I am currently in Bogota, Colombia, doing a seminar in risk. One of the topics that came up yesterday was about the choice of currency to do a valuation in, and how it affects your inputs. In particular, the question that I was asked was whether an analyst should value a Colombian company in Colombian pesos or US dollars, and the implications of this choice. Here is how I responded:
Which currency should I do my valuation in?
If you do your valuation right, it should not matter. Your value for a company should be the same, no matter what currency you choose to value it in. Thus, a company that is under valued by 20%, when you do your valuation in pesos, should remain under valued by 20%, when you do your valuation in US dollars.
Given this proposition, you should pick the currency with which you are most comfortable with and where it is easiest to get the financial information. My instinct, given the latter requirement, is to do valuations in the local currency since most financial statements are richer and more detailed in the local currency. Your choice of currency should not be a function of the investor for whom you are doing the valuation. Thus, you should not try to value a Colombian company in US dollars, just because the investor for whom you are doing the valuation is dollar based.
How is my discount rate affected by my currency choice?
In the context of discount rates, the input that is most influenced by the currency choice is the riskfree rate. If you work with a higher inflation currency, the riskfree rate will be higher. In the Colombian context, the Colombian peso riskfree rate was 6.5% and the US dollar riskfree rate was 4% last week. The difference of 2.5% is entirely attributable to differences in expected inflation.
Just as a side note, while getting a US dollar riskfree rate is easy (I used the T.Bond rate), I had to work a little harder to get the riskfree rate in pesos, since the peso-denominated Colombian government bond does have some default risk embedded in it. In particular, I subtracted out the default spread for the Colombian government (about 2%) from the bond rate (8.5%) to get to the riskfree rate.
The other inputs remain pretty stable. Betas should measure the business risk of the company. I have never understood the rationale of a widely used practice of using betas against the S&P 500, when doing dollar based analysis, and switching to betas against local indices, for local currency analysis. Those of you who follow my work know that I am firm believer in using sector or bottom up betas. For Ecopetrol, the Colombian company, I estimated a beta of about 0.80, based on the fact that it was an oil company, and used that beta for both US dollar and Colombian peso analysis. Even more dangerous is the practice of using the US equity risk premium, for US dollar analysis, and the much larger Colombian equity risk premium, for peso analysis. The company is a Colombian company and you cannot make the country risk go away by switching currencies. Both the dollar and the peso analysis therefore should use the higher Colombian risk premium.
As a final note, the cost of debt should be in the same currency that you estimate the cost of equity in and this is true no matter what currency the company actually borrows in. Therefore, if the company borrows in US dollars but you are doing your analysis in pesos, you will have to restate the cost of debt in peso terms.
How are my cash flows affected by my choice of currency?
The key rule here is that your cash flows have to be in the same currency as your discount rate. Thus, if you decide to do your analysis in pesos, you cash flows have to be in nominal pesos. If you decide to do your analysis in dollars, your cash flows have to be in nominal dollars. If it is a company with Colombian operations, this will often mean that you have estimate the cash flows in pesos and convert them into dollars. You have to use forward or expected exchange rates (and not the current spot rate) to make the conversion. In fact, if you want to preserve consistency, your expected exchange rate has to be computed from either interest rate or purchasing power parity. In the context of Colombia, for instance, the 2.5% higher inflation in Colombia that I have built into the riskfree rate will translate into an expected devaluation in the peso of about 2.5% a year.
Can I avoid this currency choice altogether?
You could, if you do your analysis in real terms. Thus, your discount rate has to be a real discount rate; the real riskfree rate is about 2% (I used the inflation-indexed US treasury to get this) and you can build the rest of the inputs on top of this rate. Your expected cash flows should be real cash flows; thus, you cannot count the inflation component of growth. Again, if you do it right, you should get the same value.
The bottom line: Make your choice of currencies at the start of the process and stay consistent with that choice all the way through. If you are wrong about expected inflation, it will cancel out - both your discount rates and cash flows will change. If you are inconsistent about inflation, applying one rate to cash flows and another to discount rates, your valuation cannot be salvaged.
Friday, April 16, 2010
Friday, April 9, 2010
Stock versus Flow: My thoughts
When analyzing companies, the three financial statements that we primarily use are the income statement, the balance sheet and the statement of cash flows. We obtain the inputs for earnings and cash flows from the income and cash flow statements and the numbers for debt, cash and working capital from the balance sheet.
While all three statements are governed by accounting standards and are audited, there is a key difference between them. Income and cash flow statements represent flow statements: they measure how much the company earned and spent over the period. Balance sheets capture the values of assets and liabilities at a point in time and thus represent "stock" statements.
So what? Stock statements are inherently less trustworthy than flow statements, because the numbers may not be representative of what the company did over the course of the year. This can be manifested in almost every number extracted from a balance sheet:
a. Debt: The debt that is reported on December 31 of a fiscal year will reflect what was owed on that day. A company can therefore pay down debt on December 30 and borrow again early the next year, manipulating its debt figures. In fact, there is a story in the Wall Street Journal about banks doing exactly this to make themselves look less indebted and thus safer.
http://online.wsj.com/article/SB10001424052702304830104575172280848939898.html
Another common way in which debt can be kept off the books is by using lines of credit or seasonal financing during the course of the year but to pay them down by the end of the year.
There a couple of clues that we can use to detect this practice. One is to look at quarterly balance sheets, in additional to the year-end balance sheet, with the intent of finding big changes in debt from quarter to quarter. While enterprising companies may still be able to hide debt, it is much more difficult to do so on a quarterly basis. The other is to look at interest expenses as a percentage of the year-end debt. If a firm has debt for the bulk of the year, it has to pay interest expenses on that debt, even if it retires the debt towards the end of the year. As a result, the book interest rate (interest expense/ book debt) will be disproportionately high (relative to what you would expect the company to pay.
b. Cash: The cash on a balance enters intrinsic valuations as an add-on to the estimated value of the operating assets and relative valuations when we use enterprise value multiples (where cash is netted out of debt). However, the cash balance on the balance sheet may bear little or no resemblance to the actual cash balance today (which is really the number we should be using in intrinsic and relative valuation). This is one reason why some firms actually trade at negative enterprise values, where market equity is updated to reflected today's value but debt and cash remain frozen at year-end values.
c. Working capital: Net working capital is the difference between non-cash current assets (inventory and receivables) and non-debt current liabilities (payables and other accrued liabilities). Any of these numbers can be altered over short periods. For instance, receivable collections can be stepped up and inventory cleared (how about those year end clearance sales) just before balance sheet dates to make working capital look smaller.
