META Lesson 1: Corporate Governance

As we get deeper into earnings season for the third quarter of 2022, the biggest negative surprises are coming from technology companies, with the tech giants leading the way. Investors, used to a decade of better-than-expected earnings and rising stock prices at these companies, have been blindsided by unexpected bad news in earnings reports, and have knocked down the market capitalization of these companies by hundreds of billions of dollars in the last few weeks. Facebook (or Meta, if you prefer its new name), in particular, has been in the eye of the storm, down more than 75% from the trillion-dollar market capitalization that it enjoyed just over a year ago. In its last earnings report, the company managed to disappoint almost every segment of the market, shocking growth investors with a drop in quarterly revenues, and value investors with a sharp decline in earnings and cash flows. In the days after the report, the reaction has predictably fallen into the extremes, with one group arguing that this is the beginning of the end for the company's business and the other suggesting that this is the time to buy the stock, as it prepares for a new growth spurt. 

Having valued and invested in Facebook multiple times in the last decade, I will throw my two cents in, but rather than make the earnings report the center of attention, I will use the company's recent travails to talk about three issues that I think are big issues not only at Facebook, but for the entire market. In this first post, I will use the investor debate about Facebook to talk about  corporate governance, what it is, why it matters and how I think governance disclosure research, rules and scoring services have lost the script in the last two decades. In the next post, I will use Facebook's most recent earnings surprise to talk about inconsistencies in how accountants categorize corporate spending, and why these inconsistencies can skew investors perceptions of corporate profitability and financial health. In the third and final post, I will argue that Facebook's troubles with the market have as much to do with a failure of narrative, as they are about disappointing numbers, and present a template for what the company needs to do, to reclaim the high ground.

Facebook: Filling in the Background

   It is worth noting that in good times, when earnings are rising and stock prices are upward bound, investors do not seem to have much interest in corporate governance, and it is only when the numbers start to move against them, that they rediscover the importance of the topic. To understand why talk about corporate governance at Facebook has been muted for much of its corporate life, and why it is a prime topic of conversation now, let's retrace Facebook's journey, over the last decade, from a young VC-backed private company to a high-profile public company.

The Market Journey

    Facebook is a young company, at least in chronological time, having been public for just over a decade. I have written about the firm many times, over that period, starting with a valuation that I did of the company in 2012, just ahead of it going public. On May 12, 2012, Facebook's debuted in financial markets, with a capitalization of $104 billion, making it one of the most valuable IPOs of all time. After a rough start, with its stock price halving by August 2012, the company embarked on an extraordinary run in markets, adding almost $900 billion to its market capitalization to briefly breach a trillion dollars in July 2021. In a post in 2020, I highlighted how much of the increase in US equity values in the 2010-2019 decade was because of the FANGAM stocks (Facebook, Amazon, Netflix, Google, Apple and Microsoft):

Since July 2021, Facebook's market standing has fallen precipitously, with its market capitalization down to less than $250 billion (down more than 75% from its high) on October 27, after its most recent earnings report. As Facebook's market capitalization has collapsed, it is worth stepping back and gaining perspective about its market performance in the long term. 

• Buy and hold returns: If you had bought shares in Facebook on its first trading day, you would have paid $38.12, and if you had held the stock through October 27, 2022, when it was trading at $93/share, that would have translated into a cumulative return of 144%. That would have left you lagging the 181% price appreciation that you would have earned on the S&P 500 during the period, and even more so, if you consider the fact that you would have earned no dividends on Facebook, while generating about a 2% dividend yield, every year on the index.
• Current standing: At a roughly $250 billion market capitalization, Facebook is a large market-cap company, but it has lost its standing among the largest market cap companies in the world that if occupied for an extended period during the last decade. 
• Trader's game: Along the way, Facebook has had its ups and downs, and a savvy trader who was able to time entry and exit into the stock at the right times, would have made a killing on the stock. I know that can be said of any stock, but the swings in fortune are much greater at companies like Facebook, making them them the preferred habitat for traders of all stripes.

In sum, the investor experience with Facebook over the last decade should be a cautionary note on passing judgment on companies after short periods, where the stock soars or sinks, sometimes for no good reasons. 

The Operating Journey

    The drop in Facebook's stock price that has occurred in 2022 is part of a larger story of a decline in tech companies during the year. For many value investors, the tech stock drop has been vindication that no sector, no matter how favored, can fight gravity in the long term, but they would be making a mistake if they bundle Facebook in with younger tech companies, many of which have unformed business models and an inability to be profitable. Through its entire life, one of Facebook's most impressive features has been its capacity not only to generate profits but very large profits, as you can see in the chart below:

Note that Facebook, then it went public, had revenues of only $3.7 billion, but it generated an operating margin of 47.3%, with its online advertising model. In the decade since, its has been able to scale up revenues dramatically, with revenues reach $118 billion in 2021, while preserving sky-high margins, close to 40% in 2021. In short, Facebook has been a profit and cash machine for its entire public market life, and there is more to this company than traders pushing up stock prices on momentum. 

    It is this historical context of high growth, albeit slowing as the company scales up, and consistently high operating margins, that should explain investor reactions to last week's earnings report. There were at least two negative surprises in the report that led to investor reassessment:

1. Flat revenues: While revenue growth has been slowing in recent quarters, and investors would perhaps have lived with single digit growth, especially with advertising spending slowing, they were blindsided when the company reported its second consecutive year-on-year quarterly revenue decline . The company's contention was that the decline was driven by a slowing down in online advertising revenues at the firm, mirroring similar slowdowns at other online advertising platforms.
   
   
   That said, there is clearly more to it than an industry-wide slowdown, since the drop in revenues at Facebook has been larger than the drops seen across the sector; Google, for instance, reported a third quarter year-on-year revenue growth rate of 6% in October 2022.
2. Drop in operating margins: The bigger shock in the most recent earnings report, in my view, was the collapse in operating margins.
   
   
   While the decline in operating income in the first two quarters of 2022 mirror drops in revenues in those quarters, the decline in the third quarter cannot be explained by lower revenues in that quarter. The company attributed the decline in operating income to its Reality Labs unit, which houses its VR headsets, with reported revenues of $285 million and an operating loss of $3.67 billion in the third quarter of 2022. 

It is undeniable that the third quarter numbers for Facebook were disappointing, but again taking a longer term perspective, most companies would gladly switch places with Facebook, with revenues of more than $100 billion, and operating margins of 20%-30%. The question that we face now, as prospective investors, is whether the market has overreacted to a quarter's bad numbers or whether this is the beginning of the end for the company's core business model. 

The Troubles

    While 2022 has been a particularly difficult year for Facebook, the troubles at the company date back to 2018, when it was revealed that Cambridge Analytica, a UK-based data service with political clients, had acquired and utilized Facebook data on tens of millions of users. In the aftermath, Facebook faced both political and investing backlash, with its stock price dropping by more than 10% and there were some doomsayers who argued that its business model was irretrievably broken, because of the privacy challenges. At the time, I pointed to the hypocrisy of critics complaining about Facebook's privacy lapses on their Facebook pages, and argued that the company would weather the scandal, albeit with scars. In the months after, that view was vindicated as Facebook spent billions on tightening security, while continuing to grow revenues and report sky-high margins, and the market responded by pushing up its stock price once again.

    While Facebook was able to deal with the privacy challenge, relatively unscathed in economic terms, there are three other problems that the company is facing that will not be as easily overcome:

1. Online Ad Market Leveling off: Facebook is an online advertising company, and for much of its early years, it benefited from growth in the online advertising market, largely at the expense of traditional advertising (newspapers, television etc.). As online advertising approaches two-thirds of all advertising, that growth is now leveling off, and as one of the two largest players (and beneficiaries) of the market, Facebook is facing a growth crunch.
2. Online advertising is cyclical: As online advertising has grown over the last decade, one of the questions has been whether it, like all advertising historically, is cyclical. Prior to this year, there were some who argued that online advertising would be more resilient than traditional advertising, in the face of economic shocks, but this year's developments have shown otherwise.  As economic growth has slowed and concerns about a recession have risen, revenue growth has dropped at all of the companies in this space has declined. The conclusion is that online advertising is cyclical, and if we are in the midst of an economic slowdown, the companies in this space will feel the pain.
3. Reputation effects: While Facebook made it through the privacy challenges with revenue growth and profitability intact, it is undeniable that the company's reputation took a beating. In my view, this toxicity, as much as the desire to enter a new market in the Metaverse, explains why Facebook changed its name to Meta in November 2021. 

