The Disruptive Duo: Amazon and Netflix!

Amazon and Netflix! Need I say more? Just the mention of those companies cleaves market participants into opposing camps. In one camp are those who believe that those who invest in these companies are out of their minds and that there is no way that you can justify buying these companies, perhaps at any price. In the other are those who argue that the old time value investors don't get it, that these companies are redefining old businesses and will emerge as winners, thus justifying their high prices. The truth, as always, lies in the middle.

Amazon and Netflix: Reading the Pricing Entrails

Amazon and Netflix have been market wonders, rising in market capitalization even in 2015, a year when most of the market was retrenching. Notwithstanding the steep drop in stock prices of both companies this year (with Amazon down 23% and Netflix down 22%), Amazon is still up 36% over the last year and Netflix is up 34% during the same period.

One simple way to measure how much these companies have to come to dominate their playing fields is to compare them with traditional heavyweights in their businesses, Walmart, in the case of Amazon, and Time Warner, in the case of Netflix.

Is it possible that Amazon is worth more than Walmart and that Netflix is more than 60% of Time Warner’s value? The answer is yes and the only way to find out is by valuing both companies.

Amazon: The Field of Dreams Company

In a post in October 2014, I described Amazon as a Field of Dreams company, with a CEO (Jeff Bezos) who has been remarkably consistent in his push to make the company larger, even if that means selling products and services at cost, or even below, with the objective of using that market power to generate profits later. His vision for the company can be seen in this 1997 letter to stockholders and the company has certainly delivered on at least one half of that vision and increased its revenues in retailing initially, entertainment later and cloud computing recently, while generating little in profits over much of its existence.

In its most recent earnings report on January 28, 2016, Amazon delivered its by-now-usual high revenue growth, delivered close to expected numbers on its revenues and guidance, but came in well below expectations on its earnings per share. 

The market reacted strongly to the earnings per share surprise, with the stock price dropping 15% and Amazon losing $45 billion in market capitalization. The response followed a pattern of large market reactions to earnings surprises at the company, perhaps suggesting that the market is dreaming less about revenues and wanting more in profits from Amazon.

From a valuation perspective, Amazon’s results reinforced my existing story, with perhaps a tweak in the pathway to profitability:

During the last year, Amazon has taken actions that suggest that it is heeding the call to show profits, shifting more of its focus to cloud computing and laying off employees for the first time in its corporate life. To get a measure of the company’s current and expected future profit margins, I decided to take Amazon’s substantial technology and product development costs, which amounted to $12.5 billion in 2015 out of the operating expenses, and capitalize them, on the rationale that as growth started to slow, the growth in this cost would level off. That adjustment does push the current operating margin for the company from 2.09% to 6.58%, while also significantly raising my estimates of how much Amazon is reinvesting to generate its high revenue growth. Assuming that there is still room for revenue growth (especially in Amazon’s media and cloud computing business) and margin expansion (to 8.80%, the weighted average of the margins in the retail, media and cloud business) gives me an updated story for Amazon. The value that I obtain is $323.55 per share and the results of the simulation in February 2016 using this updated story are below:

Amazon Valuation Spreadsheet

At $507 per share, the price on February 12, 2016, Amazon still looks over valued to me, but as you can see from the simulation, there is a sizeable probability that assuming higher growth and higher margins can get you values that exceed the price. If your rationale for buying Amazon is the cloud computing dream, I would suggest caution. The business is a big, potentially profitable one, but it is also one where other big players are stirring.

Netflix: House of Cards or Global Streamer?

Like Amazon, Netflix has a CEO in Reed Hastings, who has been both consistent and credible in selling a story of growth and potential. As the company approaches saturation in the US market, the growth story has a global twist to it. In its earnings report on January 19, 2016, Netflix beat expectations on both earnings per share and subscribers, with the growth in global subscribers tipping the scale. 

While the report initially evoked a positive response, that price bounce quickly faded as investors took profits.

I have never posted a Netflix valuation on my blog, but in my prior valuations of the firm, I have tended to value it as a primarily domestic company that acquires others’ content and streams it to subscribers While that remains the core business model, it seems to me that the story is shifting to a company that is increasingly global and more willing to generate its own content, with this earnings report providing further backing for the view. The connection between this story and my valuation inputs is below:

Note that Netflix’s shift to content has mixed effects, decreasing profit margins (at least as I have defined them) while also reducing the reinvestment needed to generate growth (as the cost of buying content is replaced with the cost of making its own). The value per share that I obtain with these inputs is $61.44. Allowing the inputs to vary and be drawn from distributions, my estimated value distribution for Netflix is as follows:

At $87.40/share per share, Netflix looks overvalued by about 40%, but as with Amazon, there are clearly combinations of revenue growth and margins that yield values that exceed the price.

To GAAP or not to GAAP?

Both Amazon and Netflix have a GAAP problem, insofar as neither company generates much in operating profits, using conventional accounting rules. I do believe that GAAP understates the profits at both companies, though not for the reasons used by many of the biggest cheerleaders for the company, including the adding back of stock-based compensation or the use of supplier credit as a source of capital (and cash flows). The problem is in the accounting categorization of expenses, with Amazon’s big investments in technology and content and Netflix’s even bigger spending on acquiring the rights to content (usually for multiple years) being treated as operating expenses. If we following accounting’s own first principle, which define capital expenditures as expenditures designed to create benefits over many years, Amazon’s technology investments and Netflix’s content commitments should both be moved out of operating expenses and the effects are captured in the table below:

In summary, reclassifying these basic expenses changes the picture of these companies from low margin companies, that grow revenues with very little reinvestment, to higher margin companies, that reinvest significant amounts to deliver higher revenues. It also has a favorable impact on value per share, not because of the obvious reasons (that operating income is increased) but because the reinvestment at both companies has been value-generating.

