As I have argued in all four of my posts, so far, about 2022, it was year when we saw a return to normalcy on many fronts, as treasury rates reverted back to pre-2008 levels, and risk capital discovered that risk has a downside. During the course of the year, investors also rediscovered that the essence of business is not growing revenues or adding users, but making profits from that growth. In this post, I will focus on trend lines in profitability at companies in 2022, with the intent of addressing multiple questions. The first is to see how the increase in inflation in 2021 and 2021 has played out in profitability for companies, since inflation can increase profits for some firms, and lower them for others. The second is on whether these profit effects vary across geographies and sectors, by estimating profitability measures across regions and industries. The third is to revisit the link between profitability and value at companies, since making money is a first step for any business to survive, but making enough money to create value in business is a much more stringent test for businesses, and one that many fail.
Profits: Levels and Trends
The end game for any business, no matter how noble its mission and how much good its products and services do, is to make money, since without profits, the business will soon run out of capital and sink into oblivion. That said, if you own the business, you may decide to accept less profits in return for social good, as you pursue your business, but you may not get the same degrees of freedom, if you are a manager at a publicly traded company, since you will now be doing good, with other people's money. Even in these cases, where you constrain your profits for the greater good, you still cannot stay on an endless path of losses. That said, there is surprising confusion about what it means for a company to make money, with different measures of profit used by investors, analysts and companies to bolster their priors about companies. To set the stage, I will start by laying out the differences measure of earnings that reported on an income statement:
At the top of the profit ladder is gross income, the earnings left over after a company has covered the direct cost of producing whatever it sells. Netting out other operating expenses, not directly related to units sold but still an integral part of operating a business (like selling and G&A expenses) yields operating income. Subtracting out interest expenses, and adding interest income and income from non-operating assets results in taxable income or pre-tax profit, and after taxes, you have the proverbial bottom line, the net income.
Not surprising, there is many a cost between the gross and the net versions of earnings, and while there remain a few firms, especially young and start-up, with negative gross income, the likelihood of losses gets progressively greater as you move down the income statement. In the graph below, I look at all publicly traded firms, listed globally at the start of 2023, and at the percent of firms, within each sector, that have positive earnings using gross, pre-tax operating and net income:
Not surprisingly, while more than 85-90% of all firms report positive gross income, that number drops down to just about 60%, with net income. All of the sectors are subject to the same phenomenon, but there are outliers in both directions, with health care have the highest drop off in money makers, as you go from gross to net income, and real estate and utilities having the smallest.
Finally, I look at the aggregated values across all companies on all three income measures, across all global companies, again broken down by sector:
Collectively, global companies reported $16.9 billion in gross profit in the last twelve months leading into 2023, but operating income drops off to $6.4 billion and need income is only $4.3 billion. With financial service firms, where gross and operating income are meaningless, we report only net income, and the sector remains the largest contributor to net income across companies.
Profit Margins
While absolute profits are a useful measure of profitability, you have to scale profits to a common scaling variable, to compare companies of different scale. One common scaling measure is revenues, and that scaling, of course, yields profit margins. The graph below draws a distinction between a medley of margins that are in use:
In addition to scaling gross, operating and net profits to revenues, to get to gross, operating and net margins, I have also added two variants. One is to compute the taxes you would have paid on operating income, if it had been fully taxable, to get after-tax operating income and margin, and the other is to add back depreciation to operating income to get EBITDA and EBITDA margin.
Starting with gross margins, and computing the number for all non-financial service firms, we report the distribution of gross margins across publicly traded companies at the start of 2023, again based upon gross income and sales in the most recent twelve months:
While the median gross margin across all publicly traded global firms is about 30%., there are variations across the globe, with Chinese companies reporting the lowest gross margins and Australian companies having the highest. Some of that variation can be attributed to different mixes of businesses in different regions, since unit economics will result in higher gross margins for technology companies and commodity companies, in years when commodity prices are high, and lower gross margins for heavy manufacturing and retail businesses.
To explore differences in profit margins across industry groups, I broke stocks down into 94 industry groups, and sorted industries, based upon operating margin, from highest to lowest. In the table below, I list the ten industry groups with the lowest margins in the twelve months leading into 2023 and the ten industry groups with the highest:
The money-losers include four industry group from the retail space, a business with a history of low operating margins, a young industry in online software, a couple of industries in long-term trouble in airlines and hotel/gaming. The money makers include a large number of energy groupings, reflecting oil prices being elevated through much of the reporting period (October 2021-September 2022), a few technology groupings (software and semiconductors) and a declining, but high-profit business in tobacco.
Accounting Returns
While profit margins tell a part of the profitability story, a high margin, by itself, may be insufficient to make a judgment on whether a business is a good one, i.e,, a business that consistently generates returns that exceed the cost of funding it. It is to remedy this defect that analysts scale profits to invested capital, with equity and capital variants:
In the equity version, you divide net income by book equity to estimate a return on equity, a measure of what equity investors are generating on the capital they have invested in a company. In the firm version, you divide after-tax operating income, again acting like the entire operating income would have been taxable, by total invested capital, the sum of book equity and book debt, with cash netted out, to obtain return on capital. The latter has several different names (return on capital employed, return on invested capital) with some mild variants on calculation, but all sharing the same end game. Both accounting returns are computed based upon book value, not because we have suddenly developed trust in accounting, but because the objective is to estimate what investors have earned on what they originally invested in a company, rather than an updated or a marked-to market value. I know that ROIC has acquired a loyal, perhaps even fanatical, following among financial analysts, and there are a few like Michael Mauboussin who use it to extract valuable insights about business economics and value creation, but I find that many analysts who use the measure are unaware, or unwilling, to learn about the limits of accounting returns. I have a long and extremely boring paper on the fixes that you need to make to the computation, especially with older companies and companies where accounting is inconsistent in its classification of expenses.
Notwithstanding its many limits, I do think there is value in knowing what return on invested capital a company is generating, and I do compute the return on invested capital for every publicly traded non-financial firm in the world, and the calculation details are below:
The distribution of resulting returns on capital for the 42,000 publicly traded, non-financial firms are shown below:
The after-tax returns on capital, at least in the aggregate, are unimpressive, with the median return on capital of a US (global) firm being 7.44% (5.19%). There are a significant number of outliers in both directions, with about 10% of all firms having returns on capital that exceed 50% and 10% of all firms delivering returns that are worse than -50%.