In fact, it is this trifecta of developments (a maturing online ad market, exposure to economic cyclicality and reputation damage), in conjunction with Facebook's disappointing operating numbers that has led investors to reassess its worth, and mark down its price. 

Corporate Governance

    As stock prices have dropped this year, not only is there an increased focus on earnings and cash flows, as I noted in my last post, but there seems to also be an reawakening among investors about the importance of corporate governance, as can be seen in this article about Facebook. Having seen these awakenings many times over the last 30 years, I am cynical that anything productive will come out of these discussions, since we seem to have lost sight of what corporate governance is and why it matters to investors.

The Stakeholders 

    To set the stage for understanding corporate governance, it is best to start with a recognition of the different stakeholders in a publicly traded company:

While all of these claim holders have stakes in the company, their interests will diverge, raising a key question of whose interests should be served by the managers of the company, when making business decisions, small or large. It is true that conventional corporate finance (and the Delaware courts) give primacy to shareholders, and it is not because shareholders are a special or protected group, but It is because they are the only claim holders that do not have a contractual claim on the firm; as shareholders you get what's left over after contractual claims (wages, interest expenses) have been met. Lenders can negotiate interest and principal payments and insert covenants to protect themselves, employees have employment contracts and sometimes unions to negotiate wages and benefits, and customers can choose to buy or not buy a company's products and services. 

    There is of course a notion that managers should be accountable to all stakeholders, not just stockholders, an idea that was born and nurtured in law schools, before finding a footing in business. In a 2019 post, I presented my arguments for why stakeholder wealth maximization is fanciful in its belief that it is management's job to juggle the divergent interests of different stakeholders and dangerous insofar as it makes managers accountable to everyone, and by extension, to no one. (Note that the G in ESG is about stakeholder governance, not shareholder governance, which may explain why CEOs have been so quick to jump on its bandwagon.)

Conflicts of Interests and Consequences

    If you are looking at a privately owned business, with a sole owner who also runs the business, the interests of owners and managers converge, but this is the exception, not the rule. Even in a family-owned business, where one family member runs the business, you can have other family members disagree about how it is run, leading to frictions and legal battles. (If you are a fan of Succession on HBO, you know exactly what I am talking about). As businesses seek external capital to grow, either from private hands (venture capitalists) or public equity, the divergence between the interests of those running businesses and the owners of these businesses will increase. That is the core challenge in corporate governance, and any discussion of the topic has to begin with answers to three questions:

1. In what types of firms is this conflict of interest greatest? If the conflict of interest that is at the heart of corporate governance is that between the owners of a business and those who manage that business, it will begin when private businesses seek out capital from external sources, as founder and venture capital interests can diverge. These conflicts will expand, as companies go first go public, and the interests of insiders and founders, who run the firm, can be at odds with the interests of outside shareholders. As companies age, founders will move on and get replaced by professional managers, and these managerial interests can clearly be at odds with those of shareholders, with boards of directors, in theory, watching out for the latter. In short, conflicts of interest exist at almost all businesses, though the nature of the conflict will change as companies go from private to public, and as they age.
2. When the interests of shareholders and corporate decision-makers diverge, what are the consequences for the company? When the interests of decision makers or managers at a business diverge from those of its owners, it is inevitable that there will be decisions made that advance the interests of the former at the expense of the latter. With private business that access venture capital, founders may make decisions (on product design, business models, marketing) that venture capitalists may not find to their liking. With public companies that are run by founders/insiders, the decisions made by inside shareholders to advance their interests may not align with the interests of outside shareholders. In older public companies, the investing, financing and dividend decisions that managers make may by in direct opposition to what shareholders would like them to do.
3. What are the checks on these conflicts of interest? In each of the scenarios described above, it is true that there are mechanisms that exist to keep these conflicts in check. In private firms with venture capital investors, VC investors are often actively involved in management, and, if they have the power, have few compunctions about pushing out founder/managers who don’t serve their interests. In public companies, with insiders and founders in charge, the only recourse that outside shareholders often have, if they feel their interests are being ignored, is to sell and move on, hoping that the resulting drop in stock prices causes a change in course. In theory, the boards of directors at these companies are supposed to protect shareholder interests, but that protection is sporadic and often ineffective.

In short, while corporate governance is often framed as being entirely about the conflicts of interests between managers and shareholders at companies with dispersed shareholdings, its reach is much broader, and it is relevant at almost every business.

The Essence of Corporate Governance

    After five decades of research in corporate governance, my sense is that we have lost the forest for the trees, with the composition of boards of directors and rules on proxy voting receiving disproportionate attention, from both legislators and regulators, often at the expense of bigger and more consequential issues. In the aftermath of the Enron and Tyco scandals in the United States, where insider-dominated boards were negligent in their oversight responsibilities, the Sarbanes-Oxley Act was passed in 2002, with improved corporate governance as one of its objectives. At about the same time, you saw the advent of services that used the disclosures that companies were required to make on governance to estimate corporate governance scores. We were told at the time that the combination of independent boards, increased disclosure and governance scores would create a revolution in corporate governance, where managers would act to advance shareholder interests. It is clear that twenty years later that all that Sarbanes Oxley has accomplished is replacing ineffective insider-dominated boards with ineffective independent boards, while creating hundreds of pages of disclosure that no one reads and giving rise to scores that are close to useless in judging governance. With the push towards diversity in board composition now taking precedence, this process is hurtling even more into irrelevance, with the only positive being that the ineffective boards of the future will meet all our diversity criteria.

    I believe that for a true shift in corporate governance to happen, we have to reframe the meaning of good corporate governance, shifting away from a board-centered, check-box driven view to one that is centered on giving shareholders the power to change company management, if they choose to. In fact, good corporate governance is like a good democracy, where shareholders (voters) get the power to change management (governments), when they believe that their interests are not being served. As in a democracy, there is no guarantee that shareholders will make the right or even informed choices, sometimes choosing not to make changes, even when change is required, and sometimes deciding to replace good managers with bad ones. Good corporate governance is sometimes chaotic and often unsettling, and it is no surprise that there are many who are drawn to the benevolent dictatorship model, where "qualified, well-intentioned managers" are given lifetime tenure, with shareholders stripped of the power to challenge them. That latter model was the default for publicly traded companies in much of the world, for the twentieth century, and even in the US, you had managerial apologists like Marty Lipton and corporate strategists arguing that corporate management would be more effective, without shareholder oversight. 

The "Right" Management: A Corporate Life Cycle Perspective

    If corporate governance is about giving more power to business owners to change management at the companies that they are invested in, if they choose to, to understand it, we have to begin by looking at why management change may be needed in the first place. I will use the corporate life cycle, a structure that I have used in many other contexts, to set the stage for this discussion, by noting that the qualities that you will look for in "good" management will change as companies move through the life cycle, from start-up to growth to mature and then on to final decline. In the figure below, I have highlighted the role that top management play at a business, and how that role will change as companies age. 

Early in the life cycle, as a start-up, the quality that you value most in your top management (and especially in your CEO) is vision, the capacity to tell the story of the business, and get investors and employees on board. As you move from idea to product, you still need vision, but it has been paired with pragmatism, and you would like the business to be run by someone who is willing to make compromises on design and strategy, to create a market for the product. The trash can of failed businesses is filled with purist founders who insisted on having their way, and refused to bend their dreams to meet reality. In the next phase, you need a CEO who is willing to do the work needed to build a business, an often unexciting job that requires attention to supply chains, marketing campaigns and product manufacturing. As businesses look to scale up, they are best led by opportunists who can seek out new markets that allow small businesses to become bigger, and once mature, you want an executive at the top who can play defense against competitors and disruptors. In decline, you need a realist who takes what the business has to offer, and does not try to overreach, in many ways the polar opposite of the visionary you sought out as a start-up.

