790" height="291" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgIaQsMSCnnmVpMzOsE4UeCSXWnq3zU1HZ2mKz-76NR_8cBL-Ov6xh-xpBPRXTh-o8urkKbPF5wYldcJYciifw-1O-HGPrHLBeaBqxpgkz-IoX4TsdbVbYAPxw4HDQHCkBDczwQnWvaGLxDoOugjiDyR8wB-h5d5RxW1dHw7w0gT4d2xopGiuXQFgdY3GY/w400-h291/USRevenues.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: justify;">Note that since companies are classified based upon their core business in this graph, the streaming component of revenues are understated, since the revenues that Disney, Paramount and Warner get from their streaming businesses are counted as movie revenues. As you can, aggregate revenues did see a drop in 2020, because of COVID, but have come back since. If you are wondering why cable company revenues have been resilient in the face of cord cutting and the loss of cable TV subscriptions, it is because cable companies remain the prime providers of broadband, without which there is no streaming business.</div><div class="separator" style="clear: both; text-align: justify;"><span> On a less upbeat note, looking at profitability at these companies, the cumulative operating profits have been less reselient, especially in the post-COVID years, with cumulative operating profits in 2022 and 2023 well below operating profits in 2019:</span></div><b><br /></b><p></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgElePyM8-xGYydhyBsv917CzP-kyw_qbzuw0hvgQNEIU0XJc5esm_IDArFSrbNU6Hp0godF3zPsdxIKZiJBiiMNCrcUOf1s70mnHbSFV_xO4CgxMMRbhdn1epV6rC6TUIvV6JUEfiZmh6KSOAt3ebLn0-UWxc9Ag4U7BDLEBhawGXkxyrqYkZhJl2Rt7I/s1784/USEBIT.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1290" data-original-width="1784" height="289" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgElePyM8-xGYydhyBsv917CzP-kyw_qbzuw0hvgQNEIU0XJc5esm_IDArFSrbNU6Hp0godF3zPsdxIKZiJBiiMNCrcUOf1s70mnHbSFV_xO4CgxMMRbhdn1epV6rC6TUIvV6JUEfiZmh6KSOAt3ebLn0-UWxc9Ag4U7BDLEBhawGXkxyrqYkZhJl2Rt7I/w400-h289/USEBIT.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: justify;">If you bring the revenues and operating numbers together to compute operating margins, you start to get a clearer sense of why movie companies, in particular, are facing a crisis:</div><b><br /></b><p></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhPGxzJjPIN20UBRKVjHjVyLgGIwrHlHdyMxWD7RJoHZOHI_YydALHioVSCazKn9K3XlkwJdcy5fRf7XpEqCkDD6gRFZqcVUnp4MGCkMzkc4vYGuTGPl0tqQWwNGXQPQSo4vvMsGcycTctPJdYsRjTrV8t6gsrEnanWiXWLD7-FWhefJWXYzOhIhLqJUgs/s1760/USMargins.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1282" data-original-width="1760" height="291" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhPGxzJjPIN20UBRKVjHjVyLgGIwrHlHdyMxWD7RJoHZOHI_YydALHioVSCazKn9K3XlkwJdcy5fRf7XpEqCkDD6gRFZqcVUnp4MGCkMzkc4vYGuTGPl0tqQWwNGXQPQSo4vvMsGcycTctPJdYsRjTrV8t6gsrEnanWiXWLD7-FWhefJWXYzOhIhLqJUgs/w400-h291/USMargins.jpg" width="400" /></a></div><div><br /></div><div style="text-align: justify;">The profitability of the movie business has collapsed in the years since COVID, with operating margins dropping below 5% in 2022 and 2023, from more than 15% in the years before COVID. Streaming seems to be settling into a modicum of profitability, but here again, we may be overstating the profitability of streaming by not bringing into the metric the losses that Disney, Warner Bros and Paramount are facing on their streaming segments.</div></div><div style="text-align: justify;"><span> In sum, entertainment companies are delivering higher revenues overall, with revenues from streaming and new technologies increasing enough to offset lost revenues in legacy businesses that are being disrupted, but the entertainment business </span>overall is becoming less profitable.</div><div><p></p><p><i>Market Effects</i></p><p><i> </i>As streaming has changed the movie and broadcasting businesses, financial markets have struggled to get a handle on how these changes affect the values of companies int these businesses. Looking at the cumulative market capitalization of all entertainment companies, there are two shifts that we can observe over time, one in the decade leading into COVID and one in the years after:</p><p><i><br /></i></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjc-crQFKJS2B9T7BYnRueQLiSlmn24PMq8MXg-1qByMx0kwLsq44P6xi6_zvMWw_r5DRP8ej_Yuhk3FS9NK0J6r55wplKnshj25IYXLRpKs14CSwWEDC2VMe_LsqeijIzAYn_BWkFqB6br5mNFKO8eGetyl0MxSucJoof5zQigun-mf75KMz_9GGWSQMo/s1762/USMktCap.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1280" data-original-width="1762" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjc-crQFKJS2B9T7BYnRueQLiSlmn24PMq8MXg-1qByMx0kwLsq44P6xi6_zvMWw_r5DRP8ej_Yuhk3FS9NK0J6r55wplKnshj25IYXLRpKs14CSwWEDC2VMe_LsqeijIzAYn_BWkFqB6br5mNFKO8eGetyl0MxSucJoof5zQigun-mf75KMz_9GGWSQMo/w400-h290/USMktCap.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: justify;">Note the surge in aggregate market capitalization between 2019 and 2021, with Netflix leading the way, and with other entertainment companies partaking, and the drop in value in the last two years. The trends in cumulative market capitalization of all entertainment companies also masks shifts in value across companies within the group, as can be seen in the graph below, where I look at the diverging fortunes across the last decade of the five largest entertainment firms (in terms of market capitalization) in September 2023:</div><p></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhsLTaGRHJcF7dfayizJebpmQtI96LlkEPj0nJAyobVC8ZTsXZctzgMHV6mg_D1gXYDitZXPr2QHss8MBu9K3gfncS_iA5LiOEcd88qV2yZAB0mSGzRlWfZHXwl-NckoGauGV3MkEhWSed52S1ILosudOfloxSoSO9H8uL75Bn4AAT817yvX8hgOlKF0to/s1848/LargestMktCapChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1352" data-original-width="1848" height="293" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhsLTaGRHJcF7dfayizJebpmQtI96LlkEPj0nJAyobVC8ZTsXZctzgMHV6mg_D1gXYDitZXPr2QHss8MBu9K3gfncS_iA5LiOEcd88qV2yZAB0mSGzRlWfZHXwl-NckoGauGV3MkEhWSed52S1ILosudOfloxSoSO9H8uL75Bn4AAT817yvX8hgOlKF0to/w400-h293/LargestMktCapChart.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: justify;">Between 2013 and September 2023, Netflix gained $174 billion in market capitalization, posting an annual return of 24.5% a year. During the same period, Comcast, Disney and Warner saw their market capitalizations stagnate, in a period when the market was up strongly, effectively translating into a lost decade of returns to shareholders. Live Nation, the fifth largest company in the group in September 2023, barely registered in the rankings in 2013, but has risen 17.19% a year to reach its current standing.</div><div class="separator" style="clear: both; text-align: justify;"><span> While the shifts in value from the status quo players to Netflix and Live Nation is buffering the impact of streaming on the cumulative market capitalization of this industry group, the market has become decidedly more negative on one segment of this group - movie theater companies. In the last graph, I look at the cumulative market cap of the four largest movie theater companies in North America - AMC, Cineplex, Cinemark and the Marcus Group. </span></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhcoUGLmDx4OAVZLbOEiW6_nBX64wJ-2B_iufGSdqG0esvTcpGI4arjEvzf11ugIpWWKQkTFNOS6uidlWb6PKOyXIyHTHPgoeDigOEuqGMEigaH7_e503Fx_5igLyfYip38iM7f1VMZ9fGurS-sBgA2ehfT9Zo4jdRruDwbkdBPOanRtrXvpZsoaIqm8UQ/s1578/theatermktcap.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1134" data-original-width="1578" height="230" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhcoUGLmDx4OAVZLbOEiW6_nBX64wJ-2B_iufGSdqG0esvTcpGI4arjEvzf11ugIpWWKQkTFNOS6uidlWb6PKOyXIyHTHPgoeDigOEuqGMEigaH7_e503Fx_5igLyfYip38iM7f1VMZ9fGurS-sBgA2ehfT9Zo4jdRruDwbkdBPOanRtrXvpZsoaIqm8UQ/s320/theatermktcap.jpg" width="320" /></a></div><div class="separator" style="clear: both; text-align: justify;">While the COVID shut down clearly impacted the 2020 numbers, note that the market decline in these companies started in 2017, and has picked up steam since.</div><p><i>Corporate Governance</i></p><p style="text-align: justify;"><i> </i>Corporate governance at companies rarely draws attention during the good times, where managerial mistakes are overlooked, and rising revenues and earnings can hide corporate flaws. However, in challenging times, and disruption clearly has created challenges for entertainment companies, it is not surprising that we are seeing more investor angst at these companies.</p><p></p><ol style="text-align: left;"><li style="text-align: justify;"><u>CEO Turnover</u>: There has been drama in the top ranks of Disney in the last few years, as Bob Iger first turned over the reins in the company to Bob Chapek in 2020, and then reclaimed it two years later. Some of that blowback can be traced to an expensive bet made by the latter on streaming, reorganizing the company around Disney+, and investing billions into streaming content, trying to attract new customers. While there are factors specific to Disney that can shed light on that company's CEO wars, I expect CEO turnover and turmoil to increase at entertainment companies, as investors look to replace management at companies that are struggling, in a sometimes futile effort to change their fortunes.</li><li style="text-align: justify;"><u>Activist Presence</u>: It is no surprise that activist investors are drawn to industries in turmoil, pushing companies to spend less on reinventing themselves and returning more cash to shareholders. Here again, the Disney experience is instructive, where Nelson Peltz's opposition to Chapek's plans clearly played a role in the CEO change this year. While Iger has been given some breathing room to fix problems after his return, the clock is ticking before activist investors return to the company. In fact, I expect the companies in the entertainment group to be prime targets for activist investors in the next few years.</li><li style="text-align: justify;"><u>Spin-offs, Divestitures and Break-ups</u>: In response to streaming challenges, entertainment companies have started exploring whether splitting up or spinning of businesses will improve their chances of survival and success in the streaming age. Warner Bros. was spun off by AT&T and merged with Discovery in 2022, precisely for this reason, and the push for Disney to spin off or divest ESPN is similarly motivated.</li><li style="text-align: justify;"><u>Bankruptcy</u>: For the companies whose financials have imploded as a result of streaming, and all have debt, you should expect to see dire news stories not just about layoffs and shrinkage, but about potential bankruptcy. In the theater business, this has become reality as Cineworld (owner of Regal, the second largest theater chain in North America) issued a bankruptcy warning in early 2023, and AMC (owner or both the largest theater chain and a streaming service) had to do a reverse stock split to keep itself from careening towards penny stock status.</li></ol><div style="text-align: justify;">There are three final notes that I would like to add to this (long) post. First, I know that this post has been US-centric in its examination of the streaming effects on entertainment, but I do believe that much of it applies to the rest of the world, with a caveat. The status quo may be better protected in other parts of the world, either because of explicit limits on or implicit barriers to entry. Thus, streaming may be less of an immediate threat to Bollywood, India's immense homegrown movie-making business, than it is to Hollywood, but change is coming nevertheless. Second, as I noted before, the line between content made by professionals (movie makers, broadcasting studios) and individuals (on platforms like YouTube and TikTok) is getting fuzzier, and they are all competing for limited viewer minutes. Third, for those in this business who are naive enough to think that artificial intelligence will rescue their companies from oblivion, I would offer the same caution that I did to the active money management business, a few months ago. If everyone has it, no one does, and with AI, content makers may very well find themselves competing with computer power and technology companies, and that is not a fight where they have the upper hand.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>What the future holds…</b></div><div style="text-align: justify;"><span> </span>The consequential and unresolved question is what the movie and broadcasting business will look like a decade from now, since the answer will determine how stakeholders in the business will be affected. To frame the answer, I start by looking at the most malignant and benign ways in which this could play out:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhpxvEHef3zt-qLW4acXDEWUxE8o6v72SnUTFU8ZvYFU86K0NjPgH8j_s8ZTFyihIllWX4ty9O8Fwhh_LxTk_I09GDbT595lxQodHZuAiGnVUJUnV9KDIgzvZB2A_EYumKFTvAEeuSFCHA7I3Z4mNCKbPPmfNs-IE7rEoygzRR3iro3zFVIpW0u7rntYv0/s1462/DisruptionSpectrum.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="894" data-original-width="1462" height="245" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhpxvEHef3zt-qLW4acXDEWUxE8o6v72SnUTFU8ZvYFU86K0NjPgH8j_s8ZTFyihIllWX4ty9O8Fwhh_LxTk_I09GDbT595lxQodHZuAiGnVUJUnV9KDIgzvZB2A_EYumKFTvAEeuSFCHA7I3Z4mNCKbPPmfNs-IE7rEoygzRR3iro3zFVIpW0u7rntYv0/w400-h245/DisruptionSpectrum.jpg" width="400" /></a></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><ul><li>At one extreme, you may see t<i>he movie and broadcasting business follow the music business and see a collapse of revenues</i>, a destruction of the status quo and a resetting of the competitive landscape. If this happens, some of the biggest names in movies and broadcasting will disappear as independent entities, either absorbed as pieces of much larger companies or cease to exist. The disruptors, including Netflix and Live Nation, will face different challenges, as they now become the status quo, and they will have to figure out how to make their business models profitable and sustainable, even as they themselves will become targets of new disruptors.</li><li>At the other exhibit, you will see entertainment continue to grow as a business, but with <i>status quo players (content makers and exhibitors) bringing their strengths into play to outflank the disruptors</i>. In this scenario, the big names in the movie and broadcasting business will modify how they make and exhibit content, and come back, bigger, stronger and more profitable than they were in the pre-streaming era. </li><li>There is a middle-ground, where <i>success will require that you draw on the strengths of both the status quo and new technologies</i>. The players in the status quo who are adaptable and willing to change will absorb those players who are not, and there will be a similar shake up among disruptors, with those disruptors who combine entertainment business wisdom with technological knowhow will win at the expense of disruptors who do not. </li></ul></div><div style="text-align: justify;">As investors in this industry group, your task is simple, if you believe in either extreme. If you believe that disruption will be absolute and upend the movie and broadcasting businesses, you should, at the minimum, avoid the status quo entertainment companies, and if you are more of a risk taker, sell short on these companies. If you believe that after all is said and done, disruption will expand entertainment business revenues, but will leave the status quo on top, you should buy Disney, Warner and perhaps even AMC, and sell short on the highest-flying newcomers in the business. </div><div style="text-align: justify;"><span> </span>If, like me, you go for the middle ground, your success will depend on how good you are at assessing adaptability in entertainment companies, buying status quo companies with speedy learning curves on streaming and new technologies and disruptors that acquire content-making skills to pair with technological prowess. That would make both Disney and Netflix works-in-progress, with the former still wrestling with the challenge of making its streaming platform a money-maker and the latter working on a content model that is more disciplined and less costly. I took a run at valuing both companies, assuming that they each find their way to a healthy balance (between growth and profits), with Disney's margins settling in below where the 18-20% levels the company delivered in pre-COVID days, and Netflix reducing its content spending (with content costs growing much slower than subscriber growth), going forward:</div></div>
<table class="tableizer-table">
<thead><tr class="tableizer-firstrow"><th></th><th style="text-align: left;">Disney</th><th style="text-align: left;">Netflix</th></tr></thead><tbody>
<tr><td>Revenues (LTM)</td><td>$87,807</td><td>$32,465</td></tr>
<tr><td>Operating Income</td><td>$7,725</td><td>$5,624</td></tr>
<tr><td>Revenue Growth (last year)</td><td>8.30%</td><td>5.44%</td></tr>
<tr><td>Operating Margin (LTM)</td><td>8.80%</td><td>17.32%</td></tr>
<tr><td>Expected Revenue Growth (Yrs 1-5)</td><td>10.00%</td><td>15.00%</td></tr>
<tr><td>Expected Operating Margin</td><td>16.00%</td><td>20.00%<br /></td></tr>
<tr><td>Sales to Capital<span> <span> <span> <span> <span> <span> <span> <span> <span> </span></span></span></span></span></span></span></span></span></td><td>1.46</td><td>3.00</td></tr>
<tr><td>Value per share</td><td>$87.52 </td><td>$238.08</td></tr>
<tr><td>Price per share</td><td>$80.00 </td><td>$443.10 </td></tr>
<tr><td>Spreadsheet</td><td><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Disney2023.xlsx">Download</a> </td><td><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Netflix2023.xlsx">Download</a></td></tr></tbody></table><div style="text-align: justify;">Put simply, the market seems to be pricing in the presumption that Netflix will continue to get content costs under control, while still delivering growth similar to what it has delivered in the past, while it is pricing Disney for low growth and margins that will fall short of their historic norms. I agree that Disney is a mess, right now, but I do believe that<u> at current pricing</u>, the odds favor me more with Disney than Netflix, but that is just me!</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>YouTube Video</b></div><div style="text-align: justify;"><b><br /><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/MxiaLeNa4jg?si=hO4Qifb3MqR2sj0U" title="YouTube video player" width="560"></iframe></b></div><div style="text-align: justify;"><br /></div>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-10083728939379195312023-08-25T17:27:00.002-04:002023-08-25T18:58:49.907-04:00Toys for Billionaires: Sports Franchises as Trophy Assets!<p style="text-align: justify;">I have always loved sports, playing tennis and cricket when I was growing up, before transitioning to fan status, cheering for my favored teams from the sidelines. I also like finance, perhaps not as much as sports, but there are winners and losers in the investment game as well. Thus, it should come as no surprise that when the two connect, as is the case when teams are bought and sold, or players are signed, I am doubly interested. The time is ripe now to talk about how professional sports, in its many variations around the world, has blown a financial gasket, as you see teams sold for prices that seem out of sync with their financial fundamentals and players signed on contracts that equate to the GDP of a small country. In this post, that is my objective, and if get sidetracked, as a sports fans, I apologize in advance.</p><p><b>The Lead In</b></p><p style="text-align: justify;"><b> </b>In its idealistic form, sports is about competition and the human spirit, and is divorced from money. That was the ideal behind not just the <a href="https://globalsportmatters.com/1968-mexico-city-olympics/2018/10/15/professional-athletes-1968-olympic-games/">Olympic ban on athletes from being paid for performing</a>, but also behind <a href="https://tenniscompanion.org/open-era-in-tennis/">major tennis tournaments being restricted to just amateurs until 1968</a> and the entire collegiate sports scene. Both restrictions eventually fell, weighted down by hypocrisy, since the same entities that preached the importance of keeping money out of sports, and insisted that the players on the field could not make a living from playing it, engorged themselves on its monetary spoils. At this point, it seems undeniable that sports and money are entwined, and that trying to separate the two is pointless.</p><p><i>The Story Lines</i></p><p style="text-align: justify;"><i> </i>As the walls between sports and money have crumbled, we have become used to seeing mind-boggling numbers on sports transactions, whether it be in the form on broadcasting networks paying for the rights to carry sporting events or player contracts pushing into the hundreds of millions. Even by those standards, though, the last few months have delivered surprises that have staggered even the most jaded sports-watchers:</p><p></p><ul style="text-align: left;"><li style="text-align: justify;"><u>Player contracts</u>: While player contracts have become bigger over time, the <a href="https://www.cbssports.com/soccer/news/kylian-mbappe-transfer-saudi-side-al-hilal-offer-huge-332-million-fee-776-million-wage-for-psg-superstar/">$776 million offer by Al-Hilal</a>, a Saudi team, to Kylian Mbappe, the French superstar on contract with PSG, for a one-year contract to play with the team was eye-popping in magnitude. While Mbappe turned down the offer and is considering a ten-year deal with PSG, the numbers involved in the Al-Hilal deal are almost impossible to justify on purely economic terms. In parallel, as the 2023 baseball season winds down, questions about which team would sign Shohei Ohtani, its best player, and f<a href="https://www.ocregister.com/2023/07/06/is-baseballs-shohei-ohtani-a-701-million-man/#:~:text=Add%20in%20that%20pricing%20factor,peerless%2C%20two%2Dway%20phenom.">or how much</a> were widely debated in the media.</li><li style="text-align: justify;"><u>Sports franchise transactions</u>: In 2023, the Washington Commanders, an NFL team with a decidedly mixed record on the field and a history of controversy around its name and owner, was <a href="https://www.commanders.com/news/josh-harris-announces-acquisition-of-washington-commanders#:~:text=WASHINGTON%20%2D%20A%20partnership%20led%20by,meeting%20on%20Thursday%2C%20July%2020th.">sold for over $6 billion to a consortium</a>, making it the highest priced sports franchise transaction in history. It followed a decade or more of ever-rising prices for sports franchises around the world, from the Premier League (soccer) in the UK, to the IPL (cricket) and across professional sports in the US. </li><li style="text-align: justify;"><u>Sport disruptions</u>: The last year has also brought threats to sports franchises, striking at their very existence. The Saudi team bid for Mbappe reflected a broader attempt by the country to disrupt professional sports, with professional golf, in particular, in the cross hairs. When LIV made its bid by <a href="https://www.sbnation.com/golf/2023/6/7/23752690/rory-mcilroy-admission-potential-liv-golf-offer">signing up some of the best-known golf players</a> in the world to play in its tournaments, few gave it a chance of success against the PGA, but in 2023, it was the <a href="https://www.nbcnewyork.com/news/sports/golf/saudi-investment-pga-tour-one-billion-norman-out-liv-ceo/4495846/">PGA that conceded the fight </a>in the money game.</li><li style="text-align: justify;"><u>Broadcasting upheaval</u>: As the revenues from sports has shifted from the playing fields to media, it is the size of the media contracts that determine how lucrative a sport is. In 2021, we saw the NFL, the richest franchise in the world, enter into <a href="https://www.nytimes.com/2021/03/18/sports/football/nfl-tv-contracts.html">new media contracts</a> to cover the next decade of broadcasting rights for the sport. These contracts are not only expected to bring in a staggering $114 billion in revenues to the NFL in the next decade, but in a reflection of the times, they are split among four different broadcasters (ESPN, CBS, NBC and Fox), with Amazon Prime picking up the slack. The increasing importance of streaming in the media business was illustrated when the IPL, India’s cricket league, <a href="https://www.bbc.com/news/world-asia-india-61793888">sold its media rights for the next five years</a> for television broadcasting to Star India, a Disney-owned subsidiary, for roughly $3 billion, and the streaming rights for the same period to Viacom18, a Reliance-controlled joint venture, for about the same amount.</li></ul><div style="text-align: justify;">While these stories cover disparate parts of sports, and the only thing they share in common is the explosively large financial numbers, I will argue, in this post, that they represent an acceleration in a phenomenon that will change how these sports will get played and watched.</div><p></p><p><i>Rising Franchise Prices</i></p><p style="text-align: justify;"><i> </i>Even a casual follower of the news on sports franchises changing hands, no matter what the sport, must have noticed the surge in the pricing of sports franchises, with little or no obvious connection to team success on the field; the Washington Commanders, the target of $6 billion acquisition, have won 63 games, while losing 97, in the last decade. In fact, the five highest prices paid for sports teams have all be paid in the last two years, as can be seen in the list of ten most expensive sports franchise transactions in history:</p><p><i><style type="text/css">
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<thead><tr class="tableizer-firstrow"><th><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">Team</blockquote></th><th><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">League</blockquote></th><th><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">Year</blockquote></th><th><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">Price (in $ billions)</blockquote></th></tr></thead><tbody>
<tr><td style="text-align: left;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">Washington Commanders</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">NFL</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">2023</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">$6.05</blockquote></td></tr>
<tr><td style="text-align: left;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">Chelsea</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">Premier League</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">2022</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">$5.30</blockquote></td></tr>
<tr><td style="text-align: left;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">Denver Broncos</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">NFL</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">2022</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">$4.70</blockquote></td></tr>
<tr><td style="text-align: left;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">Phoenix Suns</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">NBA</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">2023</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">$4.00</blockquote></td></tr>
<tr><td style="text-align: left;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">Milwaukee Bucks</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">NBA</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">2023</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">$3.50</blockquote></td></tr>
<tr><td style="text-align: left;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">New York Mets</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">MLB</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">2020</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">$2.40</blockquote></td></tr>
<tr><td style="text-align: left;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">Brooklyn Nets</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">NBA</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">2019</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">$2.40</blockquote></td></tr>
<tr><td style="text-align: left;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">Carolina Panthers</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">NFL</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">2018</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">$2.20</blockquote></td></tr>
<tr><td style="text-align: left;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">Houston Rockets</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">NBA</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">2017</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">$2.20</blockquote></td></tr>
<tr><td style="text-align: left;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">Los Angeles Dodgers</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">MLB</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">2012</blockquote></td><td style="text-align: center;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">$2.00</blockquote></td></tr></tbody></table><p></p><p style="text-align: justify;">These high prices, though, represent the continuation of a trend that we have seen over the last few decades in franchise pricing, with the graph below looking at every major sports transaction between 1998 and 2023:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhA-gSr1VXLlnIXVZsZdZ3cx4Fnf6NNrVSBvfAyXkxyXHE-uKTaL97doRX1c4Am9TNnLvX0iG46tNYOxjgBWeSjHspOpqttnQgSLbImR-CM3n2OM8ncBKTaiP-q81LbYLnOHyMpAyr36qzcr6Mf0ZkYzqCcs22QMHk-vdQj_dMqj8VGY29kgRfJ6jWmlJE/s2644/SportsTransactionsoverTime.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1564" data-original-width="2644" height="236" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhA-gSr1VXLlnIXVZsZdZ3cx4Fnf6NNrVSBvfAyXkxyXHE-uKTaL97doRX1c4Am9TNnLvX0iG46tNYOxjgBWeSjHspOpqttnQgSLbImR-CM3n2OM8ncBKTaiP-q81LbYLnOHyMpAyr36qzcr6Mf0ZkYzqCcs22QMHk-vdQj_dMqj8VGY29kgRfJ6jWmlJE/w400-h236/SportsTransactionsoverTime.jpg" width="400" /></a></div><script type="text/javascript">!function(){"use strict";window.addEventListener("message",(function(a){if(void 0!==a.data["datawrapper-height"]){var e=document.querySelectorAll("iframe");for(var t in a.data["datawrapper-height"])for(var r=0;r<e.length;r++)if(e[r].contentWindow===a.source){var i=a.data["datawrapper-height"][t]+"px";e[r].style.height=i}}}))}();
</script><p style="text-align: justify;">As you can see, transaction prices for sports franchises have been marching upwards for the last two decades, with NBA and NFL teams registering the biggest increases, but have seen breakaway surges in the last few years.</p><p style="text-align: justify;"><span> </span>Some of you may be familiar with the Forbes annual listings of the most valuable teams in the world, and you may have wondered how they value sports teams. The truth, and I will clarify what I mean shortly, is that Forbes does not value sports franchises, but prices them. Since Forbes gets draws on actual transaction prices as guidance in their estimates, the pricing that Forbes attaches to teams has risen with transaction prices. In the graph below, for instance, I report the cumulative pricing of all NFL teams, as estimated by Forbes, from 2012 to 2022:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgRvbt2bdlNtPq0zly2PhtMyBIUx4Qisa_JuhoMIfX8J6E8wivYlOTfg9JbSuiXErK8lnf3kHxUJrb3K5MzRvA4QgwipWRVMFGKZLyK2OVPsWy3kKyr750l7NRzfacRFPw5H1U9IecHzQUS05fTPC3z8B8Tj9BLz6kP4Ex4tV8QLZTWCyHdX24Qq12E7mA/s1684/NFLOverTime.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1234" data-original-width="1684" height="293" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgRvbt2bdlNtPq0zly2PhtMyBIUx4Qisa_JuhoMIfX8J6E8wivYlOTfg9JbSuiXErK8lnf3kHxUJrb3K5MzRvA4QgwipWRVMFGKZLyK2OVPsWy3kKyr750l7NRzfacRFPw5H1U9IecHzQUS05fTPC3z8B8Tj9BLz6kP4Ex4tV8QLZTWCyHdX24Qq12E7mA/w400-h293/NFLOverTime.jpg" width="400" /></a></div><p>The collective pricing of all NFL teams, according to Forbes, has risen from $37.6 billion in 2012 to $132.5 billion in 2022. In fact, I will be willing to predict that given the Washington Commanders transaction, the pricing of every NFL team on the Forbes list will be higher in 2023.</p><p><span> </span>With the pricing process in mind, it is instructive to look at the collective pricing, in millions of US dollars, of global sports franchises, as of the most recent updates from 2022 and 2023:</p><table class="tableizer-table">
<thead><tr class="tableizer-firstrow"><th></th><th>Cumulative Pricing (in $ mil) </th><th>Highest Priced </th><th>Lowest Priced</th></tr></thead><tbody>
<tr><td style="text-align: left;">NFL (US Football)</td><td style="text-align: center;">$132,500</td><td style="text-align: center;">$7,640</td><td style="text-align: center;">$4,140</td></tr>
<tr><td style="text-align: left;">NBA (Basketball) </td><td style="text-align: center;">$85,910</td><td style="text-align: center;">$7,000</td><td style="text-align: center;">$1,600</td></tr>
<tr><td style="text-align: left;">MLB (Baseball)</td><td style="text-align: center;">$69,550</td><td style="text-align: center;">$7,100</td><td style="text-align: center;">$1,000</td></tr>
<tr><td style="text-align: left;">NHL (Hockey)</td><td style="text-align: center;">$32,350</td><td style="text-align: center;">$2,200</td><td style="text-align: center;">$450</td></tr>
<tr><td style="text-align: left;">MLS (US Soccer)</td><td style="text-align: center;">$16,200</td><td style="text-align: center;">$1,000</td><td style="text-align: center;">$350</td></tr>
<tr><td style="text-align: center;">Premier League (To 20) </td><td style="text-align: center;">$30,255</td><td style="text-align: center;">$5,950</td><td style="text-align: center;">$145</td></tr>
<tr><td style="text-align: left;">IPL (Indian Cricket)</td><td style="text-align: center;">$10,430</td><td style="text-align: center;">$1,300</td><td style="text-align: center;">$850</td></tr></tbody></table><p>The NFL is the most valuable franchise in the world, in terms of collective pricing of all of its teams, followed by basketball and baseball. The collective pricing of all soccer teams around the world may actually be close to or even exceed the pricing of baseball or basketball teams, but just the top 20 Premier League teams have a pricing of about $30 billion. The ten teams that comprise the IPL, the Indian cricket league, have a collective pricing in excess of $10 billion. One interesting difference across franchises is the differences between the highest and lowest priced franchises, with the NFL having the smallest difference, and we will talk about how the way broadcasting revenue are shared can explain this divergence across sports franchises.</p><p style="text-align: justify;"><span> Finally, there is a subset of sports franchises that are publicly traded, but it is a very small one. Among US sports franchises, the one that comes closes is <a href="https://www.marketwatch.com/investing/stock/msgs">Madison Square Garden Sports</a>, which in addition to owning the arena (Madison Square Garden) also owns the New York Knicks (NBA) and the New York Rangers (hockey), but it is closely held, with the Dolan family firmly in control. Outside of the US, <a href="https://www.marketwatch.com/investing/stock/manu">Manchester United</a> is the highest-profile example of a publicly traded company, but it too is closely held, with control in the hands of the Glazer family. There are a few European soccer teams that are publicly traded, but they all tend to be closely held, with light liquidity. </span></p><p><b>Price vs Value</b></p><p style="text-align: justify;"><i> </i>If you find me finicky, when I label the Forbes estimates for franchises as prices, rather than values, it is best understood by contrasting price and value, two words that, at least to me, mean very different things and require different mindsets:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgu_BQMFXjaAr866P_meS1icIo3yPbqAAmHeJpFy93pQe-sNKcphAO1smmkJjYTa1cp56YPUJn2LapfKtCM0GNaUi4nwAM2nUNpRrmyted1VKIoPAanv-Nw5RUxqG12Z_g1mWARM4Eek3YXkF9RNO96EAO-9DgR9H0Zr8VPfiDd5y8Zgtbb7EFmlvdz44w/s1438/pricevsvalue.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="658" data-original-width="1438" height="183" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgu_BQMFXjaAr866P_meS1icIo3yPbqAAmHeJpFy93pQe-sNKcphAO1smmkJjYTa1cp56YPUJn2LapfKtCM0GNaUi4nwAM2nUNpRrmyted1VKIoPAanv-Nw5RUxqG12Z_g1mWARM4Eek3YXkF9RNO96EAO-9DgR9H0Zr8VPfiDd5y8Zgtbb7EFmlvdz44w/w400-h183/pricevsvalue.jpg" width="400" /></a></div><p style="text-align: justify;">As you can see from the picture, while value is driven by familiar fundamentals (cash flows, growth and risk), price is determined by demand and supply, which, in turn, are driven by mood and momentum, behavioral factors that don’t play a key role in determining value. I used this contrast, a few years ago, to classify investments and talk about price and value with each one:</p><div style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhONyPi8UC06mBiqQQmLVoMZvaaziJ9oWx3U6OfRor4u1BCaT2Ks63MQrAGLjwqutpvMV7nrJ6xBtfwssAJjSUCxw0Oak9W2blgLiOJvoSfkyCYNd4ig3PwB469mkynW5zA1xZ70qrjBFycurlf_h0hYnQLJ-Gg3m25x9-d7k-vQfcgxSBtcfEl9Pqqb4s/s1874/InvestmentGroups.jpg"><img border="0" data-original-height="702" data-original-width="1874" height="150" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhONyPi8UC06mBiqQQmLVoMZvaaziJ9oWx3U6OfRor4u1BCaT2Ks63MQrAGLjwqutpvMV7nrJ6xBtfwssAJjSUCxw0Oak9W2blgLiOJvoSfkyCYNd4ig3PwB469mkynW5zA1xZ70qrjBFycurlf_h0hYnQLJ-Gg3m25x9-d7k-vQfcgxSBtcfEl9Pqqb4s/w400-h150/InvestmentGroups.jpg" width="400" /></a></div><p style="text-align: justify;">As you can see, collectibles and currencies can only be priced, and while commodities may have an aggregate fundamental value, they are more likely to be priced than valued. It is only with assets that are expected to generate cashflows in the future that value even comes into play. A company or a business can be valued, and that value will reflect its capacity to generate cash flows in the future, but it can also be priced, based upon what others are paying for similar companies. In fact, almost every investment philosophy <a href="https://aswathdamodaran.blogspot.com/2013/10/twitter-ipo-why-good-trade-be-bad.html">can be framed</a> in terms of whether you believe that there can be a gap between value and price, and when there is a gap, how quickly it will cause, as well as catalyst that cause that closing.</p><p style="text-align: justify;"><span> </span>There is a sub-grouping of assets, though, that is worth carving out and considering differently, and I will call these <b>trophy assets</b>. A trophy asset has expected cash flows, and can be valued like any other asset, but the people who buy it often do so, less for its asset status and more as a collectible. Powered by emotional factors, the prices of trophy assets can rise above values and stay higher, since, unlike other assets, there is no catalyst that will cause the gap between price and value to close. So, what is it that makes it for a "trophy assets"?</p><p></p><ol style="text-align: left;"><li style="text-align: justify;"><u>Emotional appeal overwhelms financial characteristics</u>: The key to a trophy asset is that the core of its attraction, to potential buyers or investors, lies less in business models and cash flows, and more in the emotional appeal it has to buyers. That appeal may be only to a subset of individuals, but these buyers want to own the asset more for the emotional dividends, not the cashflows.</li><li style="text-align: justify;"><u>It is unique</u>: Trophy assets pack a punch because they are unique, insofar as they cannot be replicated by someone, even if that someone has substantial financial resources.</li><li style="text-align: justify;"><u>It is scarce</u>: For trophy assets to command a pricing that is significantly higher than value, they have to be scarce.</li><li style="text-align: justify;"><u>It is bought and held for non-financial reasons</u>: If trophy assets are opened up for bidding, the winning bidder will almost always be an individual or entity that is buying the asset more for its history or provenance, not its financial characteristics.</li></ol><div>Examples of trophy assets can range the spectrum from legendary real estate properties, such as <a href="https://luxurylondon.co.uk/travel/london/the-ritz-london-sale-2020/">the Ritz Carlton in Londo</a>n, to publications like <a href="https://www.politico.eu/article/agnellis-rothschilds-close-in-on-economist-magazine-sale-pearson/">the Economist</a> or <a href="https://www.nytimes.com/2015/07/24/business/dealbook/pearson-financial-times-sale.html">the Financial Times</a>. </div><div style="text-align: justify;"><span> Once an asset crosses the threshold to trophy status, you can expect the following to occur. First, <i>it will look over priced</i>, relative to financial fundamentals (earnings, revenues, cash flows), and relative to peer group assets that do not enjoy the same trophy status. Second, and this is critical, even as price increases relative to value,<i> the mechanism that causes the gap to close, often stemming from a recognition that the you have paid too much for something, given its capacity to generate earnings and cash flows, will stop working</i>. After all, if buyers price trophy assets based upon their emotional connections, they are entering the transaction, knowing that they have paid too much, and do not care. Third, and this follows from the firs point, the forces that cause the prices of trophy assets to change from period to period will have a <i>weak or no relationship to the fundamentals</i> that would normally drive value. </span><br /></div><div style="text-align: justify;"><span><span> There is an interesting question of whether a publicly traded company can acquire trophy status, and while my answer, ten or twenty years ago, would have been a quick no, I have to pause before I answer it now. As many of you know, I have tried to value Tesla, based upon my story for the company, and the expected cash flows that emerge from that story, many times over the last decade. While some of the pushback has come from those who disagree with the contours of my story, and my expectations, some of it has come from people who have not only invested a large proportion of their wealth in the company, but have done so because they want to be part of what they see as a historical disruptor, one that will upend the way we not only drive, but live. The implication then is that Tesla will trade at prices that are difficult to justify, given the company's financials, that it will attract a subset of investors who receive emotional dividends from owning the stock and that short selling the stock, on the expectation that the gap will close, will be a perilous </span>exercise.</span></div><p><b>Sports Franchises as Trophy Assets</b></p><p style="text-align: justify;"><span><span> When the Rooney family bought the Pittsburg Steelers, now a storied franchise in the most highly priced sports league (NFL) is 1932 for $2,500, it was very likely that they were buying it as a business, hoping to generate enough in ticket sales to cover their costs and earn a profit. After all, football (at least the American version) was a nascent sport, not widely followed, and with just a few teams and no organized structure. In fact, you can still view the Steelers as a business, and value them as such, but as we will argue in this section, that number will bear little resemblance to the $4 billion pricing that Forbes attached to the team. In fact, sports franchises across the world have already become, or are increasingly on the pathway to becoming trophy assets. </span></span><br /></p><p><i>1. Prices disconnect from Fundamentals</i></p><p style="text-align: justify;"><i> </i>To value a sports franchise as a business, it is worth examining how the revenues for franchises have evolved over time. Until the last 50 years, almost all of the revenues for sports franchises came from gate receipts collected from fans coming in to watch games, and the food and merchandise that these fans bought, usually at the games they attended. With television entering the picture, and streaming augmenting it, the portion of revenues that sports franchises get from media has become a larger and larger slice of the pie, as can be seen in the graph below, where we look at gate receipts, media revenue and other (merchandizing and sponsorship) revenues for all US sports franchises between 2006 and 2022:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgj86cRzvESBu4OguXKOt4-OwhbO1Bfge7dNFRBNrcXw5rJ6CE2RGXey6qXkj57MV-2XWnS_Q3b_rzASTtQ6bckTNrXLAzFU-uetSTlZx_Q-is15YZshpcoRvoXwBLMvxrDzDgVcdaUf6WBHrXJrNxmFCA7JkIgXNDYmPAxo2Y8YShRoJlk-vo0wwASjR0/s1544/SportsRevenuesovertime.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1136" data-original-width="1544" height="235" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgj86cRzvESBu4OguXKOt4-OwhbO1Bfge7dNFRBNrcXw5rJ6CE2RGXey6qXkj57MV-2XWnS_Q3b_rzASTtQ6bckTNrXLAzFU-uetSTlZx_Q-is15YZshpcoRvoXwBLMvxrDzDgVcdaUf6WBHrXJrNxmFCA7JkIgXNDYmPAxo2Y8YShRoJlk-vo0wwASjR0/s320/SportsRevenuesovertime.jpg" width="320" /></a></div><p style="text-align: justify;">As you can see, the overall revenues for sports franchises has grown between 2006 and 2022, with 2020 being the COVID outlier, but much of that growth has come from the media slice of revenues, as gate receipts have flatlined. This is clearly not just a US phenomenon, and you are seeing the same process play out in Europe (with <a href="https://frontofficesports.com/premier-league-reportedly-making-moves-to-grow-media-rights-value/#:~:text=The%20potential%20move%20comes%20at,with%20the%202024%2D25%20season.">soccer the big beneficiary</a>) and in India (<a href="https://www.bbc.com/news/world-asia-india-61793888">with cricket the winner</a>). </p><p style="text-align: justify;"><span> </span>To value a sports franchise, you not only have to consider how much of a draw the team is at the stadium, but how much revenues the team gets from its media contracts, as well as merchandising and sponsorship revenues. While the gate receipts and merchandising revenues are significant, they are relatively easy to forecast, given history and ticket sales. Media revenues, though, are tricky, since they are determined partly by the size of the media market that the team operates in, and partly by how the sports franchise that the team belongs to shares its media revenues. In the US, for example, baseball teams get a significant portion of their broadcasting revenues from local TV rights, and as a consequence, teams in the <a href="https://www.sportsmediawatch.com/nba-market-size-nfl-mlb-nhl-nielsen-ratings/">biggest media markets </a>(Yankees and Mets in New York, Dodgers in Los Angeles) have higher revenues than teams in smaller media market (Mariners in Seattle). In contrast, the media revenues for football (NFL) are mostly national, and those revenues are equally divided across the teams, resulting in more equitable media revenues across NFL teams. That difference explains why the divergence between the highest and lowest priced teams is greater in baseball than the NFL. The table below provides a comparison of how media revenues are shared across teams, by franchise:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiF66k54b0kOq3gFTwjPI3orRjj_LEgKjqeY-KmFO8ruVRI3uje-pi8k53EXHLV2nHdALb2ZR3fbIgQHVrbLHWYh5dklJipY7daH1D5KnDyHj0VAmNgW788b2Blo_k-IEe9_JAjX-tW-vpKu-XbJ_1K0j7BG0y-vOi0o9VxDrCKyMNJO71z5oDeFRIJ9ZY/s1186/mediashare.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="590" data-original-width="1186" height="199" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiF66k54b0kOq3gFTwjPI3orRjj_LEgKjqeY-KmFO8ruVRI3uje-pi8k53EXHLV2nHdALb2ZR3fbIgQHVrbLHWYh5dklJipY7daH1D5KnDyHj0VAmNgW788b2Blo_k-IEe9_JAjX-tW-vpKu-XbJ_1K0j7BG0y-vOi0o9VxDrCKyMNJO71z5oDeFRIJ9ZY/w400-h199/mediashare.jpg" width="400" /></a></div><div><br /></div><div style="text-align: justify;">While all of the franchises pay lip service to the need for balance, with large media-market teams subsidizing small media-market teams, there is wide variation across franchises in how they follow through on fixing that imbalance. Only the NFL has a strong enough system in place to create full balance, and that is partly because of the fact that almost all of its broadcasting revenues are national (rather than local) and partly because it is a league with a strong commissioner.</div><div style="text-align: justify;"><span> While revenues have risen, aided by richer broadcasting contracts, sports franchises have been faced with rising player costs; in almost every major sports franchise in the United States, player expenses account to 50% of revenues, or more, and they have risen over time. Once the other expenses associated with a team are netted out, the operating profits at sports franchises are, for the most part, moderate</span>. Looking across sports franchises, you can see that the cumulated revenue and operating income numbers, in conjunction with the collective pricing of teams (as estimated by Forbes) in the most recent year:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjauxD5U7XWsEfkiUKoeFTafNRl461KQV9LJuxwMhMj71IALLcALWCh7a4dwa5bNMn_Rce_lrw8hkv_P1NP82EMAutQUvsRC82yDi_w6sii8bIIgB8H7xzw7BiRVUfH3xS7Io96GkXI7lwHnqbAPTsPGrBW_iCWuJhllHkCC-fUYNtT6XwQdi-B5OcNyDs/s1782/ProLeagueFundas.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="260" data-original-width="1782" height="59" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjauxD5U7XWsEfkiUKoeFTafNRl461KQV9LJuxwMhMj71IALLcALWCh7a4dwa5bNMn_Rce_lrw8hkv_P1NP82EMAutQUvsRC82yDi_w6sii8bIIgB8H7xzw7BiRVUfH3xS7Io96GkXI7lwHnqbAPTsPGrBW_iCWuJhllHkCC-fUYNtT6XwQdi-B5OcNyDs/w400-h59/ProLeagueFundas.jpg" width="400" /></a></div><div style="text-align: justify;">While team financials tend to be opaque, Forbes estimated that the NFL, the richest sports franchise in the world, generated about $4.7 billion in operating profit on revenues of approximately $16 billion, in 2022. The NBA is the next-most profitable franchise, whereas baseball collectively struggles to make money. More to the point, if you use the Forbes pricing estimates for teams, note that four of the seven franchises (NFL, NBA, MLS and IPL) trade at 8-10 times revenues and at high multiples of operating income. It is true that there are tech companies in the market that trade at similar multiples, but those companies have extraordinary growth potential ahead of them and new markets to conquer. Even if you believe that media rights will continue to the the goose that lays the golden eggs for sports franchises, it is difficult to see how you justify these pricing multiples. To show that the disconnect between what buyers are paying for franchises, and what they are getting back in return, has been growing over time, I look at the pricing of NFL teams over time, relative to revenues at these teams (which include the richer media contracts) from 2012 to 2022:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi884jyNaBa2rgMbNOmu0jCLLt7JX2cB6R8447wXDk241VzBHXey5GrO2B8iaAc7LUWDS5D0jLsJSbu4nG_rWwgMrN778f0kBUL8Ui6DYX0akh0AMqVxSJgpO3uJozUiYEzj2--rjWiWsua9RUKhP_H2OZaud4sGmbPTwGqUI2TjkTNy6gj7Pfw6LC3yXs/s1654/NFLoverTimePricing.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1204" data-original-width="1654" height="291" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi884jyNaBa2rgMbNOmu0jCLLt7JX2cB6R8447wXDk241VzBHXey5GrO2B8iaAc7LUWDS5D0jLsJSbu4nG_rWwgMrN778f0kBUL8Ui6DYX0akh0AMqVxSJgpO3uJozUiYEzj2--rjWiWsua9RUKhP_H2OZaud4sGmbPTwGqUI2TjkTNy6gj7Pfw6LC3yXs/w400-h291/NFLoverTimePricing.jpg" width="400" /></a></div><br /><div style="text-align: justify;">Over the last decade, you can see that the pricing of NFL teams has risen from just over four times revenues in 2012 to more than seven times revenues in 2022. In short, NFL franchise prices are rising at rates that cannot be explained by revenue growth, richer media contracts notwithstanding, or higher profitability.</div><div><br /></div><div style="text-align: justify;"><span> </span>If you want to see how intrinsic valuation would work at a sports franchise, you are welcome to check out <a href="https://aswathdamodaran.blogspot.com/2014/06/ballmers-bid-for-clippers-investment.html">my intrinsic valuation of the Los Angeles Clippers</a>, when Steve Ballmer offered $2 billion for that franchise in 2014. Looking at four scenarios, ranging from an extrapolation of the Clipper's 2012 financials to a best case scenario, where I modeled out a much larger media revenue stream, I got the following:</div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhh3jVDXkYwLhsigOVNMH5XQkA0hZRAl02IGJPtvRwp7en5NU7gnCuo0pfcP0goL44hjuMEQWWwF00tQrzg3M22Lpa1VMZ_0cF9LHZwtmT9pwAlotZi9Hj0EkXmw1GgUzetHXzT5ccI3xabyL2paogJCr9kRxf7az9omz7bk9XENQuttqjKPK0i0OSgxdQ/s1242/ClippersScenarios.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="556" data-original-width="1242" height="179" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhh3jVDXkYwLhsigOVNMH5XQkA0hZRAl02IGJPtvRwp7en5NU7gnCuo0pfcP0goL44hjuMEQWWwF00tQrzg3M22Lpa1VMZ_0cF9LHZwtmT9pwAlotZi9Hj0EkXmw1GgUzetHXzT5ccI3xabyL2paogJCr9kRxf7az9omz7bk9XENQuttqjKPK0i0OSgxdQ/w400-h179/ClippersScenarios.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Clippervaluation.xlsx">Download spreadsheet</a></td></tr></tbody></table><br /><div><div style="text-align: justify;">I used the same framework to <a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Commanders.xlsx">value the Washington Commanders today</a>, and my values range from $2.5 billion, with current profitability, $2.7 billion, if you give them the median operating margin of an NFL team and a value of $4.5 billion, if you give them Dallas Cowboy level margins (the highest in the NFL). In short, getting to the $6.05 billion pricing with an intrinsic valuation is beyond reach.</div><div><p><i>2. A new breed of owners</i></p><p style="text-align: justify;"><i> </i>At the start of this section, I mentioned the Rooneys buying the Pittsburg Steelers in 1932 for $2,500, and they continue to own the Steelers. While it is conceivable that they think of the Steelers as a business they own that has to continue to deliver earnings for them, much of the rest of the NFL has seen a changing of the guard, with new owners replacing the older holdouts. Many of these new owners are already wealthy, with their wealth accumulated in a different setting (real estate, private equity, venture capital), when they buy professional sports teams, and from the outset, it seems clear that they are less interested in turning a profit , and more in playing the role of team owner. To illustrate, I focus on the NBA, where there has been much turnover in the ownership ranks, with close to two-thirds of the teams acquiring new owners in the last two decades:<br /></p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgkX5EHcNEESKR7fbYECrecbBl_3AfYPZGQYOr5aJyA42jekre78qRiSVkBX9KmcpCpBUAedCuazPFSft4rAc_N8ExlHnIbXMgtGqEh5M-0kIJoUB0l0D3lngSLGIghmYIHcN54nIJjnIAeUJ2MWLF8aMBy9OmiTfNU2uLxffY--klsEgj9kYOWdplr4ZM/s1306/NBAOnwers.