I don't worship at the GAAP altar and have come to the conclusion that while accountants might do some things well, measuring earnings at companies that are not stable, manufacturing firms is not one of those things.  They not only violate their own first principles (as evidenced by the treatment of R&D and contractual commitments as operating expenses) but also create inconsistencies across companies, making earnings at Amazon and Netflix not quite comparable with the earnings at GM or even at Walmart. That is one reason that I give short shrift to arguments against investing in Amazon, because it trades at several hundred times earnings, since cutting its technology development costs by $10 billion could quickly solve that PE problem while destroying the basis for the company's value.

As businesses, the two companies share a common characteristic: they are willing to spend money now (on Prime and technology, in the case of Amazon, and original and acquired content, in the case of Netflix) to generate revenue growth, which they believe that they can turn into positive cash flows later. Both companies also realize that their growth ambitions will require them to grow outside the US, in less friendly regulatory standpoint and competitive environments. The biggest danger that the two companies face is that their revenue growth plans come to fruition, but that their costs stay high, as they have to keep spending money to keep their customers. There is one other characteristic that they share and it is one that may add to their value, though it is disquieting, at least to me. I have a feeling that Amazon knows more about my buying habits, and Netflix about my TV and movie watching proclivities, than I do myself. As an Amazon Prime user and Netflix subscriber of long standing, I know that they will use this knowledge to draw me deeper into their web, but I must confess that I am going in willingly.

Investor or Trader?

In the first post in this series, I differentiated between investors and traders and no two companies better illustrate the divide than Amazon and Netflix. The two stocks have created a Rorschach test  by forcing you to choose between staying true to your investing beliefs or capitulating to your pricing instincts. I would be lying if I said that I have not revisited my Amazon valuation from October 2014, when the stock was trading at about $300 and I found it to be over valued, as the stock doubled to more than $600 during the course of the next year or that I have not looked wistfully at Netflix, during its stock price rise last year.  That said, I have made my peace, for the moment, with the market, on these companies. I am an investor, for better or worse, and have to go with my estimates of value, flawed thought they might be, and will not buy either Amazon or Netflix, at their current prices. At the same time, I have enough respect for the power of markets to not sell short on either stock, since I have seen what momentum can do with both stocks. You can call me chicken, but I don't have the luxury of investing other people's money!

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Datasets

1. Amazon 10K (2015)
2. Netflix 10K (2015)

Spreadsheets

1. Amazon - Valuation in February 2016
2. Netflix - Valuation in February 2016

Blog posts in this series

1. A Violent Earnings Season: The Pricing and Value Games
2. Race to the top: The Duel between Alphabet and Apple!
3. The Disruptive Duo: Amazon and Netflix 
4. Management Matters: Facebook and Twitter
5. Lazarus Rising or Icarus Falling? The GoPro and LinkedIn Question!
6. Investor or Trader? Finding your place in the Value/Price Game! (Later this year)
7. The Perfect Investor Base? Corporation and the Value/Price Game (Later this year)
8. Taming the Market? Rules, Regulations and Restrictions (Later this year)

Race to the top: The Duel between Alphabet and Apple!

Apple and Alphabet, the two companies jockeying for the  prize of “largest market cap company in the world” are both incredibly successful businesses, with unparalleled cash machines (the iPhone and Google Search) at their core. That said, the last month has been eventful for both companies, just as it has for the rest of the market, as their latest earnings reports seem to suggest that these firms are on divergent paths. Having valued Apple multiple times on this blog over the last five years, and bought and sold the stock based on those valuations, the most recent earnings report is an opportune time for me to revisit Apple’s value. Having never valued Alphabet on this blog, though I have valued it in my classes multiple times, its earnings report is a good time to initiate the process with a valuation.

The Apple Rollercoaster

Apple’s most recent earnings report came out on January 26, 2016, and it contained mixed news. On the good news front, Apple announced the largest quarterly earnings in corporate history and higher earnings per share than expected by analysts. The bad news was that these earnings were generated on revenues that were close to flat for the year, that iPhone sales were lower than expected and that the management expected revenues to stay weak through next quarter (in its guidance). The market’s reaction was negative, with Apple’s stock declining by 6.57%, a drop in market capitalization of more than $30 billion, right after the announcement. In the picture below, I capture the pricing reaction to Apple, with its earnings history as background information:

In summary, it looks like the market is weighing the iPhone and guidance bad news far more than the earnings good news in making its assessment, with Apple's history of beating earnings every quarter for the last eight weighing against it.

To evaluate whether the earnings report merited the negative market reaction, I went back to the intrinsic value drawing board and updated my valuation of Apple, the last of which I posted in August 2015 and subsequently updated in November 2015, after its annual report (with a September 2015 year end) came out. My assessment of Apple’s value in November of 2015 was $134/share, but more importantly, the narrative that I had for Apple was that of a slow-growth , cash rich company (revenue growth rate of 3% in the next five years and a cash balance of $200 billion), with operating margins under pressure (declining from the 32.03% it earned as a pre-tax operating margin in the 2015 fiscal year to 25% over the next decade) and a very low probability of a difference-making disruption. Looking at the earnings report, it is true that revenue growth came in below expectations (but not by much, given my low expectations) and operating margins dropped, again in line with expectations.

The net effect is that  my narrative changed little, and using a slightly lower revenue growth rate (2.2% instead of 3%) leads me to an updated assessment of value per share of $126 in February 2016 and almost all of the difference is coming from a repricing of risk (higher equity risk premiums and default spreads in the market). In keeping with my view that estimated value is a distribution, not a single number, I ran a simulation on Apple's value in February 2016:

At the price of $94 at close of trading on February 12, 2016, Apple looks under valued by about 25% and at least based on my distribution, there is a more than 90% chance that it is under valued.

Alphabet Soup

Alphabet surprised markets on February 1, 2016, with on earnings report where the company reported higher revenue growth than anticipated, coupled with higher profit margins. Since it was also the first report that the company was releasing as holding company, where it was breaking itself down  by business, there was also excitement about what you would learn about the company from this report. As with Apple, I start by looking at the pricing effect of the earnings report, comparing, actual numbers to expectations and tallying the stock price reaction to the report:

Markets were impressed by both the revenue and earnings numbers and the stock price increased by 8% in the immediate aftermath, briefly leading Alphabet to the front of the market cap race.

