Aswath Damodaran's Blog / en-US Tue, 03 Jun 2025 04:33:39 -0700 60 Aswath Damodaran's Blog / 144 41 /images/layout/goodreads_logo_144.jpg /author_blog_posts/25808015-sovereign-ratings-default-risk-and-markets-the-moody-s-downgrade-after Mon, 02 Jun 2025 11:31:00 -0700 <![CDATA[Sovereign Ratings, Default Risk and Markets: The Moody's Downgrade Aftermath!]]> /author_blog_posts/25808015-sovereign-ratings-default-risk-and-markets-the-moody-s-downgrade-after ÌýI was on a family vacation in August 2011 when I received an email from a journalist asking me what I thought about the S&P ratings downgrade for the US. Since I stay blissfully unaware of most news stories and things related to markets when I am on the beach, I had to look up what he was talking about, and it was S&P's , which had always enjoyed AAA, the highest sovereign rating Ìýthat can be granted to a country, to AA+, reflecting their concerns about both the fiscal challenges faced by the country, with mounting trade and budget deficits, as well as the willingness of its political institutions to flirt with the possibility of default. For more than a decade, S&P remained the outlier, but in 2023, Fitch joined it by also , citing the same reasons. That left Moody's, the third of the major sovereign ratings agencies, as the only one that persisted with a Aaa (Moody's equivalent of AAA) for the US, but that changed on May 16, 2025, when it too downgraded the US from Aaa (negative) to Aa1 (stable). Since the ratings downgrade happened after close of trading on a Friday, there was concern that markets would wake up on the following ÌýMonday (May 19) to a wave of selling, and while that did not materialize, the rest of the week was a down week for both stocks and US treasury bonds, especially at the longest end of the maturity spectrum. Rather than rehash the arguments about US debt and political dysfunction, which I am sure that you had read elsewhere, I thought I would take this moment to talk about sovereign default risk, how ratings agencies rate sovereigns, the biases and errors in sovereign ratings and their predictive power, and use that discussion as a launching pad to talk about how the US ratings downgrade will affect equity and bond valuations not just in the US, but around the world.

Sovereign Defaults: A History

Ìý Ìý Through time, governments have often been dependent on debt to finance themselves, some in the local currency and much in a foreign currency. A large proportion of sovereign defaults have occurred with foreign currency sovereign borrowing, as the borrowing country finds itself short of the foreign currency to meet its obligations. However, those defaults, and especially so in recent years, have been supplemented by countries that have chosen to default on local currency borrowings. I use the word "chosen" because most countries Ìýhave the capacity to avoid default on local currency debt, being able to print money in that currency to pay off debt, but chose not to do so, because they feared the consequences of the inflation that would follow more than the consequences of default.
While the number of sovereign defaults has ebbed and flowed over time, there are two points worth making about the data. The first is that, over time, sovereign defaults, especially on foreign currency debt, have shifted from bank debt to sovereign bonds, with three times as many sovereign defaults on bonds than on bank loans in 2023. The second is that local currency defaults are persistent over time, and while less frequent than foreign currency defaults, remain a significant proportion of total defaults. Ìý Ìý The consequences of sovereign default have been both economic and political. Besides the obvious implication that lenders to that government lose some or a great deal of what is owed to them, there are other consequences. Researchers who have examined the aftermath of default have come to the following conclusions about the short-term and long-term effects of defaulting on debt:Default has a negative impact on the economy, with real GDP dropping between 0.5% and 2%, but the bulk of the decline is in the first year after the default and seems to be short lived.Default does affect a country’s long-term sovereign rating and borrowing costs. One study of credit ratings in 1995 found that the ratings for countries that had defaulted at least once since 1970 were one to two notches lower than otherwise similar countries that had not defaulted. In the same vein, defaulting countries have borrowing costs that are about 0.5 to 1% higher than countries that have not defaulted. Here again, though, the effects of default dissipate over time.Sovereign default can cause trade retaliation. One study indicates a drop of 8% in bilateral trade after default, with the effects lasting for up to 15 years, and another one that uses industry level data finds that export-oriented industries are particularly hurt by sovereign default.Sovereign default can make banking systems more fragile. A study of 149 countries between 1975 and 2000 indicates that the probability of a banking crisis is 14% in countries that have defaulted, an eleven percentage-point increase over non-defaulting countries.Sovereign default also increases the likelihood of political change. While none of the studies focus on defaults per se, there are several that have examined the after-effects of sharp devaluations, which often accompany default. A study of devaluations between 1971 and 2003 finds a 45% increase in the probability of change in the top leader (prime minister or president) in the country and a 64% increase in the probability of change in the finance executive (minister of finance or head of central bank).In summary, default is costly, and countries do not (and should not) take the possibility of default lightly. Default is particularly expensive when it leads to banking crises and currency devaluations; the former has a longstanding impact on the capacity of firms to fund their investments whereas the latter create political and institutional instability that lasts for long periods.

Sovereign Ratings: Measures and Process

Ìý ÌýÌýSince few of us have the resources or the time to dedicate to understanding small and unfamiliar countries, it is no surprise that third parties have stepped into the breach, with their assessments of sovereign default risk. Of these third-party assessors, bond ratings agencies came in with the biggest advantages:They have been assessing default risk in corporations for a hundred years or more and presumably can transfer some of their skills to assessing sovereign risk.Bond investors who are familiar with the ratings measures, from investing in corporate bonds, find it easy to extend their use to assessing sovereign bonds. Thus, a AAA rated country is viewed as close to riskless whereas a C rated country is very risky.ÌýMoody’s, Standard and Poor’s and Fitch’s have been rating corporate bond offerings since the early part of the twentieth century. Moody’s has been rating corporate bonds since 1919 and started rating government bonds in the 1920s, when that market was an active one. By 1929, Moody’s provided ratings for almost fifty central governments. With the Great Depression and the Second World War, investments in government bonds abated and with it, the interest in government bond ratings. In the 1970s, the business picked up again slowly. As recently as the early 1980s, only about thirteen Ìýgovernments, mostly in developed and mature markets, had ratings, with most of them commanding the highest level (Aaa). The decade from 1985 to 1994 added 34 countries to the sovereign rating list, with many of them having speculative or lower ratings and by 2024, Moody's alone was rating 143 countries, covering 75% of all emerging market countries and almost every developed market.Ìý
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Not only have ratings agencies become more active in adding countries to their ratings list, but they have also expanded their coverage of countries with more default risk/ lower ratings. ÌýIn fact, the number of Aaa rated countries was the same in 1985, when there were thirteen rated countries, as in 2025, when there were 143 rated countries. In the last two decades, at least five sovereigns, including Japan, the UK, France and now the US, have lost their Aaa ratings. ÌýIn addition to more countries being rated, the ratings themselves have become richer. Moody’s and S&P now provide two ratings for each country â€� a local currency rating (for domestic currency debt/ bonds) and a foreign currency rating (for government borrowings in a foreign currency).ÌýÌý Ìý In assessing these sovereign ratings, ratings agencies draw on a multitude of data, quantitative and qualitative. Moody's describes its sovereign ratings process in the picture below: The process is broad enough to cover both political and economic factors, while preserving wiggle room for the ratings agencies to make subjective judgments on default that can lead to different ratings for two countries with similar economic and political profiles.ÌýThe heat map below provides the sovereign ratings, from Moody's, for all rated countries the start of 2025:
Moody's sovereign ratings
Note that the greyed out countries are unrated, with Russia being the most significant example; the ratings agencies withdrew their rating for Russia in 2022 and not reinstated it yet.ÌýThere were only a handful of Aaa rated countries, concentrated in North America (United States and Canada), Northern Europe (Germany, Scandinavia), Australia & New Zealand and Singapore (the only Aaa-rated Asian country. In 2025, there have been a eight sovereign ratings changes, four upgrades and four downgrades, with the US downgrade from Aaa to Aa1 as the highest profile change
With the US downgrade, the list of Aaa-rated countries has become shorter, and as Canada and Germany struggle with budget imbalances, the likelihood is that more companies will drop off the list.
Sovereign Ratings: ÌýPerformance and AlternativesÌý Ìý If sovereign ratings are designed to measure exposure to default risk, how well do they do? The answer depends on how you evaluate their performance. The ratings agencies provide tables that list defaults by rating that back the proposition that sovereign ratings and default are highly correlated. A Moody's update of default rates by sovereign ratings classes, between 1983 and 2024, yielded the following:


Default rates rise as sovereign ratings decline, with a default rate of 24% for Ìýspeculative grade sovereign debt (Baa2 and below) as opposed to 1.8% for investment grade (Aaa to Baa1) sovereign debt.Ìý Ìý That said, there are aspects of sovereign ratings that should give pause to anyone considering using them as their proxy for sovereign default, they do come with caveats and limitations:Ratings are upward biased: Ratings agencies have been accused by some of being far too optimistic in their assessments of both corporate and sovereign ratings. While the conflict of interest of having issuers pay for the rating is offered as the rationale for the upward bias in corporate ratings, that argument does not hold up when it comes to sovereign ratings, since not only are the revenues small, relative to reputation loss, but a proportion of sovereigns are rated for no fees.There is herd behavior: When one ratings agency lowers or raises a sovereign rating, other ratings agencies seem to follow suit. This herd behavior reduces the value of having three separate ratings agencies, since their assessments of sovereign risk are no longer independent.Too little, too late: To price sovereign bonds (or set interest rates on sovereign loans), investors (banks) need assessments of default risk that are updated and timely. It has long been argued that ratings agencies take too long to change ratings, and that these changes happen too late to protect investors from a crisis.Vicious Cycle: Once a market is in crisis, there is the perception that ratings agencies sometimes overreact and lower ratings too much, thus creating a feedback effect that makes the crisis worse. This is especially true for small countries that are mostly dependent on foreign capital for their funds.Regional biases: There are many, especially in Asia and Latin America, that believe that the ratings agencies are too lax in assessing default risk for North America and Europe, Ìýoverrating countries in Ìýthose regions, while being too stringent in their assessments of default in Asia, Latin America and Africa, underrating countries in those regions.ÌýIn sum, the evidence suggests that while sovereign ratings are good measures of country default risk, changes in ratings often lag changes on the ground, making them less useful to lenders and investors.Ìý Ìý If the key limitation of sovereign ratings is that they are not timely assessors of country default risk, that failure is alleviated by the development of the sovereign CDS market, a market where investors can buy insurance against country default risk by paying an (annualized) price. While that market still has issues in terms of counterparty risk and legal questions about what comprises default, it has expanded in the last two decades, and at the start of 2025, there were about 80 countries with sovereign CDS available on them. The heat map below provides a picture of sovereign (10-year) ÌýCDS spreads onÌýJanuary 1, 2025:
As you can see, even at the start of 2025, the market was drawing a distinction between Ìýthe safest Aaa-rated countries (Scandinavia, Switzerland, Australia and New Zealand), all with sovereign CDS spreads of 0.20% or below, and more risky Aaa-rated countries (US, Germany, Canada). During 2025, the market shocks from tariff and trade wars have had an effect, with sovereign CDS spreads increasing, especially in April.ÌýThe US, which started 2025 with a sovereign CDS spread of 0.41%, saw a widening of the spread to 0.62% in late April, before dropping back a bit in May, with the Moody's downgrade having almost no effect on the US sovereign CDS spread.
The US Downgrade: Lead-in and AftermathÌý Ìý With that background on sovereign default and ratings, let's take a look at the story of the moment, which is the Moody's downgrade of the US from Aaa to Aa1. In the weeks since, we have not seen a major upheaval in markets, and the question that we face as investors and analysts is whether anything of consequence has changed as a result of the downgrade.

