January 2016 Data Update 6: Debt, the double edged sword!

In corporate finance, the decision on whether to borrow money, and if so, how much has divided both practitioners and theorists for as long as the question has been debated. Corporate finance, as a discipline, had its beginnings in Merton Miller and Franco Modigliani's classic paper on the irrelevance of capital structure. Since then, theorists have finessed the model, added real life concerns and come to the unsurprising conclusion that there is no one optimal solution that holds across companies. At the same time, practitioners have also diverged, with the more conservative ones (managers and investors) arguing that debt brings more pain than gain and that you should therefore borrow as little as possible, and the most aggressive players positing that you cannot borrow too much.

The Trade off on debt

The benefits of debt, for better or worse, are embedded in the tax code, which in much of the world favors borrowers. Specifically, a company that borrows money is allowed to deduct interest expenses before paying taxes, whereas one that is equity funded has to pay dividends out of after-tax earnings. This, of course, makes it hypocritical of politicians to lecture any one on too much debt, but then again, hypocrisy is par for the course in politics. A secondary benefit of debt is that it can make managers in mature, cash-rich companies a little more disciplined in their project choices, since taking bad projects, when you have debt, creates more pain (for the managers) than taking that same projects, when you are an all equity funded company.

On the other side of the ledger, debt does come with costs. The first and most obvious one is that it increases the chance of default, as failure to make debt payments can lead to financial distress and bankruptcy. The other is that borrowing money does create the potential for conflict between stockholders (who seek upside) and lenders (who want to avoid downside), which leads to the latter trying to protect themselves by writing in covenants and/or charging higher interest rates.

Pluses of Debt	Minuses of Debt
1. Tax Benefit: Interest expenses on debt are tax deductible but cash flows to equity are generally not. The implication is that the higher the marginal tax rate, the greater the benefits of debt.	1. Expected Bankruptcy Cost: The expected cost of going bankrupt is a product of the probability of going bankrupt and the cost of going bankrupt. The latter includes both direct and indirect costs. The probability of going bankrupt will be higher in businesses with more volatile earnings and the cost of bankruptcy will also vary across businesses.
2. Added Discipline: Borrowing money may force managers to think about the consequences of the investment decisions a little more carefully and reduce bad investments. The greater the separation between managers and stockholders, the greater the benefits of using debt.	2. Agency Costs: Actions that benefit equity investors may hurt lenders. The greater the potential for this conflict of interest, the greater the cost borne by the borrower (as higher interest rates or more covenants). Businesses where lenders can monitor/control how their money is being used can borrow more than businesses where this is difficult to do.

In the Miller-Modigliani world, which is one without taxes, bankruptcies or agency problems (managers do what's best for stockholders and equity investors are honest with lenders), debt has no costs and benefits, and is thus irrelevant. In the world that I live in, and I think you do too, where taxes not only exist but often drive big decisions, default is a clear and ever-present danger and conflicts of interests (between managers and stockholders, stockholders and lenders) abound, some companies borrow too much and some borrow too little.

The Cross Sectional Differences

Looking at the trade off, it is clear that 2015 tilted more towards the minus side than plus side of the equation for debt, as the Chinese slowdown and the commodity price meltdown created both geographic and sector hot spots of default risk. As in prior years, I started by looking at the distribution of debt ratios across global companies, in both book and market terms:

Debt to capital (book) = Total Debt/ (Total Debt + Book Equity)

Debt to capital (market) = Total Debt/ (Total Debt + Market Equity)

In keeping with my argument that all lease commitments should be considered debt, notwithstanding accounting foot dragging on the topic, I include the present value of lease commitments as debt, though I am hamstrung by the absence of information in some markets. I also compute net debt ratios, where I net cash out against debt, for all companies:

Damodaran Online

While debt ratios provide one measure of the debt burden at companies, there are two other measures that are more closely tied to companies getting into financial trouble. The first is the multiple of debt to EBITDA, with higher values indicative of a high debt burden and the other is the multiple of operating income to interest expenses (interest coverage ratio), with lower values indicating high debt loads. In 2015, the distribution of global companies on each of these measures is shown below:

By itself, there is little that you can read into this graph, other than the fact that there are some companies that are in danger, with earnings and cash flows stretched to make debt payments, but that is a conclusion you would make in any year.

The Industry Divide

To dig a little deeper into where the biggest clusters of companies over burdened with debt are, I broke companies down by industry and computed debt ratios (debt to capital and debt to EBITDA) by sector. You can download the entire industry data set by clicking here, but here are the 15 sectors with the most debt (not counting financial service firms), in January 2016.

Damodaran Online, January 2016

There is a preponderance of real estate businesses on this list, reflecting the history of highly levered games played in that sector. There are quite a few heavy investment businesses, including steel, autos, construction shipbuilding, on this list. Surprisingly, there are only two commodity groups (oil and coal) on this section, oil/gas distribution, but it is likely that as 2016 rolls on, there will be more commodity sectors show up, as earnings lag commodity price drops.

In contrast, the following are the most lightly levered sectors as of January 2016.

Damodaran Online, January 2016

The debt trade off that I described in the first section provides some insight into why companies in these sectors borrow less. Notice that the technology-related sectors dominate this list, reflecting the higher uncertainty they face about future earnings. There are a few surprises, including shoes, household products and perhaps even pharmaceutical companies, but at least with drug companies, I would not be surprised to see debt ratios push up in the future, as they face a changed landscape.

The Regional Divides

If the China slow-down and the commodity pricing collapse were the big negative news stories of 2015, it stands to reason that the regions most exposed to these risks should also have the most companies in debt trouble. The regional averages as of January 2016 are listed below:

Damodaran Online, Data Update of 41,889 companies in January 2016

The measure that is most closely tied to the debt burden is the Debt to EBITDA number and that is what I will focus on in my comparisons. Not surprisingly, Australia, a country with a disproportionately large number of natural resource companies, tops the list and it is followed closely by the EU and the UK.  Canada has the highest percentage of money-losing companies in the world, again due to its natural resource exposure. The companies listed in Eastern Europe and Russia have the least debt, though that may be due as much to the inability to access debt markets as it is to uncertainty about the future. With Chinese companies, there is a stark divide between mainland Chinese companies that borrow almost 2.5 times more than their Hong Kong counterparts. If you are interested in debt ratios in individual countries, you can see my global heat map below or download the datasets with the numbers.

via chartsbin.com

If the biggest reason for companies sliding into trouble in 2015 were China and Commodities, the first three weeks of 2016 have clearly made the dangers ever more present. As oil prices continue to drop, with no bottom in sight, and the bad news on the Chinese economy continue to come out in dribs and drabs, the regions and sectors most exposed to these risks will continue to see defaults and bankruptcies. These, in turn, will create ripples that initially affect the banks that have lent money to these companies but will also continue to push up default spreads (and costs of debt) for all firms. 