As a counter to the market's excitement, I decided to compare the narrative (and value) that I had for Alphabet in November 2015 (after their last earnings report) to the narrative (and value) after this one (in February 2016).  In November 2015, my narrative for Google was that it would continue to be a dominant and profitable player in a growing online advertising market, growing 12% a year in the near term, maintaining its operating margins (left at 30% in pre-tax terms, in perpetuity).

It is true that in their most recent earnings report, Alphabet reported double-digit growth in revenues (impressive given their size and the state of the global economy) and higher operating margins than they did in the previous quarter. I left my original narrative largely intact, with revenue growth remaining at 12% and pushed up the target pre-tax operating margin to 32%, and arrived at a value per share of $631/share. Presenting Google's value as a distribution, here is what I get:

At $682.40, the price at which the class C shares were trading at on February 12, 2016, the stock is trading at about 8% above the median price, with a 35% chance of being under valued. Since these shares have no voting rights, attaching a value to voting rights, will make the shares a little more over priced.

I know that one reason for Google's restructuring/renaming exercise last year was an ostensible desire to improve transparency, but I think that there may be less here than promised, at least at the moment. There were a few things that became transparent in Google's last earnings release, as captured in this picture of a key part of the earnings release from the company:

1. It became transparently obvious that Google is almost entirely an online advertising company. All of Google's other businesses generate collective revenues of $448 million, while reporting operating losses of $3,567 million. To even call them businesses is perhaps stretching the definition of the word "business", since all they do well, right now, is spend money. While it is reasonable to cut them some slack because they are young, start-ups, there is nothing in this report that would lead you to think about them any differently than you always have, if you were a Google-watcher.
2. It is transparently clear that in spite of its technological sophistication, this company uses financial terms loosely.  Note that what the company reports in its earnings release as operating income of $23,245 million in the 2015 fiscal year is really EBITDA, and perhaps the only thanks that we can give is that it is not an adjusted EBITDA. If you are going to be transparent, it is best if you not follow the dictum of Humpty Dumpty in Alice in Wonderland, and claim that a "word is what you choose it to mean".

Transparency is good for investors, but with Alphabet, I will reserve my cheers until I see real evidence of it (and perhaps I will, in the full 10Q).

Apple vs Alphabet

If this were a boxing match, Apple and Alphabet would be the super heavyweights, fighting it out for the world championship. To judge which is the better company, though, you would have to specify on what dimension you are making the comparison, i.e., as a business, an investment or as a trade.

I. As Businesses

Apple and Alphabet share a few common features. First, each of them derives their value from one cash cow, the iPhone for Apple and the search engine for Google, that individually have values so large that they would exceed the GDPs of many small countries. Second, both companies are known for their attention to detail and customer focus, at least on their core products, perhaps explaining why they have been so successful over time. Third, both companies have work forces filled with brilliant people who seem to like working for them. In short, these companies are perfect illustrations of how customer focus, employee satisfaction and shareholder value maximization often go hand in hand.

Each company, though, has areas where it has advantages. The Alphabet advantage is that its core product, its search engine, enriched with YouTube and the Google ecosystem, requires less care and maintenance to keep cash flows going, with Facebook perhaps being the only threat in the short or the medium term to profits. In contrast, Apple's iPhone franchise requires the company to constantly reinvent the product and make its own prior models obsolete, creating a two-year cycle that is both expensive and gut wrenching to watch. The Apple advantage, though, comes from its history of having survived a near-death experience (in the late 1990s) and reinvented itself. Consequently, the company is much more aware of how tenuous its hold on value is and it does try harder to find new game changers. There is one final difference that, at least at the moment, is working for Alphabet and against Apple, which is that Apple has made China its biggest foreign bet and Google has little exposure to the Chinese economy, thanks to the Chinese government's fear that all that stands between it and chaos is a good search engine.

If I were to pick a better business at the moment, it has to be Google. The company's core is strong and will get stronger and the biggest threat it faces, i.e., that the way we look for things may change from search engines to social media sites, is more distant that the the one faced by Apple.

II. As an Investment

The quality of an investment does not always correlate with its quality as a business, with the price driving the divergence. Buying a great business at too high a price is a bad investment, just as buying a bad business at a low enough price can be a good investment. Both Apple and Alphabet are good businesses, but as an investor, my money is on Apple, rather than Alphabet, at the prevailing price:

1. The break even points for the two companies to be fairly priced are wildly divergent. Apple does not need any revenue growth and can see its operating margins slashed by a third and it would still be a fairly valued investment at its current price. Google will have to deliver 12% revenue growth with its current already high pre-tax operating margin to break even. 
2. This may just reflect my personal predilections, but I need a bonus to invest in a company that wants my money but is not interested in my input (my vote on key decisions). I have had my disagreements with Tim Cook, but Apple is a much stronger corporate democracy than Alphabet, which remains a dictatorship, albeit a benevolent one (at the moment). 

I would hasten to add that I have never owned Google, as an investor, and that may reflect the fact that I continually under estimate the profit-making power of its online advertising engine. So, feel free to download my valuation, change the inputs you don't like and make it your own.

III. As a Trade

If momentum is the biggest driver in the pricing game, it is Alphabet that has the advantage right now, notwithstanding the decline in its price in the days since its last earnings report. Whether fair or not, markets have found the good news in almost every Alphabet story and find the storm clouds even on Apple's sunniest days. As long as the momentum game continues, you will make money far more easily and quickly with Alphabet than with Apple, but just a note of warning, from Apple's own recent past. Momentum will change, almost always without any advance warning and for no good fundamental reason, and when it does, I hope that you are able to get ahead of it.