The Lead-inÌý Ìý As I noted at the start of this post, Moody's was the last of the big three sovereign ratings agencies giving the United States a Aaa rating, with S&P (in 2011) and Fitch (in 2023) having already downgraded the US. In fact, the two reasons that both ratings agencies provided at the time of their downgrades were rising government debt and politically dysfunction were also the reasons that Moody's noted in their downgrade. On the debt front, one of the measures that ratings agencies use to assess a country's financial standing is its debt to GDP ratio, and it is undeniable that this statistic has trended upwards for the United States:
The ramping up of US debt since 2008 is reflected in total federal debt rising from 80% of GDP in 2008 Ìýto more than 120% in 2024. While some of the surge in debt can be attributed to the exigencies caused by crises (the 2008 banking crisis and the 2020 COVID bailouts), the troubling truth is that the debt has outlasted the crises and blaming the crises for the debt levels today is disingenuous.ÌýÌý Ìý The problem with the debt-to-GDP measure of sovereign fiscal standing is that it is an imperfect indicator, as can be seen in this list of countries that scored highest and lowest on this measure in 2023:
Many of the countries with the highest debt to GDP ratios would be classified as safe and some have Aaa ratings, whereas very few of the countries on the lowest debt to GDP list would qualify as safe. Even if it it the high debt to GDP ratio for the US that triggered the Moody's downgrade, the question is why Moody's chose to do this in 2025 rather than a year or two or even a decade ago, and the answer to that lies, I think, in the political component. A sovereign default has both economic and political roots, since a government that is intent on preserving its credit standing will often find ways to pay its debt and avoid default. For decades now, the US has enjoyed special status with markets and institutions (like ratings agencies), built as much on its institutional stability (legal and regulatory) as it was on its economic power. The Moody's downgrade seems to me a signal that those days might be winding down, and that the United States, like the rest of the world, will face more accountability for lack of discipline in its fiscal and monetary policy.
Market ReactionÌý Ìý The ratings downgrade was after close of trading on Friday, May 16, and there was concern about how it would play out in markets, when they opened on Monday, May 19. US equities were actually up on that day, though they lost ground in the subsequent days:

If equity markets were relatively unscathed in the two weeks after the downgrade, what about bond markets, and specially, the US treasury market? After all, an issuer downgrade for any bond is bad news, and rates should be expected to rise to reflect higher default risk:
While rates did go up in the the first few days after the downgrade, the effect was muddled by the passage of a reconciliation bill in the house that potentially could add to the deficit in future years. In fact, by the May 29, 2025, almost all of the downgrade effect had faded, with rates close to where they were at the start of the year.ÌýÌý ÌýYou may be surprised that markets did not react more negatively to the ratings downgrade, but I am not for three reasons:Lack of surprise effect: While the timing of the Moody's downgrade was unexpected, the downgrade itself was not surprising for two reasons. First, since S&P and Fitch had already downgraded the US, Moody's was the outlier in giving the US a Aaa rating, and it was only a matter of time before it joined the other two agencies. Second, in addition to reporting a sovereign rating, Moody's discloses when it puts a country on a watch for a ratings changes, with positive (negative) indicating the possibility of a ratings upgrade (downgrade). Moody's changed its outlook for the US to negative in November 2023, and while the rating remained unchanged until May 2025, it was clearly considering the downgrade in the months leading up to it.Magnitude of private capital: The immediate effect of a sovereign ratings downgrade is on government borrowing, and while the US does borrow vast amounts, private capital (in the form of equity and debt) is a far bigger source of financing and funding for the economy.ÌýRatings change: The ratings downgrade ws more of a blow to pride than to finances, since the default risk (and default spread) difference between an Aaa rating and a Aa1 rating is small. Austria and Finland, for instance, had Aa1 ratings in May 2025, and their ten-year bonds, denominated in Euros, traded at a spread of about 0.15- 0.20% over the German ten-year Euro bond; Germany had a Aaa rating.Consequences for valuation and investment analysisÌý ÌýWhile the immediate economic and financial consequences of a downgrade from Aaa to Aa1 will be small, there are implications for analysts around the world. In particular, analysts will have to take steps when working with US dollars that they may already be taking already when working with most other currencies in estimating basic inputs into financial analysis.
Ìý Ìý Let's start with the riskfree rate, a basic building block for estimating costs of equity and capital, which are inputs into intrinsic valuation. In principle, the riskfree rate is what you will earn on a guaranteed investment in a currency, and any risk premiums, either for investing in equity (equity risk premium) or in fixed income securities (default spreads), are added to the riskfree rate. It is standard practice in many textbooks and classrooms to use the government bond rate as the risk free rate, but that is built on the presumption that governments cannot default (at least on bonds issued in the local currency). Using a Aaa (AAA) rating as a (lazy) proxy for default-free, that is the rationale we used to justify government bond rates as riskfree rates at the start of 2025, in Australian, Singapore and Canadian dollars, the Euro (Germany). Swiss francs and Danish krone.ÌýAs we noted in the first section, the assumption that governments don't default Ìýis violated in practice, since some countries choose to default on local currency bonds, rather than face up to inflation. If that is the case, the government bond rate is no longer truly a riskfree rate, and getting to a riskfree rate will require netting out a default spread from the government bond rate:
Risk free rate = Government Bond rate −ÌýDefault spread for the governmentÌý
The default spread can be estimated either from the sovereign bond rating (with a look up table) or a sovereign CDS spread, and we used that process to get riskfree in rates in a Ìýhost of currencies, where local currency government bonds had default risk, at the start of 2025:

Thus, to get a riskfree rate in Indian rupees, Brazilian reals or Turkish lira, we start with government bonds in these currencies and net out the default spreads for the countries in question. We do this to ensure that we don't double count country risk by first using the government bond (which includes default risk) as a riskfree rate and then using a larger equity risk premium to allow for the same country risk. ÌýÌýÌý ÌýNow that the US is no longer Aaa rated, we have to follow a similar process to get a riskfree rate in US dollars:
US 10-year treasury bond rate on May 30, 2025 Ìý= 4.41%Default spread based on Aa1 rating on May 30, 2025 Ìý= 0.40%Riskfree rate in US dollars on May 30, 2025 = US 10-year treasury rate - Aa1 default spread = 4.41% - 0.40% = 4.01%
This adjustment yields a riskfree rate of 4.01% in US dollars, and it is also built on the presumption that the default spread manifested after the Moody's downgrade on May 16, when the more realistic reading is that US treasury markets have been carrying a Ìýdefault spread embedded in them for years, and that we are not making it explicit.Ìý Ìý The ratings downgrade for the US will also affect the equity risk premium computations that I use to estimate the cost of equity for companies. As some of you who track my equity risk premiums by country know, I estimate an equity risk premium for the S&P 500, and at least until the start of this year, I used that as a premium for all mature markets (with a AAA (Aaa) rating as the indicator of maturity). Thus, countries like Canada, Germany, Australia and Singapore were all assigned the same premium as that attributed to the S&P 500. For countries with ratings below Aaa, I added an "extra country risk premium" Ìýcomputed based upon the default spreads that went with the country ratings:
With the ratings downgrade, I will have to modify this process in three ways. The first is that when computing the equity risk premium for the S& P 500, I will have to net out the adjusted riskfree rate in US dollars rather than the US treasury rate, yielding a higher equity risk premium for the US. Second, for Aaa rated countries, to the extent that they are safer than the US will have to be assigned an equity risk premium lower than the US, with the adjustment downward reflecting the Aa1 rating for the US. The third is that for all other countries, the country risk premium will be computed based upon the the their default spreads and the equity risk premium estimated for Aaa rated countries (rather than the US equity risk premium):
How will the cost of equity for a firm with all of its revenues in the United States be affected as a consequence? Let's take three companies, one below-average risk, one average-risk and one above average risk, and compute their costs of equity on May 30, 2025, with and without the downgrade factored in:
As you can see, the expected return on the S&P 500 as of May 30, 2025, reflecting the index level then and the expected cash flows, is 8.64%. Incorporating the effects of the downgrade changes the composition of that expected return, resulting in a lower riskfree rate (4.01% instead of 4.41%) and a higher equity risk premium (4.63% instead of 4.23%). Thus, while the expected return for the average stock remains at 8.64%, the expected return increases slightly for riskier stocks and decreases slightly for safer stocks, but the effects are so small that investors will hardly notice. If there is a lesson for analysts here, it is that the downgrade's effects on the discount rates (costs of equity and capital) are minimal, and that staying with the conventional approach (of using the ten-year US treasury bond rate as the riskfree rate and using that rate to compute the equity risk premium) will continue to work.
ConclusionÌý Ìý The Moody's ratings downgrade of the US made the news, and much was made of it during the weekend that followed. The financial and economic consequences, at least so far, have been inconsequential, with equity and bond markets shrugging off the downgrade, perhaps because the surprise factor was minimal. The downgrade also has had only a minimal impact on costs of equity and capital for US companies, and while that may change, the changes will come from macroeconomic news or from crises. For the most part, analysts should be able to continue to work with the US treasury rate as a riskfree rate and forward-looking equity risk premiums, as they did before the downgrade. With all of that said, though, the Moody's action does carry symbolic weight, another indicator that US exceptionalism, which allowed the US to take economic and fiscal actions that would have brought blowback for other countries, especially in emerging markets, is coming to an end. That is healthy, in the long term, for both the United States and the rest of the world, but it will come with short term pain.