The Bottom Line

Debt is a double edged sword, where as you, as the borrower, wield one edge against the tax code and slice your taxes, the other edge, just as sharp, is turned against you and can hurt you, in the event of a downturn. In good times, companies that borrow reap the benefits of debt, slashing taxes paid and getting rewarded with high values by investors, who are just as caught up in the mood of the moment. In bad times, which inevitably follow, that debt turns against companies, pushing them into financial distress and perhaps putting an end to their existence as ongoing businesses.  One constraint that I will bring into my own investments decisions in 2016 is a greater awareness of financial leverage, where in addition to valuing businesses as going concerns, I will also look at how much debt they owe. I will not reflexively avoid companies that have borrowed substantial amounts, but I will have to realistically assess how much this debt exposes them to failure risk, before I pull the "buy" trigger.

Datasets

1. Debt Ratios, by sector (January 2016)
2. Debt Ratios, by country (January 2016)

Data Update Posts

1. January 2016 Data Update 1: The US Equity Market 
2. January 2016 Data Update 2: Interest Rates and Exchange Rates - Currencies 
3. January 2016 Data Update 3: Country Risk and Pricing
4. January 2016 Data Update 4: Costs of Equity and Capital
5. January 2016 Data Update 5: Investment Returns and Profitability
6. January 2016 Data Update 6: Capital Structure
7. January 2016 Data Update 7: Dividend Policy
8. January 2016  Data Update 8: Pricing, with an end of month update

January 2016 Data Update 5: Making a case for corporate governance

In my last post, I looked at the cost of capital, a measure of what it costs firms to raise capital. That capital, if put to good use by businesses, should earn returns higher than the costs to generate value. Simply put, the end game in business is not just to make money but to make enough to cover a risk-adjusted required return. In publicly traded companies, it is managers at these companies, for the most part, who are investing the capital that comes from stockholders and bondholders (or banks), and corporate governance is a measure of whether these managers are being held accountable for their investment decisions.

Defining a good investment

It is true that there are differences of opinion about how best to measure the cost of raising funds, but disagreements about the cost of capital are drowned out by disputes on how best to measure the returns that are generated by investing this capital. There are two widely used proxies for profitability. One is the profit margin, obtained by dividing the earnings by the revenues of the firm, and it can be estimated using either operating income (operating margin) or net income (net margin). Since the latter is a function of both the profitability of businesses and how much they have chosen to borrow, I will focus on operating margins and report on the distribution of both pre-tax and after-tax operating margin in the graph below:

Source: Damodaran Online

The second measure of profitability, and perhaps the more useful one in the context of measuring the quality of an investment, is obtained by scaling the operating earnings to the capital invested in a project or assets to estimate a return on invested capital. The capital invested is usually computed by aggregating the book values of debt and equity in a business and netting out the cash. The resulting return on invested capital can be compared to the cost of capital to arrive at the excess return (positive or negative) earned by a firm. In the figure below, I look at the mechanics of the return on capital computation in the picture below.

Note the caveats that I have added  to the picture, listing the perils of trusting two accounting numbers: operating income and invested capital. I did try to correct for the accounting misclassifications, converting leases into debt and R&D into capital assets, and also computed an alternate return on capital measure, based on average earnings over the last ten years. Notwithstanding these adjustments, I am still exposed to a multitude of accounting problems and I have to hope and pray that the law of large numbers will bail me out on those.

I computed the return on invested capital for each of the 41,889 firms in my sample and subtracted out the cost of capital for each one to arrive at an excess return. The graph below captures the distribution of this excess return across global firms in 2015:

Overall, more than half of all publicly traded firms, listed globally, earned returns on capital that were lower than the cost of capital in 2015 and this conclusion is not sensitive to using average income or my adjustments for R&D and leases. The return on capital is a flawed measure and I have written about the adjustments that are often needed to it. That said, with the corrections for leases and R&D, it remains the measure that works best across businesses in capturing the quality of investments.

Industry Excess Returns

In the second part of the analysis, I broke down the 41,889 companies into 95 industry grouping and computed the excess returns for each industry group.  The full results are at this link, but I ranked companies based on the magnitude of the excess returns. Again, with all the reservations that you can bring into this measure of investment quality, the businesses that delivered the highest spreads (over and above the cost of capital) are listed below.

The best-performing sector is tobacco, where companies collectively earned a return on capital almost 22% higher than the cost of capital. One potential problem is that many of the businesses on this list also happen to be asset-light, at least in the accounting sense of the word, and some of these returns may just reflect our failure to fully capitalize assets in these businesses.

Looking at the other end of the spectrum, the following is a list of the worst performing businesses in 2015, based on returns generated relative to the cost of capital.

Note that oil companies are heavily represented on this list, not surprising given the drop in oil prices during the year. That, of course, does not make them bad businesses since a turning of the commodity price cycle will make the returns pop. There are other businesses that have been affected by either the slowing down of the China growth engine, such as steel and shipbuilding, and the question is whether they can bounce back if Chinese growth stays low. Finally, there are some perennially bad businesses, with auto and truck being one that has managed to stay on this list every year for the last decade, grist for my post on bad businesses and why companies stay in them.

In computing this excess return, I deliberately removed financial service firms from the mix, because computing operating income or invested capital is a difficult, if not impossible task, at these firms. Lest you feel that I am giving managers at these firms a pass on the excess return question, I would replace the excess return spread (ROIC - Cost of capital) with an equity excess return spread (ROE - Cost of Equity) for these companies.

Regional Differences

Are firms in some parts of the world  better at putting capital to work than others? To answer that question, I broke my global sample into sub-regions and computed both operating margins and excess returns (return on invested capital, netted out against cost of capital) in each one.

Looking at the list, the part of the world where companies seem to have the most trouble delivering their cost of capital is Asia, with Chinese companies being the worst culprits and India being the honorable exception. US and UK companies do better at delivering returns that beat their hurdle rates than European companies.

Again, I would be cautious about reading too much into the differences across regions, since they may be just as indicative of accounting differences, as they are of return quality. It is also possible that some of the regions might have a tilt towards industries that under performed during the year and their returns will reflect that. Thus, the excess returns in Australia and Canada, which have a disproportionate share of natural resource companies, may be reflecting the drubbing that these companies took in 2015. 