Management Mismatches across the Life Cycle

    Understanding how the qualities that you look for in good management change, as the company changes, provides a framework for assessing why you can end up with management mismatches, where the managers running the firm are unsuited to running it. In some cases, it can happen because the business changes (from start up to young growth or from high growth to mature), but the person running it does not, will not or cannot change. In other cases, it can represent a hiring mistake, as is the case when the board of directors at a high growth firm seek out the CEO of a mature company, competent but risk-averse, to run their business.  In still others, it can just be hopeful thinking, where the board of directors at a declining firm seek out a visionary CEO, hoping that this hire can reverse aging and become young again. In the figure below, I have listed CEO/Company mismatches across the life cycle:

I also highlight the catalysts for management change at each stage.  In very young firms, it is disgruntled venture capitalists who pressure founders who, they believe, are not paying enough attention to business-building, to change their ways or even leave their positions. In publicly traded firms, the catalysts can be activist investors, who pressure businesses to change the way they are run or even who runs them, hostile acquirers, hoping for revamps, or private equity funds, with plans for liquidating or breaking up the firm.

Management Mismatch Consequences

    In most firms, even in the countries that are viewed as strong on corporate governance, there are barriers to change that are daunting, which explains why forced management changes are infrequent. Thus, venture capitalists may be stymied, when trying to replace founders, by the founders' controlling stakes. With high-growth firms that are publicly traded, insiders and founders holding large stakes can make it difficult for outside shareholders to push for charge, and as firms mature and age, it is the passivity of institutional investors that is the biggest impediment to change. 

    When a management mismatch persists, the consequences can range from the benign to very damaging:

In the most benign case, the mismatched manager recognizes his or her limitations and hires help to remedy them. In my view, the biggest difference between Steve Jobs in his first iteration at Apple, when his stubbornness damaged the company, and his legendary second stint at the company, was the presence of Tim Cook, as his chief operating officer. In an intermediate scenario, the board of directors eventually faces up to the reality of the mismatch, often because of poor stock price performance, and replaces the management, but not before serious damage has been done. In the most malignant scenario, the mismatched manager stays in place, destroying value and running the business into the ground, and perhaps into bankruptcy.

Corporate Governance at Technology Companies

    With that long lead-in on corporate governance, let's look at technology companies, partly because they are the largest sector in terms of market capitalization, and partly because this post is on Facebook, a large technology company. I will argue, using the life cycle structure, that tech companies age much faster than non-tech businesses, and are thus more exposed to management mismatches. Troublingly, it is precisely in these companies, where the need for corporate governance is greatest, that we (as investors) seem to have acquiesced to structures that give us the least power to push for change.

The Compressed Life Cycle

    A corporate life cycle resembles the human life cycle, in terms of its sequence, but there are two significant differences. The first is that the mortality rate is far higher in the corporate life cycle, as more than two thirds of businesses do not make it through the early stages, than it is for human beings, at least in the twenty first century. The second is that unlike the human life, the corporate life cycle does not follow chronological time. Kongo Gumi, a family-owned Japanese company in the business of constructing temples and shrines, lasted for almost 1500 years, before being acquired in 2006. In contrast, there are businesses that are shooting stars that survive for only 15 or 20 years, before liquidating or selling themselves. In the figure below, I look at the variables that determine  how quickly a business grows, how long it stays at the top and the speed of its decline:

Companies in businesses with low capital intensity and ease of access to the market and capital will grow much more quickly than businesses without these characteristics, but those same features will make it difficult for them to stay at the top for very long and accelerate their decline. That is the basis for a post that I wrote about why technology companies have compressed life cycles, relative to manufacturing or infrastructure companies:

Just to illustrate, the great companies of the twentieth century, such as Exxon Mobil, GE and Ford, might be looking at the declining phases of their life cycles now, but they have had extraordinarily long lives (Exxon was founded in 1859, GE in 1892 and Ford in 1903). In contrast, a company like Yahoo! was able to get from its founding in 1994 to a hundred-billion dollar market capitalization five years later, but its glory days lasted until 2004, when Google entered the game, and decline, once it started, was unstoppable, leading to its demise in 2017. (Marissa Mayer tried, but she never had a chance...)

    We believe that this compressed life cycle has consequences for management mismatches. With the long life-cycle companies that characterizes the twentieth century, companies and managers both aged over time, allowing for transitions to occur more naturally. To see, why consider how corporate governance played out at Ford, a twentieth century corporate success story. Henry Ford, undoubtedly a visionary, but a crank on some dimensions, was Ford's CEO from 1906 to 1945. His vision of making automobiles affordable to the masses, with the Model T (but only in black), was a catalyst in Ford's success, but by the end of his tenure in 1945, his management style was already out of sync with the company. With Ford, time and mortality solved the problem, and his grandson, Henry Ford II, was a better custodian for the firms in the decades that followed. Put simply, when a company lasts for a century, the progression of time naturally takes care of mismatches and succession. In contrast, consider how quickly Blackberry, as a company, soared, how short its stay at the top was, and how steep its descent was, as other companies entered the smartphone business. Mike Lazaridis, one of the co-founders of the company, and Jim Balsillie, the CEO he hired in 1992 to guide the company, presided over both its soaring success, gaining accolades for their management skills for doing so, as well as its collapse, drawing jeers from the same crowd. By the time, the change in top management happened in 2012, it was viewed as too little, too late. Put simply, if the companies that dominate the market today have compressed life cycles, relative to the companies of the last century, we should ready ourselves for far more cases of management mismatches.

The Investor Surrender

    If you accept my thesis that shorter corporate life cycles increase the likelihood of management mismatches at companies, it follows that we, as investors, need tools and processes that increase our power to change management at these firms. It is in this context that we have look back, with dismay at how willingly we have given away the power to create change at companies, and especially so at technology companies. While corporate governance measurement services and academics were obsessing over board composition and management compensation, companies have been changing the rules of the governance game, tilting power decisively away from shareholders, with little or no pushback. In the last two decades, US companies,  have increasingly turned to dual-class shares, with one class having significantly more voting rights than the other, and with founders/insiders holding these voting shares. You can see this phenomenon play out in the chart below, where I graph out the percentage of companies, going public with dual-class shares, each year from 1980 to 2021:

By 2021, almost a third of all companies going public had two classes of shares, with different voting rights, and that trend was even stronger at tech companies, where close to half of all companies, going public, had shares with different voting rights in 2021. 

    Facebook, which went public in 2012, followed this path when it issued class A shares to the public, with one voting right per share, while Zuckerberg and a few insiders kept class B shares, with ten voting rights per share. In the figure below, you see the breakdown of share holding in both class A and class B shares at Facebook:

Cutting to the chase, Zuckerberg controls 57% of the voting rights in the company, while owning only 13.52% of all outstanding shares, largely because he holds the bulk of the voting shares. Rather Han a corporate democracy, Facebook’s elections resemble those in authoritarian regimes, where you can vote for whoever you want, but the winner is pre-determined. (Just as an aside, I found a Facebook proposal to the SEC, thankfully stillborn, to create Class C shares with no voting rights, in 2017. That would have added insult to injury!)

    In short, shareholders have been disempowered at some of our largest and most valuable companies, and they have, for the most part, gone along. There is plenty of blame to go around, but the following culprits stand out:

1. Market-share seeking Stock Exchanges: For much of the last century, starting with a de facto ban in 1926 and a rule in 1940, the New York Stock Exchange barred companies listed on the exchange from  from issuing shares with different voting rights, and with its dominance over US equity markets, that became the rule followed by most US companies. The American Stock Exchange adopted slightly looser rules, hoping to get market share from the NYSE, but it was the NASDAQ that threw caution to the winds entirely and removed all restrictions on voting and non-voting shares. That proved to be a great business decision, since the largest tech companies of this century have not only listed on the NASDAQ, but chosen to stay there, but it came at the expense of shareholder powers.
2. Founder Worshippers: For the last few decades, we have glorified the founders of technology companies, and while there is much to admire in their accomplishments, there is a danger in putting them on pedestals and attributing to them heroic or superhuman qualities. In the case of companies like Google and Facebook, and especially so at the time of their public offerings, there were many investors, including some of the largest institutional players, that were willing to make the trade off of giving up power to change management in return for being invested in companies run by "young, tech geniuses". In fact, there are some researchers who were willing to argue that removing the threat of shareholder power made founder-run companies more valuable, because founders are smarter and think more long-term than investors. 
3. Lazy Investors: Much as we would like to blame others for our misfortunes, the truth is that get the corporate governance we deserve. Most of us, as investors, chose to give away our voting rights willingly because we wanted shares of the "next big thing", and at the time we did so, we rationalized it by arguing it that we would not need that voting power any time soon. I have little sympathy for the hand wringing and complaints from investors, institutional or retail, in Facebook that management is not listening to them. Investing in Facebook and complaining that Mark Zuckerberg will not listen to you is like getting married to one of the Kardashians and complaining that your privacy is being invaded.
4. Lax Regulators: For some of you reading this post, the villain is going to be the SEC and regulators, with the argument being that they could have protected you by banning dual class shares. I see your point, but remember that the inertia, laziness or me-tooism that led you to buy dual-class shares, will outlast the regulatory ban. Regulators cannot protect us from our own worst instincts!