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posted by Aswath Damodaran on June, 03 ]]>
/author_blog_posts/25727654-the-greed-fear-tango-the-markets-in-april-2025 Sat, 03 May 2025 07:30:00 -0700 <![CDATA[The Greed & Fear Tango: The Markets in April 2025!]]> /author_blog_posts/25727654-the-greed-fear-tango-the-markets-in-april-2025 Equities: Storm Clouds gather (and dissipate)!Ìý Ìý It would be an understatement to describe equity markets in April 2025 as volatile, with the equity indices going through stomach wrenching up and down movements intraday and across days, as investors struggled to price in a world of tariffs, trade wars and policy uncertainty.
The journey that the indices went through during the course of the month has been extraordinary. Each of the indices lost close to 10% Ìýin the first two days of the month, went deeper into the hole in the second week of the month, but by the end of the month, they had each found their way back to almost where they started the month at, with the S&P 500, NASDAQ and the MSCI world index all within 1% of their start-of-the-month levels.ÌýÌý ÌýAs I noted , where I framed the market crisis around tariffs, the indices sometimes obscure markets shifts that are occurring under the surface, and that looking at all publicly traded stocks on an aggregated basis provides a more complete picture. I will start by looking at the regional breakdown of what the month delivered in terms of change in market cap, in both dollar and percentage terms:

The crisis may have been birthed in the United States, but as has been the case with market crises in this century, it has spread across the world, with disparate impacts. There are truly no standouts in either direction, with China being the worst performing region, in terms of percentage change in dollar value, down 3.69%, and India and Latin America tied for best performing, up 3.57%. ÌýThese are dollar returns, and since the US dollar came under selling pressure during the course of the month, the local currency returns were worse, especially in markets, like the EU, where the Euro gained about 5% in the courser of the month.Ìý Ìý At the start of the month, as has been the case for much of the last decade, the focus was on technology, partly because ofÌýits large weight in overall equity value at the start of 2025, and partly because of the punishment meted out to tech stocks during the first quarter of the year. ÌýFocusing just on US equities, technology companies, which accounted for 29.4% of the overall market capitalization of all US companies at the start of 2025, lost $2.34 trillion (about 13.19%) in market capitalization in the first quarter of 2025. In the first few days of April, that trend continued as technology initially led the rout, losing an additional $1.78 trillion, but by the end of April, tech had made at least a partial comeback:
As you can see, technology ended the month as the second best performing sector, up 1.67% for the month, and in spite of the handwringing about their poor performance, their share of the market cap pie has barely changed after the first four months of 2025. While the first quarter continues to weigh the sector down, as was the case in 2022, the obituaries written for technology investing may have been premature.Ìý Ìý Staying in the weeds, I also looked at the push and pull of growth versus value, by breaking US equities down into deciles based on earnings to price ratiosÌýand assessing their performance leading into April and in April 2025 alone:

As you can see, while there is no clearly discernible pattern across deciles of US stocks based upon earnings to price ratios, breaking down US stocks into a top and bottom half, based upon the ratio, yields the conclusion that while high PE stocks had a bad start to the year, losing 10.9% of their value in the first quarter, they made a comeback in April, up 1.74% for the year, Ìýwhile low PE stocks were down 2.22% for the month. That pattern of a reversal in April 2025 of trends that had been forming in the first quarter of 2025 shows upon in other proxies for the value versus growth tussle:Looking at companies broken down by market capitalization into deciles, you find that larger cap companies outperformed small cap stocks during April,ÌýBreaking down stocks based on dividends, dividend paying stocks and companies buying back stock underperformed non-cash returning stocks, indicating that there was no flight to safety in April.Ìý Ìý Finally, I classified companies based upon their stock price performance in 2024 to see if what we are seeing in 2025 is just a correction of overreach in 2024. After all, if that is the case, we should see the stocks that have performed the best in 2024 be the ones that have taken the most punishment this year:
As you can see, momentum returned in force in April, with the best performing stocks in 2024 up 0.76% during the month, while the worst performing stocks of 2024 were down 5.31% for the month. In fact, the year-to-date numbers for 2025 indicate that momentum remains in the driver's seat, extending a long period of outperformance.ÌýÌý Ìý In sum, the market stressesÌýin April 2025 seems to have pushed the market back into its 2024 ways, after a first quarter that promised reversal, as technology, growth and momentum all made a comeback in the last three weeks of April. The performance of the Mag Seven, which represent a combination of all three forces (large, high growth and technology), in April provides a tangible measure of this shift:


The Mag Seven have had a bad year to date, losing $2.6 trillion in market capitalization, but they made a comeback from the depths to finish April at about the same market cap that they had at the start of the month, recovering almost all of the $1.55 trillion that they lost in the first week of the month.Ìý Ìý In short, not only did equities recover in the last three weeks of April 2025, but there seems have been a shift in sentiment back the forces that have borne markets upwards for the last few years,Ìýwith technology, growth and momentum returning as market drivers. Of course, three weeks is a short time, but this is a trend worth watching for the rest of this year.
The Rest of the Market: Swirling Winds?Ìý Ìý As equities careened through April 2025 between panic and delirium, the other asset classes were surprisingly staid, at least on the surface, starting with the US treasuries. Unlike other crises, where US treasuries saws funds flow in, pushing down yields and pushing up prices, treasury rates remained relatively stable through much of April:



Not only did rates remain almost unchanged across the maturity spectrum, but they were stable on a week-to-week basis. The yield curve, downward sloping for much of the last two years, Ìýis now u-shaped, with 3-month rates and 2-year rates higher than 5-year rates, before reverting back to higher longer term (10-year and 30-year rates). Coming from the camp that we read too much economic significance into yield curve slopes and dynamics, I am reluctant to draw big conclusions, but some of this can be attributed to expectations of higher inflation in the near term. There is another force at play in this crisis that has not been as visible in past ones, at least in the US treasury market, and that is concerns about the trustworthiness of the US government Though this is still an early indicator, that can be seen in the sovereign CDS market, where investors pay for insurance against default risk, and where the US CDS spread has risen in April:

The sovereign CDS spread for the US has risen about 38% during the course of this month, and the interesting part is that much of that rise happened in the last three weeks of the month, and during the first week, when equities were collapsing. The rise in perceptions of US default risk is more likely to have been precipitated by the threat to fire Jerome Powell, and by extension to the independence of the Fed as an institution. While that threat was withdrawn, the sovereign CDS spread has stayed high, and it will be worth watching whether it will come back down or whether some permanent damage has been done to US treasuries as a safe haven. As some of you who follow my thinking on riskfree rates may know, I argue that the riskfree rate in a currency is not necessarily the government bond rate in that currency, and that the default spread has to netted out from the government bond rate two get to a riskfree rate, if the sovereign in question is not viewed as default-free. Building on that principle, I may soon have to revisit my practice of using the US treasury rate as the riskfree rate in US dollars and net out a default spread for the US from that rate to get to a riskfree rate.Ìý Ìý During April 2025, commodity prices were also on the move, and in the graph below, I look at oil prices as well as an overall commodity index during the month:Ìý


In the first third of the month, oil prices, in particular, and commodity prices, in general, joined equities, as they moved down, but in the last part of the month, they delinked, and stayed down, even as stock prices bounced back up. To the extent that the demand for commodities is driven by real economic growth, that would suggest that at least in the near term, the tariffs that precipitated the crisis will slow down global economies and reduce demand for commodities.ÌýÌý Ìý The concerns about central banking independence that triggered the surge in the US sovereign CDS spread also played out in currency markets, where the US dollar, already weakened in the first quarter, continued its decline in April. In the graph below, I look at the dollar-euro exchange rate and an index measuring the strength of the dollar against multiples currencies.

The dollar continued its decline in April, down about 3% against a broad basket of currencies, and more than 5% against the Euro.ÌýÌý Ìý Finally, I looked at two other investment classes - gold and bitcoin - for the same reasons that I brought them into the discussion at the start of April. They are collectibles, i.e., investments that investors are drawn to during crisis periods or when they lose faith in paper currencies and governments:


Gold had a good month in April, up about 5.3%, and hitting $3.500 towards the end of the month, but Bitcoin did even better rising almost 14.12% during the course of the month. That said, the fact that financial asset markets (equity and bond) recovered over the second part of the month made this a month where collectibles were not put to their test as crisis investments, and the rise in both can be attributed more to the loss of trust that has driven Ìýthe sovereign CDS spread up and the US dollar down.
Risk and Co-movementÌý Ìý Early in April, I argued that the one number that would track the balance between greed and fear in markets would be the price of risk in markets, and I resolved to estimate that price every day, through April, for both equity and bond markets. With equity markets, the price of risk is the equity risk premium, and at least Ìýin my estimation process, it is a forward-looking number determined by the level of stock prices and expected cash flows. In the table below, I report on my estimates of the equity risk premium for the S&P 500 every trading day in April, in conjunction with the VIX, and equity volatility index that should be correlated:

After rising above 5% in the first third of the month, the equity risk premium decreased in fits and starts over the rest of the month to end at almost the same value (4.58%) as at the start of the month (4.59%). In parallel, the VIX soared in the first few days of the month to peak at 52.33 on April 8, and then decreased over the rest of the month to a level (24.70) close to where it was at the start of the month (22.28).Ìý Ìý In the bond market, the price of risk takes the form of default spreads, and these spreads followed a similar path to the equity risk measures:
The default spread on high yield bonds surged, rising by more than 1% between the start of the month and April 7, before declining, but unlike the equity risk measures, the bond default spreads did end the month at levels higher than at the start, indicating at least at this point that near term concerns about the economy and the ensuing default risk have not subsided.Ìý Ìý As a final exercise, I looked at the correlation in price changes across investment classes - stocks, treasuries, investment-grade and high-yield corporate bonds, commodities, gold and bitcoin:

With the caveat that this is just 22 trading days in one month, it does yield some preliminary results about co-movements. First, stock and treasury bond prices moved together much of the month, not something that you would expect during a crisis, when bond prices gain as stock prices fall. Second, while both gold and bitcoin prices moved with stocks, gold prices movements were more closely tied to stock price movements, at least during the month. In sum, the movement across asset markets affirms our conclusion from looking at company-level data that this was more a month of asset reprising than panic selling or buying.Ìý Ìý In sum, if I were to summarize what the data is pointing me towards, here are the general conclusions that I would draw, albeit with a small sample:
The market movements through much of the month were less driven by panic and more by investors trying to reprice companies to reflect a world with more trade barriers and tariffs and political turmoil.While equities, in the aggregate, ended the month roughly where they started the month, a shift in sentiment seemed to occur in the last three weeks of the month, as technology, growth and momentum, three forces that seemed to be in retreat in the first quarter of 2025, made a come back.With US treasuries, there was little movement on the rates, but under the surface, there were shifts Ìýthat could be tectonic in the long term. There was clearly a drop in trust in the US government and its institutions, which played out in rising sovereign CDS spreads and a declining dollar, and trust once lost can be difficult to gain back.The investment classes that are most vulnerable to the real economy, i.e.. commodities and higher yield corporate bonds, were down for the month, indicating a slowing down of global economic growth.In the coming months, we will see whether the last three weeks of April were an aberration or the start of something bigger.
Lessons LearnedÌý ÌýÌýEvery market meltdown carries pain to investors, but that pain is often spread unevenly across these investors, with the variation driven as much as by what they held coming into the crisis, as it is by how they behaved in response to the sell off. I am not sure April 2025 falls into the crisis column, but it did feel like one early in the month, and as I look back at the month, I come back to three market characteristics that stood out.Market resilience: In the last five years, markets have repeatedly not only got the big trends right, but they have also shown far more resilience than any expert group. I would wager that if you had given a group of macro economists or market strategists just the news stories that came out during the course of the month and asked them to guess how they would play out in market reaction, almost none of them would have guessed the actual outcome (of flat markets). At the time of COVID, I argued that one reason for market resilience is that market influence has become diffuse, with social media and alternative sources of information supplementing and often replacing the traditional influencers - the financial press, media and investment talking heads, and market movements are less driven by large portfolio managers exhibiting herd behavior and more by disparate groups of traders, with different motives, models and patterns.ÌýMarket power: A key reason for the turnaround in markets during April was the administration's decision to walk back, reverse or delay actions that the market reacted to strongly and negatively. The "liberation day" tariffs that triggered the initial sell off have largely been put on hold or suspended, and the talk about replacing the Fed Chair was walked back quickly the week after it was made. In short, an administration that has been impervious to Wall Street journal editorials, warnings from economists and counter threats from other governments has been willing to bend to market selling pressure.Market unpredictability: As markets rose and fell during the course of the month, the debate about the value added by active investing kicked into full gear. I heard quite a few advocates of active investing argue that it was during times like this (volatility and crisis) that the "sage counsel" and "timely decisions" of wealth or fund managers would protect investors on the downside. I would suggest the opposite, and am willing to bet that the extent of damage that April did to investor portfolios was directly proportional to how much time they spent watching CNBC and listening to (or reading) what market experts told them to do.On a personal note, I stuck to my resolution early in the crisis to use it to stay true to my investment philosophy. As someone who stinks at market timing, I made no attempt to buy and sell the market through the month, perhaps leaving a great deal of money on the table, or more likely, saving myself just as much from getting the timing wrong. In the middle of April, I, and in that post, I put myself Ìýin the opportunistic contrarian camp. I did use the mid-month sell off to add BYD, a stock that I like, to my portfolio, when its price dipped below my limit price ($80). Palantir and Mercado Libre (my two other limit buys) came close but not low enough to break through my limits, but I am willing to wait, revisiting my valuations along the way.Ìý Ìý I do have some portfolio maintenance work that I need to do in the coming weeks, especially on the six of the seven Mag Seven stocks that remain in my portfolio (Tesla is out of my portfolio and Nvidia is at a quarter of my original holding). As these companies report their first quarter earnings, I plan to revisit my valuations from last year, when in the face of mild to moderate over valuation, I chose to maintain my holdings. As in prior years, I will post my assessments of value and my hold/sell judgments, but that has to wait because I do have more immediate priorities. First, as a teacher, with the semester end approaching, I have a stack of grading that has to get done.ÌýSecond, as a father, I am looking forward to my daughter having her first child next week, and the market and my portfolio take a distant second place to getting acquainted with my new granddaughter.
YouTube Video
My Posts (from April 2025)
Data Links



posted by Aswath Damodaran on May, 04 ]]>
/author_blog_posts/25690957-buy-the-dip-the-draw-and-dangers-of-contrarian-investing Sun, 20 Apr 2025 18:48:00 -0700 <![CDATA[Buy the Dip: The Draw and Dangers of Contrarian Investing!]]> /author_blog_posts/25690957-buy-the-dip-the-draw-and-dangers-of-contrarian-investing ÌýÌý Ìý WhenÌýmarkets are in free fall, there is a great deal of Ìýadvice that is meted out to investors, and one is to just buy the dip, i.e., buy beaten down stocks, in the hope that they will recover, or the entire market, if it is down. Ìý"Buying the dip" falls into a broad group of investment strategies that can be classified as "contrarian", where investors act in contrast to what the rest of the market is doing at the time, buying (selling) when the vast majority are selling (buying) , and it has been around through all of market history. There are strands of research in both behavioral finance and empirical studies that back up contrarian strategies, but as with everything to do with investing, it comes with caveats and constraints. In this post, I will posit that contrarian investing can take different forms, each based on different assumptions about market behavior, and present the evidence that we have on the successes and failures of each one. I will argue that even if you are swayed intellectually by the arguments for going against the crowd, it may not work for you, if you are not psychologically attuned to the stresses and demands that contrarian strategies bring with them.

Contrarianism - The Different Strands

Ìý Ìý All contrarian investing is built around a common theme of buying an investment, when its price goes down significantly, but there are wide variations in how it is practiced. In the first, knee-jerk contrarianism, you use a bludgeon, buying either individual companies or the entire market when they are down, on the expectation that you will benefit from an inevitable recovery in prices. In the second, technical contrarianism, you buy beaten-up stocks or the entire market, but only if charting or technical indicators support the decision. ÌýIn the third, constrained contrarianism, you buy the stocks that are down, but only if they pass your screens for qualify and safety. In the fourth, opportunistic contrarianism, you use a price markdown as an opportunity to buy companies that you have always wanted to hold, but had not been able to buy because they were priced too high.

1. Knee-jerk Contrarianism

Ìý Ìý The simplest and most direct version of contrarian investing is to buy any traded asset where the price is down substantially from its highs, with the asset sometimes being an individual company, sometimes a sector and sometimes the entire market. Implicit in this strategy is an absolute belief in mean reversion, i.e., Ìýthat what goes down will almost always go back up, and that buying at the beaten down price and being willing to wait will therefore pay off.

Ìý Ìý The evidence for this strategy comes from many sources. For the market, it is often built on papers (or books) that look at the historical data on what equity markets have delivered as returns over long periods, relative to what you would have made investing elsewhere. Using data for the United States, a Ìýmarket with the longest and most reliable historical records, you can see the substantial payoff to investing in equities:


No matter what time period you use for your time horizon, stocks deliver the highest returns, of all asset classes, and there some who look at this record and conclude that "stocks always win in the long term", with the implication that you should stay fully invested in stocks, even through the worst downturns, if you have a reasonably long time horizon. These returns to buying stocks become greater, when you buy them when they are cheaper, measured either through pricing metrics (low PE ratios) or after corrections. There are two problems with the conclusion. The first is that there is selection bias, where using historical data from the United States, one of the most successful equity markets of the last century, to draw general conclusions about the risk and returns of investing in equities will lead you to underestimate equity risk and overestimate equity returns. The second is that, even with US equities, an investor who bought stocks just before a major downturn would have to wait a long time before being made whole again. Thus, investors who put their money in stocks in 1929, just ahead of the Great Depression, would not have recovered until 1954.Ìý

Ìý Ìý With individual stocks, the strongest backing for buying the dip comes from studies of "loser" stocks, i.e., stocks that have gone down the most over a prior period. In a classifiedÌýstocks based upon stock price performance in the prior three years into winner and loser portfolios, with the top fifty performers going into the "winner" portfolio, and the bottom fifty into the "losers portfolio", and estimated the returns you could have made on each group in the following city months:

As you can see, the loser portfolio dramatically outperforms the winner portfolio, delivering about 30% more on a cumulative basis than the winner portfolio in the thirty six months after the portfolios are created, which DeBondt and Thaler argued was evidence that markets overreact. About a decade later, revisited the study, with more granular data on time horizons, and found that the results were reversed, if you shorten the holding period, with winner stocks continuing to win over the first year after portfolio creation.Ìý

The reversal eventually kicks in after a year, but over the entire time period, the winner portfolio still outperforms the loser portfolio, on a cumulative basis. Jegadeesh and Titman also noted a skew in the loser portfolio towards smaller market cap and lower-priced stocks, with higher transactions costs (from bid-ask spreads and price impact). As other studies have added to the mix, the consensus on winner versus loser stocks is that there is no consensus, with evidence for both momentum, with winner stocks continuing to win, and for reversal, with loser stocks outperforming, depending on time horizon, and questions about whether these excess returns are large enough to cover the transactions costs involved.

Ìý Ìý Setting aside the mixed evidence for the moment, the biggest danger in knee-jerk contrarian investing at the market level is that buying the dip in the market is akin to catching a falling knife, since that initial market drop can be a prelude to a much larger sell off, and to the extent that there was an economic or fundamental reason for the sell off (a banking crisis, a severe recession), there may be no near term bounceback. With individual stocks, that danger gets multiplied, with investors buying stocks that are being sold off to for legitimate reasons (a broken business model, dysfunctional management, financial distress) and waiting for a market correction that never comes.Ìý

ÌýÌý ÌýTo examine the kinds of companies that you would invest in, with a knee-jerk contrarian investing strategy , I looked at all US stocks with a market capitalization exceeding a billion dollars on December 31, 2024, and found the companies that were the biggest losers, on a percent basis,Ìýbetween March 28 and April 18 of 2025:

You will note that technology and biotechnology firms are disproportionately represented on the list, but that is the by-product of a bludgeon approach.