Excess Returns
If your reaction to the median return on capital being 7.44% for US companies and 5.19% for global companies is that they are making money, you are right, but when you invest capital in risky businesses you need to not just make money, but make enough to cover what you could have earned on investments of equivalent risk. It was in attempting to estimate the latter that I computed the costs of equity in my second post and costs of capital in my third. In fact, comparing the accounting returns from the last section to the costs of equity and capital that we computed earlier allows us to compute excess returns to equity and the firm:
Put simply, value creation comes from delivering returns on equity and capital that are higher than the costs of equity and capital, and while you can take issue with using accounting returns from the most twelve months as a proxy for long term returns, the comparison is still a useful one to make:
As you can see in this table, almost 70% of all listed companies earned accounting returns that were lower than their costs of equity or capital. On a regional basis, US companies have the highest percent of companies that earn more than the cost of capital, but still falling short of 50%, and Canadian companies performed the worst, with more than 80% of companies delivering returns that were lower than the cost of capital.
It is certainly true that while the typical company had trouble making its costs of equity or capital, there are industry groups that generate returns that significantly exceed their costs, just as there are industry groups that operate as drags on the market. I look at the ten industry groups with the most positive and the most negative excess returns in the table below:
The rankings are similar to those that we got with margins, but it is clearly an ESG advocate's nightmare, as the list of companies that deliver the most positive excess returns are a who's who of companies that would be classified as bad, with tobacco, oil and mining dominating the list.
Conclusion
If 2022 was a reminder to investors that the end game for every business is to not just generate profits, but to generate enough profits to cover its opportunity costs, i.e, the returns you can make on investments of equivalent risk, and that game became a lot more difficult to win in 2022. As I noted in my second and third posts, a combination of rising risk free rates and surging risk premiums (equity risk premiums and default spreads) has conspired to push the cost of capital of both US and global companies more than any year in my recorded history (which goes back to 1960). A company generating a 7.44% return on capital (the median value at the start of 2023) in the US, would have comfortably cleared the 5.60% cost of capital that prevailed at the start of 2022, but not the 9.63% cost of capital at the start of 2023. There will be, and has already been, investor remorse about investments taken a year or more ago, but hoping that the cost of capital will come back to 2021 levels is not the solution. While there is little that can be done about past mistakes, we can at least stop adding to those mistakes, and one place to start is by updating hurdle rates, as investors and businesses, to reflect the world we live in, rather than some normalized past version of it.
I describe myself as a dabbler, and it does get in the way of my best laid plans. A few weeks ago, I posted my first data update pulling together what I had learned from looking at the data in 2023, and promised many more on the topic. In the month since, I have added two more data updates, one on US equities and one on interest rates, but my attention was drawn away by other interesting stories. Thus, I took a detour to value Tesla, around the time of their most recent earnings report on January 26, and added a second post to respond to the pushback that I got. About a week and a half ago, just as I was getting ready to start on my fourth data update, I got distracted again, this time by a story of a short seller (Hindenburg) targeting one of India's most visible companies (Adani Group) and I don't regret it, because that story is a good lead in to talking about country risk, which is the topic of my fourth data update. Irrespective of whether you think Hindenburg's short selling thesis against the Adani Group has legs, it is undeniable that the fate and value of this family group's companies is intertwined with the India story. A strongly growing India needs massive investments in infrastructure to succeed, and the Adani Group seemed uniquely qualified because of its perceived capacity to deliver on its promises, as well as its political connections.
Country Risk - The Ingredients
At the outset of this discussion, it is worth emphasizing that there is risk in investing in every country in the world, with the differences being one of degree. Thus, you would be making a mistake, if you assume that this discussion only applies if you are investing in India, Brazil or Belarus, and that it does not, if your investments are in the United States, Germany or Australia. The developed/emerging market divide was created by practitioners as a convenience, and while it sometimes has consequential effects, as is the case when a company is reclassified as developed from emerging, or vice versa, much of what I will say about how governments, legal systems and regulatory frameworks can affect corporate value applies to all countries.
Determinants
If you accept my premise that not only is it more risky to operate in some parts of the world than others, but also that risk varies across countries and time, the next question become one of deciding what determines the magnitude of country risk in a country. In my annual updates on country risk, I go through these determinants in detail, but the picture below summarizes the drivers of country risk:
It should come as no surprise that the determinants of country cut across all dimensions, with politics, exposure to violence, legal systems and corruption all determining country risk exposure. It is not required, but it is generally true, that countries that score poorly on one dimension tend to also score poorly on others, with countries that are most exposed to war and violence also having dysfunctional or nonfunctioning governments and courts.
A Life Cycle Perspective
When asked to explain differences in country risk around the world, it is unfortunately true that much of that categorization is lazy and overly broad, often centered around geography, culture and race. Thus, Asian countries were viewed as incapable of reaching first-world status, until Singapore showed that this was not true, at least on the city-state level, and Japan established its falsehood, with explosive growth and prosperity in the 1970s and 1980s. The stigma of being a Latin American or African economy persists, but there are success stories in both continents. At the same time, there are others who argue that groups with shared cultural or racial identities are incapable of elevate their countries to developed status. That is nonsense, since individuals within these groups often become success stories in a different setting or economy, unencumbered by the systemic inadequacies of their own countries. I believe that any country is capable of being a "first world" country, if it works systematically at creating a system that is perceived to be fair, timely in delivering legal redress and blessed with a government that has the interests of its populace as its first priority. By the same token, a country that is viewed as "first world" can lose that status, if people start perceiving the system as unfair, legal systems filled with delay and waster and a government that becomes capricious in its actions, or worse.
On the specific question of how much governments matter in determining country risk exposure, I am going to adapt a structure that I use to look at companies, the life cycle, and apply it to countries:
In my simplistic picture, you can see how as countries evolve through the life cycle, the influence of government and country narratives changes on investment success/failure:
Role of Governments: In younger economies, the influence of government is central, in both good and bad ways, since these economies are almost entirely dependent on growth, and a combination of good (bad) tax, licensing and regulatory policies by the government can an act as a growth accelerator (destroyer). As economies mature, the effect that governments have on companies will recede, at lease on overall growth, though tax policy can still redistribute that wealth and influence business behavior. When countries decline, government attempts to stem or slow decline can make them relevant again, in good and bad ways.
Country versus Investment/Company Narrative: That structure explains why when investing in a company in some countries, you have to not only do due diligence on these countries, but also form a narrative for how these countries will evolve over time. After all, your investment in Dangote Cement, a cement company with a dominant position in Nigeria nd West Africa, will do much better if that part of the world does well and will be handicapped, perhaps even fatally, if there is political and economic upheaval. In contrast, your investment in Krupps is less likely to be affected much by your views on the German economy.
Uncertainty: When investing, uncertainty is part of the process, but when that investment is in a project or company in a young country, a significant portion of the uncertainty is about the country, rather than about the company or investment. Put simply, you are unlikely to find safe projects in risky countries, since country risk will undercut whatever perceived stability there is in the project's cash flows.
If your views on investing and valuation were formed by reading Ben Graham, and nurtured by listening to Warren Buffett, it is worth remembering the time and the setting for their sage advice. Put simply, the rostrum that when investing in a company, you should focus on the company's management and moats, and pay little or no heed to governments or macroeconomic indicators, may have worked for value investors in the United States, in the 1980s, but will not hold up not just in other parts of the world, but even in the United States in the 2020s. Globalization and the emergence of a world economy that is no longer centered on the United States has made it an imperative for all investors to think about and understand country risk.