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="998" data-original-width="1306" height="306" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgkX5EHcNEESKR7fbYECrecbBl_3AfYPZGQYOr5aJyA42jekre78qRiSVkBX9KmcpCpBUAedCuazPFSft4rAc_N8ExlHnIbXMgtGqEh5M-0kIJoUB0l0D3lngSLGIghmYIHcN54nIJjnIAeUJ2MWLF8aMBy9OmiTfNU2uLxffY--klsEgj9kYOWdplr4ZM/w400-h306/NBAOnwers.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://justrichest.com/all-the-nba-team-owners-and-their-net-worth/">Source</a></td></tr></tbody></table><p style="text-align: justify;">As you browse this list, you will note that while many of the owners are billionaires, not counting their NBA team ownership, there are a few owners, towards the bottom of the list, whose wealth is primarily in their team ownership. Looking for trends, the more recent a sports franchise transaction, the more likely it is that the buyer is not just wealthy, but immensely so, and this pattern is playing out across the world.</p><p style="text-align: justify;"><span> </span>So, why would these wealthy, and presumably financially savvy, individuals put their money into sports teams? In keeping with the saying that a picture is worth a thousand words, take a look at this picture of Steve Ballmer on the sidelines of a Clippers game:</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgJ5RjxC3S4MDIWkvMVH78LAuG_IeKNsPzKRQT96ZUaZua1uUHbVI7Ud2jcxkXVL3scsEAtLxH6zR-XZtwcCDXzTq_PI0ryo_kGxWH35KJyxbcd1MSJf0xzRz_zHdc-lkWC8t-Q6wvyWcsNuidaBdH7PbwM8EjsjIvVSbWWrvxNgpcSQjjzhmQBCSwJjII/s1100/Ballmer%20on%20sideline.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1100" data-original-width="896" height="400" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgJ5RjxC3S4MDIWkvMVH78LAuG_IeKNsPzKRQT96ZUaZua1uUHbVI7Ud2jcxkXVL3scsEAtLxH6zR-XZtwcCDXzTq_PI0ryo_kGxWH35KJyxbcd1MSJf0xzRz_zHdc-lkWC8t-Q6wvyWcsNuidaBdH7PbwM8EjsjIvVSbWWrvxNgpcSQjjzhmQBCSwJjII/w326-h400/Ballmer%20on%20sideline.jpg" width="326" /></a></div><br /><div style="text-align: justify;">To my untrained eye, it seems to me that the Clippers are not just another investment in Ballmer's portfolio. In 2014, at the <a href="https://aswathdamodaran.blogspot.com/2014/06/ballmers-bid-for-clippers-investment.html">end of my post on the Clippers</a>, and after attempting in every conceivable way to find a financial justification why Ballmer would pay $2 billion for an NBA team that was a distant second to the other NBA team that played in the same city, I threw up my hands and concluded that Ballmer was buying a toy. By my estimated, it was an expensive toy that I estimated to cost about a billion (my estimate of the difference between the price he paid and my estimated value), but one that he could well afford, given his wealth.</div><p></p><p style="text-align: justify;"><span> In many ways, sports franchises are the ultimate trophy assets, since they are scarce and owning them not only allows you to live out your childhood dreams, but also gives you a chance to indulge your friends and family, with front-row seats and player introductions. In fact, it also explains the entry of sovereign wealth funds, especially from the Middle East, into the ownership ranks, especially in the Premier League. If you couple this reality with the fact that winner-take-all economies of the twenty-first century deliver more billionaires in our midst, you can see why there is no imminent correction on the horizon for sports franchise pricing. As long as the number of billionaires exceeds the number of sports franchises on the face of the earth, you should expect to see fewer and fewer owners like the Rooneys and more and more like the Steves (Cohen and Ballmer).</span></p><p><b>Consequences of Trophy Asset Status</b></p><p style="text-align: justify;"><b> </b>If you are a sports fan, you may be wondering why any of this matters to you, since you are not a billionaire and are not planning to buy any teams, either as businesses or as trophy assts. I think that you should care because the trophy asset phenomenon is already reshaping how teams are structured, sports get played and perhaps what your favorite team will look like next year, when it takes the field. <br /></p><p></p><ol style="text-align: left;"><li style="text-align: justify;"><i>For Owners: </i>For the owners of franchises that are not members of the billionaire club, there will be pressure to cash out, and the key to getting a lucrative offer is to increase the team's attraction to potential buyers, as toys. Adding a high-profile player, even one who is approaching the end of his or her playing life, can add to the attraction of a sports team, as a trophy, even as it reduces its quality on the field, as is moving to a city that a potential buyer may view as a better setting for their expensive toy (Oakland A's and San Diego Clipper or Charger fans, take note!). For billionaire owners of franchises, the reactions to owning an expensive toy that does not perform as expected, can range from impatience with managers and players, to trades driven by impulse rather than sports sense. </li><li style="text-align: justify;"><i>For Players</i>: As sports franchises become trophy assets, players become the jewels that add dazzle to these trophies. Not surprisingly, the superstars of every sport will be prized even more than they used to be, not just for what they can do on the field, but for what they can do for an owner’s bragging right. The recent billion dollar bid for Mbappe and the upcoming bidding war for Shohei Ohtani make sense from this perspective, and you should expect to see more mind-glowingly large player contracts in the future. To the extent that a player's trophy appeal is as much a function of that player's social media presence and following, as it is of performance on the field, you should expect to see sports players aspire for celebrity status.</li><li style="text-align: justify;"><i>For Fans</i>: If you are the fan of a sports franchise that is owned by someone to whom money is no object, you will have much to celebrate, as your team chases down and signs the biggest names in the sport. As a negative, if your team owner tires of their trophy asset, you may be stuck with the consequences of benign (or not so benign) neglect. If on the other hand, you happen to be a fan of the team that continues to be owned by an old-guard owner, intent on running the team as a business, you will find yourself frustrated as homegrown stars get signed by other teams. The old divide of rich teams/poor teams that was based on unequal media markets or stadium sizes will be replaced with a new divide between rich team owners and poorer team owners, where the latter still have to make their teams work as businesses, whereas the former do not.</li></ol><p></p><p style="text-align: justify;">In sum, if your concern has been that sports has become too business-like and driven by data, the entry of owners who are less interested in the business of sports and more interested in acquiring trophies may very well change the game, but at a cost, where sports becomes entertainment, where players and teams chase social media status, and what happens on the field itself becomes secondary to what happens off the pitch.</p><p style="text-align: justify;"><b>YouTube Video</b></p><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/sx2Jx5vaRhc?si=tvCO6H0E4B5uABp-" title="YouTube video player" width="560"></iframe><p style="text-align: justify;"><b>Data</b></p><p style="text-align: justify;"></p><ol><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/ProSportsData.xlsx">Professional Sports Data (Pricing)</a></li></ol><div><b>Spreadsheets</b></div><div><ol><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Clippervaluation.xlsx">Valuation of the Clippers in 20</a>14</li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Commanders.xlsx">Valuation of Washington Commanders in 2023</a></li></ol></div><p></p></div></div>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-223264168497033912023-08-15T16:34:00.003-04:002023-08-16T10:04:51.009-04:00In Search of Safe Havens: The Trust Deficit and Risk-free Investments!<p style="text-align: justify;">In every introductory finance class, you begin with the notion of a risk-free investment, and the rate on that investment becomes the base on which you build, to get to expected returns on risky assets and investments. In fact, the standard practice that most analysts and investors follow to estimate the risk free rate is to use the government bond rate, with the only variants being whether they use a short term or a long term rate. I took this estimation process for granted until 2008, when during that crisis, I woke up to the realization that no matter what the text books say about risk-free investments, there are times when finding an investment with a guaranteed return can become an impossible task. In the aftermath of that crisis, I wrote a series of what I called my nightmare papers, starting with one titled, "<a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1648164">What if nothing is risk free</a>?", where I looked at the possibility that we live in a world where nothing is truly risk free. I was reminded of that paper a few weeks ago, when Fitch downgraded the US, from AAA to AA+, a relatively minor shift, but one with significant psychological consequences for investors in the largest economy in the world, whose currency still dominates global transactions. After the rating downgrade, my mailbox was inundated with questions of what this action meant for investing, in general, and for corporate finance and valuation practice, in particular, and this post is my attempt to answer them all with one post.</p><p style="text-align: justify;"><b>Risk Free Investments: Definition, Role and Measures</b></p><p style="text-align: justify;"><span><span> The place to start a discussion of risk-free rates is by answering the question of what you need for an investment to be risk-free, following up by seeing why that risk-free rate plays a central role in corporate finance and investing and then looking at the determinants of that risk-free rate.</span></span><br /></p><p style="text-align: justify;"><i>What is a risk free investment?</i></p><p style="text-align: justify;"><span> For an investment to be risk-free, you have feel certain about the return you will make on it. </span>With this definition in place, you can already see that to estimate a risk free rate, you need to be specific about your time horizon, as an investor. </p><p></p><ul><li style="text-align: justify;">An investment that is risk free over a six month time period will not be risk free, if you have a ten year time horizon. That is because you have <i>reinvestment risk</i>, i.e., the proceeds from the six-month investment will have to be reinvested back at the prevailing interest rate six months from now, a year from now and so on, until year 10, and those rates are not known at the time you take the first investment.</li><li style="text-align: justify;">By the same token, an investment that delivers a guaranteed return over ten years will not be risk free to an investor with a six month time horizon. With this investment, you face <i>price risk</i>, since even though you know what you will receive as a coupon or cash flow in future periods, since the present value of these cash flows, will change as rates change. During 2022, the US treasury did not default, but an investor in a 10-year US treasury bond would have earned a return of -18% on his or her investment, as bond prices dropped.</li></ul><p style="text-align: justify;">For an investment to be risk free then, it has to meet two conditions. The first is that there is <i>no risk that the issuer of the security will default</i> on their contractual commitments. The second is that the <i>investment generates a cash flow only at your specified duration</i>, and with no intermediate cash flows prior to that duration, since those cash flows will then have to be reinvested at future, uncertain rates. For a five-year time horizon, then, you would need the rate on a five-year zero default-free zero coupons bond as your risk-free rate.</p><p style="text-align: justify;"><span> You can also draw a contrast between a nominal risk-free rate, where you are guaranteed a return in nominal terms, but with inflation being uncertain, the returns you are left with after inflation are no longer guaranteed, and a real risk-free rate, where you are guaranteed a return in real terms, with the investment is designed to protect you against volatile inflation. While there is an appeal to using real risk-free rates and returns, we live in a world of nominal returns, making nominal risk-free rates the dominant choice, in most investment analysis.</span><br /></p><p></p><p style="text-align: justify;"><i>Why does the risk-free rate matter?</i></p><p style="text-align: justify;"><i> </i>By itself, a risk-free investment may seem unexceptional, and perhaps even boring, but it is a central component of investing and corporate finance:</p><p></p><ol style="text-align: left;"><li style="text-align: justify;"><u>Asset Allocation</u>: Investors vary on risk aversion, with some more willing to take risk than others. While there are numerous mechanisms that they use to reflect their differences on risk tolerance, the simplest and the most powerful is in their choice on how much to invest in risky assets (stocks, corporate bonds, collectibles etc.) and how much to hold in investments with guaranteed returns over their time horizon (cash, treasury bill and treasury bonds).</li><li style="text-align: justify;"><u>Expected returns for Risky Investments</u>: The risk-free rate becomes the base on which you build to estimate expected returns on all other investments. For instance, if you <a href="https://aswathdamodaran.blogspot.com/2023/08/the-price-of-risk-with-equity-risk.html">read my last post on equity risk premiums</a>, I described the equity risk premium as the additional return you would demand, over and above the risk free rate. As the risk-free rate rises, expected returns on equities will be pushed up, and holding all else constant, stock prices will go down., and the reverse will occur, when risk-free rates drop.</li><li style="text-align: justify;"><u>Hurdle rates for companies</u>: Using the same reasoning, higher risk-free rates push up the costs of equity and debt for all companies, and by doing so, raise the hurdle rates for new investments. As you increase hurdle rates, new investments will have to earn higher returns to be acceptable, and existing investments can cross from being value-creating (earning more than the hurdle rate) to value-destroying (earning less). </li><li style="text-align: justify;"><u>Arbitrage pricing</u>: Arbitrage refers to the possibility that you can create risk-free positions by combining holdings in different securities, and the benchmark used to judge whether these positions are value-creating becomes the risk-free rate. If you do assume that markets will price away this excess profit, you then have the basis for the models that are used to value options and other derivative assets. That is why the risk-free rate becomes an input into <a href="https://www.mathworks.com/help/symbolic/the-black-scholes-formula-for-call-option-price.html">option pricing</a> and <a href="https://corporatefinanceinstitute.com/resources/derivatives/forward-price/">forward pricing models</a>, and its absence leaves a vacuum.</li></ol><p></p><p style="text-align: justify;"><i>Determinants</i></p><p style="text-align: justify;"><i> </i>So, why do risk-free rates vary across time and across currencies? If your answer is the Fed or central banks, you have lost the script, since the rates that central banks set tend to be short-term, and inaccessible, for most investors. In the US, the Fed sets the Fed Funds rate, an overnight intra-bank borrowing rate, but US treasury rates, from the 3-month to 30-year, are set at auctions, and by demand and supply. To understand the fundamentals that determine these rates, put yourself in the shoes of a buyer of these securities, and consider the following:</p><p></p><ol style="text-align: left;"><li style="text-align: justify;"><u>Inflation</u>: If you expect inflation to be 3% in the next year, it makes little sense to buy a bond, even if it is default free, that offers only 2%. As expected inflation rises, you should expect risk-free rates to rise, with or without central bank actions. </li><li style="text-align: justify;"><u>Real Interest Rate</u>: When you buy a note or a bond, you are giving up current consumption for future consumption, and it is fitting that you earn a return for this sacrifice. This is a real risk-free rate, and in the aggregate, it will be determined by the supply of savings in an economy and the demand for those savings from businesses and individuals making real investments. Put simply, economies with a surplus of growth investments, i.e., with more real growth, should see higher real interest rates, in steady state, than stagnant or declining economies.</li></ol><p></p><p style="text-align: justify;">The recognition of these fundamentals is what gives rise to the Fisher equation for interest rates or the risk free rate:</p><p style="text-align: justify;"><span> </span>Nominal Risk-free Rate = (1 + Expected Inflation) (1+ Real Interest Rate) -1 (or)</p><p style="text-align: justify;"><span> <span> <span> <span> <span> <span> <span> <span> <span> <span> <span> = </span></span></span></span></span></span></span></span></span></span></span> Expected Inflation + Expected Real Interest Rate (as an approximation)</p><p style="text-align: justify;">If you are wondering where central banks enter this equation, they can do so in three ways. The first is that central banking actions can affect expected inflation, at least in the long term, with more money-printing leading to higher inflation. The second is central banking actions can, at least at the margin, push rates above their fundamentals (expected inflation and real interest rates), by tightening monetary policy, and below their fundamentals by easing monetary policy. Since this is often achieved by raising or lowering the very short term rates set by the central bank, the central banking effect is likely to be greater at the shorter duration risk-free rates. The third is that central banks, by tightening or easing monetary policy, may affect real growth in the near term, and by doing so, affect real rates. </p><p style="text-align: justify;"><span> Having been fed the mythology that the Fed (or another central bank) set interest rates by investors and the media, you may be unconvinced, but there is no better way to show the emptiness of "the Fed did it" argument than to plot out the US treasury bond rate each year against a crude version of the fundamental risk-free rate, computed by adding the actual inflation in a year to the real GDP growth rate that year:</span></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhqSX4DOKjeJPu04kFkqOdJr_1s2X8HSFg_JhghRtXadceSPjGqVTWV823MDjqpT8hN4Au7EDRUN4oHM9c3n5L1TnCY0OT1JvcYAu4K1KxJgiMLjFn9BKH78kVAdZstXGAENoornaoa6eRchVcQPCIodtv_fRO-nwBv_uB5m30k8Tqv1_pnlp1EVNIhFIc/s1674/IntrinsicRiskFreeAug23.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1448" data-original-width="1674" height="346" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhqSX4DOKjeJPu04kFkqOdJr_1s2X8HSFg_JhghRtXadceSPjGqVTWV823MDjqpT8hN4Au7EDRUN4oHM9c3n5L1TnCY0OT1JvcYAu4K1KxJgiMLjFn9BKH78kVAdZstXGAENoornaoa6eRchVcQPCIodtv_fRO-nwBv_uB5m30k8Tqv1_pnlp1EVNIhFIc/w400-h346/IntrinsicRiskFreeAug23.jpg" width="400" /></a></div><p style="text-align: justify;">As you can see, the primary reasons why we saw historically low rates in the 2008-2021 time period was a combination of very low inflation and anemic real growth, and the main reason that we have seen rates rise in 2022 and 2023 is rising inflation. It is true that nominal rates follow a smoother path than the intrinsic risk free rates, but that is to be expected since the ten-year rates represent expected values for inflation and real growth over the next decade, whereas my estimates of the intrinsic rates represent one-year numbers. Thus, while inflation jumped in 2021 and 2022 to 6.98%, and investors are expecting higher inflation in the future, they are not expecting inflation to stay at those levels for the next decade.<span> </span></p><p style="text-align: justify;"><b>Risk Free Rate: Measurement</b></p><p style="text-align: justify;"><span><span> Now that we have established what a risk-free rate is, why it matters and its determinants, let us look at how best to measure that risk-free rate.</span> We will begin by looking at the standard practice of using government bond rates as riskfree rates, and why it collides with reality, move on to examine why governments default and end with an assessment of how to adjust government bond rates for that default risk.</span><br /></p><p style="text-align: justify;"><i>Government Bond Rates as Risk Free</i></p><p style="text-align: justify;"><i> </i>I took my first finance class a long, long time ago, and during the risk-free rate discussion, which lasted all of 90 seconds, I was told to use the US treasury rate as a risk-free rate. Not only was this an indication of how dollar-centric much of finance education used to be, but also of how much faith there was that the US treasury was default-free. Since then, as finance has globalized, that lesson has been carried, almost unchanged, into other currencies, where we are now being taught to use government bond rates in those currencies as risk-free rates. While that is convenient, it is worth emphasizing two implicit assumptions that underlie why government bond rates are viewed as risk-free:<br /></p><p></p><ol style="text-align: left;"><li style="text-align: justify;"><u>Control of the printing presses</u>: If you have heard the rationale for government bond rates as risk-free rates, here is how it usually goes. A government, when it borrows or issues bonds in its local currency, preserves the option to print more money, when that debt comes due, and thus should never default. This assumption breaks down, of course, when countries share a common currency, as is the case with the dozen or more European countries that all use the Euro as their domestic currency, and none of them has the power to print currency at will. </li><li style="text-align: justify;"><u>Trust in government</u>: Governments that default, especially on their domestic currency borrowings, are sending a signal that they cannot be trusted on their obligations, and the implicit assumption is that no government that has a choice would ever send that signal. (Governments send the same signal when they default on their foreign currency debt/bonds, but they can at least point to circumstances out of their control for doing so.)</li></ol><div style="text-align: justify;">The problem with these assumptions is that they are at war with the data. As we noted in our country risk discussion, governments do default on their local currency borrowings and bonds, albeit at a lower rate than they do on their foreign currency obligations. </div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjwuvfqUl7IDbnd54nd5sNGPN9qlT33mviDnUYOeQ9hH4PFGsn7k1odh1LwWUp_66cXG1bXKVsJ6CKAhiJm6mYC9szyHHeRzvIN6MZ5n8cd1rbeFgVgBTwZku6mhxHVrk4HJm1pkbcYO7KT9c-apfWg64c1dKPHiam4gYVkC9_f6P1Q06Rfza3hZhM-9tg/s968/DefaultRateTable.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="920" data-original-width="968" height="380" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjwuvfqUl7IDbnd54nd5sNGPN9qlT33mviDnUYOeQ9hH4PFGsn7k1odh1LwWUp_66cXG1bXKVsJ6CKAhiJm6mYC9szyHHeRzvIN6MZ5n8cd1rbeFgVgBTwZku6mhxHVrk4HJm1pkbcYO7KT9c-apfWg64c1dKPHiam4gYVkC9_f6P1Q06Rfza3hZhM-9tg/w400-h380/DefaultRateTable.jpg" width="400" /></a></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">If you are wondering why a government that has a choice of not defaulting would choose to default, it is worth remembering that printing more money to pay off local currency debt has a cost of its own, since it debases the currency, pushing up inflation. Inflation, especially when it becomes stratospheric, causes investors and consumers to lose trust in the currency, and given a choice between default and debasement, many governments choose the latter.</div><div style="text-align: justify;"><span> Once you open the door to the possibility of sovereign default in a local currency, it stands to reason that a government bond rate in the local currency may not always yield a risk-free rate for that currency. It is also worth noting that until 2008, investors had that door firmly shut for some currencies, believing that some governments were so trustworthy that they would not even consider default. Thus, the notion that the US or UK governments would default on their debt would have been unthinkable, but the 2008 crisis, in addition to the financial damage it created, also opened up a trust deficit, which has made the unthinkable a reality. In fact, you would be hard pressed to find any government that is trusted the way it was prior to this crisis, and that loss of trust also implies that the clock is ticking towards expiration, for the "government bonds are risk free" argument.</span><br /></div><p></p><p style="text-align: justify;"><i>When and Why Governments Default</i></p><p style="text-align: justify;"><span> Now that we have established that governments can default, let’s look at why they default. The most obvious reason is economic, where a crisis and collapse in government revenues, from taxes and other sources, causes a government to be unable meet its obligations. The likelihood of this happening should be affected by the following factors:</span><br /></p><p></p><ol style="text-align: left;"><li><div style="text-align: justify;"><u>Concentrated versus Diversified Economy</u>: A government's capacity to cover its debt obligations is a function of the revenues it generates, and those revenues are likely to be more volatile in a country that gets its revenues from a single industry or commodity than it is in a country with a more diverse economy. One measure of economic concentration is the percent of GDP that comes from commodity exports, and the picture below provides that statistic, by country:</div><table cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEilQwaPIEqfR4JmlDrLDdGj9kVfTA2RCz2in35PTgzPil_0Nvw3i2MxAG16Kp0dXtmFAXwfrv3yKgKWBI1ebrnrX_7JUBNmPPtCom_otiqBL8N93EKsy2Ql9lzTbofxxg1TMxnKxk6YLEKjusheL0rcoVd9-cTLjIcq8_7x-qIKPvc3NH3PnjlRt9Pliic/s1356/CommodityDepedence.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="722" data-original-width="1356" height="170" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEilQwaPIEqfR4JmlDrLDdGj9kVfTA2RCz2in35PTgzPil_0Nvw3i2MxAG16Kp0dXtmFAXwfrv3yKgKWBI1ebrnrX_7JUBNmPPtCom_otiqBL8N93EKsy2Ql9lzTbofxxg1TMxnKxk6YLEKjusheL0rcoVd9-cTLjIcq8_7x-qIKPvc3NH3PnjlRt9Pliic/s320/CommodityDepedence.jpg" width="320" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i>Source: UNCTAD</i></td></tr></tbody></table><div style="text-align: justify;"><br /></div><div style="text-align: justify;">As you can see, much of Africa, Latin America, the Middle East and Asia are commodity dependent, effectively making them more exposed to default, with a downturn in commodity prices.</div></li><li><div style="text-align: justify;"><u>Degree of Indebtedness</u>: As with companies, countries that borrow too much are more exposed to default risk than countries that borrow less. That said, the question of what to scale borrowing to is an open question. One widely-used measure of country indebtedness is the total debt owed by the country, as a percent of its GDP. Based on that statistic, the most indebted countries are listed below:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhwi6mnR1hGnbftlJHRi74zHbRN0gDuvtzFItup3Vox7-a4xVTw8Fycvi5KP4I5DqJWfac2KoeqDZn4j2_ChJ_kc7XaMVwfC0GuoepV0eLK8YHtYRr2IgrBeoXCbpFrRLjDTnS-MlYC9GVsdXyc4wUsb9wtJVNBIq4uh2W1Hy6nHpIFQ_lRcDIXjAG2TdQ/s1210/Debtas%25ofGDP.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1210" data-original-width="1056" height="400" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhwi6mnR1hGnbftlJHRi74zHbRN0gDuvtzFItup3Vox7-a4xVTw8Fycvi5KP4I5DqJWfac2KoeqDZn4j2_ChJ_kc7XaMVwfC0GuoepV0eLK8YHtYRr2IgrBeoXCbpFrRLjDTnS-MlYC9GVsdXyc4wUsb9wtJVNBIq4uh2W1Hy6nHpIFQ_lRcDIXjAG2TdQ/w349-h400/Debtas%25ofGDP.jpg" width="349" /></a></div><div style="text-align: justify;">As you can see, this table contains a mix of countries, with some (Venezuela, Greece and El Salvador) at high risk of default and others (Japan, US, UK, Canada and France) viewed as being at low risk of default. </div></li><li style="text-align: justify;"><u>Tax Efficiency</u>: It is worth remembering that governments do not cover debt obligations with gross domestic product or country wealth, but with their revenues, which come primarily from collecting taxes. Holding all else constant, governments with more efficient tax systems, where most taxpayers comply and pay their share, are less likely to default than governments with more porous tax systems, where tax evasion is more the rule than the exception, and corruption puts revenues into the hands of private players rather than the government.</li></ol><p></p><p style="text-align: justify;">There is a second force at play, in sovereign defaults. Ultimately, a government that chooses to default is making a political choice, as much as it is an economic one. When politics is functional, and parties across the spectrum share in the belief that default should be a last resort, with significant economic costs, there will be shared incentive in avoiding default. However, when politics becomes dysfunctional, and default is perceived as partisan, with one side of the political divide perceived as losing more from default than the other, governments may default even though they have the resources to cover their obligations.</p><p style="text-align: justify;"><span> As a lender to a government, you may not care about why a government defaults, but economic defaults generally represent more intractable problems than defaults caused by political </span>dysfunction, which tend to be solved once the partisan pounds of flesh are extracted. In my view, the ratings downgrades of the US government fall into the latter category, since they are triggered by a uniquely US phenomenon, which is a debt limit that has to be reset each time the total debt of the US approaches that value. Since that reset has to be approved by the legislature, it becomes a mechanism for political standoffs, especially when there is a split in executive and legislative power. In fact, the first downgrade of the US occurred more than a decade ago, when <a href="https://www.bbc.com/news/world-us-canada-14428930">S&P lowered its sovereign rating for the US from AAA to AA+ in 2011</a>, after a debt-limit standoff at the time. The Fitch downgrade of the US, this year, was triggered by a stand-off between the administration and Congress a few months ago on the debt-limit, and one that may be revisited in a few weeks again. </p><p style="text-align: justify;"><i>Measuring Government Default Risk</i></p><p style="text-align: justify;"><i> </i>With that lead-in on sovereign default risk, let us look at how sovereign default risk gets measured, again with the US as the focus. The first and most widely used measure of default risk is sovereign ratings, where ratings agencies rate countries, just as they do companies, with a rating scale that goes from AAA (Aaa) down to D(default). Fitch, Moody's and S&P all provide sovereign ratings for countries, with separate ratings for foreign currency and local currency debt. With sovereign ratings, the implicit assumption is that AAA (Aaa) rated countries have negligible or no default risk, and the ratings agencies back this up with the statistic that no AAA rated country has ever defaulted on its debt within 15 years of getting a AAA rating. That said, the number of AAA (Aaa) rated countries has dropped over time, and there are only nine countries left that have the top rating from all three ratings agencies: Germany, Denmark, Netherlands, Sweden, Norway, Switzerland, Luxembourg, Singapore and Australia. Canada is rated AAA by two of the ratings agencies, and after the Fitch downgrade, the US is rated Aaa only by Moody's, whereas the UK is AAA rated only by S&P.</p><p style="text-align: justify;"><span> In a reflection of the times, there have been two developments. The first is that the number of countries with the highest rating has dropped over time, as can be seen in the graph below of countries with Aaa ratings from Moody's: </span></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi96zBD0nH_qSTotJe-BYFRnqf3_DaYpUkZfFUoizDoGJV77rGZFqy_B-AbUx0UU12UiIju8yUhQ_9ibI6IolUPZgO8xLl9xdjc7z5sw8oAoXyG5fC1QScEEwWpQcWB1qyHV79nwZsEqlg_MzCjBaCIWOaZMC2mFRArWs9s-rHYbfE2HkRCK1P_YdeCBQs/s1604/AaaRatedCountriesoverTime.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1604" data-original-width="1130" height="400" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi96zBD0nH_qSTotJe-BYFRnqf3_DaYpUkZfFUoizDoGJV77rGZFqy_B-AbUx0UU12UiIju8yUhQ_9ibI6IolUPZgO8xLl9xdjc7z5sw8oAoXyG5fC1QScEEwWpQcWB1qyHV79nwZsEqlg_MzCjBaCIWOaZMC2mFRArWs9s-rHYbfE2HkRCK1P_YdeCBQs/w281-h400/AaaRatedCountriesoverTime.jpg" width="281" /></a></div><p style="text-align: justify;"><br /></p><div style="text-align: justify;">Second, even the ratings agencies have become less decisive about what a AAA sovereign rating implies for default risk, especially after the 2008 crisis, when S&P announced that not all AAA countries were equal, in terms of default risk, thus admitting that each ratings class included variations in default risk. </div><p></p><p style="text-align: justify;"><span> </span>If you recognize that default risk falls on a continuum, rather than in the discrete classes that ratings assign, the sovereign CDS market gives you not only more nuanced estimates of default risk, but ones that are reflect, on an updated basis, what investors think about a country's default risk. The graph below contains the sovereign CDS spreads for the US going back to 2008, and reflect the market's reactions to events (including the 2011 and 2023 debt-limit standoffs) over time: </p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiU56VSp5-kr2Blw5qu-p_deRk-0y1m3GXeVpYphfsCeNk5Db6y62eqrJYiexk23o9ZKlAgmjEMcjNKbGaGZS50CwBqdByL25xsIRYkSRkWn1p5Fzhj-78KBAQAlM7Y0ak_bQiMy1JUGYiHYxoIYbxNphNnY1EzB4Y4TDzan7CYl0aZBvAZoIn8qt3jSWw/s1442/SovCDSChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1052" data-original-width="1442" height="291" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiU56VSp5-kr2Blw5qu-p_deRk-0y1m3GXeVpYphfsCeNk5Db6y62eqrJYiexk23o9ZKlAgmjEMcjNKbGaGZS50CwBqdByL25xsIRYkSRkWn1p5Fzhj-78KBAQAlM7Y0ak_bQiMy1JUGYiHYxoIYbxNphNnY1EzB4Y4TDzan7CYl0aZBvAZoIn8qt3jSWw/w400-h291/SovCDSChart.jpg" width="400" /></a></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">As you can see, the debt-limit and tax law standoffs created spikes in 2011 and 2012, and, to a lesser extent, in early 2023, and that these spikes preceded the ratings changes, and were not caused by them, and that the market very quickly recovered from them. In fact, the Fitch ratings downgrade has barely registered on the US CDS spread, in the market, indicating that investors are neither surprised nor spooked by the ratings downgrades (so far). </div><p></p><p style="text-align: justify;"><i>Dealing with Government Default Risk</i></p><p style="text-align: justify;"> <span> </span>No matter what you think about the Fitch downgrade of US government debt, the big-picture perspective is that we are closer to the scenario where no entity is viewed as default-free than we were fifteen years ago, and it may be only a matter of time before we have to retire the notion that government bonds are default-free entirely. The questions for investors and analysts, if this occurs, becomes practical ones, including how best to estimate risk-free rates in currencies, when governments have default risk, and what the consequences are for equity risk premiums and default spreads.</p><p style="text-align: justify;"><i>1. Clean up government bond rate</i></p><p style="text-align: justify;"><i> </i>Consider the two requirements that have to be met for a local-currency government bond rate to be used as a risk-free rate in that currency. The first is that the government bond has to be widely traded, making the interest rate on the bond a rate set by demand and supply in the market, rather than government edict. The second is that the government be perceived as default-free. The Swiss 10-year government bond rate, in July 2023, of 1.02% meets both criteria, making it the risk-free rate in Swiss Francs. Using a similar rationale, the German 10-year bund rate (in Euros) of 2.47% becomes the risk-free rate in Euros. With the British pound, if you stay with the Moody's ratings, things get trickier. The government bond rate of 4.42% is no longer risk-free, because it has default risk embedded in it. To clean up that default risk, we estimated a default spread of 0.64%, based upon UK's rating of Aa3, and netted this spread out from the government bond rate:</p><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px; text-align: left;"><p style="text-align: justify;">Risk-free Rate in British Pounds <span> </span></p><p style="text-align: justify;">= Government Bond Rate in Pounds - Default Spread for UK = 4.42% - 0.64% = 3.78%</p></blockquote><p style="text-align: justify;">Extending this approach to all currencies, where there is a government bond rate present, we get the riskfree rates in about 30 currencies:</p><p style="text-align: justify;"><i><br /></i></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhjj07YkoFNMSeLgeOoUf-WisRxO5W8bkcNjAl-dvIsW1Ix5qA6HKVNW1iaug8khFXXT05Nhs_KYMQV2sR9mhvQ7adZYxKVSGJxKbuS9WIR6HKTKMQryrgTMWluX4ZeGJ0fFBkbuBoboqYTdHCeVKS-QbO8hd_iZpdI4OWouGgn1nQmYiVM39s_nRQHYJg/s1458/CurrencyRiskFree.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1058" data-original-width="1458" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhjj07YkoFNMSeLgeOoUf-WisRxO5W8bkcNjAl-dvIsW1Ix5qA6HKVNW1iaug8khFXXT05Nhs_KYMQV2sR9mhvQ7adZYxKVSGJxKbuS9WIR6HKTKMQryrgTMWluX4ZeGJ0fFBkbuBoboqYTdHCeVKS-QbO8hd_iZpdI4OWouGgn1nQmYiVM39s_nRQHYJg/w400-h290/CurrencyRiskFree.jpg" width="400" /></a></div><div style="text-align: justify;">Since the US still preserves a bond rating of Aaa (for the moment), with Moody's, the US treasury rate of 3.77% on July 1, 2023, was used as the riskfree rate in US dollars. </div><div style="text-align: justify;"><span> </span>As you look at these rates, especially in some emerging market currencies, you should be cautious about the numbers you get, especially since the liquidity is light or non-existent in government bonds in these markets. Thus, it is possible that the Vietnamese Dong has the lowest risk-free rate in the world in mid-2023, among all currencies, or it may reflect distortions in the Vietnamese government bond. <span> </span>One way to check these riskier rates for reasonableness is to extend on the insight that the key driver of the risk free rate is inflation, and that in a world where capital moves to equalize real returns, the differences in risk-free rates across currencies come from differential inflation In my post on country risk, In fact, as I argued in my post on country risk, you can convert a riskfree rate in any currency into a risk-free rate in another currency by adjusting for the differential inflation between the currencies: </div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhNuNwcdSBgGjUviZ3jKEg-xEdCQZRkJYuoE3JuWDUQgVjae_cdZV_ISRDO4DdbUeoN2ElAWQj6j1kIMvsodSEo9SSjpKEGJTDeUNT9aMCbRSFplrl3H9XPX7riaNxwc5gKvFvsXfIDEeT3rvFLsGixSATZj3Fx2iamyOhgNlZqXXgy9LmOYA9YwQv0AOE/s1670/CurrencyRfEquation.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="244" data-original-width="1670" height="59" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhNuNwcdSBgGjUviZ3jKEg-xEdCQZRkJYuoE3JuWDUQgVjae_cdZV_ISRDO4DdbUeoN2ElAWQj6j1kIMvsodSEo9SSjpKEGJTDeUNT9aMCbRSFplrl3H9XPX7riaNxwc5gKvFvsXfIDEeT3rvFLsGixSATZj3Fx2iamyOhgNlZqXXgy9LmOYA9YwQv0AOE/w400-h59/CurrencyRfEquation.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><span style="text-align: justify;">Thus, using the IMF's forecasted inflation rates for the US (3%) and Vietnam (5.08%), in conjunction with the US dollar risk-free rate of 3.77% on July 1, 2023, yields a Vietnamese Dong risk-free rate of 5.87% (or 5.85% with the approximation).</span></div><div style="text-align: justify;"><span> </span><span>If you believe that S&P and Fitch are right on their default risk assessments for the US, and that it should get a rating lower than Aaa (say Aa1), from Moody's, the path to getting a US risk-free rate has an added step. You have to net out the default spread for the US </span>treasury bond rate to get to a risk-free rate:</div><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;"><div style="text-align: justify;">Riskfree Rate in US dollars = US Treasury Bond Rate - Default spread on US T.Bond</div></blockquote><div style="text-align: justify;">Using the sovereign CDS market's estimate of 0.30% in August 2023, for instance, when the US treasury bond rate hit 4.10%, would have yielded a risk-free rate of 3.80% for the US dollar.</div><p></p><p style="text-align: justify;"><i>2. Risk Premia</i></p><p style="text-align: justify;"><i> </i>If you focus just on risk-free rates, you may find it counter intuitive that an increase in default risk for a country lowers the risk free rate in its currency, but looking at the big picture should explain why it is necessary. An increase in sovereign default risk is usually triggered by events that also increase risk premia in markets, pushing up government bond rates, equity risk premiums and default spreads. In fact, if you go back to my post on country risk, it becomes the key driver of the additional risk premiums that you demand in countries:<br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgaxU6tz5EZoRKkfidwPk9TjcK1hqi6A13xdC7Jy9MoQ2VYRNMOqUKLjmehjcXYjGFAmrGbOv3Jmf1mPCNsOef4j9sRPpYtzmzetGrSmpMOnoVkANzp__uAH9XcVE8k0SKjEQGyXWM7pV9PpfErDIiOF7KcEpNweWB-QQ-ZOc4sIefu9jRbrd9qqllWjkM/s1796/ERPJuly2023Picture.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1362" data-original-width="1796" height="304" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgaxU6tz5EZoRKkfidwPk9TjcK1hqi6A13xdC7Jy9MoQ2VYRNMOqUKLjmehjcXYjGFAmrGbOv3Jmf1mPCNsOef4j9sRPpYtzmzetGrSmpMOnoVkANzp__uAH9XcVE8k0SKjEQGyXWM7pV9PpfErDIiOF7KcEpNweWB-QQ-ZOc4sIefu9jRbrd9qqllWjkM/w400-h304/ERPJuly2023Picture.jpg" width="400" /></a></div><p style="text-align: justify;">You will notice that in my July 2023 update, I used the implied equity risk premium for the US of 5.00% as my estimate of a premium for a mature market, and assumed that any country with a Aaa rating (from Moody's) would have the same premium. </p><p style="text-align: justify;"><span> </span>Since Moody's remains the lone holdout on downgrading the US, I would use the same approach today, but assuming that Moody's downgrades the US from Aaa to Aa1, the approach will have to be modified. The implied equity risk premium for the US will still be my starting point, but countries with Aaa ratings will then be assigned equity risk premiums lower than the US, and that lower equity risk premium will become the mature market premium, to be used to get equity risk premiums for the rest of the world. Using the sovereign CDS spread of 0.30% as the basis, just for illustration, the mature market premium would drop from 5.00%, in my July 2023 update, to 4.58% (5.00% -1.42*.30%).</p><p style="text-align: justify;"><i>When safe havens become scarce...</i></p><p style="text-align: justify;"><i> </i>During crises, investors seeks out safety, but that pre-supposes that there is a safe place to put your money, where you know what you will make with certainty. The Fitch downgrade of the US, by itself, is not a market-shaking event, but in conjunction with a minus 18% return on the ten-year US treasury bond in 2022, these events undercut the notion that there is a safe haven for investors. When there is no safe haven, market corrections when they happen will not follow predictable patterns. Historically, when stock prices have plunged, investors have sought out US treasuries, pushing down yields and prices. But what if government securities are viewed as risky? Is it any surprise that the loss of trust in governments that has undercut the perception that they are default-free has also given rise to a host of other investment options, each claiming to be the next safe haven. While my skepticism about crypto currencies and NFTs is well documented, a portion of their rise over the last 15 years has been driven by the erosion of trust in institutions. </p><p style="text-align: justify;"><b>Conclusion</b></p><p style="text-align: justify;"><span> I started this post by noting that we pay little attention to risk-free rates in theory and in practice, taking it as a given that it is easy to estimate. As you can see from this post, that casual acceptance of what comprises a risk-free investment can be a recipe for disaster. In closing, here are a few general propositions about risk-free rates that are worth keeping in mind:</span></p><p></p><ol style="text-align: left;"><li style="text-align: justify;"><u>Risk-free rates go with currencies, not countries or governments</u>: You estimate a risk-free rate in Euros or dollars, not one for the Euro-zone or the United States. Thus, if you choose to analyze a Brazilian company in US dollars, the risk-free rate you should use is the US dollar risk free rate, not the rate on Brazilian US-dollar denominated bond. It follows, therefore, that the notion of a global risk-free rate, touted by some, is fantasy, and using the lowest government bond rate, ignoring currencies, as an estimate of this rate, is nonsensical.</li><li style="text-align: justify;"><u>Investment returns should be currency-explicit and time-specific</u>: Would you be okay with a 12% return on a stock, in the long term? That question is unanswerable, until you specify the currency in which you are denominating returns, and the time you are making the assessment. An investment that earns 12%, in Zambian Kwacha, may be making less than the risk-free rate in Kwachas, but one that earns that same return in Swiss Francs should be a slam-dunk as an investment. In the same vein, an investment that earns 12% in US dollars in 2023 may well pass muster as a good investment, but an investment that earned 12% in US dollars in 1980 would not (since the US treasury bond rate would have yielded more than 10% at the time).</li><li style="text-align: justify;"><u>Currencies are measurement mechanisms, not value-enhancer or destroyers</u>: A good financial analysis or valuation should be currency-invariant, with whatever conclusion you draw when you do your analysis in one currency carrying over into the same analysis, done in different currencies. Thus, switching from a currency with a high risk-free rate to one with a much lower risk-free rate will lower your discount rate, but the inflation differential that causes this to happen will also lower your cash flows by a proportional amount, leaving your value unchanged.</li><li style="text-align: justify;"><u>No one (including central banks) cannot fight fundamentals</u>: Central banks and governments that think that they have the power to raise or lower interest rates by edict, and the investors who invest on that basis, are being delusional. While they can nudge rates at the margin, they cannot fight fundamentals (inflation and real growth), and when they do, the fundamentals will win.</li></ol><p></p><p><b>YouTube Video</b></p><p><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/XcywXZAbB8U" title="YouTube video player" width="560"></iframe></p><p><br /></p>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-32913296232470494412023-08-05T13:40:00.004-04:002023-08-05T19:44:37.999-04:00The Price of Risk: With Equity Risk Premiums, Caveat Emptor!<p style="text-align: justify;"> If you have been reading my posts, you know that I have an obsession with equity risk premiums, which I believe lie at the center of almost every substantive debate in markets and investing. As part of that obsession, since September 2008, I have estimated an equity risk premium for the S&P 500 at the start of each month, and not only used that premium, when valuing companies during that month, but shared my estimate on my <a href="http://Damodaran.com">webpage</a> and on social media. In <a href="https://aswathdamodaran.blogspot.com/2023/07/country-risk-july-2023-update.html">my last post, on country risk premiums</a>, I used the equity risk premium of 5.00% that I estimated for the US at the start of July 2023, for the S&P 500. That said, I don't blame you, if are confused not only about how I estimate this premium, but what it measures. In fact, an <a href="https://www.marketwatch.com/story/buying-stocks-is-just-not-worth-the-risk-today-these-analysts-say-they-have-a-better-way-for-you-to-get-returns-as-high-as-5-2758e4f1">article in MarketWatch</a> earlier this year referred to the equity risk premium as an esoteric concept, a phrasing that suggested that it had little relevance to the average investor. Adding to the confusion are the proliferation of very different numbers that you may have seen attached to the current equity risk premium, each usually quoting an expert in the field, but providing little context. Just in the last few weeks, I have seen a <a href="https://www.wsj.com/articles/the-benefit-of-owning-stocks-over-bonds-keeps-shrinking-20528203">Wall Street Journal article</a> put the equity risk premium at 1.1%, a <a href=" https://www.reuters.com/markets/europe/us-earnings-recession-fades-wall-st-is-expensive-2023-07-12/">Reuters report</a> put it at 2.2%, and a bearish (and widely followed) money manager estimate the <a href="http://www.hussmanfunds.com/wmc/wmc120402.htm">equity risk premium to be negative</a>. How, you may ask, can equity risk premiums be that divergent, and does that imply that anything goes? In this post, I will not try to argue that my estimate is better than others, since that would be hubris, but instead focus on explaining why these ERP differences exist, and let you make your own judgment on which one you should use in your investing decisions.</p><p><b>ERP: Definition and Determinants</b></p><p style="text-align: justify;"><b> </b>The place to start this discussion is with an explanation of what an equity risk premium is, the determinants of that number and why it matters for investors. I will try to steer away from models and economic jargon in this section, simply because they do little to advance understanding and much to muddy the waters.<br /></p><p><i>What is it?</i></p><p style="text-align: justify;"><span> Investors are risk averse, at least in the aggregate, and while that risk aversion can wax and wane, they need at least the expectation of a higher return to be induced to invest in riskier investments. In short, the expected return on a risky investment can be constructed as the sum of the returns you can expect on a guaranteed investment, i.e., a riskfree rate, and a risk premium, which will scale up as risk increases. </span><br /></p><p style="text-align: center;"><span>Expected Return = Risk free Rate + Risk Premium</span></p><p style="text-align: justify;"><span>Note that this proposition holds even if you believe that there is nothing out there that is truly risk free, which is the case when you worry about governments defaulting, though it does imply that you have cleaning up to do to get to a riskfree rate. Note also that expectations do not always pan out, and the actual returns on a risky investment can be much lower than the risk free rate, and sometimes sharply negative.</span></p><p style="text-align: justify;"><span><span> The risk premium that you demand has different names in different markets. In the corporate bond market, it is a <i>default spread</i>, an augmentation to the interest rate that you demand on a bond with more default risk. In the real estate market, it is embedded in a <i>capitalization rate</i>, an expected return used by real estate investors to convert the income on a real estate property into a value for that property. In the equity market, it is the <i>equity risk premium</i>, the price of risk for investing in equities as a class.</span></span></p><p style="text-align: justify;"><span></span></p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiZWiPnsCS4GA8P8NFo4XVd-4OuOD_Vrzlfd9wF0j2MV9M-Rl0qcKQGBszX4VjB0xhwIPoy33kasKf9ApzezvAcZtEliw-mRfyH5ab0DiDagOYUJLFcueZCmJhwtC1PhgxPVa6QxqiqXxJQz7PvZCRtegonS2c2LLtmZu-b_l1CtEa4pKdteJWJlmTCxzI/s1336/Risk%20Premia%20in%20Markets.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1068" data-original-width="1336" height="320" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiZWiPnsCS4GA8P8NFo4XVd-4OuOD_Vrzlfd9wF0j2MV9M-Rl0qcKQGBszX4VjB0xhwIPoy33kasKf9ApzezvAcZtEliw-mRfyH5ab0DiDagOYUJLFcueZCmJhwtC1PhgxPVa6QxqiqXxJQz7PvZCRtegonS2c2LLtmZu-b_l1CtEa4pKdteJWJlmTCxzI/w400-h320/Risk%20Premia%20in%20Markets.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><br /></td></tr></tbody></table><div class="separator" style="clear: both; text-align: center;"><span></span></div><span><br /><span>As you can see, every asset class has a risk premium, and while those risk premiums are set by investors within each asset class, these premiums tend to move together much of the time.</span></span><p></p><p style="text-align: justify;"><i>Determinants</i></p><p style="text-align: justify;"><span> </span>Since the equity risk premium is a price for risk, set by demand and supply, it stands to reason that it is driven not only by economic fundamentals, but also by market mood. Equities represent the residual claim on the businesses in an economy, and it should come as no surprise that the fundamentals that determine it span the spectrum:</p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgxQUeDSmrl_J2EppbkVe7TOVHx4N6psLbnzulbPhByphMCU6CqdHdzKwaXelkLsVpZxuZj8eHkDo1rtP0PIeggImpSAEW0dvgDKpBqORg-Nsiqe9q5_H-kSFMt3kK9ZlLKBbCKXcfapMU2RTGTh2oGqn9mXm2I-cpiR5zkRKkT1HXocLUMxUufPRRxli4/s1296/ERPDeterminants.