2. Technical Contrarianism

Ìý ÌýÌýIn technical contrarianism, you start with the same basis as knee-jerk contrarianism, by Ìýlooking at stocks and markets that have dropped significantly, but with an added requirement that the price has to meet a charting or technical indicator constraint before becoming a buy. While there are many who consign technical analysis to voodoo investing, I believe that charting patterns and technical indicators can provide signals of shifts in mood and momentum that drive price movements, at least in the near term. Thus, you can view technical contrarianism as buying stocks or markets when they are down, but only if the charts and technical indicators point to a shift in market mood.

Ìý Ìý One of the problems with testing technical contrarianism, to see if it works, is that even among technical analysts, there seems to be no consensus as to the best indicator to use, but broadly speaking, these indicators can be based on either price and/or volume movements. They range in sophistication from simple measures like relative strength (where you look at percentage price changes over a period) and moving averages to complex ones that combine price and volume. In recent decades, investors have added pricing in other markets to the mix, with the VIX (a traded volatility index) as well as the relative pricing of puts and calls in the options market being used in market timing. In sum, all of these indicators are directed at measuring fear in the market, with a "market capitulation" viewed as a sign that the market has bottomed out.Ìý

Ìý Ìý With market timing indicators, there is research backing up the use of VIX and trading volume as predictors of market movements, though with substantial error.

As the VIX rises, the expected return on stocks in future periods goes up, albeit with much higher volatility around these expected returns. ItÌýis ironic that some of the best defenses of technical analysis have been offered by academics, especially in their studies of price momentum and reversal. present a fairly convincing defense of technical analysis from the perspective of financial economists. They use daily returns of stocks on the New York Stock Exchange and NASDAQ from 1962 and 1996 and employ sophisticated computational techniques (rather than human visualization) to look for pricing patterns. They find that the most common patterns in stocks are double tops and bottoms, followed by the widely used head and shoulders pattern. In other words, they find evidence that some of the most common patterns used by technical analysts exist in prices. Lest this be cause for too much celebration among chartists, they also point out that these patterns offer only marginal incremental returns (an academic code word for really small) and offer the caveat that these returns may not survive transaction costs.

3. Constrained Contrarianism

Ìý Ìý If you are in the old-time value investing camp, your approach to contrarian investing will reflect that worldview, where you will buy stocks that have dropped in value, but only if they meet the other criteria that you have for good companies. In short, you will start with a list of beaten up stocks, and then screen them for high profitability, strong moats and low risk, hoping to separate companies that are cheap from those that deserve to be cheap.

Ìý Ìý As a constrained contrarian, you are hoping to avoid value traps, every value investor's nightmare , where a company looks cheap on a pricing basis (low PE, low price to book) and proceeds to become even cheaper after you buy it. The evidence on whether screening helps avoid value traps comes largely from studies of the interplay between proxies of value (such as lowÌýprice to book ratios) and proxies for quality, including measures for both operating/capital efficiency (margins and returns on capital) and low risk (low debt ratios and volatility). Proponents of quality screens note that while value proxies alone no longer seem to deliver excess returns, incorporating quality screens seems to preserve these excess returns. ÌýResearch Affiliates, an investment advisory service, looked at returns to pure value screens versus value plus quality screens and presents the following evidence on how screening for quality improves returns:


The evidence is supportive of the hypothesis that adding quality screens improves returns, and does so more for stocks that look cheap (low price to book) than for expensive stocks. That said, the evidence is underwhelming in terms of payoff, at least on an annual return basis, though the payoff is greater, if you factor in volatility and estimate Sharpe ratios (scaling annual return to volatility).Ìý Ìý While much of the research on quality has been built around value and small cap investing, the findings can be extrapolated to contrarian investing, with the lesson being that rather than buy the biggest losers, you should be buying the losers that pass screening tests for highÌýprofitability (high returns on equity or capital) and low risk (low debt ratios and volatility). That may provide a modicum of protection, but the problem with these screens is that they are based upon historical data and do not capture structural changes in the economy or disruption in the industry, both of which have not yet found their way into the fundamentals that are in your screens.Ìý Ìý To provide just an illustration of constrained contrarianism, I again returned to the universe of about 6,000 publicly traded US stocks on April 18, 2025, and after removing firms with market capitalizations less than $100 million (with the rationale that these companies will have more liquidity risk and transactions costs), I screened first for stocks that lost more than 20% of their market capitalization between March 28 and April 18, and then added three value screens:
A PE ratio less than 15, putting the stock in the bottom quintile of US stocks as of December 31, 2024A dividend yield that exceeded 1%, a paltry number by historical norms, but ensuring that the company was dividend-paying in 2024, a year in which 60% of US stocks paid no dividendsA net debt/EBITDA ratio of less than two, dropping it into the bottom quintile of US companies in terms of debt loadThe six companies that made it through the screens are below:
I am sure that if you are a value investor, you will disagree about both the screens that I used as well as my cut offs, but you are welcome to experiment with your own screens to find bargains.

4. Opportunistic Contrarianism

Ìý Ìý In a fourth variant of contrarian investing, you use a market meltdown as an opportunity to buy companies that youÌýhave always wanted to own but could not because they were over priced before the price drop, but look under priced after. ÌýThe best place to start an assessment of opportunistic investing is with my post on with the first being determined by all of the considerations that go into separating great businesses from badÌýbusinesses, including growth and profitability, and the second by the price you have to pay to buy them. In that post, I had a picture drawing the contrast between good companies and good investments:


Put simply, most great companies are neutral or even bad investments, because the market prices them to be great. A year ago, when I s, I argued that these were, for the most part, great businesses, with a combination of growth at scale, high profitability and deep moats, but that at the prices that they were trading Ìýthey were not great investments.Ìý

I also argued that even great companies have their market travails, where for periods of time, investors lose faith in them and drive their prices down not just to value, but below. It happened to Microsoft in 2014, Apple in 2017, Nvidia in 2018, Tesla at multiple times in the last decade, and to . While those corrections were caused by company-specific news stories and issues, the same process can play out, when you have significant market markdowns, as we have had over the last few weeks.Ìý

Ìý Ìý The process of opportunistic contrarianism starts well before a market correction, with the identification of companies that you believe are good or great businesses:

At the time that you first value them, you are likely to find them to be over valued, which will undoubtedly be frustration. You may be tempted to play with the numbers to make these companies look undervalued, but a better path is to put them Ìýon your list of companies you would like to own, and leave them there. During a market crisis, and especially when investors are marking down the prices of everything, without discriminating between good and bad companies, you should revisit that list, with a caveat that you cannot compare the post-correction price to your pre-crisis valuation of your company. Instead, you will have to revalue the company, with adjustments to expected cash flows and risk premiums, given the crisis, and if that value exceeds the price, you should buy the stock.Ìý

Contrarian Investing: The Psychological Tests!

Ìý Ìý In the abstract, it is easy to understand the appeal of contrarian investing. Both behavioral and empirical research identify the existence of herd behavior in crowds, and point to tipping points where crowd wisdom becomes crowd madness. A rational decision-maker in the midst of animal spirits may feel that he or she has an advantage in this setting, and rightly so. That said, buying when the rest of the market is selling takes a mindset, a time horizon and a stronger stomach than most of us do not have.

The Mindset: Investing against the market will not come easily to those who are easily swayed by peer pressure, since they will have to buy, just as other investors (the peer group) will be selling, and often in companies that the market has turned against. There are Ìýsome who march to their own drummers, willing to take a path that is different from the rest, and these are better suited to being contrarians.The Time Horizon: To be a contrarian, you don't always need a long time horizon, since correlations can sometimes happen quickly, but you have to be willing to wait for a long period, if that is what is necessary for the correction. Relatively few investors have this capacity, since it is determined as much by your circumstances (age, health and cash needs) as it is by your personality.The Stomach: Even if your buy decision is based on the best thought-through contrarian investing strategies, it is likely that in the aftermath of that decision, momentum will continue to push prices down, testing your faith. Without a strong stomach, you will capitulate, and while your decision may have been right in the long term, your investment will not reflect that success.As you can see, the decision on whether to be a contrarian is not just one that you can make based upon the evidence and theory, but will depend on who you are as a person, and your makeup.ÌýÌý Ìý I have the luxury of a long time horizon and the luck of a strong stomach, for both food and market surprises. I am not easily swayed by peer pressure, but I am not immune from it either. I know that buying stocks in the face of market selling will not come easily, and that is the reason that I initiated limit buys on three companies that I have wanted to have in my portfolio, BYD, the Chinese electric car maker, Mercado Libre, the Latin American online retail/fintech firm, and Palantir, a company that I believe is closest to delivering on thee promise of AI products and services. The limit buy kicked in on BYD on April 7, when it briefly dipped below $80, Ìýmy limit price, and while Palantir and Mercado Libre have a way to go before they hit my price limits, the crisis is young and the order is good until canceled!

YouTube Video



posted by Aswath Damodaran on April, 21 ]]>
/author_blog_posts/25655506-anatomy-of-a-market-crisis-tariffs-markets-and-the-economy Mon, 07 Apr 2025 14:10:00 -0700 <![CDATA[Anatomy of a Market Crisis: Tariffs, Markets and the Economy!]]> /author_blog_posts/25655506-anatomy-of-a-market-crisis-tariffs-markets-and-the-economy I was boarding a plane for a trip to Latin America late in the evening last Wednesday (April 2), and as is my practice, I was checking the score on the Yankee game, when I read the tariff news announcement. Coming after a few days where the market seemed to have found its bearings (at least partially), it was clear from the initial reactions across the world that the breadth and the magnitude of the tariffs had caught most by surprise, and that a market markdown was coming. Not surprisingly, the markets opened down on Thursday and spent the next two days in that mode, with US equity indices declining almost 10% by close of trading on Friday. Luckily for me, I was too busy on both Thursday and Friday with speaking events, since as the speaker, I did not have the luxury (or the pain) of checking markets all day long. In my second venue, which was Buenos Aires, I quipped that while Argentina was trying its best to make its way back from chaos towards stability, the rest of the world was looking a lot more like Argentina, in terms of uncertainty. On Saturday, on a long flight back to New York, I wrestled with the confusion, denial and panic that come with a market meltdown, and tried to make sense of what had happened, and more importantly of what is coming. That thinking is still a work-in-progress but as in prior crises, I find that putting even unfinished thoughts down on paper (or in a post) is healthy, and perhaps a critical component to finding your way back to serenity.