Country Risk: The Measures
If investors have no choice but to deal with country risk frontally, in most parts of the world, it follows that we have to come up with measures of country risk that can be incorporated into investment decisions. In this section, I will begin measures of country default risk, including sovereign ratings and CDS spreads, before moving to more expansive measures of country risk before concluding with measures of equity risk premiums for countries, a pre-requisite for estimating the values of companies with operations in those countries.
Default Risk
As with individuals and businesses, governments (sovereigns) borrow money and sometimes struggle to pay them back, leading to to the specter of sovereign default. Through time, these defaults have led to consequences that range from mildly negative to catastrophic, with some defaults triggering invasions and political revolutions. It is also the aspect of country risk, where there is the longest history of measurement, and there are widely used measurement tools.
1. History of Sovereign Default
In 2022, there were five sovereign defaults, with three (Russia, Belarus and Ukraine) a direct consequence of Russia's invasion of Ukraine, and Sri Lanka and Ghana joining the ranks, for different reasons. Those sovereign defaults are the latest in a long list of defaults that stretches back into the nineteenth century, and the graph below shows defaults in the most recent few decades, across geographies:
For much of the documented history, Latin America has been the epicenter for sovereign defaults, though there has been an upswing in Africa in recent years. Looking at the defaults over time, it is also worth noting that local currency defaults (where a sovereign defaults on a bond denominated in the local currency) have comprised a sizable portion of defaults over time, as can be seen in the graph below:
What does this all mean? The conventional practice, when estimating risk free rates, has been to use the government bond rate in the local currency, if available, as the riskfree rate in that currency, and that practice is wrong when markets perceive default risk in the sovereign and build that into the government bond rate. It is for this reason that I net out default spreads, based upon local currency ratings, from government bond rates to estimate riskfree rates in multiple currencies at the start of 2023:
The differences in riskfree rates across currencies can be attributed to differences in expected inflation, which is at the heart of why a valuation that is consistent in its treatment of that inflation will be currency invariant. (Valuing a company in Turkish Lira should give you the same value as valuing the same company in Euros, differences in riskfree rates notwithstanding.)
2. Sovereign Ratings
The ratings agencies that rate corporate default with ratings have also had a long history of assessing sovereign default risk, with sovereign ratings, with the numbers of rated countries increasing dramatically over time, with the number of countries rated by Moody's (S&) increasing from 33 (35) in 1990 to 152 (131) at the start of 2023. Sovereign ratings, like corporate ratings, range from Aaa (AAA) in Moody's (S&P's) scale, to D (in default, with a couple of differences in how you read the ratings:
While each company generally gets one rating, countries are usually assigned two ratings, one for local currency borrowings and one for foreign currency borrowings.
The fundamentals that feed corporate ratings come primarily from its financial disclosures, though qualitative factors play a role. Sovereign ratings start with quantitative measures of a country's economic standing, but there are far more non-financial forces that seem to come into play.
No matter what you think about sovereign ratings as a measure of default risk, they are the most freely accessible measures of country default risk. At the start of 2023, I summarize the sovereign ratings for countries in the heat map below:
The red and orange part of the worlds have the highest default risk, at least according to Moody's, and you can see it covers large swaths of Latin America, Africa and Eurasia.
While sovereign rating agencies have been accused of bias, with a skew towards giving lower ratings to emerging market countries, while over rating developed market countries, I believe that their real sin is that they are late in reacting to changes in default risk. The last year (2022) was one that saw more bad news than good news on the ratings front, with Fitch downgrading 21 countries and S&P downgrading 16 countries (while posting a negative outlook, a pre-cursor to a ratings downgrade for 8 countries).
3. Sovereign CDS spreads
The sovereign CDS market, a relatively recent entrant into the sovereign default risk game, has for the last two decades offered investors a market where they can buy insurance against default risk by sovereigns, and by doing so, provided a constantly updated, albeit noisy, measure of the default spreads of countries. In January 2023, there were 76 countries with sovereign CDS spreads available on the market, and they are listed below:
During 2022, there was a suspension on trading on sovereign Russian and Ukrainian CDS, leaving us at the tender mercies of just the ratings agencies, It is worth noting that despite the abuse that ratings agencies get for ineptitude and bias, there is a signifiant overlap between their assessments and the market's assessments of country risk.
Overall Risk
While default risk measures are widely available and used, they can be rightly challenged as taking too narrow a view of risk. After all, there are countries that score low on the default risk dimension but are exposed to political and economic risks that are considerable, as is the case with much of the oil-rich countries of the Middle East. There are no easy remedies for this problem, but there are services that generate country risk scores that bring in multiple measures of risk. While the Economist, the World Bank and private services provide country risk scores, I will stay with Political Risk Services, a data service I have used for a long time, more because of my familiarity with it than for any perceived superiority in how it measures risk. The PRS reports risk scores for different dimensions of country risk, and a composite risk score, that includes all of them. The heat map below reports on PRS scores, by country, at the start of 2023:
More than in prior years, this year's PRS map reveals a divide between the default risk perspective on risk and the PRS perspective. For instance, India is viewed as marginally less risky than China, and both are viewed as riskier than Kazakhstan., and the United States is perceived as much riskier than Germany or the Scandinavian countries.
Equity Risk
Having traveled the long and winding road from talking about the drivers of country risk to measuring country risk, we can take a shot at estimating the risk premiums we would use when investing in businesses, as equity investors, in these countries. Rather than bore with you the details of my approach to estimating equity risk premiums, which are described in excruciating detail in my paper on equity risk premiums (linked below), I will summarize how I estimated the equity risk premiums for countries at the start of 2023:
I start with the implied equity risk premium for the S&P 500 of 5.94% (see my second data update for 2023 for details) as my premium for mature market, and build up to the premiums for other markets from that, using default spreads as my starting point, and scaling them for the additional risk of equities. The resulting equity risk premiums, by country, are shown in the picture below:
With all of the caveats about country ratings and default spreads, the map still provides consistent estimates of equity risk premiums around the world. In fact, there are about a dozen countries that are unrated, where I have used their PRS scores to make estimates of their equity risk premiums.
Company Risk Exposure to Country Risk
As a final piece of this post, I want to contest what seems to be the default assumption in much of valuation, which is that the risk of a company comes from where it is incorporated and traded, rather than where it does business. Effectively, it is what leads analysts to value US companies using the US equity risk premium and Indian companies with the Indian equity risk premium, even though both groups of companies may make their products in and derive their revenues from other parts of the world. I believe that a company's exposure to country risk should be based upon where it operates, though we can debate how best to measure this country exposure, with revenues, production or a mix of the two in play, for weighting.