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1006" data-original-width="1296" height="310" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgxQUeDSmrl_J2EppbkVe7TOVHx4N6psLbnzulbPhByphMCU6CqdHdzKwaXelkLsVpZxuZj8eHkDo1rtP0PIeggImpSAEW0dvgDKpBqORg-Nsiqe9q5_H-kSFMt3kK9ZlLKBbCKXcfapMU2RTGTh2oGqn9mXm2I-cpiR5zkRKkT1HXocLUMxUufPRRxli4/w400-h310/ERPDeterminants.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4398884">My equity risk premium paper</a></td></tr></tbody></table><p style="text-align: justify;">Even a cursory examination of these fundamentals should lead you to conclude that not only will equity risk premiums <i>vary across markets</i>, providing an underpinning for the divergence in country risk premiums in my last post, but should also <i>vary across time</i>, since the fundamentals themselves change over time. </p><p style="text-align: justify;"><span> </span>Market prices are also driven by <i>mood and momentum</i>, and not surprisingly, equity risk premiums can change, as these moods shift. In particular, equity risk premiums can become too low (too high) if investors are excessively upbeat (depressed) about the future, and thus become the ultimate receptacles for market hope and fear. In fact, <i>one symptom of a market bubble is an equity risk premium that becomes so low that it is disconnected from fundamentals</i>, setting up for an inevitable collision with reality and a market correction.</p><p style="text-align: justify;"><i>Why it matters</i></p><p style="text-align: justify;"><b> </b>If you are a trader, an investor or a market-timer, and you are wondering why you should care about this discussion, it is worth recognizing that the equity risk premium is a central component of what you do, even if you have never explicitly estimated or used it.</p><p></p><ol style="text-align: left;"><li style="text-align: justify;"><u>Market Timing</u>: When you time markets, you are making a judgment on how an entire asset class (equities, bonds, real estate) is priced, and reallocating your money accordingly. In particular, if you believe that stocks are over priced, you will either have less of your portfolio invested in equities or, if you are aggressive, sell short on equities. Any statement about market pricing can be rephrased as a statement about equity risk premiums; if you believe that the equity risk premium, as priced in by the market, has become too low (relative to what you believe is justified, given history and fundamentals), you are arguing that stocks are over priced (and due for a correction). Conversely, if you believe that the equity risk premium has become too high, relative again to what you think is a reasonable value, you are contending that stocks are cheap, in the aggregate. </li><li style="text-align: justify;"><u>Stock Picker</u>: When you invest in an individual stock, you are doing so because you believe that stock is trading at a price that is lower than your estimate of its value. However, to make this judgment, you have to assess value in the first place, and while we can debate growth potential and profitability, the equity risk premium becomes an input into the process, determining what you should earn as an expected return on a stock. Put simply, if you are using an equity risk premium in your company valuation that is much lower (higher) than the market-set equity risk premium, you are biasing yourself to find the company to be under (over) valued. A market-neutral valuation of a company, i.e., a valuation of the company given where the market is today, requires you to at least to try to estimate a premium that is close to what the market is pricing into equities.</li><li style="text-align: justify;"><u>Corporate Finance</u>: The role of the equity risk premium in determining the expected return on a stock makes it a key input in corporate finance, as well, because that expected return becomes the company's cost of equity. That cost of equity is then embedded in a cost of capital, and as equity risk premiums rise, all companies will see their costs of capital rise. In a post from the start of this year, I noted how the surge in equity risk premiums in 2022, combined with rising treasury bond rates, caused the cost of capital to increase dramatically during the course of the year.</li></ol><p></p><div style="text-align: justify;">Put simply, the equity risk premiums that we estimate for markets have consequences for investors and businesses, and in the next section, I will look at ways of estimating it.</div><p style="text-align: justify;"><b>Measurement</b></p><p style="text-align: justify;"><b> </b>If the equity risk premium is a market-set number for the price of risk in equity markets, how do we go about estimating it? Unlike the bond market, where interest rates on bonds can be used to back out default spreads, equity investors are not explicit about what they are demanding as expected returns when they buy stocks. As a consequence, a range of approaches have been used to estimate the equity risk premium, and in this section, I will look at the pluses and minuses of each approach.</p><p style="text-align: justify;"><i>1. Historical Risk Premium</i></p><p style="text-align: justify;"><span> While we cannot explicitly observe what investors are demanding as equity risk premiums, we can observe what they have earned historically, investing in stocks instead of something risk free (or close). In the US, that data is available for long periods, with the most widely used datasets going back to the 1920s, and that data has been sliced and diced to the point of diminishing returns. At the start of every year, I update the data to bring in the most recent year's returns on stocks, treasury bonds and treasury bills, and the start of 2023 included one of the most jarring updates in my memory:</span></p><p></p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjTp_uPkave1vOo7zoHtkm5vvi1veFM4ZpxCpy3ANWxyWK_BN6wO3D-mkzjtH_T6_VDONeCLMcJOXN3EgN76Ia8aCmI7oK0EcDzSDFd_4-dsJQgWaK8lzEBhhX9dZVGzTXmK_RK1NB9ol4vV--qOkyIUft03UdjnLMbvEn6D4bI96l6zIbTmP7LnPJfRhU/s1154/HistRiskPremiums.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1154" data-original-width="1069" height="400" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjTp_uPkave1vOo7zoHtkm5vvi1veFM4ZpxCpy3ANWxyWK_BN6wO3D-mkzjtH_T6_VDONeCLMcJOXN3EgN76Ia8aCmI7oK0EcDzSDFd_4-dsJQgWaK8lzEBhhX9dZVGzTXmK_RK1NB9ol4vV--qOkyIUft03UdjnLMbvEn6D4bI96l6zIbTmP7LnPJfRhU/w370-h400/HistRiskPremiums.jpg" width="370" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/histretSP.xls">Spreadsheet with historical data</a></td></tr></tbody></table><div style="text-align: justify;"><br /></div><div class="separator" style="clear: both; text-align: justify;"><span style="text-align: left;">It was an unusual year, not just because stocks were down significantly, but also because the ten-year treasury bond, a much touted safe investment, lost 18% of its value. Relative to treasury bills, stocks delivered a negative risk premium in 2022 (-20%), but it would be nonsensical to extrapolate from a single year of data. In fact, even if you stretch the time periods out to ten, fifty or close to hundred years, you will notice that your estimates of expected returns come with significant error (as can be seen in the standard errors). </span></div><div class="separator" style="clear: both; text-align: justify;"><span style="text-align: left;"><span> In much of valuation, especially in the appraisal community, historical risk premiums remain the prevalent standard for measuring equity risk premiums, and there are a few reasons. </span></span></div><div class="separator" style="clear: both; text-align: justify;"><ul><li><span style="text-align: left;">Perhaps, the fact that you can compute </span><span style="text-align: left;">averages precisely gets translated into the delusion that these averages are facts, when, in fact, they are not just estimates, but very noisy ones. For instance, even if you use the entire 94-year time period (from 1928-2022), your estimate for the equity risk premium for stocks over ten-year treasury bonds is that it falls somewhere between 2.34% to 10.94%, with 95% confidence (6.64% ± 2* 2.15%). </span></li><li><span style="text-align: left;">It is also true that the menu of choices that you have for historical equity risk premiums, from a low of 4.12% to a high of 13.08%, depending on then time period you look at, and what you use as a riskfree rate, gives analysts a chance to let their biases play out. After all, if your job is to come up with a low value, all you have to do is latch on to a high number in this table, claim that it is a historical risk premium and deliver on your promise. </span></li></ul></div><div class="separator" style="clear: both; text-align: justify;"><span style="text-align: left;"><span> When using historical equity risk premiums, you are assuming <i>mean reversion</i>, i.e., that returns revert to historic norms over time, though, as you can see, those norms can be different, using different time periods. You are also assuming that the <i>economic and market structure has not changed significantly over the estimation period</i>, i.e., that the fundamentals that determine the risk premium have remained stable. For much of the twentieth century, historical equity risk premiums worked well as risk premium predictors in the United States, precisely because these assumptions held up. With China's rise, increased globalization and the crisis of 2008 as </span>precipitating factors, I would argue that the case for using historical risk premiums has become much weaker.</span></div><p></p><p style="text-align: justify;"><i>2. Historical Returns-Based Forecasts</i></p><p style="text-align: justify;"><i> </i>The second approach to using historical returns to estimate equity risk premiums starts with the same data as the first approach, but rather than just use the averages to make the estimates, it looks for time series patterns in historical returns that can be used to forecast expected returns. Put simply, this approach brings into the estimate the correlation across time in returns:<br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhiM6lbmX3YNiTzs7gPsV5wWfKDhHTxd4f_27VjMij0ILhUGFVHLnJypWge-_CUQmD2xrKH_XCwkNSHvkTq80qL4CB5Yp4AIS58nbxAdqXv85t2StOI8rqWxILyTJo-McNfI2EWuPSxk5l-tpxOEF11b-czN45NSwdIb0ngJFqX6O4R_lt7czuE7T3uWsY/s1458/SerialCorrelationStockReturns.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="626" data-original-width="1458" height="171" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhiM6lbmX3YNiTzs7gPsV5wWfKDhHTxd4f_27VjMij0ILhUGFVHLnJypWge-_CUQmD2xrKH_XCwkNSHvkTq80qL4CB5Yp4AIS58nbxAdqXv85t2StOI8rqWxILyTJo-McNfI2EWuPSxk5l-tpxOEF11b-czN45NSwdIb0ngJFqX6O4R_lt7czuE7T3uWsY/w400-h171/SerialCorrelationStockReturns.jpg" width="400" /></a></div><p style="text-align: justify;">If the correlations across time in stock returns were zero, this approach would yield results similar to just using the averages (historical risk premiums), but it they are not, it will lead to different predictions. Looking at historical returns, the correlations start off close to zero for one-year returns but they do become slightly more negative as you lengthen your time periods; the correlation in returns over 5-year time periods is -0.15, but it is not statistically significant. However, with 10-year time horizon, even that mild correlation disappears. In short, while it may be possible to coax a predictive model using only historical stock returns, that model is unlikely to yield much in actionable predictions. There are sub-periods where the correlation is higher, but I remain skeptical of any ERP prediction model built around just the time series of stock returns.</p><p style="text-align: justify;"><span> In an extension of this approach, you could bring in a measure of the cheapness of stocks (PE ratios or earnings yields are the most common ones) into the historical return data and exploit the relationship (if any) between the two. If there is a relationship, positive or negative, between PE ratios and subsequent returns, a regression of returns against PE (or EP) ratios can be used to generate predictions of expected annual returns in the next year, next 5 years or the next decade. The figure below is the scatter plot of earnings to price ratios against stock returns in the subsequent ten years, using data from 1960 to 2022:</span></p><p style="text-align: justify;"></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh44thRRHnOKpx4taXz_aqF5bAVItKNnnFR2kWvm9s17_L_BYZPijiTadql1_Uwhjg28P_YNKSteA6QUTf7MNk75Q-ohgGl0cavu6Usz882Bi3TwbXXIm2KDTs650rRPw4h2GBWiLrPqVtZd5oaxxama8zDMLhRBCvtEgIXcRfo323576k5sCvY4fUpbUw/s1572/EPRegression.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1280" data-original-width="1572" height="326" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh44thRRHnOKpx4taXz_aqF5bAVItKNnnFR2kWvm9s17_L_BYZPijiTadql1_Uwhjg28P_YNKSteA6QUTf7MNk75Q-ohgGl0cavu6Usz882Bi3TwbXXIm2KDTs650rRPw4h2GBWiLrPqVtZd5oaxxama8zDMLhRBCvtEgIXcRfo323576k5sCvY4fUpbUw/w400-h326/EPRegression.jpg" width="400" /></a></div><p></p><p style="text-align: justify;"><span>A regression using this data yields some of the lowest estimates of the ERP, especially for longer time horizons, because of the elevated levels of PE ratios today. In fact, at the current EP ratio of about 4%, and using the historical statistical link with long-term returns, the estimated expected annual return on stocks, over the next 10 years and based on this regression is:</span></p><p style="text-align: justify;"></p><ul><li>Expected Return on Stocks, conditional on EP = .00254 + 1.4543 (.04) = .0607 or 6.07%</li><li>ERP based on EP-based Expected Return = 6.07% - 3.97% = 2.10%</li></ul><p></p><p style="text-align: justify;"><span>It is worth remembering that the expected return predictions come with error, and the more appropriate use of this regression is to get a range for the expected annual return, which yields predictions ranging from 4% to 8%. Extending the regression back to 1928 increases the R-squared and results in some regressions that yield predicted stock returns that are lower than the treasury-bond rate, i.e., a negative equity risk premium, given the EP ratio today. </span></p><p style="text-align: justify;"><span> Note that the results from this regression just reinforce rules of thumb for market timing, based upon PE ratios, where investors are directed to sell (buy) stocks if PE ratios move above (below) a “fair value” band. Since those rules of thumb have yielded questionable results, it pays to be skeptical about these regressions as well, and</span> there are three limitations that those who use it have to keep in mind. </p><p style="text-align: justify;"></p><ul><li style="text-align: justify;"><span>First, with the longer time-period predictions, where the predictive power is strongest, the same data is counted multiple times in the </span>regression. Thus, with 5-year returns, you match the EP ratio at the end of 1960 with returns from 1961 to 1965, and then the EP ratio at the end of 1961 with returns from 1962 to 1966, and so on. While this does not imply that you cannot run these regression, it does indicate that the statistical significance (R squared and t statistics) are overstated for the longer time horizons. In addition, the longer your time horizon, the more data you lose. With a 10-year time horizon, for instance, the last year that you can use for predictions is 2012, with the EP ratio in that year matched up to the returns from 2013-2022. </li><li style="text-align: justify;">Second, as is the case with the first approach (historical risk premiums), you are assuming that the structural model is stable and that there will be mean reversion. In fact, within this time period (1928 - 2022), the predictive power is far greater between 1928 and 1960 than it is betweeen 196 and 2022.</li><li style="text-align: justify;">Third, while these models tout high R-squared, the number that matters is the standard error of the predictions. Predicting that your annual return will be 6.07% for the next decade with a standard error of 2% yields a range that leaves you, as an investor, in suspended animation, since you face daunting questions about follow through: Does a low expected return on stocks over the next decade mean that you should pull all of your money out of equities? If yes, where should you invest that cash? And when would you get back into equities again?</li></ul><div>Proponents of this approach are among the most bearish investors in the market today, but it is worth noting that this approach would have yielded “low return” predictions and kept you out of stocks for much of the last decade. </div><p></p><p style="text-align: justify;"><i>3. The Fed Model: Earnings Yield and ERP</i></p><p style="text-align: justify;"><span> The problem with historical returns approaches is that they are backward-looking, when equity risk premiums should be about what investors expect to earn in the future. To the extent that value is driven by expected future cash flows, you can back out an equity risk premium from current stock prices, if you are willing to make assumptions about earnings growth and cash flows in the future. </span>In the simplest version of this approach, you start with a stable-growth dividend discount model, where the value of equity can be written as the present value of dividends, growing at a constant rate forever:</p><span><span><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhxhqeYG_FvEjgB9ixPXpdJvzgLdj4inPSr1Ychhqr2EbQyY8obdKiVtTZz-e2CsvE-p9Qd1TDYbZGPDHojC39c1kur24ED-05DKWx-PuCBA13lWxlhA5Wm_A5RilpmDU_4pA4YeMI137i9Asn0b6e4W6H3iDVuz_sJDIGyxiGI45n4L9s37KkPqIUlGjA/s663/GordonGrowthModel.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="69" data-original-width="663" height="41" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhxhqeYG_FvEjgB9ixPXpdJvzgLdj4inPSr1Ychhqr2EbQyY8obdKiVtTZz-e2CsvE-p9Qd1TDYbZGPDHojC39c1kur24ED-05DKWx-PuCBA13lWxlhA5Wm_A5RilpmDU_4pA4YeMI137i9Asn0b6e4W6H3iDVuz_sJDIGyxiGI45n4L9s37KkPqIUlGjA/w400-h41/GordonGrowthModel.jpg" width="400" /></a></div><div style="text-align: justify;"><br /></div></span><div style="text-align: justify;">If you assume that earnings will stagnate at current levels, i.e., no earnings growth, and that companies pay out their entire earnings as dividends (payout ratio = 100%), the cost of equity can be approximated by the earnings to price ratio:</div></span><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj8fqUjLtkhsagJuWk78TIWFyh9WW1ishs-8InD97gPVAnr8h7fT2_-yahX6_6VG_m4kdpkVzwMZQJ4HNOpVeV6Hq1uEJKeGjBQFmwfe5miKvR3mjFBc5uGM9cR1b-d93EIlwxh-s4qBijqNNzYRdt5p1EQ4vwszMDwQrjxmS_DcER2EG9lh9gWXtKq74E/s820/EPNoGrowth.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="236" data-original-width="820" height="92" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj8fqUjLtkhsagJuWk78TIWFyh9WW1ishs-8InD97gPVAnr8h7fT2_-yahX6_6VG_m4kdpkVzwMZQJ4HNOpVeV6Hq1uEJKeGjBQFmwfe5miKvR3mjFBc5uGM9cR1b-d93EIlwxh-s4qBijqNNzYRdt5p1EQ4vwszMDwQrjxmS_DcER2EG9lh9gWXtKq74E/s320/EPNoGrowth.jpg" width="320" /></a></div><p style="text-align: justify;">Alternatively, you can assume that there is earnings growth and that companies earn returns on equity equal to their costs of equity, you arrive at the same result:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgiAGERqysFT-ZZOQsfjSD7ue6WP4Hmp_uYZ3V8jsWdwIWeFPpfPTJD0LXeH0tODNnmCyHf6aX-K7Oncs1NgoPE9v7qQP20MOOF0bJPOpx-29sDpb1JqvOAigzeVQ0ht16I5ydU2xdx_lz7rk-N6nkZKtLsPMwUSnzlJXifsXQ0wvUbttla_UUffH4HrgU/s1304/EPNoExcessReturns.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="406" data-original-width="1304" height="125" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgiAGERqysFT-ZZOQsfjSD7ue6WP4Hmp_uYZ3V8jsWdwIWeFPpfPTJD0LXeH0tODNnmCyHf6aX-K7Oncs1NgoPE9v7qQP20MOOF0bJPOpx-29sDpb1JqvOAigzeVQ0ht16I5ydU2xdx_lz7rk-N6nkZKtLsPMwUSnzlJXifsXQ0wvUbttla_UUffH4HrgU/w400-h125/EPNoExcessReturns.jpg" width="400" /></a></div><p style="text-align: justify;">In short, <i>the earnings to price ratio becomes a rough proxy for what you can expect to earn as a return on stocks, if you are willing to assume no earnings growth or that firms generate no excess returns</i>.</p><p style="text-align: justify;"><span> This is the basis for the widely used Fed model, where the earnings yield is compared to the treasury bond rate, and the equity risk premium is the difference between the two. In the figure below, you can see the equity risk premiums over time that </span>emerge from this comparison, on a quarterly basis, from 1988 to 2023:</p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg54mN9c_7Mx15ULiPly9yyUw-PzFw2vyyCwYQukGJaOr3QE9_yBOo2tJxnNELFtvAYtFfv5erK8-IVqnxZi-ti6f7L-VHlpedrclbRM1ykzNKKj3VLApWmEdae463bMyNlh_uGMSWRYLUzEuHQz3oVC28PsAtYBOCJT1d7T7NqOmtWx8gwlKl_s0AbfNM/s1446/QuarterlyEPRatios.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1056" data-original-width="1446" height="293" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg54mN9c_7Mx15ULiPly9yyUw-PzFw2vyyCwYQukGJaOr3QE9_yBOo2tJxnNELFtvAYtFfv5erK8-IVqnxZi-ti6f7L-VHlpedrclbRM1ykzNKKj3VLApWmEdae463bMyNlh_uGMSWRYLUzEuHQz3oVC28PsAtYBOCJT1d7T7NqOmtWx8gwlKl_s0AbfNM/w400-h293/QuarterlyEPRatios.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/EPQuarterly2023.xlsx">Download quarterly data</a></td></tr></tbody></table><p style="text-align: justify;">As you can see, this approach yields some "strange" numbers, with negative equity risk premiums for much of the 1990s, one of the best decades for investing in stocks over the last century. It is true that the equity risk premiums have been much more positive in this century, but that is largely because the treasury bond rate dropped to historic lows, after 2008. As interest rates have risen over the last year and a half, with stock prices surging over the same period, the equity risk premium based on this approach has dropped, standing at 0.41% at the start of August 2023. Since this is the approach used in the Wall Street Journal article, it explains the ERP being at a two-decade low, but I do find it odd that there is no mention that this approach yielded negative premiums in the 1980s and 1990s. In a variant, the Wall Street Journal article also looks at the difference between the earnings yield and the inflation-protected treasury rate, which yields a higher value for the ERP, of about 3%, but suffers from many of the same issues as the standard approach.</p><p style="text-align: justify;"><span> My problem with the earnings yield approach to estimating equity risk premiums is that the <i>assumptions that you need to make to justify its use are are at war with the data</i>. First, while earnings growth for US stocks has been negative in some years, it has been positive every decade for the last century, and there are no analysts (that I am aware of) expecting it be zero (in nominal terms) in the future. Second, assuming that the return on equity is equal to the cost of equity may be easy on paper, but the actual return on equity for companies in the S&P 500 was 19.73% in 2022, 17.04% over the last decade and has been higher than the cost of equity even in the worst year in this century (9.35% in 2008). <i>If you allow for growth in earnings and excess returns, it is clear that earnings yield will yield too low a value for the ERP, because of these omissions, and will yield negative values in many periods, making it useless as an ERP estimator for valuation.</i></span></p><p style="text-align: justify;"><i>4. Implied ERP</i></p><p style="text-align: justify;"><span> I start with the same general model for value that the earnings yield approach does, which is the dividend discount model but change three components</span><br /></p><p></p><ol style="text-align: left;"><li style="text-align: justify;"><u>Augmented Dividends</u>: It is undeniable that companies around the world, but especially in the US, have shifted from returning cash in the form of dividends to stock buybacks. Since two-thirds of the cash returned in 2022 was in the form of buybacks, ignoring them will lead to understating expected returns and equity risk premiums. Consequently, I add buybacks to dividends to arrive at an augmented measure of cash returned and use that as the base for my forecasts.</li><li style="text-align: justify;"><u>Allow for near-term growth in Earnings</u>: Since the objective is to estimate what investors are demanding as an expected return, given their expectations of growth, I use analyst estimates of growth in earnings for the index. To get these growth rates, I focus on analysts who estimate aggregated earnings growth the index, rather than aggregating the growth rates estimated by analysts for individual companies, where you risk double counting buybacks (since analyst estimates are often in earnings per share) and bias (since company analysts tend to over estimated growth).</li><li style="text-align: justify;"><u>Excess Returns and Cashflows</u>: I start my forecasts by assuming that companies will return the same percentage of earnings in cash flows, was they did in the most recent year, but I allow for the option of adjusting that cash return percentage over time, as a function of growth and return on equity (Sustainable cash payout = Growth rate/ Return on Equity). </li></ol><div style="text-align: justify;">The resulting model in its generic form is below:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiK9jgrg2vwHl-XUZkaktveB1EvQd2iT4Y5TbCaWkq4XgnY5ETCLRTbjzG_dehKkKhU9lwKMDvwiH759XsbtqUwz28o0vbNM9Ml2b8fMlgDtfcbP38SHz6J2j4ieFjhTGkNhqzHcyMu5YIIaz0v9zlcMnbMoF2dhaY98IACYwOCuOjlv0G3n5W_nx9fIGs/s1116/ImpliedERPPicture.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="632" data-original-width="1116" height="226" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiK9jgrg2vwHl-XUZkaktveB1EvQd2iT4Y5TbCaWkq4XgnY5ETCLRTbjzG_dehKkKhU9lwKMDvwiH759XsbtqUwz28o0vbNM9Ml2b8fMlgDtfcbP38SHz6J2j4ieFjhTGkNhqzHcyMu5YIIaz0v9zlcMnbMoF2dhaY98IACYwOCuOjlv0G3n5W_nx9fIGs/w400-h226/ImpliedERPPicture.jpg" width="400" /></a></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">In August 2023, this model would have yielded an equity risk premium of 4.44% for the S&P 500, using trailing cash flows from the last twelve months as a starting point, estimating aggregate earnings for the companies from analyst estimates, for the next three years, and then scaling that growth down to the risk free rate, as a proxy for nominal growth in the economy, after year 5:</div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgt_f2PVuOqueCVakJknoxitD9g2v4xgH4coN3YiVubz7yHMt0j5AmVo-g8TiWgs5km3BWImcLHtywpcowGJUS5fev7BfQ8oe9eOsCULw5ed2-wiGY6u8Y1DUeST-Bh6IGxUkWU8ty3JrJS4POSwzfNKtiqS58461EOxZhJWwt15AKRfAh6Rf5PozXYSqQ/s1598/ImpliedERPAug23.jpg" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1016" data-original-width="1598" height="203" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgt_f2PVuOqueCVakJknoxitD9g2v4xgH4coN3YiVubz7yHMt0j5AmVo-g8TiWgs5km3BWImcLHtywpcowGJUS5fev7BfQ8oe9eOsCULw5ed2-wiGY6u8Y1DUeST-Bh6IGxUkWU8ty3JrJS4POSwzfNKtiqS58461EOxZhJWwt15AKRfAh6Rf5PozXYSqQ/s320/ImpliedERPAug23.jpg" width="320" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/implprem/ERPAug23.xlsx"><i><span style="font-size: x-small;">Download implied ERP spreadsheet</span></i></a></td></tr></tbody></table><div style="text-align: justify;"><br /></div><div style="text-align: justify;">To reconcile my estimate of the equity risk premium with the earnings yield approach, you can set the earnings growth rate to zero and the cash payout to 100%, in this model, and you will find that the equity risk premium you get converges on the 0.41% that you get with the earnings yield approach. Adding growth and excess returns to the equation is what brings it up to 4.44%, and I believe that the data is on my side, in this debate. To the critique that my approach requires estimates of earnings growth and excess returns that may be wrong, I agree, but I am willing to wager that whatever mistakes I make on either input will be smaller than the input mistakes made by assuming no growth and no excess returns, as is the case with the earnings yield approach.</div><div><br /></div><div><b>Picking an Approach</b></div><div style="text-align: justify;"><span> I prefer the implied equity risk premium approach that I just described, as the best estimate of ERP, but that may just reflect my comfort with it, developed over time. </span>Ultimately, the test of which approach is the best one for estimating equity risk premium is not theoretical, but pragmatic, since your estimate of the equity risk premium is used to obtain predictions of returns in subsequent periods. In the figure below, I highlight three estimates of equity risk premiums - the historical risk premium through the start of that year and the EP-based ERP (EP Ratio minus the T.Bond Rate) and the implied equity risk premiums, at the start of the year:</div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh20dnkaYOrAfYQEcGXZON_RvDRyyQB7On_U8xudnuObRGV5s-mDpGpMGiIY5fNmp820xJXCXYE4adJ_ixLFroM9YoBY9XLx8KdOnGC0ruUFXswbs3zZFQupTUqgAL9xFLXgYw3r0d5Tiwziur0aijOFZlR06s5ZK0uKSli25o2jIcq38sgKaKOOnR7Ujk/s2924/CompetingERPChart.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="2714" data-original-width="2924" height="297" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh20dnkaYOrAfYQEcGXZON_RvDRyyQB7On_U8xudnuObRGV5s-mDpGpMGiIY5fNmp820xJXCXYE4adJ_ixLFroM9YoBY9XLx8KdOnGC0ruUFXswbs3zZFQupTUqgAL9xFLXgYw3r0d5Tiwziur0aijOFZlR06s5ZK0uKSli25o2jIcq38sgKaKOOnR7Ujk/s320/CompetingERPChart.jpg" width="320" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"></td></tr></tbody></table><div><br /></div>The historical risk premium is stable, but that stability is a reflection of a having a long tail of historical data that keeps it from changing, even after the worst of years. The implied and EP-based ERP approaches move in the same direction much of the time (as evidenced in the positive correlation between the two estimates), but the latter yields negative values for the equity risk premium in a large number of periods. <br /><div><span> Ultimately, the test of whether an equity risk premium measure works lies in how well it predicts future returns on stocks, and in the table below, I try to capture that in a correlation matrix, where I look at the correlation of each ERP measure with returns in the next year, in the next 5 years and in the next 10 years:</span><br /></div><div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgeW3u9O91xaTFHmMWY7nIqPyjwce1VWLkbRBwrdUqw83887hR_gwcDzQe88lSCP_GJeQ__r0UfqlZcIOZ7L1UuvNm6I9PX1jkueOIxunf2Uos0DgSkoJzUxxAOcrM7_0W7oWMVGrw1VIfqwWZ_eg--RLcsX6uFsqF5fl1Y3Uiu_0jT9q8Y9Fzwn6Z85Kw/s936/ERPCorrelationwithREturns.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="588" data-original-width="936" height="251" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgeW3u9O91xaTFHmMWY7nIqPyjwce1VWLkbRBwrdUqw83887hR_gwcDzQe88lSCP_GJeQ__r0UfqlZcIOZ7L1UuvNm6I9PX1jkueOIxunf2Uos0DgSkoJzUxxAOcrM7_0W7oWMVGrw1VIfqwWZ_eg--RLcsX6uFsqF5fl1Y3Uiu_0jT9q8Y9Fzwn6Z85Kw/w400-h251/ERPCorrelationwithREturns.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/ERP&Returns.xlsx">Download data</a></span></i></td></tr></tbody></table><br /><div class="separator" style="clear: both; text-align: justify;">None of the approaches yield correlations that are statistically significant, for stock returns in the next year, but the implied ERP and historical ERP are strongly correlated with returns over longer time periods, with a key difference; the former moves with stock returns in the next ten years, while the latter moves inversely. </div><div class="separator" style="clear: both; text-align: justify;"><span> While that correlation lies at the heart of why I use implied ERP in my valuations as my estimate of the price of risk in equity markets, I am averse to using it as a basis for market timing, for the same reasons that I cautioned you on using the EP ratio regression: the predictions are noisy and there is no clear pathway to converting them into investment actions. To see why, I have summarized the results of a regression of stock returns over the next decade against the implied ERP at the start of the period, using data from 1960 to 2022:</span><br /></div><div class="separator" style="clear: both; text-align: justify;"><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh35mVSMzqu1E1i9QvRgqYlaoE93nstwQ8EQGbwxZYVl90DyaGUeSRDh0VSbAfUSGjLoHlfQvz-pvF4NPOL25--d7rQwGcG_XIFE6h73E7Z2vI-g2BUqgvNW1EOnRnEAY8y0DFe2mxyoIcTlRjQ-H2K4bEN1A0XiLGejXfotwz5zHta9Bz5gDRGemXbnqk/s1498/ERPRegression.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1154" data-original-width="1498" height="309" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh35mVSMzqu1E1i9QvRgqYlaoE93nstwQ8EQGbwxZYVl90DyaGUeSRDh0VSbAfUSGjLoHlfQvz-pvF4NPOL25--d7rQwGcG_XIFE6h73E7Z2vI-g2BUqgvNW1EOnRnEAY8y0DFe2mxyoIcTlRjQ-H2K4bEN1A0XiLGejXfotwz5zHta9Bz5gDRGemXbnqk/w400-h309/ERPRegression.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/ERP&Returns.xlsx">Download data</a></span></i></td></tr></tbody></table><br /><span>You can see, from the scatter plot, that implied ERPs move with stock returns over the subsequent decades, but that movement is accompanied by significant noise, and that noise translates into a wide range around the predicted returns for stocks. </span>If you are a market timer, you are probably disappointed, but this type of noise and prediction errors is what you should expect to see with almost any fundamental, including EP ratios. </div></div><div><b><br /></b></div><div><b>Conclusion</b></div><div style="text-align: justify;"><b> </b>I hope that this post has helped to convince you that the equity risk premium is central to investing, and that even if you have never used the term, your investing actions have been driven by its gyrations. I also hope that it has given you perspective on why you see the differences in equity risk premium numbers from different sources. With that said, here are some thoughts for the road that can help you in future encounters with the ERP:</div><div style="text-align: justify;"><ol><li><u>There is a true, albeit unobservable, ERP</u>: The fact that the the true equity risk premium is unobservable does not mean that it does not exist. In other words, the notion that you can get away using any equity risk premium you want, as long as you have a justification and are consistent, is absurd. So, whatever qualms you may have about the estimation approaches that I have described in this post, please keep working on your own variant to get a better estimate of the ERP, since giving up is no an option.</li><li><u>Not all estimation approaches are created equal</u>: While there are many approaches to estimating the equity risk premium, and they yield very different numbers, some of these approaches have more heft, because they offer better predictive power. Picking an approach, such as the historical risk premium, because its stability over time gives you a sense of control, or because everyone else uses it, makes little sense to me.</li><li><u>Your end game matters</u>: As I noted at the start of this post, the equity risk premium can be used in a multitude of investment settings, and you have to decide, for yourself, how you will use the ERP, and then pick an approach that works for you. I am not a market timer and estimate an equity risk premium primarily because I need it as an input in valuation and corporate finance. That requires an approach that yields positive values (ruling out the EP-based ERP) and moves with with stock returns in subsequent periods (eliminating historical ERP). </li><li><u>Market timers face a more acid test</u>: If you are using equity risk premiums or even earnings yield for market timing, recognize that having a high R-squared or correlation in past returns will not easily translate into market-timing profits, for two reasons. First, the past is not always prologue, and market and economic structures can shift, undercutting a key basis for using historical data to make predictions. Second, even if the correlations and regressions hold, you may still find it hard to profit from them, since you (and your clients, if you are a portfolio manager) may be bankrupt, before your predictions play out. Statistical noise (the standard errors on your regression predictions) can create havoc in your portfolios, even if it eventually gets averaged out.</li></ol></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>YouTube Video</b></div><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/uJN3CUcgF8A" title="YouTube video player" width="560"></iframe><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Data Links</b></div><p></p><p></p><ol style="text-align: left;"><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/histretSP.xls">Historical returns on Stocks, Bonds and Real Estate: 1928 - 2022</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/EPQuarterly2023.xlsx">Earnings to Price Ratios and Dividend Yields, by Quarter: 1988 Q4- 2023 Q2</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/histimpl.xls">Implied ERP from 1960 to 2022: Annual Data</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/ERP&Returns.xlsx">ERP and Stock Returns: 1960 to 2022</a></li></ol><p></p><p><b>Spreadsheet</b></p><p></p><ol style="text-align: left;"><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/implprem/ERPAug23.xlsx">Implied ERP Spreadsheet for August 2023</a></li></ol><div>Papers</div><div><ol style="text-align: left;"><li><a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4398884">Equity Risk Premiums (ERP): Determinants, Estimation and Implications- The 2023 Edition</a></li></ol></div><p></p>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-44662622688022514612023-07-25T17:38:00.007-04:002023-07-26T11:39:33.508-04:00Country Risk: A July 2023 Update!<p style="text-align: justify;">I have looked at country risk, in all its dimensions, towards the middle of each year, for the last decade, for many reasons. One is <i>curiosity</i>, as political and economic crises roll through regions of the world, roiling long-held beliefs about safe and risky countries. The other is <i>pragmatic</i>, since it is almost impossible to value a company or business, without a clear sense of how risk exposure varies across the world, since for many companies, either the inputs to or their production processes are in foreign markets or the output is outside domestic markets. Coca Cola is a US company, in terms of history and incorporation, but it generates a significant portion of its revenues from the rest of the world. Royal Dutch may be a UK (or Dutch) company, in terms of incorporation and trading location, but it extracts its oil and gas from some of the riskiest parts of the world. Since country risk is multidimensional and dynamic, <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4509578">my annual country risk update runs to more than a hundred (boring) pages</a>, but I will try to summarize what the last year has brought in this post.</p><p style="text-align: justify;"><b>Drivers of Country Risk</b></p><p style="text-align: justify;"><b> </b>What makes some countries riskier than others to operate a business in? The answer is complicated, because everything has an effect on risk, starting with the political governance system (democracy, dictatorship or something in between), the extent of corruption in the system, the legal system (and its protection for property rights) and the presence or absence of violence in the country (from wars within or without). The table below, which I have used in prior updates, captures the mail drivers of country risk:<br /></p><p style="text-align: justify;"></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg3PIGYBOcKJgNRGf7Y3vweZlxZiJvYq1Zs67-b-9EqFYdMVkJ2MgbOMG64TsvJZppK1DC6J0ETJva9yXn-ekwc5Xd0l4vyfzmW0YcMKWh1fQT35N0P6PCrBlWl3C7TTNfRrL43qStySmyk5y5bqBiE7ZCqSHNGpIOtujN-CK6vWtuwtXc2ExKnAnucLkI/s1392/CountryRiskDrivers.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1000" data-original-width="1392" height="288" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg3PIGYBOcKJgNRGf7Y3vweZlxZiJvYq1Zs67-b-9EqFYdMVkJ2MgbOMG64TsvJZppK1DC6J0ETJva9yXn-ekwc5Xd0l4vyfzmW0YcMKWh1fQT35N0P6PCrBlWl3C7TTNfRrL43qStySmyk5y5bqBiE7ZCqSHNGpIOtujN-CK6vWtuwtXc2ExKnAnucLkI/w400-h288/CountryRiskDrivers.jpg" width="400" /></a></div><br /><div style="text-align: justify;">Things get even more complicated when you recognize that these drivers are often correlated with, and drive, each other. Thus, a country that is ravaged by war and violence is more likely to have a weak legal system and be corrupt. Furthermore, all of these risk exposures are dynamic, and change over time, as governments change, violence from internal or external forces flares up. </div><div style="text-align: justify;"><span> As you assess these factors, you can see very quickly that country risk is a continuum, with some countries exposed less to it than others. It is for that reason that we should be cautious about discrete divides between countries, as is the case when we categorize countries into developed and emerging markets, with the implicit assumption that the former are safe and the latter are risky. To the extent that divide is not just descriptive, but also drives real world investment, both companies and investors may be misallocating their capital, and I will argue for finer delineations of risk.</span><br /></div><p></p><p style="text-align: justify;"><i>1. Democracy across the Globe</i></p><p style="text-align: justify;"><span> If your focus stays on economic risk, t</span>he question of whether democracies or authoritarian regimes are less risky for businesses to operate in depends in large part on whether these businesses are more unsettled by day-to-day <i>continuous risk</i>, which is often the case with democracies, where the rules can change when new governments gets elected, or by <i>discontinuous risk</i>, which can lie dormant for long periods, but when it does occur, it is larger and sometimes catastrophic, in an authoritarian government. Assessing freedom and democracy in countries is a fraught exercise, with both political and regional biases playing out, and that should be kept in mind when you look at the heat map that shows the results of the Economist's measures of democracy, by country and region, in 2022, as well as trend lines across time: </p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhw9rrOeAGaYw4o-nSdN9nwoY7BPeILbGIHupR1D3pmjgVMQ0VABdBaWdCtlH3Y7xezRNyFP8P07EkUwbVCzln7UrNydxfDxRc3QELLTqKKXqikvEg0PIjvyyBFKUFLe6h3uiVuWTvQdISThx4XzJBKfoILw7TbneKwJhC48A9GblQXf2hmPLew4YsZrJE/s1726/DemocracyMap.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1726" data-original-width="1520" height="400" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhw9rrOeAGaYw4o-nSdN9nwoY7BPeILbGIHupR1D3pmjgVMQ0VABdBaWdCtlH3Y7xezRNyFP8P07EkUwbVCzln7UrNydxfDxRc3QELLTqKKXqikvEg0PIjvyyBFKUFLe6h3uiVuWTvQdISThx4XzJBKfoILw7TbneKwJhC48A9GblQXf2hmPLew4YsZrJE/w353-h400/DemocracyMap.jpg" width="353" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;"><a href="https://www.economist.com/graphic-detail/2023/02/01/the-worlds-most-and-least-democratic-countries-in-2022">Source: Economist Intelligence Unit (EIU)</a></span></i></td></tr></tbody></table><div style="text-align: justify;"><br /></div><div style="text-align: justify;">While the global aggregate value for 2022 is very similar to the value in 2021, there has been a significant drop off since 2016, at least according to this measure. In 2022, North America and Western Europe scored highest on the democracy index, and Middle East and Africa scored the lowest. </div><p style="text-align: justify;"><span> </span>In my view, the question of whether businesses prefer the continuous change (or, in some cases, chaos) that characterizes democracies or the potential for discontinuous and sometimes jarring change in authoritarian regimes has driven the debate of whether a business should feel more comfortable investing in India, a sometimes chaotic democracy where the rules keep changing, or in China, where Beijing is better positioned to promise continuity. For three decades, China has won this battle, but in 2023, the battleground seems to be shifting in favor of India, but it is still too early to make a judgment on whether this is a long term change, or just a hiccup.</p><p style="text-align: justify;"><i>2. Violence across the Globe</i></p><p style="text-align: justify;"><span> When a country is exposed to violence, either from the outside or from within, it not only exposes its citizens to physical risk (of assault or death), but also makes it more difficult to run businesses within its borders. That risk can show up as costs (of buying protection or insurance) or as uninsurable risks that drive up the rates of return investors and businesses need to make, in order to operate. Again, there are subjective judgments at play in these measures, but the map below gives you 2023 scores for peace scores, with lower (higher) scores indicating less (more) exposure to violence.</span><br /></p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjPIIv6WdEPi00yTVQEaAHZSqr2Wo-4ik6e9tKPd7Jurn4KMGbkKZU_vIlV4wsiYkZXtiIf0-9lemq_A6aoJnjTITYAgPLK_CKodHtrlG5vnkku_VLw4sFnWdTz8iNaB8O5ukPRoLOUJilBcS6pxDGI1qWAvPcssAhtou0qRGUeFV7gf2fU3SY3sOxJpDM/s1524/PeaceMap.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1244" data-original-width="1524" height="326" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjPIIv6WdEPi00yTVQEaAHZSqr2Wo-4ik6e9tKPd7Jurn4KMGbkKZU_vIlV4wsiYkZXtiIf0-9lemq_A6aoJnjTITYAgPLK_CKodHtrlG5vnkku_VLw4sFnWdTz8iNaB8O5ukPRoLOUJilBcS6pxDGI1qWAvPcssAhtou0qRGUeFV7gf2fU3SY3sOxJpDM/w400-h326/PeaceMap.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;"><a href="https://www.visionofhumanity.org/maps/#/">Source: Vision of Humanity</a></span></i></td></tr></tbody></table><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Iceland and Denmark top the list of most peaceful countries, but in a sign that geography is not destiny, Singapore makes an appearance on that list as well. On the lease peaceful list, it should come as no surprise that Russia and Ukraine are on the list, but Sub-Saharan Africa is disproportionately represented. </div><p style="text-align: justify;"><i>3. Corruption across the Globe</i></p><p style="text-align: justify;"><i> </i>Corruption is a social ill that manifests itself as a cost to every business that is exposed to it. As anyone who has ever tried to get anything done in a corrupt setting will attest, corruption adds layers of costs to routine operations, thus become an implicit tax that companies pay, where the payment instead of going to the public exchequer, finds its way into the pockets of intermediaries. Transparency International measures corruption scores, by country, across the world and their 2022 measures are in the map below:</p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEig_hJnayxA7YwGuUx9CJW04iz5m54dMv6aFTbC5KBlCSrT7r4RQuWf-TkGzaWMWdVIv2RdTm9EWtRq1JYmch94iN3BpfdqMKpAPES8BAB6aMwNlnDuTIt5psqsKGATGacoNZttQfGIBfBxd72L-ihupQ-MjOxvza1x5n9T6ZOaA-9bF2a9irvMGlqLeC4/s1882/CorruptionMap.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1882" data-original-width="1498" height="400" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEig_hJnayxA7YwGuUx9CJW04iz5m54dMv6aFTbC5KBlCSrT7r4RQuWf-TkGzaWMWdVIv2RdTm9EWtRq1JYmch94iN3BpfdqMKpAPES8BAB6aMwNlnDuTIt5psqsKGATGacoNZttQfGIBfBxd72L-ihupQ-MjOxvza1x5n9T6ZOaA-9bF2a9irvMGlqLeC4/w319-h400/CorruptionMap.jpg" width="319" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://www.transparency.org/en/cpi/2022"><i><span style="font-size: x-small;">Transparency International</span></i></a></td></tr></tbody></table><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Much of Western Europe, Australia & New Zealand and Canada/United States fall into the least corrupt category, but corruption remains a significant concern in much of the rest of the world. While it easy to attribute the corruption problem to politicians and governments, it is worth noting that once corruption becomes embedded in a system, it is difficult to remove, since the structure evolves to accommodate it. Put simply, a system where the rule-makers, regulators and bureaucrats get paid a pittance (on the assumption that they will be supplement their pay with side payments) to sign off on contracts that are worth billions will inevitably create corruption as a side cost.</div><p style="text-align: justify;"><i>4. Legal Protection across the Globe</i></p><p style="text-align: justify;"><span> To operate a business successfully, you need a legal system that enforces contractual obligations and protects property rights, and does so in a timely manner. When a legal system allows contracts and legal agreements to be breached, and property </span>rights to be violated, with no or extremely delayed consequences, the only businesses that survive will be the ones run by lawbreakers, and not surprisingly, violence and corruption become part of the package. The Property Rights Alliance measures the protection offered for property rights (intellectual, physical), with higher (lower) scores going with better (worse) protection, and their most recent update (from 2022) is captured in the picture below:</p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjLEQJa5XmfS6kfpW0uOp3S526QvJwDM09WDflfPpqog_lmqXUrwQS-pQkHMB4hPj5KH1l-Sjdm0HDVTJ98lrg000rq8IYOU-D_iBEeo_rAKXLka5bC7mRXpwlH9l2NImzZz6vu1y6J1SOKHs7SZ_U4KwN21HJV96n_2c_0Fykl3O-WhaqImhUAjfEwdnQ/s1724/IPRIMap.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1724" data-original-width="1524" height="400" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjLEQJa5XmfS6kfpW0uOp3S526QvJwDM09WDflfPpqog_lmqXUrwQS-pQkHMB4hPj5KH1l-Sjdm0HDVTJ98lrg000rq8IYOU-D_iBEeo_rAKXLka5bC7mRXpwlH9l2NImzZz6vu1y6J1SOKHs7SZ_U4KwN21HJV96n_2c_0Fykl3O-WhaqImhUAjfEwdnQ/w354-h400/IPRIMap.jpg" width="354" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;"><a href="https://www.internationalpropertyrightsindex.org">Source: Property Rights Alliance</a></span></i></td></tr></tbody></table><p style="text-align: justify;">By now, you can see the point about the correlation across the various dimensions of country risk, with the parts of the world (North America, Europe, Australia and Japan) that have the most democratic systems and the least corruption scoring highest on the legal protection scores. Conversely, the regions (Africa, large portions of Asia and Latin America) that are least democratic, with the most violence and corruption, have the most porous legal systems. </p><p style="text-align: justify;"><b>Measures of Country Risk</b></p><p style="text-align: justify;"><b> </b>With the long lead in on the dimensions of country risk, we can now turn to the more practical question of how to convert these different components of risk into country risk measures. We will start with a limited measure of the risk of default on the part of governments, i.e., sovereign default risk, before expanding that measure to consider other country risks, in political risk scores.<br /></p><p style="text-align: justify;"><i>1. Default Risk</i></p><p style="text-align: justify;"><i> </i>Businesses and individuals that borrow money sometimes find themselves unable to meet their contractual obligations, and default, and so too can governments. The difference is that government or sovereign default has much greater spillover effects on all entities that operate within its borders, thus creating business risks. We start with an assessment of sovereign ratings, a widely accessible and hotly contested, of government default risk and then move on to market-based measures of this risk in the form of sovereign default spreads.<br /></p><p style="text-align: justify;"><i>a. Sovereign Ratings</i></p><p style="text-align: justify;"><i> </i>The most widely used measures of sovereign default risk come from a familiar source for default risk measures, the ratings agencies. S&P, Moody's and Fitch, in addition to rating companies for default risk, also rate governments, and they rate them both on local currency debt, as well as foreign currency debt. The reason for the differentiation is simple, since countries should be less likely to default, when they borrow in their domestic currencies, than when they borrow in a foreign currency. The table below summaries the sovereign local currency ratings for countries in June 2023, from S&P and Moody's:</p><p style="text-align: justify;"></p><div style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjtDN_d2eDSq64vCjdHhHWVS9uLLFsy7FsVxJb_XWscW48nxCXdnBJcxV4n40W9hOai7M2kNWDFw06Eagp_KIJNdAF2-I5l10DV16xvCpoESJkgWhP8NOqnrdFwf0E8wNnbHi3mb77Wl59D7JOU0q-yKXBa0Pdc-KS3dYY5Ifk9YFY0EYGu3G6vkcXgbgI/s2072/SovRatings.jpg"><img border="0" data-original-height="1356" data-original-width="2072" height="261" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjtDN_d2eDSq64vCjdHhHWVS9uLLFsy7FsVxJb_XWscW48nxCXdnBJcxV4n40W9hOai7M2kNWDFw06Eagp_KIJNdAF2-I5l10DV16xvCpoESJkgWhP8NOqnrdFwf0E8wNnbHi3mb77Wl59D7JOU0q-yKXBa0Pdc-KS3dYY5Ifk9YFY0EYGu3G6vkcXgbgI/w400-h261/SovRatings.jpg" width="400" /></a></div><i><div style="text-align: center;"><i><span style="font-size: xx-small;">Local Currency Ratings for countries (Some UAE emirates have ratings that are independent of the ratings for the UAE, because they issue their own sovereign debt) </span></i></div></i><div style="text-align: justify;">The ratings scheme mirrors the one used to rate companies, with the key difference being at the Aaa (AAA) rating, with a sovereign getting that rating viewed as having no default risk, whereas a corporate with that rating still has some. If you are wondering why there should be any default risk when governments borrow in a domestic currency, since these governments should be able to print money to pay off debt, the answer is that money-printing debases a currency and given a choice between currency debasement and default, many countries choose to default. The figure backs up this proposition:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjAO-fGf2_pKvuw0Wew3T2Iuio-d4OP2jAVUmVaml8DN4-2rCzAhkCXN2y2IUv6ujrhYwB_0m8a5rnxstCb5ujCGAn9xUv6arWmQNc30Bepn73uy8u57_Z0-JFFqgFGa5e1enArMbGRjWAiumtE_qTIC4Tm1kAfwgNKUWSYqU22ZahSuCUe_mwQQjq6aJI/s1848/DefaultRatesRatings.