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Raw Data

1. Apple Last 10K (September 2015) and Current 10Q (December 2015)
2. Google Last 10K, Last 10Q and Earnings Release (no current 10Q at the time of post)

Spreadsheets

1. Valuation of Apple in November 2015 and February 2016
2. Valuation of Alphabet (Google) in November 2015 and February 2016

Blog posts in this series

1. A Violent Earnings Season: The Pricing and Value Games
2. Race to the top: The Duel between Alphabet and Apple!
3. The Disruptive Duo: Amazon and Netflix 
4. Management Matters: Facebook and Twitter
5. Lazarus Rising or Icarus Falling? The GoPro and LinkedIn Question!
6. Investor or Trader? Finding your place in the Value/Price Game! (Later this year)
7. The Perfect Investor Base? Corporation and the Value/Price Game (Later this year)
8. Taming the Market? Rules, Regulations and Restrictions (Later this year)

A Violent Earnings Season: Pricing and Value Perspectives

The earnings season is upon us once again, the quarterly rite of passage where companies report their earnings results, the numbers get measured up against expectations, expectations get reset and prices adjust. As an investor, I sometimes find the process unsettling, but as a market observer, I cannot think of a better Petri dish to illustrate both the magic of markets and the vagaries of human behavior. This earnings season has been among the violent, in terms of market reaction, in quite a few years, as tens of billions of dollars in market capitalization have been wiped out overnight in some high flyers. In order to get perspective during these volatile times, it helps me to go back to a contrast that I have drawn before between the pricing and value games and how they play out, especially around earnings reports.

Price versus Value: The Information Effect

In finance, we use the words price and value, as if they were interchangeable and I have sometimes been guilty of this sin. It is worth noting that price and value not only come from different processes and are determined by different variables, but can also yield different numbers for the same asset at the same point in time. I try to capture the difference in a picture:

The essence of value is that it comes from a company's fundamentals, i.e., its capacity to generate and grow cash flows; you can attempt to estimate that value using accounting numbers (book value) or intrinsic valuation (discounted cash flow). Fundamental information causes changes in a company's cash flows, growth or risk and by extension, will change its value. Pricing is a market process, where demand and supply intersect to produce a price. While that demand may be affected by fundamentals, it is more immediately a function of market mood/sentiment and incremental information about the company, sometimes about fundamentals and sometimes not.

In an earlier post, I drew a distinction between investors and traders, arguing that investing is about making judgments on value and letting the price process correct itself, and trading is about making judgments on future price movements, with value not being in play. While the line between fundamental and incremental information is where the biggest battles between investors and traders are fought, it is not an easy one to draw, partly because it is subjective and partly because there are wide variations within each group on making that assessment. For instance, consider Apple, a company followed closely by dozens of analysts, and its earnings report on January 26, 2016. The company beat earnings expectations, delivering the most profitable quarterly earnings in corporate history, but also sold fewer iPhones than expected; the company lost almost $30 billion in market capitalization in the immediate aftermath. An investor valuing the company based on dividends would conclude that it was an overreaction, since not only are dividends not under immediate threat but the cash balance of $200 billion plus should allow the company to maintain those dividends in the  long term. A different investor whose valuation of the company was based on its operating cash flows might have viewed the same information as more consequential, especially since 65-70% of Apple's cash flows come from iPhones. A trader whose pricing of Apple is based on iPhone units sold would have drastically lowered the price for the stock, if his expectations for sales were unmet, but another trader whose pricing is based on earnings per share, would have been unaffected.

Earnings Reports: The Pricing and Value Reaction

While almost any story (rumor, corporate announcement) can be incremental information, it is quarterly earnings reports that keep the incremental information engine running, as revelations about what happened to a company in the most recent three-month period become the basis for reassessments of price and value.

Earnings Reports: The Pricing Game

The way traders react to earnings reports is, at least on the surface, uncomplicated. Investors form expectations about what an earnings report will contain, with analysts putting numbers on their expectations. The actual report is then measured up against expectations, and prices should rise if the actuals beat expectations and fall if they do not. The picture below captures this process, with potential complications thrown in.

While the game is about actual numbers and expectations, it remains an unpredictable one for three reasons. The first is that the price catalyst in the earnings report, i.e, whether the market reacts to surprises on management guidance, revenues, operating income or earnings per share, can not only vary across companies but across time for the same company. The second is that while analyst expectations are what we focus on and get reported, the market's expectations can be different. The third is that the effect on stock prices, for a given surprise (positive or negative) can be different for different companies and in different time periods.

1. Price Catalyst: It is easy enough to say that if the actual numbers beat expectations, it is good news, but actual numbers on what? While earnings reports two decades ago might have been  focused almost entirely on earnings per share, the range of variables that companies choose to report, and investors react to, has expanded to not only include items up the income statement, such as revenues and operating income, but also revenue drivers which can include units sold, number of users and subscribers, depending on the company in question.  In the last decade, companies have also increasingly turned to providing guidance about key operating numbers in future quarters, which also get measured against expectations. Not surprisingly, therefore, most earnings reports yield a mixed bag, with some numbers beating expectations and some not. Thus, Apple's earnings report on January 26, 2016, delivered an earnings per share that was higher than expected but revenue and iPhone unit numbers that were lower than anticipated.
2. Whose expectations? News stories about earnings reports, like this one, almost always conflate analyst estimates with market estimates, but that may not always be correct. It is true that analysts spend a great deal of their time working on, finessing and updating their forecasts for the next earnings report, but it is also true that most analysts bring very little new information into their forecasts, are overly dependent on companies for their news and are more followers than leaders. To the extent that companies play the earnings game well and are able to beat analyst forecasts most or even in all quarters, the market seems to build this behavior into a "whispered earnings" number, which incorporates that behavior. 
3. Effect of surprise: The market reaction to a surprise is also unpredictable, passing through what I call the market carnival or magic mirror, which can distort, expand or shrink effects, and three factors come into play in determining that image. The first is the company's history on on delivering expected earnings and providing guidance. Companies that have consistently delivered promised numbers and provided credible guidance tend to be cut more slack by markets that those that have a history of volatile numbers or stretching the truth. The second is the investor base acquired by the firm, with the mix of investors and traders determining the price response. On a pricing stock, it is traders who dominate the action and the market response is therefore usually more volatile, whereas on a value stock, it is investors who drive a more muted market reaction. The third has less to do with the company and more to do with the market mood. In a month like the last one, when fear is the dominant emotion, good news is oft overlooked or ignored, bad news is highlighted and magnified and the price reaction will tilt negative.

