The Corporate Life Cycle: Managing, Valuation and Investing Implications!

As I reveal my ignorance about TikTok trends, social media celebrities and Gen Z slang, my children are quick to point out my age, and I accept that reality, for the most part. I understand that I am too old to exercise without stretching first or eat a heaping plate of cheese fries and not suffer heartburn, but that does not stop me from trying occasionally. For the last decade or so, I have argued that businesses, like human beings, age, and struggle with aging, and that much of the dysfunction we observe in their decision making stems from refusing to act their age. In fact, the business life cycle has become an integral part of the corporate finance, valuation and investing classes that I teach, and in many of the posts that I have written on this blog. In 2022, I decided that I had hit critical mass, in terms of corporate life cycle content, and that the material could be organized as a book. While the writing for the book was largely done by November 2022, publishing does have a long lead time, and the book, published by Penguin Random House, will be available on August 20, 2024, at a book shop near you. If you are concerned that you are going to be hit with a sales pitch for that book, far from it!  Rather than try to part you from your money, I thought I would give a compressed version of the book in this post, and for most of you, that will suffice.

Setting the Stage

    The notion of a business life cycle is neither new nor original, since versions of it have floated around in management circles for decades, but its applications in finance have been spotty, with some attempts to tie where a company is in the life cycle to its corporate governance and others to accounting ratios. In fact, and this should come as no surprise to anyone who is familiar with his work, the most incisive piece tying excess returns (return on invested capital minus cost of capital) to the corporate life cycle was penned by Michael Mauboussin (with Dan Callahan) just a few months ago.

    My version of the corporate life cycle is built around six stages with the first stage being an idea business (a start-up) and the last one representing decline and demise. 

As you can see, the key tasks shift as business age, from building business models in the high growth phase to scaling up the business in high growth to defending against competition in the mature phase to managing decline int he last phase. Not surprisingly, the operating metrics change as companies age, with high revenue growth accompanied by big losses (from work-in-progress business models) and large reinvestment needs (to delivery future growth) in early-stage companies to large profits and free cash flows in the mature phase to stresses on growth and margins in decline. Consequently, in terms of cash flows, young companies burn through cash, with the burn increasing with potential, cash buildup is common as companies mature followed by cash return, as the realization kicks in that a company’s high growth days are in the past.

    As companies move through the life cycle, they will hit transition points in operations and in capital raising that have to be navigated, with high failure rates at each transition. Thus, most idea businesses never make it to the product phase, many product companies are unable to scale up, and quite a few scaled up firms are unable to defend their businesses from competitors. In short, the corporate life cycle has far higher mortality rates as businesses age than the human life cycle, making it imperative, if you are a business person, that you find the uncommon pathways to survive and grow.

Measures and Determinants

    If you buy into the notion of a corporate life cycle, it stands to reason that you would like a way to determine where a company stands in the life cycle. There are three choices, each with pluses and minuses. 

• The first is to focus on corporate age, where you estimate how old a company is, relative its founding date; it is easy to obtain, but companies age at different rates (as well will argue in the following section), making it a blunt weapon.
• The second is to look at the industry group or sector that a company is in, and then follow up by classifying that industry group or sector into high or low growth; for the last four decades, in US equity markets, tech has been viewed as growth and utilities as mature. Here again, the problem is that high growth industry groups begin to mature, just as companies do, and this has been true for some segments of the tech sector.
• The third is to focus on the operating metrics of the firm, with firms that deliver high revenue growth, with low/negative profits and negative free cash flows being treated as young firms. It is more data-intensive, since making a judgment on what comprises high (revenue growth or margins) requires estimating these metrics across all firms.

While I delve into the details of all three measures, corporate age works surprisingly well as a proxy for where a company falls in the life cycle, as can be seen in this table of all publicly traded companies listed globally, broken down by corporate age into ten deciles:

As you can see, the youngest companies have much higher revenue growth and more negative operating margins than older companies.

    Ultimately, the life cycles for companies can vary on three dimensions - length (how long a business lasts), height (how much it can scale up before it plateaus) and slope (how quickly it can scale up). Even a cursory glance at the companies that surround you should tell you that there are wide variations across companies, on these dimensions. To see why, consider the factors that determine these life cycle dimensions:

Companies in capital-light businesses, where customers are willing to switch from the status quo, can scale up much faster than companies in capital-intensive businesses, where brand names and customer inertia can make breakthroughs more difficult. It is worth noting, though, that the forces that allow a business to scale up quickly often limit how long it can stay at the top and cause decline to be quicker, a trade off that was ignored during the last decade, where scaling up was given primacy.