There may not be much you can do about companies that have already adopted dual-class shares, but marking their prices down will make them pay attention. Who knows? Losing a chunk of their wealth may lead the founders who run some of these companies to reassess their positions on differential voting rights.

The Consequences

    If the essence of corporate governance is the giving shareholders the power to change management at companies, where there is a mismatch, and if those mismatches are more likely to occur at tech companies, where shareholders have unilaterally disarmed, there are predictable consequences:

1. Chaotic Management Transitions: It is true that we have made it more difficult to change management at tech companies, even when that change is overdue. That said, there will be tech companies where change will occur, but my prediction is that this change will often be forced by either insider in-fighting (where co-founders and insiders turn on each other) or precipitated by a pricing collapse. While Elon Musk’s acquisition of Twitter is one of a kind, the chaos that you are observing at the company is a precursor to changes that you will see at other tech companies in the years to come.
2. Locked-in Mismatches: There are other tech companies where the game has been so thoroughly tilted in favor of insiders and incumbent management that change is impossible. In these companies, as an outside investor, you have to build that reality into your valuations, leading to discounts to your value that reflect how much you trust management. In short, if management has adopted policies that are value-destructive, in the long term, there will be a much smaller chance of reversal at companies with locked-in management than at companies where change remains possible. In the case of Facebook, the company has clearly made a huge bet on the Metaverse, investing $15 billion in the most recent year and planning almost $100 billion in additional investments in the coming years. It is too early to pass judgment on whether these investments will pay off, but assume that the data that comes in over the next two years indicates that Facebook should scale back its investments and slow down. I would like to believe that Zuckerberg is too smart a businessman not to do the right thing, but the qualities that made him a successful founder (over confidence, stubbornness in the face of failure, arrogance) may very well keep him on his pre-determined path, and without checks and balances, Facebook will lose a lot more money over a longer period, before he gives in. 
3. Voting Share/Non-voting Shares: In a paper on valuing control from a  few years ago, I argued that the differential in prices between voting and non-voting shares will reflect the value of expected control in a company, and will be higher at companies where management change is plausible than in firms where it is unlikely. When tech companies go public, it is entirely possible that there will be a honeymoon period, perhaps even an extended one, where investors are dazzled by scaling successes and are willing to overlook shortcoming, when shares with different voting rights trade at the similar prices. As disillusionment sets in, I would expect voting share premiums to rise, and to rise more at those firms where investors trust managers the least.

As investors, should you avoid investing in tech companies with dual-voting right shares? If I said yes, I would be violating one of my own precepts, which is that I will buy any company, no matter what its faults, at the right price. You should avoid investing in these companies when they are priced on the presumption that their founder-managers can do no wrong, but as fear overcomes greed in markets, investors in these companies will start pricing in the worst-case scenarios, where founders continue with dysfunctional behavior in perpetuity, and at those prices, you may be getting bargains.  That is what I see happening, in 2022, at Facebook, in particular, and large tech companies, in general. It is the reason that having lost money on Facebook, since buying it in April, I will continue to hold it and I did add to my holdings, when the stock hit $100/share. I know that my Facebook investment will ride and fall with Mark Zuckerberg's ego, and while I have no delusions about being able to influence him, I think that at today's prices, the odds are in my favor. Time will tell!

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Earnings and Cash Flows: A Primer on Free Cash Flow

It is never pleasant to be in the midst of a market correction, but a market correction does operate as a cleanser for excesses that enter into even the most disciplined investors' playbooks in the good times. This correction has been no exception, as the threat of losing investment capital has focused the minds of investors, and led many to reexamine practices adopted during the last decade. In particular, there has been more talk of earnings than of revenue or user growth this year, and the notion of cashflows driving value seems to be back in vogue. As someone who believes that intrinsic value comes from expected cash flows, I find that development welcome, but I do find myself doing double takes when I see concoctions of free cash flow that violate first financial principles. While I understand that there is no one overriding definition of cash flow that trumps others, it is essential that we define what we mean when we talk about free cash flows, and get perspective on what companies look like, on these cash flow measures.

Free Cash Flows: The What and The Why!

    Free cash flow is one of the most dangerous terms in finance, and I am astonished by how it can be bent to mean whatever investors or managers want it to, and used to advance their sales pitches. I have seen analysts and managers argue that adding back depreciation to earnings gives you free cash flow, an intermediate stop, at best, if you truly are intent on computing free cash flow. In the last two decades, I have seen free cash flow measures stretched to cover adjusted EBITDA, where stock-based compensation is added back to EBITDA, and with WeWork, to community-adjusted EBITDA, where almost all expenses get added back to get to the adjusted value.  I will use this section to clarify what free cash flows are trying to measure, how they get used in investing and valuation, and the measurement questions that can cause measurement divergences.

What is Free cash flow (FCF)?

    I believe that any measurement of free cash flow has to begin with a definition of to whom those cash flows accrue. Since a business can raise capital from owners (equity) and lenders (debt), the free cash flows that you compute can be to just the equity investors in the business, in which case it is free cash flow to equity, or to all capital providers in the business, as free cash flow to the firm.    

In short, the free cash flow to equity is the cash flow that a business generates after taxes, reinvestment and debt payments (interest and principal). The free cash flow to the firm is a pre-debt cash flow, before interest payments and debt repayments or issuances, but still after taxes and reinvestment. An alternate way of describing free cash flow to the firm is that it measures the cash flows that would have been available for equity investors, if there were no debt in the firm, and it is for this reason that some call it an unlevered cash flow.

To measure free cash flows for equity, you have to define reinvestment and debt cash flows, and we do that below on the left.  Note that we start with net income, earnings that is already after interest expenses and taxes, and that we consider reinvestment in both short term assets (change in non-cash working capital) as well in long term assets (as the difference between capital expenditures and depreciation). To complete the calculation, we incorporate the cash inflows that equity investors receive when they issue new debt and the cash outflows from repaying debt. 

Since FCFF is a pre-debt cashflow, starting with net income which is after interest expenses would be inconsistent. Thus, we start with operating income or earnings before interest and taxes (EBIT) replacing net income. (I know that you can start with net income and add back after-tax interest expenses, but it leaves embedded other items that can create distortions in FCFF). The taxes that are netted out from operating income are not actual taxes paid (accrued or cash) but hypothetical taxes, on the assumption that all of operating income would be taxed, in the absence of interest expenses (since you are working as if you have no debt), but the reinvestment in long term and short term assets is identical to the calculation used for FCFE. 

Estimation of FCFE

    If you have to compute the FCFE for a firm, you can see that every item that you need for the calculation should be accessible in its statement of cash flows, and there seems to be little room for disagreement. However, you will wrestle with what items to include and which ones to exclude, when computing the FCFE for a firm. To illustrate, we have used the statement of cash flows for Microsoft for the 2021 fiscal year (from July 2020- June 2021) as the basis for computing its FCFE in the figure below:

Source: Microsoft Annual Report for FY 2021 (Year ended June 2021)

To estimate the FCFE, I start with net income and add back depreciation & amortization and non-cash gains reported during the year. I do not add back stock-based compensation, and will provide a rationale for why in the next section, but I do subtract out the changes in non-cash working capital (provided in broken down form in the cash flow statement, but consolidated in my FCFE calculation). I net out capital expenditures and cash acquisitions, as reported, to get to FCFE prior to debt of $41,901 million. Since Microsoft did not raise any new debt, while repaying $5,504 million in existing debt, the FCFE after debt cash flows is $36,397 million. Another way of presenting this FCFE is to consolidate the working capital, capital expenditure and depreciation items into a reinvestment number ($19,370 million) and net this reinvestment out of net income to estimate FCFE. Estimating the free cash flow to the firm will require leaving the confines of the statement of cash flows and obtaining two numbers from the income statement - the operating income for the company and its effective tax rate, computed as taxes paid divided by taxable income. For Microsoft, this would yield values of $69,916 million for operating income and an effective tax rate of 13.83% in 2021, resulting in a FCFF of $40,879 million in 2021.