Earnings Reports: The Value Game

It is difficult to characterize the value game, precisely because it is played so differently by its many proponents. Some old-time value investors' concept of value is tied to dividends and other value investors are more open to expanding their measures of cash flows. To me, the one area where there should be agreement across investors is that every good intrinsic valuation should be backed by a narrative that not only provides structure to the numbers in the valuation, but also provides them with credibility. As I noted in this post from August 2014, it is this framework that I find most useful, when looking at earnings reports and I capture the "value" effect of earnings reports in this picture:

If you accept the notion that value changes when your narrative changes, the following propositions follow:

1. An earnings report can cause big change in value: For an earnings report to significantly affect value, a key part or parts of the narrative have to be changed by an earnings report. This could be news that a company has entered and is growing strongly in a market that you had not expected it to be successful in or on the flip side, news that the market that you see it is in is smaller and/or growing less than anticipated. 
2. Big value changes are more likely in young companies: These significant shifts in value are more likely to occur with young companies than where business models are still in flux than with more established firms. Consequently, you should not be too quick in classifying a big price move on an earnings report as a market overreaction, especially with young firms like GoPro and Linkedin.
3. There is more to an earnings report than the earnings per share: The relentless focus on earnings per share can sometimes distract investors from the real news in the earnings report which can be embedded in less publicized numbers on product breakdown, geographical growth or cost patterns.

If you believe, like I do, that investing requires you to constantly revisit and revalue the companies that you have or wish you to have in your portfolio, new earnings reports from these companies provide timely reminders that no valuation is timeless and no corporate narrative lasts forever.

The Rest of the Story

This post has gone on long enough, but it will be the first in a series that I hope to do around earnings reports, built around four topics.

1. Make it real: In the first set of posts, I will be looking at a few companies that I have valued before. I will start by looking at two companies, dueling for the honor of being the largest market cap company in the world, Alphabet (Google) and Apple, seemingly on different trajectories at the moment. I will follow up with Amazon and Netflix, two firms that are revolutionizing the entertainment business and were among the very best stocks to invest in last year. In the third post, I will turn my attention to two social media mainstays, one of which (Facebook) has unlocked the profit potential of its user base and the other (Twitter) that has (at least so far) frittered away its advantages. In the final post, I plan to pay heed to two high flyers, GoPro and Linkedin, that have hit rough patches and lost large portions of their value, after recent earnings reports.
2. The Players: In the second set of posts, I will first focus on investors and traders and how they might be able to play the earnings game to their advantage, often using the other side as foil. I will then examine how corporations can adapt to the earnings game and look at different strategies that they use for playing the game, with the pluses and minuses of each. 
3. The Government/Regulators/Society: In the final post, I will play a role that I am uncomfortable with, that of market regulator, and examine whether as regulator, there is a societal or economic benefit to trying to manage how and what companies report in their earnings reports and the investor reaction to these reports. In the process, I will look at the debate on whether the focus on delivering quarterly earnings diverts companies from a long term focus on value and how altering the rules of the game (with investor restrictions and tax laws) may make a difference.

YouTube Video

Blog posts in this series

1. A Violent Earnings Season: The Pricing and Value Games
2. Race to the top: The Duel between Alphabet and Apple!
3. The Disruptive Duo: Amazon and Netflix 
4. Management Matters: Facebook and Twitter
5. Lazarus Rising or Icarus Falling? The GoPro and LinkedIn Question!
6. Investor or Trader? Finding your place in the Value/Price Game! (Later this year)
7. The Perfect Investor Base? Corporation and the Value/Price Game (Later this year)
8. Taming the Market? Rules, Regulations and Restrictions (Later this year)

January 2016 Data Update 8: Pricing, with an end of month update

If you have been tracking the posts that I have about my data updates, you probably noticed that early on, I had planned eight posts but that this shrunk to seven by the time I was done. The reason was that the last post that I was planning to make was going to be on pricing numbers, i.e., the multiples that companies are trading at around the world, relative to book value and earnings. However, as the market dropped in January, I decided that posting the PE and EV/EBITDA multiples from January 1, 2016, would be pointless, since the numbers would be dated. I was also considering a post on the stock market turmoil during the month, and during the weekend, I decided that I could pull off a combined post, where I could look at both the pricing on January 1, and how it has changed during January 2016, by region, country and sector.

The US story, as told through the ERP

In my very first post this month, I looked at the equity risk premium for the S&P 500 on January 1, 2016, and estimated it to be 6.12%, based on dividends and buybacks over the last 12 months. I noted my discomfort with the fact that the cash returned in those twelve months exceeded the earnings, and estimated a buyback adjusted ERP of 5.16%, with buybacks reduced over time to a sustainable level. As in prior volatile months, I computed the ERP at the end of each trading day, using both measures of cash flows (trailing 12 months and modified to reflect earnings). The numbers are in the table below:

Download spreadsheet

The ERP rose about 0.60% (on both measures) during the month to peak on January 20, though it dropped back again in the last few days of the month. It is true that I left the cash flows and growth periods unchanged over the trading days, and that the bad news of the month may reverberate, with lower buybacks and growth expectations in the coming months. thus, the increase in the ERP is exaggerated, but, in my view, the bulk of the change will remain. The essence of a crisis month, like this one, is that the price of risk will increase during the month.

The Five Trillion Dollar Heist: Who did it?