    The drivers of the corporate life cycle can also explain why the typical twenty-first century company faces a compressed life cycle, relative to its twentieth century counterpart. In the manufacturing-centered twentieth century, it took decades for companies like GE and Ford to scale up, but they also stayed at the top for long periods, before declining over decades. The tech-centered economy that we live in is dominated by companies that can scale up quickly, but they have brief periods at the top and scale down just as fast. Yahoo! and BlackBerry soared from start ups to being worth tens of billions of dollars in a blink of an eye, had brief reigns at the top and melted down to nothing almost as quickly. 

Tech companies age in dog years, and the consequences for how we manage, value and invest in them are profound. In fact, I would argue that the lessons that we teach in business school and the processes that we use in analysis need adaptation for compressed life cycle companies, and while I don't have all the answers, the discussion about changing practices is a healthy one.

Corporate Finance across the Life Cycle

    Corporate finance, as a discipline, lays out the first principles that govern how to run a business, and with a focus on maximizing value, all decisions that a business makes can be categorized into investing (deciding what assets/projects to invest in), financing (choosing a mix of debt and equity, as well as debt type) and dividend decisions (determining how much, if any, cash to return to owners, and in what form).

While the first principles of corporate finance do not change as a company ages, the focus and estimation processes will shift, as shown in the picture below:

With young companies, where the bulk of the value lies in future growth, and earnings and cash flows are often negative, it is the investment decision that dominates; these companies cannot afford to borrow or pay dividends. With more mature companies, as investment opportunities become scarcer, at least relative to available capital, the focus not surprisingly shifts to financing mix, with a lower hurdle rate being the pay off. With declining businesses, facing shrinking revenues and margins, it is cash return or dividend policy that moves into the front seat. 

Valuation across the Life Cycle

    I am fascinated by valuation, and the link between the value of a business and its fundamentals - cash flows, growth and risk. I am also a realist and recognize that I live in a world, where pricing dominates, with what you pay for a company or asset being determined by what others are paying for similar companies and assets:

All companies can be both valued and priced, but the absence of history and high uncertainty about the future that characterizes young companies makes it more likely that pricing will dominate valuation more decisively than it does with more mature firms. 

    All businesses, no matter where they stand in the life cycle, can be valued, but there are key differences that can be off putting to some. A well done valuation is a bridge between stories and numbers, with the interplay determining how defensible the valuation is, but the balance between stories and numbers will shift, as you move through the life cycle:

With young companies, absent historical data on growth and profitability, it is your story for the company that will drive your numbers and value. As companies age, the numbers will become more important, as the stories you tell will be constrained by what you have been able to deliver in growth and margins. If your strength as an analyst or appraiser is in bounded story telling, you will be better served valuing young companies, whereas if you are a number-cruncher (comfortable with accounting ratios and elaborate spreadsheet models), you will find valuing mature companies to be your natural habitat. 

    The draw of pricing is strong even for those who claim to be believers in value, and pricing in its simplest form requires a standardized price (a multiple like price earnings or enterprise value to EBITDA) and a peer group. While the pricing process is the same for all companies, the pricing metrics you use and the peer groups that you compare them to will shift as companies age:

For pre-revenue and very young companies, the pricing metrics will standardize the price paid (by venture capitalists and other investors) to the number of users or subscribers that a company has or to the total market that its product is aimed at. As business models develop, and revenues come into play, you are likely to see a shift to revenue multiples, albeit often to estimated revenues in a future year (forward numbers). In the mature phase, you will see earnings multiples become more widely used, with equity versions (like PE) in peer groups where leverage is similar across companies, and enterprise value versions (EV to EBITDA) in peer groups, where leverage is different across companies. In decline, multiples of book value will become more common, with book value serving as a (poor) proxy for liquidation or break up value. In short, if you want to be open to investing in companies across the life cycle, it behooves you to become comfortable with different pricing ratios, since no one pricing multiple will work on all firms.

Investing across the Life Cycle

    In my class (and book) on investment philosophies, I start by noting that every investment philosophy is rooted in a belief about markets making (and correcting) mistakes, and that there is no one best philosophy for all investors. I use the investment process, starting with asset allocation, moving to stock/asset selection and ending with execution to show the range of views that investors bring to the game:    

Market timing, whether it be based on charts/technical indicators or fundamentals, is primarily focused  on the asset allocation phase of investing, with cheaper (based upon your market timing measures) asset classes being over weighted and more expensive asset classes being under weighted. Within the stock selection phase, there are a whole host of investment philosophies, often holding contradictory views of market behavior. Among stock traders, for instance, there are those who believe that markets learn slowly (and go with momentum) and those who believe that markets over react (and bet on reversals). On the investing side, you have the classic divide between value and growth investors, both claiming the high ground. I view the differences between these two groups through the prism of a financial balance sheet:

Value investors believe that the best investment bargains are in mature companies, where assets in place (investments already made) are being underpriced by the market, whereas growth investors build their investment theses around the idea that it is growth assets where markets make mistakes. Finally, there are market players who try to make money from market frictions, by locking in market mispricing (with pure or near arbitrage). 