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1348" data-original-width="1848" height="291" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjAO-fGf2_pKvuw0Wew3T2Iuio-d4OP2jAVUmVaml8DN4-2rCzAhkCXN2y2IUv6ujrhYwB_0m8a5rnxstCb5ujCGAn9xUv6arWmQNc30Bepn73uy8u57_Z0-JFFqgFGa5e1enArMbGRjWAiumtE_qTIC4Tm1kAfwgNKUWSYqU22ZahSuCUe_mwQQjq6aJI/w400-h291/DefaultRatesRatings.jpg" width="400" /></a></div><br /><div style="text-align: justify;">Note that while countries are less likely to default on local currency than foreign currency bonds, the default rates in the former remain substantial. In addition, the good news, if you are a user of sovereign ratings, is that they clearly are correlated strongly with ratings, with higher default rates for lower-rated sovereigns. </div><div style="text-align: justify;"><span> I know that there are many who have issues with the ratings agencies, but I do think that the conflict of interest story, where ratings agencies </span>attach higher ratings to entities, because they get paid to rate them, is overdone, and especially so with sovereign ratings (where the revenue streams are paltry). In my view, the biggest problem with ratings agencies is not that they are biased, but that <u>they take too long to adjust ratings</u> to changes in a country and that they <u>sometimes underrate or overrate regions</u> of the world, because of their histories. Consequently, Latin American countries have to work harder to improve their ratings, or sustain current ratings, than the US or European countries, which get a bye, because they do not have a history of default.</div><p></p><p style="text-align: justify;"><i>b. Sovereign CDS Spreads</i></p><p style="text-align: justify;"><i> </i>One of the advantages of a market-based measure is that the market price reflects investor perceptions of risk at the moment. Sovereign Credit Default Swaps (CDS) offer a market-based measure of default risk, since investors buy these swaps as protection against default on government bonds. When the sovereign CDS market came into being a few decades ago, there were only a handful of countries that were traded, but the market has expanded, and there are traded credit default swaps on almost 80 countries in June 2023. The graph below shows the sovereign CDS levels, by country:<br /></p><p style="text-align: justify;"></p><table cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhRMA4o4pVGMYM6SjveUGHZocIMS1KlZmE7RAFV-MS1YvPAtP9FbMl8grjhNQcxTtg8aLTz-LIL96lI3aQXRuWB5eKOiDBd0fL9aXqa2SoZCakwj5sc513BHPq9SFk8_6yQacDj17KP80XErfpA2-9pJ9TdB3vMyuJxzPpngFudvweihJoOeqbUmJPWNu0/s2276/SovCDSMap.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="2086" data-original-width="2276" height="366" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhRMA4o4pVGMYM6SjveUGHZocIMS1KlZmE7RAFV-MS1YvPAtP9FbMl8grjhNQcxTtg8aLTz-LIL96lI3aQXRuWB5eKOiDBd0fL9aXqa2SoZCakwj5sc513BHPq9SFk8_6yQacDj17KP80XErfpA2-9pJ9TdB3vMyuJxzPpngFudvweihJoOeqbUmJPWNu0/w400-h366/SovCDSMap.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;">Source: Bloomberg (<a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Ratings&CDS2023.xlsx">July 2023 data</a>)</span></i></td></tr></tbody></table><div style="text-align: justify;"><br /></div><div style="text-align: justify;">There are three things to note, as you browse these numbers. The first is that these are dollar spreads (though a Euro CDS market exists as well), and thus are most suited for use with dollar-denominated government bonds. The second is that what comprises default in the sovereign CDS market may not coincide with investor definitions of default , though there are approaches that can be used to <a href="https://www.chicagofed.org/publications/working-papers/2023/2023-17">back out the likelihood of default from a CDS value</a>. The third is that there are no countries with traded CDS that have zero risk of default, at least according to the sovereign CDS market. Consequently, I have also computed a version of the sovereign CDS spread that is net of the US CDS (on the assumption that default risk is zero in the US, a debatable proposition after the recent debt ceiling debate).</div><div><div style="text-align: justify;"> Is a sovereign CDS spread a better measure of default risk than a sovereign rating? The answer is mixed. It is true that a sovereign CDS spread gives you a more updated measure of default risk, since it is market-set, but as with all market-based measures, it comes with far more volatility and overshooting than a ratings-based spread, and it is available for only a subset of countries. My suggestion is that for countries where recent political or economic events would lead you to believe that sovereign rating is dated, you should switch to using sovereign CDS spreads.</div><p style="text-align: justify;"><i>2. Risk Scores</i></p><p style="text-align: justify;"><i> </i>The advantage of default spreads is that they provide an observable measure of risk that can be easily incorporated into discount rates or financial analysis. The disadvantage is that they are focused on just default risk, and do not explicitly factor in the other risks that we enumerated in the last section. Since these other risks are so highly correlated with each other, for most counties, it is true that default risk becomes an reasonable proxy for overall country risk, but there are some countries where this is not the case. Consider portions of the Middle East, and especially Saudi Arabia, where default risk is not significant, since the country borrows very little and has a huge cash cushion from its oil reserves. Investors in Saudi Arabia are still exposed to significant risks from political upheaval or unrest, and may prefer a more comprehensive measure of country risk. </p><p style="text-align: justify;"><span> </span>There are many services, including the World Bank and the Economist, who offer comprehensive country risk scores, and the map below includes composite country risk scores from <a href="https://www.prsgroup.com">Political Risk Services</a> in June 2023:</p><p style="text-align: justify;"></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEguy91sRQP0iV98B4zwg0chOJejFOe03lKlDgo0jge621xIdCPOP5uWDBBomXfOmCpWwgPUJJhTL1JOAYwNqE7Yv6U4mTMLSIH7eDNM-Fgk2urD6jOdg_6D9NXcDfT6t3e1Xq0MWHcxkbqilD-2dc9hfqDaw0hnB-2Ijh3oMUndv-SfCX2JRWewm1twb48/s2964/PRSScores.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="2964" data-original-width="2180" height="400" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEguy91sRQP0iV98B4zwg0chOJejFOe03lKlDgo0jge621xIdCPOP5uWDBBomXfOmCpWwgPUJJhTL1JOAYwNqE7Yv6U4mTMLSIH7eDNM-Fgk2urD6jOdg_6D9NXcDfT6t3e1Xq0MWHcxkbqilD-2dc9hfqDaw0hnB-2Ijh3oMUndv-SfCX2JRWewm1twb48/w294-h400/PRSScores.jpg" width="294" /></a></div><div style="text-align: justify;">The pluses and minuses of comprehensive risk scores are visible in this table. In addition to capturing risks that go beyond default, Political Risk Services also measures risk scores for frontier markets (like Syria, Sudan and North Korea), which have no sovereign ratings. The minuses are that the scores are not standardized; for instance, PRS gives its highest scores to the safest countries, whereas <a href="https://www.eiu.com/landing/risk_analysis#:~:text=The%20Country%20Risk%20Service%20analyses,policy%20and%20economic%20structure%20risks.">the Economist</a> gives the lowest scores to the safest countries. In addition, the fact that the country risk is measured with scores may lead some to believe that they are objective measures of country risk, when, in fact, they are subjective judgments reflecting what each service factors into the scores, and the weights on these factors. Just to illustrate the contradictions that can result, PRS gives Libya a country risk score that is higher (safer) than the scores it gives United States or France, putting them at odds with most other services that rank Libya among the riskiest countries in the world.</div><p></p><p style="text-align: justify;"><b>Equity Risk across Countries</b></p><p style="text-align: justify;"><b> </b>Default risk measures how much risk investors are exposed to, when investing in bonds issued by a government, but when you own a business, or the equity in that business, your risk exposure is not just magnified, but also broader. For three decades, I have wrestled with measuring this additional risk exposure and converting that measurement into an equity risk premium, but it remains a work in progress. </p><p style="text-align: justify;"><span> To estimate the equity risk premium, for most countries I start with default spreads, either based on the sovereign ratings assigned by the ratings agencies, or from the market, in the form of sovereign CDS spreads. To account for the fact that equities are riskier than bonds, I scale the standard deviation of an emerging market equity index (<a href="https://www.spglobal.com/spdji/en/indices/equity/sp-emerging-bmi/#overview">S&P Emerging BMI</a>) to an emerging market government bond ETF <a href="https://www.ishares.com/us/products/239572/EMB?cid=ppc:ishares_us:google:fund-names-priorities&gclid=EAIaIQobChMI17fenf6ogAMVNgetBh2e8wqdEAAYASAAEgLhufD_BwE&gclsrc=aw.ds">(iShares JPM USD Emerging Markets Bond ETF</a>), and use this ratio (1.42 in my July 2023 update) and apply this scalar to the default spread, to arrive at a <i>country risk premium</i>. Adding that country risk premium on to the premium that I estimate for the S&P 500 (which was 5.00% at the start of July 2023, and is my measure of a mature market premium), yields the total equity risk premium for a country:</span></p><p style="text-align: justify;"></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg23f5nmabJ6gKQJDiJwVwFwoDYPEbi7Kwz8LzkxjMyQEzg2CUres4L0ITw_CJLKHG9uJNGxbOgJyjGq_yawXCcilKRPmQb6GxKmaeo-uwcWdqfJbZrkX8anjL3r5O2CbaUMADHcbualOEcKvPvC1HzWBu-R4RWdI4Xn0e6kDrnLZgHVzBRA1HNyQ63a4Q/s1494/ERPComputationPicture.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1028" data-original-width="1494" height="275" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg23f5nmabJ6gKQJDiJwVwFwoDYPEbi7Kwz8LzkxjMyQEzg2CUres4L0ITw_CJLKHG9uJNGxbOgJyjGq_yawXCcilKRPmQb6GxKmaeo-uwcWdqfJbZrkX8anjL3r5O2CbaUMADHcbualOEcKvPvC1HzWBu-R4RWdI4Xn0e6kDrnLZgHVzBRA1HNyQ63a4Q/w400-h275/ERPComputationPicture.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: justify;">To provide an example, consider India, which with a sovereign rating of Baa3, has a default spread of 2.35% in July 2023. Multiplying this default spread by the scalar (1.42) and adding to the equity risk premium for the S&P 500 results in an equity risk premium of 8.33% for India. </div><div class="separator" style="clear: both; text-align: justify;">India ERP <span> </span>= Implied ERP for S&P 500 + Default spread for India * Scalar for Equity Risk</div><div class="separator" style="clear: both; text-align: justify;"><span> <span> <span> <span> <span> <span> = 5.00% + 2.35% (1.42) = 8.33%</span></span></span></span></span></span></div><div style="text-align: justify;">It is worth noting that using the sovereign CDS spread for India of 1.42% would have resulted in a lower equity risk premium for India, at 7.02%.</div></div><div><div style="text-align: justify;"> Using the ratings-based default spreads as starting points, I estimate the equity risk premiums for all countries rated by either S&P and Moody's in the picture below. (For the many people who will point to their country's geographical boundaries being misrepresented on this map, please cut me some slack. This map is purely a device to summarize equity risk premiums, by countries, not arbitrate on where borders should go. Suffice to say that if you are operating a business in a part of the world that is contested by two countries, your risk levels are in the danger zone, no matter where in the world you are.)</div><p style="text-align: justify;"></p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhLR34BRKJhhZae-8SLI8rHrs0Usn33DkU-FtV-3n6xjyJ5jkHzaY4MR1Ipp0KEnhv8NcURE0cx910RWs4lgDcseyPxGgIxA1wMAWjyghFNR67zbr9lE5xDHnL59miJqGXslhTZK9PWSNAKvf9WjAeYG6DTcJQ93T1UZrZta21fQONkOyFhVlr_dxl9Whg/s1792/ERPJuly2023Picture.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1360" data-original-width="1792" height="304" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhLR34BRKJhhZae-8SLI8rHrs0Usn33DkU-FtV-3n6xjyJ5jkHzaY4MR1Ipp0KEnhv8NcURE0cx910RWs4lgDcseyPxGgIxA1wMAWjyghFNR67zbr9lE5xDHnL59miJqGXslhTZK9PWSNAKvf9WjAeYG6DTcJQ93T1UZrZta21fQONkOyFhVlr_dxl9Whg/w400-h304/ERPJuly2023Picture.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/ctrypremJuly23.xlsx"><i>Download spreadsheet with data</i></a></td></tr></tbody></table><br /></div><div>You will notice that there are countries that are not rated (NR) that have equity risk premiums attached to them. For these frontier markets, I used the PRS score for the country as a starting point, found other (rated) countries with similar PRS scores, and extrapolated an equity risk premium. The caveat, though, is that these equity risk premiums are only as good as the PRS scores that goes into them, and you can see the effect in Libya, which if PRS is right, is a green (low risk) standout in a region (North Africa) of red.<br /><p></p><p style="text-align: justify;"><i>Caveats and Questions</i></p><p style="text-align: justify;"><i> </i>I started publishing equity risk premiums about 30 years ago, and while data sources have become richer and more complete, the core approach that I use for the estimation has remaining stable. That said, there is no intellectual firepower or research behind these numbers, since I am letting the default ratings agencies and risk measurement services carry that weight. I am not a country risk researcher, and I try not to let my personal views alter the numbers that emerge from the analysis, since that would open the door to my biases. I will use three countries in the latest update to illustrate my point:</p><p style="text-align: justify;"></p><ol><li style="text-align: justify;"><u>Saudi Arabia</u>: As I noted earlier, using default spreads as my starting point can result in understating the risk premium for countries like Saudi Arabia, which score low on default risk but high on other risks. </li><li style="text-align: justify;"><u>Libya</u>: As indicated in the last section, the equity risk premium for Libya, an unrated country, is entirely based upon the country risk score from PRS. That country risk score is surprisingly high (indicating low risk) and it results in an equity risk premium that is low, relative to other countries in the region. </li><li style="text-align: justify;"><u>China</u>: China has a high sovereign rating and a low sovereign CDS spread, indicating that investors in Chinese government bonds don't see much default risk in the country. In the aftermath of a Beijing crackdown on Chinese tech giants and talk of a trade war between China and the US, the perception seems to be that China has become a riskier place to invest. That may or may not be true, but looking at how Chinese equities are priced, trading still at some of the highest multiples of earnings in the world, investors in equity markets don't seem to share that view.</li></ol><div style="text-align: justify;">With all three of these countries, I chose not to change the numbers that emerged from the data, but if you have strong views on these countries or others, nothing is stopping you from replacing my numbers with yours. </div><div style="text-align: justify;"><br /></div><b>Company Hurdle Rates</b><p></p><p style="text-align: justify;"><b> </b>This post has already become much longer than I intended it to be, but I want to end by bringing these equity risk premiums down to the company level, and examining how they play out in hurdle rates, to be used in investment analysis by companies and valuation by investors.<br /></p><p style="text-align: justify;"><i>The Currency Question</i></p><p style="text-align: justify;"><b> </b>In my discussion so far, you will notice that I have stayed away from talking about currency risk in my equity risk premium discussion and from currency choices in investment analysis. I have my reasons.</p><p style="text-align: justify;"></p><ul style="text-align: left;"><li><div style="text-align: justify;">I know that the currency choice is the source of angst for many analysts, and I think unnecessarily so. Your choice of currency will affect your cash flows and your discount rates, but only because each currency brings it's own expectations of inflation, with higher inflation currencies leading to higher growth rates for cash flows and higher discount rates.</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhcUNTP5fqk2Y517zMYTpGdah8wwULmY1xCc03zPw4SPX0UX9LC9P_iQ-MRbfkIOTdhJ4LJPTtYrh9QkzfwzCSSTNr6fXthFiDq4EIRT7863SUL7sY24EOCiLySJ9vjiamFu4Kaa-CGnQzvw8bAyubgKcCcci31NkvD729UV-FqttixlUIsbRkS8NIrSyk/s1544/CurrencyChoiceinDCF.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="526" data-original-width="1544" height="136" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhcUNTP5fqk2Y517zMYTpGdah8wwULmY1xCc03zPw4SPX0UX9LC9P_iQ-MRbfkIOTdhJ4LJPTtYrh9QkzfwzCSSTNr6fXthFiDq4EIRT7863SUL7sY24EOCiLySJ9vjiamFu4Kaa-CGnQzvw8bAyubgKcCcci31NkvD729UV-FqttixlUIsbRkS8NIrSyk/w400-h136/CurrencyChoiceinDCF.jpg" width="400" /></a></div><br /><div style="text-align: justify;">The mechanism that allows for the discount rate adjustment to reflect currency is the risk free rate, with currencies with higher expected inflation carrying higher risk free rates. In a downloadable dataset linked at the end of this post, I estimate riskfree rates in global currencies, based upon the US T.Bond rate as the riskfree rate in US dollars) and differential inflation. To provide an example, using the IMF's estimate of expected inflation for 2023-28 of 3% for the US and 13.50% for Egypt, and building on the US treasury bond rate of 3.80%. the riskfree rate in Egyptian pounds is 14.38%. </div><div style="text-align: justify;">Riskfree Rate in EGP = (1+ US T.Bond Rate) (1 + Exp Infl in Egypt) (1+ Exp Infl in US) -1</div><div style="text-align: justify;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;"><blockquote style="border: medium; margin: 0px 0px 0px 40px; padding: 0px;">= (1.038)* (1.135/1.03) -1 = .1438 or 14.38%)</blockquote></blockquote></blockquote></blockquote></div></li><li style="text-align: justify;">To the extent that currency risk adds to the operating risk of a company, it is, in my view, already embedded in the equity risk premiums that I have computed in the last section. After all, countries with unstable governments, plagued by war and corruption, also have the most unstable currencies. The other reason to tread lightly with currency risk is that for investors with global portfolios, it becomes diversifiable risk, as some companies benefit as a currency strengthens or weakened more than expected and others lose for exactly the same reason.</li></ul><div style="text-align: justify;">My advice to you when you make a currency choice for your analysis is that you pick a currency that you are comfortable working with, but then make sure that you stay consistent with that currency in all of your estimates. Thus, if you choose to value a Russian company in Euros, rather than rubles, make sure that your growth rates reflect inflation in the Euro zone, but that you risk premiums and real growth reflect its Russian operations.</div><p></p><p style="text-align: justify;"><i>Exposure to Country Risk</i></p><p style="text-align: justify;"><i> </i>For much of my valuation journey, the status quo in valuation has been to look at where a company is incorporated to determine its risk exposure (and the equity risk premium to use in assessing a hurdle rate). While I understand that where you are incorporated and traded can have an effect on your risk exposure, I think it is dwarfed by the risk exposure from where you operate. A company that is incorporated in Germany that gets all of its revenues in Turkey, is far more exposed to the country risk of Turkey than that of Germany. In the picture below, I contrast the traditional country-of-incorporation based risk measure with my alternative, where equity risk premiums come from where you operate:<br /></p><p style="text-align: justify;"></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhPE_GhF8fV23HInhS8yoSwdKFUQTuZDaDSQJ9gdxTBYyoiZhXFTcHRvhL0bHArrukf-EcNXpaGfL_-8-Bp_G2R1OZM4w6_Hb0CCaouRYtoUQrZfvxSH0MXUd9fnvxLpasjR2J0ShN-W0u7t7YDninB1z1_Bpt9NEuPC2JKYzqo_BMBDGW6dXgEpFBN9dQ/s1492/Company%20Exposure.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1036" data-original-width="1492" height="278" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhPE_GhF8fV23HInhS8yoSwdKFUQTuZDaDSQJ9gdxTBYyoiZhXFTcHRvhL0bHArrukf-EcNXpaGfL_-8-Bp_G2R1OZM4w6_Hb0CCaouRYtoUQrZfvxSH0MXUd9fnvxLpasjR2J0ShN-W0u7t7YDninB1z1_Bpt9NEuPC2JKYzqo_BMBDGW6dXgEpFBN9dQ/w400-h278/Company%20Exposure.jpg" width="400" /></a></div>We can debate how best to measure operating risk exposure, since it can come from both where you sell your products and services (revenues) as well as where you produce those products and services. </div><div class="separator" style="clear: both; text-align: center;"><br /></div><div><div style="text-align: justify;"> There are implications not just for investors, but for companies. For investors, an operating-risk perspective will mean that there are some emerging market companies that others may perceive as risky, simply because of their country of incorporation, but are much safer, because they get their revenues from much safer parts of the world. Embraer, the Brazilian aerospace company, and Tata Consulting Services, an Indian software company, would be good examples. Conversely, there are developed market companies that are significantly exposed to country risk, either because of where they produce (Royal Dutch) or where they sell their products and services (Coca Cola). For multinational companies, an operating risk perspective will imply that there can be no one hurdle rate across geographies, since a project in Turkey should require a higher equity risk premium (and hurdle rate) than an otherwise similar project in Germany.</div><p style="text-align: justify;"><b>Conclusion</b></p><p style="text-align: justify;"><b> </b>It is ironic that a post that was meant to shorten and summarize a long paper has itself stretched to become the equivalent of a long paper, and I apologize. I do hope that you get a chance to read <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4509578">the paper</a> or at least review my country risk measures in this post, since there is significant room for improvement. I don't have all the answers, and I probably never will, but progress is incremental, and each year, I hope that I can add a tweak or a component that will move me in the right direction. Also, please don’t take any of these numbers personally. In short, if you feel that I have overestimated the risk in your country and given it an equity risk premium that you believe is undeservedly high, it is not because I do not like you and your country. It is entirely Moody’s fault for giving your country too low a rating, and you should take it up with them!</p><p style="text-align: justify;"><b>YouTube Video</b></p><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/F-6_XeUxbmI" title="YouTube video player" width="560"></iframe><p style="text-align: justify;"><b>Country Risk Paper</b></p><p style="text-align: justify;"></p><ol><li><a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4509578">Country Risk: Determinants, Measures and Implications - The 2023 Edition</a></li></ol><p></p><p style="text-align: justify;"><b>Country Risk Data</b></p><p style="text-align: justify;"></p><ol><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/CountryRiskDimensions2023.xlsx">Democracy, Violence, Corruption and Legal System Scores, by Country, in July 2023</a></li><li><a href="Ratings&CDS2023.xlsx">Sovereign Ratings and CDS Spreads for Countries in July 2023</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/ctrypremJuly23.xlsx">Equity Risk Premiums, by Country, in July 2023</a></li></ol><div><b>Currency Data</b></div><div><ol><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Currency&Inflation2023.xlsx">Expected Inflation and Riskfree Rates</a></li></ol></div><p></p></div>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-12158585762590967132023-07-17T18:35:00.001-04:002023-07-17T18:35:33.568-04:00Market Resilience or Investors In Denial? A Mid-year Assessment for 2023!<div style="text-align: justify;">I am not a market prognosticator for a simple reason. I am just not good at it, and the first six months of 2023 illustrate why market timing is often the impossible dream, something that every investor aspires to be successful at, but very few succeed on a consistent basis. At the start of the year, the consensus of market experts was that this would be a difficult year for markets, given the macro worries about inflation and an impending recession, and adding in the fear of the Fed raising rates to this mix made bullishness a rare commodity on Wall Street. Markets, as is their wont, live to surprise, and the first six months of 2023 has wrong-footed the experts (again).</div><p><b>The Start of the Year Blues: Leading into 2023</b></p> <span><div style="text-align: justify;"> As we enjoy the moment, with markets buoyant and economists assuring us that the worst is behind us, both in terms of inflation and the economy, it is worth recalling what the conventional wisdom was, coming into 2023. <span class="Apple-tab-span" style="white-space: pre;"> </span>After a bruising year for every asset class, with the riskiest segments in each asset class being damaged the most, there were fears that inflation would not just stay high, but go higher, and that the economy would go into a tailspin. <span> </span>While this may seem perverse, the first step in understanding and assessing where we are in markets now is to go back and examine where things stood then.</div><div style="text-align: justify;"><span> </span> <span>In </span>my <a href="https://aswathdamodaran.blogspot.com/2023/01/data-update-2-for-2023-rocky-year-for.html">second data update post from the start of this year</a>, I looked at US equities in 2022, with the S&P 500 down almost 20% during the year and the NASDAQ, overweighted in technology, feeling even more pain, down about a third, during the year.</div></span><p><i><span> </span><br /></i></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgQsWrN9uMNbv1PmYH8mnRjA8cETlnnTHZoNEB2mmlSmPRSXHHKTt7z4wCUweoygR44EgGjQ-utiwpoim6j3TmWOVgO2jcgQV9FIPlq7j8mHi0jScQYX4Zfw19Ez_LO-0Oc4RFePYPG27Jc5qEludSBQ3dSpJgqaW67XPUxyVReQ4Wh2jQGQsvyG3b4HTk/s1648/Stocksin2022.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1190" data-original-width="1648" height="289" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgQsWrN9uMNbv1PmYH8mnRjA8cETlnnTHZoNEB2mmlSmPRSXHHKTt7z4wCUweoygR44EgGjQ-utiwpoim6j3TmWOVgO2jcgQV9FIPlq7j8mHi0jScQYX4Zfw19Ez_LO-0Oc4RFePYPG27Jc5qEludSBQ3dSpJgqaW67XPUxyVReQ4Wh2jQGQsvyG3b4HTk/w400-h289/Stocksin2022.jpg" width="400" /></a></div><div style="text-align: justify;">Looking across company groupings, returns on stocks in 2022 flipped the script on the market performance over much of the prior decade, with the winners from that decade (tech, young companies, growth companies) singled out for the worst punishment during the year.</div><div style="text-align: justify;"><span> </span>While stocks had a bad year (the eighth worst in the last century), the bond market had an even worse one. In <a href="https://aswathdamodaran.blogspot.com/2023/01/data-update-3-for-2023-inflation-and.html">my third post</a> at the start of 2023, I looked at US treasuries, the long-touted haven of safety for investors. In 2022, they were in the eye on the storm, with the ten-year US treasury bond depreciating in price by more than 19% during the year, the worst year for US treasury returns in a century.</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgIf925JeS9pj2ALqEZrwiY711h1zBwUcPDOrDKCp9KuukRieb5_v8NdaDm_vHpJcbedLqIR4d1zjQU0i-p3nCJxe1rHYo1QgzPUcrNlAd6XsxecCmAwbLyc4e7MT1Sa3y_6xb6MUAK0Aq3n-DW-7O_RGyi1spx_LvUzgU6IToQcyf09Q7OlEEwV2ToSh0/s1638/USTreasuriesin2022.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1204" data-original-width="1638" height="294" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgIf925JeS9pj2ALqEZrwiY711h1zBwUcPDOrDKCp9KuukRieb5_v8NdaDm_vHpJcbedLqIR4d1zjQU0i-p3nCJxe1rHYo1QgzPUcrNlAd6XsxecCmAwbLyc4e7MT1Sa3y_6xb6MUAK0Aq3n-DW-7O_RGyi1spx_LvUzgU6IToQcyf09Q7OlEEwV2ToSh0/w400-h294/USTreasuriesin2022.jpg" width="400" /></a></div><div><br /></div><span face="-webkit-standard, serif" style="border: medium; font-size: 12pt;">The decline in bond prices was driven by surging interest rates, with short term treasuries rising far more than longer term treasuries, and the yield curve inverted towards the end of the year.</span><div><span face="-webkit-standard, serif"><span> </span></span><span face="-webkit-standard, serif">The rise in US treasury rates spilled over into the corporate bond market, causing corporate bond yields to rise. Exacerbating the pain, corporate default spreads rose during the course of 2022:</span><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhbGaEa-m4gtCalbCTHDxoCUu6TwzvFLJj7LZsngwStL1oPW79PS1GQwCp4wl-eiogAL1MWo1A1mnpZv6puqSNFVu-kC2RtFlH08DrR02K3AMONFdQEWHqkflm2XPJVzu2rKUpzIzuLm8rgerXs-5Sj4Jq_Zq-4tgdzXzDrnAWgkBUaHTsLZoK4YFQmPoA/s1640/Def%20Spreads%20in%202022.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1410" data-original-width="1640" height="344" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhbGaEa-m4gtCalbCTHDxoCUu6TwzvFLJj7LZsngwStL1oPW79PS1GQwCp4wl-eiogAL1MWo1A1mnpZv6puqSNFVu-kC2RtFlH08DrR02K3AMONFdQEWHqkflm2XPJVzu2rKUpzIzuLm8rgerXs-5Sj4Jq_Zq-4tgdzXzDrnAWgkBUaHTsLZoK4YFQmPoA/w400-h344/Def%20Spreads%20in%202022.jpg" width="400" /></a></div><div><br /></div><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;"><span face="-webkit-standard, serif">While default spreads rose across ratings classes, the rise was much more pronounced for the lowest ratings classes, part of a <a href="https://aswathdamodaran.blogspot.com/2022/07/risk-capital-and-markets-temporary.html">bigger story about risk capital that spilled across markets and asset classes</a>. After a decade of easy access, translating into low risk premiums and default spreads, accompanied by a surge in IPOs and start-ups funded by venture capital, risk capital moved to the sidelines in 2022.<o:p></o:p></span></p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;"><span face="-webkit-standard, serif"> In sum, investors were shell shocked at the start of 2023, and there seemed to be little reason to expect the coming year to be any different. That pessimism was not restricted to market outlooks. Inflation dominated the headlines and there was widespread consensus among economists that a recession was imminent, with the only questions being about how severe it would be and when it would start. </span></p><p></p><p><b style="font-family: "Times New Roman", serif;"><span face="-webkit-standard, serif">The Market (and Economy) Surprises: The First Half of 2023</span></b></p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in;"><span face="-webkit-standard, serif"><o:p></o:p></span></p><p style="text-align: justify;"><b><span> </span></b><span face="-webkit-standard, serif">Halfway through 2023, I think it is safe to say that markets have surprised investors and economists again, this year. The combination of high inflation and a recession that was on the bingo cards of some economists at the start of 2023 did not manifest, with inflation declining sooner than most expected during the year:</span></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjtLNMxSK8Deeas_oOoPGECpqWcWnbPGSoVG9aVUL7Rd10x77IUtQj6w-sMVnYf_va6S7QVXagQANeMC7zFk7QJwaJey942RBoQ4Z9DP3WjV-D8B4fpK90DTq0Fhcq6j7P4UJb0kmyVER5xEeV76PY9LKAnfB3M0WgS6-4GuwXrlYtcJT0xt-Q8hDR-2Hg/s968/InflationPicture.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="701" data-original-width="968" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjtLNMxSK8Deeas_oOoPGECpqWcWnbPGSoVG9aVUL7Rd10x77IUtQj6w-sMVnYf_va6S7QVXagQANeMC7zFk7QJwaJey942RBoQ4Z9DP3WjV-D8B4fpK90DTq0Fhcq6j7P4UJb0kmyVER5xEeV76PY9LKAnfB3M0WgS6-4GuwXrlYtcJT0xt-Q8hDR-2Hg/w400-h290/InflationPicture.jpg" width="400" /></a></div><br /><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;"><span face="-webkit-standard, serif">It is true that the drop in inflation was anticipated by some economists, but most of them also expected that decline to come from a rapidly slowing economy, i.e., a recession and to be Fed-driven. That has not happened either, as employment numbers have stayed strong, housing prices have (at least up till now) absorbed the blows from higher mortgage rates and the economy has continued to grow.<o:p></o:p></span></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhizuRFmeTXwTuLtlUlJyE3IPoQekcD124hLt5fT0tJMKkHAR8oyssBe4vlog1NbRL3OweXgAtJy3h2clalgAqtvTnW4OQirGlqc6FInzabsh48vMrD-R0xvMNCBUURQ_lM2NgJ4XmSVODx2pGYsDCRlS1mChHzzxvvQgq-PdxmVSAbZoT5GQ4J6w0k9CE/s2444/EconomyChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1754" data-original-width="2444" height="288" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhizuRFmeTXwTuLtlUlJyE3IPoQekcD124hLt5fT0tJMKkHAR8oyssBe4vlog1NbRL3OweXgAtJy3h2clalgAqtvTnW4OQirGlqc6FInzabsh48vMrD-R0xvMNCBUURQ_lM2NgJ4XmSVODx2pGYsDCRlS1mChHzzxvvQgq-PdxmVSAbZoT5GQ4J6w0k9CE/w400-h288/EconomyChart.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div style="text-align: justify;">It is true that economic activity has leveled off and housing prices have declined a little, relative to a year ago, but given the rise in rates in 2022, those changes are mild. If anything, the economy seems to have settled into a stable pattern, albeit at the high levels that it reached in the second half of 2021. <span style="font-family: "Times New Roman", serif;">I know that the game is not done, and the long-promised pain may still arrive in the second half of the year, but for the moment, at least, markets have found some respite.</span></div><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;"><span face="-webkit-standard, serif"> During the course of 2023, the Fed was at the center of most economic storylines hero to some and villain to many others, with every utterance from Jerome Powell and other Fed officials parsed for signals about future actions. That said, it is worth noting that there is very little of consequence in the economy or the market, in 2023, that you can attribute to Fed activity. The Fed has raised the Fed Funds rate multiple times this year, but those rate increases have clearly done nothing to slow the economy down and inflation has stabilized, not because of the Fed but in spit of it. I know that there are many who still like to believe that the Fed sets interest rates, but here is what market interest rates (in the form of US treasury rates) have done during 2023: <o:p></o:p></span></p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in;"></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgK5l6w33NFLsPZnLINtLboQEu_LmQPtp78pWZEKMX-qQKlKs1ebky1om0gPHjazFwZwYU7FP5ADRSltymoX2OF57X-KOvlIjsBAVZ4E8PmAvhrGJWgRFT1O2Af6sIhjF6gw0_TnCz9gK2diK0iNmF38IV5fiIb4DwH4IKcaGBeFgIU6sVEUaqUcCpUouQ/s1638/USTreasuriesin2023.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1190" data-original-width="1638" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgK5l6w33NFLsPZnLINtLboQEu_LmQPtp78pWZEKMX-qQKlKs1ebky1om0gPHjazFwZwYU7FP5ADRSltymoX2OF57X-KOvlIjsBAVZ4E8PmAvhrGJWgRFT1O2Af6sIhjF6gw0_TnCz9gK2diK0iNmF38IV5fiIb4DwH4IKcaGBeFgIU6sVEUaqUcCpUouQ/w400-h290/USTreasuriesin2023.jpg" width="400" /></a></div><br /><p></p><div style="text-align: justify;">If there is a Fed effect on interest rates, it is almost entirely on the very short end of the spectrum, and not on longer term rates; the ten-year and thirty-year treasury bond rates have declined during the year. That does not surprise me, since I have never bought into the “Fed did it” theme, and have written multiple posts about why it is inflation and economic growth that drive interest rates, not central banks. As inflation has dropped and the economy has kept its footing, the corporate bond market has benefited from default spreads declining, as fears subside:</div><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEitD27Pdyp6MY3s-Y5JLLB6vfbMwiWfla2Vs3sF45x9UT0ybuPMkjVENPhoQGkmpl9kbJl_mooCFHbXpmybsbeXx-EJBoTYKPHvLceJzkGuPXlYIobTRmgdkmKqQGCMGc5qVvpLh81pDAbh-Ofdisco-Geyn4kynGsr5_U4scXIN6eheLJZzJOeCqY0ERk/s1644/Def%20Spreads%20in%202023.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1402" data-original-width="1644" height="341" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEitD27Pdyp6MY3s-Y5JLLB6vfbMwiWfla2Vs3sF45x9UT0ybuPMkjVENPhoQGkmpl9kbJl_mooCFHbXpmybsbeXx-EJBoTYKPHvLceJzkGuPXlYIobTRmgdkmKqQGCMGc5qVvpLh81pDAbh-Ofdisco-Geyn4kynGsr5_U4scXIN6eheLJZzJOeCqY0ERk/w400-h341/Def%20Spreads%20in%202023.jpg" width="400" /></a></div><br /><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in;"><span face="-webkit-standard, serif">As in 2022, the change in default spreads is greatest at the lowest ratings, with the key difference being that spreads are declining in 2023, rather than increasing, though the spreads still remain significantly higher than they were at the start of 2022.</span></p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in;"><span face="-webkit-standard, serif"><br /></span></p><p class="MsoNormal" style="margin: 0in;"><span face="-webkit-standard, serif"><b>Stock Markets Perk Up: The First Half of 2023</b></span></p><p class="MsoNormal" style="margin: 0in; text-align: justify;"><span> </span> I noted that risk capital retreated from markets in 2022, with negative consequences for risky asset classes. To the extent that some of that risk capital is coming back into the markets, equity markets have benefited, with benefits skewing more towards the companies and markets that were punished the most in 2022. To understand the equity comeback in 2023, I start by looking at the increase in market capitalizations, in US $ terms, across the world in the first six months of the year, with the change in market capitalizations in 2022 to provide perspective:</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjIu238l8scrUyh5YEfviuYgEAok_JnDCcUxk4EVXrhUknS3Qj1thPX5XjsLCN8fP25dUkYXPR9knC5eClIPgJbimB5doyOcJp_TX8bxjtdo-y4pn9pClKsMRqLdTFxg8zsZorxqM9_4j4LvK7TdbT77PBbN5MVvQ30TUBRJPg5gGVqYh8A4ZauiiLnugI/s1008/RegionTable.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="244" data-original-width="1008" height="96" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjIu238l8scrUyh5YEfviuYgEAok_JnDCcUxk4EVXrhUknS3Qj1thPX5XjsLCN8fP25dUkYXPR9knC5eClIPgJbimB5doyOcJp_TX8bxjtdo-y4pn9pClKsMRqLdTFxg8zsZorxqM9_4j4LvK7TdbT77PBbN5MVvQ30TUBRJPg5gGVqYh8A4ZauiiLnugI/w400-h96/RegionTable.jpg" width="400" /></a></div><div><br /></div><div style="text-align: justify;">In US dollar terms, <u>global equities have reclaimed $8.6 trillion in market value in the first six months in the year</u>, but the <u>severity of last year's decline has still left them $14.4 trillion below their values from the start of 2022</u>. Looking across regions, US equities have performed the best in the first six months of 2023, adding almost 14% ($5.6 trillion) to market capitalizations, regaining almost half of the value lost in last year's rout. In US dollar terms, China was the worst performing region of the world, with equity values down 1.01% in the first six months on 2023, adding to the 18.7% that was lost last year. The two best performing parts of the world in 2022, Africa and India, performed moderately well in the first half of 2023. In US dollar terms, Latin America was flat in the first half of 2023, though there were a couple of Latin American markets that delivered stellar returns in local currency terms, albeit with high inflation eating away at these returns. It is currency rate changes that explains that contrast between local currency and dollar returns, and in the graph below, I look at the US dollar's performance broadly (against other currencies) as well as against emerging market currencies , between 2020 and 2023;</div></div><div><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi5vHciRUJC3WVsuHVqV-LtfPzdxfD_isy__RNSiOdmqn3wnXoCuL526LR3Apx-Q5RQHNjYZjVEKwE-0XQzGmPhI3VeyGgr-Xr8P9Y6fXUU296LMaByvJnxMVttW8K37fpgjenTh4XbGPKkg9CzIhyRIIvYRO5XpTBKp3oatra82-g2md0g-mPzFsEQcRc/s972/DollarChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="695" data-original-width="972" height="286" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi5vHciRUJC3WVsuHVqV-LtfPzdxfD_isy__RNSiOdmqn3wnXoCuL526LR3Apx-Q5RQHNjYZjVEKwE-0XQzGmPhI3VeyGgr-Xr8P9Y6fXUU296LMaByvJnxMVttW8K37fpgjenTh4XbGPKkg9CzIhyRIIvYRO5XpTBKp3oatra82-g2md0g-mPzFsEQcRc/w400-h286/DollarChart.jpg" width="400" /></a></div><br />After strengthening in 2022, the US dollar has weakened against most currencies in 2023, albeit only mildly.<br /><p></p><p><b>US Equities in 2023: Into the Weeds!</b></p><p style="text-align: justify;"><b> </b>The bulk of the surge in global equities in 2023 has come from US stocks, but there are many investors in US stocks who are looking at their portfolio performance this year, and wondering why they don't seem to be sharing in the upside. In this section, I will start by looking with an overall assessment of US equities (levels and equity risk premiums) before delving into the details of the winners and losers this year.<b> </b><br /></p><p><i>Stocks and the Equity Risk Premium </i></p><p><i> </i>I start my assessment of US equities by looking at the performance of the S&P 500 and the NASDAQ during the first half of this year:<br /></p><p><i><br /></i></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjp35KrqMjVoue5bHFREEGvb3NDyld1vfIz9bs6pB81_f8koOvdsTb2vr9A-grNqXY9zHH7o6EmMcV_97YeMNGd2PidcJpLRU-vEUHLABR0wg4L_q9s3COYBRyjEQDvPOG6hshGRenWPPylOZUNBkjrBavcPzsVRre6CRdzoW1PNVJHGrLcw-igDg_Eylo/s1642/Stocksin2023.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1180" data-original-width="1642" height="288" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjp35KrqMjVoue5bHFREEGvb3NDyld1vfIz9bs6pB81_f8koOvdsTb2vr9A-grNqXY9zHH7o6EmMcV_97YeMNGd2PidcJpLRU-vEUHLABR0wg4L_q9s3COYBRyjEQDvPOG6hshGRenWPPylOZUNBkjrBavcPzsVRre6CRdzoW1PNVJHGrLcw-igDg_Eylo/w400-h288/Stocksin2023.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: justify;">As you can see, why the S&P has had a strong first half of 2023, increasing 15.91%, the NASDAQ has delivered almost twice that return, with its tech focus. One reason for the rise in stock prices, at least in the aggregate, has been a dampening of worries of out-of-control inflation or a deep recession, and this drop in fear can be seen in the equity risk premium, the price of risk in the equity market. In the figure below, I have graphed my estimates of expected returns on stocks and implied equity risk premiums through 2022 and the first six months of 2023:</div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiayB6E-PJ7-wGyajUH6EJWEvVL3gGEzm0s9Bihu1tZcDCxIHNmFs5p1MtUGIYbshnUTkf62lRwvP7uvw5O8S7daGSoo_Pj2vAftdwEqg3sWKp7appbiLR_AFsJ5HSDrkCCAiK0MMrpQcrHrIw2orrmyva0U9VADm5bOdBDDMdA5wGE4RvhDuWBbovR7sQ/s917/ERPin2023Chart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="631" data-original-width="917" height="275" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiayB6E-PJ7-wGyajUH6EJWEvVL3gGEzm0s9Bihu1tZcDCxIHNmFs5p1MtUGIYbshnUTkf62lRwvP7uvw5O8S7daGSoo_Pj2vAftdwEqg3sWKp7appbiLR_AFsJ5HSDrkCCAiK0MMrpQcrHrIw2orrmyva0U9VADm5bOdBDDMdA5wGE4RvhDuWBbovR7sQ/w400-h275/ERPin2023Chart.jpg" width="400" /></a></div><div style="text-align: justify;">After a year for the record books, in 2022, when the expected return on stocks (the cost of equity) increased from 5.75% to 9.82%, the largest one-year increase in that number in history, we have had not just a more subdued year in 2023, but one where the expected return has come back down to 8.81%. In the process, the implied equity risk premium, which peaked at 5.94% on January 1, 2023, is back down to 5% at the start of July 2023. Even after that drop, equity risk premiums are still at roughly the average value since 2008, and significantly higher than the average since 1960. If the essence of a bubble is that equity risk premiums become "too low", the numbers, at least for the moment, don't seem to signaling a bubble (unlike years like 1999, when the equity risk premium dropped to 2%).</div><p></p><p><i>Sector and Industry</i></p><p><i> </i>The divergence between the S&P 500 and the NASDAQ's performance this year provides clues as to which sectors have benefited the most this year, as risk has receded. In the table below, I break all US equities into sectors and report on performance, in 2022 and in the first half of 2023:<br /></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjUauCs8zQWv4Rej8kiBwXAczACk_HhdQp0vVt3SCvcNp2x8R4XDgo6lEvDoOpPmGr6f2m5dLYoIqcYMySTvEvDMif7S164EhaWzOdSPewVxC7_qSEITs4EVF9FeJhSeaaBsQhlyLZKufe94kpz_wpjnH0QBflMgnKWlx_mP4ocL_9_48YYkrlVPNhrS70/s970/USSectorTable.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="225" data-original-width="970" height="93" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjUauCs8zQWv4Rej8kiBwXAczACk_HhdQp0vVt3SCvcNp2x8R4XDgo6lEvDoOpPmGr6f2m5dLYoIqcYMySTvEvDMif7S164EhaWzOdSPewVxC7_qSEITs4EVF9FeJhSeaaBsQhlyLZKufe94kpz_wpjnH0QBflMgnKWlx_mP4ocL_9_48YYkrlVPNhrS70/w400-h93/USSectorTable.jpg" width="400" /></a></div><div style="text-align: justify;">As you can see, <u>four of the twelve sectors have had negative returns in 2023</u>, with energy stocks down more than 17% this year. The biggest winner, and this should come as no surprise, has been technology, with a return of 43% in 2023, and almost entirely recovering its losses in 2022. Financials, handicapped by the bank runs at SVB and First Republic, have been flat for the year, as has been real estate. Communication services and consumer discretionary have had a strong first half of 2023, but remain more than 20% below their levels at the star of 2022.</div><div style="text-align: justify;"><span> Breaking sectors down into industry-level details, we can identify the biggest winners and losers, among industries. In the table below, I list the ten worst performing and best performing industry groups, based purely on market capitalization change in the first half of 2023:</span><br /></div><div style="text-align: justify;"><span><br /></span></div><div style="text-align: justify;"><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiwJezAJo8rnu81jjSUQOvSxq7Niqxh-TIhbRmjxSy0UVZP_mon1-2zmWG4QBoeM_RFzLIJ3LWUc3pWfsjzJSMEzRi76Kt5CQRa9_mLh0nAzBRi-QLVkgE_dtTzT52T2_Fa_RXZa-jtjjeta6v124hPoCeTQhJ15qxOAIJWVBKPe48cB-dlNgeDYsN92HI/s2016/USIndustryBest&Worst.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="886" data-original-width="2016" height="176" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiwJezAJo8rnu81jjSUQOvSxq7Niqxh-TIhbRmjxSy0UVZP_mon1-2zmWG4QBoeM_RFzLIJ3LWUc3pWfsjzJSMEzRi76Kt5CQRa9_mLh0nAzBRi-QLVkgE_dtTzT52T2_Fa_RXZa-jtjjeta6v124hPoCeTQhJ15qxOAIJWVBKPe48cB-dlNgeDYsN92HI/w400-h176/USIndustryBest&Worst.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/USIndustry2023.xlsx"><i><span style="font-size: x-small;">Download market performance in 2023, by industry</span></i></a></td></tr></tbody></table><br /></div><div style="text-align: justify;">The worst performing industry groups are in financial services and energy, with oilfield services companies being the worst impacted. The best performing industry group is auto & truck, but those results are skewed upwards, with one big winner (Tesla) accounting for a large portion of the increase in market capitalization in the sector. There are several technology groups that are on the winner list, not just in terms of percentage increases, but also in absolute value changes, with semiconductors, computers/peripherals and software all adding more than a trillion dollars in market capitalization apiece.<br /></div><p><i>Market Capitalization and Profitability</i></p><p style="text-align: justify;"><i> </i>The first six months of the year have also seen concentrated gains in a larger companies and this can be seen in the table below, where I break companies down based upon their market capitalizations at the start of 2023 into deciles, and then break the stocks down in each decile into money-making and money-losing companies, based upon net income in 2022:<br /></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjcZz9S-lJHwg9WOByJzK4oVgB08tz0je0Yhv6CebvWNv5tNLFDC5PGM6hfRP6KD6FH2lnwdW1NiAftgt8N_ri5aoEglZJlt6wSINrBX1e6wtDMXXIgGQwB_b-A6VIFjV7v7JPLS9Dxcmdas4c_9dpcQRqxFgHHVVqXCH7GwBtjiSZbY1g7D1lNT29r0Gg/s1284/Money%20Making%20versu%20Losing.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="816" data-original-width="1284" height="254" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjcZz9S-lJHwg9WOByJzK4oVgB08tz0je0Yhv6CebvWNv5tNLFDC5PGM6hfRP6KD6FH2lnwdW1NiAftgt8N_ri5aoEglZJlt6wSINrBX1e6wtDMXXIgGQwB_b-A6VIFjV7v7JPLS9Dxcmdas4c_9dpcQRqxFgHHVVqXCH7GwBtjiSZbY1g7D1lNT29r0Gg/w400-h254/Money%20Making%20versu%20Losing.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div style="text-align: justify;">Again, the numbers tell a story, with the <u>money-making companies in the largest market cap decile accounting for almost all of the gain in market cap for all US equities</u>; the market capitalization of these large money-making companies increased by $5.3 trillion in the first six months of 2023, 97.2% of the $5.45 trillion increase in value for all US equities.</div><div><br /></div><div><i>Value and Growth </i></div><div style="text-align: justify;"><span> Over the last decade, I have written many posts about how old-time value investing, with its focus low PE and low price to book stocks, has lagged growth investing, with high growth stocks that trade at higher multiples of earnings and book value delivering much higher returns than old-time value stocks (low PE ratios, high dividend yields etc.). In 2022, old-time value investors felt vindicated, as the damage that year was inflicted on the highest growth companies, especially in technology. That </span>celebration has not lasted long, though, since in 2023, we saw a return to a familiar pattern from the last decade, with the highest price to book stocks earning significantly higher returns than the stocks with the lowest price to book ratios:</div><div style="text-align: justify;"><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgUC9owG105nF29ovfOh4aShEqc2oAlBEMlN2dLBD6oe9B-hwrrgI5x8FGLFWmBbQBTX1XO-wtdLWlrQGokfhOKmmjfrUdzF6b9NPMMg_igMvWxBJ941KZZRQg4U3Aa58HI7x0veOIlihCjVXJmr1dMSaJixWoYM8mNvjPhzGHT01RSCKhMgLhXgbmDmXI/s4322/PBVChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="3136" data-original-width="4322" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgUC9owG105nF29ovfOh4aShEqc2oAlBEMlN2dLBD6oe9B-hwrrgI5x8FGLFWmBbQBTX1XO-wtdLWlrQGokfhOKmmjfrUdzF6b9NPMMg_igMvWxBJ941KZZRQg4U3Aa58HI7x0veOIlihCjVXJmr1dMSaJixWoYM8mNvjPhzGHT01RSCKhMgLhXgbmDmXI/w400-h290/PBVChart.jpg" width="400" /></a></div><br /><div style="text-align: justify;">As you can see from the chart, almost all of the value increase in US equities has come from the top two deciles of stocks, in terms of price to book ratios. Looking at value and growth go back and forth between the winning and losing columns in 2023, I believe that this is a pattern that will continue to play out for the rest of the decade, with no decisive winner.</div><p></p><p><i>An Assessment</i></p><p style="text-align: justify;"><i> </i>I know that one of the critiques of this market rise is that it has been uneven, but almost all market recoveries are uneven, with some groupings of companies always doing better than others. That said, there are lessons to be learned from looking at the winners and the losers in the first half of 2023 market sweepstakes:<br /></p><p></p><ul style="text-align: left;"><li style="text-align: justify;"><u>Big tech</u>: There is no doubt that this market has been largely elevated not just by tech companies, but by a <u>subset of large tech companies</u>. Seven companies (Apple, Microsoft, NVIDIA, Amazon, Tesla, Meta and Alphabet) have seen their collective market capitalization increase by $4.14 trillion in the first half of 2023, accounting for almost 80% of the overall increase in equity values at all 6669 publicly traded US equities. If these stocks level off or drop, the market will have trouble finding substitutes to keep the market pushing higher, simply because of the size of the hole that will need to be filled. </li><li style="text-align: justify;"><u>With a profitability skew</u>: While this does seem like a reversion to the tech boom that drove markets prior to 2022, the market seems to be more inclined to rewarding money-making tech companies, at the expense of money-losers. If risk capital is coming back in 2023, it is being more selective about where it is directing its money, and it is therefore not surprising that IPOs, venture capital and high yield bond issuances have remained mired in 2022 (low) levels.</li><li style="text-align: justify;"><u>And an economic twist</u>: One reason that these big and money-making tech companies may be seeing the return of investor money is that they have navigated the inflation storm relatively unscathed and some have emerged more disciplined, from the experience. The two best cases in point are Meta and Google, both of which have not only reduced payrolls but also seem to have shifted their narrative from a relentless pursuit of growth to one of profitability.</li></ul><p></p><p style="text-align: justify;">It is true that as market rallies lengthen, they draw in more stocks into their orbit, and it is possible that the market rally will broaden over the course of the year. That said, this has been a decade of unpredictability, starting with the first quarter of 2020, where COVID ravaged stocks, and I don't think it makes much sense to take charts from 2008 or 2001 or earlier and extrapolating from those.</p><p><b>The Rest of the Year: What's coming?</b></p><p style="text-align: justify;"><b> </b>The market mood is buoyant, as investors seem to be convinced that we have dodged the bullet, with inflation cooling and a soft landing for the economy. <b> </b>The lesson that I have learned not just from the first six months of 2023, but from market performance over the last three years, has been that macro forecasting is pointless, and that trying to time markets is foolhardy. If I were to make guesses about what the rest of the year will bring, here are my thoughts:</p><p></p><ul style="text-align: left;"><li style="text-align: justify;"><i>On inflation</i>, the good news on inflation in the first half of the year should not obscure the reality that the inflation rate, at 3% in June, still remains higher than the Fed-targeted value (of 2%). That last stretch getting inflation down from 3% to below 2% will be trench warfare, and we will be exposed to macro shocks (from energy prices or regional unrest) that can create inflationary shocks.