As you can see, the FCFE and FCFF share a common foundation, insofar that they are both after taxes and reinvestment, but FCFE adds a layer of cash flows to and from debt that can sometimes make it higher than FCFF and sometimes lower.

Using Free Cash Flows

   While there are facile reasons that you can give for computing free cash flows, including the usual “we don’t trust accounting earnings” and  “cash is king”, calculating it does involve added computations and there are three contexts where free cash flows get used. The first is that is that computing free cash flows for a past period helps in explaining what happened at a business during that period, in operating, investing and financing terms. The second is that it is that the free cash flows that you compute for a past period can be used as the basis for forecasting expected free cash flows in the future, a key ingredient if you are doing intrinsic valuation. The third is to compute the free cash flow as a base to be used to compare pricing across companies, where the market price is scaled to free cash flow, rather than to earnings. Since each of these missions has a different end game, there can be consequences for how we estimate free cash flows in each one; put simply, the free cash flow you compute, if you just want to explain what a firm did last year, can be different from the free cash flow you compute as the base year number for intrinsic valuation, which, in turn, can be different from the free cash flow that you estimate, if you are computing a pricing multiple.

1. Explain the past

    It is true that when investing in a company, it is what happens in the future that will determine whether you make money, but it is also true that to make these future assessments, a good place to start is by understanding what that company has done in the past. Notwithstanding the mission bloat that has bedeviled accounting in the last few decades, where the notion of fair value has distracted accountants, explaining what a company has done in the past, and where it stands now remains the core mission that should animate financial statements. As a believer in cash flows, I have always gravitated to the statement of cash flows as the accounting disclosure that is least contaminated by accounting overreach and the one that best reflects the true operations of a business. 

Note that the statement of cash flows looks at cash flows through the eyes of equity investors, starting as it does with net income and working its way down through investing and financing cash flows, before concluding with an explanation of the change in the company’s cash balance. As you can see in my earlier computation of FCFE for Microsoft, every item that you need for the calculation is in the FCFE, with your key decisions becoming which items not to count (any cash flows to equity, investments in securities etc.) and which ones to include (cash acquisitions, foreign exchange gains or losses etc.)

An intuitive reading of the FCFE is that it is cash available to be returned to equity investors, either in the form of dividends or as cash buybacks. It is the rare firm that follows a residual cash policy, returning its FCFE every year as dividends and/or buybacks. Some firms hold back and return less than they can, for good reasons (buffer against future bad years, set aside to cover investment opportunities) as well as bad ones (managers/insiders control the cash, over priced acquisitions); when they do hold back, the difference adds to their cash balances. Others choose to return more cash than they should be, and funding the difference from cash balances accumulated in the past and in some cases, fresh equity issuances, again for good reasons (a cyclical or commodity company riding out a down phase of a cycle) and for bad ones (inertia, an unwillingness to cut dividends, me-tooism on dividend policy or buybacks).

Companies with negative FCFE start in a hole, and even if they do not return any cash, they will find themselves with declining cash balances and/or new equity issuances, and if they do choose to pay dividends or buy back stock, they will make the cash deficits bigger. This approach of computing FCFE and comparing it actual cash return can be a device that can explain how some companies end up with huge cash balances and why other companies, especially young and money losing, will be dependent on equity infusions to stay alive. 

One of the limitations of focusing of free cash flows to equity is that you can get tunnel vision, since borrowing money operates as a cash inflow, inflating free cash flow to equity. That can explain why a firm with moderate or even below-average profitability can use debt to fund large dividends and buybacks, and to the extent that the firm is borrowing too much, it can dig a hole for itself. Estimating free cash flows to the firm can alert you to this occurrence, since it is a pre-debt cash flow and new debt issuances or repayments cannot alter it. In fact, the free cash flows to the firm, while less intuitive, are the source of cash flows to all claim holders (lenders as well as equity investors):

Mapping out these cash flows can provide a big picture perspective on where a firm’s cash flows are coming from and going, as well as a better assessment of the operating health of its business. It can also provide advance warning of the company’s exposure to downside risk, since the cash flows to lenders (interest and debt payments) are contractually set.

2. Intrinsic Valuation

    In intrinsic value, the value of an asset, business or equity stake in a business is the present value of the expected cash flows on it. Thus, in intrinsic valuation, the free cash flows (to equity or the firm) that you compute for the most recent year or time period is never part of value, but is useful only because it provides a base for forecasting the future. The question of whether you should be estimating free cash flows to equity or to the firm cannot be answered until you decide whether you are valuing just the equity in a business or the entire operating assets of the business.

• If you are valuing just the equity, you’ll be estimate the free cash flows to equity in future years, and discounting back at the cost of equity, i.e., the rate of return that equity investors can make on other investments in the public market, of equivalent risk.
• If you are valuing all operating assets in a business, you will estimate free flows the entire firm or business, and discount these cash flows back to today at a weighted average of the costs of equity and debt, with the weights reflecting the proportions of each funding type.

The picture below provides the contrasting uses of FCFE and FCFF in valuation:

With either estimate of free cash flow, the end game is estimating the free cash flows in the future, and the way we compute free cash flows  can be different from when we computed free cash flow for explaining the past. Here are a few reasons why:

1. Unusual or Extraordinary items: When explaining last year’s cash flows, you should consider all items, even if they are one-time or extraordinary, since they are cash flows. However, if you are computing cash flows as a base for forecasting the future, you should eliminate any items that you don’t expect to recur in the future. Thus, a cash inflow from a one-time divestiture of a division or a cash outflow due to a loss in a lawsuit, though part of free cash flows last year, will be excluded, if you are computing a base-year free cash flow for estimating future cash flows.
2. Normalized vs Actual numbers: For items that are recurring, but volatile, there is a good case to be made that while you will use the actual values, if computing free cash flows for the most recent year, you should be normalizing them, though the methods you use for normalization can vary across items. With the change in non-cash working capital, a notoriously volatile item on a year-to-year basis, I have found that looking at non-cash working capital as a percent of revenues, and using that statistic to reestimate the change in non-cash working capital in the most recent year provides a better base year foundation. In the Microsoft FCFE calculation, shown in the earlier section, using the historical average of non-cash working as percent of revenues of -10.18% (average from 2012-21), would have yielded a change in non-cash working capital of -$2,552 million in the base year, making it a cash inflow, rather than the outflow of $1,086 million that we attributed to working capital that year. With cash acquisitions, where a company may do only one big acquisition every three or four years, taking a long time series and averaging acquistions over that period will yield a better recurring value.
3. Stock-based Compensation and Acquisitions: The most hotly discussed item in cash flow estimation is stock-based compensation, in the form of restricted stock or options. A simplistic reading is to argue that is non-cash and add it back, just as you depreciation and amortization, but stock-based compensation is not comparable. While depreciation and amortization are truly non-cash, stock-based compensation is more of an in-kind expense, where you give away shares of equity in the company instead of paying cash. If you are estimate free cash flows (to the firm or to equity), with the intent of valuing that firm, adding back stock-based compensation is equivalent to arguing that you can either stop paying employees in the future (and still hold on to them) or that you can keep giving away equity stakes in your company with no consequences for value per share. In short, there is no justification for adding back stock-based compensation to get to cash flows, and none of the numerous variants of adjusted EBITDA that you see populating annual reports or prospectuses holds up to scrutiny. Using the logic that paying for something with shares, instead of cash, still has an effect on free cash flows, we would argue that a company that plans to grow through acquisitions, using its own stock as currency, is reinvesting, and that this reinvestment should reduce expected free cash flows to equity, to existing shareholders. During the 2021 fiscal year, Microsoft bought Nuance Communications for $19.76 billion in all stock transaction, and that amount should be treated as reinvestment for the year, even though it is technically non-cash.
4. Taxes: With free cash flows to equity, you start with net income but that net income can be skewed up if the company had a low effective tax rate that year, either because of write offs or losses carried forward into that year, or down, if it faced an unusually high tax rate that year. With free cash flows to the firm, the effective tax rate plays an even more direct role in determining cash flows, when you use it compute your after-tax operating income. In both cases, it makes sense to leave the effective tax rate at its actual level, when computing free cash flows for the past, but to rethink that when your objective is to forecast future free cash flows. I would suggest looking at an average effective tax rate over a longer period, in computing the base year free cash flow, and then also targeting the marginal tax rate, as you forecast taxes for the future. In the Microsoft FCFF calculation, this would imply replacing the effective tax rate of 13.83% with an average effective tax rate of 22%, using the 2017-2021 time period, which would lower free cash flows to the firm.
5. Accounting Inconsistencies: I have written about the inconsistency in how accountants calculate capital expenditure at firms with significant investments in intangible assets and R&D, and that inconsistency can play out in your FCFE computation. While R&D remains a cash outflow, whether you treat it as an operating or a capital expenditure, moving it from operating to capital expenditures can alter your perception of a company's operations. In the case of Microsoft, for instance, capitalizing the $20,716 million that the company spent on R&D in 2021, will increase the net income for the company, while also raising the reinvestment by an equivalent amount. Put simply, Microsoft is much more profitable than the accounting statements lead you to believe, while reinvesting more than you thought it was, and both of those conclusions will have implications for valuation