    Drawing on the earlier discussion of value versus price, you can classify market players into investors (who value companies, and try to buy them at a lower price, while hoping that the gap closes) and traders (who make them money on the pricing game, buying at a low price and selling at a higher one).  While investors and traders are part of the market in every company, you are likely to see the balance between the two groups shift as companies move through the life cycle:

Early in the life cycle, it is undeniable that traders dominate, and for investors in these companies, even if they are right in their value assessments, winning will require much longer time horizons and stronger stomachs. As companies mature, you are likely to see more investors become part of the game, with bargain hunters entering when the stock drops too much and short sellers more willing to counter when it goes up too much. In decline, as legal and restructuring challenges mount, and a company can have multiple securities (convertibles, bonds, warrants) trading on it, hedge funds and activists become bigger players.

    In sum, the investment philosophy you choose can lead you to over invest in companies in some phases of the life cycle, and while that by itself is not a problem, denying that this skew exists can become one. Thus, deep value investing, where you buy stocks that trade at low multiples of earnings and book value, will result in larger portions of the portfolio being invested in mature and declining companies. That portfolio will have the benefit of stability, but expecting it to contain ten-baggers and hundred-baggers is a reach. In contrast, a venture capital portfolio, invested almost entirely in very young companies, will have a large number of wipeouts, but it can still outperform, if it has a few large winners. Advice on concentrating your portfolio and having a margin of safety, both value investing nostrums, may work with the former but not with the latter.

Managing across the Life Cycle

    Management experts who teach at business schools and populate the premier consulting firms have much to gain by propagating the myth that there is a prototype for a great CEO. After all, it gives them a reason to charge nose-bleed prices for an MBA (to be imbued with these qualities) or for consulting advice, with the same end game. The truth is that there is no one-size-fits-all for a great CEO, since the qualities that you are looking for in top management will shift as companies age:

Early in the life cycle, you want a visionary at the top, since you have to get investors, employees and potential customers to buy into that vision. To turn the vision into products and services, though, you need a pragmatist, willing to accept compromises. As the focus shifts to business models, it is the business-building skills that make for a great CEO, allowing for scaling up and success. As a scaled-up business, the skill sets change again, with opportunism becoming the key quality, allowing the company to find new markets to grow in. In maturity, where playing defense becomes central, you want a top manager who can guard a company's competitive advantages fiercely. Finally, in decline, you want CEOs, unencumbered by ego or the desire to build empires, who are willing to preside over a shrinking business, with divestitures and cash returns high on the to-do list.

    There are very few people who have all of these skills, and it should come as no surprise that there can be a mismatch between a company and its CEO, either because they (CEO and company) age at different rates or because of hiring mistakes. Those mismatches can be catastrophic, if a headstrong CEO pushes ahead with actions that are unsuited to the company he or she is in charge off, but they can be benign, if the mismatched CEO can find a partner who can fill in for weaknesses:

While the possibilities of mismatches have always been part of business, the compression of corporate life cycles has made them both much more likely, as well as more damaging. After all, time took care of management transitions for long-lived twentieth century firms, but with firms that can scale up to become market cap giants in a decade, before scaling down and disappearing in the next one, you can very well see a founder/CEO go from being a hero in one phase to a zero in the next one. As we have allowed many of the most successful firms that have gone public in this century to skew the corporate finance game, with shares with different voting rights, we may be losing our power to change management at those firms where the need for change is greatest.

Aging gracefully? 

    The healthiest response to aging is acceptance, where a business accepts where it is in the life cycle, and behaves accordingly. Thus, a young firm that derives much of its value from future growth should not put that at risk by borrowing money or by buying back stock, just as a mature firm, where value comes from its existing assets and competitive advantages, should not risk that value by acquiring companies in new and unfamiliar businesses, in an attempt to return to its growth days. Acceptance is most difficult for declining firms, since the management and investors have to make peace with downsizing the firm. For these firms, it is worth emphasizing that acceptance does not imply passivity, a distorted and defeatist view of karma, where you do nothing in the face of decline, but requires actions that allow the firm to navigate the process with the least pain and most value to its stakeholders.

    It should come as no surprise that many firms, especially in decline, choose denial, where managers and investors come up with excuses for poor performance and lay blame on outside factors. On this path, declining firms will continue to act the way they did when they were mature or even growth companies, with large costs to everyone involved. When the promised turnaround does not ensue, desperation becomes the alternative path, with managers gambling large sums of other people’s money on long shots, with predictable results.