The Tariffs and Markets

Ìý Ìý Since talk of tariffs has filled the airwaves for most of this year, you may wonder why markets reacted so strongly to the announcement on Wednesday. One reason might have been that investors and businesses were not expecting the tariff hit to be as wide and as deep as they turned out to be.ÌýÌý ÌýÌý

Note that while Canada and Mexico were not on the Wednesday list of tariff targets that was released on Wednesday, they have been targeted separately, and that the remaining countries that do not show up on this map (Russia and North Korea, for instance) are under sanctions that prevent them from trading in the first place.Ìý

ÌýÌý ÌýAnother reason for the market reaction was that the basis for the tariff estimates, which have now been widely shared, are not easily fixable, since they are not based on tariffs imposed by other countries, but on the magnitude of the trade deficit of the United States with these countries. Thus, any country with which the US runs a significant trade deficit faces a large tariff, and smaller countries are more exposed than larger ones since the trade deficit is computed on a percentage basis, from exports and imports related to that country. ÌýThus, the easy out, where other countries offer to reduce or even remove their tariffs may have no or little effect on the tariffs, to the extent that the trade deficit may have little to do with tariffs. ÌýÌýÌý Ìý

Equities

Ìý Ìý The extent of the market hit can be seen by looking at the major US equity indices, the Dow, the S&P 500 and the NASDAQ, all of which shed significant portions of their value on Thursday and Friday:

Looking beyond these indices and across the globe, the negative reaction has been global, as can be seen in the returns to equity across sub-regions, with all returns denominated in US dollars:

The worst hit regions of the world is Small Asia, which is Asia not counting India, China and Japan, which saw equity values in the aggregate decline by 12.61% in the last week. US equities had the biggest decline in dollar value terms, losing $5.3 trillion in value last week, a 9.24% decline in value from the Friday close on March 28, 2025. China and India have held up the best in the last week, perhaps because both countries have large enough domestic markets to sustain them through a trade war. It is also a factory that with time differences, these markets both closed before the Friday beatdown on Wall Street unfolded, and the open on Monday may give a better indication of the true reaction. Breaking down just US equities, by sector, we can see the damage across sectors:The technology sector lost the most in value last week, both in dollar terms, shedding almost $1.8 trillion (and 11.6%) in equity value, and consumer staples and utilities held up the best, dropping 2.30% and 4.40% respectively. In percentage terms, energy stocks have lost the most in value, with market capitalizations dropping by 14.2%, dragged down by declining oil prices.Ìý Ìý Staying with US equities, and breaking down companies, based upon their market capitalizations coming into 2025, we can again see write downs in equity value across the spectrum from last week's sell off:As you can see, it looks like there is little to distinguish across the market cap spectrum, as the pain was widely distributed across the market cap classes, with small and large companies losing roughly the same percent of value. To the extent that market crisis usually cause a flight to safety, I looked at US stocks, broken down by decile into earnings yield (Earnings to price ratios), over the last week:
The lowest earnings to price ratio (highest PE) stocks, in the aggregate, lost 10.91% of their market capitalization last week, compared to the 8.08% decline in market cap at the highest earnings to price (lowest PE ratio) companies, providing some basis for the flight to safety hypothesis. Staying with the safety theme, I looked at US companies, broken down by debt burden (measured as debt to EBITDA):

On this dimension, the numbers actually push against the flight to safety hypothesis, since the companies with the least debt performed worse than those with the most debt. Finally, I looked at whether dividend paying and cash returning companies were better protected in the sell off, by looking at dividend paying (buying back stock) companies versus non-dividend paying (not buying back stock) companies:

While dividend paying stocks did drop by less than non-dividend paying stocks, companies buying back stock underperformed those that did not buy back stock in 2024.Ìý

ÌýÌýÌý Ìý If you came into last week, believing that stocks were over priced, you would expect the correction to be worse at companies that have been bid up the most, and to test this, I classified US stocks based upon percentage stock price performance in 2024:


While the worst performers from last year came into the week down only 1.83% through March 28, whereas the best performers from 2024 were down 6.46% over the same period, there was little to distinguish between the two groups last week.ÌýÌýÌý ÌýFinally, I looked at the Mag Seven stocks, since they have, in large part, carried US equities for much of the last two years;Collectively, the Mag Seven came into last last week, already down 14.79% for the year (2025), but their losses last week, which massive in dollar value terms ($1.55 trillion) were close in percentage terms to the losses in the rest of the market.

Other Markets

Ìý Ìý As equity markets reacted to the tariff announcement, other markets followed. US treasury rates, which had entered the week down from the start of the year, continued to decline during the course of the week:


While the 3-month treasury bill rate remained fairly close to what it was at the start of the week, the rates at the longer end, from 2-year to 30-year all saw drops during the week, perhaps reflecting a search for safety on the part of investors. The drops, at least so far, have been modest and much smaller than what you would expect from a market sell off, where US equities dropped by $5.3 trillion.ÌýÌý ÌýLooking past financial markets, I focused on three diverse markets - the oil market as a stand-in for commodity markets overall, the gold market, representing theÌýtime-tested collectible, and Bitcoin, which is perhaps the millennial version of gold:

Oil prices dropped last week, especially as financial asset markets melted down on Thursday and Friday, while both gold and bitcoin held their own last week. For bitcoin advocates, that is good news, since in other market crises since its creation, it has behaved more like risky stock than a collectible. Of course, it I still early in this crisis, and the true tests will come in the next few weeks. Ìý

Summing up

ÌýÌý ÌýIn sum, the data seems to point more to a mark down in equity values than to panic selling, at least based upon the small sample of two days from last week. There was undoubtedly some panic selling on Friday, but the flight to safety, whether it be in moving into treasuries or high dividend paying stocks, was muted. Ìý

ÌýThe Crisis Cycle

Ìý Ìý Each crisis is unique both in its origins and in how it plays out, but there is still value in looking across crises, to see how they unfold, what causes them to crest, and how and why they recede. In this section, I will present a crisis cycle, which almost every crisis works its way through, with big differences in how quickly, and with how much damage. The crisis cycle starts with a trigger event, which can be economic, political or financial, though there are often smaller events ahead of is occurrence that point to its coming.ÌýThe immediate effect is in markets, where investors respond with the only instrument the they control, which is the prices they pay for assets, which they mark down to reflect at least their initial response to the crisis. In the language of risk, they are demanding higher prices for risk, translating into higher risk premiums. In conjunction, they often move their money to safer assets, with treasuries and collectibles historically benefiting from the fund flows. In the days and weeks that follow, there are aftershocks from the trigger event, both on the news and the market fronts, and while these aftershocks can sometimes be positive for markets, the net effect is usually negative. The effects find their way into the real economy, as consumers and businesses pull back, causing an economic slowdown or a recession, with negative effects on earnings and cash flows, at least in the near term. In the long term, the trigger event can change the economic dynamics, causing a resetting of real growth and inflation expectations, which then feed back into markets;


To illustrate, consider the 2008 banking crisis, where the Lehman collapse over the weekend before September 15 triggered a sell off in the stock market that caused equities to drop by 28% between September 12 and December 31, 2008, and triggered a steep recession, causing unemployment to hit double digits in 2009. The earnings for S&P 500 companies took a 40% hit in 2008, and long term, neither the economy nor earnings recovered back to pre-crisis levels until 2012.

During that crisis, I started a practice of estimating equity risk premiums by day, reflecting my belief that it is day-to-day movements in the price of risk that cause equity markets to move as much as they do in a crisis:

Equity risk premiums which started the crisis at around 4% peaked at almost 8% on November 21, 2008, before ending the year at 6.43%, well above the levels at the start of 2008. Those equity risk premiums did not get back to pre-2008 levels until almost 15 years later.Ìý Ìý Moving to 2020 and looking at the COVID crisis, the trigger event was a news story out of Italy about COVID cases in the country that could not be traced to either China or cruise ships, shattering the delusion that the pandemic would be contained to those settings. In the weeks after, the S&P 500 shed 33% of its value before bottoming out on March 23, 2020, and treasury rates plunged to historic lows, hitting 0.76% on that day. The key difference from 2008 was that the damage to the economy and earnings was mostly short term, and by the end of the year, both (economy and earnings) were on the mend, helped undoubtedly by multi-trillion dollar government support and central banking activism:


As in 2008, I computed equity risk premiums by day all through 2020, and the graph below tells the story:
As you can see, the equity risk premium which started at 4.4% on February 14, 2020, peaked a few weeks later at 7.75% on March 23, 2020, and as with the economy and earnings, it was back down to pre-crisis levels by September 2020.

The Perils of Post Mortems

Ìý Ìý Each crisis gives rise to postmortems, where investors, regulators and researchers pore over the data, often emerging with conclusions that extrapolate too much from what happened.

For investors: The lesson that many investors get out of looking at past crises is that markets come back from even the worst meltdowns, and that contrarian investing with a long time horizon always works. While that may be comforting, this lesson ignores the reality that the fact that a catastrophe did not occur in the crisis in question does not imply that the probability of it occurring was always zero. Markets assess risks in real time.For regulators: To the extent that crises expose the weakest seams in markets and businesses, regulators often come in with fixes for those seams, mostly by dealing with the symptoms, rather than the causes. After the 2008 crisis, the conclusions were that the problems was banks behaving badly and ratings agencies that were not doing their job, both merited judgments, but the question of risk incentives that had led them on their risk taking misadventures were largely left untouched.For researchers: With the benefit of hindsight, regulators weave stories about crises that are built around their own priors, by selectively picking up data items that support them. Thus, behavioral economists find every crisis to be an example of bubbles bursting and corrections for irrational investing, and efficient market theorists use the same crisis as an illustration of the magic of markets working.It is worth remembering that each crisis is a sample size of one, and since each crises is different, aggregating or averaging across them can be difficult to do. Thus, the danger is that we try to learn too much from past crises rather than too little.