In closing, I am not suggesting dynamic balance sheets. That would be too expensive and not quite practical. However, I am suggesting that we be more careful about balance sheet based analysis. Never trust a single balance sheet; if you can get quarterly balance sheets, do so; if you have access to the current numbers (on cash, debt and working capital), even better. The last may seem unrealistic but if you are the acquirer in a friendly merger, you should be able to demand and get this information from the target company.
While all three statements are governed by accounting standards and are audited, there is a key difference between them. Income and cash flow statements represent flow statements: they measure how much the company earned and spent over the period. Balance sheets capture the values of assets and liabilities at a point in time and thus represent "stock" statements.
So what? Stock statements are inherently less trustworthy than flow statements, because the numbers may not be representative of what the company did over the course of the year. This can be manifested in almost every number extracted from a balance sheet:
a. Debt: The debt that is reported on December 31 of a fiscal year will reflect what was owed on that day. A company can therefore pay down debt on December 30 and borrow again early the next year, manipulating its debt figures. In fact, there is a story in the Wall Street Journal about banks doing exactly this to make themselves look less indebted and thus safer.
http://online.wsj.com/article/SB10001424052702304830104575172280848939898.html
Another common way in which debt can be kept off the books is by using lines of credit or seasonal financing during the course of the year but to pay them down by the end of the year.
There a couple of clues that we can use to detect this practice. One is to look at quarterly balance sheets, in additional to the year-end balance sheet, with the intent of finding big changes in debt from quarter to quarter. While enterprising companies may still be able to hide debt, it is much more difficult to do so on a quarterly basis. The other is to look at interest expenses as a percentage of the year-end debt. If a firm has debt for the bulk of the year, it has to pay interest expenses on that debt, even if it retires the debt towards the end of the year. As a result, the book interest rate (interest expense/ book debt) will be disproportionately high (relative to what you would expect the company to pay.
b. Cash: The cash on a balance enters intrinsic valuations as an add-on to the estimated value of the operating assets and relative valuations when we use enterprise value multiples (where cash is netted out of debt). However, the cash balance on the balance sheet may bear little or no resemblance to the actual cash balance today (which is really the number we should be using in intrinsic and relative valuation). This is one reason why some firms actually trade at negative enterprise values, where market equity is updated to reflected today's value but debt and cash remain frozen at year-end values.
c. Working capital: Net working capital is the difference between non-cash current assets (inventory and receivables) and non-debt current liabilities (payables and other accrued liabilities). Any of these numbers can be altered over short periods. For instance, receivable collections can be stepped up and inventory cleared (how about those year end clearance sales) just before balance sheet dates to make working capital look smaller.
In closing, I am not suggesting dynamic balance sheets. That would be too expensive and not quite practical. However, I am suggesting that we be more careful about balance sheet based analysis. Never trust a single balance sheet; if you can get quarterly balance sheets, do so; if you have access to the current numbers (on cash, debt and working capital), even better. The last may seem unrealistic but if you are the acquirer in a friendly merger, you should be able to demand and get this information from the target company.
Wednesday, March 31, 2010
Goodwill: Plug Variable or Real Asset?
Of all the items on a conventional accounting balance sheet, none gives me more trouble than goodwill. It is not an insignificant item for some companies, amounting to a large percentage of overall assets, but it does not show up on the balance sheets of other companies. To anyone who encounters it, there are five questions that follow: What is it? Why it is there? What does it measure? Can it change over time? What do we do with it?
What is it?
While goodwill connotes something substantial, it is a plug variable. Note that it shows up on a balance sheet only when a company does an acquisition. Some accounting text books define it as the difference between the price paid for a target company and the fair value of its assets, but that would be a lie. Stripped to basics, goodwill is the difference between the market price paid for a target company and the book value of its assets, with a little fair value modification thrown in for good measure. Thus, if company A pays $ 10 billion for company B, and the book value of company B's assets is $ 4 billion, there will be goodwill of $ 6 billion on company A's balance sheet after the acquisition.
Why is it there?
The answer to that is very simple. Because balance sheets need to balance. There are two fundamental disconnects between market value and accounting book value:
a. Book value reflects historical cost (not current value): An acquisition lays bare one of the fundamental problems with an accounting balance sheet, which is that the values of assets (at least operating ones) are recorded at historical cost, rather than current value. An acquisition of another company is at current market value and has to be recorded as such by the acquiring company. If you cannot write up the values of the acquired company's assets to reflect the price paid, you will have to record the difference as goodwill.
b. Value of growth potential: The fair value of a company reflects both the value of its existing assets and the expected value of future growth potential. The former is what is captured in accounting balance sheets but market value includes the latter. Thus, when an acquirer buys a target company, it will have to pay a premium on book value (which reflects the value only of existing assets), even if existing assets were fairly valued.
In effect, acquisitions create an inconsistency in accounting. While internal investments made by a firm get recorded at historical cost, acquisitions are recorded at market value. Goodwill then reflects the accounting attempt to make things whole again.
What does it measure?
So, what does goodwill measure? Building on the last part, the goodwill in an acquiring company's balance sheet is a composite of three inputs:
a. Misvaluation of existing assets: As we noted in the last section, if existing assets are misvalued, there will be goodwill even in the absence of growth. Consequently, the more existing assets are misvalued, the greater will be the goodwill.
b. Growth potential: Goodwill be larger, when you acquire a firm with greater growth potential, since the market value will reflect this growth potential but book value will not.
c. Overpayment by the acquirer: There is substantial evidence that acquirers over pay for target firms and this overpayment is attributed to multiple factors - managerial self interest and hubris, over confidence on the part of managers, and conflicts of interests. Whatever the reason, this overpayment, if it occurs, has only one place to go and that is goodwill.