    The siren song that draws declining firms to make these attempts to recreate themselves, is the hope of a rebirth, and an ecosystem of bankers and consultants offers them magic potions (taking the form of proprietary acronyms that either restate the obvious or are built on foundations of made-up data) that will make them young again. They are aided and abetted by case studies of companies that found pathways to reincarnation (IBM in 1992, Apple in 2000 and Microsoft in 2013), with the added bonus that their CEOs were elevated to legendary status. While it is undeniable that companies do sometimes reincarnate, it is worth recognizing that they remain the exception rather than the rule, and while their top management deserves plaudits, luck played a key role as well.

    I am a skeptic on sustainability, at least as applied to companies, since its makes corporate survival the end game, sometimes with substantial costs for many stakeholders, as well as for society. Like the Egyptian Pharaohs who sought immortality by wrapping their bodies in bandages and being buried with their favorite possessions, companies that seek to live forever will become mummies (and sometimes zombies), sucking up resources that could be better used elsewhere.

In conclusion

    It is the dream, in every discipline, to come up with a theory or construct that explains everything in that disciple. Unlike the physical sciences, where that search is constrained by the laws of nature, the social sciences reflect more trial and error, with the unpredictability of human nature being the wild card. In finance, a discipline that started as an offshoot of economics in the 1950s, that search began with theory-based models, with portfolio theory and the CAPM, veered into data-based constructs (proxy models, factor analysis), and behavioral finance, with its marriage of finance and psychology. I am grateful for those contributions, but the corporate life cycle has offered me a low-tech, but surprisingly wide reaching, construct to explain much of what I see in business and investment behavior. 

    If you find yourself interested in the topic, you can try the book, and in the interests of making it accessible to a diverse reader base, I have tried to make it both modular and self-standing. Thus, if you are interested in how running a business changes, as it ages, you can focus on the four chapters that look at corporate finance implications, with the lead-in chapter providing you enough of a corporate finance foundation (even if you have never taken a corporate finance class) to be able to understand the investing, financing and dividend effects. If you are an appraiser or analyst, interested in valuing companies across the life cycle, it is the five chapters on valuation that may draw your interest, again with a lead-in chapter containing an introduction to valuation and pricing. As an investor, no matter what your investment philosophy, it is the four chapters on investing across the life cycle that may appeal to you the most. While I am sure that you will have no trouble finding the book, I have a list of book retailers listed below that you can use, if you choose, and the webpage supporting the book can be found here. 

    If you are budget-constrained or just don't like reading (and there is no shame in that), I have also created an online class, with twenty sessions of 25-35 minutes apiece, that delivers the material from the book. It includes exercises that you can use to check your understanding, and the link to the class is here. 

YouTube Video

Book and Class Webpages

1. Book webpage: https://pages.stern.nyu.edu/~adamodar//New_Home_Page/CLC.htm
2. Class webpage: https://pages.stern.nyu.edu/~adamodar//New_Home_Page/webcastCLC.htm
3. YouTube Playlist for class: https://www.youtube.com/playlist?list=PLUkh9m2BorqlpbJBd26UEawPHk0k9y04_

Links to booksellers

1. Amazon: https://www.amazon.com/Corporate-Lifecycle-Investment-Management-Implications/dp/0593545060
2. Barnes & Noble: https://www.barnesandnoble.com/w/the-corporate-life-cycle-aswath-damodaran/1143170651?ean=9780593545065
3. Bookshop.org: https://bookshop.org/p/books/the-corporate-lifecycle-business-investment-and-management-implications-aswath-damodaran/19850366?ean=9780593545065
4. Apple: https://books.apple.com/us/audiobook/the-corporate-life-cycle-business-investment/id1680865376

There is an Indian edition that will be released in September, which should be available in bookstores there. The Indian edition can be found on Amazon India.

1. Amazon India: https://www.amazon.in/Corporate-Life-Cycle-Investment-Implications/dp/0143471392

A Teaching Manifesto: An Invitation to my Spring 2020 classes

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

The Structure

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

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

The Classes

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

I. Corporate Finance

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

Chapters: Applied Corporate Finance Book, Sessions: Class session

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

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

For whom?

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

Links to Offerings

1. Spring 2020 Corporate Finance MBA class (Free)

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

2. Online Corporate Finance Class (Free)

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

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

• NYU Entry Page

II. Valuation

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

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

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

For whom?

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

Links to Offerings

1a. Spring 2020 Valuation MBA class (Free)

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

1b. Spring 2020 Valuation Undergraduate class (Free)

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

2. Online Valuation Class (Free)

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

3. NYU Certificate Class on Valuation (Paid)

• NYU Entry Page

III. Investment Philosophies

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

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

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

Links to Offerings

1. Online Investment Philosophies Class (Free)

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

2. NYU Certificate Class on Valuation (Paid)

• NYU Entry Page (Coming soon)

Conclusion

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

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The Softbank-WeWork End Game: Savior Economics or Sunk Cost Problem?