I know that there are risks that derive from where a company is incorporated, and that its regulatory and tax structure may be affected by that choice, but to argue that this is the dominant risk at play does not stand up to common sense.
The implications for investment and valuation are simple. Investors and analysts who paint country risk with a broad brush, using country of incorporation to measure equity risk premiums, will over value developed market companies like Coca Cola, Apple and Netflix, with significant operating exposure in emerging markets and under value companies like Infosys (India), Embraer (Brazil) and Vinamilk (Vietnam) by assigning the domestic equity risk premium to them, even though they generate large portions of revenues from foreign, and often much safer, markets.
The End Game for Governments
I know that I am going against the current political trend, but I believe that the end game for a good government is analogous to that of a good founder, and that is, once it has provided the structure and the basis for economic growth and prosperity, it should make itself less central to the economy, not more so. Note that while this may seem like the libertarian position, there are significant differences. I do believe that it is a government's role to craft laws and regulations that minimize the externalities that businesses create, but those laws/regulations should be few in number and changes, when they happen, should be reasoned and infrequent and enforcement should be fair and timely. There is nothing more unsettling than being a business person, consumer or citizen in a setting, where you are faced an avalanche of rules, sometimes contradictory, that are constantly changing, and enforced inconsistently.
The India Rising story hit some turbulence last week, as one of its biggest corporate success stories, the Adani Group, was hit with a report from Hindenburg Research, an investing group that specializes in targeting and shorting companies that it believes have dubious accounting and business practices. In response, people have fallen into two groups, with the Adani family and its supporters arguing that the short selling report is a hit job by a "foreign" entity to bring down not just the company, but also the country, and others noting that the report just reinforces what has troubled them about the company's meteoric rise in the last decade. I will confess that I know very little about the Adani Group, and I have nothing invested financially or emotionally in the company's fortunes. If you are looking for advice on whether you should buy or sell Adani shares, based upon my analysis, you will be disappointed. Instead, I will argue that the ingredients that led to the Adani stock price meltdown last week, which include an ambitious family group obsessed with control, a financial market where trading momentum trumps financial fundamentals and a capital market (debt and equity) where governments and regulators put their thumbs on the scale, are embedded in many Indian companies, and represent the weakest links in the India story.
The Lead In
As noted in the introductory paragraph, I start from a position of ignorance about the Adani Group, and it thus made sense to fill in that gap. In doing so, I will undoubtedly bore those of you who have followed the company closely, and know far more than I do, and I apologize.
The History
The Adani Group, founded by Gautam Adani, started life as a commodity trading partnership business in Gujarat, and listed on stock markets in 1994, as Adani Exports, with a large chunk of its revenues coming from its operation of a local port in Mundra, with a subsequent entry into the edible oil business. The group's investments were regionally concentrated, but over time, they have expanded into other businesses and across India, and while I seldom draw on corporate presentations, I will make an exception and use a slide from Adani's January 2023 pitch to describe their business mix:
With the exception of Adani Wilmar, a food processing business that has recently been bolstered by acquisition of leading brands, the rest of the Adani businesses share some common characteristics. First, they are infrastructure businesses, requiring large up-front investments and having long gestation periods, with regulatory and government oversight. Second, an increasing proportion of the company's investments are related to energy, in green energy and gas transmission/distribution, but the company's most significant investments are in logistics, especially in airports and ports . While each of these businesses is operated by a stand-alone Adani company, the businesses flow through a holding company, Adani Enterprises. The percentages of each company that is held by the Adani family is shown in brackets in the picture, and we will return to examine the implications later in this section.
The Rise to Market Prominence
The Indian economy, in general, and Indian public markets, in specific, have always been dominated by family group companies, with many of the family groups tracing their history back a century or more. Given the historical roots of the biggest Indian family groups, the Adani Group has been a recent entrant, not making the top ten list (in terms of either operating metrics like revenues or market-based numbers like market capitalization or enterprise value) as recently as ten years ago, and barely making the top ten list five or six years ago. That has clearly changed, and at the start of 2023, four Adani companies were in the top twenty Indian companies, in terms of market capitalization, and the collective value of the seven publicly traded Adani companies was $220 billion (₹ 17,600 billion), greater than the market capitalization of Reliance, the Ambani family flagship, and India's largest company. In fact, for a brief period at the start of 2023, Gautam Adani was the second richest man in the world, based upon his holdings in his group's companies:
The surge in market capitalization at the any company, by itself, is not surprising, especially after a decade where companies (like Tesla and Facebook) have added (and lost) hundreds of billions in market capitalization in individual years. The surprise, though, is that this dramatic boost in market capitalization happened at a family group built around infrastructure businesses, where investors have to wait for decades for payoffs, and often not driven to sudden changes in value assessment.
Adani's Operating History
In an attempt to understand Adani's rise to market prominence, I started by looking at revenues and operating income at Adani Enterprises, the flagship company for the group:
I broke the 20-year history into three sub-periods, the 2002-2015 time period, where the company grew its revenues steadily and reported solid, albeit low, profitability, the 2016-2021 time period after a major restructuring in 2015 that spun off Adani Ports Adani Power and Adani Transmission, as separate companies, and the most recent year and a half (from March 2021 to September 2022), where the company reported a quantum leap in revenues. During that most recent period, the Adanis acquired a stake in the cement business, another capital-intensive and low profitability business, when they bought Hochim's stake in ACC and Ambuja Cements.
While the revenue part of the story is one of almost unstoppable growth, it is worth noting that through its entire operating history, the Adani Group has had low operating margins, with the trend lines in the wrong direction. While some of the decline can be attributed to the revving up of reinvestment in new businesses, it is also worth emphasizing that even when these investments start paying off, they will remain low-margin businesses.
Adani's Investment Push
It is rare to see infrastructure companies grow as quickly as Adani has, and the reason is that growth in this business requires large investments in capacity. Looking at the capital invested at Adani Enterprises provides us with a sense of how much capital this company has employed over the last twenty years to get to its current standing.
Again, the steep drop off in invested capital that you see in 2015 is just a reflection of the restructuring of the company that year, as the invested capital in Adani Ports and Power was removed from the mix.
Bringing in the operating income from the previous section, and adjusting for taxes, I scale those after-tax operating earnings to invested capital to estimate a return on invested capital at Adani Enterprises, and as you can see the Adani success story hits a roadblock. The company's return on invested capital has steadily declined, even as it has scaled up, hovering just over 3% in 2021-2022. Again, it is true that in infrastructure businesses, returns on capital improve as assets age, partly driven by higher operating income and partly by declining invested capital, but as with margins, the reality check is that these businesses will struggle to earn their costs of capital.