In short, in intrinsic valuation, where your objective is get the best estimates that you can for the future, you have a great deal more flexibility and discretion in which items you include (and exclude) in computing free cash flows, and how you estimate values for those items. If you are wondering whether it makes enough of a difference to bother, consider what Microsoft's FCFE look like with all five adjustments made to them below:

The capitalization of R&D adds about $3.7 billion to net income, about $17 billion to depreciation and amortization and about $20.7 billion to cap ex, netting out to no effect on FCFE but with significant changes to profits and reinvestment. Incorporating the stock-based acquisition pushed up total reinvestment substantially, though the question of whether this should be built in as a recurrent component will depend on the story you tell about Microsoft.

Pricing

    The final arena where free cash flows can be used is in pricing, and more specifically, in scaling market price. Again, the question of which variants (FCFE or FCFF) can be used depends on whether you are using an equity pricing multiple (where the market cap or share price is in the numerator) or an enterprise value multiple (where it is the market value of operating assets in the numerator):

• With equity multiples, you can scale the market value of equity (or market capitalization) of a company to its free cash flow to equity, to estimate a Price to FCFE multiple, and offer it as an alternative to the much more widely used PE ratio, where market capitalization is scaled to net income. 
• With enterprise value multiples, you can scale enterprise value to FCFF, instead of using EBITDA or revenues as your scalar. Again, you could argue for the benefits of a more complete measure of cash flow, but as with FCFE, FCFF will be more volatile than revenues or EBITDA, making it difficult to pass pricing judgment. 

The logic that analysts use for the use of free cash flows is simple and seems compelling. If the value of a business is the present value of its expected cash flows, as we argue in intrinsic valuation, it seems reasonable to also argue that the free cash flow that a business generates is a better measure of its value than the accounting earnings. 

In sum, there is nothing inherently better about using free cash flows instead of earnings in a pricing setting, and you can argue that the additional volatility and loss of perspective that comes with free cash flow numbers yields worse pricing. I agree, with one caveat. Even if you choose to stay with PE ratios, as your pricing multiple, knowing how much of earnings gets reinvested back into the firm is a useful input in making your pricing judgments.

Free Cash Flows: Perspective

    With that long lead in on free cash flows, let us talk about why free cash flows vary across companies and across time. To make the connection, I am going to fall back on a structure that I have used before, the corporate life cycle, to look at the evolution of FCFE, as companies age, and use that structure to also examine how these FCFE play out as cash returned to shareholders, over time.

The Life Cycle Effect

    In a corporate life cycle structure, you trace a business from start-up (birth) to the toddler years (very young businesses) through their teenage years into middle and old age. I have found it useful in explaining why the focus of a business changes from finding investment opportunities, when young, to finessing capital structure, as middle age companies, to deciding how best to return cash to investors, in old age, as well as why the challenges you face in valuation are different for young companies than more mature businesses. The corporate life cycle also provides a framework for explaining how free cash flows evolve, as companies move through the life cycle:

Focusing on free cash flows to equity, you should expect to see negative values, early in the life cycle, as businesses struggle to make money and have to reinvest to deliver on their growth potential at the same time, and a resultant dependence on raising fresh equity capital (from VCs and public market investors) to keep going. As their business models take form, and they turn the corner on profitability, you should continue to see negative cash flows because of the need to reinvest to grow; in general, you should expect to see positive cash flows lag positive earnings. At mature businesses, you should expect to see free cash flows to equity to not only stay positive, but also to grow faster than earnings, and in decline, while earnings will follow revenues on their path down, divestitures and asset sales can allow FCFE to be higher than earnings. To see how net income and FCFE evolve, as a company ages, I computed the net income and FCFE for Tesla every year from 2006 to 2021:

Source: Capital IQ

For much of its existence, Tesla has been a money-losing company, reflecting its young, high growth status. It turned the profitability corner in 2020, though FCFE stayed mildly negative that year, and in 2021, the FCFE also turned positive. In corporate life cycle terms, Tesla is growing up, which is good news in terms of profitability and cash flows but bad news, if growth is what rings your bell.

To see if the corporate life cycle has relevance in explaining differences in free cash flows to equity across companies, I looked at US companies, broken down by age, into ten deciles, from youngest to oldest, and computed each component of the FCFE, by decile:

As you can see in the table, among the youngest companies (in the lowest decile), more than 73% are money-losing and more than three quarters of these companies have negative free cash flows to equity. As companies age, the proportion of companies that are money making increasing, as does the percent that has positive FCFE. In relative terms, the companies in the middle of the corporate life cycle, deliver the highest FCFE as a percent of market capitalization

Dividends and Buybacks

    You can critique FCFE as an abstraction, since shareholders cannot lay claim on them, and argue that it is only cash flows that are paid out to equity investors that count. You could focus just on dividends, but by doing so, you are missing a large proportion of cash returned by companies; in 2021, more than two thirds of all cash flows returned to shareholders were in the form of buybacks. Staying with the corporate life cycle construct, we looked at dividends and stock buybacks by companies in each age decile: 

Consistent with what we unearthed in the FCFE table, where younger companies are more likely to be money losing and have negative FCFE, we see that the a much higher percent of older companies pay dividends and buy back stock than younger companies. In the aggregate, this table suggests that it is the presence or absence of FCFE that drives dividend policy, with most firms that have negative FCFE choosing not to return cash and many that have positive FCFE deciding to return cash. 

Pricing

    Earlier, we noted that there are some analysts who use free cash flows, as a basis for pricing, than for intrinsic valuation, with price to FCFE replacing price earnings ratios in equity pricing, and EV to FCFF taking the place of EV to EBITDA multiples, in enterprise valuation. While there are some cash flow purists who prefer cash flow multiples to earnings multiples, they will never be widely used for two reasons. First, the reason that investors like to price companies, using multiples, is because they have frames of reference on these multiples, i.e., a sense of what a typical number should like like in a sector. With PE ratios, their long history of usage has left investors with frames of reference that they can use, rightfully or wrongfully, in pricing stocks, but with Price to FCFE ratios, there is no such reference frame. Second, as you can see from how FCFE is computed, with the netting out of reinvestment and incorporating debt cash flows, it will always be a more volatile number than earnings, with much of the additional volatility telling you little about current earnings power.

   If one problem with using a price to FCFE ratio to judge whether a stock is cheap and expensive is a lack of perspective on what comprises a high, low or typical value, we can counter this problem by estimating the price to FCFE ratio for every publicly traded company globally and compare the distribution of the ratio to distribution for PE ratios.

Source: S&P Capital IQ

The good news is that the distribution for price to FCFE resembles the distribution for PE ratios, but the bad news is that you are replacing a multiple where you lose almost half the firms in your sample, with PE ratios, with an even more flawed multiple in Price to FCFE, which cannot be calculated in more than 63% of publicly traded companies. Put simply, if you start with a peer group of 25 firms, you may end up with a final sample of 10 firms or less, if you are pricing with a price to FCFE multiple. Moreover, price to FCFE ratios show more divergence than PE ratios, as can be seen in the spread between the first and third quartiles of each one.