Since my pre-IPO post on WeWork, where I valued the company ahead of its then imminent offering, much has happened. The company’s IPO collapsed under the weight of its own pricing contradictions, and after a near-death experience, Softbank emerged as the savior, investing an additional $ 8 billion in the company, and taking a much larger stake in its equity. As the WeWork story continues to unfold, I am finding myself more interested in Softbank than in WeWork, largely because its actions cut to the heart of so many questions in investing, from how sunk costs can affect investing decisions, to the feedback effects from mark-to-market accounting, and finally on the larger question of whether smart money is really smart or just lucky.

WeWork: The IPO Aftermath

It has been only a few weeks since I valued WeWork for its IPO, but it seems much longer, simply because of how much has changed since then. As a reminder, I valued WeWork at about $10 billion pre-money, and $13.75 billion with the anticipated proceeds of $3.5 billion added on. I also argued that this was a company on a knife’s edge, a growth machine with immense operating and financial leverage, where misstep could very quickly tip them into bankruptcy, with a table illustrating how quickly the equity slips into negative territory, if the operating assumptions change:

Download spreadsheet

Soon after my post, the ground shifted under WeWork, as a combination of arrogance (on the part of VCs, bankers and founders) and business model risks caught up with the company, and the IPO was delayed, albeit reluctantly by the company. That action, though, left the company in a cash crunch, since it had been counting on the IPO to bring in $3 billion in capital to cover its near-term needs. In conjunction with a loss of trust in the top management of the company, created a vicious cycle with the very real possibility that the company would implode. As WeWork sought rescue packages, Softbank offered a lifeline, with three components to it:

1. Equity Buyout: A tender offer of $3 billion in equity to buy out of existing stockholders in the firm to increase its share of the equity ownership to 80%. In an odd twist, Softbank contended that, after the financing, “it will not hold a majority of the voting rights… and does not control the company… WeWork will not be a subsidiary of Softbank. WeWork will be an associate of Softbank”. I am not sure whether this is a true confession of lack of control or a ploy to keep from consolidating WeWork (and its debt load) into Softbank's financials.
2. Added Capital: Softbank would provide fresh debt financing of $5 billion ($1.1 billion in secured notes, $2.2 billion in unsecured notes and $1.75 billion as a line of credit) and an acceleration of a $1.5 billion equity investment it had been planning to make into WeWork in 2020, giving WeWork respite, at least in the short term, from its cash constraints.
3. Neutering Adam Neumann (at a cost): The offer also includes a severing of Adam Neumann’s leadership of the company, in return for which he will receive $1 billion in cash, $500 million as a loan to repay a JP Morgan credit line and $185 million for a four-year position as a consultant. I assume that the consulting fee is more akin to a restraining order, preventing him from coming within sighting distance of any WeWork office or building.

Since that deal was put together, the storyline has shifted, with Softbank now playing the lead role in this morality play, with multiple questions emerging:

1. What motivated Softbank to invest so much more in a company where it had already lost billions? Some are arguing that Softbank had no choice, given the magnitude of what they had invested in WeWork, and others are countering that they were throwing good money after bad. 
2. With mark-to-market rules in effect at Softbank, how will accountants reflect the WeWork disaster on Softbank’s books? I think that fair-value accounting is neither fair nor is it about value, but the WeWork write down that Softbank had to take is a good time to discuss how fair-value accounting can have a feedback effect on corporate decision making.
3. Is Masa Son a visionary genius or an egomaniac in need of checks and balances? A year ago, there were many who viewed Masa Son, with his 300-year plans and access to hundreds of billions of dollars in capital, was a man ahead of his time, epitomizing smart money. Today, the consensus view seems to be that he is an impulsive and emotional investor, not to be trusted in his investment judgments. The truth, as is often the case, lies somewhere in the middle.
4. Since Softbank is a holding company, deriving a chunk of its value from its perceived ability to find start-ups and young companies and convert them into big wins, how will its value change as a result of its WeWork missteps? To answer this question, I will look at how Softbank’s market capitalization has changed over time, especially around the WeWork fiasco, and examine the consequences for its Vision fund plans.

Sunk Cost or Corporate Rescue!

In the years that WeWork was a private company, Softbank was, by far, the largest investor in the company. In August 2019, when the IPO was first announced, Softbank had not only been its largest capital provider, investing $7.5 billion in the company, but had also supplied the most recent round of capital, at a pricing of $47 billion. That lead-in, though, raises questions about the motives behind its decision to invest an extra $ 8 billion to keep WeWork afloat. 

• It’s a corporate rescue: There are some who would argue that Softbank had no choice, since without an infusion of capital, WeWork was on a pathway to being worth nothing and that by investing its capital, Softbank would avoid that worst-case scenario. In fact, if you believe Softbank, with the infusion, WeWork has a pre-money value of $8 billion, with the infusion, and while that is a steep write down from the $47 billion pricing, it is still better than nothing. 
• Good money chasing bad: The sunk cost principle, put simply, states that when you make an investment decision, your choice should be driven by its incremental effects and not by how much you have already expended leading up to that decision. In practice, though, investors seem to abandon this principle, trying to make up for past mistakes by making new ones. In the context of Softbank’s new WeWork investment, this would imply that Softbank is investing $ 8 billion in WeWork, not because it believes that it can generate more than that amount in incremental value from future cash flows, but because it had invested $7.5 billion in the past.