</li><li style="text-align: justify;"><i>On the economy</i>, notwithstanding good employment numbers, there are signs that the economy is cooling and it is again entirely possible that this turns into a slow-motion recession, as real estate (especially commercial) succumbs to higher interest rates and consumers start retrenching. </li><li style="text-align: justify;"><i>On interest rates</i>, I do think that hoping and praying that rates will go back to 2% or lower is a pipe dream, as long as inflation stays at 3% or higher. In short, with or without the Fed, long term treasury rates have found a steady state at 3.5% to 4%, and companies and investors will have to learn to live with those rates. I have never attached much significance to the yield curve inversion as a predictor of economic growth, but that inversion is unlikely to go away soon, as near term inflation remains higher than long term expectations.</li><li><div style="text-align: justify;"><i>On equities</i>, the one certainty is that there will be uncertainties, and it is unlikely that the market will repeat its success in the second half of 2023. I did value the S&P 500 at the start of the year, and and argued that it was close to fairly valued then. Updating this valuation to reflect updated perspectives on both dimensions, as well as an index price that is about 16% higher, here is what I see:</div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhaZErEISxEji_Ho0ZpRSb1QGfVg59aVDewAmrQd2WP5OB2j1T5KmoQfnlp1FS4wKn692a56mQgLaOxmtUFRqSBsyMuoimn2-URl3kkuZIGbYJuZWt-cwmRmuu2dEggzMqjNxh0mNhx-gUvO1BET-l1iq5ZVLSsejc7-xx3MUCz5eNtGONlixjgvm2CW3I/s1496/S&P500inJuly2023.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="814" data-original-width="1496" height="217" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhaZErEISxEji_Ho0ZpRSb1QGfVg59aVDewAmrQd2WP5OB2j1T5KmoQfnlp1FS4wKn692a56mQgLaOxmtUFRqSBsyMuoimn2-URl3kkuZIGbYJuZWt-cwmRmuu2dEggzMqjNxh0mNhx-gUvO1BET-l1iq5ZVLSsejc7-xx3MUCz5eNtGONlixjgvm2CW3I/w400-h217/S&P500inJuly2023.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/S&P500ValueJuly2023.xlsx">Download spreadsheet with valuation</a></span></i></td></tr></tbody></table><br /><div style="text-align: justify;">Note that I have used the analyst projections of earnings for the index for 2023 to 2025, and adjusted the cash payout over time to reflect reinvestment needed to sustain growth in the long term (set to 3.88%, after 2027). After the run up in stock prices in the first six months, stocks look fairly valued, given estimated earnings and cash flows, and assuming that long term rates have found their steady state. (Unlike market strategies who provide target levels for the index, an intrinsic value delivers a value for the index today; to get an estimate of what translates into as a target level of the index, you can apply the cost of equity as the expected return factor to get index levels in future time periods.)</div></li></ul><div><span style="text-align: justify;">It goes without saying, but I will say it anyway, that the economy may still go into a recession, analysts may be over estimating earnings and inflation may make a come back (pushing up long term rates). If you have concerns on those fronts, your investing should reflect those worries, but your returns will be only as good as your macro forecasting abilities. Mine are not that good, and it is why I steer away from grandiose statements about equities being in a bubble or a bargain. </span>While uncertainties abound, there is one thing I am certain about. I will be wrong on almost every single one of these forecasts, and there is little that I can or want to do about that. That is why I demand an equity risk premium in the first place, and all I can do is hope that it large enough to cover those uncertainties.</div><div><br /></div><div><b>A Time for Humility</b></div><div style="text-align: justify;"><span> If t</span>he greatest sin in investing is arrogance, markets exist to bring us back to earth and teach us humility. The first half of 2023 was a reminder that no matter who you are as an analyst, and how well thought through your investment thesis is, the market has other plans. As you listen to market gurus spin tales about markets, sometimes based upon historical data and compelling charts, it is worth remembering that forecasting where the entire market is going is, by itself, an act of hubris. In the spirit of humility, I would suggest that if you were a winner in the first half of this year, recognize that much of that can be attributed to luck, and what the market gives, it can take away. By the same token, if you were a loser over the course of the last six months, regret should not lead you to try to load up on the winners over that period. That ship has sailed, and who knows? Your loser portfolio may be well positioned to take advantage of whatever is coming in the next six months.<span> </span></div><div style="text-align: justify;"><span><br /></span></div><div style="text-align: justify;"><span><b>YouTube Video</b></span></div><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/lp7D1fwjCBI" title="YouTube video player" width="560"></iframe><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><span><b>Data Spreadsheets</b></span></div><div style="text-align: justify;"><ol><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Country2023.xlsx">Market Performance in first half of 2023, by country</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/USIndustry2023.xlsx">Market Performance in first half of 2023, by industry</a></li></ol></div><div style="text-align: justify;"><span><b>Valuation Spreadsheets</b></span></div><div style="text-align: justify;"><ol><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/S&P500ValueJuly2023.xlsx">Valuation of the S&P 500 on July 1, 2023</a></li></ol></div><p><br /></p></div>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-33952869093751402792023-06-23T15:39:00.003-04:002023-06-23T20:07:01.907-04:00AI's Winners, Losers and Wannabes: An NVIDIA Valuation, with the AI Boost!<p style="text-align: justify;">I will start this post with a couple of confessions. The first is that my portfolio has held up well this year, in a market that has been top-heavy and tech-driven, and one big reason is that it contains both NVIDIA and Microsoft, two companies that have benefited from the AI story. The second is that much as I would like to claim credit for foresight and forward thinking, AI was not even a speck in my imagination when I bought these stocks (Microsoft in 2014 and NVIDIA in 2018). I just happened to be in the right place at the right time, a reminder again that being lucky often beats being smart, at least in markets. That said, NVIDIA’s soaring stock price has left me facing that question of whether to cash out, or let my money ride, and thus requires an assessment of how the promise of AI play’s out in its value. Along the way, I will take a look at the promise of AI, as well as the perils for investors, drawing on lessons from the past.</p><p style="text-align: justify;"><b>The Semiconductor Business</b></p><p style="text-align: justify;"><span> The semiconductor business, in its current form, had its growth spurt as a consequence of the PC revolution of the 1980s, as personal computers transitioned from tools and playthings for geeks to everyday work instruments for the rest of us. In the last four decades, computer chips have become part of almost everything we use, from appliances to automobiles, and the companies that manufacture these chips have seen their fortunes rise, and sometimes be put at risk, as technology shifts.</span><br /></p><p style="text-align: justify;"><i>1. From High Growth to Maturity!</i></p><p style="text-align: justify;"><span><i> </i>It was the personal computer business in the 1980s that gave the semiconductor business, as we know it, its boost, and as technology has increasingly entered every aspect of life, the semiconductor business has grown. To map the growth, I started by looking at the aggregated revenues of all global semiconductor companies in the chart below from 1987 to 2023 (through the first quarter):</span></p><p><span></span></p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgfr0O-RT97SdKnzhvXhwOSENFGrJuVT15KkHEVYH9K2NpDgwWOkcBmpPqVHa9S69KRF7Sx1bhdM0EosbERL7N1ATBYKRccOMbD3ADE2uCvJbZXt5FkHgEQFKtGlzVSpwnK4FcCX0Hx9CzRMG_VZqLBmUX0s9D4oUu00mTIoyyXblmkSo9EAU5Z3lxq/s1430/semirevenues.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1036" data-original-width="1430" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgfr0O-RT97SdKnzhvXhwOSENFGrJuVT15KkHEVYH9K2NpDgwWOkcBmpPqVHa9S69KRF7Sx1bhdM0EosbERL7N1ATBYKRccOMbD3ADE2uCvJbZXt5FkHgEQFKtGlzVSpwnK4FcCX0Hx9CzRMG_VZqLBmUX0s9D4oUu00mTIoyyXblmkSo9EAU5Z3lxq/w400-h290/semirevenues.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i>Source: Semiconductor Industry Association</i></td></tr></tbody></table><p style="text-align: justify;">From close to nothing at the start of the 1980s, revenues at semiconductor companies surged in the 1980s and 1990s, first boosted by the PC business and then by the dot-com boom. From 2001 to 2020, revenue growth at semiconductor businesses has dropped to single digits, as higher demand for chips in new uses has been offset by loss of pricing power, and declining chip prices. While revenue growth has picked up again in the last three years, the business has matured.</p><p style="text-align: justify;"><i>2. Sustained Profitability, with Cycles!</i></p><p style="text-align: justify;"><span> The semiconductor business has generally been a profitable one for much of its existence, as can be seen in the aggregate margins of companies in the business below:</span><br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhEszFY_PBJHgxm_5E6eq6fAoGL1bpnOI7UhF7cW_fXmeXJ9LILjLR1uZRrsulGdqLVvRR0lu1CyDP4BQ8dpkm4Lm2iFhpYMQ2lM3Kwa4_dNShC4lSCScHqNPtWLYxzNxn1tDx8SwD1e6yvU8Oyso8kjvBbiuPldQTNjuAGywK4Da0MM5a1-r27NWp94U4/s1429/SemiProfits.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1283" data-original-width="1429" height="359" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhEszFY_PBJHgxm_5E6eq6fAoGL1bpnOI7UhF7cW_fXmeXJ9LILjLR1uZRrsulGdqLVvRR0lu1CyDP4BQ8dpkm4Lm2iFhpYMQ2lM3Kwa4_dNShC4lSCScHqNPtWLYxzNxn1tDx8SwD1e6yvU8Oyso8kjvBbiuPldQTNjuAGywK4Da0MM5a1-r27NWp94U4/w400-h359/SemiProfits.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div style="text-align: justify;">While gross and operating margins have always been healthy, the pick up in both metrics since 2010 is a testimonial to the higher profitability in some segments of the chip business, even as competition commoditized other segments. As can be seen in the periodic dips in profitability across time, there are cycles of profitability that have continued, even as the business has matured. </div><div style="text-align: justify;"><span> It is worth noting that these margins are understated, because of the accounting treatment of R&D as an operating expense, instead of as a capital expenditure. The R&D adjusted operating margin at semiconductor companies is higher by about 2-4%, in every time period, with the adjustment to operating taking the form of adding back the R&D expense from the year and subtracting out the amortization of R&D expenses over the prior five years (using straight line amortization).</span></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><i>3. Love-Hate Relationship with Markets!</i></div><p style="text-align: justify;"><span> As the semiconductor business has acquired heft, in terms of revenues and profitability, investors have priced those operating results into the market capitalization assigned to these companies. In the graph below, I report the collective enterprise value and market capitalization of global semiconductor companies, stated in US dollar terms:</span><br /></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjvQGQIeRYO8Ycnli0HNLglGP6KQ7AvPY_dTvHmrK9Pc0FZ5myl0hXTEp3zphx7mA569xB_nQXSCjZbZkvzWsm0knhB0QDVqroHl3le271-Q8Ux8aL7Of7WVE2QTE3iNYNq1PETm6rESK80dkgr8C0uOje0KxlJ7mpIFRy-jwKhVuRb_UBVSw8a3JiH/s1435/SemiMktCap.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1034" data-original-width="1435" height="289" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjvQGQIeRYO8Ycnli0HNLglGP6KQ7AvPY_dTvHmrK9Pc0FZ5myl0hXTEp3zphx7mA569xB_nQXSCjZbZkvzWsm0knhB0QDVqroHl3le271-Q8Ux8aL7Of7WVE2QTE3iNYNq1PETm6rESK80dkgr8C0uOje0KxlJ7mpIFRy-jwKhVuRb_UBVSw8a3JiH/w400-h289/SemiMktCap.jpg" width="400" /></a></div><div style="text-align: justify;"><br /></div><span><div style="text-align: justify;">As you can see, the semiconductor companies have enjoyed long periods of glory, interspersed with periods of pain in markets, starting with a decade of surging market capitalizations in the 1990s, followed by a decade in the wilderness, with stagnant market capitalization, between 2000 and 2010, before another decade of growth, with market capitalizations surged six-fold between 2011 and 2020. Note that for the most part, semiconductor companies carry light debt loads, leading to enterprise values that either trail in market capitalization in some years (because cash exceeds debt) or are very close to market capitalization in other years (because net debt is close to zero). </div><div style="text-align: justify;"><span> </span>As market capitalizations have risen and fallen, the multiple of revenues that semiconductor companies has also fluctuated, reaching a high in the dot-come era, with semiconductor companies trading collectively at more than seven times revenues to a long stretch where they traded at between two and three times revenues, before spiking again between 2019 and 2021. If prices are a reflection of what the market thinks about the future, the pricing of semiconductor companies seems to indicate an acceptance on the part of investors that the business has matured.</div></span><p><i>4. Shifting Cast of Winners and Losers!</i></p><p style="text-align: justify;"><span><i> </i>As the semiconductor business has matured, it has also changed in terms of both the biggest players in the business, as well as the largest customers for its products . In the table below, we show the evolution of the top ten semiconductor companies, in terms of revenues, from 1990 through 2023, at ten-year intervals:<br /></span></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhg90suGOvWAchPWzpDMkvbK0wFz46iJ04QWOwTjOrwyM7h1T7sBz3l24j1sLbycouKEhdhHYqmuuthlfQ4u5W3KwoUtJpmXoZgZcxYwOG_CFf-43PwGVjOLOL2vWkAnyVRZDtdfg0Yxdhd69I5UTtL0ywJXoGkqR3WZ5J2DIfA1XnZYH_isRxYpBq6/s1023/BiggestSemi.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="218" data-original-width="1023" height="85" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhg90suGOvWAchPWzpDMkvbK0wFz46iJ04QWOwTjOrwyM7h1T7sBz3l24j1sLbycouKEhdhHYqmuuthlfQ4u5W3KwoUtJpmXoZgZcxYwOG_CFf-43PwGVjOLOL2vWkAnyVRZDtdfg0Yxdhd69I5UTtL0ywJXoGkqR3WZ5J2DIfA1XnZYH_isRxYpBq6/w400-h85/BiggestSemi.jpg" width="400" /></a></div><br /><div style="text-align: justify;">The cast of players has changed over time, with only two companies from the 1990 list (Intel and Texas Instruments) making it to the 2023 list. Over the decades, the Japanese companies on the list have slipped down or disappeared, to be replaced by Korean and Taiwanese firms, with Taiwan Semiconductors being the biggest mover, moving to the top of the list in 2022. After a long stretch at the top, Intel has dropped back down the list and ranked third, in terms of revenues, in 2022. Note that NVIDIA, the subject of this post, was eighth on the list in 2023, and has remained at that ranking from 2010. That may seem at odds with its rising market capitalization but it is indicative of the company's strategy of going after niche markets with high profitability, rather than trying to grow for the sake of growth.</div><p></p><p style="text-align: justify;"><span> The customers for semiconductor chips have also changed over time, with the shift away from personal computers to smartphones, with demand emerging from automobile, crypto and gaming companies in the last decade. Over the last few years, data processing has also emerged as demand driver, and it is </span>safe the say that more and more of the global economy is driven by computer chips:</p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjTiav9wno1b85vQ3JoVyvxFpeHN_rOg56HbNnXllvbjok-VDOXkwzdX-Kf469aaHg962PJu2S_4bZnYnc0n3OLPc1mxYzq5ABuKEGyrpaecQk04T9NJO_eTatFiHQA5mozXmIZft7hw-sKQjR_S3NrDCaiM_mfmpY2kP7QlqkIeQ87LqNnpy_iDTFrC4A/s3037/UserPieChartNew.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="956" data-original-width="3037" height="101" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjTiav9wno1b85vQ3JoVyvxFpeHN_rOg56HbNnXllvbjok-VDOXkwzdX-Kf469aaHg962PJu2S_4bZnYnc0n3OLPc1mxYzq5ABuKEGyrpaecQk04T9NJO_eTatFiHQA5mozXmIZft7hw-sKQjR_S3NrDCaiM_mfmpY2kP7QlqkIeQ87LqNnpy_iDTFrC4A/s320/UserPieChartNew.jpg" width="320" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;">Semiconductor Industry Association</span></i><br /></td></tr></tbody></table><div style="text-align: justify;">The forecasts for the future (2030), were for faster growth in automobile and industry electronics, but the potential surge in demand from AI products was largely underplayed, showing how quickly market forecasts can be subsumed by changes on the ground.</div><p><b>NVIDIA: The Opportunist!</b></p><p style="text-align: justify;"><span> NVIDIA was founded in 1993 by <a href="https://nvidianews.nvidia.com/bios/jensen-huang">Jensen Huang</a>, but it remained a niche player until the early parts of this century. Much of its rise has come in the last decade, just as revenues for the overall semiconductor business were starting to level off, and in this section, we will look through the company's history, looking for clues to its success and current standing.</span></p><p><span>1. <i>Opportunistic Growth, with Profitability</i></span></p><p style="text-align: justify;"><i> </i>NVIDIA went public in January 22, 1999, with the dot-com boom well under way, and its stock price popped by 64% on the offering date. At the time of its public offering, the company was money-making, but with small revenues of $160 million, making it a bit player in the business. As you can see in the graph below, those revenues grew between 2000 and 2005, to reach $2.4 billion in 2005. In the following decade (2006-2015), the annual revenue growth rate dropped back to 7-8% a year, but that growth allowed the company to make the top ten list of semiconductor companies by 2010. Well-timed bets on gaming and crypto created a surge in the revenue growth rate to 27.19% between 2016-2020, and that growth has continued into the last two years:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgQHgeSd1lPqW3rBmeZwTmRdCZy_CXx-RNbpQpqKKMkWjYw7UIYJwaamuWW9Uqi4rccHgnSrafzNH1C4expURWGKOqd9czp0JACFqyVmoKfdJ6uw51G4Wu0yrMaDB2ri3APP3EsZRFK7iENSHcr6GbjGsKEIQClyYujnS7HlH4GgXrCIgQbNZuSesXY/s1092/NVIDIAOperating.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="788" data-original-width="1092" height="289" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgQHgeSd1lPqW3rBmeZwTmRdCZy_CXx-RNbpQpqKKMkWjYw7UIYJwaamuWW9Uqi4rccHgnSrafzNH1C4expURWGKOqd9czp0JACFqyVmoKfdJ6uw51G4Wu0yrMaDB2ri3APP3EsZRFK7iENSHcr6GbjGsKEIQClyYujnS7HlH4GgXrCIgQbNZuSesXY/w400-h289/NVIDIAOperating.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: justify;"><br /></div><div style="text-align: justify;">There are two impressive components to NVIDIA's history. The first is that it has been able to <i>maintain impressive growth</i>, even as the industry saw a slowing of revenue growth (3.97% between 2011-2020). The second is that <i>this high revenue growth has been accompanied not just with profits, but with above-average profitability</i>, as NVIDIA's gross and operating margins have run ahead of industry averages. NVIDIA has clearly embraced a strategy of investing ahead of, and going after, growth markets for the chip business, and that strategy has paid off well. Thus, its current dominant positioning in the AI chip business can be viewed as more evidence of that strategy at play.</div><div style="text-align: justify;"><span> There is one final component to NVIDIA's business model that needs noting, both from a profitability and risk perspective. NVIDIA 's core business is built around research and chip design, not chip manufacturing, and it outsources almost all of its chip production to TSMC. Its margins then come from its capacity to mark up the prices of these chips and it is exposed to the risks that any future China-Taiwan tensions can disrupt its supply chain.</span><br /></div><div><p style="text-align: justify;"><span><span><i>2. Large, albeit Productive Reinvestment</i></span></span></p><p style="text-align: justify;"><span><span> While NVIDIA's growth and profitability have been impressive, the value cycle is not complete until you bring in the investment that the company has had to make to deliver that growth. With a semiconductor company, that reinvestment includes not only investing in manufacturing capacity, but also in the R&D to create the next generation of chips, in terms of power and capability. As with the sector, I <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1609799">capitalized R&D at NVIDIA, using a 5-year life</a>, and recalculated my operating income (since the reported version is built on the accounting mis-reading of R&D as an operating expense). That results in a corrected version of pre-tax operating margin for NVIDIA that was 37.83% and a pre-tax return on capital of 24.42% in 2021-2023:</span></span><br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjFoCimCjxnDt3GJWO65pKMUF_-KbMU8GViQLPs9OTDLg4GGOK896rmeXW0aMVqLN-Qirp7lIAyJ5W--VFNhmym4vzCtQXqfsV97Em_Sp9gn2FAx_dOY8UkZJffeirDic--V7ku68B82R21cR9Hi5ZbFd97rdbQnz4HI1wMV0-U-ouPtwDwxQiGULMP/s1091/NVIDIAInvestHistory.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="783" data-original-width="1091" height="288" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjFoCimCjxnDt3GJWO65pKMUF_-KbMU8GViQLPs9OTDLg4GGOK896rmeXW0aMVqLN-Qirp7lIAyJ5W--VFNhmym4vzCtQXqfsV97Em_Sp9gn2FAx_dOY8UkZJffeirDic--V7ku68B82R21cR9Hi5ZbFd97rdbQnz4HI1wMV0-U-ouPtwDwxQiGULMP/w400-h288/NVIDIAInvestHistory.jpg" width="400" /></a></div><p style="text-align: justify;">I also computed a sales to capital ratio, measuring the dollars of sales for each dollar of capital invested. In 2022, that number, for NVIDIA, was 0.65, indicating that this is definitely not a capital-light business and that NVIDIA has invested heavily to get to where it is today, as a company.</p><p><i>3. With a Mega Market Payoff</i></p><p style="text-align: justify;"><span> NVIDIA's success on the operating front has impressed financial markets, and its rise in market capitalization from its IPO days to a trillion-dollar value can be seen below:</span><br /></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhiRji-4Nn1fdmPac2PB-4PLw4sHh1ONMYpF6o62EZxOPnmLrvqRBWORmVhDfUTnwAJMtfl7beyC4EQCadW1o6oxm4PflXuEQCGS3vQeTSoViZcxr4nH8-hd_rYklycBPOMngnJuI2gAi6GEjwlWuHTNYb4-UFEPWdPHB1amcTI3EM_oo4o8hlXsEJLwlA/s1792/NVIDIAMktCap.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1290" data-original-width="1792" height="288" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhiRji-4Nn1fdmPac2PB-4PLw4sHh1ONMYpF6o62EZxOPnmLrvqRBWORmVhDfUTnwAJMtfl7beyC4EQCadW1o6oxm4PflXuEQCGS3vQeTSoViZcxr4nH8-hd_rYklycBPOMngnJuI2gAi6GEjwlWuHTNYb4-UFEPWdPHB1amcTI3EM_oo4o8hlXsEJLwlA/w400-h288/NVIDIAMktCap.jpg" width="400" /></a></div><div style="text-align: justify;">I know that there are many who are regretting their lack of foresight, in not owning NVIDIA through its entire run, but recognize that this was not a smooth ride to the top. In fact, the company had near-death experiences, at least in market value term, in 2002 and 2008, losing more than 80% of its market value. That said, I owe my lucky run with NVIDIA to one of those downturns in 2018, when the company lost more than 50% of its market value, and it is a lesson that I hope will come through this chart. Even the biggest winners in the market have had periods when investors have turned intensely negative on their prospects, making them attractive as investments for value-focused investors.</div><p></p><p><b>AI: From Promise to Profits</b></p><p><b> </b>Since much of the run-up in NVIDIA in the last few months has come from talk about AI, it is worth taking a detour and examining why AI has become such a powerful market driver, and perhaps looking at the past for guidance on how it will play out for investors and businesses.</p><p><i>Revolutionary or Incremental Change?</i></p><p style="text-align: justify;"><i> </i>I am old enough to be both a believer and a skeptic on revolutionary changes in markets, having seen major disruptors play out both in my personal life and my portfolio, starting with personal computers in the 1980s, the dot-com/online revolution in the 1990s, followed by smartphones in the first decade of this century and social media in the last decade. What set these changes apart was that they not only affected wide swathes of businesses, some positively and some adversely, but that they also changed the ways that we live, work and interact. In parallel, we have also seen changes that are more incremental, and while significant in their capacity to create new businesses and disruption, don't quite qualify as revolutionary. I won't claim to have any special skills in being able to distinguish between the two (revolutionary versus incremental), but I have to keep trying, since failing to do so will result in my losing perspective and making investing mistakes. Thus, I was unable to share the belief that some seemed to have about the "Cloud" and "Metaverse" businesses being revolutionary, since I saw them more as more incremental than revolutionary change. </p><p style="text-align: justify;"><span> So, where does AI fall on this spectrum from revolutionary to incremental to minimalist change? A year ago, I would have put it in the incremental column, but <a href="https://openai.com/blog/chatgpt">ChatGPT </a>has changed my perspective. That was not because ChatGPT was at the cutting edge of AI technology, which it is not, but because it made AI relatable to everyone. As I watched my wife, who teaches fifth grade, grapple with students using ChatGPT to do homework assignments. and with my own students asking ChatGPT questions about valuation that they would have asked me directly, the potential for AI to upend life and work is visible, though it is difficult to separate hype from reality.</span><span style="text-align: left;"> </span></p><p><i>Business Effects</i></p><p><i> </i>If AI is revolutionary change and will be a key market driver for this decade, what does this mean for investors? Looking back at the revolutionary changes from the last four decades (PCs, dot-com/internet, smartphones and social media), there are some lessons that may have application to the AI business.<br /></p><p></p><ol style="text-align: left;"><li style="text-align: justify;"><u>A Net Positive for Markets?</u> Does revolutionary change help the overall economy and/or equity markets? The results from the last four decades is mixed. The PC-driven tech revolution of the 1980s coincided with a decade of high stock market returns, as did the dot-com boom in the next decade, but the first decade of this century was one of the worst in market history as stock prices flatlined. Stocks did well again over the last decade, with technology as the big winner, and over the four decades of change (1980-2022), the annual return on stocks has been marginally higher than in the five decades prior. <table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg-kwPbFToPi6EKDEJe2MR8kz7TYFQxrgjQ2qre8YHXAG9cEtGFxzgPOd7l0tOyNQuWCexJq_kvUKBPk7xLK4ahY44OfgxYSXo_ELI_iIGgPOezCVQE9hBUesAVYu9TlKEPcCUEVwGBw0cvyag5jDzjyxLekl_7x3Taq9tX_F3MU78EerFGY6S8ljAQbfs/s1690/USStockReturns.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1248" data-original-width="1690" height="295" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg-kwPbFToPi6EKDEJe2MR8kz7TYFQxrgjQ2qre8YHXAG9cEtGFxzgPOd7l0tOyNQuWCexJq_kvUKBPk7xLK4ahY44OfgxYSXo_ELI_iIGgPOezCVQE9hBUesAVYu9TlKEPcCUEVwGBw0cvyag5jDzjyxLekl_7x3Taq9tX_F3MU78EerFGY6S8ljAQbfs/w400-h295/USStockReturns.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/histretSP.xlsx">Historical Stock Returns for US</a></td></tr></tbody></table><br /><span style="text-align: justify;">Given equity market volatility, four decades is a short time period, and the most that we can discern from this data is that the technological changes have been a net positive, for markets, albeit with added volatility for investors.</span></li><li style="text-align: left;"><u style="text-align: justify;">With a few Big Winners and Lots of Wannabes and Losers</u><span style="text-align: justify;">: </span>It is indisputable that each of the revolutionary changes of the last four decades has created winners within the space, but a few caveats have also emerged. The first is that these changes have given rise to businesses where there are <i>a few big winners</i>, with a few companies dominating the space, and we have seen this paradigm play out with software, online commerce, smartphones and social media. The second is that the e<i>arly leaders in these businesses have often fallen to the wayside</i> and not become the big winners. Finally, each of these businesses, successful though they have been in the aggregate, have seen more than their share of false starts and failures along the way. For investors, the lesson has to be that investing in revolutionary change, ahead of others in the market, does not translate into high returns, if you back the wrong players in the race, or more importantly, miss the big winners. It is true that at this very early stage of the AI game, the market has anointed NVIDIA and Microsoft as big winners, but it is entirely possible that a decade from now, we will be looking at different winners. At the stage of the hype cycle, it is also true that almost every company is trying to wear the AI mantle, just as every company in the 1990s aspired to have a dot-com presence and many companies claimed to have "user-intensive" platforms in the last one, As investors, separating the wheat from the chaff will only get more difficult in the coming months and years, and it is part of the learning process. To the argument that you could buy a portfolio of companies that will benefit from AI and make money from the few that succeed, past market experience suggests that this portfolio is more likely to be over than under priced.</li><li style="text-align: left;"><u style="text-align: justify;">With Disruption</u><span style="text-align: justify;">: </span>The market is littered with the carcasses of what used to be successful businesses that have been disrupted by technological change. Investors in these disrupted companies not only lose money, as they get disrupted, but worse, invest even more in them, drawn by their "cheapness". This happened, just to provide two examples, with investors in the brick-and-mortar retail companies that were devastated by online retail, and with investors in the newspaper/traditional ad companies that were upended by online advertising. If AI succeeds in its promise, will there be businesses that are upended and disrupted? Of course, but we are in the hype phase, where much more will be promised than can be delivered, but the biggest targets will come into focus sooner rather than later.</li></ol><div style="text-align: justify;">The bottom line is that even if we all agree that AI will change the way businesses and individuals behave in future years, there is no low-risk path for investors to monetize this belief. </div><div style="text-align: justify;"><i><br /></i></div><div style="text-align: justify;"><i>Value Effects</i></div><div style="text-align: justify;"><i> </i>If history is any guide, we are in the hype phase of AI, where it is oversold as the solution to just about every problem known to man, and used to justify large price premiums for the companies in its orbit, without any attempt to quantify and back up these premiums. The primary argument that will be used by those selling these AI premiums is that there is too much uncertainty about how AI will affect numbers in the future, an argument that is at odds with paying numbers up front for those expectations. In short, if you are paying a high price for an AI effect in a company, it behooves you to put aside your aversion to making estimates, and use your judgment (and data) to arrive at the effect of AI on cashflows, growth and risk, and by extension, on value.</div><div style="text-align: justify;"><span> In making these estimates, it does make sense to break down AI companies based upon what part of the AI ecosystem they inhabit, and I would suggest the following breakdown:</span><br /></div><div style="text-align: justify;"><ul><li><u>Hardware and Infrastructure</u>: Every major change over the last few decades has brought with it requirements in terms of hardware and infrastructure, and AI is no exception. As you will see in the next section, the AI effect on NVIDIA comes from the increased demand for <a href="https://cset.georgetown.edu/publication/ai-chips-what-they-are-and-why-they-matter/">AI-optimized computer chips</a>, and as that market is expected to grow exponentially, the companies that can grab a large share of this market will benefit. There are undoubtedly other investments in infrastructure that will be needed to make the AI promise a reality, and the companies that are on a pathway to delivering this infrastructure will gain, as a consequence.<br /></li><li><u>Software</u>: AI hardware, by itself, has little value unless it is twinned with software that can take advantage of that computing power. This software can take multiple forms, from AI platforms, chatbots, deep learning algorithms (including image and voice recognition, as well as natural language processing) and machine learning, and while there is less form and more uncertainty to this part of the AI business, it potentially has much greater upside than hardware, precisely for the same reason.<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhTj0DcyRV31VCOt7fHun6s82zim4cZ5BKItrJr8926W9916Dd9W2cpVVxRRwfvnnlWnrVHMZfX8GxUJKbAqYoGUffR0Y-PXLmLrDL_CXOGOrAPijyrkvmHSUvTM9jNvcXFCnIwCbuVSMksjjUhD2i_ewEi7euU1pmYhZlxKPh81x9sPl4y4ig7lJpBUpQ/s875/AISoftwareCategories.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="468" data-original-width="875" height="214" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhTj0DcyRV31VCOt7fHun6s82zim4cZ5BKItrJr8926W9916Dd9W2cpVVxRRwfvnnlWnrVHMZfX8GxUJKbAqYoGUffR0Y-PXLmLrDL_CXOGOrAPijyrkvmHSUvTM9jNvcXFCnIwCbuVSMksjjUhD2i_ewEi7euU1pmYhZlxKPh81x9sPl4y4ig7lJpBUpQ/w400-h214/AISoftwareCategories.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://www.g2.com/categories/artificial-intelligence">Source</a></td></tr></tbody></table><br /></li><li><u>Data</u>: Since AI requires immense amounts of data, there will be businesses that will gain value from collecting and processing data specifically for AI applications. Big data, used more as a buzzword than a business proposition, over the last decade may finally find its place in the value chain, when twinned with AI, but that pathway will not be linear or predictable. </li><li><u>Applications</u>: For companies that are more consumers of AI than its purveyors, the promise of AI is that it will change the way they do business, with positive and negative implications. The biggest pluses of AI, at least as presented by its promoters, is that it will allow companies to reduce costs (primarily by replacing manual labor with AI-driven applications) and make them more efficient, and by extension, more profitable. Even if I concede the first claim (though I think that the AI replacements will be neither as efficient nor as cost-saving as promised), I am even more wary of the second claim for a simple reason. If every company has AI, and AI reduces costs and increases efficiency as promised for all of them, it is far more likely that they will end up with lower prices for their products/services and not higher profits. At the risk of repeating one of my favorite sayings, "If everyone has it, no one does" and it is the basis for my argument that AI, if it succeeds, will make companies less profitable, in the aggregate. The other minus of AI is that if it delivers on even a portion of its promise of automating aspects of business, it will be damaging and perhaps even devastating for existing companies that derive their value currently from delivering these services for lucrative fees. In these businesses, AI will not just be a zero-sum game, but a negative-sum one.</li></ul></div><div style="text-align: justify;"><span>On the specific questions of how AI will affect investing, in general, and active investing, in specific, I believe that if it is used as a tool, it can enrich valuation and </span>investing, and I look forward to being able to develop valuation narratives and numbers, with its aid. For those who are active investors, individuals as well as institutions, I believe that AI will make a difficult game (delivering excess returns or alpha from investing) even more so. Any edge you have as an active investor will be more quickly replicated in an AI world, and to the extent that AI tools will be accessible and available to every investor, by itself, AI will not be a sustainable edge for any active investor. </div><p></p><p></p><p><i>Social Effects</i></p><p style="text-align: justify;"><span> Will AI make our lives easier or more difficult? More generally, will it make the world a better or worse place to inhabit? I know that there are some advocates of AI who paint a picture of goodness, where AI takes over the menial tasks that </span>presumably cause us boredom and brings an unbiased eye to data analysis that lead to better decisions. I know that there are others who see AI as an instrument that big companies will use to control minds and acquire power. With the experience of the big changes that have engulfed us in the last few decades still fresh, I would argue that they are both right. AI will be a plus is some occupations and aspects of our lives, just as it will create unintended and adverse consequences in others.</p><p style="text-align: justify;"><span> There are some who believe that AI can be held in check and made to serve its more noble impulses, by restricting or regulating its development, but I am not as optimistic for many reasons. First, I believe that both regulators and legislators are woefully incapable of understanding the mechanics of AI, let alone pass sensible restrictions on its usage, and even if they do, their motives are not altruistic. Second, any regulation or law that is aimed at preventing AI's excesses will almost certainly set in motion unintended consequences, that at least in some cases will be worse than the problems that the </span>regulation/law was supposed to hold in check. Third, having seen how badly regulators and legislators have handled the consequences of the social media explosion, I am skeptical that they will even know where to start with AI. While this is a pessimistic take, I believe that it a realistic one, and that just as with social media, it will be up to us, as consumers of AI products and services, to try to draw lines and separate good from bad. We may not succeed, but what choice do we have, but to try?</p><p><i>The AI Chip Story</i></p><p style="text-align: justify;"><i> </i>The AI story has particular resonance with NVIDIA because unlike most other companies, where it is mostly hand-waving about potential, it has substance in place already and a market that is its target. In particular, NVIDIA has spent much of the last few years investing and developing products for a nascent AI market. This lead time has given NVIDIA not just market leadership, but revenues and profits already. Much of the excited reaction to NVIDIA's most recent earnings report came from the company reporting a surge in its data center revenues, with much of the increase coming from AI chips. While the company does not explicitly break out how much of the data center revenues are from AI chips, it is estimated that the total market for those chips in 2022 was about $15 billion, with NVIDIA holding a dominant market share of about 80%. If those estimates are right, the bulk of the data center revenues for NVIDIA in 2022, which amounted to $15 billion in all, comes from AI-optimized chips.<br /></p><p style="text-align: justify;"><span> The ChatGPT jolt to market expectations has played out in increases in expected growth of the AI chip market over the next decade, with estimates for the overall AI chip market in 2030 ranging from $200 billion at the low end to close to $300 billion at the high end. While there is a huge amount of uncertainty about this estimate, there are two assertions that can be made about NVIDIA's presence in this business. The first is that this will be the growth engine for NVIDIA's revenues over the next decade, even as their gaming and other chip revenue growth levels off. The second is that NVIDIA has a lead over its competition, and while AMD, Intel and TSMC will all allocate resources to building their AI businesses, NVIDIA's dominance will not crack easily.</span><br /></p><p><b>NVIDIA: Valuation and Decision Time</b></p><p style="text-align: justify;"><span> As you look at NVIDIA's growth and success in the last decade, and its recent ascent into the rarefied air of "trillion dollar market cap" companies, there are two impulses that come into play. One is to extrapolate the past and assume that assume that the company will continue to not just succeed in the future, but do so in a way that beats the market's expectations for it. The other is to argue that the outsized success of the past has raised investors expectations so much that it will be difficult for the company to meet them. In my story, I will draw on both impulses, and try to thread the needle on the company.</span></p><p><i>Story and Valuation</i></p><p style="text-align: justify;"><span style="font-style: italic;"> </span><i> </i>The driver of NVIDIA's success has been its high-performance GPU cards, but it is very likely that the businesses that bought these cards and drove NVIDIA's success in the last decade will be different from the businesses that will make it successful in the next one. For much of the last decade, it was gaming and crypto users that allowed the company to set itself apart from the competition, but the bad news is that both of these markets are maturing, with lower expected growth in the future. The good news, for NVIDIA, is that it has two other businesses that are ready to step in and contribute to growth. The first is AI, where NVIDIA commands a hefty market share of what is now a relatively small market, but one that is almost certain to grow ten-fold or greater over the decade. The other is in the automobiles business, where more powerful computing is seen as the ingredient needed to open up automated driving and other enhancements. NVIDIA is only a small player in this space, and while it does not enjoy the dominance that it does in AI, a growing market will allow NVIDIA to acquire a significant market share. </p><p><span> I will start with a familiar construct (at least to those who follow my valuations), and break down the inputs that drive value as a precursor to introducing my NVIDIA story:</span><br /></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEifycePfSnqMorncakmdjAUWQWpAHZn_qKysqpSvLoNnRr9-CMJHkexCwtfhIktQMUGaekBoGit1GpaXanquPjcJqUgzs3KpBUODQMsgssZKNVUj-qQjWnS4RD8Y18p21JkFnZYB6b8GPpWmxmuGz8TCxLMbIQ3xn7CGwY4qH0SSze7GBUA7NfxjrMZkrE/s1484/ValueDrivers.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="698" data-original-width="1484" height="189" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEifycePfSnqMorncakmdjAUWQWpAHZn_qKysqpSvLoNnRr9-CMJHkexCwtfhIktQMUGaekBoGit1GpaXanquPjcJqUgzs3KpBUODQMsgssZKNVUj-qQjWnS4RD8Y18p21JkFnZYB6b8GPpWmxmuGz8TCxLMbIQ3xn7CGwY4qH0SSze7GBUA7NfxjrMZkrE/w400-h189/ValueDrivers.jpg" width="400" /></a></div><div style="text-align: justify;">Put simply, the value of a company is a function of four broad inputs - revenue growth, as a stand-in for its growth potential, a target operating margin as a proxy for profitability, a reinvestment scalar (I use sales to invested capital) as a measure of the efficiency with which it delivers growth and a cost of capital & failure rate to incorporate risk. </div><div style="text-align: justify;"><span> W</span>hile all of NVIDIA's different businesses (AI, Auto, Gaming) share some common features in terms of gross and operating margins, and requiring R&D for innovation, the businesses are diverging in terms of revenue growth potential. </div><p></p><p></p><ul style="text-align: left;"><li style="text-align: justify;"><u>Revenue Growth</u>: NVIDIA will remain a high growth company for two reasons. The first is that in spite of its scaling up due to growth over the last decade, at least in terms of revenues, it has a modest market share of the overall semiconductor market, with revenues that are less than half of the revenues posted by Intel or TSMC. The second, and more important reason, is that while its gaming revenue growth is starting to flag, it is well-positioned in AI and Auto, two markets poised for rapid growth. In my story, I will a<u>ssume that these markets will deliver on their growth promise</u> and that NVIDIA will maintain <u>a dominant, albeit lower, market share of the AI chip business, while gaining a significant share (15%) of the Auto chip business</u>:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEilC05cAP2hD_UtvrLiTR8dgdkaxdu9Zg5Gae4MUNgcff1lWPYyOP8uFyjI0K7FjWqP1ADoHYGC9bTHIA8VRqZN0HpRhh1sLa4sFrE0_hXZXrtnsaMUPjN7HZ40S1P9Yuj8Z2xLLeUAR2z52eKdQyoDv-I6swLw2jloTZPRjPhSWavQ-lqGjSRfRXfGkP0/s1330/RevenueStory.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="214" data-original-width="1330" height="64" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEilC05cAP2hD_UtvrLiTR8dgdkaxdu9Zg5Gae4MUNgcff1lWPYyOP8uFyjI0K7FjWqP1ADoHYGC9bTHIA8VRqZN0HpRhh1sLa4sFrE0_hXZXrtnsaMUPjN7HZ40S1P9Yuj8Z2xLLeUAR2z52eKdQyoDv-I6swLw2jloTZPRjPhSWavQ-lqGjSRfRXfGkP0/w400-h64/RevenueStory.jpg" width="400" /></a></div>Clearly, there is room for disagreement on both total market and market share for the AI and Auto businesses, and I will return to address the effects. I am still allowing the gaming and other business revenues to grow at 15% a year, a healthy number that reflects other businesses (like the omniverse) contributing to the top line.</li><li style="text-align: justify;"><u>Profitability</u>: The semiconductor business has a cost structure that has relatively little flex to it, but I will assume in my NVIDIA story that the right margin to focus on is the<u> R&D adjusted version</u>, and that NVIDIA will bounce back quickly from its 2022 margin setback to deliver higher margins than its peer group. While <u>my target R&D adjusted margin of 40% may look high</u>, it is worth remembering that the company delivered 42.5% as margin in 2020 and 38.4% as margin in 2021. As noted earlier, NVIDIA's dependence on TSMC for the production of the chips it sells implies that any increases in margins have to come more from price increases than cost efficiencies.</li><li style="text-align: justify;"><u>Investment Efficiency</u>: NVIDIA has invested heavily in the last decade, generating only 65 cents in revenues for every dollar of capital invested (including the investment in R&D), in 2022. That investment has clearly been productive, as the company has been able to find growth and generate excess returns. I believe that given the company's larger scale, with the payoff from past investments augmenting revenues, <u>the company's sales to invested capital will approach the global industry median, which is $1.15 in revenues for every dollar of capital invested.</u></li><li style="text-align: justify;"><u>Risk</u>: As we noted in the section on the semiconductor business, this remains, even for its most successful proponents, a cyclical business, and that cyclicality contributes to keeping the cost of capital higher than for the median company. I estimated NVIDIA's cost of capital based upon its geographic exposure and very low debt ratio to be 13.13%, but chose to use the industry average for US semiconductor companies, which was 12.21%, as the cost of capital in the initial growth period. Over time, <u>I will assume that this cost of capital will drift down towards the overall market average cost of capital of 8.85%</u>.</li></ul><div style="text-align: justify;">With this story in place, and the resulting input numbers, the value that I get for NVIDIA is shown below:</div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg7gIpeuXQrMuvy1jDlqCOMcW19Lx2qlrxtO0Y7MPQboHe1OpC-azgBHvA-HJp2Wx_ht8HfbE3Cx4kCsFU-iKzRNmkoSmq-iTYALNa-17Y833JT-aGq9D5WkNzMkk5t7f1lpVAtq_5OrTyEXiI9caLuCevY_DeKfSe8JpzI5biwOMjqBed6BQaIQeNVg7A/s1322/NVIDIAValuationPicture.jpg" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="537" data-original-width="1322" height="163" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg7gIpeuXQrMuvy1jDlqCOMcW19Lx2qlrxtO0Y7MPQboHe1OpC-azgBHvA-HJp2Wx_ht8HfbE3Cx4kCsFU-iKzRNmkoSmq-iTYALNa-17Y833JT-aGq9D5WkNzMkk5t7f1lpVAtq_5OrTyEXiI9caLuCevY_DeKfSe8JpzI5biwOMjqBed6BQaIQeNVg7A/w400-h163/NVIDIAValuationPicture.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/NVIDIA2023.xlsx">Download spreadsheet</a><br /><br /></i></td></tr></tbody></table><div style="text-align: justify;"><span style="text-align: left;">Based on story, the value per share that I arrive at for NVIDIA on June 10, 2023, is about $240, well below the stock price of $409 that the stock traded at on June 10, 2023. (The stock has risen since then to $434 a share on June 20, 2023.)</span></div><p><i>Simulation and Breakeven Analysis</i></p><p style="text-align: justify;"><i> </i>At the risk of stating the obvious, I am making assumptions about market growth and market share that you may or even should take issue with. In the interests of examining how value varies as a function of the assumptions, I fell back on an approach that I find helps me deal with estimation uncertainty, which is a simulation. I built the simulation around the key inputs, including:<br /></p><p></p><ol style="text-align: left;"><li><div style="text-align: justify;"><u>Revenues</u>: In my base case valuation, incorporating high growth in the AI and Auto Chip businesses, and giving NVIDIA a dominant share of the first and a significant share of the second resulted in revenues of $267 billion in 2033. However, this is built on assumptions about the future for both markets that can be wrong, in either direction, and that uncertainty is incorporated into the simulation as distributions for each of the three segments of NVIDIA's revenues:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgdBQrOW8M7XFEnwO0GXAYH_IbpuSI9cYqtb6RWZGpsR_9VciTx2lHxNtnm2XPHcK-li4ALMq-Cax_qb3tlJtyYvv7u8yhTVKZ-d_qH9cpwKUXqcgtWNjvmR7Xjq4QagofxzXbDCwpkC1u_k2DnFDXFU_pvwqVCo7xldMDd5SxF1acxAAb7fN849Ra1gFc/s1180/RevenueSimulation.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="244" data-original-width="1180" height="83" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgdBQrOW8M7XFEnwO0GXAYH_IbpuSI9cYqtb6RWZGpsR_9VciTx2lHxNtnm2XPHcK-li4ALMq-Cax_qb3tlJtyYvv7u8yhTVKZ-d_qH9cpwKUXqcgtWNjvmR7Xjq4QagofxzXbDCwpkC1u_k2DnFDXFU_pvwqVCo7xldMDd5SxF1acxAAb7fN849Ra1gFc/w400-h83/RevenueSimulation.jpg" width="400" /></a></div><div style="text-align: justify;">As these distributions play out, there are simulations where NVIDIA's revenues exceed $600 billion and some where it is less than $100 billion, in 2033.</div></li><li style="text-align: justify;"><u>Operating Margin</u>: In my base case story, I increase NVIDIA's R&D adjusted margin to 35% next year, and target an operating margin of 40% in 2027, that it maintains in perpetuity after that. While I provide my justifications for those assumptions, it is entirely possible that I am being too optimistic, in raising margins that are already above industry-average levels to even higher values, or that I am being pessimistic, and not factoring in NVIDIA's higher pricing power in the AI and Auto businesses. I capture that uncertainty in my (triangular) distribution for the target operating margin in 2027 (and beyond), where I set the upper end of the range at 50%, which would be a significant premium over NVIDIA's own past margins, and the lower end at 30%, which would put them closer to their peer group.</li><li style="text-align: justify;"><u>Reinvestment</u>: The input that drives reinvestment is the sales to capital ratio, and while I set NVIDIA's sales to capital ratio at 1.15, the semiconductor industry average, it is possible that the company may continue to reinvest at closer to its historic average of 0.65 (leading to more reinvestment). Alternatively, it is also conceivable that the company's investments over the last decade, especially in its AI chips, will put it on a glide path to reinvesting a lot less in the next decade (a sales to capital ratio closer to 1.94, the 75th percentile of the semiconductor business.</li><li><u>Risk</u>: Ruling out failure risk, and focusing on the cost of capital, I center my estimates on 12.21%, the industry average that I used in the base case, but allow for the possibility that a growing AI business may reduce the cyclicality of revenues, lowering the cost of capital towards the market-average of 8.85%) or conversely, increase uncertainty and uncertainty, raising the cost of capital towards 15%, the 90th percentile of global companies):</li></ol><p></p><p>With these estimates in place, the simulated value per share is shown below:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEghnr6aGFnOkeY5bYL9jx03JWgJIto-yozP2_RAP9WCxjiML2DxCxj-P9ahmpz-msI6t90vih-iRbKbudmc8q2Q_BtHV2c3XIdK54cVHSW565sLcI5MQ-NsUKvV1GAh73hnV9sFS4s1pqN56mTE1JMptgb0OZZqjyohEodqoeETdSVtpVq-8g-v1yBczUw/s745/NVIDIASimulation.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="538" data-original-width="745" height="289" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEghnr6aGFnOkeY5bYL9jx03JWgJIto-yozP2_RAP9WCxjiML2DxCxj-P9ahmpz-msI6t90vih-iRbKbudmc8q2Q_BtHV2c3XIdK54cVHSW565sLcI5MQ-NsUKvV1GAh73hnV9sFS4s1pqN56mTE1JMptgb0OZZqjyohEodqoeETdSVtpVq-8g-v1yBczUw/w400-h289/NVIDIASimulation.jpg" width="400" /></a></div><p style="text-align: justify;">To the question of whether NVIDIA could be worth $400 a share or more, the answer is yes, but the odds, at least based on my estimates, are low. In fact, the current stock price is pushing towards the 95th percentile of my value distribution.</p><p style="text-align: justify;"><span> An alternative look at what has to happen for NVIDIA's intrinsic value to exceed $400, I looked at the two key variables that determine its value: revenues in year 10 and operating margins:</span><br /></p><p></p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhJmMyNpydMOhL6tnSWCbRtWEojZ7l-oiu0_Cc9uAu7_Vz8U_fecKQLrN2QIJ4f0mgLFgHpOu03CsLpI0g2gLjlfMThEsIVglZ-N-g1lrgKx8YuNu1wjZHgymYXV68ClCkyuEAwkvZk0wNNj9fjgscm0YEXi43IE3X89gKZux2qLSeXgpJNBhbHw0AJvvY/s860/NVIDIABreakevenTable.