The month started badly, with the Chinese markets dropping on the first trading day of the year and taking other markets down with them. Much of the month followed in the same vein, with extended periods of market decline followed by strong up days. Oil and China continued to be the market drivers, with oil prices continuing their inexorable decline and news of economic slowdown from China coming in at regular intervals. The damage inflicted during the month is captured in the chart below:

The global equity markets collectively lost $5.54 trillion in value during the month, roughly 8.42% of overall value. The global breakdown of value also reflects some regional variations, with Chinese equities declining from approximately 17% of global market capitalization to closer to 15%. To the question of how the month measures up against the worst months in history, the good news is that there have been dozens of months that delivered worse returns in the aggregate. In fact, the US equity market's performance in January 2016 would not even make the list of 25 worst months in US market history, all of which saw double-digit losses or worse or even the 50 worst month list. 

Whodunnit? Surveying the Regional Damage

As you can see in the pie chart, the pain was not inflicted equally across the world. China was the worst affected market and the details of the damage by region are captured in the table below. 

Country Performance Spreadsheet

Not only did mainland Chinese stocks lose more than 20% of their market capitalization, more than 75% of all stocks in that country dropped more than 10% and 59% dropped by more than 20%; Hong Kong listings fared a little better, but still managed to come in second in the race for worst regional market. Indian and Japanese stocks were hard hit, but the rest of Asia (small Asia) did not do as badly. Among the developed markets, Australia was the worst affected but the UK, US and EU regions saw market capitalizations drop by 6-7%. 

If you are a knee-jerk contrarian, you may be tempted to jump into the Chinese market, especially since mainland Chinese stocks traded at 15.73 times earnings, on January 31, 2016, down from 20.28 times earnings at the start of the month, and Hong Kong based Chinese stocks look even cheaper. In the global heat map below, you can look up how stock markets fared in each country during January 2016 and pricing multiples at which equities are trading at the end of the month. 

via chartsbin.com

The Sector Effects

Just as the market damage varied across countries in January 2016, it also varied across industry groupings. Using my industry categorization, I looked at the change in market capitalizations, by industry, and key pricing multiples (PE, Price to Book, EV to EBITDA, EV to Invested Capital) at the start and end of January 2016. The entire list can be downloaded at this link, but the fifteen industries that fared the worst, in terms of drop in market capitalization, are listed below:

Industry Spreadsheet

The biggest surprise, given the news about continued drops in oil prices, is that none of the oil groupings (I have four) showed up on the list, with integrated oil companies dropping only 4.20%  and oil distribution companies dropping 8.93% during the month. Not surprisingly, there are a host of cyclical companies on this list, but biotech and electronics companies also suffered large drops in value. Looking at the fifteen industries that fared the best during the month, tobacco topped the list, as one of the three industries that managed to post positive returns, with utilities and telecom services being the other two. 

Precious metals did well, reflecting the tendency of investors to flee to them during crisis, but most of the rest of the list reflects industries that sell the essentials (food and household products, health care).

Where next?

As investors, we often feel the urge to extrapolate from small slices of market history, and I am sure that there will be some who see great significance in the last month's volatility. They will dredge up temporal anomalies like the January effect to explain why stocks are doomed this year and that if Denver wins the Super Bowl, it is going to be catastrophic for investors. I am not willing to make that leap. What I learned from January 2016 is that stocks are risky (I need reminders every now and then), that market pundits are about as reliable as soothsayers, that the doomsayers will remind you that they "told you so" and that life goes on. I am just glad the month is over!

Datasets

1. ERP by day for the S&P 500 with ERP spreadsheet, if you want to do it yourself.
2. Industry Price Performance (with multiples before and after)
3. Country Price Performance 

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

Corporate Finance 101: A Big Picture, Applied Class!

In my last seven posts, I played my version of Moneyball with company data from the end of 2015, looking at how companies invest their shareholders' money, how much they borrow and the determinants of how much cash they return to stockholders. That structure is the one that underlies the corporate finance class that I have taught every year since 1984, the first two years at UC Berkeley, and the last 30 years at the Stern School of Business. Each semester, for the last few years, I have also invited you, even if you are not a Stern MBA student, to follow the class online, if you so desire, in all its gory details. If you are considering this options, I thought it would make sense to take you on a mini-tour of corporate finance, as a discipline, and how I aim to tackle it in this class.

Corporate Finance: The Big Picture

There are many versions of corporate finance that are taught in class rooms. There is the accounting version of corporate finance, that uses the historical, rule-bound construct of accounting as the basis for corporate finance. Decision making is driven by accounting ratios and financial statements, rather than first principles. There is the banking version of corporate finance, where the class is structured around what bankers do for firms, with the bulk of the class being spent on areas where firms interact with financial markets (M&A, financing choices) and the focus is less on what's right for the firms, and more on how the deal making works. My version of corporate finance is built around the first principles of running a business and it covers every aspect of business from production to marketing to even strategy. In case you are skeptical about the big picture version of this class, here is what it looks like:

All of corporate finance boils down to three broad decisions, the investment decision, which looks at where you should invest your resources, the financing decision, where you decide the right mix and type of debt to use in funding your business and the dividend decision, where you determine how much to hold back in the business (as cash or for reinvestment) and how much to return to the owners of the business.

Applied, not Theory

I find theory for the sake of theory to be arid, and I build my classes around a very simple proposition: if it cannot be applied, I don't talk about it. That application focus may put you off, but my class is essentially the equivalent of a corporate finance lab, where when I introduce a model or a hypothesis,  I get to try it out on real companies in real time. I use six companies through the entire class to illustrate both the theory and how its application can vary across companies:

Thus everything I do in the class, from estimating hurdle rates to determining finance mix to assessing dividend policy, I try on Disney (a large, US, entertainment firm), Vale (a global mining company, based in Brazil, with a government interest in it), Tata Motors (an India-based auto company, part of a family group), Baidu (a Chinese search engine company, traded as a shell company on the NASDAQ), Deutsche Bank (a messy, money center bank, with regulatory constraints) and a small privately owned bookstore in New York City (owned by a third-generation owner).