Adani's Debt Load
The investment side of the Adani story is not complete without bringing in the financing part, since the money for these investments has to come from somewhere, either internally, residual cash flows from existing operations, or externally, from new debt or equity. Using the statement of cashflows from Adani Enterprises, I present a picture of how the company funded its investments:
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As you can see from the percentages of financing that Adani Enterprises raised from debt and equity, it is incontestable that the company funded almost all of its growth with debt through this period. In fact, the company continued to pay a dividend to shareholders, even as it raised fresh debt to keep growing, in effect using debt to pay dividends during the 2016-2021 time period,. In the most recent period (2021-22), there does seem to be a push to raise fresh equity, and that may or may not be in response to pressures from investors and lenders to reduce the debt burden.
The cumulated effects of adding to debt each year, as Adani Enterprises has grown, can be seen in three debt metrics that I report for the company in the graph below: debt as a percent of book capital (debt plus book equity), debt as a percent of market capital (debt plus market capitalization) and an interest coverage ratio, estimated by dividing operating income by the interest expenses:
The debt to book capital ratio has stayed high through the period, but the rise in market capitalization in 2021 and 2022 lowered the debt to market capital ratio. The interest coverage ratio better captures the limited buffer that the company has on its debt load, since the operating income is barely higher than interest expenses.
In defense of the Adanis, it is not uncommon for infrastructure companies to borrow money and carry heavy debt loads, especially as they make new investments, on the expectation that as their projects mature, this debt will be repaid as well. What sets Adani apart thought is it scale, since a failure on its part to make debt payments will create ripple effects that are vastly greater than a much smaller infrastructure company.
Adani's Ownership Structure
It is no secret that family group companies are controlled by the families that run them, but the degree of ownership that the Adanis have in their companies is high, even by Indian family group companies. In fact, the slide that I drew from the company's own slide deck is open about the family's percentage ownership of each of the Adani companies. Consolidating across the Adani companies, it looks like the family owns about 73% of the outstanding equity in these companies:
(Afro Asia, Universal Trade, Worldwide Emerging and Flourishing Trade are counted as part of Adani holdings)
This not a secret and these details are available from an Adani SEBI filing, where the family also includes the holdings of four corporate bodies that they control, as extensions of their holdings. While a family controlling a significant portion of the equity in a family group may not surprise you, the fact that this ownership stake has hardly budged over a decade where the company has increased in scale more than ten-fold, with dependence on external capital for that growth, is striking. The reason, of course, lies in the earlier graph, where we looked at how dependent the Adani companies have been on debt for their funding, rather than equity. There is a control story here that needs to be told, and we will come back to it.
Of the 27.5% that is not held by the family, a significant percentage is held by foreign institutional investors, with Vanguard and Blackrock making the list, largely through their index funds holdings. Among Indian institutions, LIC is the largest holder with just over 4% of the shares, but the retail investor presence in this company is small, largely because of the low float, though the surge in the company's price in the last two years has drawn some traders to it.
Adani's Market Capitalization
In our final assessment, I look at how the market have priced Adani Enterprises over time, looking at the multiples that investors have been willing to pay for its operating numbers from earnings to revenues to EBITDA, as well as relative to its accounting value (book value):
With every pricing metric, the surge in the last two years is striking. The PE ratio for the stock has gone from a modest 15 times earnings in the 2016-21 time period to 214 times earnings in the most recent two years, and the enterprise value has jumped from about 12 times EBITDA during 2016-21 to 53 times EBITDA in the most recent two years. You see similar movements in the price to book, where the stock has gone from trading under book value to 6.7 times book value, and the enterprise value, which was less than revenue in 2016-21 to 2.71 times revenues in the most recent two years.
By itself, the surge in pricing multiples is a feature of volatile markets, and it is a phenomenon that we saw with technology companies in the last decade. What makes it surprising at Adani is the fact that this is an infrastructure company, and the irrational exuberance that animates pricing in tech or software usually has little play in this sector. In addition, the question of which group of investors is leading the push to higher prices is a puzzle, since, unlike an Agatha Christie mystery, the list of suspects (see ownership structure) is short. One benign explanation is that foreign institutional investors are using Adani listed shares to make a joint bet on Indian growth, infrastructure investment and Indian politics, and that the pricing is being pushed up because of the limited float, but as we will see when we get to the short sellers' thesis, there are more malignant explanations, as well.
The Shorts Speak up
All of the information that I used in the last section came from publicly disclosed documents, and there are no secrets. In fact, it is common knowledge that the Adani Group has grown, with a disproportionate dependence on debt, and that the rise in stock prices in the last two years has worked to the family's advantage, as it considers selling some of its ownership stake to raise fresh capital. It is also widely known that one of the competitive advantages of the group is its closeness to political power, and arguing that the company is benefiting from its political connections is neither novel nor uncommon in Indian business setting.
When the Hindenburg Research report targeting the Adani Group came out a couple of weeks ago, I was surprised for a simple reason. I have seen this group target companies before, using the game plan that they are using with Adani, but their typical target firms are usually much smaller, under-the-radar firms, where public market investors may have missed troubling aspects of operations. The Adani Group is a huge target, by the standards of any market, and it is one of most widely talked-about Indian firms. I must confess that I find the Hindenburg shock-and-awe approach of throwing up dozens, perhaps hundreds of accusations of wrong doings at a firm, hoping that something sticks, off putting, since even if I am in agreement, I find myself spending time trying to separate the wheat from the chaff, the big wrongdoings from the minor distractions. I may be doing a disservice to Hindenburg and other Adani naysayers, but it seems to me that what they call the "biggest con" in history has three legs to it, and everything in the report feeds into one of the legs:
Almost every contention in the Hindenburg report can be traced to one of these three groupings, and I will try to regroup them on that basis.
Use of Shell companies: The most damaging of the Hindenburg contentions is that Vinod Adani, Gautam Adani's oldest brother has created a large number (38, by Hindenburg's count) of shell companies, based in Mauritius, and used them specifically for "(1) stock parking / stock manipulation (2) and laundering money through Adani’s private companies onto the listed companies’ balance sheets in order to maintain the appearance of financial health",
Dubious intra-party transactions: Hindenburg contends that the Adani Group has used its shell companies, in conjunction with transactions among its holding companies, some of which are privately owned by the family, to "inflate revenues" and for "manipulate earnings" at their listed companies.
Inexperienced (or worse) auditors: Hindenburg notes that the accounts at Adani Enterprises and Adani Total Gas are audited by a tiny and largely unknown auditing firm, Shah Dhandaria, with four partners and eleven employees, some young and inexperienced. Implicit in this statement is the contention that this auditing firm is either incapable of or unwilling to highlight the accounting irregularities at the Adani companies.
Listing rules: Publicly traded companies are required to have at 25% of their shares be held by non-promoters to stay listed on exchanges. Hindenburg contends that there are some of the foreign funds that the Adani Group lists as non-promoter holding to pass the listing threshold are almost entirely invested in Adani companies, and controlled by the Adani family. In short, Adani is being accused of violating listing rules, and covering it up.