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="240" data-original-width="860" height="111" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhJmMyNpydMOhL6tnSWCbRtWEojZ7l-oiu0_Cc9uAu7_Vz8U_fecKQLrN2QIJ4f0mgLFgHpOu03CsLpI0g2gLjlfMThEsIVglZ-N-g1lrgKx8YuNu1wjZHgymYXV68ClCkyuEAwkvZk0wNNj9fjgscm0YEXi43IE3X89gKZux2qLSeXgpJNBhbHw0AJvvY/w400-h111/NVIDIABreakevenTable.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/NVIDIA2023.xlsx">Download spreadsheet</a></i></td></tr></tbody></table><br /><div style="text-align: justify;">This table reinforces the findings in the simulation, insofar as it shows that there are plausible paths that lead to the current price being a fair value or under value, but these paths require a daunting combination of extraordinary revenue growth and super-normal margins. In my view, a target margin of 50% is pushing the limits of possibility, in the semiconductor business, and if NVIDIA finds a way to deliver value that justifies current pricing, it has to be through explosive revenue growth. Put simply, you need another market or two, with potential similar to the AI market, where NVIDIA can wield a dominant market share to justify its pricing.</div><p></p><p><b>Judgment Day</b></p><p><b> </b>As I noted at the start of this post, I have a selfish reason for valuing NVIDIA, which is that I own it shares and I am exposed to its price movements, and much more so now than I was when I bought the stock in 2018, as a result of its inflated pricing. I have also been open about the fact that my investment philosophy is built around value, buying when price is less than value and by the same token, selling when price is much higher than value.<br /></p><p><i>NVIDIA as an Investment</i></p><p style="text-align: justify;"><span> I love NVIDIA as a company, and have nothing but praise for Jensen Huang's leadership of the company. Operating in a business where revenue growth was becoming scarce (single digit revenue growth) and segments of the product market are commoditized (lowering margins), NVIDIA found a pathway to not just deliver growth, but growth with superior profit margins and excess returns. While some may argue that NVIDIA was lucky to catch a growth spurt in the gaming and crypto businesses, a closer look at its successes suggests that it was not luck, but foresight, that put the company in a position to succeed. In fact, as the AI and Auto businesses look poised to grow, NVIDIA's positioning in both indicates that this is a company that is built to be opportunistic. My valuation </span>story for NVIDIA reflects all of these positive features, and assumes that they will continue into the next decade, but t<u>hat upbeat narrative still yields a value well below the current price</u>.</p><p style="text-align: justify;"><span> I would be lying if I said that selling one of my biggest winners is easy, especially since there is a plausible pathway, albeit a low-probability one, that the company will be able to deliver solid returns, at current prices. I chose a path that splits the difference, selling half of my holdings and cashing in on my profits, and holding on to the other half, more for the optionality (that the company will find other new markets to enter in the next decade). The value purists can argue, with justification, that I am acting inconsistently, given my value philosophy, but I am pragmatist, not a purist, and this works for me. It does open up an interesting question of whether you should continue to hold a stock in your portfolio that you would not buy at today's stock prices, and it is one that I will return to in a future post.</span><br /></p><p><i>NVIDIA as a Trade</i></p><p style="text-align: justify;"><span><span> I have written many posts about the divide between investing and trading, arguing that the two are philosophically different. In investing, you assess the value of a stock, compare that value to the price, act on that difference (buying when price is less than value and selling when it is greater) and hope to make money as the gap between value and price </span>closes. In trading, you buy at a low price, hoping to sell at a higher price, but you are agnostic about what causes the price to move and whether that movement is rational or not. </span></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjup94shz3-9BpzjjhxCdYVUoM8tyFiOjw6O-er-CXnDGxuiYjKR9TgyT7cyEFlxvxMueHblJD9HfVQHLT_RgSsGy99hL9xGjSFinXeJCiy-LCxZHBoi5DRKob6aCY7KJkr-pCyxOIemKsUX6STidHR19SZ_kYCY-aJnWrXVNC3_If9IqtAs4IeGoZurQc/s1272/InvestingvsTrading.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="560" data-original-width="1272" height="176" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjup94shz3-9BpzjjhxCdYVUoM8tyFiOjw6O-er-CXnDGxuiYjKR9TgyT7cyEFlxvxMueHblJD9HfVQHLT_RgSsGy99hL9xGjSFinXeJCiy-LCxZHBoi5DRKob6aCY7KJkr-pCyxOIemKsUX6STidHR19SZ_kYCY-aJnWrXVNC3_If9IqtAs4IeGoZurQc/w400-h176/InvestingvsTrading.jpg" width="400" /></a></div><p></p><p style="text-align: justify;">Bringing this difference to play in NVIDIA, you can see why, no matter what you think about NVIDIA's value, you may continue to trade it. Thus, even if you believe that NVIDIA's value is well below its price, you may buy NVIDIA on the expectation that the stock will continue to rise, borne upwards by momentum or incremental information. Given the strength of momentum as a market-driver, you may very well generate high returns over the next weeks, months or even years, and you should not let "value scolds" get in the way of your enjoyment of your winnings. My only pushback would be against those who argue that momentum can carry a stock forward forever, since it is the gift that both gives and takes away. The strength of momentum in the rise in NVIDIA's stock price will be played out in the the opposite direction, when (not if) momentum shifts, and if you are trading NVIDIA, you should be working on indicators that give you early warning of those shifts, not worrying about value.</p><p style="text-align: justify;"><b>The Bottom Line</b></p><p style="text-align: justify;"><span> As we hear the relentless pitches for AI, and how it will change our live and affect our investments, there are lessons, to draw on, from the other big changes that we have seen over our lifetime. The first is that even if you buy into the argument that AI will change the ways that we work and play, it does not necessarily follow that investing in AI-related companies will yield returns. In other words, you can get the macro story right, but you need to also consider how that story plays out across </span>companies to be able to generate returns. The second, is that refusing to make estimates or judgments about how AI will affect the fundamentals (cash flows, growth and risk) in a business, just because you face significant uncertainty, will not make that uncertainty go away. Instead, it will create a vacuum that will be filled by arbitrary AI premiums and make us more exposed to scams and wannabes. The third is that, as a society, it is unclear whether adding AI to the mix will make us better or worse off, since every big technological change seems to bring with it unintended consequences. To end, I was considering asking ChatGPT to write this post for me, using my own language and history, and I am open to the possibility that it could do a better job than I have. Stay tuned!</p><p style="text-align: justify;"><b>YouTube</b></p><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/2N0IDShsTyc" title="YouTube video player" width="560"></iframe><p style="text-align: justify;"><b>Spreadsheets</b></p><p style="text-align: justify;"></p><ol><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/NVIDIA2023.xlsx" target="_blank">NVIDIA Valuation (June 2023)</a></li></ol></div>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-67461790815904377592023-05-07T17:36:00.005-04:002023-05-07T18:53:36.357-04:00Good (Bad) Banks and Good (Bad) Investments: At the right price...<p style="text-align: justify;">In my last post, I looked at banking as a business, and used a simple banking framework to advance the notion that the key ingredient tying together the banks that have failed so far in 2023 is <u>an absence of stickiness in deposits</u>, created partially by depositor and deposit characteristics (older are stickier than younger) and partly by growth in deposits (high growth increases stickiness). I also used the banking framework to argue that <u>good banks have stickier deposits, with a higher precent of these deposits being non-interest bearing, that they invest in loans and investment securities on which they earn interest rates that cover and exceed the default risk in these investments</u>. While differentiating between good and bad banks can be straightforward, it does not follow that buying good banks and selling bad banks is a good investment strategy, since its success depends entirely on what the market is incorporating into stock prices. An investor who buys a good bank at too high a price, given its goodness, will underperform one who buys a bad bank at too low a price, given its badness. In this post, I will begin by looking at how to value banks and follow up with an examination of investor views of banking have changed, by looking at pricing, before examining divergences in how banks are priced in the market today.</p><p style="text-align: justify;"><b>The Intrinsic Value of Bank Equity</b></p><p style="text-align: justify;"><b> </b>I am a dabbler in all things valuation-related, and I find the process fascinating, as stories about businesses get translated into valuation inputs, and finally into value. I enjoy challenging valuations, but banks remain, at least for me, the last frontier in valuation, simply because so much of what we do in conventional valuation does not work with banks, and a crisis or panic can upend even the most carefully done bank valuation.</p><p style="text-align: justify;"><i>All Equity, All the time!</i></p><p style="text-align: justify;"><span> </span>With most non-financial service businesses, you face a choice in how you approach valuation. You can value the enterprise or the entire business, focusing on valuing the operations or assets of the business, and consider capital as inclusive of both debt and equity. Alternatively, you can value just the equity in the business, focusing on cash flows left over after debt payments and discounting back at a rate of return that reflects the risk that equity investors face:</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg-EPguiZ9n9IeFLm1YhTLaUs1tuGjg-svGzPZrg5XpFVSDYAVRJpNpTF-aRwf2VcPoirsj888F80_Q8AecLyPXcCVxxJ7zh3desgAd_K6h7RTpiBmRoKGC6g74QQo4Q0yEf8cdRZLGNvNeLR-0aHET5kTDgHcQieQ506tj8p23Nc-HY5vMbXpIEYHw/s518/EQuityvsFirms.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="509" data-original-width="518" height="393" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg-EPguiZ9n9IeFLm1YhTLaUs1tuGjg-svGzPZrg5XpFVSDYAVRJpNpTF-aRwf2VcPoirsj888F80_Q8AecLyPXcCVxxJ7zh3desgAd_K6h7RTpiBmRoKGC6g74QQo4Q0yEf8cdRZLGNvNeLR-0aHET5kTDgHcQieQ506tj8p23Nc-HY5vMbXpIEYHw/w400-h393/EQuityvsFirms.jpg" width="400" /></a></div><p></p><p style="text-align: justify;"><span>With banks, this choice does not exist, since debt to a bank can be expansively defined to include deposits as well, making it effectively raw material for the bank's operations, where the objective is borrow money (from depositors and lenders) at a low rate and lend it out or invest it at a higher rate. Consequently, you can only value the equity in a bank, and by extension, the only pricing multiples you can use to price banks are equity multiples (PE, Price to Book etc.). The notion of computing a cost of capital for a bank is fanciful and fruitless, and any attempt to compute an enterprise value for a bank is destined to end in failure.</span></p><p style="text-align: justify;"><span><i>Equity Valuation 101 and Dividend Discount Model</i></span></p><p style="text-align: justify;"><span><span> </span>Staying on equity valuation, the intrinsic value of equity can be written as a function of the cash flows left for equity investors, after reinvestment and taxes, and after all other claim holders have been paid, and the cost of equity:</span></p><p style="text-align: justify;"></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgdB3i6t05XCO7Reg8ED5Rul8x16nox6A6CscUOJj6X94sJ9S_EdZar28jBg2czglfagPkAy-7Uygd5KxVvioBMKRiZLYHcRKfFAPNvKvoUEva-E5AFACaPeOqMmC2CJWkDqOZFia4IcwmONpUgbxIGFwnQUN8A5SimLMKW4cP-WthX64TPAzPQdyvW/s1212/FCFEPicture.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="524" data-original-width="1212" height="173" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgdB3i6t05XCO7Reg8ED5Rul8x16nox6A6CscUOJj6X94sJ9S_EdZar28jBg2czglfagPkAy-7Uygd5KxVvioBMKRiZLYHcRKfFAPNvKvoUEva-E5AFACaPeOqMmC2CJWkDqOZFia4IcwmONpUgbxIGFwnQUN8A5SimLMKW4cP-WthX64TPAzPQdyvW/w400-h173/FCFEPicture.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><p></p><p style="text-align: justify;"><span>Over the decades, analysts trying to put this model into practice with banks have run into trouble estimating cash flows for banks, using the traditional structure, since items like capital expenditures and working capital are impossible to measure at banks. It should come as no surprise that, at least with banks, analysts fell back on the only observable cash flows to equity, i.e., dividends;</span></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiBYwubWdU1_tcVMM3FrkaDiaM10c_RGx1hj20DtTaiEyrAW86r6eXfvYOVEhUpWOF-FDPGFdH2Tg16TMN7_CoFzS3UhqYMTv_ZHOYT6IvNUM_ZZsFqipHra631xQiuSDP7JlF5IbHBHUSXLFlhDJ-mo74wu2XQSibhBC-et3-qH_GTrArzFS-xjF0E/s1547/DDMPicture.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="663" data-original-width="1547" height="171" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiBYwubWdU1_tcVMM3FrkaDiaM10c_RGx1hj20DtTaiEyrAW86r6eXfvYOVEhUpWOF-FDPGFdH2Tg16TMN7_CoFzS3UhqYMTv_ZHOYT6IvNUM_ZZsFqipHra631xQiuSDP7JlF5IbHBHUSXLFlhDJ-mo74wu2XQSibhBC-et3-qH_GTrArzFS-xjF0E/w400-h171/DDMPicture.jpg" width="400" /></a></div><br /><div class="separator" style="clear: both; text-align: center;"><br /></div><p style="text-align: justify;">It is this line of reasoning, i.e., that it is difficult, if not impossible, to estimate banking free cashflows to equity, that I used prior to 2008, when I argued for the use of the dividend discount model to value banks In using the dividend discount model, I was making two implicit assumptions. The first was that <u>banks were run by sensible people</u>, who paid out what they could afford to in dividends, neither holding back on paying dividends nor paying too much in dividends. The other was that <u>the bank regulatory framework operated effectively</u>, preventing banks from overreaching on risk or being under capitalized. </p><p style="text-align: justify;"><i>A Bank FCFE Model</i></p><p style="text-align: justify;"><span> </span>The events of 2008 dispelled me of both delusions that allowed for the use of the dividend discount model, as it became clear that the managers of banks were anything but sensible and the regulatory framework had large holes in it that were exploited. In the years after, I have replaced dividends with a variant on free cash flow to equity, defined through the lens of a banking business, discounted back at a cost of equity reflecting banking risks (duration mismatches, low regulatory capital and riskiness of loan/investment portfolios).</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgzrJdLwYL9Z4rhBvnNnYo-4UURtVHiYJ4fsb9dNInVHSNFnYbIhMwpKhd717m8q-T8zJkEmXd64bQ5O1xP2kavw-H4lJSp5JyV1NV1OHcGpW85NB5mDabk_Y8-Hc3aPlfKIs7kULCYLBVOi5s3mFa-uQsjc6z9hfNw1Rzk8Co3zqCGnSJMWJV_q6AB/s1211/FCFEBankVal.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="532" data-original-width="1211" height="176" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgzrJdLwYL9Z4rhBvnNnYo-4UURtVHiYJ4fsb9dNInVHSNFnYbIhMwpKhd717m8q-T8zJkEmXd64bQ5O1xP2kavw-H4lJSp5JyV1NV1OHcGpW85NB5mDabk_Y8-Hc3aPlfKIs7kULCYLBVOi5s3mFa-uQsjc6z9hfNw1Rzk8Co3zqCGnSJMWJV_q6AB/w400-h176/FCFEBankVal.jpg" width="400" /></a></div><p style="text-align: justify;">Note the differences between the bank FCFE and bank dividend discount models. </p><p style="text-align: justify;"></p><ul><li>The first is that unlike dividends, which are floored at zero, the free cash flow to equity for a growing or severely undercapitalized bank can be negative, reflecting the need to raise fresh equity to survive. </li><li>The other is that by tying cashflows to capitalization, it allows us to bring in that same factor into risk and costs of equity, with under capitalized banks have higher costs of equity. </li><li>As a final component of bank equity value, and 2023 has brought this home to us is the reality that even a healthy, profitable bank can see its value melt away in days, if its depositors decide, for good, bad or no reasons at all, to withdraw their deposits and put the bank into the death spiral from which recovery can be close to impossible. Since this risk is existential, it is almost impossible to build into a discounted cash flow model, which is for a going-concern, and has to be incorporated as a risk of failure.</li></ul><div>In short, the banking version of a FCFE model gives us access to levers that allow us to differentiate across banks and bring in the elements that make some banks better than others.</div><p></p><p style="text-align: justify;"><i>Valuing Citi</i></p><p style="text-align: justify;"><i> </i>Intrinsic valuation models connect only when applied to real companies, and in the table below, I used the Bank FCFE model described above in <u>my valuation of Citi</u> (a choice that may strike you as odd, but which you will understand if you read the rest of my post). To set the table, in the battle of big banks for investor acclaim, Citi has clearly lost the battle not only against JP Morgan Chase, but against most of the other big US banks. It has delivered low growth and subpar profitability, but it has built up buffers in its capital ratios and still has a banking model that delivers a lucrative interest rate spread.<br /></p><p style="text-align: justify;"><span> In my </span>valuation, I will assume that <i>Citi will continue on its cautious, low-growth path</i>, growing its <u>risk-adjusted assets at 3% a year in perpetuity, </u>a little lower than its 3.74% growth rate over the last 5 years. Over time, I expect some improvement in the return on equity, which was 8.78% in 2022, to its five-year average of 9.50%, which is still lower than the cost of equity of 11.67% that I am using for large commercial banks (see picture below for how I am computing an implied cost of equity for the 25 largest banks). Finally, I will assume that the bank will continue to marginally improve its Tier 1 capital ratio, currently at 14.80% to reach a target of 15.00%, in five years:</p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgk0s1hSDGPyn_rSiLjc693noSzwqT5x_lI9GGmmmTgH5JsLryvnTr6S0p1KC0gfbDgLazW6XA1909fy2C74F7_xBQCIV-n6B2JdxwGmyTxyS-TNAW32WKqEieW2XjrqM_FsBYivMELtYZA5-VA4Ox0YbQuPr6-hQREiOzNuPbQLm0NKpkobMtwXSMY/s904/CitiDCF.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="493" data-original-width="904" height="219" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgk0s1hSDGPyn_rSiLjc693noSzwqT5x_lI9GGmmmTgH5JsLryvnTr6S0p1KC0gfbDgLazW6XA1909fy2C74F7_xBQCIV-n6B2JdxwGmyTxyS-TNAW32WKqEieW2XjrqM_FsBYivMELtYZA5-VA4Ox0YbQuPr6-hQREiOzNuPbQLm0NKpkobMtwXSMY/w400-h219/CitiDCF.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/CitiVal2023.xlsx">Download spreadsheet to value Citi (or any bank</a>)</td></tr></tbody></table><p style="text-align: justify;">Note that the combination of low growth and a healthy, current regulatory capital ratio keep the needs for reinvesting in regulatory capital low, allowing for large potential dividends. Those high cash flows, even though they are delivered by a bank that earns and expects to continue to earn an ROE less than its cost of equity translate into a value of equity for Citi of about $69, making it about 32% under valued auto the stock price of $46.32, at close of trading on May 5, 2023. Obviously, you will have very different views about Citi than I do, and you are welcome to<a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/CitiVal2023.xlsx"> download the spreadsheet</a> and input your numbers not just for Citi, but for any bank.</p><p><b>The Pricing of Bank Equity</b></p><p><span> You have heard me say this before, but I don't think there is any harm in repeating this. Value and price are words that are often used interchangeably, but they come from different processes and can yield different numbers for the same asset or company.</span> <br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgCcz-TsGdxUbjs_qN5t1KpZY-F9ZZdWjaOTy9lYCtFoWF_21FvzMxCMpOmikHx5zxD4TV1kLcoJrh2_fZFuiDibv4N3M7vfUozy99786v0qB-LGxzuqIFV0vZ6SzCjzmZqw4rv0wMuHEM3RWv0G3ENIfMHE2WZoA1TYZPIMTv2TPEHGvEYihvL6Iar/s709/PricevsValueBanks.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="325" data-original-width="709" height="184" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgCcz-TsGdxUbjs_qN5t1KpZY-F9ZZdWjaOTy9lYCtFoWF_21FvzMxCMpOmikHx5zxD4TV1kLcoJrh2_fZFuiDibv4N3M7vfUozy99786v0qB-LGxzuqIFV0vZ6SzCjzmZqw4rv0wMuHEM3RWv0G3ENIfMHE2WZoA1TYZPIMTv2TPEHGvEYihvL6Iar/w400-h184/PricevsValueBanks.jpg" width="400" /></a></div><p style="text-align: justify;">Since pricing requires comparison across companies, often with different units (numbers of shares outstanding), we generally convert market values into pricing multiples, to allow for this comparison. As we noted in the last section, the pricing multiples that we use to compare banks have to be equity multiples, with price earnings rations and price to book ratios being the most common choices. </p><p><i>Price to Book Ratio: Choice and Drivers</i></p><p style="text-align: justify;"><span> There is no sector where price to book ratios get used more than in banking and financial services, for two reasons. The first is that the book value of equity for a bank, by becoming the basis for regulatory capital, has operating consequences, since actions or events that lower than book value of equity (an unexpected loss, a regulatory fine, a trading shortfall) can cause a bank to become undercapitalized and go out of business. The other is that marking to market is more common in banks than at other sectors, the hold-to-maturity loophole notwithstanding, and that should make book value of equity a more meaningful figure than book value of equity at a software or a consumer product company. </span><br /></p><p style="text-align: justify;"><span><span> To use the price to book ratio to price banks, I begin by identifying its drivers, and that is simple to do, if you start with an intrinsic equity valuation model. In fact, using the simplest equity valuation model that I can think of, which is a stable growth dividend discount model, we get:</span><br /></span></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjhWSGlxDL2UhU4a3KoJUIg6TiP_jKhcvFkkA2Z9veoKEpgvdOMiVQLgBUrP7F77P2wZZ-1DSv3TNMbYMAYjAzDlcpO_rg1hxvm--x4iidaShVO66HqduRKSm7ZhDVEw_CVbH4ugsmnwAK8oqPqui-Z1UbpBAplVjDNuEshk0u_EYBTBHbKJn3S4gaE/s608/StableDDM.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="84" data-original-width="608" height="44" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjhWSGlxDL2UhU4a3KoJUIg6TiP_jKhcvFkkA2Z9veoKEpgvdOMiVQLgBUrP7F77P2wZZ-1DSv3TNMbYMAYjAzDlcpO_rg1hxvm--x4iidaShVO66HqduRKSm7ZhDVEw_CVbH4ugsmnwAK8oqPqui-Z1UbpBAplVjDNuEshk0u_EYBTBHbKJn3S4gaE/s320/StableDDM.jpg" width="320" /></a></div><span><span><br /></span></span><p></p><p style="text-align: justify;">Dividing both sides by book value of equity, and setting growth rate = (1- Payout ratio) ROE, we can simplify this equation:</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiMCdv6tGrcCbdvGS2u06UavYBUhFdcNh0VjvHdoL6Vvaw_YM52Rp7borBZSC5zbRKLKQqRF1RGhjA7JCrTi-yZStcPrmyobbw0oricokkeWTxQP25baVkOEbkEUdVvZRZa6o4_SpYWqbVoX9RBw2KMPB-nYGanwljdk28HkN_l385I2hnD1yruhRvV/s616/BVEquation.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="104" data-original-width="616" height="54" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiMCdv6tGrcCbdvGS2u06UavYBUhFdcNh0VjvHdoL6Vvaw_YM52Rp7borBZSC5zbRKLKQqRF1RGhjA7JCrTi-yZStcPrmyobbw0oricokkeWTxQP25baVkOEbkEUdVvZRZa6o4_SpYWqbVoX9RBw2KMPB-nYGanwljdk28HkN_l385I2hnD1yruhRvV/s320/BVEquation.jpg" width="320" /></a></div><p></p><p style="text-align: justify;">This equation, in its simple, stable growth form, suggests that whether a bank trades at below or above its book value of equity will be driven by whether investors expect banks to earn more than their cost of equity (price to book>1), roughly the cost of equity (price to book = 1) or less than the cost of equity (price to book <1).</p><p><i>Price to Book for Banks: Over time</i></p><p style="text-align: justify;"><i> </i>To get a measure of how banks are being priced today, it is worth getting perspective as to how investor views on bank profitability and risk have changed over time. To gain this perspective, I looked at the aggregated price to book ratio of all US banks, obtained by first aggregating the market capitalizations of all banks and dividing by the aggregated book equity from 2004 to 2022, at the end of each year, and in May 2023:<br /></p><p><span><span> </span><br /></span></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiHLBAhGAP1dBhEn0GHPhafoXUq_V5cF6-Pob0Br-kSwC_ah4MwZH_did3z5kmQge40P4kI3Qgr6HabjF-sAY_LvKPBEPnwh1XqS1xzX_22DutMb4yMlkKd3Ms34l-ifhvCf7zxPOwJ5tvxDg3snR6StaDOLNk4e7eJ1MDrBlkBsHUpc0D-2405TPpV/s883/AggregayePriceBookChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="637" data-original-width="883" height="289" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiHLBAhGAP1dBhEn0GHPhafoXUq_V5cF6-Pob0Br-kSwC_ah4MwZH_did3z5kmQge40P4kI3Qgr6HabjF-sAY_LvKPBEPnwh1XqS1xzX_22DutMb4yMlkKd3Ms34l-ifhvCf7zxPOwJ5tvxDg3snR6StaDOLNk4e7eJ1MDrBlkBsHUpc0D-2405TPpV/w400-h289/AggregayePriceBookChart.jpg" width="400" /></a></div><div><br /></div><div style="text-align: justify;">If there is a lesson in the graph, it is that the 2008 crisis has left a lasting impression, as US banks have struggled since that crisis to elevate price to book ratios. Even as returns on equity have slowly recovered close to pre-2008 levels, the price to book ratios have not recovered, even as the rest of the market has seen rising price to book ratios, due to lower interest rates. In fact, the 2023 crisis has reduced the aggregate price to book ratio for US banks to close to one, the Maginot line below which investors are assuming that banks will generate return on equity roughly equal to their cost of equity in the long term.</div><div style="text-align: justify;"><span> For some, this drop in price to book ratios over time is a sign of market overreaction, and there are some value investors who have overweighted their bank holdings as a consequence. That may very well be the case, but I think it is prudent to see if there are fundamental reasons for the shift:</span><br /></div><div><ul style="text-align: left;"><li><div style="text-align: justify;"><u><b>Higher Risk</b></u>: One explanation is that investors perceive banks to be riskier than they were prior to 2008, and at first sight, that seems puzzling since banks have become better capitalized over the last decade, as the regulatory authorities have reacted to the 2008 crisis by tightening safety capital requirements: </div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhhurnQiIBMJgoA0YVsbHUxUTTACdsmhGW9yDKHCRONi28tVGGAAzA8Nvqu_yWRzwEAzv9LFxlKUhB2j1crhww_jv2QjBH6p2L0XHj3ZoPyolShDxb8OvKMtEzUbVElwv45UbGTK3v2bQOKUoduYqh-eFl85yOfLEnM-K-IikfuQ1GTmT2DHWkHOcff/s847/CapitalChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="616" data-original-width="847" height="291" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhhurnQiIBMJgoA0YVsbHUxUTTACdsmhGW9yDKHCRONi28tVGGAAzA8Nvqu_yWRzwEAzv9LFxlKUhB2j1crhww_jv2QjBH6p2L0XHj3ZoPyolShDxb8OvKMtEzUbVElwv45UbGTK3v2bQOKUoduYqh-eFl85yOfLEnM-K-IikfuQ1GTmT2DHWkHOcff/w400-h291/CapitalChart.jpg" width="400" /></a></div><br /><div style="text-align: justify;">As you can see the Tier 1 capital at US banks collectively has risen to 13-14% from 10-11% in the years leading into the 2008 crisis and after. It is true, though, that equity as a percent of total assets dipped especially in 2020 and 2021, before bouncing back, but even that statistic has shown little change over the decade.</div></li><li><div style="text-align: justify;"><b><u>Lower Profitabilit</u></b>y: Another is that investors don't trust net income reported by banks as final numbers, given the propensity of some banks to surprise them with after-the fact and unexpected losses (from trading mistakes and asset write-downs) or believe that banks are becoming less profitable over time. To see if this is the case, I looked at the interest income and expenses over time at banks:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiD4C33NyGfbBGK8ASkorkLNvQV3w8c5PoGGQhXstGg4dJfHetuP9GARGm4r37_uckyBhsZ_awfidNeSV04X4gL-LnHmxKtOWhwPVR_AQzCXOShOC-oLq6_jVTbpMBWeRmRMM9WElyp1VyIBcbcwCNj04zucqTEh0NJUpSzKLRS1mnMbQE4096eEfvl/s841/SpreadChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="618" data-original-width="841" height="294" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiD4C33NyGfbBGK8ASkorkLNvQV3w8c5PoGGQhXstGg4dJfHetuP9GARGm4r37_uckyBhsZ_awfidNeSV04X4gL-LnHmxKtOWhwPVR_AQzCXOShOC-oLq6_jVTbpMBWeRmRMM9WElyp1VyIBcbcwCNj04zucqTEh0NJUpSzKLRS1mnMbQE4096eEfvl/w400-h294/SpreadChart.jpg" width="400" /></a></div><br /><div style="text-align: justify;">Like the book equity, the spread dropped in 2020 and 2021, with 2022 showing a recovery. However, as interest rates have risen, it is likely that rates on deposits will rise faster than rates earned on loans and investments in the near term, perhaps a source of concern for investors.</div></li><li style="text-align: justify;"><b><u>Business Economics</u></b>; If banks are not more risky, at least collectively, and interest spreads have held their own, the only remaining explanation is that investors believe that the banking business is much less likely to be value-adding now than two decades ago. Almost every aspect of banking is under stress, with deposits becoming less sticky, increased competition for the loan business from fintech and other disruptors and increased risks of contagion and crisis, and while banks remain profitable on the surface, investors have good reason to wonder whether the good times will last.</li></ul></div><div><div style="text-align: justify;">I know that a contrarian take, especially after the last few months, would suggest investing in banking as a sector, but I believe that the long term trends for the business are negative.</div><p><i>The Pricing of Banks - Across Banks</i></p><p style="text-align: justify;"><span><span> Even though I would not make a collective bet on banks collectively, I do believe that, as in any crisis, individual banks are getting mis-placed. Thus, as investors panic and sell regional banks, it is likely that good regional banks and lumped in bad ones, in the sell off, and if that money is being redirected to the bigger banks, some of those banks may not merit the price increases.</span></span><i> </i>Staying with price to book as my pricing metric for banks, I looked at the distribution of price to book ratios across banks, both at the end of 2022, and in May 2023, as the banking crisis has unfolded:</p><p><br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgc_FeUh3uRg8zFKTHX5swZHX4JoI9jw5M0giaq-DS2eZAbzEm4F4wzDrguT96DCZznKtwFHNyZkoGvQ5HRRG5ccxSgq_s75IlsqR-eCj30VzBmBBKuLzNjINL_BpCqqn7d88TOYsSl6NMB-TIkctted1jNeGcpu34Lwu0AtwlQc6UwvE9NU61K9O8I/s1192/PBVHistogram.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="869" data-original-width="1192" height="292" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgc_FeUh3uRg8zFKTHX5swZHX4JoI9jw5M0giaq-DS2eZAbzEm4F4wzDrguT96DCZznKtwFHNyZkoGvQ5HRRG5ccxSgq_s75IlsqR-eCj30VzBmBBKuLzNjINL_BpCqqn7d88TOYsSl6NMB-TIkctted1jNeGcpu34Lwu0AtwlQc6UwvE9NU61K9O8I/w400-h292/PBVHistogram.jpg" width="400" /></a></div><div><br /></div>As you can see, the crisis has lowered price to book ratios across the board, with the median price to book ratio dropping from 1.12 at the end of 2022 to 0.94 in May 2022. That decline is almost entirely the result of a decline in market capitalization, since the book values of equity for banks were little changed between the third quarter of 2022 (used for the end of 2022 calculation) and the end of 2022 (used for the May 2023 calculation).<p style="text-align: justify;"><span> Since the key driver of price to book ratio is the return on equity, I looked at the distribution of returns on equity at US banks in 2021 and 2022:</span></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgIIiiOR7mA3P2xbMzqqcu3mAfABUOimOkhHBzmCCtbKQpvn6EHuC4exxM2EQ6cj_tw2C9mpQUlhtDATDVkPEn2sFxQBxPWLb460bjKqX9n8LP4JAu0RNb8UUdJNBvbJi-F-1B_sp3pVfYVjzFm0SSzo28iK-ZQdJZmWtgyxHpI7ob0oIv_RCTzgjAJ/s1190/ROEChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="872" data-original-width="1190" height="293" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgIIiiOR7mA3P2xbMzqqcu3mAfABUOimOkhHBzmCCtbKQpvn6EHuC4exxM2EQ6cj_tw2C9mpQUlhtDATDVkPEn2sFxQBxPWLb460bjKqX9n8LP4JAu0RNb8UUdJNBvbJi-F-1B_sp3pVfYVjzFm0SSzo28iK-ZQdJZmWtgyxHpI7ob0oIv_RCTzgjAJ/w400-h293/ROEChart.jpg" width="400" /></a></div><br /><p>Unlike companies in other sectors, where there are wide variations across companies, the returns on equity at banks is tightly clustered, with 50% of banks having 9.38% (9.24%) and 14.80% (13.75%) in 2021 (2022). However, there are clearly banks that generate higher returns on equity than other banks, and that should play a role in explaining differences in price to book ratios. To check how closely price to book ratios at banks hew to the returns on equities generated by banks, I did a scatter plot of price to book against ROE, both at the end of 2022 and again in May 2023:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh98qn64CxmgIeQ6u5s41dUosVBWXSuwWAX3tUVUeQKuMM8a6XNehBT4qkXxOWFQdF860aAqbyBLeqyitdLOVCxBQ6teFO2B7Lna9AxNnfIfdEZqdN3C5mEA7VIqoMn4LjNOca2Ex_AQbuOyCfD0CP1NyPraQ898OtVuV3uALZdcdV-mMXY61hJ8UpX/s1833/ScatterPlotComp.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="564" data-original-width="1833" height="195" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh98qn64CxmgIeQ6u5s41dUosVBWXSuwWAX3tUVUeQKuMM8a6XNehBT4qkXxOWFQdF860aAqbyBLeqyitdLOVCxBQ6teFO2B7Lna9AxNnfIfdEZqdN3C5mEA7VIqoMn4LjNOca2Ex_AQbuOyCfD0CP1NyPraQ898OtVuV3uALZdcdV-mMXY61hJ8UpX/w640-h195/ScatterPlotComp.jpg" width="640" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div>While banks with higher ROE generally trade at higher price to book ratios, there is significant noise in the relationship, though more in May 2023 (with an R squared just above 11%) than in December 2022 (with an R squared just above 14%). In a final visual display, I looked a 3D scatter plot, of PBV against ROE and Tier 1 capital ratios:<br /><p><br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh4H1AIj7fCkQRMNSPkjcBeC3HwDV7F7XaLelrorKCGutlKpeYWRjfCxTAyfJrCDdqScvUw0dypYmagOkw7mrtLIB5iXTfHch1HWEz2B1wXUaq-7mnnQ4TJ2bi_Zl5WQ_2DFIlJ-OWfY_r9LNSpTYLZctg3C3h3_5aLgcoSovfZFFNFU-2jn9UaOGfA/s598/PBV3DScatter.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="381" data-original-width="598" height="204" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh4H1AIj7fCkQRMNSPkjcBeC3HwDV7F7XaLelrorKCGutlKpeYWRjfCxTAyfJrCDdqScvUw0dypYmagOkw7mrtLIB5iXTfHch1HWEz2B1wXUaq-7mnnQ4TJ2bi_Zl5WQ_2DFIlJ-OWfY_r9LNSpTYLZctg3C3h3_5aLgcoSovfZFFNFU-2jn9UaOGfA/s320/PBV3DScatter.jpg" width="320" /></a></div><br /><p>I have highlighted the combination that characterizes the most under valued banks (low price to book, high ROE and a high Tier 1 capital ratio) as well as the combination for the most over valued banks (high price to book, low ROE and low Tier 1 capital</p><p><i>The Biggest Banks- Trawling for Bargains!</i></p><p style="text-align: justify;"><span> One of the exercises that I find useful, when pricing, is to look for the perfect underpriced stock, one that looks cheap with no good reason for why it is so cheap. Applying that practice to banks, here is what you would want to see in your underpriced bank:</span><br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiUOm6gXGBAu76nH-F8FH9oAggJ386WHQM_RYNPdvn2vUDWeMm1Ns1Y2OVvF56QPqQhrIoVeNuVRON8PjVIxqrcGOrSJ3wbiVOgnTBkP4ASn9zo5ReayG8vSoB-03p2okp8SCbOQxlG7uRwm8CxxqE8usM45cGp83q4MLBYU5S4bmlXsfm8LUZ9AOQy/s507/BankCheapnessIndicator.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="311" data-original-width="507" height="245" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiUOm6gXGBAu76nH-F8FH9oAggJ386WHQM_RYNPdvn2vUDWeMm1Ns1Y2OVvF56QPqQhrIoVeNuVRON8PjVIxqrcGOrSJ3wbiVOgnTBkP4ASn9zo5ReayG8vSoB-03p2okp8SCbOQxlG7uRwm8CxxqE8usM45cGp83q4MLBYU5S4bmlXsfm8LUZ9AOQy/w400-h245/BankCheapnessIndicator.jpg" width="400" /></a></div><div style="text-align: justify;">Applying this approach to the 25 largest banks, for instance, I computed the median values for each of these variables for the 25 largest US banks, in terms of market cap, and used it as the dividing line for good and bad on each of the variables. Thus, a return on equity higher than the median of 12% is considered a good (and in green) and less than 12% is considered bad (and in red). </div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg22vzlEsmwlUgbk6jBdE3tnKD0MnfTbHrD9GNDnLqwDxHCAbKB4n-x5lnH02bcbPP_HDvW1XpOkTiQjVjMsTwXN52qsIHAC9sdJUpvyzZNV7JdoTOULuNFQ9xFKsmlOQqpimU9ZEvlIr2jqnF5VUA2u5qJDb2BjDYa1XOh8h75bQuf_T80RWdaPhGg/s1120/BigBanksTable.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="614" data-original-width="1120" height="219" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg22vzlEsmwlUgbk6jBdE3tnKD0MnfTbHrD9GNDnLqwDxHCAbKB4n-x5lnH02bcbPP_HDvW1XpOkTiQjVjMsTwXN52qsIHAC9sdJUpvyzZNV7JdoTOULuNFQ9xFKsmlOQqpimU9ZEvlIr2jqnF5VUA2u5qJDb2BjDYa1XOh8h75bQuf_T80RWdaPhGg/w400-h219/BigBanksTable.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;">Source: S&P Capital IQ</td></tr></tbody></table><br /><div style="text-align: justify;">Put simply, you are looking for a preponderance of green numbers for your under priced banks, and while there no all green banks, Citi comes closest to meeting the tests, scoring well on risk (with a higher than median Tier 1 capital ratio and a lower percent of securities held to maturity among the five biggest banks), deposit stickiness (with low deposit growth) and trades at half of book value (the lowest price to book ratio). Its weakest link is a return on equity of 8.11% (in 2022) and 9.50% (average from 2018-2022), lower than the median for US banks, and while that would suggest a lower than median price to book ratio, the discount at Citi exceeds that expectation. Citi's banking business, though slow growing, remains lucrative with the higher interest rate spread in this sample. I will be adding Citi to my portfolio, since it offers the best mix of cheapness and low risk, and hope that it can at least maintain its profitability, though an increase would be icing on the cake. It is a slow-growth, stodgy bank that seems to be priced on the presumption that it will not only never earn a ROE even close to its cost of equity, and that makes it a good investment. </div><div style="text-align: justify;"><span> </span>At the other end of the expectation scales, JP Morgan Chase scores well on operating metrics, with a high ROE, low deposit growth and a high Tier 1 capital ratio, but it trades at a much higher price to book ratio than the other banks, and iwith a lower dividend yield. I have owned JPM Chase for close to a decade in my portfolio, and I don't see anything in this table that would lead me to sell, though I would not be in a hurry to buy either, at today's prices, if I did not own it.</div><div style="text-align: justify;"><span> As a value investor, I would be uncomfortable making an investment in Citi, purely based upon this pricing analysis, and it is for that reason that I retraced my steps to do the intrinsic valuation of the bank that you saw in the last section. That reinforces a more general point that even investors who are true believers in valuation can benefit from understanding and using pricing, just as traders, who play the pricing game, can benefit from an understanding of the core principles of intrinsic valuation.</span><br /></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Wrapping up</b></div><div style="text-align: justify;">In my last post, my focus was on the qualities that made for the distinction between good and bad banks, and those qualities includes deposit stickiness, a low interest rate on deposits combined with a high interest rate (given default risk) on loans and investments and a big buffer against shocks (with high book equity and Tier 1 capital ratios). In this post, I shifted attention to the investing side of the picture, and that puts the price you pay to acquire banks on center stage. Acquiring a good bank, while paying too high a price, will make for a bad investment, just as acquiring a bad bank, at a bargain price, will be a good investment. On the contest of banking quality, JP Morgan Chase would beat Citi handily, with a high return on equity and continued growth, combined with safety, but in the contest for investing dollars, Citi is the better priced bank. Since I will have both stocks in my portfolio starting tomorrow, I will have a ringside seat to watch this contest play out over the next few years.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>YouTube Video</b></div><div style="text-align: justify;"><br /><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/CdhTVs36z4c" title="YouTube video player" width="560"></iframe></div><p><br /></p><p><b>Posts on the Banking Crisis 2023</b></p><p></p><ol style="text-align: left;"><li><a href="https://aswathdamodaran.blogspot.com/2023/05/breach-of-trust-decoding-banking-crisis.html">Breach of Trust: Decoding the Banking Crisis (of 2023)</a></li><li><a href="https://aswathdamodaran.blogspot.com/2023/05/good-bad-banks-and-good-bad-investments.html">Good (Bad) Banks and Good (Bad) Investments: At the right price...</a></li></ol><p></p><p><b>Bank Valuation Spreadsheet</b></p><p></p><ol style="text-align: left;"><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/CitiVal2023.xlsx">Bank Valuation Spreadsheet (with Citi Valuation)</a></li></ol><p></p></div>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-21573741861655822582023-05-05T19:23:00.004-04:002023-05-07T16:06:30.656-04:00Breach of Trust: Decoding the Banking Crisis<p style="text-align: justify;">In March 2023, the fall of Silicon Valley Bank shocked investors not only because it was unforeseen, but also because of the speed with which it unfolded. That failure has had a domino effect, with Signature Bank falling soon after, followed by Credit Suisse in April 2023 and by First Republic last week. The banks that have fallen so far collectively controlled more deposits than all of the banks that failed in 2008, but unlike that period, equity markets in the United States have stayed resilient, and even within banking, the damage has varied widely across different segments, with regional banks seeing significant draw downs in deposits and market capitalization. The overarching questions for us all are whether this crisis will spread to the rest of the economy and market, as it did in 2008, and how banking as a business, at least in the US, will be reshaped by this crisis, and while I am more a dabbler than an expert in banking, I am going to try answering those questions.</p><p style="text-align: justify;"><b>The Value of a Bank</b></p><p style="text-align: justify;"><span> Banks have been an integral part of business for centuries, and while we have benefited from their presence, we have also been periodically put at risk, when banks over reach or get into trouble, with their capacity to create costs that the rest of us have to bear. After every banking crisis, new rules are put into place to reduce or minimize these risks to the economic system, but in spite of these rules or sometimes because of them, there are new crisis. To understand the roots of bank troubles, it is important that we understand how the banking business works, with the intent of creating criteria that we can use to separate good banks from average or bad ones.</span><br /></p><p style="text-align: justify;"><i>The Banking Business Model</i></p><p style="text-align: justify;"><i> </i>The banking business, when stripped down to basics, is a simple one. A bank collects deposits from customers, offering the quid quo pro of convenience, safety and sometimes interest income (on those deposits that are interest-beating) and either lends this money out to borrowers (individuals and businesses), charging an interest rate that is high enough to cover defaults and leave a surplus profit for the bank. In addition, banks can also invest some of the cash in securities, usually fixed-income, and with varying maturities and degrees of default risk, again earning income from these holdings. The profitability of a bank rests on the spread between its interest income (from loans and financial investments) and its interest expenses (on deposits and debt), and the leakages from that spread to cover defaulted loans and losses on investment securities:<br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjI_6bnw433xn-wBVnTHqpswMnni4hRrfYNzDbS0EvAkJgjYEdqA3NJd2K86WdT-vcZe8bDLSYdbG1L9DQQLvpvLk2stklyTyuqSQuubD3zR11baXniezcRGMcldnX635dwCN2Rml50p6BZB-QSggSS7VrzusIQwpzNwJTppigbB-_JfcFt-Lu_UvNZ/s819/BankingBusiness.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="497" data-original-width="819" height="243" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjI_6bnw433xn-wBVnTHqpswMnni4hRrfYNzDbS0EvAkJgjYEdqA3NJd2K86WdT-vcZe8bDLSYdbG1L9DQQLvpvLk2stklyTyuqSQuubD3zR11baXniezcRGMcldnX635dwCN2Rml50p6BZB-QSggSS7VrzusIQwpzNwJTppigbB-_JfcFt-Lu_UvNZ/w400-h243/BankingBusiness.jpg" width="400" /></a></div><div style="text-align: justify;"><br /></div><p style="text-align: justify;">To ensure that a bank survives, it's owners have to hold enough equity capital to buffer against unanticipated defaults or losses. </p><p style="text-align: justify;"><i>The Bank Regulators</i></p><p style="text-align: justify;"><span> </span>If you are wondering where bank regulators enter the business model, it is worth remembering that banks predate regulators, and for centuries, were self regulated, i.e., were responsible for ensuring that they had enough equity capital to cover unexpected losses. Predictably, bank runs were frequent and the banks that survived and prospered set themselves apart from the others by being better capitalized and better assessors of default risk than their competition. In the US, it was during the civil war that the National Banking Act was passed, laying the groundwork for chartering banks and requiring them to maintain safety reserves. After a banking panic in 1907, where it fell upon J.P. Morgan and other wealthy bankers to step in and save the system, the Federal Reserve Bank was created in 1913. The Great Depression gave rise to the Glass-Steagall Act in 1933 which restricted banks to commercial banking, with the intent of preventing them from investing their deposit money in riskier businesses. The notion of regulatory capital has always been part of bank regulation, with the FDIC defining "capital adequacy" as having enough equity capital to cover one-tenth of assets. In subsequent decades, these capital adequacy ratios were refined to allow for risk variations across banks, with the logic that riskier assets needed more capital backing than safer ones. These regulatory capital needs were formalized and globalized after the G-10 countries created the Basel Committee on Banking Supervision and explicitly created the notions of "risk-weighted assets" and "Tier 1 capital", composed of equity and equity-like instruments, as well as specify minimum capital ratios that banks had to meet to continue to operate. Regulators were given punitive powers, ranging from restrictions of executive pay and acquisitions at banks that fell below the highest capitalization ranks to putting banks that were undercapitalized into receivership.</p><p style="text-align: justify;"><i> </i>The Basel accord and the new rules on regulatory capital have largely shaped banking for the last few decades, and while they have provided a safety net for depositors, they have also given rise to a dangerous game, where some banks arrived at the distorted conclusion that their end game was exploiting loopholes in regulatory capital rules, rather than build solid banking businesses. In short, these banks found ways of investing in risky assets that the regulators did not recognize as risky, either because they were new or came in complex packages, and using non-equity capital (debt and deposits), while getting that capital classified as equity or equity-like for regulatory purposes. The 2008 crisis exposed the ubiquity and consequences of this regulatory capital game, but at great cost to the economy and tax payers, with the troubled assets relief program (TARP) investing $426 billion in bank stocks and mortgage-backed securities to prop up banks that had over reached, mostly big, money-center banks, rather than small or regional banks. The phrase "too big to fail" has been over used, but it was the rationale behind TARP and is perhaps at the heart of today's banking crisis.</p><p style="text-align: justify;"><i>Good and Bad Banks</i></p><p style="text-align: justify;"><span><span> If the banking business is a simple one, what is that separates good from bad banks? If you look back at the picture of the banking business, you can see that I have highlighted key metrics at banks that can help gauge not just current risk but their exposure to future risk. </span></span></p><p></p><ol style="text-align: left;"><li style="text-align: justify;"><u>Deposits</u>: Every banks is built around a deposit base, and there are deposit base characteristics that clearly determine risk exposure. First, to the extent that some deposits are not interest-bearing (as is the case with most checking accounts), banks that have<i> higher percentages of non-interest bearing deposits start off at an advantage, </i>lowering the average interest rate paid on deposits. Second, since a big deposit base can very quickly become a small deposit base, if depositors flee, <i>having a stickier deposit base gives a bank a benefit</i>. As to the determinants of this stickiness, there are numerous factors that come into play including <u>deposit size</u> (bigger and wealthier depositors tend to be more sensitive to risk whispers and to interest rate differences than smaller ones), <u>depositor homogeneity</u> (more diverse depositor bases tend to be less likely to indulge in group-think) and deposit age (depositors who have been with a bank longer are more sticky). In addition to these bank-specific characteristics, there are two other forces that are shaping deposit stickiness in 2023. One is that the actions taken to protect the largest banks after 2008 have also tilted the scales of stickiness towards them, since the perception, fair or unfair, among depositors, that your deposits are safer at a Chase or Citi than they are at a regional bank. The other is the rise of social media and online news made deposits less sticky, across the board, since rumors (based on truth or otherwise) can spread much, much faster now than a few decades ago.</li><li style="text-align: justify;"><u>Equity and Regulatory Capital</u>: Banks that have more book equity and Tier 1 capital have built bigger buffers against shocks than banks without those buffers. Within banks that have high accumulated high amounts of regulatory capital, I would argue that banks that get all or the bulk of that capital from equity are safer than those that have created equity-like instruments that get counted as equity. </li><li style="text-align: justify;"><u>Loans</u>: While your first instinct on bank loans is to look for banks that have lent to safer borrowers (less default risk), it is not necessarily the right call, when it comes to measuring bank quality. A bank that lends to safe borrowers, but charges them too low a rate, even given their safer status, is undercutting its value, whereas a bank that lends to riskier borrowers, but charges them a rate that incorporates that risk and more, is creating value. In short, to assess the quality of a bank's loan portfolio, you need to consider the <u>interest rate earned on loans</u> in conjunction with the <u>expected loan losses on that loan portfolio</u>, with a combination of high (low) interest rates on loans and low (high) loan losses characterizing good (bad) banks. In addition, banks that lend to a <u>more diverse set of clients </u>(small and large, across different business) are less exposed to risk than banks that lend to homogeneous clients (similar profiles or operate in the same business), since default troubles often show up in clusters.</li><li style="text-align: justify;"><u>Investment Securities</u>: In the aftermath of the 2008 crisis, where banks were burned by their holdings in riskier mortgage-backed securities, regulators pushed for more safety in investment securities held by banks, with safety defined around default and liquidity risk. While that push was merited, and banks with safer and more liquid holdings are safer than banks with riskier, illiquid holdings, there are two other components that also determine risk exposure. The first is the <u>duration of these securities</u>, relative to the duration of the deposit base, with a greater mismatch associated with more risk. A bank that is funded primarily with demand deposits, which invests in 10-year bonds, is exposed to more risk than if invests in commercial paper or treasury bills. The second is whether these securities, <u>as reported on the balance sheet, are marked to market or not</u>, a choice determined (at least currently) by how banks classify these holdings, with <a href="https://libertystreeteconomics.newyorkfed.org/2015/02/available-for-sale-understanding-bank-securities-portfolios/">assets held to maturity</a> being left at original cost and assets held for trading, being marked to market. As an investor, you have more transparency about the value of what a company holds and, by extension, its equity and Tier 1 capital, when securities are marked to market, as opposed to when they are not.