This can be illustrated with a simple example. Assume that company A acquires company B for $ 1 billion and that the book value of company B is $350 million. Assume further that the fair value of company B's existing assets is $400 million and that the value of its growth potential is $ 500 million. If existing assets are not marked up to fair value, the goodwill of $650 million has three components:
the misvaluation of existing assets ($400 - $350), the value of growth assets ($500 million) and overpayment ($100 million).
Accounting changes over the last decade have been directed at addressing the first of these three - misvaluation of existing assets. Thus, appraisers, working under the tight constraints of both accounting standards and tax rules, are allowed to reassess the value of existing assets to better reflect their current value. In the example above, this would lead to existing assets being reassessed to $ 400 million and goodwill to $ 600 million. For the most part, there is little that accountants can do about growth potential, since those assets exist only in investor perceptions.
Can it change over time?
To the extent that goodwill is market-based, the value of goodwill will change from period to period. Thus, the value of existing assets and existing assets can change from year to year and the overpayment has to be recognized at some point in time. Until a decade ago in the US and still in most parts of the world, these reassessments of goodwill are put on auto pilot, with goodwill being amortized over 30 or 40 years, irrespective of the facts on the ground.
In the last decade, accountants have argued that the value of goodwill can be reassessed to reflect changes in the three components and the change should be reflected in earnings. While the amortization or impairment of goodwill tries to reflect this reassessment, there are three issues in how it is done:
a. Timing lag: To make their assessment of whether and how much to reassess goodwill, accountants look to markets. Thus, the goodwill accrued by Time Warner from the acquisition of AOL was impaired by $54 billion in 2002, but only because technology stocks had collapsed in the market in the previous two years. Since everyone in the market already had made this adjustment, the actual impairment of goodwill was treated by the market as being of no consequence.
b. Unidirectional: Goodwill impairments almost always seem to lower the value of goodwill. If this were a fair reassessment, you should see a significant number of companies where the value of goodwill gets assessed upwards.
c. Composite adjustment: The impairment of goodwill is provided as one number, when it includes reassessments of existing asset values, growth potential and overpayment. Since the implications of each are different for valuation, it is one more reason why goodwill impairment is not a particularly useful piece of information.
In summary, goodwill impairment has become an earnings management tool for many companies rather than a test of fair value changes. In the process, it has lost its informational content and is of little help to investors.
a. Book capital and Earnings: The minute a company acquires another company, the characteristics of book equity and capital change. Rather than reflect just historical values (which is the case when a company has only internal investments), they incorporate market values for at least the target company's assets. Thus, book capital for an acquisitive firm includes the three components mentioned above for a target firm - a mark-to-market of existing assets, growth assets and overpayment. Since the rest of the acquiring firm's assets remain at their old values, the resulting book equity and capital is inconsistently defined. Earnings are also contaminated for a different reason. The impairment of goodwill can cause big swings in earnings from period to period. Since earnings and book capital are the key inputs into return on equity and return on invested capital (ROIC), the presence of goodwill can dramatically alter these returns.
To correct for goodwill, many analysts adopt the policy of ignoring it all together in the computation. Thus, return on capital is measured as:
ROC = Earnings before goodwill amortization/ (Book value of capital - Goodwill)
However, I have a paper on measuring returns where I have argued that while it is perfectly reasonable to net out the first two components of goodwill - misvaluation of existing assets and growth potential- from book capital, overpayment should not be netted out. In effect, companies like Time Warner should not be allowed to wipe out their mistakes and return their capital to pre-mistake levels, since stockholders have paid the price for these mistakes. Of course, separating out what portion of the goodwill is for overpayment is tough to do, but we need to make an effort. (I propose that we call this stupid goodwill and contrast it with smart goodwill)
b. Valuation: In a discounted cash flow valuation, goodwill really has no direct effect, since we estimate the value from expected future cash flows. Those cash flows will reflect the true value of existing assets and growth potential. Thus, it is in incorrect to add goodwill on to a DCF value, since it double counts these values. If you are doing asset based valuation, where you try to estimate current market values for individual assets on the balance sheet, it becomes trickier, since goodwill is not a conventional asset. Here, there is no easy way out. You have to either take the accounting estimate of goodwill as a fair value or estimate the value of future growth (which would require a DCF). In relative valuation, goodwill does not really affect much if you are using operating income multiples (Operating income or EBITDA is pre-goodwill amortization anyway) but it can affect equity earnings multiples (PE ratio or PEG ratios), since those earnings per share can be affected by goodwill charges. Goodwill can become a problem with book value based multiples. In effect, if you do not adjust for goodwill, companies that do a lot of acquisitions will have lower price to book and EV to Book ratios (and thus look cheaper) than companies that grow with internal investments.
One final thought. Given that goodwill, as an item, really changes nothing about the underlying assets and their value, no company should make or change decisions based upon the accounting measurement and treatment of goodwill. If you pay too much for a target company, what accountants do with or to goodwill cannot undo the damage already done.
What is it?
While goodwill connotes something substantial, it is a plug variable. Note that it shows up on a balance sheet only when a company does an acquisition. Some accounting text books define it as the difference between the price paid for a target company and the fair value of its assets, but that would be a lie. Stripped to basics, goodwill is the difference between the market price paid for a target company and the book value of its assets, with a little fair value modification thrown in for good measure. Thus, if company A pays $ 10 billion for company B, and the book value of company B's assets is $ 4 billion, there will be goodwill of $ 6 billion on company A's balance sheet after the acquisition.
Why is it there?
The answer to that is very simple. Because balance sheets need to balance. There are two fundamental disconnects between market value and accounting book value:
a. Book value reflects historical cost (not current value): An acquisition lays bare one of the fundamental problems with an accounting balance sheet, which is that the values of assets (at least operating ones) are recorded at historical cost, rather than current value. An acquisition of another company is at current market value and has to be recorded as such by the acquiring company. If you cannot write up the values of the acquired company's assets to reflect the price paid, you will have to record the difference as goodwill.
b. Value of growth potential: The fair value of a company reflects both the value of its existing assets and the expected value of future growth potential. The former is what is captured in accounting balance sheets but market value includes the latter. Thus, when an acquirer buys a target company, it will have to pay a premium on book value (which reflects the value only of existing assets), even if existing assets were fairly valued.