    I did the same assessment for EV to FCFF, with the contrast drawn to EV to EBITDA, both to see contrasts and get perspective:

Source: S&P Capital IQ

Not surprisingly, the multiple of EBITDA, a pre-tax and pre-reinvestment cash flows, is lower than the multiple of FCFF, which is post-tax and after reinvestment. While you lose about 42% of firms with EV to EBITDA multiples, where EBITDA is negative, you lose close to 55% of global firms, because of negative FCFF. 

    As a cash flow advocate, it pains me to say this, but if your game is pricing stocks, I see little benefit from replacing traditional multiples (like PE and EV to EBITDA) with free cash flow scaled pricing measures. That is because a single year’s free cash flow (to equity or the firm) actually has more noise in it, and is less informative about a company’s operating health, than a single year’s earnings (net income or EBITDA). 

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Reaping the Whirlwind: A September 2022 Inflation Update!

In my early 2021 posts on inflation, I argued that while the higher inflation that we were just starting to see could be explained by COVID and supply chain issues, prudence on the part of policy makers required that it be taken as a long term threat and dealt with quickly. Not only did they not do so, but the fiscal and monetary actions they took in 2021 exacerbated inflationary pressures. By the start of 2022, the window for early action had closed and for much of this year, inflation has been the elephant in the room, driving markets and forcing central banks to be reactive, and its presence has already induced me to write three posts on its impact. In my first on May 6, 2022, I put the surge in inflation, in 2022, in historical context and argued that it is unexpected inflation that shakes up the economy and caused damage to financial assets, and that until we reached a steady state, where expectations and actual inflation converge, markets would continue to be unsettled. In a follow-up post on May 20, I looked at the disparate effects of inflation on individual companies, positing that safer companies with pricing power are more protected against inflation than riskier companies in competitive businesses. In a third post on July 1, 2022, I pointed to inflation as a key culprit in the retreat of risk capital, i.e., capital invested in the riskiest segments of every market, and presented evidence of the impact on risk premiums (bond default spreads and equity risk premiums) in markets. In terms of content, I am afraid this post will contain nothing new, but the fresh uncertainties about inflation, and its impact, that have opened up this summer require at least an updating of the numbers. 

Inflation: Actual and Expected

In September 2022, there is no denying that inflation is back, and with a vengeance, though we can still debate how quickly it will fade, and to what level. The happy talk of 2021, where many policy makers and investors were dismissive of its emergence, attributing it almost entirely to the COVID recover and supply chain problems, has largely faded and a grim acceptance has set in that we have an inflation problem, the solution to which may be perhaps as painful as the problem. One reason investors and businesses are struggling with this latest bout of inflation is that they have been spoiled by a decade of low and stable inflation, and as a consequence, have neither planned for high and unstable inflation, in their business models, nor developed analytical tools to deal with that inflation. To see the inflation break in 2022, relative to history, I report on four widely used measures of inflation in the US - the consumer price index (CPI ), with & without seasonal adjustments, the producer price index (PPI) and the GDP Price Deflator below:

Source: Federal Reserve, St. Louis (FRED)

On every measure, inflation exploded in the first half of 2022, with a leveling off, albeit at high rates in the summer. The table below the graph also backs up my point about the 2011-2020 time period being an outlier, in terms of inflation being low (with the average at 1.73%) and stable (with the standard deviation across the years of 0.81%). The graph above is one of actual inflation, but as I have emphasized all through this year, it is expected inflation that drives markets, and it is on measures that try to capture inflation expectations that you see the turn in 2022. While spending the bulk of 2021 in denial, investors seem to have woken up, and expected inflation numbers are reflecting that. In the charts below, I graph out the inflation that consumers are expecting in two different surveys, one from the University of Michigan and the other from the NY Fed that show the rise in expected inflation:

As you can see, in both surveys, the expected inflation number has risen, to 5.20% in the University of Michigan survey and to 5.7% in the NY Fed survey. This rise in expected inflation also shows up in a different survey of expectations, from the Fed (St. Louis), measuring the probabilities of expected inflation in consumer expenditures:

Fed Reserve, St. Louis

After a decade where most expected inflation to be less than 1.5%, with a small percentage even expecting deflation, more than 80% now expect inflation to be higher than 2.5%, in the future and none expect deflation. The problem with survey-based expectations is that they are volatile and often are responses to recent experiences with inflation. There is a market-based estimate of inflation that comes from the US treasury market, where a comparison of yields on a treasury bond with that on a inflation-protected treasury bond of equivalent maturity provides a measure of expected inflation. This measure is reported, for the 10-year US Treasuries, from 2003 through September 2022, in the graph below:

On September 23, 2022, the market-imputed inflation number stood at 2.37%, the difference between the 10-year T.Bond rate of 3.69% and the 10-year TIPs rate of 1.32% on that day. It is lower than the survey-based inflation expectations, but  it a long term expected inflation rate, and you can use the term structure of Treasury and TIPs rate to extract an expected inflation term structure:

Put simply, investors are expecting inflation to peak over the next year and subside in the long term, close to the levels that we saw in the last decade. That may be hopeful thinking, and the returns on stocks and bonds over the rest of the decade will be determined by the correctness of this assessment; if investors are under estimating expected inflation in the long term, as they did in the 1970s, we are in for an extended period of malaise in markets.

Inflation’s First Order Effects: Interest Rates and Exchange Rates

Since 2008, it has become fashionable to attribute all movements in interest rates to Fed action or inaction, and as a consequence, we have lost sight of the fundamentals that determine interest rates. The most critical fundamental, and the one that best explains big movements in rates, over time, is expected inflation. For the last decade, it was not quantitative easing or Fed alchemy that kept interest rates low, but low inflation, in conjunction with anemic real growth. 

As investor expectations of inflation have risen in 2022, treasury rates have risen inexorably, across the term structure:

In keeping with our earlier assessment of investors expecting higher inflation in the near term, than the long term, rates have risen across the term structure, but short term treasuries have risen more than long term treasuries. To get a measure of the damage done to bond prices as a consequence, note that the increase in the 10-year treasury rate from 1.51% to 3.69%, in 2022, has resulted in a return of -16.45% on a constant maturity bond.

As rates have risen at different rates in the short and the long term, the US treasury yield curve, which started the year with a steep upward slope has become distorted, and on September 23, 2022, the 2-year rate, at 4.20%, was higher than the 10-year rate, at 3.69%, with a relatively flat curve beyond 10 years:

Source: US Treasury

While I am remain a skeptic on inverted yield curves as cannot-fail predictors of recessions, the message in the distortions in the yield curve on September 23, 2022, is not a positive one about the future of the economy. 

The other first order effect from inflation, and the Fed's reaction to it, has also been in the currency market, where the US dollar has soared against almost every currency, with the Euro and the British pound trading at or close to historic lows. 

At one level, this is interest rate parity at play, as US interest rate rise faster than rates in other countries. At another, it is a flight to safety, as worries about the global economy and markets take hold. At every level, though, exchange rate movements that are this strong create chaos and disruption in the economies of both the strengthening and weakening currencies.

Second Order Effects: Risk Capital and Risk Premia

If the only consequence of higher expected inflation was higher interest rates, the damage from it would be contained and perhaps even neutralized by earnings and cash flows growing at higher rates, aided by inflation. However, higher inflation almost always seems to be accompanied with more uncertainty about inflation, and it is this second order impact that does real damage, in terms of how it impacts risk capital. In my July 2022 post, I defined risk capital broadly as capital invested in the riskiest segments of each asset class, and used the picture below to illustrate its reach:

Note the contrast between risk capital and safety capital, and in a healthy market, you need a balance between the two, with the excess of safety capital leading to stagnant economies and markets, and an excess of risk capital creating bubbles in markets and distortions in the economy. The last decade, for better or worse, has seen an explosion of risk capital, aided and abetted by central banks and policy makers. Inflation’s return to the center stage has, at least for the moment, broken the spell, and risk capital has withdrawn significantly from markets. 

• Venture capital: The VC focus on start-ups and young companies makes it a focal point of any measure of risk capital, and it has ebbed and flowed over time, with sharp pullbacks in the aftermath of the dot-com bust in 2001 and the banking crisis in 2008. The graph below updates venture capital investments, by quarter, from the first quarter of 2020 to July/August 2022:

  

  Source: Crunchbase

  
  Note the drop off in venture capital in the first quarter of 2022, and the even steeper decline in the second quarter suggests that this may not be a temporary retreat.