So, how do you resolve this question? As I see it, the Softbank rescue of WeWork may have helped it avoid a near term liquidity meltdown, but it has not addressed any of the underlying issues that I noted with the company’s business model. In fact, it has taken a highly levered company whose only pathway to survival was exponential growth and made it an even more levered company with constrained growth. In fact, Softbank has been remarkably vague about the economic rationale for the added investment and their story does not hold up to scrutiny. I do realize that Masa Son claims that “(t)he logic is simple. Time will resolve . . . and we will see a sharp V-shaped recovery,” in WeWork, but I don’t see the logic, time alone cannot resolve a $30 billion debt problem and there are enough costs in non-core businesses to cut to yield a quick recovery. At least from my perspective, Softbank’s investment in WeWork is good money chasing bad, a classic example of how sunk costs can skew decisions. To those who would counter that Softbank has a lot of money to lose and smart people working for it, note that the more money you have to lose and the smarter people think they are, the more difficult it becomes to admit to past mistakes, exacerbating the sunk cost problem. In fact, now that Softbank will have more than $15 billion invested in WeWork, they have made the sunk cost problem worse, going forward.

Accounting Fair Value

I understand the allure of fair value accounting to accountants. It provides them with a way to update the balance sheet, to reflect real world changes and developments, and make it more useful to investors. The fact that it also creates employment for accountants all over the world is a bonus, at least from their perspective. I think that the accounting response to Softbank’s WeWork mistake illustrates why fair value accounting is an oxymoron, more likely to do damage than good:

1. It is price accounting, not value accounting: In Softbank’s latest earnings report, we saw the first installment of accounting pain from the WeWork mistake, with Softbank writing down its WeWork investment by $4.6 billion and reporting a hefty loss for the quarter. The reason for the write-down, though, was not a reassessment of WeWork’s value, but a reaction to the drop in the pricing of the company’s equity from the $47 billion before the IPO to $8 billion after the IPO implosion. 
2. With Softbank supplying the pricing: If you are dubious about the use of pricing in accounting revaluations, you should even more skeptical in this case, since Softbank was setting the pricing, at both the $47 billion pre-IPO, and the $8 billion, post-collapse. As I noted in the last section, there is nothing tangible that I can see in any of Softbank’s numerous press releases to back these numbers. In fact, if WeWork had not been exposed in its public offering, my guess is that Softbank would have probably invested more capital in the company, marked up the pricing to some number higher than $47 billion and that we would not be having this conversation.
3. Too little, too late: As is always the case with accounting write-downs and impairments, there was very little news in the announcement. In fact, given that the write down was based upon pricing, not value, the market knew that a write off was coming and approximately how much the write off would be, which explains why even multi-billion write offs and impairments usually have no price effect, when announced. Incidentally, the accountants will offer you intrinsic valuations (DCF) to back up their assessments, but I would not attach to much weight to them, since they are what I call “kabuki valuations”, where the analysts decide, based on the pricing, what they would like to get as value, and then reverse engineer the inputs to deliver that number.
4. With dangerous feedback effects: If all fair value accounting did was create these write downs and impairments that don’t faze investors, I could live with the consequences and treat the costs incurred in the process as a jobs plan for accountants. Unfortunately, companies still seem to think that these accounting charges are news that moves markets and take actions to minimize them. In fact, a cynic might argue that one motivation for Softbank’s rescue of WeWork was to minimize the write down from its mistake. 

I am not a fan of fair value accounting, partly because it is a delayed reaction to a pricing change and is not a value reassessment, and partly because companies are often tempted to take costly actions to make their accounting numbers look better. 

Smart Money, Stupid Money!

I hope that this entire episode will put to rest the notion of smart money, i.e., that there are investors who have access to more information than we do, have better analytical tools than the rest of us and use those advantages to make more money than the rest of us. In fact, it is this proposition that leads us to assume that anyone who makes a lot of money must be smart, and by that measure, Masa Son would have been classified as a smart investor, and wealthy investors funneled billions of dollars into Softbank Vision funds, on that basis. I am not going to argue that the WeWork misadventure makes Masa Son a stupid investor, but it does expose the fact that he is human, capable of letting his ego get ahead of good sense and that at least some of his success over time has to be attributed being in the right place at the right time. 