A Case for Corporate Governance

I have been doing this analysis of excess returns globally, each year for the last few, and my bottom line conclusions have stayed unchanged.

1. The value of growth: If the value of growth comes from making investments that earn more than your hurdle rate, growth in a typical publicly traded company is more likely to destroy value than to increase value (since more than 50% of companies earn less than their cost of capital). For investors and management teams in companies, I would view this as a signal to not rush headlong into the pursuit of growth.
2. Bad management stays bad: In my sample, there are firms that have been earning excess returns year after year for most of the last decade, casting as a lie any argument that managers at these firms might make about "passing phases" and "bad years" affecting the numbers. To the question of why these managers continue to stay on, the answer is that in many parts of the world, it is almost impossible to dislodge these managers or even change how they behave.
3. Bad businesses: There are entire businesses that have crossed the threshold from neutral to bad businesses, but management seems to be in denial. These are the businesses that I have described in my corporate life cycle posts as the "walking dead" companies and I have explored why they soldier on, often investing more into these investing black holes.

Is good corporate governance the answer to these problems? In much of the world, the notion that stockholders are part owners of a company is laughable, as corporations continue to be run as if they were private businesses or family fiefdoms, and politics and connections, not stockholder interests,  drive business decisions in others.. Even in countries like the United States, where there is talk of good corporate governance, it has become, for the most part, check-list corporate governance, where the strength of governance is measured by how many independent directors you have and not by how aggressively they confront managers who misallocate capital. Institutional investors have been craven in their response to managers, not just abdicating their responsibility to confront managers, where needed, but actively working on behalf of incumbent managers to fight off change. The sorry record of value creation at publicly traded companies around the globe should act as a clarion call for good corporate governance. In the words of Howard Beale, from Network, we (as stockholders) should be "mad as hell and should not take it any more".

Datasets

1. Industry level profitability and excess returns (ROIC versus Cost of Capital) in 2015

Paper on measuring accounting returns

1. Paper on measuring ROIC, ROC and ROE (Warning: Extremely boring but could be cure for amnesia. Don't read for excitement value!)

Data Update Posts

1. January 2016 Data Update 1: The US Equity Market 
2. January 2016 Data Update 2: Interest Rates and Exchange Rates - Currencies 
3. January 2016 Data Update 3: Country Risk and Pricing
4. January 2016 Data Update 4: Costs of Equity and Capital
5. January 2016 Data Update 5: Investment Returns and Profitability
6. January 2016 Data Update 6: Capital Structure
7. January 2016 Data Update 7: Dividend Policy
8. January 2016  Data Update 8: Pricing, with an end of month update

January 2016 Data Update 4: The Costs of Capital

In this post, the fourth in my data update series, I turn my focus to the cost of capital. While the discussion of cost of capital is often obscured by debates about risk and return models, it is a number central to much of what we do in corporate finance and valuation, and it predates modern portfolio theory. You cannot run a business without a sense of what you need to make on your investments to break even and you cannot value a business without a measure of your opportunity cost. 

The Swiss Army Knife of Finance

I teach two classes, corporate finance and valuation, and I wear different hats, when looking at the same questions. In corporate finance, my focus is on how to run a business, using fundamental financial principles, and in valuation, I shift my attention to how value that business, using the same principles. Like Waldo, the cost of capital is a constant part of both classes, playing a key role in almost every discussion.

In the corporate finance class, it shows up in each of the three big questions that every business has to answer. It helps you answer the first one, on where you should direct your investments, by suppling your business with a hurdle rate or rates for investments, with riskier investments having to meet a higher threshold, to be acceptable.

In capital structure, the cost of capital  becomes an optimizing tool that helps you decide the right mix of debt and equity.

In dividend policy, the cost of capital becomes the divining rod for whether you should be returning more or less cash to your stockholders. If you operate in a business where your returns on new investments consistently fall short of your cost of capital, you should be returning more cash to your investors. 

In the valuation class, the cost of capital is the discount rate that you use to bring operating cash flows back to today, to arrive at a value for a business. It has, unfortunately, also become the instrument that analysts use to bring their hopes, fears and worries into value, adding premiums to the discount rate, if an asset is illiquid, or reducing it, if it provides other benefits.

In short, it is difficult to do financial analysis without at least getting a sense of what the cost of capital is, for a business. The many uses to which it is put has also meant that it has become all things to all people, a number that is misused, misestimated and misunderstood.

The Mechanics of Estimating Cost of Capital

About a year ago, in the context of my 2015 data update, I had an extensive post on the mechanics of computing cost of capital. Rather than repeat that post, I will direct you to it and summarize the process in a picture, for estimating the cost of capital for a company in US dollars:

Thus, the cost of capital is a composite cost of equity and debt and incorporates the tax benefits of debt (through the after-tax cost of debt) and the risk added by debt in increased costs for both equity and debt. If you want to estimate the cost of capital in a different currency, you have two choices. The first is to replace the US dollar risk free rate with the other currency's risk free rate (seem my earlier post on currencies) or to add the differential inflation rate between the US dollar and the currency in question to a US dollar cost of capital. Thus, if your US dollar cost of capital is 10%, the inflation rate in rubles is 9.5% and the US dollar inflation rate is 1.5%, your Russian ruble cost of capital will be approximately 18%. (It is a little more precise to compute this rate allowing for the compounding: (1.10) (1.095/1.015) -1, but I will leave it up to you to decide whether it is worth the effort.)

The Cost of Capital - US companies

Let me start off with the US-centric portion of this post, where I look at the distribution of costs of capital across my sample of 7480 firms that are listed in the United States. In making my assessments, I made some simplifying assumptions:

1. I used the US 10-year bond rate of 2.27%, on January 1, 2016, as my risk free rate. I don't like to play games normalizing risk free rates.
2. I used the average unlevered beta for the sector as the beta for the company and levered this beta with the current debt to equity ratio of the firm.
3. I used the implied equity risk premium for the S&P 500 (6.12% on January 1, 2016, rounded down to 6%) as the equity risk premium for all US companies in estimating the cost of equity. I know that some US companies have operating risk exposure outside the US, but I see no easy way that I can compute regional-weighted ERPs for this many companies.
4. For the cost of debt, I used the S&P bond rating, if one was available, to estimate the default spreads and pre-tax cost of debt of the firm. For non-rated company, I used the standard deviation in equity in conjunction with a look up table (see the cost of capital spreadsheet) to estimate the default spread and pre-tax cost of debt. I used 40% as the marginal tax rate for the US in estimating the after-tax cost of debt.
5. I used the current market capitalization as the value of equity and added up all interest bearing debt with the present value of lease commitments (for the next 5 years and beyond) to get to the debt, in computing the weights for debt and equity.