In effect, acquisitions create an inconsistency in accounting. While internal investments made by a firm get recorded at historical cost, acquisitions are recorded at market value. Goodwill then reflects the accounting attempt to make things whole again.
What does it measure?
So, what does goodwill measure? Building on the last part, the goodwill in an acquiring company's balance sheet is a composite of three inputs:
a. Misvaluation of existing assets: As we noted in the last section, if existing assets are misvalued, there will be goodwill even in the absence of growth. Consequently, the more existing assets are misvalued, the greater will be the goodwill.
b. Growth potential: Goodwill be larger, when you acquire a firm with greater growth potential, since the market value will reflect this growth potential but book value will not.
c. Overpayment by the acquirer: There is substantial evidence that acquirers over pay for target firms and this overpayment is attributed to multiple factors - managerial self interest and hubris, over confidence on the part of managers, and conflicts of interests. Whatever the reason, this overpayment, if it occurs, has only one place to go and that is goodwill.
This can be illustrated with a simple example. Assume that company A acquires company B for $ 1 billion and that the book value of company B is $350 million. Assume further that the fair value of company B's existing assets is $400 million and that the value of its growth potential is $ 500 million. If existing assets are not marked up to fair value, the goodwill of $650 million has three components:
the misvaluation of existing assets ($400 - $350), the value of growth assets ($500 million) and overpayment ($100 million).
Accounting changes over the last decade have been directed at addressing the first of these three - misvaluation of existing assets. Thus, appraisers, working under the tight constraints of both accounting standards and tax rules, are allowed to reassess the value of existing assets to better reflect their current value. In the example above, this would lead to existing assets being reassessed to $ 400 million and goodwill to $ 600 million. For the most part, there is little that accountants can do about growth potential, since those assets exist only in investor perceptions.
Can it change over time?
To the extent that goodwill is market-based, the value of goodwill will change from period to period. Thus, the value of existing assets and existing assets can change from year to year and the overpayment has to be recognized at some point in time. Until a decade ago in the US and still in most parts of the world, these reassessments of goodwill are put on auto pilot, with goodwill being amortized over 30 or 40 years, irrespective of the facts on the ground.
In the last decade, accountants have argued that the value of goodwill can be reassessed to reflect changes in the three components and the change should be reflected in earnings. While the amortization or impairment of goodwill tries to reflect this reassessment, there are three issues in how it is done:
a. Timing lag: To make their assessment of whether and how much to reassess goodwill, accountants look to markets. Thus, the goodwill accrued by Time Warner from the acquisition of AOL was impaired by $54 billion in 2002, but only because technology stocks had collapsed in the market in the previous two years. Since everyone in the market already had made this adjustment, the actual impairment of goodwill was treated by the market as being of no consequence.
b. Unidirectional: Goodwill impairments almost always seem to lower the value of goodwill. If this were a fair reassessment, you should see a significant number of companies where the value of goodwill gets assessed upwards.
c. Composite adjustment: The impairment of goodwill is provided as one number, when it includes reassessments of existing asset values, growth potential and overpayment. Since the implications of each are different for valuation, it is one more reason why goodwill impairment is not a particularly useful piece of information.
In summary, goodwill impairment has become an earnings management tool for many companies rather than a test of fair value changes. In the process, it has lost its informational content and is of little help to investors.
What should we do with goodwill?
Here is the million or billion dollar question. Assume that you are valuing a company with a significant goodwill item on its balance sheet. How should it affect the way in which we value or view the firm?a. Book capital and Earnings: The minute a company acquires another company, the characteristics of book equity and capital change. Rather than reflect just historical values (which is the case when a company has only internal investments), they incorporate market values for at least the target company's assets. Thus, book capital for an acquisitive firm includes the three components mentioned above for a target firm - a mark-to-market of existing assets, growth assets and overpayment. Since the rest of the acquiring firm's assets remain at their old values, the resulting book equity and capital is inconsistently defined. Earnings are also contaminated for a different reason. The impairment of goodwill can cause big swings in earnings from period to period. Since earnings and book capital are the key inputs into return on equity and return on invested capital (ROIC), the presence of goodwill can dramatically alter these returns.
To correct for goodwill, many analysts adopt the policy of ignoring it all together in the computation. Thus, return on capital is measured as:
ROC = Earnings before goodwill amortization/ (Book value of capital - Goodwill)
However, I have a paper on measuring returns where I have argued that while it is perfectly reasonable to net out the first two components of goodwill - misvaluation of existing assets and growth potential- from book capital, overpayment should not be netted out. In effect, companies like Time Warner should not be allowed to wipe out their mistakes and return their capital to pre-mistake levels, since stockholders have paid the price for these mistakes. Of course, separating out what portion of the goodwill is for overpayment is tough to do, but we need to make an effort. (I propose that we call this stupid goodwill and contrast it with smart goodwill)
b. Valuation: In a discounted cash flow valuation, goodwill really has no direct effect, since we estimate the value from expected future cash flows. Those cash flows will reflect the true value of existing assets and growth potential. Thus, it is in incorrect to add goodwill on to a DCF value, since it double counts these values. If you are doing asset based valuation, where you try to estimate current market values for individual assets on the balance sheet, it becomes trickier, since goodwill is not a conventional asset. Here, there is no easy way out. You have to either take the accounting estimate of goodwill as a fair value or estimate the value of future growth (which would require a DCF). In relative valuation, goodwill does not really affect much if you are using operating income multiples (Operating income or EBITDA is pre-goodwill amortization anyway) but it can affect equity earnings multiples (PE ratio or PEG ratios), since those earnings per share can be affected by goodwill charges. Goodwill can become a problem with book value based multiples. In effect, if you do not adjust for goodwill, companies that do a lot of acquisitions will have lower price to book and EV to Book ratios (and thus look cheaper) than companies that grow with internal investments.