Stock as collateral for debt: The motive for the stock price manipulation, at least according to Hindenburg, is that some of the debt in the Adani companies has been backed up or secured by shares in the company, with a higher market capitalization then allowing these companies to borrow more than they should.
Guilt by association: Along the way, Hindenburg notes connections that the Adani Group has to a host of individuals, some within the family (Samir Vora, Vinod Adani and Rajesh Adani) and many outside, who have been accused of fraud and manipulation, or in some cases, been found found guilty and barred from trading.
Hindenburg should be complimented for their legwork, but their critique of the Adani Group rests on a mix of serious contentions, circumstantial evidence and questionable claims. On the first, I would include the Mauritius-based shell entities, with no real operating purpose, and their links to the Adani Group companies. In the second, I would list many of the stock price manipulation charges, since the primary evidence offered is that the Mauritius shell companies hold material stakes in the company, with secondary evidence on delivery volume. To be able to manipulate and move the market capitalization of a company by a hundred billion, roughly the increase in value in 2022, you would expect to see huge numbers of shares being traded by these entities, and I don't see that. On the questionable claims are the ones to do with earnings manipulation, since if Adani is manipulating earnings, it is not doing a very good job, reporting low margins and return.
I am puzzled that Hindenburg's short thesis spends as much time as it does trying to convince us that the company is over levered. Even if you believe Hindenburg's contention that a low current ratio equates to higher default risk, being over levered is not a con game, but a risk, perhaps a poorly thought through one, but one that equity investors in many investments take to increase their returns. In fact, the infrastructure business is full of companies that borrow heavily, with little or no earnings buffer, and I am not sure that many of them will withstand the Hindenburg test for over leverage.
My Adani Assessment
In sum, I am willing to believe that the Adani Group has played fast and loose with exchange listing rules, that it has used intra-party transactions to make itself look more credit-worthy than it truly is and that even if it has not manipulated its stock price directly, it has used the surge in its market capitalization to its advantage, especially when raising fresh capital. As for the institutions involved, which include banks, regulatory authorities and LIC, I have learned not to attribute to venality or corruption that which can be attributed to inertia and indifference.
It is possible that Hindenburg was indulging in hyperbole when it described Adani to be "the biggest con" in history. A con game to me has no substance at its core, and its only objective is to fool other people, and part them from their money. Adani, notwithstanding all of its flaws, is a competent player in a business (infrastructure), which, especially in India, is filled with frauds and incompetents,. A more nuanced version of the Adani story is that the family group has exploited the seams and weakest links in the India story, to its advantage, and that there are lessons for the nation as a whole, as it looks towards what it hopes will be its decade of growth.
First, in spite of the broadening of India's economy, it remains dependent on family group businesses, some public and many private, for its sustenance and growth. While there is much that is good in family businesses, the desire for control, sometimes at all cost, can damage not just these businesses but operate as a drag on the economy. Family businesses, especially those that are growth-focused, need to be more willing to look outside the family for good management and executive talent.
Second, Indian stock markets are still dominated by momentum traders, and while that is not unusual, there is a bias towards bullish momentum over its bearish counterpart. In short, when traders, with no good fundamental rationale, push up stock prices, they are lauded as heroes and winners, but when they, even with good reason, sell stocks, they are considered pariahs. The restrictions on naked short selling, contained in this SEBI addendum, capture that perspective, and it does mean that when companies or traders prop up stock prices, for good or bad reasons, the pushback is inadequate.
Third, I believe that stock market regulators in India are driven by the best of intentions, but so much of what they do seems to be focused on protecting retail investors from their own mistakes. While I understand the urge, it is worth remembering that the retail investors in India who are most likely to be caught up in trading scams and squeezes are the ones who seek them out in the first place, and that the best lessons about risk are learnt by letting them lose their money, for over reaching.
Fourth, Indian banks have always felt more comfortable lending to family businesses than stand alone enterprises for two reasons. The first is that the bankers and family group members often are members of the social networks, making it difficult for the former to be objective lenders. The second is the perception, perhaps misplaced, that a family's worries about reputation and societal standing will lead them to step in and pay of the loans of a family group business, even if that business is unable to. It is easy to inveigh against the crony relationships between banks and their borrowers, but it will take far more than a Central Banking edict or harshly worded journalistic pieces to change decades of learned behavior.
I know that there are some of you who may view me as unpatriotic for pointing to these flaws, but I think that for the India story to unfold, it has to deal with these weaknesses. The short thesis against Adani can start that process, and I hope that the foreigner card does not get played on Hindenburg, dismissing its claims. There are plenty of Indians (analysts, investors, fund managers) who have been saying and thinking what is made explicit in the Hindenburg report, and the question that we should be asking is why they have not been given bigger platforms to air out their views.
There is another seam or weakness in the global economic setting that Adani Enterprises exploited, and that is ESG, an acronym far more deserving of the "biggest con" label than Adani, since it is threatening to lay waster to trillions of dollars, not billions. If you review the Adani website and sales pitch, it is quite clear that the company learned to play the ESG game well, creating an entire ESG universe to underpin its companies, and exploiting the green bond market, presumably for its green energy business. The notion that a family group that build ports, airports and gas transmission lines qualifies for green bond issuance, tells you less about the group making the issuance, and more about the emptiness of the green bond promise. In fact, if Adani happens to default on its debt, I hope that it starts with the green bond holders, since I cannot think of a group that deserves default more.
Valuation and Investment Judgment
I know that your intent in reading this thesis might be a more pragmatic one, where you wonder whether the Adani companies were over valued at the start of this year, when they hit their all time high, and whether they are a bargain, at half that price today.
On the first question, I don't think that there is much doubt that the market was over stretched when it valued the Adani companies collectively at $220 billion (₹ 17,600 billion) and Adani Enterprises at $53 billion (₹ 4,243 billion). In fact, a valuation of Adani Enterprises with upbeat assumptions on revenue growth and operating margins, and without factoring any of the Hindenburg accusations of fraud and malfeasance, yields a value of just about ₹ 945 per share, well below the stock price of ₹ 3,858 per share.
On the second question, even with the share price at 1,531 per share, I still think the company is priced too high, given its fundamentals (cash flows, growth and risk) and before factoring the damage that might have done to the company's reputation and long term value, by this short selling episode.
Even with a further share drop, I am not tempted to buy shares in Adani companies, and it has little to do with the Hindenburg report. I have likened buying shares in a family group company to getting married, and then having all of your in-laws move into the bedroom with you. Investors in family group companies, no matter how honorable the family, are buying into cross holdings, opacity and the possibility of wealth transfers across family group companies. Those risks increase, if the family group companies are built around political connections, where you are one political election loss away your biggest competitive advantage. It is true that at the right price, I would be willing to expose myself to those risks, but it would require a significant discount on intrinsic value, and we are not even to close to that point yet. In short, I will watch this tussle between the Adani Group and Hindenburg from the sidelines, with less interest in the firm and more in what changes it may (or may not) bring to business, investing and regulatory practices in India.