The resulting distribution of costs of capital across US companies is summarized below. Note that 90% of US firms have costs of capital between 5.23% and 10% and 50% of US firms have costs of capital between 6.60% and 9.20%.

If you are skeptical about betas and don't like computing costs of equity based upon them, I have a suggestion. Use the distribution of costs of capital in this graph, as your basis, for estimating a cost of capital for your firm. Use the cost of capital at the 90th percentile as your cost of capital for a risky firm, 8% as your cost of capital for a mature firm and 5.23% as your cost of capital for a very safe firm, and you should be relatively safe.

The Cost of Capital - Global Distribution

I also computed the cost of capital differences across global regions. Note that the differences are not rooted in currency, since the cost of capital for every firm is computed in US dollars. As to why costs of capital vary across countries, the answer can be traced back to two factors. The first is that debt ratios vary across the world, and that this may explain some of the variation. The second is that the regions of the world with higher sovereign default spreads and equity risk premiums (they go together in my approach) will have higher costs of capital than regions that have less risk. The table below summarizes the difference.

US companies have the lowest costs of capital, on average, in the world and East European and Russian companies carry the highest costs of capital. These are all in US dollars, but you can use the differential inflation approach to convert them into other currencies.

The Cost of Capital - Sector Differences

 Starting with the 41,889 firms that I have in my global sample at the start of 2016, I estimated the cost of capital for each company in dollar terms and then looked at the average costs of capital by sector. While you can find the entire sector list for cost of capital at the bottom of this post, I have listed the ten non-financial sectors with the highest costs of capital and the ten with the lowest:

Source: Damodaran Online

So, what now? If you have to estimate the cost of capital for a sector or a company in that sector, in US dollar terms, you could use the cost of capital for any companies that you value, in this sector. Again, adding the inflation differential will give you the cost of capital in any other currency. 

The Bottom line

The cost of capital may be the most used number in finance, but it is also the most misused. Companies often use one cost of capital to assess investments with different risk profiles, acting on the presumption that the cost of capital is the cost of raising company, rather than a risk adjusted required return for investing in a  risky asset. Investors use the cost of capital as a dumping ground for all their fears about investments, augmenting the standard risk-adjusted discount rate with premiums for liquidity, small market capitalization and opacity. We can do better!

Presentation

1. Cost of Capital: Misused, Misestimated and Misunderstood

Data Update Posts

1. January 2016 Data Update 1: The US Equity Market 
2. January 2016 Data Update 2: Interest Rates and Exchange Rates - Currencies 
3. January 2016 Data Update 3: Country Risk and Pricing
4. January 2016 Data Update 4: Costs of Equity and Capital
5. January 2016 Data Update 5: Investment Returns and Profitability
6. January 2016 Data Update 6: Capital Structure
7. January 2016 Data Update 7: Dividend Policy
8. January 2016  Data Update 8: Pricing, with an end of month update

Past Blog Posts on Interest Rates and Currencies

1. Putting the D in the DCF: The Cost of Capital

January 2016 Data Update 3: Country Risk and Pricing

I had a long  post on country risk in July 2015, as part of series of posts on the topic. At the time of the post, the Chinese market was in the midst of a meltdown, emerging markets were in turmoil and exchange rates were on the move. It is six months later, and nothing seems to have changed, but I think that the core lesson is worth reemphasizing. In a world of multinational businesses and global investors, there is no place to hide from country risk. 

Country Risk Measurement

I will not bore you by repeating much of what I said in my earlier post on how I view country risk in valuation, but it is built on two presumptions. First, a company's risk exposure is based on where it does business, not where it is incorporated or headquartered. Thus, Coca Cola and Nestle may be incorporated in developed markets (US and Switzerland) but derive a significant portion of their revenues from emerging markets and are thus exposed to risk in those markets. By the same token, Embraer is a Brazilian company that derives a substantial portion of its revenues in developed markets. Second, the risk of investing in equities varies across the world, resulting in higher equity risk premiums in some markets than others.  To estimate these risk premiums, I follow a four-step process:

My paper on equity risk premiums

As an example, let's assume that I want to estimate the equity risk premium for operating in India in January 2016. 

1. I start with the implied equity risk premium for the S&P in January 2016, which I estimated to be 6.12% in my first data post a few days ago. I use a rounded down estimate of 6% as my mature market premium for the start of 2016.
2. As a second step, I look up the local currency sovereign rating for India from Moody's and arrive at a Baa3 rating; the typical default spread for a Baa3 rated country at the start of 2016 was 2.44%.  I check this estimate against the sovereign CDS spread for India, which was 2.11% on January 1, 2016. I use the ratings-based spread of 2.44% as the default spread for India, though I would not raise too much of a fight, if you insisted on using the CDS spread.
3. In the third step, I try to estimate how much riskier equities are than government bonds in emerging markets by using proxies for each one: the S&P Emerging BMI Index (an index of emerging market equities) for stocks, and the S&P Emerging Market Public (government and quasi government) bond index yield. The standard deviation in the former is 17.36% and the coefficient of variation in the latter is 12.91% and the ratio of the former to the latter is 1.34. Multiplying this ratio by the default spread in step 2 yields a country risk premium for India of 3.28%. (CRP for India = 2.44% * 1.34 = 3.28%)
4. In the fourth step, I add the country risk premium to the implied premium of 6% that I estimated in step 1 to arrive at an equity risk premium for India of 9.28%.

Is this number an estimate? Of course! Would you get a different number if you used the CDS spread as your measure of default risk and different indices for emerging market equities and bonds? The answer is yes. It is for this reason that the spreadsheet that I create for equity risk premiums allows you to replace my defaults with yours for any or all of these variables. Before you exhaust yourself in this effort, I would suggest that small differences in this number will not make or break your valuation. So, make your best estimates and move on!