The Class Structure

The class starts on February 1, with a session from 10.30 to 11.50, and continues through May 9, with sessions every Monday and Wednesday, with a break week starting March 14. The lectures are supplemented with slides and my book on applied corporate finance, with the latter being completely optional, since you can live without it.  The calendar for the class is at this link.

There will be three 30-minute quizzes in the class, each worth 10%, spread out almost evenly across the first 22 sessions, and each quiz will be non-cumulative, covering only the 6-7 sessions prior. In keeping with my view that this is not about memorizing equations and formulas, the quizzes will be open books and open notes. There is a two-hour final exam, which is cumulative and will be after the final session  in May that will account for 30% of the grade.

There will be two projects, with the first being an investment case (that I have not written yet) that will make you decide on whether to make a big investment or not (Apple in the electric car market, Google buying Twitter etc.) and the second being a semester-long exercise of trying every aspect of corporate finance on a company of your choice.

The Online Version

If you are in my class, there is little more to be said, since I will see you in class on Monday. If you are not, you can still partake in almost all of the class. The lectures will not be carried live, but will be recorded and the webcasts should be up by late in the day, Mondays and Wednesdays, through the entire semester. You can find those webcasts in one of three forums:

1. My website: The links to the webcasts, as well as links to my other material (lecture notes, handouts, even emails to the class) can be found at this link. 
2. iTunes U: If you prefer a more polished format, I will also be putting the class online on iTunes U, the app that you can download from the Apple store for any Apple device. The link to the class is here and if already have Apple iTunes U installed on your device, you can add this class with the enroll code of EPF-JFH-SHE. 
3. YouTube Playlist: I will also be putting the classes up on a playlist on my YouTube account. With each session that I put up, I will also add links to the lecture notes used in the session and additional exercise. 

Not only can you watch the lectures and review the notes, you can also try your hand at the quizzes and final exam, when they are given. I will post the exams, after the class has taken them, online and  I will post the solution, with the grading template that I used in class. You will be your own grader and may be tempted to go easy on yourself, but that's your choice. You can even do the case and the project, but I will unfortunately not have the resources to review or grade either. The good news is that none of this should dent your pocket book, but the bad news is that you will not get class credit or a certificate.

Alternative Routes

Each semester, I know that quite a few people start with my classes, but life very quickly gets in the way. One of the problems of online classes is that without the discipline of having to get to a physical class or concern about credit/grades, it is difficult to persevere to the end. I entirely understand this problem and if, after trying one or two classes or even a few, you decide that your life is too full for more stuff to be added on. I do have a few suggestions, if you still feel that you will gain from the class:

1. Stretch it out: The class will stay online on all three forums for at least a year or two. Thus, you can stretch out the class to match your time schedule, instead of taking it in calendar time. I had at least three or four people completing the Spring 2012 class, last year.
2. Online Corporate Finance class: If you find the 80-minute class sessions that make up this class unendurable, I do have a compressed version of the class, where I take each session and do it in 10-15 minutes, instead of 80 minutes. In a testimonial to how much we bulk up college classes, it was not that tough to do and you can find it on my website at this link, on iTunes U at this one or on YouTube at this one.
3. Executive Corporate Finance class: I just completed a three-day corporate finance class for executive MBAs that is only a mildly compressed version of my regular class and you can find the links to the webcasts for that class on my website.

The End Game

I know that some of you may wonder what the catch is and where I plan to hit you up for fees. While you search for my hidden agenda, I have only one request of you. If you find any of the material in these classes to be useful to you, rather than thank me for it, please pass the favor on, by helping someone else learn, understand or do something. Not only will you get far more out of this simple act of kindness than the person that you offer it to, but I hope that you will also get a sense of why teaching is its own reward.

YouTube Intro to Class


Class links (Spring 2016 MBA class)

1. My website
2. iTunes U
3. YouTube Playlist

Lecture Notes for Class

1. Syllabus and Project
2. Lecture Note Packet 1
3. Lecture Note Packet 2

 Book if you want it

1. Applied Corporate Finance, 4th Edition (Warning: It is obscenely over priced but there is not much that I can do about it. Sorry!)

January 2016 Data Update 7: Dividends, Potential Dividends and Cash Balances

In the last six posts, I have tried to look at the global corporate landscape, starting with how the market is pricing risk in the US and globally, how much investors are getting as risk free returns in different currencies and then moving on to differences across companies on the costs of raising funding (it varies by sector and region),  the quality of their investments (not that good) and their indebtedness (high in pockets). In this, the last of these posts, I propose to look at the final piece of the corporate finance picture, which is how much companies around the world returned to stockholders in dividends (and stock buybacks) and by extension, how much cash they chose to hold on for future investments. 

Dividends, Potential Dividends and Cash

Dividend policy is often the ignored step child of corporate finance, treated either as an obligation that has to be met by companies or as a sign of weaknesses by those who believe that companies exist only to build factories and invest resources. The reality is that dividends are a central reason for investing and unless cash gets returned to investors, and I am willing to expand my notion of dividends to include buybacks, there is no real payoff to investing. That said, the question of how much a company can pay in dividends is affected in most businesses, by investing and financing choices. If equity is a residual claim, as it is often posited to be, dividends should be the end-result of a series of decisions that companies make:

If  you accept the logic of this process, companies that have substantial cash from operations, access to debt and few investment opportunities should return more cash than companies without these characteristics.

In practice, the sequencing is neither this clean, nor logical. Dividend policy, more than any other aspect of corporate finance, is governed by inertia (an unwillingness to let go of past policy) and me-too-ism (a desire to be like everyone else in the sector) and as a consequence, it lends itself to dysfunctional behavior. In the first dysfunctional variant, rather than be the final choice in the business sequence, dividends become the first and the dominant part driving a business, with the decision on how much to pay in dividends or buy back in stock made first, and investment and financing decisions tailored to deliver those dividends. 