I wrote about my most recent valuation of Tesla just over a week ago, and as has always been the case when I value this company, I have heard from both sides of the Tesla divide. Some of you believe that I am being far too generous in my forecasts of revenues and profitability for a company that is facing significant competition, as it pursues growth, especially with questions about who's in charge of the company. Others, just as passionately, have argued that I am under estimating the company's capacity to grow, enter new businesses and generate additional profits, and have pointed to my history of undershooting with the company. I am not defensive about my valuations, and am completely unfazed by the pushback, but I do think that since some of the pushback revolves around first principles of intrinsic value, rather than specifics about the company, there is value in discussing the issues raised.
My Tesla Valuation: Filling in the Missing Pieces
When I posted my Tesla valuation, I hoped, perhaps naively, that it would be self-standing, with the combination of the valuation picture and the spreadsheet filling in the details. Based at least on the reactions, I have realized that some may be misreading my story and valuation, ore reacting just to a picture in a tweet. To fill in the missing pieces, I redid the valuation picture, adding the revenue growth rate, by year:
As you look at the sheet, it is worth emphasizing a few estimation details that you may have missed in my original post:
First, the revenue growth rate, at least for me, is a means to an end, not an end in itself. A few of you did take issue with the fact that the growth rate that I used for the first five years dropped from 35%, in my November 2021 valuation, to 24%, in my most recent one. That may seem like a negative reassessment of the company, but growth rates can deceptive as companies get larger, and my revenues in 2032 in both valuations converge on almost exactly the same number ($420 billion in November 2021 valuation and $412 billion in this one). Just to provide perspective, using a 35% growth rate now would inflate revenues to $600 billion in 2032 or higher, requiring a very different narrative for the company.
Second, as you get past year 5, the revenue growth rate does not drop precipitously to 3.47% in year 6 (more on that in the next bullet), and instead declines, in linear terms, between years 6 and 10 to approach 3.47% in 2032. In short, the company has ten years of growth, not five, but growth rates have to get smaller as revenues gets bigger.
Third, if it is what happens after year 10 that puzzles you, it has less to do with Tesla the company and more to do with answers to two questions. The first of the is as companies scale up, there will be a point where they will hit a growth wall, and their growth will converge on the growth rate for the economy. The second is the question of what the nominal growth in the global economy, in US dollar terms, will be, and my best answer to that question is the nominal risk free rate, which was 3.47% at the time of this valuation. I am assuming that Tesla will hit its growth wall at about $400 billion in annual revenues, but as I will note in the next section, that can be debated, but the growth rate forever is bound by mathematical constraints to override.
Fourth, on my operating margin assumptions, it does look like I am downbeat about the near future, since my operating margin is dropping from 17.93% to 16% over the next five years, but that is because the former is the operating margin during 2022, and the number careened wildly during the course of the year from more than 19% in the first quarter of the year, to just about 16% in the last quarter. In short, I am assuming that the price cuts and cost pressures of the fourth quarter are more representative of what Tesla will face in the future, as competition steps up.
Finally, my starting cost of capital of 10.15% reflects the reality that the riskfree rate and equity risk premiums have risen over 2022, and my ending number of 9% is an indication that I expect Tesla to become less risky over time. There is not much room to maneuver on either number, since half of all US companies have costs of capital between 7.3% and 10.9%.
In short, my value of $130/share reflects the confluence of these assumptions, and as I conceded, I can and will be wrong on each of them.
The Pushback
I must confess that I have not read every single comment and critique of my valuation, since they are dispersed over multiple platforms, but I do know that the pushback has come from both sides. There are Tesla bulls who are convinced that I am understating its value, and Tesla bears, who are just as convinced that I am overstating its value. Some of the reasons provided are substantive, and merit serious debate, others reflect a serious misreading of intrinsic valuation and a few are just assertions, with nothing to debate.
From Tesla Bulls
Given that I found Tesla to be overvalued, albeit only mildly, about three quarters of the disagreements posted online to the valuation came from Tesla bulls, some of whom have disagreed with me for a decade, and have, for the most part, been on the right side of the Tesla trade and made a lot of money on the stock. In the section below, I will summarize some of the key arguments, with my responses.
Revenues of "only $400 billion": The most common critique seems to be that I am giving Tesla "only $400 billon in revenues" in 2032, and that this "much too conservative", given its multiple business lines and immense potential. My response to that is that it is only because of Tesla's multiple business lines and immense potential that I am estimating revenues of $400 billion for Tesla, and that number is hard to reach. In fact, in January 2023, there were only five companies in the world that reported annual revenues exceeding $400 billion and they are listed below:
Since the $400 billion is in 2032 dollars, I have also reported companies with revenues that exceed $300 billion in 2023 on the table and the list expands, but only to ten firms. There are three lessons that I draw from this table. The first is that while $400 billion in revenues is clearly plausible, it is a difficult target for a firm to hit, and while you can use a higher growth rate than I use, and arrive at end revenues of a $1 trillion or more, you are estimating revenues that no company in history has ever generated. The second is that barring the oil companies, whose revenues and margins ebb and flow with oil prices, the only firm on this list that generates double digit margins is Apple, which has been rewarded with the largest market capitalization of any company in the world. Put simply, there are very, very few companies that generate big revenues and earn high margins at the same time. Third, there are only two companies on this list that have had double digit revenue growth rates in the last decade, Amazon and United Health, and the former generates operating margins in the low single digits. Firms with large revenues find it difficult to maintain high growth, as they scale up.
Operating margins of only 16%: The second critique of my valuation is that I am using an operating margin of "only 16%", backed by two arguments. The first is that Tesla has a superior product to sell and that its customers are loyal, giving it pricing power, and that should lead to higher margins. The second, and more compelling one, is that Tesla has actually been able to deliver margins that exceed 16%, and that as it scales up, economies of scale will lead to increasing margins. On both fronts, I am more cautious. The operating margins that you can deliver as a company depend on product quality and pricing power, but they are also underpinned by unit economics. The companies that deliver the highest margins incur very low costs in producing the next units that they sell, and that is why software companies, tobacco companies and Aramco have sky-high margins. The bulk of Tesla's revenues, in my view, will come from its auto business (cars, trucks, automated cars...) and the costs of manufacturing an automobile, no matter how efficient you are at operations, are substantial. With legacy auto companies, the median operating margin is about 5-6%, with very few (perhaps a few luxury or niche auto companies) with double-digit margins. It is true that Tesla has businesses, perhaps in energy and software, where it can generate operating margins that are higher, but these businesses, by their very nature, are more likely to deliver billions of dollars in revenues, rather than hundred of billions. On the second point, the notion that economies of scale continue to show up no matter how large a company is a myth; economies of scale are greatest as companies go from small to large, but they level off once you scale up. I believe that Tesla has already harvested the bulk of its economies of scale benefits, and will face a tougher grind going forward , and time will tell whether I am wrong on this front.