Country Risk Update - January 2016

Using the approach described for India, I compute equity risk premiums for the 130 countries with a Moody's sovereign rating. For about fourteen more, with no Moody's rating for the country, I was able to find a sovereign rating on S&P that I convert to a Moody's rating and estimate an ERP. Finally, there are about 20 countries, loosely categorized as frontier markets, for which there is no rating or CDS spread; these include the hot spots of the world such as Syria and Iraq. For these, I use the only measure of country risk that I can find, a composite risk score from Political Risk Services (PRS) and use that score to compute an equity risk premium; I create a look up table using the countries that have both PRS scores and ERP to make these judgments. Desperation move? Perhaps, but if you can find a better way of doing it, I would be glad to follow your lead. The resulting equity risk premiums by country are available in the spreadsheet that I referenced earlier but are also in the map below (which adds nothing in terms of content but looks much better):

via chartsbin.com

Country Pricing Update - January 2016

In my July 2016 updates, I also included one on how stocks are priced around the world, using multiples (PE, PBV, EV/Sales, EV/EBITDA, EV/Invested Capital). While that post has a more extensive explanation of why stocks should trade at different multiples around the world, I have updated the multiples, by country, in this spreadsheet. As you peruse these numbers, keep in mind that the number of companies that I have in data set is very small for some countries and the multiples can therefore yield strange values. To prevent outliers from hijacking my estimation, I also compute the multiple using aggregated values; thus, the PE ratio for China is computed by adding the market capitalizations of all companies listed in the market and dividing by the aggregated net income of these companies. 

via chartsbin.com

Much as I would like to read more into this picture (especially about cheap and expensive markets), these country numbers are more a first step in the investment process than a last one. 

Bottom line

I think that we are far too casual in our treatment of country risk, estimating equity risk premiums on auto pilot for countries and attaching these premiums to companies based on where they are incorporated, rather than where they do business. If there is a lesson from the last week's implosion in the Chinese market, it is that the emerging market growth story that so many developed market companies have pushed for the last two decades has a dark side, and that dark side takes the form of higher risk. It is easy to forget this intuitive concept in the good times, but the market lulls us into complacency before shocking us. 

Datasets

1. Equity Risk Premiums - By Country
2. Pricing Multiples - By Country

Data Update Posts

1. January 2016 Data Update 1: The US Equity Market 
2. January 2016 Data Update 2: Interest Rates and Exchange Rates - Currencies 
3. January 2016 Data Update 3: Country Risk and Pricing
4. January 2016 Data Update 4: Costs of Equity and Capital
5. January 2016 Data Update 5: Investment Returns and Profitability
6. January 2016 Data Update 6: Capital Structure
7. January 2016 Data Update 7: Dividend Policy
8. January 2016  Data Update 8: Pricing, with an end of month update

Past Blog Posts on Interest Rates and Currencies

1. Valuing Country Risk - Pictures of Global Risk
2. Pricing Country Risk - Pictures of Global Risk

January 2016 Data Update 2: Interest Rates, Exchange Rates and Currencies

In both corporate finance and valuation, interest rates and exchange rates play a big role, the former because they form the basis for estimating required returns on risky investments, and the latter, since they affect your earnings and cash flows. That said, the biggest mistakes that we make in finance often come from trying to forecast one or both variables, implicitly or explicitly, when making corporate finance or investment decisions. 

Interest Rates

For much of the last year, the focus for US interest rates stayed on the Fed and whether it would  abandon its "low rate" policy. I contested the notion that the Fed sets interest rates in a post on September 4, 2015, leading into a FOMC meeting, and argued that even if the Fed did change its policy, the effect on rates would be muted. The Fed did not act in September but it finally did in December, when it raised the Fed Funds rate for the first time since the 2008 crisis. Given the long and involved lead up to this action, you would have expected treasury rates to jump sharply right after, but they did not. In the graph below, the 3-month treasury bill rate and the 10-year treasury bond rate are plotted by day, through 2015:

Source: Federal Reserve in St. Louis (Download spreadsheet)

There was some action on the treasury bill front, with rates rising from close to zero percent to 0.25% in the weeks around the action (mostly between September and December), before ending the year at 0.21%. It was an uneventful year for treasury bonds, with barely perceptible movements for much of the year and no discernible effect from the Fed's actions; we started the year with a ten-year treasury bond rate of 2.17% and ended the year at 2.27%, still well below historic norms:

Source: Federal Reserve in St. Louis (FRED) (Download spreadsheet)

I know that looking at this graph, you feel the urge to normalize, just as you probably have each year for the last few, replacing today's rates with a longer term average. I have long argued against this practice and I will do so again. I believe that today's low rates across developed markets is not a passing phase or a central bank set anomaly but more a reflection of a low inflation (perhaps even deflation) and low real growth. Updating a data series that I have used before, I compute the intrinsic treasury bond rate as the sum of the inflation rate and real GDP growth rate that year and compare it to the actual treasury bond rate:

Download spreadsheet

The intrinsic ten-year bond rate, if you add the latest estimates for inflation (0.40%) and real GDP growth (2.1% annualized, through 3rd quarter), is 2.50%, close to the treasury bond rate of 2.27% on December 31, 2015. Unless one or the other of these variables changes significantly over the next year, I don't see rates moving back this year, with or without Fed action.

While there was little movement in US treasury rates during the course of the year, there was volatility in the corporate bond market, especially in the last few weeks of the year.

Source: Merrill Lynch Indices (from FRED) (Download spreadsheet)

Corporate default spreads (over the US T.Bond) increased across the board during the course of the year, unusual for a year where the US economy was showing signs of strength, but indicative of both the globalization of the US corporate bond market and the corrosive effects of the commodity price meltdown. In November and December, the lowest rated bonds (CCC and below) saw default spreads widen dramatically, perhaps a precursor to the repricing of risk both in this and the equity markets.

Currencies and Exchange Rates

The world used to be a much simpler place before globalization. Most companies did business in the countries that they were incorporated in and raised their financing (debt and equity) in the local currency. If exchange rates were an issue, they had only a marginal impact on earnings and value and the effects were easily eliminated through hedging. Those days are in the past, as multinationals are now more the rule than the exception, not only spreading their operations around the world, but also raising funding in multiple currencies.  In a post in July 2015, I looked at how corporate financial decisions and valuations are distorted by decision makers mixing and mismatching currencies. As China's markets melt down and threaten to take the rest of the world down with them, and exchange rates are in turmoil, I decided to revisit some of the basic rules of dealing with currencies, using my most recent data update to fill in the blanks.