One final thought. Given that goodwill, as an item, really changes nothing about the underlying assets and their value, no company should make or change decisions based upon the accounting measurement and treatment of goodwill. If you pay too much for a target company, what accountants do with or to goodwill cannot undo the damage already done.
Tuesday, March 30, 2010
Accounting inconsistencies
In the next few posts, I plan to focus on the accounting inconsistencies that bedevil analysts. In particular, here are the items that I will highlight:
1. Goodwill: When a company acquires another, goodwill shows up on the balance sheet of the acquiring company. While the name connotes something of substantial value, goodwill as it is currently computed is really a plug variable, designed to make the balance sheet "balance". Goodwill skews book values of equity and capital and wreaks havoc on earnings.
2. Minority interests: This is perhaps the most misleading item on a balance sheet, at least to the non-accountant. While it suggests something of value that you own (an asset), it is a by-product of another accounting practice termed consolidation. In effect, a company that owns more than 50% of another is required to "consolidate" its financial statements and report 100% of that subsidiary's earnings, capital and assets as its own. Minority interest reflects the value of equity in the subsidiary that does not belong to the parent company and is thus a liability. Not only is the treatment of minority interest a problem in discounted cash flow valuations but it is also an issue when computing enterprise value and related multiples.
3. Investments in other companies: With a firm with minority holdings in other companies (less than 50%), accountants face a different issue. What is the value that should be attached to these holdings on the balance sheet? Unfortunately, there is no one template in accounting and these holdings are sometimes shown at original cost (what was paid to acquire the holdings), sometimes at an updated book value (reflecting retained earnings since acquisition) and sometimes marked to market. Thus, an unsuspecting analyst can make significant mistakes in valuation, if he or she makes an incorrect assumption about accounting treatment.
4. Extraordinary gains and losses: This should be simple, right. Any items that do not comprise regular operating income or earnings should be consigned to this line item. If that were the case, dealing with extrardinary items would be simple. Since they are extraordinary, we can assume that they will not occur in the normal course of events and ignore them. In practice, though, companies use extraordinary income (expenses) for line items that are recurrent but with shifting effects (exchange rates gains and losses), related to operating adjustments (restructuring charges) as well as a device to show higher operating earnings (by shifting operating expenses into the extraordinary expense column). Thus, separating the truly extraordinary from the ordinary has consequences for both discounted cash flow valuations (by changing base earnings) and earnings multiples (PE ratios, EV/EBITDA etc.)
5. Deferred taxes: Deferred taxes can show up either as assets or liabilities. A deferred tax asset reflects a company's belief that it has paid too much in taxes over prior periods and can thus expect to get tax relief in future periods. A deferred tax liability is a measure of the opposite - a company that has been able to use the tax code to good effect and paid less in taxes (legally) than it should have (assuming the statutory tax code were applied to taxable income) can reasonably expect to pay higher taxes in future periods and has to show this as a liability. While the logic for both items is impeccable, it is worth noting that they reflect expectations of future tax savings (in the case of deferred tax assets) and tax liabilities (in the case of deferred tax liabilities). There is no contractual obligation or time line for these expected cash flows and that can create problems in valuation.
6. Intangible assets: In the last decade, accountants have discovered that accounting standards are not consistent about how they deal with intangible assets as opposed to tangible assets. The rules on capitalizing the latter are well established and the assets on a manufacturing firm's balance sheets reflect the firm's investment in land, buildings and equipment. For firms with intangible assets, which can range from technological prowess (Google) to brand name (Coca Cola) to patents (Amgen), the treatment of the assets has generally been benign neglect. As a consequence, the earnings and book capital at these firms is skewed and can affect both intrinsic and relative valuations.
7. Leases: The biggest source of off-balance sheet debt in the world is leases. A firm that leases its assets (rather than borrowing money and buying these same assets) can hide these assets (and the implicit debt in these assets) if it can meet the accounting requirements for lease expenses to be treated as operating expenses. As a result, we understate the debt ratios of retail firms and restaurants and misvalue these firms.
While the accounting logic behind the treatment of each of these items make sense to accountant, I think that they lead to poor measures of earnings and value. The post that highlights each item will examine not only the potential problems created by the current accounting treatment but also present solutions to those problem.
1. Goodwill: When a company acquires another, goodwill shows up on the balance sheet of the acquiring company. While the name connotes something of substantial value, goodwill as it is currently computed is really a plug variable, designed to make the balance sheet "balance". Goodwill skews book values of equity and capital and wreaks havoc on earnings.
2. Minority interests: This is perhaps the most misleading item on a balance sheet, at least to the non-accountant. While it suggests something of value that you own (an asset), it is a by-product of another accounting practice termed consolidation. In effect, a company that owns more than 50% of another is required to "consolidate" its financial statements and report 100% of that subsidiary's earnings, capital and assets as its own. Minority interest reflects the value of equity in the subsidiary that does not belong to the parent company and is thus a liability. Not only is the treatment of minority interest a problem in discounted cash flow valuations but it is also an issue when computing enterprise value and related multiples.
3. Investments in other companies: With a firm with minority holdings in other companies (less than 50%), accountants face a different issue. What is the value that should be attached to these holdings on the balance sheet? Unfortunately, there is no one template in accounting and these holdings are sometimes shown at original cost (what was paid to acquire the holdings), sometimes at an updated book value (reflecting retained earnings since acquisition) and sometimes marked to market. Thus, an unsuspecting analyst can make significant mistakes in valuation, if he or she makes an incorrect assumption about accounting treatment.
4. Extraordinary gains and losses: This should be simple, right. Any items that do not comprise regular operating income or earnings should be consigned to this line item. If that were the case, dealing with extrardinary items would be simple. Since they are extraordinary, we can assume that they will not occur in the normal course of events and ignore them. In practice, though, companies use extraordinary income (expenses) for line items that are recurrent but with shifting effects (exchange rates gains and losses), related to operating adjustments (restructuring charges) as well as a device to show higher operating earnings (by shifting operating expenses into the extraordinary expense column). Thus, separating the truly extraordinary from the ordinary has consequences for both discounted cash flow valuations (by changing base earnings) and earnings multiples (PE ratios, EV/EBITDA etc.)