So, if investors cannot be classified into smart and stupid, what is a better break down? One would be to group them into lucky and unlucky investors, but that implies a complete surrender to the forces of randomness that I am not yet willing to make. I think that investors are better grouped into humble and arrogant, with humble investors recognizing that success, when it comes, is as much a function of luck as it is of skill, and failure, when it too arrives, is part of investing and an occasion for learning. Arrogant investors claim every investing win as a sign of their skill and view every loss as an affront, doubling down on their mistakes. If I had to pick someone to manage my money, the quality that I would value the most in making that choice is humility, since humble investors are less likely to overpromise and overcommit. I think of the very act of demanding obscene fees for investment services is an act of arrogance, one reason that I find it difficult to understand why hedge funds are allowed to get away with taking 2% of your wealth and 20% of your upside.

Leading into the WeWork IPO, the question of where Masa Son fell on the humility continuum was easy to answer. Anyone who makes three hundred year plans and things that bigger is always better has a God complex, and success feeds that arrogance. I would like to believe that the WeWork setback has chastened Mr. Son, and in his remarks to shareholders this week, he said the right things, stating that he had “made a bad investment decision, and was deeply remorseful”, speaking of WeWork. However, he then undercut his message by not only claiming that the pathway to profit for WeWork would be simple (it is not) but also asserting that his Vision fund was still better than other venture capitalists in seeking out and finding promising companies. in my view,  Masa Son needs a few more reminders about humility from the market, since neither his words nor his actions indicate that he has learned any lessons. 

Softbank: The WeWork Effect

WeWork may have been Masa Son’s mistake, but the vehicle that he used to make the investment was Softbank, through the company and its Vision fund. As WeWork has unraveled, it is not surprising that Softbank has taken a significant hit in the market. 

Note that Softbank has lost more than $15 billion in value since August 14, when the WeWork IPO was announced, and much of that loss can be attributed to the unraveling of the IPO, and how investor perceptions of Masa Son’s investing skills have changed since.

The knocking down of Softbank’s value by the market may strike some of you as excessive, but there is reason that Softbank’s WeWork investment has ripple effects. Softbank may be built around a telecom company, but like Berkshire Hathaway, the company that Masa Son is rumored to admire and aspire to be, it is a holding company for investments in other companies. In fact, its most valuable holding remains an early investment in Alibaba, now worth tens of billions dollars. While Alibaba is publicly traded and its pricing is observable, many of Softbank’s most recent investments have been in young, private companies like WeWork. With these investments, the pricing attached to them by Softbank, in its financials, comes from recent VC funding rounds and their valuations reflect trust in Softbank’s capacity to pick winners and the WeWork meltdown hurts on both counts. First, investors are more wary about trusting VC pricing, especially if Softbank has been a lead investor in funding rounds, since that is how you arrived at the $47 billion pricing for WeWork in the first place. Second, the notion of Masa Son as an investing savant, skilled at picking the winners of the disruption game, has been damaged, at least for the moment and perhaps irreparably. The easiest way to measure how investor perceptions have changed is to compare the market capitalization of Softbank to its book value, a significant proportion of which reflects its holdings, marked to market:

Investors have been wary of Softbank’s investing skills, even before the WeWork IPO, but the write offs on Uber and WeWork has made them even more skeptical, as the price to book ratio continues its march towards parity, with the market capitalization at 123% of the book value of equity in November 2019. In fact, if you focus just on Softbank’s non-consolidated holdings, public and private, note that the market capitalization of Softbank now stands at 73% of the value of just these holdings, most of which are marked to market. Put simply, when you buy Softbank, you are getting Uber and Alibaba at a discount on their traded market prices, but before you put your money down on what looks like a great deal, there are two considerations that may affect your decision. The first is that the company has a vast amount of debt on its balance sheet that has to be serviced, potentially putting your equity at risk, and the second is that you are getting Softbank (and Masa Son) as the custodian of the investments. If you have lost faith in Masa Son’s investing judgments (in people and in companies), you may view the 27% discount that the market is attaching to Softbank’s holdings as entirely justifiable and steer away from the stock. In contrast, if you feel that WeWork was an aberration in an otherwise stellar investment picking record, you should load up on Softbank stock. As for me, I don’t plan to own Softbank! I don't like grandiosity and Masa Son seems to have been soaked in it.

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Blog Posts

1. Runaway Story to Meltdown in Motion: The Unraveling of the WeWork IPO
2. Sunk Costs and Investing

Investing and Valuation Lessons from the Renaissance

I just got back a few days ago from a two-week family holiday in Italy, where we spent the bulk of the second week in Florence, which we used as a springboard to see Tuscany. I kept away from work through much of the period, though I did check my emails once in a while and even tried answering a few on my iPhone, where my awful typing skills restricted me to one-sentence responses. So, if you were one of those people that I responded to, I apologize if I seemed brusque. That said, I am also afflicted with a disease of seeing connections between everything I see around me and investing, and this vacation was no exception. Thus, in Florence, as I gazed at Brunelleschi’s magnificent Duomo on the Cathedral and marveled at the beauty of Michelangelo’s David, I could not help but think about how much we (as investors) can learn from those renaissance geniuses.