1. There is no global risk free rate: While 2.27% is the US dollar risk free rate, it cannot be used as the risk free rate if you are working in Euros, Yen, Yuan or Reais. At the start of each year and again mid-year, I estimate risk free rates in different currencies, starting with the government bond rate in that currency (if available) and then adjusting for any default risk that may be embedded in that bond, using the local currency rating for the country. Thus, to estimate the risk free rate in Chilean pesos on December 31, 2015, I subtract out a default spread of 0.67% for Chile (based on its Moody's local currency rating of Aa3) from the 4.75% at which the ten-year Chilean government bond,  denominated in pesos, was trading to get a risk free rate of 4.08% in Chilean Pesos. I was able to repeat this process for 42 currencies and they are captured in the picture below:

   

   Spreadsheet with risk free rates

   The weakest links in these estimates are not the default spreads, but the government bond rates, since many government bonds are illiquid and controlled.
2. Inflation is the core fundamental: In the long term, interest rates in different currencies and exchange rates across them are determined by inflation differentials. In fact, one check of whether the interest rates computed in the last section for different currencies are reasonable is to compare them to inflation in these currencies. For instance, consider the Vietnamese dong, where my estimate of the risk free rate (based on the government bond rate) was 2.06%, but where inflation averaged 10.54% over the last five years. Using the rate on the inflation-indexed treasury bond (0.73% on December 31, 2015) as a measure of the real interest rate (globally), the synthetic risk free rate for Vietnam would be 11.27%, much higher than the computed risk free rate. (This spreadsheet has synthetic risk free rates computed for countries.)
3. The key to dealing with currencies is to be consistent: In my post on currencies in July 2015, I argued that valuation/corporate financial decisions should be currency invariant; a company that looks expensive, if you value it in US dollars, should not magically become cheap, if you value it in Indian rupees. The reason is simple. If you value a company in Indian rupees instead of US dollars, you will be using a higher discount rate (since the risk free rate in Indian rupees is about 3% higher than the risk free rate in US dollars) but the effect will be offset by the growth rate being higher by 3% as well. For companies with operations and financing in many countries and currencies, you therefore have two choices. The first is to pick a single currency to value the company in and to convert all of the numbers into that currency before doing your valuation; you can value Nestle in Swiss francs, US dollars or Russian Rubles. The second is to value each currency stream separately, using that currency's inflation in both the cash flows and the discount rate, and to add the values of the different streams. That may sound more precise but it is not only a lot more work but may require information at the regional level on investment and cash flows that is not always available.
4. Exchange rates are momentum driven, but fundamentals ultimately win out: Currencies are momentum driven, allowing traders to make money for extended periods on strategies that build on momentum. However, when momentum shifts in currency markets (either because of a market mood shift or a government intervention), the profits generated from years of momentum trading can be wiped out in a fraction of the period. In my valuations, when I have to forecast exchange rates (to convert cash flows in future periods from one currency to another), I adopt a very simple strategy, using the differential inflation rates between the currencies as my basis for expected currency appreciation or depreciation (purchasing power parity). Thus, if I were required to forecast the US dollar/Indian rupee exchange rate for the next decade in a valuation, I would build in an expected depreciation in the rupee of about 3% (the same inflation differential between the Indian rupee and the US dollar that I used in the risk free rate computation). Not only does it keep my valuations internally consistent but it comes with two bonuses. The first is that my inflation mistakes cancel out; thus, if the expected inflation in India turns out to be 6% higher than the US inflation rate, instead of 3%, both my cash flows and my discount rates will be understated and the effects will offset. The second is that I save myself the aggravation of having to listen to currency experts, whose expertise seems to lie not in forecasting in the future but in providing elaborate rationales for past forecasting errors.

Bottom line

This has been the worst opening few days for equity markets in the United States in history, and the damage has been greater in many emerging markets. The US dollar is stronger, emerging market currencies are weaker and interest rates are on the move. The macroeconomic soothsayers will be out in full force, with predictions aplenty about where interest rates and exchange rates will be going this year. Much as you will tempted to alter your asset allocation mixes and investment strategies, based on their forecasts, my advice is that you chart your own course. I plan to take the karmic route for macro variables, accepting that change is the only constant and completely out of my control. While that strategy may do little to protect my portfolio, it does wonders for my psyche.

Datasets

1. US treasury bond rates (actual and intrinsic) - 1960-2015
2. US treasury bond and bill rates (Daily for 2015)
3. US corporate bond yield spreads (Daily for 2015)
4. Risk free rates by Currency (January 1, 2016)
5. Synthetic Risk free rates by Currency (January 1, 2016)

Data Update Posts

1. January 2016 Data Update 1: The US Equity Market 
2. January 2016 Data Update 2: Interest Rates and Exchange Rates - Currencies 
3. January 2016 Data Update 3: Country Risk and Pricing
4. January 2016 Data Update 4: Costs of Equity and Capital
5. January 2016 Data Update 5: Investment Returns and Profitability
6. January 2016 Data Update 6: Capital Structure
7. January 2016 Data Update 7: Dividend Policy
8. January 2016  Data Update 8: Pricing, with an end of month update

Past Blog Posts on Interest Rates and Currencies

1. The Fed, Interest Rates and Stock Prices - Fighting the Fear Factor (September 2015)
2. Decoding Currency Risk (July 2015)

January 2016 Data Update 1: The US Equity Markets

Like most of you, I start every new year with optimism and hopeful resolutions, but the first week each year for the last two decades has been what I term my “Moneyball” week. During the week, I download the raw data on every publicly traded company that is listed globally, and work at converting that data into the industry averages that you see on my website. I do the analyses to keep myself grounded, since it is so easy to form preconceptions about market and corporate behavior that have no basis in reality. As I update the data, I will be doing a series of posts on how the numbers have or have not changed during the course of the last year. In this, the first of the series, I will start by looking at US equity markets, as we start the new year.

Looking Back

It was not a good year for US equity markets, but given circumstances, it could have been a lot worse. The S&P 500 was almost unchanged during the course of the year, though indices of some subsets of the market did worse:

Source: Standard and Poor's

During 2015, large cap stocks did better than small cap stocks, growth outperformed value and momentum investing provided a positive payoff. 

If there is a word that I would use to describe US equity markets in 2015, it is “resilient”, since they had to weather two significant crises. During the summer, China, the engine for global economic growth for much of the last decade, had a market meltdown, triggered by an economic slowdown. (Take a look at the post that I did at the height of the crisis in late August). The commodity markets, which collapsed in 2014, continued their decline in 2015, albeit at a slower pace. Notwithstanding these developments, the S&P 500 ended 2015, with a return of 1.36%, if you count in dividends, higher than the returns you would have generated on T.Bills (0.21%) or T.Bonds (1.28%) for the year. Incorporating the returns from 2015 into the historical data, the compounded annual returns on stocks, T.Bonds and T.Bills are shown below for periods going back as far as 1928:

Source: Damodaran Online

The historical premium earned by stocks, relative to treasury bonds, inched down to 4.54% for the 1928-2015 time period, from 4.60% for the 1928-2014 time period. 