5. Deferred taxes: Deferred taxes can show up either as assets or liabilities. A deferred tax asset reflects a company's belief that it has paid too much in taxes over prior periods and can thus expect to get tax relief in future periods. A deferred tax liability is a measure of the opposite - a company that has been able to use the tax code to good effect and paid less in taxes (legally) than it should have (assuming the statutory tax code were applied to taxable income) can reasonably expect to pay higher taxes in future periods and has to show this as a liability. While the logic for both items is impeccable, it is worth noting that they reflect expectations of future tax savings (in the case of deferred tax assets) and tax liabilities (in the case of deferred tax liabilities). There is no contractual obligation or time line for these expected cash flows and that can create problems in valuation.
6. Intangible assets: In the last decade, accountants have discovered that accounting standards are not consistent about how they deal with intangible assets as opposed to tangible assets. The rules on capitalizing the latter are well established and the assets on a manufacturing firm's balance sheets reflect the firm's investment in land, buildings and equipment. For firms with intangible assets, which can range from technological prowess (Google) to brand name (Coca Cola) to patents (Amgen), the treatment of the assets has generally been benign neglect. As a consequence, the earnings and book capital at these firms is skewed and can affect both intrinsic and relative valuations.
7. Leases: The biggest source of off-balance sheet debt in the world is leases. A firm that leases its assets (rather than borrowing money and buying these same assets) can hide these assets (and the implicit debt in these assets) if it can meet the accounting requirements for lease expenses to be treated as operating expenses. As a result, we understate the debt ratios of retail firms and restaurants and misvalue these firms.
While the accounting logic behind the treatment of each of these items make sense to accountant, I think that they lead to poor measures of earnings and value. The post that highlights each item will examine not only the potential problems created by the current accounting treatment but also present solutions to those problem.
Monday, March 22, 2010
Government Default and Riskfree Rates
I have several posts on potential government default and riskfree rates. I noticed this story in Business Week.
I know that this is only one observation but it is a troubling one. In emerging markets, it is not uncommon for companies to borrow money at rates lower than the government, but the saving grace is that the borrowings are in a foreign currency. I can see why bond holders saw less default risk in dollar bonds issued by Petrobras in 2004 than in dollar bonds issued by the Brazilian government.
In this case, lenders are actually perceiving less default risk to Berkshire Hathaway than to the US Government, for a US dollar bond. I know that Berkshire Hathaway has a much healthier balance sheet than the US government, but the US government has the power to print currency. Thus, I would not read too much analytical significance into the 3.5 basis point different. However, I think the market is sending a message to the US government which might or might not be getting through: You have to get your financial house in order soon or you will pay a price. Let's hope that someone is listening.
I know that this is only one observation but it is a troubling one. In emerging markets, it is not uncommon for companies to borrow money at rates lower than the government, but the saving grace is that the borrowings are in a foreign currency. I can see why bond holders saw less default risk in dollar bonds issued by Petrobras in 2004 than in dollar bonds issued by the Brazilian government.
In this case, lenders are actually perceiving less default risk to Berkshire Hathaway than to the US Government, for a US dollar bond. I know that Berkshire Hathaway has a much healthier balance sheet than the US government, but the US government has the power to print currency. Thus, I would not read too much analytical significance into the 3.5 basis point different. However, I think the market is sending a message to the US government which might or might not be getting through: You have to get your financial house in order soon or you will pay a price. Let's hope that someone is listening.
Monday, March 15, 2010
How do you measure profitability?
I have assiduously stayed out of the health care debate that has dominated the news in the United States for the last year, since everyone involved in it seems to come out of it looking worse for the wear. However, there is one aspect of the debate which I have found fascinating, revolving around how profitable or unprofitable the health care business is for insurers, pharmaceutical firms and hospitals. Let me be clear up front, though. This is not a post about health care reform but about how best to measure profitability.
On one side of the debate, you have proponents of health care reform arguing that health care companies, in general, and health insurers, in particular, make huge profits. By extension, they also suggest that one way to reduce health care costs is to reduce these profits. On the other side of the debate, you have opponents of health care reform noting that health care firms really fall in the lower rung of the market in terms of profitability. Each side uses its own measure of profitability to make its point.
Generically, there are three ways to measure profitability and they all come with caveats:
1. Dollar profits: For shock value, there is nothing better than dollar profits. Since most of us are unused to thinking in billions of dollars, noting that an industry generated $ 100 billion in profits seems awe inspiring. In 2009, the aggregate numbers (in billions) for p
ublicly traded firms in the health care business were as follows. In terms of dollar profits, pharmaceutical firms deliver much higher profits than other parts of the health care business. While $130 billion in pretax operating profits is large, note that the aggregate pretax operating income for the market is $3.5 billion. In terms of net profits, pharmaceutical firms account for almost 14% of the net profits for the entire market. The problem with dollar profits is that they have no moorings. A profit of $ 20 billion sounds large by itself, but does not look that large, if compared to revenues of $ 1 trillion or capital invested of $ 500 billion.
2. Profit margins: We can scale profits to total revenues. Looking at equity investors in firms, the most logical measure is net profit margin, obtained by dividing net profits by total sa
les. From the perspective of all claim holders in the firm, a more complete measure is the operating margin, estimated by dividing operating profits by revenues. The latter is less likely to be skewed by financing decisions. After all, a firm that borrows more will have less net income after interest expenses and a lower net margin. Looking at the health care business again, here are the numbers.
While pharmaceutical firms deliver much higher margins than the market, the rest of the health care business delivers margins in line with the market. I personally do not find profit margins, by themselves, to be particularly informative and here is why. As every introductory marketing book points out, there is a trade off between margins and turnover. In other words, you can set high prices (and high margins) and sell less or go for lower prices and higher sales. In retailing, for instance, you see both strategies at play. Walmart has low margins but uses its turnover ratio (measured as sales as a percent of capital) to end up with huge profits. Many luxury retailers have much higher margins than Walmart but struggle to report even meager profits. More generally, differences in the way business is conducted makes it impossible to compare margins across businesses.