</li></ol><div style="text-align: justify;">At the risk of over simplifying the discussion, the picture below draws a contrast between good and bad banks, based upon the discussion above:</div><p></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEivhk55BXgC3L75K_EcZIWKY8FGWV8QVAnyCsrnZ9D8de26Wt4A_aOTqXzJGnTS4Vb5bLhPYHfH7XPGdLkC6UtnoPOCyHo_6QoKPQq9kWwwgPdfstfJswDudlB8OMJRienYhLpETxo70trDP_DCsNlIwKza5UPDgzKxtS0dHbUgll_255DPERBqUwDD/s720/GoodvsBadBanks.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="414" data-original-width="720" height="230" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEivhk55BXgC3L75K_EcZIWKY8FGWV8QVAnyCsrnZ9D8de26Wt4A_aOTqXzJGnTS4Vb5bLhPYHfH7XPGdLkC6UtnoPOCyHo_6QoKPQq9kWwwgPdfstfJswDudlB8OMJRienYhLpETxo70trDP_DCsNlIwKza5UPDgzKxtS0dHbUgll_255DPERBqUwDD/w400-h230/GoodvsBadBanks.jpg" width="400" /></a></div><div style="text-align: justify;">Banks with sticky deposits, on which they pay low interest rates (because a high percentage are non-interest bearing) and big buffers on equity and Tier 1 capital, which also earn "fair interest rates", given default risk, on the loans and investments they make, add more value and are usually safer than banks with depositor bases that are sensitive to risk perceptions and interest rates paid, while earning less than they should on loans and investments, given their default risk. </div><p></p><p style="text-align: justify;"><i>Macro Stressors</i></p><p style="text-align: justify;"><i> </i>While we can differentiate between good and bad banks, and some of these differences are driven by choices banks make on how they build their deposit bases and the loans and investments that they make with that deposit money, these differences are often either ignored or overlooked in the good times by investors and regulators. If often requires a crisis for both groups to wake up and respond, and these crises are usually macro-driven:</p><p style="text-align: justify;"></p><ol><li><i>Recessions: </i>Through banking history, it is the economy that has been the biggest stressor of the banking system, since recessions increase default across the board, but more so at the most default-prone borrowers and investment securities. Since regulatory capital requirements were created in response to one of the most severe recessions in history (the Great Depression), it is not surprising that regulatory capital rules are perhaps most effective in dealing with this stress test.</li><li><i>Overvalued Asset Classes: </i>While banks should lend money using a borrower's earnings capacity as collateral, it is a reality that many bankers lend against the value of assets, rather than their earning power. The defense that bankers offer is that these assets can be sold, if borrowers default, and the proceeds used to cover the outstanding dues. That logic breaks down when asset classes get overvalued, since the loans made against the assets can no longer be covered by selling these assets, if prices correct. This boom and bust cycle has long characterized lending in real estate, but became the basis for the 2008 crisis, as housing prices plunged around the country, taking down not just lenders but also holders of real-estate based securities. In short, when these corrections happen, no matter what the asset class involved, banks that are over exposed to that asset class will take bigger losses, and perhaps risk failure.</li><li><i>Inflation and Interest Rates: </i>Rising inflation and interest rates are a mixed blessing for banks. On the one hand, as rates rise, longer life loans and longer term securities will become less valuable, causing losses.. After all, the market price of even a default-free bond will change, when interest rates change, and bonds that were acquired when interest rates were lower will become less valuable, as interest rates rise. In most years, those changes in rates, at least in developed markets like the US, are small enough that they create little damage, but 2022 was an uncommon year, as the treasury bond rate rose from 1.51% to 3.88%, causing the price of a ten-year treasury bond to drop by more than 19%.</li></ol><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhXq-zLayynkYm0eKvlZVyDOi4Woc_mLbCGhTe0GUkNOqkgF8F9kVotAWJprAuoVvlZLIBSQLh4Sf5w6f2r76XXowxA7yWNz3Lr5uF8QUST9k8h8W5tyv5iKSE8qwmmqIN_HVi6Bi5l3e2rdvbEtVvTpycc7-5Xj1dD9QPDXwa5kP6G8Fg6GmKnqF-X/s747/TBondReturnin2022.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="573" data-original-width="747" height="306" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhXq-zLayynkYm0eKvlZVyDOi4Woc_mLbCGhTe0GUkNOqkgF8F9kVotAWJprAuoVvlZLIBSQLh4Sf5w6f2r76XXowxA7yWNz3Lr5uF8QUST9k8h8W5tyv5iKSE8qwmmqIN_HVi6Bi5l3e2rdvbEtVvTpycc7-5Xj1dD9QPDXwa5kP6G8Fg6GmKnqF-X/w400-h306/TBondReturnin2022.jpg" width="400" /></a></div><p style="text-align: justify;">Put simply, every bank holding ten-year treasury bonds in 2022 would have seen a mark down of 19% in the value of these holdings during the year, but as investors, you would have seen the decline in value only at those few banks which classified these holdings as held for sale. That pain becomes worse with bonds with default-risk, with Baa (investment grade) corporate bonds losing 27% of their value. On the other hand, banks that have higher percentages of non-interest bearing deposits will gain value from accessing these interest-free deposits in a high interest world. The net effect will determine how rising rates play out in bank value, and may explain why the damage from the crisis has varied across US banks in 2023.</p><p style="text-align: justify;"><b>The Banks in Crisis</b></p><p style="text-align: justify;"><b> </b>It is worth noting that all of the pain that was coming from writing down investment security holdings at banks, from the surge in interest rates, was clearly visible at the start of 2023, but there was no talk of a banking crisis. The implicit belief was that banks would be able to gradually realize or at least recognize these losses on the books, and use the time to fix the resulting drop in their equity and regulatory capital. That presumption that time was an ally was challenged by the implosion of Silicon Valley Bank in March 2023, where over the course of a week, a large bank effectively was wiped out of existence. To see why Silicon Valley Bank (SVB) was particularly exposed, let us go back and look at it through the lens of good/bad banks from the last section:</p><p></p><ol style="text-align: left;"><li style="text-align: justify;"><u>An Extraordinary Sensitive Deposit Base</u>: SVB was a bank designed for Silicon Valley (founders, VCs, employees) and it succeeded in that mission, with deposits almost doubling in 2021. That success created a deposit base that was anything but sticky, sensitive to rumors of trouble, with virally connected depositors drawn from a common pool and big depositors who were well positioned to move money quickly to other institutions. </li><li style="text-align: justify;"><u>Equity and Tier 1 capital that was overstated</u>: While SVB's equity and Tier 1 capital looked robust at the start of 2023, that look was deceptive, since it did not reflect the write-down in investment securities that was looming. While it shared this problem with other banks, SVB's exposure was greater than most (see below for why) and explains its <a href="https://www.bloomberg.com/news/articles/2023-03-10/svb-abandons-equity-raise-imperiling-efforts-to-restore-calm">attempt to raise fresh equity</a> to cover the impending shortfall.</li><li style="text-align: justify;"><u>Loans</u>: A large chunk of SVB's loan portfolio was composed of venture debt, i.e., lending to pre-revenue and money-losing firms, and backed up by expectations of cash inflows from future rounds of VC capital. Since the expected VC rounds are conditional on these young companies being repriced at higher and higher prices over time, venture debt is extraordinarily sensitive to the pricing of young companies. In 2022, <a href="https://aswathdamodaran.blogspot.com/2022/07/risk-capital-and-markets-temporary.html">risk capital pulled back from markets</a> and as venture capital investments dried up, and down rounds proliferated, venture debt suffered. </li><li style="text-align: justify;"><u>Investment Securities</u>: All banks put some of their money in investment securities, but SVB was an outlier in terms of how much of its assets (55-60%) were invested in treasury bonds and mortgage-backed securities. Part of the reason was the surge in deposits in 2021, as venture capitalists pulled back from investing and parked their money in SVB, and with little demand for venture debt, SVB had no choice but to invest in securities. That said, the choice to invest in long term securities was one that was made consciously by SVB, and driven by the interest rate environment in 2021 and early 2022, where short term rates were close to zero and long term rates were low (1.5-2%), but still higher than what SVB was paying its depositors. If there is an original sin in this story, it is in this duration mismatch, and it is this mismatch that caused SVB's fall.</li></ol><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhaHTXyXR2c-vjRv6-m-bRUG6YuvrAm8Cr5shYi7dl4OdPQlVAnpDPK1pZlmuxr9pnAdZQ_6IwoacQdeWd2MB9o2K_KHrAvezeig3pUZofJmOD-d_vMiW17nzPhT8BT9VPtLseeKgN5DtEKUxnymMjH73XP2Wk6g5EBB36knGg6t4HG2pl32kpQS1dx/s869/SVBPicture.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="695" data-original-width="869" height="320" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhaHTXyXR2c-vjRv6-m-bRUG6YuvrAm8Cr5shYi7dl4OdPQlVAnpDPK1pZlmuxr9pnAdZQ_6IwoacQdeWd2MB9o2K_KHrAvezeig3pUZofJmOD-d_vMiW17nzPhT8BT9VPtLseeKgN5DtEKUxnymMjH73XP2Wk6g5EBB36knGg6t4HG2pl32kpQS1dx/w400-h320/SVBPicture.jpg" width="400" /></a></div><div style="text-align: justify;"><br /></div><p style="text-align: justify;">In short, if you were building a bank that would be susceptible to a blow-up, from rising rates, SVB would fit the bill, but its failure opened the door for investors and depositors to reassess risk at banks at precisely the time when most banks did not want that reassessment done.</p><p style="text-align: justify;"><span> In the aftermath of SVB's failure, Signature Bank was shut down in the weeks after and First Republic has followed, and the question of what these banks shared in common is one that has to be answered, not just for intellectual curiosity, because that answer will tell us whether other banks will follow. It should be noted that neither of these banks were as exposed as SVB to the macro shocks of 2022, but the nature of banking crises is that as banks fall, each subsequent failure will be at a stronger bank than the one that failed before. </span></p><p></p><ul style="text-align: left;"><li style="text-align: justify;">With <a href="https://www.cnbc.com/2023/03/13/signature-bank-third-biggest-bank-failure-in-us-history.html">Signature Bank</a>, the trigger for failure was a run on deposits, since more than 90% of deposits at the bank were uninsured, making those depositors far more sensitive to rumors about risk. The FDIC, in shuttering the bank, also pointed to "poor management" and failure to heed regulatory concerns, which clearly indicate that the bank had been on the FDIC's watchlist for troubled banks.</li><li style="text-align: justify;">With First Republic bank, a bank that has a large and lucrative wealth management arm, it was a dependence on those wealthy clients that increased their exposure. Wealthy depositors not only are more likely to have deposits that exceed $250,000, technically the cap on deposit insurance, but also have access to information on alternatives and the tools to move money quickly. Thus, in the first quarter of 2023, the bank reported a 41% drop in deposits, triggering forced sale of investment securities, and the realization of losses on those sales.</li></ul><div style="text-align: justify;">In short, it is the <u>stickiness of deposits</u> that seems to be the biggest indicator of banks getting into trouble, rather than the composition of their loan portfolios or even the nature of their investment securities, though having a higher percentage invested in long term securities leaves you more exposed, given the interest rate environment. That does make this a much more challenging problem for banking regulators, since deposit stickiness is not part of the regulatory overlay, at least at the moment. One of the outcomes of this crisis may be that regulators monitor information on deposits that let them make this judgment, including:</div><div style="text-align: justify;"><ol><li><u>Depositor Characteristics</u>: As we noted earlier, depositor age and wealth can be factors that determine stickiness, with younger and wealthier depositors being less sticky that older and poorer depositors. At the risk of opening a Pandora's box, depositors with more social media presence (Twitter, Facebook, LinkedIn) will be more prone to move their deposits in response to news and rumors than depositors without that presence.</li><li><u>Deposit age</u>: As in other businesses, a bank customer who has been a customer for longer is less likely to move his or her deposit, in response to fear, than one who became a customer recently. Perhaps, banks should follow subscriber/user based companies in creating deposit cohort tables, breaking deposits down based upon how long that customer has been with the bank, and the stickiness rate in each group. </li><li><u>Deposit growth</u>: In the SVB discussion, I noted that one reason that the bank was entrapped was because deposits almost doubled in 2021. Not only do very few banks have the capacity to double their loans, with due diligence on default risk, in a year, but these deposits, being recent and large, are also the least sticky deposits at the bank. In short, banks with faster growth in their deposit bases also are likely to have less sticky depositors.</li><li><u>Deposit concentration</u>: To the extent that the deposits of a bank are concentrated in a geographic region, it is more exposed to deposit runs than one that has a more geographically diverse deposit base. That would make regional bank deposits more sensitive that national bank deposits, and sector-focused banks (no matter what the sector) more exposed to deposit runs than banks that lend across businesses. </li></ol><div>Some of this information is already collected at the bank level, but it may be time for bank regulators to work on measures of deposit stickiness that will then become part of the panel that they use to judge exposure to risk at banks.</div></div><div style="text-align: justify;"><b><br /></b></div><div style="text-align: justify;"><b>The Market Reaction</b></div><div style="text-align: justify;"><b> </b>The most surprising feature of the 2023 banking crisis has been the reaction of US equity markets, which have been resilient, rising in the face of a wall of worry. To illustrate how the market reaction has played out at different levels, I looked at four indices, starting with the S&P 500, moving on the S&P Financials and Banks Index to the S&P Select Bank Index and finally, the S&P Regional Bank Index.<br /></div><div style="text-align: justify;"><b><br /></b></div><div style="text-align: justify;"><b><br /></b></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh8SHrrMV8jvSV4yij1WFxwUNr2iKfG_42x98LMwvRqIEOuCOxNRFNvdPfudd_aPP5qzJvPxqNmHvARjxxty1TZPdNp8ipeFXFADrbBqMtQx6_GS1Rkl9AqErNKL_2qWXTB-vdqhjAm1kuPdwvmmmLwVAiE-doxFzvNLeX91MCAjBrIt1iJ5fpRLl7l/s1244/S&PIndexReturns.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="891" data-original-width="1244" height="286" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh8SHrrMV8jvSV4yij1WFxwUNr2iKfG_42x98LMwvRqIEOuCOxNRFNvdPfudd_aPP5qzJvPxqNmHvARjxxty1TZPdNp8ipeFXFADrbBqMtQx6_GS1Rkl9AqErNKL_2qWXTB-vdqhjAm1kuPdwvmmmLwVAiE-doxFzvNLeX91MCAjBrIt1iJ5fpRLl7l/w400-h286/S&PIndexReturns.jpg" width="400" /></a></div><div style="text-align: justify;"><br /></div><div class="separator" style="clear: both; text-align: justify;">The S&P 500 index is up 6.5% this year, indicative of the resilience on the part of the market, or denial on the part of investors, depending on your perspective. The S&P Financial Sectors index is down 5.72%, but the S&P Select Banks index is down 26.2% and the regional bank index has taken a pummeling, down more than 35%. The damage from this banking crisis, in short, has been isolated to banks, and within banks, has been greater at regional banks than at the national banks.</div><div class="separator" style="clear: both; text-align: justify;"><span> The conventional wisdom seems to bethat big banks have gained at the expense of smaller banks, but the data is more </span>ambiguous. I looked at the 641 publicly traded US banks, broken down by market capitalization at the start of 2023 into ten deciles and looked at the change in aggregate market cap within each decile. </div></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEglcl9SwhPSkGgTg6k-rbBmNI_gNMMpOPzUecJFNHXNFt2h3t9M7bglbiy9hHnY3UuaiQ_AVAuCrCS5xDL3WEXxiv1pE8Ckg_M3njmIQWaeR37NcRBwojbzlRK-bFCXggT-n83fAKIEm7hGid6VSDQCRnDqwbiJWNKgRnDMD3AMFvwt-tPrmrvbkJqN/s642/MktCapChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="470" data-original-width="642" height="293" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEglcl9SwhPSkGgTg6k-rbBmNI_gNMMpOPzUecJFNHXNFt2h3t9M7bglbiy9hHnY3UuaiQ_AVAuCrCS5xDL3WEXxiv1pE8Ckg_M3njmIQWaeR37NcRBwojbzlRK-bFCXggT-n83fAKIEm7hGid6VSDQCRnDqwbiJWNKgRnDMD3AMFvwt-tPrmrvbkJqN/w400-h293/MktCapChart.jpg" width="400" /></a></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><br /></div><div class="separator" style="clear: both; text-align: justify;"><br /></div><div style="text-align: justify;">As you can see the biggest percentage declines in market cap are bunched more towards the bigger banks, with the biggest drops occurring in the eighth and ninth deciles of banks, not the smallest banks. After all, the highest profile failures so far in 2023 have been SVB, Signature Bank and First Republic Bank, all banks of significant size. </div><div style="text-align: justify;"><span> If my hypothesis about deposit stickiness is right, it is banks with the least stick deposits that should have seen the biggest declines in market capitalization. My proxies for deposit stickiness are limited, given the data that I have access to, but I used deposit growth over the last five years (2017-2022) as my measure of stickiness (with higher deposit growth translating into less stickiness):</span><br /></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgF95cKkH-G6Etble1ukN6cWeQcP5lcOnjJmHIW4BdinVT5pFReQs5qfY6bsbCAOK2HPlXMv1DeryLlknMkgSZpdUaNMVeQ-VmLTcIK3NWMPdyTWRQSnw4Chd4sXTUmKDfUGdR8OBeMMyggVllVE2rfVvEOUKxV94JtUb1raIC-os-OWEEGisoDpVm6/s1127/DepGrowthChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="821" data-original-width="1127" height="291" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgF95cKkH-G6Etble1ukN6cWeQcP5lcOnjJmHIW4BdinVT5pFReQs5qfY6bsbCAOK2HPlXMv1DeryLlknMkgSZpdUaNMVeQ-VmLTcIK3NWMPdyTWRQSnw4Chd4sXTUmKDfUGdR8OBeMMyggVllVE2rfVvEOUKxV94JtUb1raIC-os-OWEEGisoDpVm6/w400-h291/DepGrowthChart.jpg" width="400" /></a></div><div style="text-align: justify;">The results are surprisingly decisive, with the biggest market capitalization losses, in percentage terms, in banks that have seen the most growth in deposits in the last five years. To the extent that this is correlated with bank size (smaller banks should be more likely to see deposit growth), it is by no means conclusive evidence, but it is consistent with the argument that the stickiness of deposits is the key to unlocking this crisis.</div><span><div style="text-align: justify;"><br /></div></span></div><div style="text-align: justify;"><b>Implications</b></div><div style="text-align: justify;"><span> I do believe that there are more dominos waiting to fall in the US banking business, with banks that have grown the most in the last few years at the most risk, but I also believe that unlike 2008, this crisis will be more likely to redistribute wealth across banks than it is to create costs for the rest of us. Unlike 2008, when you could point to risk-seeking behavior on the part of banks as the prime reason for banking failures, this one was triggered by the search for high growth and a failure to adhere to first principles when it comes to duration mismatches. </span>That said, I would expect the following changes in the banking structure:</div><div><ol style="text-align: left;"><li style="text-align: justify;"><u>Continued consolidation</u>: Over the last few decades, the US banking business has consolidated, with the number of banks operating dropping 14,496 in 1984 to 4,844 in 2022. The 2023 bank failures will accelerate this consolidation, especially as small regional banks, with concentrated deposit bases and loan portfolios are assimilated into larger banks, with more diverse structure.</li><li style="text-align: justify;"><u>Bank profitability</u>: For some, that consolidation is worrisome since it raises the specter of banks facing less competition and thus charging higher prices. I may be naive but I think that as banks consolidate, they will struggle to maintain profitability, and perhaps even see profits drop, as disruptors from fintech and elsewhere eat away at their most profitable segments. In short, the biggest banks may get bigger, but they may not get more profitable.</li><li style="text-align: justify;"><u>Accounting rule changes for banks</u>: The fact that SVB's failure was triggered by a drop in value of the bank's investments in bonds and mortgage backed securities, and that this write down came as a shock to in investors, because SVB classified these securities as being held till maturity (and thus not requiring of mark-to-market) will inevitably draw the attention of accounting rule writers. While I don't foresee a requirement that every investment security be marked to market, a rule change that will create its own dangers, I expect the rules on when securities get marked to market to be tightened.</li><li style="text-align: justify;"><u>Regulatory changes</u>: The 2023 crises have highlighted two aspects of bank behavior that are either ignored or sufficiently weighted into current regulatory rules on banks. The first is <u>duration mismatches at bank</u>s, which clearly expose even banks that invest in default free securities, like SVB, to risk. The other is <u>deposit stickiness</u>, where old notions of when depositors panic and how quickly they react will have to be reassessed, given how quickly risk whispers about banks turned into deposit flight at First Republic and Signature Bank. I expect that there will be regulatory changes forthcoming that will try to incorporate both of these issues, but I remain unsure about the form that these changes will take.</li></ol></div><div style="text-align: justify;"><span>I know I have said very little in this post about whether banks are good investments today, either collectively or subsets (large money center, regional etc.), and have focused mostly on what makes for good and bad banks. The reason is simple. Investing is not about judging the quality of businesses, but about buying companies at the right price, and that discussion requires a focus on what expectations markets are incorporating into stock prices. I will address the investing question in my next post, which I hope to turn to very soon! </span></div><p></p><p><b>YouTube Video</b></p><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/nNCXA2S1oeE" title="YouTube video player" width="560"></iframe>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-90577167491205086202023-03-08T12:38:00.001-05:002023-03-08T18:36:36.841-05:00Data Update 7 for 2023: Dividends, Buybacks and Cash Flows<div style="text-align: justify;">This is the last of my data update posts for 2023, and in this one, I will focus on dividends and buybacks, perhaps the most most misunderstood and misplayed element of corporate finance. To illustrate the heat that buybacks evoke, consider two stories in the last two weeks where they have been in the news. In the first, critics of Norfolk Southern, the corporation that operates the trains that were involved in a dreadful chemical accident in Ohio, pointed to buybacks that it had done as the proximate cause for brake failure and the damage. In the second, Warren Buffet used some heated language to describe those who opposed buybacks, calling them “economic illiterates” and “silver tongued demagogues “. Going back in time to last year’s inflation reduction act, buybacks were explicitly targeted for taxes, with the perspective that they were damaging US companies. I think that there are legitimate questions worth asking about buybacks, but I don’t think that neither the critics nor the defenders of buybacks seem to understand why their use has surged or their impact on shareholders, businesses and the economy.</div><p><b>Dividend Policy in Corporate Finance</b></p><p style="text-align: justify;"><b> </b>To understand where dividend policy fits in the larger context of running a business, consider the following big picture description of corporate finance, where every decision that a business makes is put into one of three buckets - investing, financing and dividends, with each one having an overriding principle governing decision-making within its contours.</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgrPk3qNB2hlIdv44Q4BU-opJs4U-cSYxmPClqjEqLmIY7WAzCpxgRHCxP21cvph6lSuW6i-PNsmQ3AlrW8RM4PheoJC1v_7PyyOGIrAYVs4odVvepktrWwXSa3VdLVD3sLxBDmgm6s9mmTXF6QkAu-j7ClPdYH1XMiJdVcX-_HZOsJdaEGnnrIuI46/s717/BigPicture.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="351" data-original-width="717" height="196" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgrPk3qNB2hlIdv44Q4BU-opJs4U-cSYxmPClqjEqLmIY7WAzCpxgRHCxP21cvph6lSuW6i-PNsmQ3AlrW8RM4PheoJC1v_7PyyOGIrAYVs4odVvepktrWwXSa3VdLVD3sLxBDmgm6s9mmTXF6QkAu-j7ClPdYH1XMiJdVcX-_HZOsJdaEGnnrIuI46/w400-h196/BigPicture.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: justify;">In my fifth data update for 2023, I focused on the investment principle, which states that businesses should invest in projects/assets only if they expect to earn returns greater than their hurdle rates, and presented evidence that using the return on capital as a proxy for returns and costs of capital as a measure of hurdle rates, 70% of global companies fell short in 2022. In my sixth data update, I looked at the trade off that should determine how much companies borrow, where the tax benefits are weighed off against bankruptcy costs, but noted that firm often choose to borrow money for illusory reasons and because of me-tooism or inertia. The dividend principle, which is the focus of this post is built on a very simple principle, which is that if a company is unable to find investments that make returns that meet its hurdle rate thresholds, it should return cash back to the owners in that business. Viewed in that context, dividends as just as integral to a business, as the investing and financing decisions. Thus, the notion that a company that pays dividends is viewed as a failure strikes me as odd, since just farmers seed fields in order to harvest them, we start businesses because we plan to eventually collect cash flows from them.</div><div class="separator" style="clear: both; text-align: justify;"><span> Put in logical sequence, dividends should be the last step in the business sequence, since they represent residual cash flows. In that sequence, firms will make their investment decisions first, with financing decisions occurring concurrently or right after, and if there are any cash flows left over, those can be paid out to shareholders in dividends or buybacks, or held as cash to create buffers against shocks or for investments in future years:</span><br /></div><div class="separator" style="clear: both; text-align: justify;"><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh5BaqLokaScVv_5mtS5NQbVbzsZj3mxTtykxEt9M9ab91C4uEdt7jcEHm2XFa4cfzCcILQLk19u2b74-wUxM7JFMYuTFjO0G9IhLiBolmCMnwasmMWNiqcnXLVZseBRuOXD8wXmk6AHJW0nCnTqH7Q88whSX6jVXQarPR_zo6iQRHa6NjqEROpIUV5/s612/DividendUtopia.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="208" data-original-width="612" height="109" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh5BaqLokaScVv_5mtS5NQbVbzsZj3mxTtykxEt9M9ab91C4uEdt7jcEHm2XFa4cfzCcILQLk19u2b74-wUxM7JFMYuTFjO0G9IhLiBolmCMnwasmMWNiqcnXLVZseBRuOXD8wXmk6AHJW0nCnTqH7Q88whSX6jVXQarPR_zo6iQRHa6NjqEROpIUV5/s320/DividendUtopia.jpg" width="320" /></a></div><div style="text-align: justify;">In practice, though, and especially when companies feel that they have to pay dividends, either because of their history of doing so (inertia) or because everyone else in their peer group pays dividends (me-tooism), dividend decisions startthe sequence, skewing the investment and financing decisions that follow. Thus, a firm that chooses to pay out more dividends than it should, will then turn out and either reject value-adding projects that it should have invested in or borrow more than it can afford to, and this dysfunctional dividend sequence is described below:</div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg2lnbM0ZJKvYBmJI4Gk-OOnZbIrUXPZw5ppGD5LMJjHryWhZo3BhZIY8TJ5bVL1K4zdSVyoanJ00q2cUz1XegpNs6lYW3Ml_MltdoCEt7oNw3L81Eyoc3lFqIu0oc-VEC2axIhf12W4iWzjGCMZx1oPGOSkqGV_RumTr914dV47Cgw2JjVma-syWj6/s2733/DivDysfunction.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="971" data-original-width="2733" height="143" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg2lnbM0ZJKvYBmJI4Gk-OOnZbIrUXPZw5ppGD5LMJjHryWhZo3BhZIY8TJ5bVL1K4zdSVyoanJ00q2cUz1XegpNs6lYW3Ml_MltdoCEt7oNw3L81Eyoc3lFqIu0oc-VEC2axIhf12W4iWzjGCMZx1oPGOSkqGV_RumTr914dV47Cgw2JjVma-syWj6/w400-h143/DivDysfunction.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div style="text-align: justify;">In this dysfunctional dividend world, some companies will pay out far more dividends than they should, hurting the very shareholders that they think that they are benefiting with their generous dividends.</div><p><b>Measuring Potential Dividends</b></p><p style="text-align: justify;"><b> </b>In the discussion of dysfunctional dividends, I argued that some companies pay out far more dividends than they should, but that statement suggests that you can measure how much the "right" dividends should be. In this section, I will argue that such a measure not only exists, but is easily calculated for any business, from its statement of cash flows.<br /></p><p><i>Free Cash Flows to Equity (Potential Dividends)</i></p><p style="text-align: justify;"><i> </i>The most intuitive way to think about potential dividends is to think of it as the cash flow left over after every conceivable business need has been met (taxes, reinvestments, debt payments etc.). In effect, it is the cash left in the till for the owner. Defined thus, you can compute this potential dividend from ingredients that are listed on the statement of cash flows for any firm:<br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi8lAWhaK-shEyXWXHB-CsTcHt8Fvy2poOd5Sw1ry_Qz0-matyJgwJB4JDSpuamyxWTPiwBTGb_zFODQX5vEnGOw-wcXcyEmXkTdHHVzRuZ0ym7ZXaI2SyxOOG_3M5IlobUfLYEnjgPBXdP4jxAYZQsTrWtx1PQ89CBthzgKxtE1pWpP23j4_iw2qJ-/s581/FCFE%20picture.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="377" data-original-width="581" height="260" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi8lAWhaK-shEyXWXHB-CsTcHt8Fvy2poOd5Sw1ry_Qz0-matyJgwJB4JDSpuamyxWTPiwBTGb_zFODQX5vEnGOw-wcXcyEmXkTdHHVzRuZ0ym7ZXaI2SyxOOG_3M5IlobUfLYEnjgPBXdP4jxAYZQsTrWtx1PQ89CBthzgKxtE1pWpP23j4_iw2qJ-/w400-h260/FCFE%20picture.jpg" width="400" /></a></div><br /><p style="text-align: justify;">Note that you start with net income (since you are focused on equity investors), add back non-cash expenses (most notably depreciation and amortization, but including other non-cash charges as well) and net out capital expenditures (including acquisitions) and the change in non-cash working capital (with increases in working capital decreasing cash flows, and decreases increasing them). The last adjustment is for debt payments, since repaying debt is a cash outflow, but raising fresh debt is a cash inflow, and the net effect can either augment potential dividends (for a firm that is increasing its debt) or reduce it (for a firm that is paying down debt).</p><p style="text-align: justify;"><span> Delving into the details, you can see that a company can have negative free cash flows to equity, either because it is a money losing company (where you start the calculation with a net loss) or is reinvesting large amounts (with capital expenditures running well ahead of depreciation or large increases in working capital). That company is obviously in no position to be paying dividends, and if it does not have cash balances from prior periods to cover its FCFE deficit, will have to raise fresh equity (by issuing shares to the market).</span></p><p><i>FCFE across the Life Cycle</i></p><p style="text-align: justify;"><i> </i>I know that you are probably tired of my use of the corporate life cycle to contextualize corporate financial policy, but to understand why dividend policies vary across companies, there is no better device to draw on. </p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg9gh2so-hzOmu263oGPM1p35hbnd_eTvlDRLhioAwlmB3zx-Q3QZ8ue50X3YmwTWehqOq28z1_yGWIZgldbQOZM8p1OSTqFyT_JHhvpsSszEFEBZDYshgd0U4giRqIMNCFhgbw8EJ5VQvdsCEkmqBUg6YqjS6UOdZBKmU1N5RAV86WK4eAIury99IH/s794/Ch8LifeCycle.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="631" data-original-width="794" height="318" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg9gh2so-hzOmu263oGPM1p35hbnd_eTvlDRLhioAwlmB3zx-Q3QZ8ue50X3YmwTWehqOq28z1_yGWIZgldbQOZM8p1OSTqFyT_JHhvpsSszEFEBZDYshgd0U4giRqIMNCFhgbw8EJ5VQvdsCEkmqBUg6YqjS6UOdZBKmU1N5RAV86WK4eAIury99IH/w400-h318/Ch8LifeCycle.jpg" width="400" /></a></div><div style="text-align: justify;">Young companies are unlikely to return cash to shareholders, because they are not only more likely to be money-losing, but also because they have substantial reinvestment needs (in capital expenditures and working capital) to generate future growth, resulting in negative free cash flows to equity. As companies transition to growth companies, they may become money-making, but at the height of their growth, they will continue to have negative free cash flows to equity, because of reinvestment needs. As growth moderates and profitability improves, free cash flows to equity will turn positive, giving these firms the capacity to return cash. Initially, though, it is likely that they will hold back, hoping for a return to their growth days, and that will cause cash balances to build up. As the realization dawns that they have aged, companies will start returning more cash, and as they decline, cash returns will accelerate, as firms shrink and liquidate themselves.</div><div><div style="text-align: justify;"> Of course, you are skeptical and I am sure that you can think of anecdotal evidence that contradicts this life cycle theory, and I can too, but the ultimate test is to look at the data to see if there is support for it. At the start of 2023, I classified all publicly traded firms globally, based upon their corporate ages (measured from the year of founding through 2022) into ten deciles, from youngest and oldest, and looked at free cash flows and cash return for each group:</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEih_BFke3dX8j9e88sBIT8PAOJtsTUfgEy1ABzNo7iH1JIczMzaQnvea2IueHpI10WKoRCjBm7KIP232LhzxyiO-1lTnvh7kYhvpY5K_S1_lfNC8m0ubkCYQWnfLoAHQw2bkJSkT_1PCVroYeGVUCzkEFKku3WGgVsJ3ZjebI4appFk_ySYVJ62lnnG/s894/AgeTable.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="281" data-original-width="894" height="126" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEih_BFke3dX8j9e88sBIT8PAOJtsTUfgEy1ABzNo7iH1JIczMzaQnvea2IueHpI10WKoRCjBm7KIP232LhzxyiO-1lTnvh7kYhvpY5K_S1_lfNC8m0ubkCYQWnfLoAHQw2bkJSkT_1PCVroYeGVUCzkEFKku3WGgVsJ3ZjebI4appFk_ySYVJ62lnnG/w400-h126/AgeTable.jpg" width="400" /></a></div><div style="text-align: justify;">As you can see, the youngest firms in the market are the least likely to return cash to shareholders, but they have good reasons for that behavior, since they are also the most likely to be money losing and have negative freee cash flows to equity. As firms age, they are more likely to be money-making, have the potential to pay dividends (positive FCFE) and return cash in the form of dividends or buybacks. </div><p><b>Dividends and Buybacks: Fact and Fiction</b></p><p style="text-align: justify;"><span> Until the early 1980s, there was only one conduit for publicly traded companies to return cash to owner, and that was paying dividends. In the early 1980s, US firms, in particular, started using a second option for returning cash, by buying back stock, and as we will see in this section, it has become (and will stay) the predominant vehicle for cash return not only for US companies, but increasingly for firms around the world. </span><br /></p><p><i><b>The Facts</b></i></p><p style="text-align: justify;"><b style="font-style: italic;"> </b> Four decades into the buyback surge, there are enough facts that we can extract by looking at the data that are worth highlighting. First, it is undeniable that US companies have moved dramatically away from dividends to buybacks, as their primary mode of cash return, and that companies in the rest of the world are starting to follow suit. Second, that shift is being driven by the recognition on the part of firms that earnings, even at the most mature firms, have become more volatile, and that initiating and paying dividends can trap firms into . Third, while much has been made of the tax benefits to shareholders from buybacks, as opposed to dividends, that tax differential has narrowed and perhaps even disappeared over time.<br /></p><p><i>1. Buybacks are supplanting dividends as a mode of cash return</i></p><p style="text-align: justify;"><i> </i>I taught my first corporate finance class in 1984, and at the time, almost all of the cash returned by companies to shareholders took the form of dividends, and buybacks were uncommon. In the graph below, you can see how cash return behavior has changed over the last four decades, and the trend lines are undeniable;</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj3pMfKazugKHlsLTkuB9DEEDJ-gOzOeoI0kGqvipnW3Sije7YM9IsxTGVpkYEqweL4Hpxmrmr9oSYU2rJEVYOj7nptclLN1KS8I17LbWqlE3fqhqvpj4ZZCMi8lgaPq3f-fkXLoeQsHqoUN4JCQ_goz9cWX7M8E13jkwbtuEiZ164Opn6PpPZauHLc/s1158/Div&Buybacksovertime.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="616" data-original-width="1158" height="213" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj3pMfKazugKHlsLTkuB9DEEDJ-gOzOeoI0kGqvipnW3Sije7YM9IsxTGVpkYEqweL4Hpxmrmr9oSYU2rJEVYOj7nptclLN1KS8I17LbWqlE3fqhqvpj4ZZCMi8lgaPq3f-fkXLoeQsHqoUN4JCQ_goz9cWX7M8E13jkwbtuEiZ164Opn6PpPZauHLc/w400-h213/Div&Buybacksovertime.jpg" width="400" /></a></div><div style="text-align: justify;">The move to buybacks started in earnest in the mid 1980s and by 1988, buybacks were about a third of all cash returned to shareholders. In 1998, buybacks exceeded dividends for the first time in US corporate history and by last year, buybacks accounted for almost two thirds of all cash returned to shareholders. In short, the default mechanism for returning cash at US companies has become buybacks, not dividends. Lest you start believing that buybacks are a US-centric phenomenon, take a look at global dividends and buybacks, in the aggregate, broken down by region in 2022:</div><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgdnX4UbnL9XuDQeOXuSBlT-ZEO-hY6LVx71QAiOuRLHJwzEtS01wxxYBEB3Q2FH9Cgha0AlnPzKd1b20Tu8BEmUy5GbQMop0M1cRwhkqiTLtJ-NtURbrXWgZYcCKi7gWpIhr9z22G8INIJZVFTHwDpjz7_98AeszE8XE5iKFNJJzSAKz7UbYA-PAzX/s1247/RegionTable.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="319" data-original-width="1247" height="103" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgdnX4UbnL9XuDQeOXuSBlT-ZEO-hY6LVx71QAiOuRLHJwzEtS01wxxYBEB3Q2FH9Cgha0AlnPzKd1b20Tu8BEmUy5GbQMop0M1cRwhkqiTLtJ-NtURbrXWgZYcCKi7gWpIhr9z22G8INIJZVFTHwDpjz7_98AeszE8XE5iKFNJJzSAKz7UbYA-PAzX/w400-h103/RegionTable.jpg" width="400" /></a></div><p style="text-align: justify;">Note that while the US is the leader of the pack, with 64% of cash returned in buybacks, the UK, Canada, Japan and Europe are also seeing a third or more of cash returned in buybacks, as opposed to dividends. Among the emerging market regions, Latin America has the highest percent of cash returned in buybacks, at 26.90%, and India and China are still nascent markets for buybacks. The shift to buybacks that started in the United States clearly has now become a global phenomenon and any explanation for its growth has to be therefore global as well.</p><p><i>2. Buybacks are more flexible than dividends</i></p><p style="text-align: justify;"><i> </i>If you buy into the notion of a free cash flow to equity as a potential cash return, companies face a choice between paying dividends and buying back stock, and at first sight, the impact on the company of doing either is exactly the same. The same amount of cash is paid out in either case, the effects on equity are identical (in both book value and market value terms) and the operations of the company remain unchanged. The key to understanding why companies may choose one over the other is to start with the recognition that in much of the world, dividends are sticky, i.e., once initiated and set, it is difficult for companies to suspend or cut dividends without a backlash, as can be seen in this graph that looks at the percent of US companies that increase, decrease and do nothing to dividends each year:<br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiDVPmkpdOGNkaXT-q70YaOZbUvqxuQeXFBHP_qT55KuqKekSTw8oLF8dtxLR-MUJaQd9qJfzJKJrqdhlai2x3xB5r14qkpY63JzIp89vOVbLMJyAcHvocLXJQKv-lKRbTHt2e8MeHXNCdCiAyf5QGbDZ0I7BQQC2K8dTEW1TveJcbt0wfqA8JhW0a-/s1126/StickyDividends.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="627" data-original-width="1126" height="223" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiDVPmkpdOGNkaXT-q70YaOZbUvqxuQeXFBHP_qT55KuqKekSTw8oLF8dtxLR-MUJaQd9qJfzJKJrqdhlai2x3xB5r14qkpY63JzIp89vOVbLMJyAcHvocLXJQKv-lKRbTHt2e8MeHXNCdCiAyf5QGbDZ0I7BQQC2K8dTEW1TveJcbt0wfqA8JhW0a-/w400-h223/StickyDividends.jpg" width="400" /></a></div><div style="text-align: justify;">Note that the number of dividend-paying companies that leave dividends unchanged dominates companies that change dividends every single year, and that when companies change dividends, they are far more likely to increase than cut dividends. The striking feature of the graph is that even in crisis years like 2008 and 2020, more companies increased than cut dividends, testimonial to its stickiness. In contrast, companies are far more willing and likely to revisit buybacks and slash or suspend them, if the circumstances change, making it a far more flexible way of returning cash:<i> </i></div></div><div><i><br /></i><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgi9JicIPkKwhhB78Bp7Kp2xmsg9ZIq3aN9soXGJzSEFTpcDlw4mLsPa2v80MBXIGhslcwo-A5O2k0KEoYRRHyaU041LIvLzgpeJNIdNOvk51Yogu8iB2byGoKImJ5PLhA-Mzyssbiy8ptD9Tco5UQWFyV0LBtuZaX09ksMbGN5HAwCtopKVIDp1UE0/s2281/Dividend%20Flexibility.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1467" data-original-width="2281" height="258" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgi9JicIPkKwhhB78Bp7Kp2xmsg9ZIq3aN9soXGJzSEFTpcDlw4mLsPa2v80MBXIGhslcwo-A5O2k0KEoYRRHyaU041LIvLzgpeJNIdNOvk51Yogu8iB2byGoKImJ5PLhA-Mzyssbiy8ptD9Tco5UQWFyV0LBtuZaX09ksMbGN5HAwCtopKVIDp1UE0/w400-h258/Dividend%20Flexibility.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><br /><div class="separator" style="clear: both; text-align: justify;">At the core, this flexibility is at the heart of the shift to buybacks, especially as fewer and fewer companies have the confidence that they can deliver stable and predictable earnings in the future, some because globalization has removed local market advantages and some because their businesses are being disrupted. It is true that there is a version of dividends, i.e., special dividends, that may offer the same flexibility, and it will be interesting to see if their usage increases as governments target companies buying back stock for punishment or higher taxes.</div><p><i>3. There are tax benefits (to shareholders) from buybacks, but they have decreased over time</i></p><p style="text-align: justify;"><i> </i>From the perspective of shareholders, dividends and buybacks create different tax consequences, and those can affect which option they prefer. A dividend gives rise to taxable income in the period that it is paid, and taxpayer have little or no way of delaying or evading paying taxes. A buyback gives investors a choice, with those opting to sell back their shares receiving a realized capital gain, which will be taxed at the capital gains tax rate, or not selling them back, giving rise to an unrealized capital gain, which will be taxed in a future period, when the stock is sold. For much of the last century, dividends were taxed in the US as ordinary income, at rates much higher than that paid on capital gains.<br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj0U8R9ouuJwlWFZA-sXv1PNBQJBASPZt5yr55kuOadP7yErAvLX5mGrPHQsVNtKq5Sf8QZ-bqmLIBNZl63b1dmeBRKGo_4WbFBcKq4XScifphqGem3ZisqQUeuLAvbMJXVmq0OcDSO8vyXwD-Y7EffTEDI9KH-NTeH88mxGDsvT5554it_OQyVZGwT/s2304/TaxRatesPicture.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1154" data-original-width="2304" height="200" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj0U8R9ouuJwlWFZA-sXv1PNBQJBASPZt5yr55kuOadP7yErAvLX5mGrPHQsVNtKq5Sf8QZ-bqmLIBNZl63b1dmeBRKGo_4WbFBcKq4XScifphqGem3ZisqQUeuLAvbMJXVmq0OcDSO8vyXwD-Y7EffTEDI9KH-NTeH88mxGDsvT5554it_OQyVZGwT/w400-h200/TaxRatesPicture.jpg" width="400" /></a></div><div style="text-align: justify;">While the differential tax benefit in the last century is often mentioned as the reason for the rise of buybacks, note that the tax differential was even worse prior to 1980, when dividends essentially dominated, to the post-1980 period, when buybacks came into vogue. For much of this century, at least in the US, dividends and buybacks have been taxed at the same rate, starting at 15% in 2003 and rising to 23.8% in 2011 (a 20% capital gains rate + 3.8% Medicare tax on all income), thus erasing much of the difference between dividends and realized capital gains for shareholder tax burdens. However, shareholders still get a benefit with unrealized capital gains that can be carried forward to a future tax-advantageous year or even passed on in inheritance as untaxed gains.</div><p style="text-align: justify;"><span> Until last year, there were no differences in tax consequences to companies from paying dividends or buying back stock, but the Inflation Reduction Act of 2022 introduced a 1% tax rate on buybacks, thus creating at least a marginal additional cost to companies that bough back stock, instead of paying dividends. If the only objective of this buyback tax is raising revenues, I don't have a problem with that because it will help close the budget gap, but to the extent that this is designed to change corporate behavior by inducing companies to not buy back stock or to invest more back into businesses, it is both wrong headed and will be ineffective, as I will argue in the next section.</span><br /></p><p><i><b>The Fiction</b></i></p><p style="text-align: justify;"><b style="font-style: italic;"> </b>The fictions about buybacks are widespread and are driven as much by ideological blinders as they are by a failure to understand what a business is, and how to operate it. The first is that buybacks can increase or decrease the value of a business, with buyback advocates making the former argument and buyback critics the latter. They are both wrong, since buybacks can only redistribute value, not create it. The second is that surge in buybacks has been fed by debt financing, and it is part of a larger and darker picture of over levered companies catering to greedy, short term shareholders. The third is that buybacks are bad for an economy, with the logic that the cash that is being used for the buybacks is not being invested back in the business, and that the latter is better for economic growth. The final argument is that the large buybacks at US companies represent cash that is being taken away from other stakeholders, including employees and customers, and is thus unfair.<b style="font-style: italic;"> </b><br /></p><p><i>1. Buybacks increase (decrease) value</i></p><p style="text-align: justify;"><i> </i>Value in a business comes from its capacity to invest money and generate cash flows into the future, and defined as such, the act of returning cash by itself, either as dividends or buybacks cannot create or destroy value. It is true that the way in which dividends and buybacks are funded or the consequences that they have for investing can have value effects, but those value effects do not come from the cash return, but from investing and financing dysfunction. The picture below captures the pathways by which the way dividends and buybacks are funded can affect value:</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgaZ8kwVJhA-3qQRJlTW-nUIebEDH7vWW-lZJZTU7XVLdFZ42ItzdwrFkZmN4olYWhr44gCvSrOsVrk4x1a3lrkAD7B8Q9Qr0Zn0PBQvuLFunXWsegJCh31LfyK9PaPN9kCaqV-gdf3ssGyvfcnJJOTtUBobRr2G9ZTyK4Bw9j8oHfTw7oLVlBSd300/s2209/BuybackValueEffects.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1711" data-original-width="2209" height="248" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgaZ8kwVJhA-3qQRJlTW-nUIebEDH7vWW-lZJZTU7XVLdFZ42ItzdwrFkZmN4olYWhr44gCvSrOsVrk4x1a3lrkAD7B8Q9Qr0Zn0PBQvuLFunXWsegJCh31LfyK9PaPN9kCaqV-gdf3ssGyvfcnJJOTtUBobRr2G9ZTyK4Bw9j8oHfTw7oLVlBSd300/s320/BuybackValueEffects.jpg" width="320" /></a></div><div style="text-align: justify;">The implications are straight forward and common sense. While a buyback or dividend, by itself, cannot affect value, the way it is funded and the investments that it displaces can determine whether value is added or destroyed.</div></div><div><ol style="text-align: left;"><li style="text-align: justify;"><u>Leverage effect</u>: If a company that is already at its right mix of debt (see my last post) choose to add to that debt to fund its dividend payments or buybacks, it is hurting its value by increasing its cost of capital and exposure to default risk. However, a firm that is under levered, i.e., has too little debt, may be able to increase its value by borrowing money to fund its cash return, with the increase coming from the skew in the tax code towards debt.</li><li style="text-align: justify;"><u>Investment effect</u>: If a company has a surplus of value-adding projects that it can take, and it chooses not to take those projects so as to be able to pay dividends or buy back stock, it is hurting it value. By the same token, a company that is in a bad business and is struggling to make its cost of capital will gain in value by taking the cash it would have invested in projects and returning that cash to shareholders.</li></ol><div style="text-align: justify;">Finally, there is a subset of companies that buy back stock, not with the intent of reducing equity and share count, but to cover shares needed to cover stock-based compensation (option grants). Thus, when management options get exercised, rather than issue new shares and dilute the ownership of existing shareholders, these companies use shares bought back to cover the exercise. The value effect of doing so is equivalent to buybacks that reduce share count, because not issuing shares each year to cover option exercises is effecting accomplishing the same objective of keeping share count lower. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">There is an element where there dividends and buybacks can have contrasting effects. Dividends are paid to all shareholders, and thus cannot make one group of shareholders better or worse off than others. Buybacks are selective, since only those shareholders who sell their shares back receive the buyback price, and they have the potential to redistribute value. In what sense? A company that buys back stock at too high a price, relative to its intrinsic value, is redistributing value from the shareholders who remain in the company to those who sell their shares back. In contrast, a company that buys back shares at a low price, relative to its intrinsic value, is redistributing value from the shareholders who sell their shares back to those who stay shareholders in the firm. This is at the heart of Warren Buffet's defense of buybacks at Berkshire Hathaway as a tool, since he adds the constraint that the buybacks will continue only if they can be done at less than intrinsic value, and the assumption is that Buffet does have a better sense of the intrinsic value of his company than market participants. It is true that some companies buy back stock at the high prices, and if that is your reason, as a shareholder in the company for taking a stand against buybacks, I have a much simpler and more effective response than banning buybacks. Just sell your shares back and be on the right side of the redistribution game! </div><div><br /></div><div><i>2. Buybacks are being financed with debt</i></div><p style="text-align: justify;">As I noted in my lead in to this section, a company that borrows money that it cannot afford to borrow to buy back stock is not just damaging its value but putting its corporate existence at risk. I have heard a few critics of buybacks contend that buybacks are being funded primarily or predominantly with debt, using anecdotal examples of companies that have followed this script, to back up their claim. But is this true across companies? To address this, I looked companies in the US (because this critique seems to be directed primarily at them), broken down by whether they did buybacks in 2022, and then examined debt loads within each group:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgT8vMZ7NAUUkOZD2hljADA02LTWfv1FgejGGNGpC0SPI6359Hy8_Jf-atb8RLoJIZn6QOuzLyqYzmOFDqGi-OsfbyjO4KgpDBP4qLRdFrtwrjrFbrmc5mrHEjHZSwhzIzM5E6yh5zek-aYw3E7lN8iDHXOqIwwLibJNu2JWZeHRjoWe0MVuEiR4IXB/s738/Debt&Buyback.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="538" data-original-width="738" height="291" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgT8vMZ7NAUUkOZD2hljADA02LTWfv1FgejGGNGpC0SPI6359Hy8_Jf-atb8RLoJIZn6QOuzLyqYzmOFDqGi-OsfbyjO4KgpDBP4qLRdFrtwrjrFbrmc5mrHEjHZSwhzIzM5E6yh5zek-aYw3E7lN8iDHXOqIwwLibJNu2JWZeHRjoWe0MVuEiR4IXB/w400-h291/Debt&Buyback.jpg" width="400" /></a></div><p style="text-align: justify;">You can be the judge, using both the debt to capital ratio and the debt to EBITDA multiple, that companies that buy back stock have lower debt loads than companies that don't buy back stock, at odds with the "debts fund buybacks" story. Are there firms that are using debt to buy back stock and putting their survival at risk? Of course, just as there are companies that choose other dysfunctional corporate finance choices. In the cross section, though, there is little evidence that you can point to that buybacks have precipitated a borrowing binge at US companies.