Looking forward

The equity risk premium is the extra return that investors demand for investing in stocks as opposed to putting their money in a riskless asset, and it is the composite statistic that best captures how stocks are priced in the aggregate. It is also a number that I have posted on extensively, that I update at the start of every month on my website, and write an extended update about, each year. My preferred approach for estimating the premium is to start with current stock prices, estimate expected cash flows from owning stocks and to solve for the discount rate (expected return or internal rate of return). At the start of 2016, using the S&P 500 as the market index, the collective cash flow from dividends and buybacks as the cash flow from stocks and a top down estimate of growth in earnings for the index as the growth rate in the cash flows, I obtain an equity risk premium (ERP) of 6.12%:

Spreadsheet

This equity risk premium serves two purposes. First, it is a key input in valuing individual companies, becoming a part of the costs of equity and capital of all companies; a higher ERP translates into higher discount rates and lower values. Second, by comparing the current ERP to what you believe a fair ERP should be (perhaps by looking at historical averages), you can make a judgment on whether you think the market is under or over valued. If the current premium is higher (lower) than what you think is fair, stocks are under (over) valued. 

Source: Damodaran Online

On that comparison, the high ERP on US stocks (or at least those in the S&P 500) is reason for optimism. 

Cautionary Notes

The optimism emanating from the high current ERP should be tempered, though, since the drivers of that premium are much softer than they were a year ago, when the ERP was 5.78%. Largely as a consequence of the commodity price decline, base year earnings for the S&P 500 companies dropped almost 10% in 2015. In fact, the ERP at the start of 2016 is being elevated by two forces, the first is that the T.Bond rate continues to be low (by historic standards) and the second is that cash returned  (about 60% in buybacks) by US companies rose last year by 4% during the year. The net result of the declining earnings and increasing buybacks is that the cash returned last year was 101.54% of earnings, unsustainable over time. 

To correct for this, I reestimated the ERP, adjusting the cash return down to a more sustainable number over the long term. In effect, I lower the cash return ratio each year over the next five years to reach about 84% of earnings in year 5:

The resulting ERP is 5.16%, still higher than the 75th percentile (4.93%) for the 1960-2015 period, but the margin for error is much smaller than it was last year. If the continued drop in commodity prices in the last quarter of 2015 affects earnings for the index in 2016 and/or T.Bond rates rise sharply, the ERP will decline. This year, I plan to monitor (and report) this buyback-adjusted ERP , in addition to my unadjusted estimates, more closely than in prior years.

Bottom Line

I am more wary about equities going into 2016 than I was entering 2015, but my feelings about the market have never been a reliable predictor of what stocks actually do during the year. Thus, I will do what I always do at the start of every year, invest on the presumption that I am not  market timer and that I am better off investing in individual companies that I think are under valued. My faith in intrinsic value will be tested by price movements in the wrong direction and I hope that I will not be found wanting.

Data

1. Historical Returns on stocks, bonds and bills: United States
2. Historical Implied ERP for S&P 500

Spreadsheets

1. Implied ERP - January 2016

Data Update Posts

1. January 2016 Data Update 1: The US Equity Market 
2. January 2016 Data Update 2: Interest Rates and Exchange Rates - Currencies 
3. January 2016 Data Update 3: Country Risk and Pricing
4. January 2016 Data Update 4: Costs of Equity and Capital
5. January 2016 Data Update 5: Investment Returns and Profitability
6. January 2016 Data Update 6: Capital Structure
7. January 2016 Data Update 7: Dividend Policy
8. January 2016  Data Update 8: Pricing, with an end of month update

Intergalactic Finance: Valuing the Star Wars Franchise

I saw the newest Star Wars movie last week and it brought back memories that stretch back almost four decades. Watching Harrison Ford and Carrie Fisher on the screen reminded me of my age, though, once I learned how much Ford made for being in this episode, I understood the movie's story line much better. As I came out of the theater, though, I decided that it would be fun to update a valuation I did of the Star Wars franchise in 2012, when Disney acquired the rights from Lucas Films.

The Movies- Box Office Bonanza
If you are one of the few people on the face of the earth that has not followed the Star Wars story, it began in 1977 when George Lucas produced the first Star Wars movie, the fourth episode in what he saw as a six-episode series. That movie made history and remains one of the highest grossing movies of all time. It was followed in 1980 by the fifth episode, The Empire Strikes Back (my favorite), and in 1983 with the sixth in the series, The Return of the Jedi.  Those first three movies created an entire generation of Star Wars fans, who then had to wait 16 years for the first in the series, The Phantom Menace (my pick for the worst of the series), which was followed  by Attack of the Clones in 2002 and Revenge of the Sith in 2005. The six movies represent one of the most valuable movie franchises of all time, generating billions of dollars in box office receipts, with the appeal spreading globally.

The movies are shown in chronological order and the box receipts on the first three movies include the collections from their re-release in theaters in the 1990s.

The Add-Ons - Bigger than the Movies?
If you stopped just at box receipts, Star Wars might not be the most valuable franchise at all time, lagging the James Bond movies and perhaps even the Harry Potter and Lord of the Rings franchises. It is the magnitude of the add-ons to box receipts that make Star Wars unique and as someone who has partaken in all of them, I can attest to their power. I have owned the Star Wars tapes and DVDs, collected every Star Wars figure made, played Star Wars video games (very badly) and even used a GPS with a Yoda voice to drive from New York to Chicago (I love Yoda but he is a really bad navigator). The Star Wars empire stretches far and wide to include:

1. VHS/DVD/Rentals: The additional revenue from this stream reflects as much the hold that Star Wars has had on our collective imaginations, as it does the changing of technologies for home video watching over the decades. Starting with video tapes (VHS) sales and rentals in the 1970s, morphing into DVD sales in the last decade and continuing into streaming in today's environment, this add-on has generated $7.7 billion (unadjusted for inflation) in revenues.
2. Toys and Merchandise: This is the crown jewel of the franchise, as toy and merchandise sales have outstripped all other sources of revenue. The revenues from action figures sold by Kenner  (1978-1985) and Hasbro (1995-2011) amounted to almost $10 billion (unadjusted for inflation) and adding in other merchandise, the collective revenues from toys and merchandise over the history of the franchise is in excess of $12 billion. 
3. Gaming: As with the video rentals, the Star Wars games track shifting technologies, starting with an unlicensed game for the Apple II on a cassette tape, followed by table-top game by Kenner and games for the Atari. Starting in 1992, the games shifted away from the films to the expanded Star Wars universe, first with the X-wing computer games and later with Dark Forces, a shooter game. In 2013, Disney revealed that Electronic Arts would retain the rights to produce games for PCs and consoles, while Disney would retain the rights for other platforms. The collective revenues from all of these games between 1977 and 2015 is $3.4 billion.
4. Books: There have been almost 360 books, with 76 authors, in the Star Wars series and total sales have amounted to more than $1.8 billion. The staying power of the franchise is backed up by the fact that the first books were in print in 1978 and that there have been at least ten Star Wars novels a year, every year from 1991 to 2014.
5. TV Series/Other: Given its success on so many dimensions, it is surprising that the Star Wars franchise has not spawned a higher profile TV series. The longest lived TV series, Clone Wars, has had seven seasons and a second one, Star War Rebels, produced by Disney, has had two seasons. There have been periodic rumors about other TV series in the works, with the latest one suggesting that Netflix is planning three live-action series. 

The collective revenues from these add-ons make the Star Wars revenue pie much larger than any competing movie franchise:

Note that the movie revenues in the table are not adjusted to 2015 $, since the revenues from the add-ons are not available in current dollars. In the table below, I scale the revenues from each of the add -ons to the box office receipts to get a measure of the value added from the rest of the Star Wars ecosystem:

In effect, for every dollar that Star Wars has made at the box office, it has generated four dollars in revenues from other sources. That number is a conservative estimate, since there have been undoubtedly others who have profited from the franchise unofficially (and illegally).

The New Series: Disney takes over

In 2012, Disney acquired the Star Wars franchise for $4 billion, from George Lucas, with plans to produce three more Star Wars movies. At the time of the acquisition, I argued that it was a fair price, given Disney's history with developing, maintaining and merchandising franchises, but had to draw on the potential for synergy to justify the number. With the release of Star Wars: The Force Awakens just about ten days ago, Disney seems to be more than delivering on its promise, as the movie has broken box office records and is on its way to delivering a global box office of $2 billion or more.

To the extent that this movie, like its predecessors, will generate add-on revenues, there will be substantially more money to be made over the next few years. The next two movies are scheduled for 2017 and 2019, and there will be three spin offs in the intermediate years, with less ambitious budgets. After 2020, Disney's plans are not specific, but if the appetite remains, there will be undoubtedly more movies in the pipeline. More importantly, the movies will not only create a new base of younger fans but augment the sales of merchandise, toys and games in the coming decade. The revenues that would have come from DVDs and video rentals will be replaced with streaming revenues and there will undoubtedly be games and apps directed at smartphones, devices and gaming systems. 

Valuing the Franchise

To value the franchise, I started with my estimates of worldwide box office receipts for Star Wars: The Force Awakens and the subsequent movies in the series. Though, the first two weekends have blown away expectations (with the movie making $1 billion), I will estimate $2 billion in revenues, for each of the three main movies, and half those proceeds for the spin offs, with an inflation adjustment of 2%.

As with the prior movies, the bulk of the revenues from the franchise will come from add-ons, and in assessing the potential, here are some of my assumptions:

1. Streaming: As viewers increasingly turn to watching streamed movies from services (Netflix, Amazon Prime) on their televisions and devices, the revenues from streaming are quickly catching up with box office receipts for movies, and by 2017, the total revenues from streaming are expected to exceed box office revenues. I will assume that each dollar in box office revenues from the new Star Wars movies will generate $1.20 in additional revenue in streaming, slightly higher than historical numbers (1.14).
2. Toys/Merchandise: The Star Wars movies have historically generated $1.80 in revenues from toys/merchandise for every dollar in box office revenues. Given Disney's prowess at merchandising, I would not be surprised to see this number go up, and I will assume that each dollar at the box office will translate into two dollars in merchandising revenues, a little higher than the historical value of $1.80 per box office dollar. Keep in mind that this franchise is a merchandisers' dream, with an almost endless potential for new opportunities in the Expanded Universe.
3. Books and eBooks: This is the stream that is perhaps most at risk, and I will assume that while a way will be found to adapt the publishing stream to changing tastes in reading, the revenues from this books/e-books will drop to $0.20 per box office dollar (from $0.27, the historical number).
4. Gaming: In keeping with the history of Star War games, I am convinced that that games will be adapted not only to gaming platforms (Xbox, Playstation and Nintendo) but also to smartphones and tablets. I will leave the gaming revenues at $0.50 per dollar in box office receipts.
5. TV Shows/Other: This is the one add-on where I will assume a significant improvement over historical numbers, as Disney, Netflix and others find ways to adapt the franchise to television viewers. I will assume that the revenues from TV shows will increase to $0.50 per dollar in box office receipts.

Download Spreadsheet

To estimate the franchise value, I used the operating margins of the movie (20.14%) and toy/merchandise businesses (15%) and netted out taxes (at a 30% tax rate), before discounting back at a 7.61% cost of capital, the entertainment sector average. (Disney will probably license most of the merchandise, passing of the risk to others, but settling for a share of the operating income.) At least based on my projections, the value of the Star Wars franchise, if it can maintain my estimated numbers (for add-ons) and deliver at the box office, is almost $10 billion. The value is obviously a function of movie revenues and the add-on dollar values:

Not only does that make Disney's $4 billion investment three years ago a very good one, but any synergies that Disney can gain in its other businesses (like this one) will create more upside. As always, you are welcome to make your own assumptions and revalue the franchise, using this spreadsheet.

An Acquisition Model that works?
I am not a fan of acquisition-driven growth, primarily because the process so often leads to over paying for growth, but Disney may have found an acquisition model (albeit a limited one) that works with its Star Wars and Marvel acquisitions. In both cases, the company bought established movie franchises and has used its merchandising machine to generate value. Those results have already borne fruit with Marvel, especially with the Avenger movies, and we may be be seeing the beginnings of the Star Wars dividends this week. 

During the week, while I was in the city (New York), I saw at least three Stormtroopers and a Darth Vader on Times Square and every store that I went into had something related to Star Wars, on sale. If you are a Star Wars purist, appalled by the shameless merchandising of the movie, I am afraid that you ain't seen nothing yet. If you are a Star Wars collector, and think that you have the entire collection already (for you or your kids), here is something for you to ponder. If you are a Disney stockholder like me,  may the force be with you!

YouTube Video


Attachments

1. Star Wars: Valuing the Franchise (Spreadsheet)
2. Star Wars: Franchise Value Picture (jpg file)