3. Returns on investment: In my view, the only profitability measure that works across sectors is to measure the return generated on a dollar invested in a business. This return can be measured to just equity inve
stors as the return on equity, obtained by dividing net income by equity invested in the business or to the entire firm as the return on invested capital, estimated by dividing after-tax operating income by capital invested (debt plus equity) in the business. Measuring the actual capital invested in a business is a difficult task and most practitioners fall back on using book values. Here are the return on equity and capital numbers for health care firms.
In my view, this table provides the most comprehensive measure of the profitability of each business. Pharmaceutical firms and health insurance companies generate returns significantly higher than their costs of equity and capital and relative to the market. I am not suggesting that returns on equity and capital are perfect. Since accountants can alter book value through their judgments and provisions, I have a paper on how best to adjust returns for the various problems in accounting measures:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1105499
I do update all of these profitability measures on my website at the start of every year. The 2010 updates are available at:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/data.html
My conclusion! Health care firms, at least in the aggregate, are financially healthy and generate returns on their investments that exceed their costs of equity (capital). While these excess returns may suggest to some that these firms are "too profitable" and that they should be taxed or regulated, two points are worth noting.
a. The first is that there is a survivorship bias, insofar as only the most successful firms in each group are represented in our samples of publicly traded firms. To illustrate, consider pharmaceutical firms. Many small biotechnology and pharmaceutical firms never make it through the FDA approval process and the capital invested in them gets wiped out when they go under. If we regulate or restrict the mature (and successful) pharmaceutical firms to generate only their cost of capital, where is the incentive to do research in the first place?
b. The second is that the aggregate profitability of the businesses should not obscure us to the reality that each of these businesses is splintered and that rules/regulations/market conditions vary widely across different products/services and markets. In other words, while insurance companies collectively generate profits, they can lose money in individual states (as Wellpoint was contending for its operations in California). Requiring the insured in other states to make up for the higher costs of health care in California will create a death spiral for the business.
On one side of the debate, you have proponents of health care reform arguing that health care companies, in general, and health insurers, in particular, make huge profits. By extension, they also suggest that one way to reduce health care costs is to reduce these profits. On the other side of the debate, you have opponents of health care reform noting that health care firms really fall in the lower rung of the market in terms of profitability. Each side uses its own measure of profitability to make its point.
Generically, there are three ways to measure profitability and they all come with caveats:
1. Dollar profits: For shock value, there is nothing better than dollar profits. Since most of us are unused to thinking in billions of dollars, noting that an industry generated $ 100 billion in profits seems awe inspiring. In 2009, the aggregate numbers (in billions) for p
ublicly traded firms in the health care business were as follows. In terms of dollar profits, pharmaceutical firms deliver much higher profits than other parts of the health care business. While $130 billion in pretax operating profits is large, note that the aggregate pretax operating income for the market is $3.5 billion. In terms of net profits, pharmaceutical firms account for almost 14% of the net profits for the entire market. The problem with dollar profits is that they have no moorings. A profit of $ 20 billion sounds large by itself, but does not look that large, if compared to revenues of $ 1 trillion or capital invested of $ 500 billion.2. Profit margins: We can scale profits to total revenues. Looking at equity investors in firms, the most logical measure is net profit margin, obtained by dividing net profits by total sa
les. From the perspective of all claim holders in the firm, a more complete measure is the operating margin, estimated by dividing operating profits by revenues. The latter is less likely to be skewed by financing decisions. After all, a firm that borrows more will have less net income after interest expenses and a lower net margin. Looking at the health care business again, here are the numbers.While pharmaceutical firms deliver much higher margins than the market, the rest of the health care business delivers margins in line with the market. I personally do not find profit margins, by themselves, to be particularly informative and here is why. As every introductory marketing book points out, there is a trade off between margins and turnover. In other words, you can set high prices (and high margins) and sell less or go for lower prices and higher sales. In retailing, for instance, you see both strategies at play. Walmart has low margins but uses its turnover ratio (measured as sales as a percent of capital) to end up with huge profits. Many luxury retailers have much higher margins than Walmart but struggle to report even meager profits. More generally, differences in the way business is conducted makes it impossible to compare margins across businesses.
3. Returns on investment: In my view, the only profitability measure that works across sectors is to measure the return generated on a dollar invested in a business. This return can be measured to just equity inve
stors as the return on equity, obtained by dividing net income by equity invested in the business or to the entire firm as the return on invested capital, estimated by dividing after-tax operating income by capital invested (debt plus equity) in the business. Measuring the actual capital invested in a business is a difficult task and most practitioners fall back on using book values. Here are the return on equity and capital numbers for health care firms.In my view, this table provides the most comprehensive measure of the profitability of each business. Pharmaceutical firms and health insurance companies generate returns significantly higher than their costs of equity and capital and relative to the market. I am not suggesting that returns on equity and capital are perfect. Since accountants can alter book value through their judgments and provisions, I have a paper on how best to adjust returns for the various problems in accounting measures:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1105499
I do update all of these profitability measures on my website at the start of every year. The 2010 updates are available at:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/data.html
My conclusion! Health care firms, at least in the aggregate, are financially healthy and generate returns on their investments that exceed their costs of equity (capital). While these excess returns may suggest to some that these firms are "too profitable" and that they should be taxed or regulated, two points are worth noting.
a. The first is that there is a survivorship bias, insofar as only the most successful firms in each group are represented in our samples of publicly traded firms. To illustrate, consider pharmaceutical firms. Many small biotechnology and pharmaceutical firms never make it through the FDA approval process and the capital invested in them gets wiped out when they go under. If we regulate or restrict the mature (and successful) pharmaceutical firms to generate only their cost of capital, where is the incentive to do research in the first place?
b. The second is that the aggregate profitability of the businesses should not obscure us to the reality that each of these businesses is splintered and that rules/regulations/market conditions vary widely across different products/services and markets. In other words, while insurance companies collectively generate profits, they can lose money in individual states (as Wellpoint was contending for its operations in California). Requiring the insured in other states to make up for the higher costs of health care in California will create a death spiral for the business.