Multiple Businesses: One of the most common critiques from Tesla bulls is that my valuation fails to incorporate all of the businesses that Tesla operates in, and that I was valuing it as an auto company. That is not true! In fact, it is precisely because Tesla has other businesses (software, energy, batteries) that it can use to augment its core auto revenues that I assume that revenues can get to $400 billion, making it larger than any other auto company in the world by a third and that operating margins will stay at 16%, which no auto company can sustain. It is true that I don't break revenues down, by business, but that reflects my view that breaking things into detail, without any real basis for forecasting detailed line items creates the illusion of precision, while actually making your valuation less so. The only business, which if it comes to fruition, that could materially affect the revenues is autonomous driving, and I have to confess that I find that there is more loose talk than analysis on that front. In fact, if the reason that you are buying Tesla is because you believe that they have the lead in this space, you may want to pause and ask what part of autonomous driving will be occupied by the company. The revenue/margin/reinvestment assumptions that you will make will be very different if Tesla just manufactures and sell cars with autonomous driving capacity to others (private car owners, ride sharing companies) in the space than if Tesla owned the cars and operates the autonomous business itself. Having watched ridesharing companies like Uber, Lyft and Didi struggle to make money in that business, I remain skeptical about this space being a gold mine for Tesla.
Angst about terminal value: As I noted in the last section, the questions around the growth rate I assume in year 10, and the 3.47% growth rate forever have less to do with Tesla and more to do with the economy. Every company, as it scales up, will hit a wall, where it has become so large that it can grow, at best, at the rate that the economy (domestic or global) that the company operates in. For some companies, that wall comes with larger revenues than others, and the very best companies are able to delay hitting the wall for longer. I have assumed that Tesla reaches this status, when it has revenues of $400 billion, and around year 10. You may decide that this is too pessimistic, but if you do so, the response is not to increase the growth rate from 3.47% to a higher value after year 10, but to either use higher growth in the next ten years to reach revenues of $500 or $600 billion in year 10, or lengthen the growth period to 15 or 20 years. If you do the latter, remember that growth dissipates between 4-6 years for most growth companies, ten years is already at the 90th percentile of growth periods for the companies and using 20-25 years of growth risks making your company a unicorn.
Exceptional company: I know that none of what I have said so far will be convincing for some of you, who believe that Tesla is not just the next great company, but a one-of-a-kind company, and I accept that. If you believe that, you may very well be okay with letting Tesla's annual revenues hit a trillion and pushing operating margins to 20%. However, exceptional companies may or may not be exceptional or even good investments, if the market prices in their payoff, just as abysmal companies may not bad investments, if the market prices that in. The picture below simplifies the choice:
In short, making the argument that Tesla is a very good, great or even exceptional company is only half the investment game, with assessing what the market is pricing in being the other half. It was the reason that I argued at a $1.2 trillion dollar market capitalization, in November 2021, even Tesla exceptionalists should reconsider investing in the company, since paying an upfront price for a company to be exceptional leaves you no upside. At best, the company will deliver on its exceptionalism, and you will make a fair return (essentially equivalent to what you would earn on an index fund), and at worst, the company may turn out to be only great or very good, both of which are now negative surprises. I am valuing Tesla to be an immensely successful company, and at the right price ($12 in 2019, $97 in December 2022), I believe that it is a good, perhaps even a great, investment.
Premiums for Vision: There is a final critique that I find almost incomprehensible, where Tesla is posited to be so special a company and Musk such an out-of-the-box visionary that you cannot capture its value in earnings and cash flows. That is sophistry, at best, since when you pay a price for Tesla's shares, you are putting a value to these ephemeral qualities, with the only difference being that you implicitly assume that these qualities will justify the price that you are paying and in an intrinsic valuation, you have to explicitly work out how these qualities translate into earnings, growth and risk characteristics.
From Tesla Bears
For the moment, Tesla bears seem to be happier with me than Tesla bulls, though that may change on my next valuation. Their arguments, though, are that I am over estimating value, and their critiques can be summarized below.
Recession and price cuts: Coming in 2023, Tesla has been cutting the prices of its products, and with economists predicting a recession, my assumptions of 24% growth in revenues and 17.99% margins have been described as "whistling past the grave yard". That is true, but a recession-induced lower revenues growth/margins in the near term will have little or no effect on the valuation, since you will recover on both counts as the economy bounces back. Lowering revenue growth to 15% in 2023 and raising it to 33% in 2024 will deliver almost the same value for the company, as what I get with my smoothed-out values. If you are a long term investor, you are buying a company across economic cycles, not just through the next one, and expectations of a recession may, at best, affect your investment timing more than it does investment value.
Just a car company: Taking the other side of the Tesla bull argument, Tesla bears view the higher revenues and margins that I am forecasting as coming from Tesla's other businesses as a pipe dream. In their view, Tesla software will be bundled with the automobiles and be incapable of delivering additional revenues or profits on its own and autonomous driving is a space that will take a lot longer to actualize, with Tesla facing competition from Google and other tech giants, not other states quo auto companies. I am truly in the middle on this one, splitting the difference between the hundreds of billions that Tesla bulls see as coming from other businesses and the zeros that the Tesla bears attribute to other businesses.
Cost of capital: To the argument that 10.15% is too low a cost of capital to use on a company like Tesla, in a cyclical business and with a unpredictable CEO at its helm, my response is the same it was to the Tesla bulls (who wanted me to use a much lower cost of capital). It is that there is not much room for disagreement on this measure, and much as analysts may want to let their senses drive them, and in the current market environment, costs of capital of 15% or 6% are just off the table.
Conclusion
I know that you may not believe me on this claim, but I am in neither the Tesla bull nor the Tesla bear camp. It is true that in my valuations of the company, I have found it to be overvalued more frequently than I have have found it to be under valued. That said, I did buy Tesla in 2019, and while I held the stock for only seven months, before I sold it, I am clearly not in the "I will never buy Tesla" camp. If your counter is that I would have been far richer, if I had just bought Tesla and held, that is true, but I would have to abandon an investment philosophy that has not only worked for me, but also allows me to pass the sleep test.
Finally, while the dissent and disagreement was mostly polite (and I thank you for that!), I am puzzled by some of the vitriol on the part of those who disagree with my Tesla story and valuation. I am not in the business of dishing out investment advice, and the only person that my valuation was meant for, was me, and I aim to act on it. I am not trying to convince you, if you are a Tesla bull, that you are wrong and should sell your stock, or if you are a Tesla bear, that you should buy the stock, if it drops below $130. The very fact that you are letting my valuation, which reflects my view and value, shake your conviction should tell you more about your conviction (or perhaps the lack of it) than about my valuation. So buy Tesla, sell Tesla or sit on the sidelines, but no matter what you do, God speed, and good luck!