</p><p><i>3. Buybacks are bad for the economy</i></p><p style="text-align: justify;"><span> The final argument against buybacks has little to do with shareholder value or debt </span>but is centered around a mathematical truth. Companies that return cash to shareholders, whether as dividends or buybacks, are not reinvesting the cash, and to buyback critics, that fact alone is sufficient to argue against buybacks. There are two premises on which this argument is built and they are both false.</p><p></p><ul style="text-align: left;"><li style="text-align: justify;">The first is that a company investing back into its own business is always better for the economy than that company not investing, and that misses the fact that investing in bad businesses, just for the sake of investing is not good for either shareholders or the economy. Is there anyone who would argue with a straight face that we would be all better off if Bed Bath and Beyond had built more stores in the last decade than they already have? Alternatively, would we not all have been better served if GE had liquidated itself as a company a decade ago, when they could have found eager buyers and returned the cash to their shareholders, instead of continuing as a walking dead company? </li><li style="text-align: justify;">The second is that the money returned in buybacks, which exceeded a trillion dollars last year, somehow disappeared into a black hole, when the truth is that much of that money got reinvested back into the market in companies that were in better businesses and needed capital to grow? Put simply, the money got invested either way, but by companies other than GE and Bed Bath and Beyond, and that counts as a win for me.</li></ul><div style="text-align: justify;">Watching the debate on buybacks in the Senate last year, I was struck by how disconnected senators were from the reality of buybacks, which is that they bulk of buybacks come from companies that have no immediate use for the money, or worse, bad uses for the monty, and the effect of buybacks is that this money gets redirected to companies that have investment opportunities and operate in better businesses.</div><p></p><p style="text-align: justify;"><i>4. Buybacks are unfair to other stakeholders</i></p><p style="text-align: justify;">If the argument against buybacks is that the money spent on buybacks could have been spent paying higher wages to employees or improving product quality, that is true. That argument is really one about how the pie is being split among the different shareholders, and whether companies are generating profits that excessive, relative to the capital invested. I argued in my fifth data post that if there is backing for a proposition, it is that companies are not earning enough on capital invested, not that they are earning too much. I will wager that if you did break down pay per hour or employee benefits, they will be much better at companies that are buying back stock than at companies that don't. Unfortunately, I do not have access to that data at the company-level on either statistic, but I am willing to consider evidence to the contrary.</p><p style="text-align: justify;"><b>The Bottom Line</b></p><p style="text-align: justify;">It is telling that some of the most vehement criticism of buybacks come from people who least understand business or markets, and that the legislative solutions that they craft reflect this ignorance. Taxing buybacks because you are unable to raise corporate tax rates may be an effective revenue generator for the moment, but pushing that rate up higher will only cause the cash return to take different forms. Just as the attempts to curb top management compensation in the early 1990s gave rise to management options and a decade of even higher compensation, attempts to tax buybacks may backfire. If the end game in taxing buybacks is to change corporate behavior, trying to induce invest more in their businesses, it will be for the most part futile, and if it does work, will do more harm than good.</p><p style="text-align: justify;"><b>YouTube Video</b></p><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/QKJt3cv7c2k" title="YouTube video player" width="560"></iframe><p style="text-align: justify;"><b>Data Links</b></p><p style="text-align: justify;"></p><ol><li>Dividend Statistics, by Industry: <a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/divfund.xls">US</a> and <a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/divfundGlobal.xls">Global</a></li><li>Dividends, Buybacks and FCFE, by Industry: <a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/divfcfe.xls">US</a> and <a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/divfcfeGlobal.xls">Global</a></li></ol><p></p><p style="text-align: justify;"><b>Data Update Posts for 2023</b></p><p style="text-align: justify;"></p><ol><li><a href="https://aswathdamodaran.blogspot.com/2023/01/data-update-1-for-2023-year-that-was.html">Data Update 1 for 2023: Setting the Table!</a></li><li><a href="https://aswathdamodaran.blogspot.com/2023/01/data-update-2-for-2023-rocky-year-for.html">Data Update 2 for 2023: A Rocky year for Equities!</a></li><li><a href="https://aswathdamodaran.blogspot.com/2023/01/data-update-3-for-2023-inflation-and.html">Data Update 3 for 2023: Inflation and Interest Rates</a></li><li><a href="https://aswathdamodaran.blogspot.com/2023/02/data-update-4-for-2023-country-risk.html">Data Update 4 for 2023: Country Risk - Measures and Implications</a></li><li><a href="https://aswathdamodaran.blogspot.com/2023/02/data-update-5-for-2023-earnings-test.html">Data Update 5 for 2023: The Earnings Test</a></li><li><a href="https://aswathdamodaran.blogspot.com/2023/02/data-update-6-for-2023-wake-up-call-for.html">Data Update 6 for 2023: A Wake up call for the Indebted?</a></li><li>Data Update 7 for 2023: Dividends, Buybacks and Cash Flows</li></ol><p></p><p style="text-align: justify;"><br /></p></div>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0tag:blogger.com,1999:blog-8152901575140311047.post-88806921287732741452023-02-27T09:22:00.001-05:002023-02-27T09:22:15.457-05:00Data Update 6 for 2023: A Wake up call for the Indebted?<div style="text-align: justify;">We have an uneasy relationship with debt, both in our personal and business lives. While it is a financial decision, it is one that is freighted with moral overtones, since almost every religion inveighs against debt's sins, labeling those who lend as sinners and those who borrow as weak. That may reflect the concern that once a person or entity starts borrowing to fund its needs, it is easy to overuse debt, and risk its wellbeing in the process. All that said, businesses around the world have borrowed money though time to fund their operations, sometimes for good reasons and sometimes for bad, and over time, these businesses have also faced cycles of too much debt leading to painful cleansing. In this post, I will focus on corporate debt in 2023, keeping in mind that it was a year where the tradeoffs changed, as interest rates rose to pre-2008 levels, and putting at risk those firms that had borrowed to capacity, or even beyond, at low interest rates.</div><p style="text-align: justify;"><b>Debt's place in business</b></p><p style="text-align: justify;"><span> </span>To understand debt's role in a business, I will start with a big picture perspective, where you break a business down into assets-in-place, i.e., the value of investments it has already made and growth assets, the value of investments you expect it to make in the future. To fund the business, you can either use borrowed money (debt) or owner's funds (equity), and while both are sources of capital, they represent different claims on the business. Debt provides contractual claims, in the form on interest payments and principal repayments, whereas equity is a residual claim, i.e., you receive whatever cash flows, if any, that are left over after other claim holders have been paid:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg0-DjmtFv2IC4ksdp2EhA6j_NuqcqhoxOQebTsHwkaGJoLgSrEk9jT8PF_Up3LyFNzNSjnYdGPlpGlU8V-BJHMfAclFH0LE4eaZZPHRiUzvoCA0oM5-WmyC7xqZdZOgEF4NWzhQrtkZqk8dQylDgNXHy8v8hkqvePujFlV2Pg-RyljAfi_ZQOfotTW/s750/DebtvsEquity.jpg" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" height="123" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg0-DjmtFv2IC4ksdp2EhA6j_NuqcqhoxOQebTsHwkaGJoLgSrEk9jT8PF_Up3LyFNzNSjnYdGPlpGlU8V-BJHMfAclFH0LE4eaZZPHRiUzvoCA0oM5-WmyC7xqZdZOgEF4NWzhQrtkZqk8dQylDgNXHy8v8hkqvePujFlV2Pg-RyljAfi_ZQOfotTW/w400-h123/DebtvsEquity.jpg" width="400" /></a></div><p></p><div style="text-align: justify;">This breakdown should take out the mystery out of debt, since it converts it into a source of capital, and the question of whether you should borrow to fund a business, and if yes, how much you should borrow becomes one of choosing between a source of capital that gives rise to contractual claims, with all of its pluses and minuses, and one that gives rise to residual claims, with all of its benefits and costs. Note that this framework applies for all businesses, from the smallest, privately owned businesses, where debt takes the form of bank loans and even credit card borrowing and equity is owner savings, the largest publicly traded companies, where debt can be in the form of corporate bonds and equity is shares held by public market investors. Even government-owned businesses fall under its umbrella, with the key difference being that equity is provided by the taxpayers.</div><p style="text-align: justify;"><i>Good Reasons for Borrowing</i></p><p style="text-align: justify;"><span> </span> What are the pluses and minuses of borrowing, if you take a clear-eyed look at it just as a capital source? First, borrowing money cannot alter the operating risk in a business, which comes from the assets that it holds, either in-place or as growth investments, but it will affect the risk to equity investors in that business, by making their residual claim (earnings) more volatile, In addition, the contractual claim that comes with debt can create truncation risk, because failing to make interest or principal payments can result in bankruptcy, and effective loss of equity. Second, borrowing money at a lower rate, by itself, cannot alter your overall cost of funding, since that cost is determined by the risk of your assets. Hence, the benefits of borrowing at a lower rate will always be offset by a higher cost for equity investors, leaving the cost of funding unchanged, unless a finger is put on the scale, giving one source special benefits. In much of the world, governments have written tax codes that do exactly this, by making interest payments on debt tax-deductible, while requiring that cash flows to equity be made out of after-tax cash flows. That tax benefit of debt will increase with the marginal tax rate, making it much more beneficial to borrow in countries with high tax rates (Germany, Japan, US) over those with lower tax rates (Ireland, much of Eastern Europe). The chart below lists the tax benefits as the primary benefit of borrowing and the expected bankruptcy cost as the primary downside of debt:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgcxLBd_TanhGcgHqErVBFuksIvjTs7tnfx2cVAJ3--GhFMM59SUXl-ktyLCQ1BidEVP7insnHJCD7VtFaDJ6NwICAzrP9mMCoZ6LdUHjxJXCd1RrwXd-eCXHp4Ig2T0-kl8HFPxKBD7oGL4m_ed7df3_r6-ZwcxxNLLNATanDpgkNd3UdAaPr1soX4/s654/DebtvsEquityRealBenefits.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="291" data-original-width="654" height="178" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgcxLBd_TanhGcgHqErVBFuksIvjTs7tnfx2cVAJ3--GhFMM59SUXl-ktyLCQ1BidEVP7insnHJCD7VtFaDJ6NwICAzrP9mMCoZ6LdUHjxJXCd1RrwXd-eCXHp4Ig2T0-kl8HFPxKBD7oGL4m_ed7df3_r6-ZwcxxNLLNATanDpgkNd3UdAaPr1soX4/w400-h178/DebtvsEquityRealBenefits.jpg" width="400" /></a></div>There are also ancillary benefits and costs that the chart notes, with debt operating as a disciplinary tool in some businesses, when managers consider taking new projects, since bad projects can plunge the firm into bankruptcy (and cause managers to lose their jobs), and the challenge of managing the conflicting interests of equity investors and lenders, that manifest in covenants, restrictions, and legal costs. <p style="text-align: justify;"><i>Bad Reasons for Borrowing</i></p><div style="text-align: justify;"><span> </span>There are many bad reasons for borrowing, and some companies seem intent on using these bad reasons. The first, and the one offered by most debt-heavy entities is that using more debt will result in higher returns on equity, since there is less equity at play. That is technically true, for the most part, but since the cost of equity rises proportionately, that benefit is an illusion. The second is that debt is cheaper than equity, to which your response should be that this is true for every business, and the reason lies in the fact that lenders have first claim on the cash flows and equity investors are last in line, not in some inherent cheapness of debt. The chart below lists these illusory benefits:</div><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify; text-indent: 0.5in;"><o:p></o:p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhQpGiI0nJrl_LKp9_5dDoMwly5Koq3vXeaZCWQ2RMmx09Sqx-YqdOiC0vQiAHypDrDxOIufjQa-iFE0daVxbuEgwOtZuNuQ7ZWEib2lDrNgX6JFu33-iT-SFAYkYMPMI51I-uaJSGr_aE5s9xNyn5ZOg2vJV8ClhnM7eRJh3B9PN5FTafinjdzeTEJ/s578/DebtvsEquityIllusoryBenefits.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="351" data-original-width="578" height="194" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhQpGiI0nJrl_LKp9_5dDoMwly5Koq3vXeaZCWQ2RMmx09Sqx-YqdOiC0vQiAHypDrDxOIufjQa-iFE0daVxbuEgwOtZuNuQ7ZWEib2lDrNgX6JFu33-iT-SFAYkYMPMI51I-uaJSGr_aE5s9xNyn5ZOg2vJV8ClhnM7eRJh3B9PN5FTafinjdzeTEJ/s320/DebtvsEquityIllusoryBenefits.jpg" width="320" /></a></div><p class="MsoNormal" style="margin: 0in;"><br />On the other side of the ledger, there are some companies that refuse to borrow money for bad reasons as well. The first is that borrowing money will lower net income, as interest expenses get deducted from operating income, but that lower net income will be accompanied by less equity invested in the firm, often leading to higher earnings per share, albeit with higher volatility. The second is that borrowing money will increase perceived default risk, and if the company is rated, lower ratings, and that too is true, but borrowing money at a BBB rating, with the tax benefit incorporated, might still yield a lower cost of funding that staying at a AA rating, with no debt in use.<br /><br /><b style="font-family: "Times New Roman", serif;">The "Right" Financing Mix</b></p><p style="text-align: justify;"><span> </span> Is there an optimal mix of debt and equity for a business? The answer is yes, though the payoff, in terms of value, from moving to that optimal may be so small that it is sometimes better to hold back from borrowing. In this section, I will lay out a mechanism for evaluating the effects of borrowing on the cost of funding a business, i.e., the cost of capital, and talk about why firms may under or overshoot this optimal.</p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;"><o:p></o:p></p><p style="text-align: justify;"><i>An Optimizing Tool</i></p><p><span> </span> In my second and third data posts for this year, I chronicled the effects of rising interest rates and risk premiums on costs of equity and capital. In computing the latter, I used the current debt ratios for firms, but made no attempt to evaluate whether these mixes were "right" or not. That said, the cost of capital can be used as an optimizing tool in assessing the right mix of debt and equity, with the optimal mix being the one that yields the lowest cost of capital. That computation, though, is a dynamic one, since both the cost of equity and the cost of debt will change as a business changes its debt ratio:</p><p style="text-align: justify;"></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjmckYz6j3bXnc7eyeYgqrzui1CNafBrh8Wx4cmdL9dK5f60thwFqa4WULsNcJeIevEn7rAVahHnncrqq9CNb6KznnDpdshQZL8CSlSYy92uHfL9h2d_I3KEgO6bu7ELYB2tmlBAL0oaYrasJv0Hm1468wzQXduKIKCt9jazGFh1lbVEOb7xk4CMtsN/s812/DebtOptimizer.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="380" data-original-width="812" height="188" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjmckYz6j3bXnc7eyeYgqrzui1CNafBrh8Wx4cmdL9dK5f60thwFqa4WULsNcJeIevEn7rAVahHnncrqq9CNb6KznnDpdshQZL8CSlSYy92uHfL9h2d_I3KEgO6bu7ELYB2tmlBAL0oaYrasJv0Hm1468wzQXduKIKCt9jazGFh1lbVEOb7xk4CMtsN/w400-h188/DebtOptimizer.jpg" width="400" /></a></div><p></p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;">In effect, you are trading off the benefits of replacing more expensive equity with lower-rate debt against the resulting higher costs of equity and debt, when you borrow more. As you can see, the net effect of raising the debt ratio on the cost of capital will depend on where a firm stands, relative to its optimal, with under levered firms seeing costs of capital decrease, as debt ratio increases, and over levered firms seeing the opposite effect. <o:p></o:p></p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify; text-indent: 0.25in;">As to the variables that determine what that optimal debt ratio is for a firm, and why the optimal debt ratio can range from 0% for some firms to close to 90% for others, they are simple and intuitive:<o:p></o:p></p><p></p><ol><li style="text-align: justify;"><u>Marginal tax rate</u>: If the primary benefit of borrowing is a tax benefit, the higher the marginal tax rate, the higher its optimal debt ratio. In fact, at a zero percent tax rate, the optimal debt ratio, if you define it as the mix that minimizes cost of capital is zero. The picture below captures differences in corporate marginal tax rates, entering 2023, across the world:<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEheqfdERsEVGHCVNiEhdgkjMk9Abmgtgl2NIWkUk2E-jkerffQp9X8lUI4Zz0jEd_kbWoDrpG8f2GYNksWtjvob5EMs0vNN0QA39hgbYRH06CPUVDhPHpVqqTNVAUZ73D6_X_JVDFbJnLqQNQ7_y6JGfBBIc7nyW-hJ1q4kOvAvLK9z6sFvBySldF47/s1468/CountryTaxRateHeatMapPicture.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1468" data-original-width="1444" height="400" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEheqfdERsEVGHCVNiEhdgkjMk9Abmgtgl2NIWkUk2E-jkerffQp9X8lUI4Zz0jEd_kbWoDrpG8f2GYNksWtjvob5EMs0vNN0QA39hgbYRH06CPUVDhPHpVqqTNVAUZ73D6_X_JVDFbJnLqQNQ7_y6JGfBBIc7nyW-hJ1q4kOvAvLK9z6sFvBySldF47/w394-h400/CountryTaxRateHeatMapPicture.jpg" width="394" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/countrytaxrates.xlsx">Download marginal tax rates, by country</a></td></tr></tbody></table><br /> As you can see from the heat map and table, most countries have converged around a tax rate of 25%, with a few outliers in Eastern Europe and parts of Middle East having marginal tax rates of 15% or lower, and a few outliers, including Australia, India and parts of Africa with marginal tax rates that exceed 30%. Of these countries, Australia does offer protection from double taxation for equity investors, effectively endowing equity with some tax benefits as well, and reducing the marginal tax benefits from adding debt.</li><li class="MsoNormal" style="mso-list: l0 level1 lfo1; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto; tab-stops: list .5in; text-align: justify;"><u>Cash generating capacity</u>: Debt payments are serviced with operating cash flows, and the more operating cash flows that firms generate, as a percent of their market value, the more that they can afford to borrow. One simplistic proxy for this cash generating capacity is EBITDA as a percent of enterprise value (EV), with higher (lower) values indicating greater (lesser) cash flow generating capacity. In fact, that may explain why firms that trade at low EV to EBITDA multiples are more likely to become targets in leveraged buyouts (LBOs) or leveraged recapitalizations..</li><li class="MsoNormal" style="mso-list: l0 level1 lfo1; mso-margin-bottom-alt: auto; mso-margin-top-alt: auto; tab-stops: list .5in; text-align: justify;"><u>Business risk</u>: Not surprisingly, for any given level of cash flows and marginal tax rate, riskier firms will be capable of carrying less debt than safer firms. That risk can come from many sources, some related to the firm (young, evolving business model, highly discretionary products/services), some to the sector (cyclical, commodity) and some to the overall economy (unstable). The company-specific factors show up in the risk parameters that you use for the firm (beta, rating) and the macro and market-wide factors show up in the macro inputs (riskfree rates, equity risk premiums)</li></ol><p></p><p style="text-align: justify;">If you are interested in checking how this optimization works, <a href="https://pages.stern.nyu.edu/~adamodar/pc/capstru.xlsx">download this spreadsheet</a>, and try changing the inputs to see the effect on the optimal. I looked Adani Enterprises, the holding company for the Adani Group and estimated the cost of capital and estimated value at different debt ratios: </p><p style="text-align: justify;"><span style="font-family: "Times New Roman", serif;"> </span></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiwOAjuiUtyZPjmENXFSZNoomCDEYEesUflNI-HW92NDWBDZwA8fNQg_k0SVGkGgTij_5jD4qSm9seFnsNLQ3TqCcmnsOQihAJMsR5ysQvIqlOogcz_WsL3pTbcJ32OaBNTy7gW18lZnXizjju_21qfNj9MOvQedFuuXsIsLRXr3kuuV-58UuLtQQ5f/s1069/AdaniEntChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="771" data-original-width="1069" height="289" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiwOAjuiUtyZPjmENXFSZNoomCDEYEesUflNI-HW92NDWBDZwA8fNQg_k0SVGkGgTij_5jD4qSm9seFnsNLQ3TqCcmnsOQihAJMsR5ysQvIqlOogcz_WsL3pTbcJ32OaBNTy7gW18lZnXizjju_21qfNj9MOvQedFuuXsIsLRXr3kuuV-58UuLtQQ5f/w400-h289/AdaniEntChart.jpg" width="400" /></a></div><br /><p></p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;">In my assessment, Adani Enterprise carries too much debt, with actual debt of 413,443 million more than double its optimal debt of 185,309 million, and reducing its debt load will not just lower its risk of failure, but also lower its cost of capital. This company is part of a family group, where higher debt at one of the Adani companies may be offset by less debt at another. To deal with this cross subsidization, <span style="font-family: "Times New Roman", serif;">I aggregated numbers across all seven publicly traded Adani companies and estimated the optimal debt mix, relative to the combined enterprise values:</span></p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;"></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjREIlhcsMFNj0bC5uDD05I7Dj5YiKVrpmvU9XakmrY1-ems9_M3lhyPxwt4Jk9aIISkpOnmKUyKaIJS1EvmPwlJan2qXOcB_czYyd11MfsGwuPzxniI1LaJwVU-68mmLrkBQdy3bu-ncRMmVPWGa1tJQkwSr0KO5B7IkjZF5OsF9w22OpgPJore-fF/s1077/AdaniGroupDebtChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="777" data-original-width="1077" height="289" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjREIlhcsMFNj0bC5uDD05I7Dj5YiKVrpmvU9XakmrY1-ems9_M3lhyPxwt4Jk9aIISkpOnmKUyKaIJS1EvmPwlJan2qXOcB_czYyd11MfsGwuPzxniI1LaJwVU-68mmLrkBQdy3bu-ncRMmVPWGa1tJQkwSr0KO5B7IkjZF5OsF9w22OpgPJore-fF/w400-h289/AdaniGroupDebtChart.jpg" width="400" /></a></div><p></p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;"><span style="font-family: "Times New Roman", serif;"><br /></span></p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;">The Adani Group collectively carries about three times as much debt as it should, confirming that the group is over levered as well, but note that this is bad business practice, not a con. In fact, as you can see from the cost of capital graph, there is little, if any, benefit in terms of value added to Adani from using debt, and significant downside risk, unless the debt is being subsidized by someone (government, sloppy bankers, green bondholders).</p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;"><span style="font-size: 12pt; text-align: start;"><span> </span>If you have taken a corporate finance class sometime in your past life are probably wondering how this approach reconciles with the Miller-Modigliani theorem, a key component of most corporate finance classes, which posits that there is no optimal debt ratio, and that the debt mix does not affect the value of a business. That theorem deserves the credit that it gets for setting up the framework that we use to assess debt today, but it also makes two key assumptions, with the first being that there are no taxes and the second being that there is no default. Removing debt's biggest benefit and cost from the equation effectively negates its effect on value. Changing your debt ratio, in the Miller-Modigliani world, will leave your cost of capital unchanged. In the real world, though, where both taxes and default exist, there is a "right" mix (albeit an approximate one) of debt and equity, and companies can borrow too much or too little.</span></p><p style="text-align: justify;"><span style="text-align: start;"></span></p><p><i>Effect on value</i></p><p style="text-align: justify;"><span> If you can see the mechanics of how changing debt ratio changes the cost of capital, but are unclear on how lowering the cost of capital changes the value of a business, the link is a simple one. The intrinsic value of a business is the present value of its expected free cash flows to the firm, computed after taxes but before debt payments, discounted back at its cost of capital:</span></p><p style="text-align: justify;"></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhe1-42NU5Ft7BL3vBapX8p0vPK_21iJE7iyVkFSQLZL8JB12q3xXsZiomvy4iR5JBeunq6-qn9P5KWV34f73LEYUEuBCeZqL3zP-fEUY9_Ng9f-QuOGaPXvnEI2t8G-o5RpBAGeEfK0xZe5G_cQeMb156NSQk35xKaSqWEgy_y5CNPgoxUSlizTGz9/s929/FCFFEquation.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="96" data-original-width="929" height="41" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhe1-42NU5Ft7BL3vBapX8p0vPK_21iJE7iyVkFSQLZL8JB12q3xXsZiomvy4iR5JBeunq6-qn9P5KWV34f73LEYUEuBCeZqL3zP-fEUY9_Ng9f-QuOGaPXvnEI2t8G-o5RpBAGeEfK0xZe5G_cQeMb156NSQk35xKaSqWEgy_y5CNPgoxUSlizTGz9/w400-h41/FCFFEquation.jpg" width="400" /></a></div><p></p><p style="text-align: justify;"><span>As you borrow more, your free cash flows to the firm should remain unaffected, in most cases, since they are pre-debt cash flows, and a lower cost of capital will translate into a higher value, with one caveat. As you borrow more and the risk of failure/bankruptcy increases, there is the possibility that customers may stop buying your products, suppliers may demand cash and your employees may start abandoning ship, creating a death spiral, where operating income and cash flows are affected, in what is termed "indirect bankruptcy costs". In that case, the optimal debt ratio for a company is the one that maximizes value, not necessarily the one at which the cost of capital is minimized.</span></p><p><i>Do companies optimize financing mix?</i></p><p><span> </span><span style="font-family: "Times New Roman", serif;"> Do companies consider the trade off between tax benefits and bankruptcy costs when borrowing money? Furthermore, do they optimize they debt ratios to deliver the lowest hurdle rates. The answer may be yes for a few firms, but for many, debt policy is driven by factors that have little to do with value and more with softer factors:</span></p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in;"><o:p></o:p></p><p></p><ol style="text-align: left;"><li><u>Inertia</u>: In my view, at most companies the key determinant of debt policy, as it is of most other aspects of corporate finance, is inertia. In other words, companies continue the debt policies that they have used in the past, on the mistaken view that if it worked then, it should work now, ignoring changes in the business and in the macro economy. That, for instance, is the only way to explain why older telecom companies, which developed a practice of borrowing large amounts during their time as monopoly phone businesses, continue that practice, even as their business have evolved into intensely competitive, technology businesses. </li><li><u>Me-to-ism</u>: The second and almost as powerful a force in determining debt policy is peer group behavior. Staying with the telecom firm theme, newer telecom companies entering the space feel the urge to borrow in large quantities, because other telecom companies borrow. It is for this reason that debt policy is far more likely to vary across industry groups than it is to vary within an industry group.</li><li><u>Because lenders are willing to lend me money</u>: There is a final perspective on debt that can lead companies to borrow money, even if that borrowing is inimical to their own well being, and it is that if lenders offer them the money, you cannot turn them away. In fact, it is the excuse that real estate developers use after every boom and bust cycle to explain away why they chose to borrow as much as they did. The "lenders made me do it" excuse for borrowing money is about as bad as the "the buffet lunch made me overeat" excuse used by dieters, and it just as futile, because ultimately, the damage is self inflicted.</li><li class="MsoNormal" style="font-family: "Times New Roman", serif; font-size: 12pt; margin: 0in;"><u>Control</u>: In my post on the Adani Group, I noted that in their zeal for control, insiders, founders and families sometimes make dysfunctional choices, and one of those is on borrowing. A growing firm needs capital to fund its growth, and that capital has to come from equity issuances or new borrowing. When control becoming the dominant prerogative for those running the firm, they may choose to borrow money, even if it pushes up the cost of funding and increases truncation risk, rather than issue shares to the the public (and risk dilution their control of the firm). <o:p></o:p></li></ol><div style="text-align: justify;">The bottom line is that since firms borrow based upon their own past histories and their peer group policies on borrowing, there will always be firms that have too much debt, given their capacity to borrow, just as there will be firms at the other end of the spectrum that refuse to borrow, even though they can, because they have never borrowed money or because they operate in industry groupings, where no one borrows.</div><p></p><p><b>Measuring Debt Loads</b></p><p><span> With the long lead in on the trade off that animates the borrowing decision, let us talk about how to measure the debt load at a company. While the answer may seem obvious to you, it is not to me, and I will start by looking at debt scaled to capital, a measure of debt's place in the financing mix, and then look at debt scaled to cash flows or earnings, often a better measure of potential default risk.</span><br /></p><p><i>Debt to Capital Ratios</i></p> <span> </span>In the financial balance sheet that I used at the start of this post, I noted that there are two ways of raising capital to fund a business, debt, with its contractual claims on cash flows, or equity, with its residual claims. Following up, it does make sense to look at the proportions of each that a firm uses in funding and that can be measured by looking at debt, as a percent of capital in the firm. That said, there are (at least) four variants that you will see in practice, depending on the composition of total debt, and whether capital is obtained from an accounting balance sheet (book value) or a financial balance sheet (market value):<p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in;"><o:p></o:p></p><ol style="text-align: left;"><li><u>Gross versus Net Debt</u>: The gross debt is the total debt owed by a firm, long and short term, whereas the net debt is estimated by netting out cash and marketable securities from the total debt. While there is nothing inherently that makes one measure superior to the other, it is important to remember that gross debt can never be less than zero, but net debt can, for firms that have cash balances that exceed their debt.</li><li><u>Book versus Market</u>: The book debt ratio is built around using the accounting measure of equity, usually shareholder's equity, as the value of equity. The market debt ratio, in contrast, uses the market's estimate of the value of equity, i.e., its market capitalization, as the value of equity. While accountants, CFOs and bankers are fond of the book value measure, almost everything in corporate finance revolves around market value weights, including the debt to equity ratios we use to adjust betas and costs of equity and the debt to capital ratios used in computing the cost of capital.</li></ol><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in;">There are sub-variants, within these four variants, with debates about whether to use only long-term debt or all debt and about whether lease debt should be treated as debt. My advice is that you consider all interest-bearing debt is debt, and that picking and choosing what to include is an exercise in futility. <o:p></o:p></p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in;"> I computed gross and net debt ratios for all publicly traded, non-financial service firms, at the start of 2023, relative to both book and market value, with the distribution of debt ratios at the start of 2023 below:<o:p></o:p></p><p></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEii70JdS4631oQY79cfP42Ana_tVEsGvWEaFHlZq1EWQQQVXpiADAqr-CIZ8p6OwK05Q-yfD0lVqz06jaD4awwm3HTuMAJ2SqLD1G6CqzkoXol-4iuRc29Dbu6yXho9rE6EG0M5B09bvU9NQwd51zw6mLjt2VTMX-o6DAsf7FXzU0fQ_a3KU7imzevW/s1070/DebttoCapitalChart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1070" data-original-width="1026" height="400" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEii70JdS4631oQY79cfP42Ana_tVEsGvWEaFHlZq1EWQQQVXpiADAqr-CIZ8p6OwK05Q-yfD0lVqz06jaD4awwm3HTuMAJ2SqLD1G6CqzkoXol-4iuRc29Dbu6yXho9rE6EG0M5B09bvU9NQwd51zw6mLjt2VTMX-o6DAsf7FXzU0fQ_a3KU7imzevW/w384-h400/DebttoCapitalChart.jpg" width="384" /></a></div><br />If you have been fed a steady diet of stories of rising indebtedness and profligate companies, you will be surprised by the results. The median debt ratio, defined both in book and market terms, for a global firm at the start of 2023 was between 10% and 20% of overall capital. It is true that there are differences across regions, as you can see in the table below, which computes the debt ratios based upon aggregated debt and equity across all firms and is thus closer to a weighted average. On a book debt ratio basis, the United States, as a region, has the highest debt ratio in the world, but on a market debt ratio basis, Latin America and Canada have the highest debt loads.<br /><span> </span>The problem with using debt to capital ratios to make judgments on whether firms are carrying too much, or too little, debt is that, at the risk of stating the obvious, you cannot make interest payments or repay debt using capital, book or market. Put simply, you can have a firm with a high debt to capital ratio with low default risk, just as you can have a firm with low debt to capital with high default risk. It is one reason that a banking focus on total assets and market value, when lending to a firm, can lead to dysfunctional lending and troubled banks. To the retort from some bankers that you can liquidate the assets and recover your loans, I have two responses. First, assuming that book value is equal to liquidation value may let bankers sleep better at night, but it can be delusional in industries where they're no ready buyers for those assets. Second, even if liquidation is an option, a banker who relies on liquidating assets to collect on loans has already lost at the lending game, where the objective is to collect interest and principal on loans, while minimizing defaults and liquidations.<br /><div><p><i>Debt to EBITDA, Interest Coverage Ratios</i></p><p><i> </i>If debt to capital is not a good measure for judging over or under leverage, what is? The answer lies in looking at a company's earnings and cash flow capacity, relative to its debt obligations. The interest coverage ratio is the first of two ratios that I will use to measure this capacity:</p><p style="text-align: center;">Interest Coverage Ratio = Earnings before interest and taxes/ Interest expenses</p><div style="text-align: justify;">As a lender, higher interest coverage ratios indicate a bigger buffer and thus more safety, other things remaining equal, than lower interest coverage ratios. While the interest coverage ratio is a widely used proxy for default risk, and the one ratio that best explains differences in bond ratings for a firm, its limit is its focus on interest expenses, to the exclusion of debt principal payments that may be coming due. The second ratio remedies this problem by looking at debt as a multiple of EBITDA:</div><p style="text-align: center;">Debt to EBITDA = Total Debt/ EBITDA</p><p>The logic behind this measure is simple. The denominator is a measure of operating cash flows, prior to a whole host of cash outflows, but a firm that borrows too much relative to EBITDA is stretching its capacity to repay that debt. </p><p><span> I compute both ratios (interest coverage and Debt to EBITDA) for all publicly traded firms and the results are graphed below, with the important caveat that they move in opposing directions, when measuring safety, with safer firms having higher </span>interest coverage rations and lower Debt to EBITDA multiples;</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjNG3PHBfAtoWGaf_ON7bJ64pTgmT4NlDWIA-Rh3yI8cEhYI5OoVcOt7f-T5g17_6tfArbznol4MCiGMBOaOlPoTYr7KXsFztTnd0mgXLrNe99QWm2MQyAU0R7AFPm0L3iUdj3xdCI2XrqI38yc_qurpYNMpE-YgnxzhfqpIIxBS9tfV49VjVSaobR8/s1034/DebtCovchart.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="975" data-original-width="1034" height="378" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjNG3PHBfAtoWGaf_ON7bJ64pTgmT4NlDWIA-Rh3yI8cEhYI5OoVcOt7f-T5g17_6tfArbznol4MCiGMBOaOlPoTYr7KXsFztTnd0mgXLrNe99QWm2MQyAU0R7AFPm0L3iUdj3xdCI2XrqI38yc_qurpYNMpE-YgnxzhfqpIIxBS9tfV49VjVSaobR8/w400-h378/DebtCovchart.jpg" width="400" /></a></div><br /><div style="text-align: justify;">Not only do interest coverage ratios and debt to EBITDA multiples vary widely across firms, but they also vary across sectors. On a pure numbers-basis, utilities look like they are the most dangerous firms to lend to, with skintight interest coverage ratios (1.17, in the aggregate) and sky high total debt to EBITDA, but that can be misleading since many of these utilities are monopolies with predictable earnings streams and the capacity to pass interest costs down to their customers. At the other end of the spectrum, technology and energy companies look the safest on an interest coverage ratio basis, but with both groups, you worry about year-to-year volatility in earnings. </div><br /> <span> </span>To get a closer look at difference across companies, I looked at the 94 industry groups that I break down companies into, and look at the most highly levered (with total debt to EBITDA as my primary sorting proxy, but reporting my other debt load measures) and least highly levered industry groups, looking at just US publicly traded companies:<div><br /></div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEioJ8sAT9_YmSI-9mvIaCRyfuzvxX9MocG8Hjwfkz0IMJvFBDPJgVNVvJW6izn-baXqImv2P2iXUFxwZZardFI28jT1K8CFTiVqfYnJHuPnQ6ufgWy4t6MvG3KKdRe24It58uYzzyMk02NthynLmfqPPK0DWc4UzcxJzhVpUM4L2Z3PVSMb06LaeY_P/s746/Most%20&%20Least%20Levered%20Industires.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="424" data-original-width="746" height="228" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEioJ8sAT9_YmSI-9mvIaCRyfuzvxX9MocG8Hjwfkz0IMJvFBDPJgVNVvJW6izn-baXqImv2P2iXUFxwZZardFI28jT1K8CFTiVqfYnJHuPnQ6ufgWy4t6MvG3KKdRe24It58uYzzyMk02NthynLmfqPPK0DWc4UzcxJzhVpUM4L2Z3PVSMb06LaeY_P/w400-h228/Most%20&%20Least%20Levered%20Industires.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/dbtfund.xls"><i><span style="font-size: x-small;">Download all industry group data</span></i></a></td></tr></tbody></table><br /><div><div style="text-align: justify;">Real estate and real estate-based business dominate he most levered industry groups, with utilities, auto and airports rounding out the list, reflecting their history as well as the willingness of bankers to lend on tangible assets. Technology and commodity industry groups proliferate on the least levered list, reflecting the higher uncertainty about future earnngs and banking unease with lending against intangibles. (at least with technology companies).</div><p><b>The Default Question</b></p><p><span> </span>The biggest downside of debt is that it increases exposure to default risk, and as the last part of this analysis, I will look at default rates over time, culminating in 2022, and then look ahead to the challenges that companies will face in 2023 and beyond.</p><p class="MsoNormal" style="margin: 0in;"><i>Business Default: The what and the why</i><br /></p><div style="text-align: justify;"> In principle, any company that fails to meet a contractual commitment is in default, at least on that commitment, but there is wide gap between that act and legal default, where there is an official declaration of bankruptcy, and courts step in. Furthermore, there is a gap between legal default and liquidation, where the assets of a firm are liquidated to pay off creditors. There are many firms that default on contractual obligations, but find ways to evade declaring bankruptcy, and among firms that declare bankruptcy, a significant subset restructure and stay in operations. If there were not the case, there would probably be a handful of airlines still in operations since the rest would have been liquidated years or even decades ago. </div> <span><div style="text-align: justify;"> No matter what definition of default you adhere to, it arises from a simple mathematical construct, which is that a firm does not have the cash flows to service its debt payments, but that can occur either because cash flows drop off or because debt payments soar. Default, as a consequence, can broadly be traced to four factors:</div></span><p></p><p class="MsoNormal" style="margin: 0in;"></p><ol style="text-align: left;"><li style="text-align: justify;"><u>Company-specific troubles</u>: A deterioration in a company’s operating business, either because of competitive pressures or the company’s own mistakes, can cause operating cash flows to drop, putting a once-healthy company at risk of default. In some cases, the shock to the company’s earnings and cash flows can come from the loss of a lawsuit (giving rise to large new commitments), a regulatory fine or other unexpected cash outflow. </li><li style="text-align: justify;"><u>Sector-wide issues</u>: If disruption is the word that has excited venture capitalists and investors across the world for much of this century, it comes with a dark side, which is that the disrupted businesses can find themselves with imploding business models (shrinking revenues and operating margins under stress). As a consequence, over time, these disrupted firms find themselves more and more exposed to default risk; Bed, Bath and Beyond has less debt outstanding now than they did a decade ago, but have gone from credit worthy to bankrupt over that period.</li><li style="text-align: justify;"><u>Macroeconomic shocks/change</u>s: Some businesses, especially in commodity and cyclical industry groups, have always been and will continue to be exposed to cycles that can cause operating earnings, even for the best run and most mature companies, to swing wildly from period to period. Oil companies, for instance, went from being money-losers (on an operating income basis) in 2020, when oil prices plunged, to among the biggest money-makers in the business world in 2022. Speaking of 2020, we all remember the COVID-driven shutting down of the global economy in the first half of the year and the havoc it wreaked on borrowers and lenders, as a consequence.</li><li style="text-align: justify;"><u>Debt payment surges</u>: There is a final reason for default, which a surge in debt payments arising from rising interest rates and the refinancing of existing debt at those higher rates. Put simply, a company with a billion dollars in debt outstanding, at a 2% interest rate, will see its interest payments double, if rates double to 4%, and the debt is refinanced. Historically, this has been more an issue in emerging markets, where businesses borrow short term and rates are volatile, than in developed markets, where a combination of longer-term debt and more stable interest rates has insulated businesses from the worst of this phenomenon. But as I noted in my data post on interest rates, the last year (2022) has been a most unusual one, in terms of interest rate moves, in developed markets.</li></ol>While all companies are exposed in one way or another to all of these factors, borrowing more money (and increasing contractual commitments) will magnify the effects; a more levered oil company will be more exposed to default risk than a less levered oil company, holding all else constant.<br /><i><br />Defaults – Historical</i><br /><div style="text-align: justify;"><span> </span>In my lead in to this section, I noted that defaulting on a loan or contractual obligation does not always lead to business default or bankruptcy, and that many bankruptcies do not conclude in liquidations. That said, though, the three data series (loan delinquencies, business defaults and business liquidations) do move together, with spikes in one coinciding with spikes in the other, In the graph below, I look at bank loan delinquencs in the United States and default rates among speculative grade companies over time:</div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEji3MWAjS789_k_yiLI2ERmCo9C7OpUUkGIsOLtUcqIqwrB4vRL19nfF5ISYpapqslF-JpQUbgVqD9esoBLEXlOdNjq9-62fkA5csKWrEDdewdDSC1Fu1Cb6O_uSwsfcegxFPFkQF-7zSOsIpZCy-kcFUBQKGw3VrD6eZb0aE8Q_ZtiAuls_c7y5RnD/s1819/DefaultRatesovertime.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1819" data-original-width="1313" height="400" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEji3MWAjS789_k_yiLI2ERmCo9C7OpUUkGIsOLtUcqIqwrB4vRL19nfF5ISYpapqslF-JpQUbgVqD9esoBLEXlOdNjq9-62fkA5csKWrEDdewdDSC1Fu1Cb6O_uSwsfcegxFPFkQF-7zSOsIpZCy-kcFUBQKGw3VrD6eZb0aE8Q_ZtiAuls_c7y5RnD/w289-h400/DefaultRatesovertime.jpg" width="289" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i><span style="font-size: x-small;">Sources: <a href="https://fred.stlouisfed.org/series/DRALACBN">Loan Delinquencies from Federal Reserve Site (FRED)</a> and <a href="https://www.spglobal.com/ratings/en/research/articles/230216-default-transition-and-recovery-growing-strains-could-push-the-u-s-speculative-grade-corporate-default-rat-12640407">Corporate Defaults from S&P</a></span></i></td></tr></tbody></table><div style="text-align: justify;">Note that the series go through cycles, with increases in delinquencies and defaults triggered by macroeconomic or market-wide factors. In the late 1990s, it was an economic recession that was the precipitating factor, but the last three increases in delinquencies have had their origins in other forces. The increase in delinquencies in the early part of the 2000s started with the dot-com bust and made worse by the 9/11 attack, and subsequent economic weakness. The 2008 market crisis had the most damaging and longest lasting effect on defaults, partly because it originated with banks, and partly because of the long term damage it did to housing prices and the economy. The 2020 increase in default rate was triggered by the COVID shutdown, but was not only milder, but also passed quickly, with large bailout packages from the government being the difference.</div><div style="text-align: justify;"><span> </span>Looking at 2022, the most striking aspect of the time series is that there is almost no discernible change in delinquencies or defaults in the year, with both remaining at the low rates that we have seen for much of the decade. It is true that in the last half of the year, there were signs of trouble, with an uptick in delinquencies and an increase in the number of corporate defaults. Since interest rates rose during the year, the absence of an effect on defaults may surprise you, but there are two considerations to keep in mind. The first is that rising interest rates usually have a lagged effect on defaults, since it is only as companies refinance that they face the higher costs. The second is that the US economy stayed strong through 2022, notwithstanding headwinds, and corporate earnings stayed resilient. </div><br /><i>Ratings Actions and The Year Ahead</i><br /><br /><div style="text-align: justify;"><span> </span>If defaults measure the inability of companies to meet their contractual obligations, the actions taken by ratings agencies to change the bond ratings of the companies that they rate can operate as a leading indicator of expected defaults in the future. Put simply, ratings agencies are more likely to downgrade companies, if they foresee a potential uptick in defaults, and upgrade them, if they expect defaults to decline. While the actual defaults in 2022 remained low, it is clear that ratings agencies were becoming more concerned about the future, as can be seen in the number of ratings downgrades in the later parts of 2022, relative to upgrades:</div><p></p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi2o_ZJPcQKPlqFJYqxHPKnz3wlzJua4xt0cL3WTIIXxFgDO0a5Td_lpSFkJM-0qAVJ5fifpdIYZrScVYryjT02v50kMcADdjhkhHaRtZm5vO6xDowvYCknSxc78ihY37VoReMcvuUv156tO43GCovFaJWbTUwKxrrt1wtSjERqtwJD3MysU4fI94oF/s765/S&PRatingsActionsin2022.jpg" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="550" data-original-width="765" height="288" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi2o_ZJPcQKPlqFJYqxHPKnz3wlzJua4xt0cL3WTIIXxFgDO0a5Td_lpSFkJM-0qAVJ5fifpdIYZrScVYryjT02v50kMcADdjhkhHaRtZm5vO6xDowvYCknSxc78ihY37VoReMcvuUv156tO43GCovFaJWbTUwKxrrt1wtSjERqtwJD3MysU4fI94oF/w400-h288/S&PRatingsActionsin2022.jpg" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><a href="https://www.spglobal.com/ratings/en/research/articles/230216-default-transition-and-recovery-growing-strains-could-push-the-u-s-speculative-grade-corporate-default-rat-12640407"><i><span style="font-size: x-small;">S&P Default and Distress, Feb 2023</span></i></a></td></tr></tbody></table><br />Note again that the downgrades in 2022 are nowhere near the downgrades that you saw in 2008, during the banking crisis, and one reason was that rising interest payments notwithstanding, the economy stayed robust during the year.<p class="MsoNormal" style="margin: 0in;"></p><div style="text-align: justify;"> Looking ahead to 2023, ratings agencies are forecasting rising default rates, perhaps because they see an economic slowdown coming. As with my forecasts for the S&P 500 and interest rates, you see a familiar duo of macroeconomic forces driving default risk:</div> <p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhIEPA0Yc_egc4pUbdnOHTMtdl0EkJdFmF80HO3gSfkid_AuRuS0C6YKurnKAOjrqhVuNEwaiwob-7TCv2eQiJY7hde1Jj8BTCYlf7pLWj5TI4LZdLULC_mwxC29oEnzqpe1dEUdjDr4GdMMuGZg6svKLNX3e1VbwIMs0bmI1cad8LGAVDKfChHzUD-/s532/ScenarioDefaults.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="187" data-original-width="532" height="140" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhIEPA0Yc_egc4pUbdnOHTMtdl0EkJdFmF80HO3gSfkid_AuRuS0C6YKurnKAOjrqhVuNEwaiwob-7TCv2eQiJY7hde1Jj8BTCYlf7pLWj5TI4LZdLULC_mwxC29oEnzqpe1dEUdjDr4GdMMuGZg6svKLNX3e1VbwIMs0bmI1cad8LGAVDKfChHzUD-/w400-h140/ScenarioDefaults.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;"><span face="-webkit-standard, serif">Not surprisingly, a combination of high inflation and a steep recession will create the most defaults, as the vice of lower earnings and higher interest rates will ensnare more firms. At the other end of the spectrum, a swift drop off in inflation with no recession will create the most benign environment for lenders, allowing default to remain low. <o:p></o:p></span></p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;"><span face="-webkit-standard, serif"><br /></span></p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;"><b>A Wrap</b></p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;"><b> </b>In both our personal and business lives, there are good reasons for borrowing money and bad ones. After all, the politicians who lecture businesses about borrowing too much are also the ones who write the tax code that tilts the playing field towards debt, and by bailing out businesses or individuals that get into trouble by borrowing too much, they reduce its dangers. That said, there is little evidence to back up the proposition that a decade of low interest rates has led companies collectively to borrow too much, but there are some that certainly have tested the limits of their borrowing capacity. For those firms, the coming year will be a test, as that debt gets rolled over or refinanced, and there are pathways back to financial sanity that they can take. </p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;"><span face="-webkit-standard, serif"><br /></span></p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;"><span face="-webkit-standard, serif"><b>YouTube Video</b></span></p><iframe allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/rtIEgXLx6MI" title="YouTube video player" width="560"></iframe><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;"><br /></p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;"><span face="-webkit-standard, serif"><b>Datasets</b></span></p><p class="MsoNormal" style="font-family: "Times New Roman", serif; margin: 0in; text-align: justify;"></p><ol><li>Debt ratios, by industry groupings (<a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/dbtfund.xls">US</a>, <a href="https://pages.stern.nyu.edu/~adamodar/pc/datasets/dbtfundGlobal.xls">Global</a>)</li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/Delinquencyovertime.xls">Delinquency rates on bank loans, by Quarter (US): 1985- 2022</a></li></ol><div><b>Spreadsheets</b></div><div><ol><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/capstru.xlsx">General Capital Structure Optimizing Spreadsheet</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/AdaniCapStru.xlsx">Adani Enterprises: Optimal Financing Mix</a></li><li><a href="https://pages.stern.nyu.edu/~adamodar/pc/blog/AdaniGroupCapStru.xlsx">Adani Group: Optimal Financing Mi</a>x</li></ol></div><div><br /></div><p></p></div></div>Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.com0