Tuesday, March 9, 2010
Equity Risk Premiums and the Fear of Catastrophe
As many of you already know, I am a little fixated on the equity risk premium. More than any variable, it explains what happens in equity markets both in the short term and the long term. In fact, I have at least a dozen posts over the last year and a half on the evolution of the equity risk premium in the US and globally.
The equity risk premium measures what investors collectively demand as a premium over and above the riskfree rate to invest in equities as a class. In practice, many analysts use historical data to estimate this premium. Thus, if investors have earned 9% on stocks over the last 80 years and 4% on treasury bonds over that same period, the historical premium is 5% and it is also used as the equity risk premium in valuation. My problem with this approach is that it is not only backward looking (you want a premium for the next decade, not the last 8 decades) but yields extremely noisy estimates. On my website, for instance, I estimate the historical risk premium for stocks over treasury bonds from 1928 - 2009 to be 4.29% but I also estimate the standard error in this number to 2.40%.
It is to remedy these problems that I compute an implied equity risk premium, where I back out the premium from the current level of stock prices and expected cash flows; it is analogous to estimating the yield to maturity on a bond. While this approach requires its share of inputs - expected growth rates and cash flows on stocks - the estimate of the premium is not only forward looking but comes with a far tighter range on the value. Furthermore, it is dynamic and reflects what is happening in the world around you.
On September 12, 2008, a couple of weeks before I made my first posting to this blog, the implied equity risk premium in the US was 4.36%. In the next 13 weeks, that implied premium rose to 6.43%, varying more than it had in the previous 25 years put together. It taught me an important lesson: even in developed markets, equity risk premiums can change quickly and need to be updated frequently. Since the crisis, I have been updating premiums every month and the implied equity risk premium at the start of March 2010 was 4.44%, back to where it was before the crisis.
How do we explain this rapid back tracking to pre-crisis premiums? While some view it as irrational, there is a rational explanation. One component in the equity risk premium is the fear of catastrophe. What is a catastrophe? It is that infrequent event, which if it occurs, essentially puts you under water as an investor for the rest of your investing life. The Great Depression was a catastrophe for the US: an investor in US stocks in 1928 would not have recovered his principal for almost 20 years. The Japanese market collapse in the late 1980s was a catastrophe. Investors who had their investments in the Nikkei in 1989 will not make their money back in their lifetimes. In good times, that fear recedes and investors are lulled into complacency; stocks go down, but it assumed that the long term trend is always up. In fact, we hear nonsensical stories about how stocks always win in the long term; if these stories were true, the equity risk premium should be zero for really long term investors. In crisis times, the fear of catastrophe rises to the top of all concerns and drowns out all other information. In December 2008, there was the real possibility of a complete financial meltdown and the equity risk premium reflected that. In January 2010, that fear had dropped off enough that people were reverting back to the pre-crisis premiums. It is entirely possible that we over estimated the likelihood of catastrophe in December 2008 and are under estimating it now, but I think that it is the only explanation that I can provide.
I have pointed you to a paper on equity risk premiums that I have. I just completed my 2010 update to the paper. Most of the changes are in the data and the text of the paper itself is relatively unchanged. If you are interested, try this link:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1556382
You can rest assured that I will nag you on this topic for as long as I maintain this blog.
The equity risk premium measures what investors collectively demand as a premium over and above the riskfree rate to invest in equities as a class. In practice, many analysts use historical data to estimate this premium. Thus, if investors have earned 9% on stocks over the last 80 years and 4% on treasury bonds over that same period, the historical premium is 5% and it is also used as the equity risk premium in valuation. My problem with this approach is that it is not only backward looking (you want a premium for the next decade, not the last 8 decades) but yields extremely noisy estimates. On my website, for instance, I estimate the historical risk premium for stocks over treasury bonds from 1928 - 2009 to be 4.29% but I also estimate the standard error in this number to 2.40%.
It is to remedy these problems that I compute an implied equity risk premium, where I back out the premium from the current level of stock prices and expected cash flows; it is analogous to estimating the yield to maturity on a bond. While this approach requires its share of inputs - expected growth rates and cash flows on stocks - the estimate of the premium is not only forward looking but comes with a far tighter range on the value. Furthermore, it is dynamic and reflects what is happening in the world around you.
On September 12, 2008, a couple of weeks before I made my first posting to this blog, the implied equity risk premium in the US was 4.36%. In the next 13 weeks, that implied premium rose to 6.43%, varying more than it had in the previous 25 years put together. It taught me an important lesson: even in developed markets, equity risk premiums can change quickly and need to be updated frequently. Since the crisis, I have been updating premiums every month and the implied equity risk premium at the start of March 2010 was 4.44%, back to where it was before the crisis.
How do we explain this rapid back tracking to pre-crisis premiums? While some view it as irrational, there is a rational explanation. One component in the equity risk premium is the fear of catastrophe. What is a catastrophe? It is that infrequent event, which if it occurs, essentially puts you under water as an investor for the rest of your investing life. The Great Depression was a catastrophe for the US: an investor in US stocks in 1928 would not have recovered his principal for almost 20 years. The Japanese market collapse in the late 1980s was a catastrophe. Investors who had their investments in the Nikkei in 1989 will not make their money back in their lifetimes. In good times, that fear recedes and investors are lulled into complacency; stocks go down, but it assumed that the long term trend is always up. In fact, we hear nonsensical stories about how stocks always win in the long term; if these stories were true, the equity risk premium should be zero for really long term investors. In crisis times, the fear of catastrophe rises to the top of all concerns and drowns out all other information. In December 2008, there was the real possibility of a complete financial meltdown and the equity risk premium reflected that. In January 2010, that fear had dropped off enough that people were reverting back to the pre-crisis premiums. It is entirely possible that we over estimated the likelihood of catastrophe in December 2008 and are under estimating it now, but I think that it is the only explanation that I can provide.
I have pointed you to a paper on equity risk premiums that I have. I just completed my 2010 update to the paper. Most of the changes are in the data and the text of the paper itself is relatively unchanged. If you are interested, try this link:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1556382
You can rest assured that I will nag you on this topic for as long as I maintain this blog.
Subscribe to:
Posts (Atom)