Not surprisingly, dividends then act as a drain on firm value, since companies will borrow too much and/or invest too little to maintain them.  In a diametrically opposite variant, managers act as if they own the companies they run, are reluctant to let go of cash and return as little as they can to stockholders, while building corporate empires.

These companies can afford to pay large dividends, choose not to do so and end up, not surprisingly, with huge cash balances. It is worth noting that the corporate life cycle, a structure that I have used repeatedly in my posts, provides some perspective on how dividend policy should vary across companies.

Dividend Policies across Companies

As with my other posts on the data, I started by looking at the dividends paid by the 41,889 companies in my sample, with an intent of getting a measure of what constitutes high or low dividends. So, here were go..

1. Measures of dividends: There are two widely used measures of dividends. The first when dividends are divided by net income to arrive at a dividend payout ratio, a measure of what proportion of earnings gets returned to stockholders (and by inversion, what proportion gets retained in the firm). The distribution of dividend payout ratios, using dividends and earnings from the most recent 12 months leading into January 2016,  is captured below:

Source: Damodaran Online

Note that more firms (23,022) did not pay dividends, than did (18,867), in 2015. Among those companies that paid dividends, the median payout ratio is between 30% and 40%.

The other dividend statistic is to divide dividends paid by market capitalization (or dividends per share by price per share) to estimate a dividend yield, a measure of the return that you as a stockholder can expect to generate from the dividends, on your investment. The rest of your expected return has to come from price appreciation. Again, using trailing 12-month dividends leading into and the price as of December 31, 2015, here is the distribution:

As with the payout, the yield is more likely to be zero than a positive number for a globally listed company, but the median dividend yield for a stock was between 2% and 3% in 2015.

2. The Buyback Option: For much of the last century, dividends were the only cash flows that stockholders in corporations received from the corporations. Starting in the 1980s, US companies have increasingly turned to a second option to returning cash to stockholders, buybacks. From an intrinsic value perspective, buybacks have exactly the same consequences to the company making them, as dividends, reducing cash in the hands of the company and increasing cash in the hands of stockholders. From the stockholders' perspective, there are differences, since every stockholder gets dividends (and has to pay taxes on it) while only those who sell their shares back get cash with buybacks, but leave the remaining stockholders with higher-priced stock. In the table below, I look at the proportion of the cash returned that took the form of buybacks for companies in different regions in the twelve months leading into January 2016:

While it is true that US companies have been in the forefront of the buyback boom, note that the EU and Japan are not far behind. Buybacks are not only here to stay, but are becoming a global phenomenon.

3. The Cash Balance Effect: Any discussion of dividends is also, by extension, a discussion of cash balances, since the latter are the residue of dividend policy. In this final graph, I look at cash balances at companies, as a percent of the market capitalizations of these companies. 

You may be a little puzzled about the companies that have cash balances that exceed the market capitalizations, but it can be explained by the presence of debt. Thus, if your market capitalization is $100 million and you have $150 million in debt outstanding, you could hold $150 million of that value in cash, leaving you with cash at 150% of market capitalization.

Industry Differences: The Me Too Effect

If a key driver of dividend policy is a desire to look like your peer group, it is useful to at least get a measure of how dividend policy varies across industries. Using my 95 industry groups as the classification basis, I looked at dividend yields and payout ratios, as well as the proportion of cash returned in buybacks and cash balances, and you can download the data here. While there are many measures on which you can rank industries on dividend policy, I decided to do the rankings based on the cash balances, as a percent of market capitalization, because it is the end result of a lifetime of dividend policy. In the table below, I list the 15 industries that have the lowest cash balances, as a percent of market capitalization, in January 2016.

While this is a diverse listing, most of these industries are in mature businesses, where there is little point to holding cash and one reason for the low cash balances is that many of the companies in these sectors return more cash than they have net income.

At the other end of the spectrum are industries, where cash accumulation is the name of the game. Below, I list the 15 industries (not including financial services, where cash has a different meaning and a reason for being) that had the highest cash balances as a percent of market capitalization.

In a few of these businesses, such as engineering and real estate development, the cash balances may reflect operating models, where the cash will be used to develop properties or on large projects and is thus transitional. There are other businesses, such as auto, shipbuilding and mining, where managers may be using cyclicality (economic or commodity) as a rationale for the cash accumulation. The ratio may also be skewed upwards in highly levered companies, since market capitalization is a smaller percent of overall value in these companies.

Regional Differences
If me-tooism is the driver of why companies in a sector often have similar dividend policies, can it also extend to regions? To examine that question, I started by looking at dividend statistics, by region:

Companies in Australia, Canada and the UK returned more cash collectively, in dividends, than they generated in net income, a reflection of both tax laws that favor dividends and a bad year for commodities (at least for the first two). Japanese companies are cash hoarders, paying the least in dividends and holding on to the most cash. Indian companies are cash poor on every dimension, paying little in dividends and having the least cash, as a percent of market capitalization, of any of the regional groupings. Finally, while much has been made about how much cash has been accumulated at US companies (about $2 trillion), the cash balance, as a percent of market capitalization, is among the  lowest in the world. Absolute values are deceptive, since they will skew you towards the largest markets.

I also computed dividend statistics (dividend yield, cash dividend payout, cash return payout and cash as a percent of market capitalization) by country and plotted them on a heat map:

via chartsbin.com

Note that in some of these countries, the sample sizes are small and the statistics have to be taken with a lot of salt.

The Bottom Line

For both managers and investors, dividends are more than just a return of cash for which companies have no use. Dividends become a divining rod for the company's health, a number that companies stick with through good times and bad and one that has its roots in imitation more than fundamentals. Consequently, companies often get trapped in dividend policies that don't suit them, either paying too much and covering up the deficit with debt and investment cut backs or paying too little and accumulating mountains of cash.

Datasets

1. Dividends, Buybacks and Cash Balances - By industry in January 2016
2. Dividends, Buybacks and Cash Balances - By industry in 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