• Initial Public Offerings: The exit path for the most successful of the ventures backed by VCs is an initial public offering, and the number and dollar value of initial public offerings operates as a proxy for the availability of and access to risk capital. In the graph below, we look at the this statistic across time, updated again through 2022:

  

  Source: Jay Ritter for historical and Pitchbook for recent IPO data

  Here again, the drop off in initial public offerings, both in number and value in 2022 has been dramatic, and if history is any guide, there will not be a quick comeback.

• High Yield Bonds: High yield debt has always been part of the landscape of corporate bond markets, but for much of the last century, it was composed of investment grade debt that had been downgraded, as a consequence of corporate distress. Since the 1980s, companies with low ratings have been able to make issuances of their debt, with the demand for this original issuance high yield debt coming from bond buyers willing to take on additional risk. In the graph below, I track the issuance of high yield bonds over time, with a focus on the most recent quarters:

  

  Source: SIFMA

  
  As with VC capital and IPOs, note the drop off in high yield debt issuances in 2022, both in dollar value terms, and as a percent of total bond issuance.

As risk capital has moved to the sidelines, the price of risk, i.e., the premium that investors demand for taking on risk has surged. You can see this in rising default spreads in corporate and sovereign bond markets, where spreads, which started 2022 at close to historic lows have risen, and more so for the lowest ratings. 

Source: FRED

In the equity market, the only immediate weapon that equity investors have for adjusting their price of risk assessment, i.e., the equity risk premium, is the stock price, pushing stock prices down, if they want higher equity risk premiums. It is for that reason that my assessments of equity risk premiums are model-agnostic and are based upon stock prices today and expected cash flows in the future being used to back out an expected return on stocks. Those assessments in the long term (1960-2021) and in the last two years (from January 2022 to September 23, 2022) are shown below:

There are two things that stand out about equity markets in 2022. The first is the surge in the equity risk premium from from 4.24% on January 1, 2022, to 6.05%, on September 23, 2022, an increase on par with what we have seen during market crises (2001, 2008 and 2020) in the past. The second is that as equity risk premiums have jumped, the treasury bond rate has more than doubled, from 1.51% on January 1, 2022, to 3.69% on September 23, 2022. In contrast to the afore-mentioned crises, where the treasury bond rate dropped, offsetting some of the impact of the rise in equity risk premiums, this inflation-induced market reaction has caused the expected return on stocks to rise from 5.75% on January 1, 2022, to 9.75%, on September 23, 2022; that increase of 4% dwarfs the increases in expected returns that we witnessed in the last quarter of 2008 or the first quarter of 2020.

Third Order Effects: The Economy and Psyches

The first and second order effects of inflation have been significant and damaging, but the question that remains unanswered is about the long term effects on the economy, and more importantly, on investor and consumer psyches. As you have probably noticed, perceptions of where the economy is headed have worsened, as we have gone through 2022, even in the face of relatively good news on unemployment. Much of the blame for the darkening forecasts has been directed toward Jerome Powell and the Federal Reserve, and while there is much that you can critique about how the Fed has played its cards during this crisis, it is inflation that is in the driver’s seat, not the Fed. Interest rates have risen this year because of inflation expectations rising, and it is these higher rates (and expected inflation) that are leading the Fed to act. In short, the Fed has two choices, neither of which is appealing. It can do nothing, which is the path that some of its critics would rather have it take, and interest rates will continue to rise, perhaps at an even faster rate, as inflation expectations surge. Alternatively, it can try to reclaim the narrative, by acting to slow the economy down,  perhaps even putting it into a recession, with length and severity still to be determined. Rock, meet hard place!

As investors, our assessments of how inflation and the economy will evolve in the coming years will determine how much we should pay for stocks and bonds today. Having chronicled how inflation has changed the level of interest rates and the price of risk, let us bring in the remaining questions on earnings, cash flows and growth that we need to address to evaluate whether the market has under or over reacted to inflation:

In the sections below, I will focus on how I see inflation playing out in  assessments of earning and growth, for the S&P 500 companies, as well as in their cash returns (dividends and buybacks).

1. Earnings: At the start of 2022, optimism was pervasive among analysts that the economy would continue to show strength and that earnings at US companies, up almost 47% in 2021, would grow strongly in 2022 and 2023. That optimism about the economy has faded, but there has not been a concurrent drop in estimated earnings, as you can see in the table below:

   

   Source: Factset, Ed Yardeni

   The earnings estimate for 2023, for S&P 500 companies, stood at 243.46, down only 0.6% from what it was on January 1. There are some subtle signs that forecasts of a recession are finding their way into earnings estimates. First, as you can see in the table, analyst estimates for what companies would generate as earnings in 2023 rose every month from January to June, but have dropped, albeit only slightly, during the summer. Second, the percentage of companies that are offering negative guidance about future earnings stood at 54%% in September 2022, suggesting that they see stormy weather ahead. 

   

   Source: Factset

   
   
2. Cash Flows: Investors in public equities have no direct claim on earnings, and are reliant on companies returning cash to them in dividends, and increasingly over the last few decades, in stock buybacks. The dividends paid change relatively little from period to period, making them sticky, but stock buybacks are more volatile, with sharp cutbacks during crises or when companies become more concerned about their economic futures. The table below graphs dividends and buybacks, by year, going back to 2001, and also the dividends and buybacks, by quarter, just for the last four years:
   
   
   
   Note the rising proportion of cash returned in buybacks, over the last 20 years, and the pullbacks in 2008/2009 and the first two quarters of 2020, in response to crises. That buyback number has largely recovered from its COVID swoon, and hit an all time high in 2021, with $734 billion in stock buybacks, across the S&P 500 companies. After rising again in the first quarter of 2022, we did see a pullback, albeit a small one, in the second quarter of 2022, with the possibility that there will be more coming in the third and fourth quarters of the year.
3. Long term inflation and interest rates: Having spent all of 2022 trying to hit a moving target on expected inflation, and the resulting interest rate, the one guarantee for the future is that there is more change coming. To make a judgment of direction, we have no choice but to take a stand on where inflation will settle in after supply chains are fixed, COVID is in the past and perhaps after the economy has cooled down. If we will revert back to inflation of 1-2%, as the market seems to believe we will, we will face a very different end game than if we revert back to 1980s levels of 3-4%. 

With the caveat that I have absolutely no new insights or information into this process, I did make my estimates for the S&P 500, with the resulting valuation shown below:

Download spreadsheet

I think that the given market pricing today, and my expectations of expected earnings and cash flows, stocks are very mildly over valued on September 23, 2022. I trust my judgments enough that I will leave my existing equity holdings intact, but I am not quite ready to jump in and make bets on market direction now. Clearly, your assumptions for the future will be different from mine, and I have a Do-It-Yourself (DIY) valuation of the S&P 500 that you can use to make your own judgment. In the table below, I list out the valuations that I get for the index with various combinations of 10-year treasury bond rates, equity risk premiums and assumptions about earnings in the future, relative to analyst forecasts:

S&P 500 Intrinsic Value Scenarios

If you are bullish, the assumption that makes the biggest difference is where you see equity risk premiums converging, with premiums closer to 4% yielding undervaluation on the index, even with significant earnings shocks built in. At the other end of the spectrum, if the equity risk premium stays at 6% or higher, the only scenario where you arrive at a value close to the index is if the 10-year T.Bond rate drops to 2% and earnings estimates come in as expected, with significant corrections to come, in scenarios where rates stay higher and/or earnings come in below estimates. 

    Given a choice between allowing inflation to play itself out and initiating polices that trigger a recession, there are some who are pushing for the former, arguing that trading off the certain pain that comes with a recession for the uncertain benefits of lower inflation is not good policy. I sympathize, but the dangers of letting inflation play out is that if it does so in unpleasant ways, where it stays high and volatile, its effects are going to be far more long term and more damaging. High and volatile inflation corrodes economies and markets from the inside out, destroying faith in currencies and making  investors and businesses behave in dysfunctional ways. 

YouTube Video

Spreadsheets

1. Intrinsic Valuation of the S&P 500 on September 23, 2022

Datasets

1. Inflation: Historical (US)
2. Inflation: Expected (US)
3. US Treasury Rates in 2022
4. Default Spreads in 2022
5. Exchange Rates in 2022