The Story of Brunelleschi’s Dome

If you have visited Florence or even read about the dome on its cathedral, I am sure that you have heard its story. The construction of the cathedral was begun in 1296 and continued in fits and starts through much of the next few decades with the Plague bringing it to a standstill in the second half of the fourteenth century. The centerpiece of the cathedral was to be its freestanding dome, but since architects of the age lacked the capacity to build one large enough to cover the church, it was left for another generation to complete. In 1418, two goldsmiths in Florence, Lorenzo Ghiberti and Filippo Brunelleschi, competed in a contest for designing the dome, with Brunelleschi winning by a hair. Brunelleschi spent time studying the Pantheon in Rome, a concrete dome built more than a thousand years prior, but one where all records of its construction had long been destroyed. He started work on his Duomo in 1420 and completed it by 1436, and the result speaks for itself:

Brunelleschi was an artist, skilled in its many forms, but to build the dome, he not only drew on science but actively used it to solve practical problems. To allow the huge dome to stay standing without visible supports, Brunelleschi came up with the ingenious concept of a dome within a dome (a double shell) and stone ribs designed to defend against the spreading created by the weight of the dome. He had to construct hoisting machines to lift the almost four million bricks and large stones and structural innovations to let workers complete the construct. The dome, once completed, was as much an engineering feat as it was an artistic triumph and it remains so today.

Investing and Valuation Lessons

I can think of at least three big lessons that investors can learn from the Renaissance masters. The first is the meaning of faith, a scarce resource in today's markets, as we eagerly seek confirmation that we are right in market movements and are quick to give up, when things don't go our way. The second is the need for humility, an acceptance that much of what we claim to be new and innovative in investing is neither, and that we can learn from looking at the past. The third is that just as the best of the Renaissance required a melding of art and science, the best of investing is built on a combination of story telling and number crunching. 

Lesson 1: The Importance of Faith

Investing is as much about faith as it is about mechanics. As our access to data and models increases, I will borrow words that Tom Friedman used in a different context, and argue that the investing world is becoming flatter. It is not getting any easier to make money from investing and one reason may be that we have no faith in either our ability to attach values to companies, in the face of uncertainty, or in the market’s capacity to correct its mistakes. As a consequence, even those investors who are well versed in valuation mechanics are generally unwilling to act on the valuations that they generate, or when they do, to hold on to them in the face of adversity.  Like many of you, I find myself getting impatient when the stock price does not correct quickly towards my estimated value on my investments and growing uncertain with my own judgment, if the divergence persists for months. As I looked up at the Florence skyline and pondered the patience of those who were willing to build a church first and then wait almost a hundred for someone to come along with its dome, I understood the meaning of faith and how far I have to go to get there.

Lesson 2: There are no new investment lessons, just old ones to relearn

With superior resources and better investment education, we tend to think that we are not only more sophisticated than investors in prior generations but less likely to make the same errors in judgment. If only that were true! Just as the skills that allowed the Romans to build the Pantheon were forgotten for a thousand years and had to be rediscovered by Brunelleschi, there are simple lessons that investors learned in past markets that we seem to forget in new markets. Each time we make collective mistakes as investors and there is a market correction, we are quick to say "never again" only to repeat the same mistakes a few years later. 

Lesson 3: Art and Science

Are you an artist or a scientist? An engineer or a poet? We live in an age where we are asked to pick sides and told that the two cannot co-exist. In the context of valuation, the battle is fought out between the story tellers and the number crunchers, with each claiming the high ground. In the last few years, I have argued not just for a truce between the two sides but also for more engagement,  a marriage of numbers and narrative in valuation and investing. Even my best efforts pale in comparison to one look at Brunelleschi’s dome, since he understood that there was no divide between art and science. It is a lesson that we seem to have forgotten over time, as we force people to choose sides in a battle where there are no winners.

An Investment Renaissance

We live in an age of specialists, and in investments, this has taken the form of experts who operate in silos, option traders who act as if their derivative securities can exist without their underlying assets, fixed income investors who function as if bonds are the only game in town and equity investors who can only talk about stocks. This specialization comes with consequences and one of them is that we tend to operate in echo chambers, talking to people who think like us, act like us and not surprisingly, agree with us. If the words "Renaissance man (or woman)" are used to describe someone whose expertise spans different subject areas, in the context of investing, I would use those words to refer to those investors who can move with ease across markets and are just as comfortable with stories as they are with numbers. This is my subjective judgment but I think that there used to be more of them three decades ago, when I started in investing, and they seem to become rarer by the day.  In corporations, banks, money management units, consulting firms and even in academia, we could use more Renaissance thinking.

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