The Tariff Crisis?

Ìý Ìý I don't believe that it is premature to put the tariff news and reaction into the crisis category. It has the potential to change the global economic order, and a market reaction is merited. It is, however, early in the process, since we are just past the trigger event (tariff announcement) and the initial market reaction, with lots of unknowns facing us down the road:


There are clearly stages of this crisis that have played out, but based on what we know now, here is how I see them:

After shocks: The tariff story will have after shocks, with both negatives (other countries imposing their own tariffs, and the US responding) and positives (a pause in tariffs, countries dropping tariffs). Those after shocks will create more market volatility, and if history is any guide, there is more downside than upside in the near term. In addition, the market volatility can feed itself, as levered investors are forced to close out positions and fund flows to markets reflect investor concerns and uncertainty. If you add on top of that the possibility that global investors may decide to reduce their US equity holdings, that reallocation will have price effects.Real economy (near term): In the near term, the real economy will slow down, with the plus being that while tariff-related price increases are coming, a cooling down in the economy will dampen inflation. The likelihood of a recession has spiked in the days since the tariff announcement, and while we will have to wait for the numbers on real growth and unemployment to come in, it does look likely that real growth will be impacted negatively. The steep declines in commodity prices suggests that investors see an economic slowdown on the horizon. AsReal economy (long term): Global economic growth will slow, and the US, as the world’s largest economy, will slow with it.. There are other dynamics at play including a restructuring of old economic and political alliances (Is there a point to having a G7 meeting?) and a new more challenging environment for global companies that have spent the last few decades building supply chains that stretch across the globe, and selling to consumers all over.

It is worth noting that if we measure winning by not the size of the pie (the size of the entire economy) but who gets what slice of that economy, it is possible that tariffs could reapportion the pie, with capital (equity markets) getting a smaller slice, and workers getting a larger slice,. In fact, much of this administration's defense of the tariff has been on this front, and time will tell whether that works out to be the case.ÌýÌý ÌýIn the two days after the announcement, stock prices have dropped and the price of risk has risen, as investors reassess the economy and markets:

The implied equity risk premium has risen from 4.57% on April 2 Ìýto 5.08% by the close of trading on Friday. The road ahead of us is long, but I plan to continue to compute these implied equity risk premiums every day for as long as I believe we are in crisis-mode, and I will keep these updated numbers . As stocks have been revalued with higher prices of risk, that same uncertainty is playing out in the corporate bond market, where corporate default spreads widened on Thursday (April 3) and Friday (April 4):


As with the equity risk premiums, the price of risk in the bond market had already risen between the start of 2025 and March 28, 2025, but they surged last week, with the lowest ratings showing the biggest surges. With treasury rates, equity risk premiums and default spreads all on the move it may be time for companies and investors to be reassessing their costs of equity and capital.Ìý

What now?

Ìý Ìý If you have stayed with me so far on this long and rambling discourse, you are probably looking for my views on how this crisis will unfold, and how investors should respond now. I am afraid that dishing out investment advice is not my cup of tea, but I will try to explain how I plan to deal with what's coming, with the caveat that what I do may not work for you

A (Personal) PostscriptÌý

Ìý Ìý In the midst of every market meltdown, you will see three groups of experts emerge. The first will be the "I told you so" group, eager to tell you that this is the big one, the threat that they have spent a decade or more warning you about. They will of course not let on that if you had followed their advice from inception, you would have been invested in cash for the last decade, and even with a market crash, you would not be made hold again. The second will include "knee jerk contrarians", arguing that stock markets always come back, and that every market dip is a buying opportunity, an extraordinarily lazy philosophy that gets the rewards (none) that its deserves. The third will be the "indecisives", who will present every side of the argument, conclude that there is too much uncertainty right now to either buy or sell, but to wait until the uncertainty passes. There are elements of truth in all three arguments, but they all have blind spots.

Ìý Ìý In the midst of a crisis, the market becomes a pricing game, where perception gets the better of reality, momentum overwhelms fundamentals and day-to-day movements cannot be rationalized. Anyone who tells you that their crystal balls, data or charts can predict what's coming is lying or delusional, and there is no one right response to this (or any other) crisis. It will depend on:

Cash needs and time horizon: If you are or will soon be in need of cash, to pay for health care, buy a home or pay tuition, and you are invested in equities, you should take the cash out now. Waiting for a better time to do so, when the clock is ticking is the equivalent of paying Russian Roulette and just as dangerous. Conversely, if you do not need the cash and are patient, you have the flexibility of waiting, though having a longer time horizon does not necessarily mean that you should wait to act.Macro views: The effects on markets and the real economy will depend on how you see the tariffs playing out, with the outcomes ranging from a no-holds-barred trade war (with tariffs and counter tariffs) to a partial trade war (with some countries capitulating and others fighting) to a complete clearing of the air (where the tariff threat is scaled down or put on the back burner). While you may be inclined to turn this over to macro economists, this is less about economics and more about game theory, where an expert poker player will be better positioned to forecast what will happen than an economic think tank.Investment philosophy: I have long argued (and teach a class to that effect) that every investor needs an investment philosophy, attuned to his or her personal make up. That philosophy starts with a set of beliefs about how markets make mistakes and corrects them, and manifests in strategies designed to take advantage of those mistakes.Ìý

My investment philosophy starts with the belief that markets, for the most part, do a remarkable job in aggregating and reflecting crowd consensus, but that they sometimes make big Ìýmistakes that take long periods to correct, especially in periods and portions of the market where there is uncertainty. ÌýI am terrible at gauging market mood and momentum, but feel that I have an edge (albeit a small one) in assessing individual companies, though that may be my delusion. My response to this crisis (or any other) will follow this script:

Daily ERP: As in prior crises, I will continue to monitor the equity risk premiums, treasury rates and the expected return on stocks every day until I feel comfortable enough to let go. Note that this process lasted for months after the 2008 and 2020 crises, but as earnings updates for the S&P 500 reflect tariffs, my confidence in my assessments will increase. (As mentioned earlier, you will find these daily updates )Revalue companies in my portfolio: While I was comfortable with the companies in my portfolio on March 28, viewing them as under valued or at least not over valued enough to merit a sell, the tariffs may have an significant effect on their values, and I plan to revalue them in batches, starting with my big tech holdings (the Mag Five, since I did sell Tesla and most of my Nvidia holdings) and working through the rest.ÌýBuy value: I have drawn a , with the former characterized by large moats, great management and strong earnings power, and the latter by being priced too low. There are companies that I believe are great companies, but are priced so highly by the market that they are sub-standard investments and I choose not to invest in them. During a crisis, where investors often sell without discrimination, there companies can become buys, and I have to be ready to buy at the right price. Since buying in the face of a market meltdown can require fortitude that I may not have, I have been scouring my list of great companies, revaluing them with the tariff effects built in, and putting buys at limit prices below those values. In the last week, both BYD, a company , a few weeks ago in my post on globalization and disruption, and Mercado Libre, a Latin American powerhouse, that has the disruptive potential of an Amazon combined with a fintech enterprise, have moved from being significantly overvalued to within shouting distance of the limit prices I have on them.ÌýGo back to living: I certainly don't see much gain watching the market hour-to-hour and day-to-day, since its doings are out of my control and anything that I do in response is more likely to do harm than good. Instead, I plan on living my life, enjoying life's small pleasures, like a Yankee win or taking my dog for a walk, to big ones, like celebrating my granddaughter's birthday in a couple of days.ÌýI hope that you find your own path back to serenity in the face of this market volatility, and that whatever you end up doing with your portfolio allows you to pass the sleep test, where you don't lie awake at night thinking about your portfolio (up or down).Ìý
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posted by Aswath Damodaran on April, 08 ]]>
/author_blog_posts/25591524-investing-politics-globalization-backlash-and-government-disruption Sat, 15 Mar 2025 09:50:00 -0700 <![CDATA[Investing Politics: Globalization Backlash and Government Disruption!]]> /author_blog_posts/25591524-investing-politics-globalization-backlash-and-government-disruption globalization, a movement that has shaped economics and markets for much of the last four decades, but that has now, in my view, crested and is facing pushback, and the other being disruption, initiated by technology start-ups in the 1990s, and extended to lay waste to the status quo in many Ìýbusinesses in the decades since, but now being brought into the political/government arena.
Globalization â€� The Rise, Effects and BlowbackÌý Ìý Globalization has taken different forms through the ages, with some violent and toxic variants, but the currentÌýversion of globalization kicked into high gear in the 1980s, transforming every aspect of our lives. I am no historian, but in this section, I will start with a very short and personal history of how globalization has played out in my classroom, examine its winners and losers, and end with an assessment of how the financial crisis of 2008 caused the movement to crest and create a political and economic backlash that has led us to today.
A Short (Personal) History of Globalization ÌýÌý ÌýThe best way that I can think of illustrating the rise of globalization is to talk about how it has made its presence felt in my classroom over the last four decades. When I started my teaching journey at the University of California at Berkeley in 1984, business education was dollar-centric, with business schools around the world using textbooks and cases written with US data and starring US companies. My class had a sprinkling of European and Japanese students but students from much of the rest of the world were underrepresented. The companies that they went to work for, after graduation, were mostly domestic in operations and in revenues, and multinationals were more the exception than the rule, with almost all of them headquarteredÌýin the United States and Europe.ÌýÌýÌý ÌýToday, business education, both in terms of location and material, has become global, with European and Asian business schools routinely making the top business school list, and class materials reflecting this trend. My classes at NYU often have more students from outside the United States than from within, Ìýand very few will go to work for entities with a purely domestic focus. Many of these hiring firms have supply chains that stretch across the world and sell their products and services in foreign markets. As businesses have globalized, consumers and investors have had no choice but to follow, and the things we buy (from food to furniture) and the companies that we invest in all reflecting these global influences.Ìý
The Winners from Globalization ÌýÌý ÌýAs consumers, companies and investors have globalized, there have clearly been many who have benefited from its rise. Without claiming to be comprehensive, here is my list of the biggest winners from globalization.ÌýChina: The biggest winner from globalization has been China, which has seen its economic and political power surge over the last four decades. Note that the rise has not been all happenstance, and China deserves credit for taking advantage of the opportunities offered by globalization, making itself first the hub for global manufacturing and then using its increasing wealth to build its infrastructure and institutions. To get a measure of China’s rise, I look at its GDP, relative to GDP from the rest of the world over the last few decades:ÌýSource: World BankChina's share of global GDP increased ten-fold between 1980 and 2023, and its centrality to global economic growth is measured in the table below, where I look at the percentage of the change in global GDP each decade has come from different parts of the world:ÌýBetween 2010 and 2023, China accounted for almost 38% of global economic growth, with only the United States having a larger share, though the winnings for the US were on a larger base and are more attributable to the other global force (disruption) that I will highlight in the next section.Consumers: Consumers have benefited from globalization in many ways, starting with more products to choose from and often at lower prices than in pre-globalization days. From being able to eat whatever we want to, anytime of the year, to wearing apparel that has become so cheap that it has become disposable, many of us, at least on the surface, have more buying power.Global Institutions : While the World Bank and the IMF predate the globalization shift, their power has amped up, at least in many emerging markets, and the developed world has created its own institutions and Ìýagreements (EU and NAFTA, to Ìýname just two) making it easier for businesses and individuals to operate outside their domestic borders. In parallel, International Commercial Courts have proliferated and been empowered to enforce the laws of commerce, often across borders.Financial Markets (and their centers): Over the last few decades, not only have more companies been able to list themselves on financial markets, but these markets has become more central to public Ìýpolicy. In many cases, the market reaction to spending, tax or economic proposals has become the determinant on whether they get adopted or continued. As financial markets have risen in value and importance, the cities (New York, London, Frankfurt, Shanghai, Tokyo and Mumbai) where these markets are centered have gained in importance and wealth, if not in livability, at the expense of the rest of the world.Experts: We have always looked to experts for guidance, but globalization has given rise to a new cadre of experts, who are positioned to identify what they believe are the world’s biggest problems and offer their solutions Ìýin forums like Davos and Aspen, with the world’s policy makers as their audience.Ìý The Losers from Globalization ÌýÌý ÌýWhen globalization was ascendant, its proponents underplayed its costs, but there were losers, and that list would include at least the following:ÌýJapan and Europe: The graph that shows the rise of China from globalization also illustrates the fading of Japan and Europe over the period, with the former declining from 17.8% of global GDP in 1995 to 3.96% in 2023 and the latter seeing its share dropping from 25.69% of global GDP in 1990 to 14.86%. You can see this drop off in the graph below:
While not all growth from globalization is zero-sum, a significant portion during this period was, with economic power and wealth shifting from Europe and Japan to newly ascendant economies.Consumers, on control: I listed consumers as winners from globalization, and they were, on the dimensions of choice and cost, but they also lost in terms of control of where their products were made, and by whom. To provide a simplistic example, the shift from buying your vegetables, fish and meat from local farmers, fishermen and butchers to factory farmers and supermarkets may have made the food more affordable, but it has come at a cost.Small businesses: While there are a host of other factors that have also contributed to the decline of small businesses, globalization has been a major contributor, as smaller businesses now find themselves competing against companies who make their products thousands of miles away, often with very different cost structures and rules restricting them. Larger businesses not only had more power to adapt to the challenges of globalization, but have found ways to benefit from it, by moving their production to the cheapest and least restrictive locales. In one of my data updates for this year, I pointed to the , where small firms historically have earned higher returns than large cap companies, and globalization is a contributing factor.Blue-collar workers in developed markets: The flip side of the rise of China and other countries as manufacturing hubs, with lower costs of operation, has been the loss of manufacturing clout and jobs for the West, with factory workers in the United States, UK and Europe bearing the brunt of the cost. While the job losses varied across sectors, with job skills and unionization being determining factors, the top line numbers tell the story. In the United States, the number of manufacturing jobs peaked at close to 20 million in 1979 and dropped to about 13 million in 2024, and manufacturing wages have lagged wage growth in other sectors for much of that period.Ìý
Democracy: In my view, globalization has weakened the power of democracy across the world. The fall of the Iron Curtain was greeted by optimists claiming the triumph of democracy over authoritarianism and the dawn of a new age of democratic freedom. That promise has largely been dashed, partly because the biggest winners from the globalization sweepstakes were not paragons of free expression and choice, but also because voters in democracies were frustrated when they voted for change, and found that the policies that followed came from a global script. The Economist, the newsmagazine, measures (albeit with their own biases) democracy in the world, and its findings in its most recent update are troubling. Not only does the world tilt more authoritarian than democratic in 2024, the trend line indicates that the world is becoming less democratic over time. While there are other forces (social media, technology) at play that may explain this shift as well, the cynicism that globalization has created about the capacity to create change at home has undoubtedly contributed to the shift away from democracy.I believe that globalization has been a net plus for the global economy, but one reason it is in retreat Ìýis because of a refusal on the part of its advocates to acknowledge its costs and the dismissal of opposition to any aspect of globalization as nativist and ignorant.Ìý
The 2008 Crisis and its Aftermath ÌýÌý ÌýComing into this century, the march of globalization seemed unstoppable, but the wave crested in 2008, with the financial market crisis. That crisis exposed the failures of the expert class, leading to a loss of trust that has never been recovered. ÌýWhile the initial public responses to the financial crisis were muted, the perception that the world was still being run by hidden (global) forces, unelected and largely unaccountable to anyone, has continued, and I believe that it has played a significant role in British voters choosing Brexit, the rise of nationalist parties in Europe, and in the elections of Donald Trump in the United States. Trump, a real estate developer with multiple international properties, is an imperfect spokesperson of the anti-globalization movement, but it is undeniable that he has tapped into, and benefited from, its anger. While he was restrained by norms and tradition in his first term, those constraints seem to have loosened in this second go around, and he has weilded tariffs as a weapon and is open about his contempt for global organizations. While economists are aghast at the spectacle, and the economic consequences are likely to be damaging, it is not surprising that a portion of the public, perhaps even a majority, are cheering Trump on.Ìý Ìý To those who are nostalgic for a return to the old times, I don't believe that the globalization genie can go back into the bottle, as it has permeated not only every aspect of business, but also significant portions of our personal lives. The world that will prevail, if a trade war plays out, will be very different than the one that existed before globalization took off. China, the second largest economy in the world today, is not returning to its much smaller stature, pre-globalization, and given the size of its population, it may be able to sustain its economy and grow it, with a domestic market focus. While investors are being sold the India story, it is worth recognizing that India will face much more hostility from the rest of the world, as it tries to grow, than China did during the last few decades. For Europe and Japan, a combination of an aging populations and sclerotic governments limit the chances of recovery, and for the United States, the question is whether technology can continue to be its economic savior, especially if global markets become more difficult to access.

Disruption â€� Origins and ExtensionsÌýÌý ÌýIn the world of my youth, disruption was not used as a compliment and disruptors were consigned to the outside edges of society, labeled as troublemakers or worse. That has changed in this century, as technology evangelists have used disruption as a sword to slay the status quo and offer, at least, in their telling, Ìýmore efficient and better alternatives.
The Disruptor Playbook ÌýÌý ÌýI have written about disruption , and at the risk of repeating myself, I will start with a generalized description of the playbook used by disruptors to break up the status quo.Find a business to disrupt: The best businesses to disrupt are large (in terms of dollars spent on their products/services), inefficient in how they make and sell these products, and filled with dissatisfied players, where no one (or at least very few) is happy. For the most part, these businesses have made legacy choices, which made sense at the time they were made, have long outlived their usefulness, but persist, because systems and practices have been built around them, and changes are fought by the beneficiaries of these inefficient systems.Target their weakestÌýlinks: Legacy businesses have a mix of products and services, and it is inevitable that some of these products are services have high margins and pay for other products that are offered at or below cost. Disruptors go after the former, weaning away unhappy customers by offering them better deals, and in the process, leaving legacy businesses with a less profitable and viable product mix. ÌýMove quickly and scale up: Speed is of the essence in disruption, since moving quickly puts status quo companies at a disadvantage, as these companies not only take more time to respond, but must weather fights within their organizations, often driven by politics and money. With access to significant capital from venture capital, private equity and even public investors, disruptors can scale up quickly, unencumbered by the need to have well formed business models or show profits at least in the near term.Break rules, ask for permission later: One feature shared by disruptive models, albeit to varying degrees, has been a willingness to break rules and norms, knowing fully well that their status quo competitors will be more averse to doing so, and that the rule makers and regulators will take time to respond.ÌýThere is no alternative: By the time the regulators or legal system catches up with the disrupters, they aim to have become so ascendant, and the status quo so damaged, that there is no going back to the old ways.In the last three decades, we have seen this process play out in industry after industry, from the retail business (with Amazon), the music business (with Apple iTunes first and Spotify later), the automobile business (with Tesla) and advertising (with Google and Facebook), to name just a few.
Disruption's Winners and Losers ÌýÌý ÌýThe obvious winners from disruption are the disruptors, but since many of them scaled up with unformed business models, the payoff is less in the form of profits, and more in terms of their market capitalizations, driven by investors dazzled by their potential. That had made the founders of these businesses (Bezos, Musk and Zuckerberg) not only unbelievably wealthy, but also given them celebrity status, and created a host of winners for those in the ecosystem, including the disruptors' employees and investors. As these disrupted businesses prioritized scaling up over profitability, consumers benefited as they received products and services, at bargain-basement prices, sometimes below cost.ÌýÌýÌý ÌýThe clearest loser from disruption is the status quo. As legacy companies melt down, in terms of profitability and value, the damage is felt in concentric circles, with employees facing wage cuts and job losses, and investors seeing write downs in their holdings ÌýThe peripheral damage is to the regulatory structures that govern these businesses, as the rule breakers became ascendant, leaving rule makers impotent and often on the side lines. To the extent that these regulations and rules were designed to protect the environment and the public, there are side costs for society as well.Ìý Ìý In short,Ìýdisruption may have been a net positive for society, but there are casualties on its battlefield. In the battle for the global economic pie, the fact that so much of the disruption has originated in the United States, aided both by access to a capital and a greater tolerance for rule-breaking, has helped the United States maintain and even grow its share of global GDP. In practical terms, this has manifested in the soaring market capitalizations of the biggest technology companies, and it is their presence that has allowed the United States to ward off the decline in economic power and market cap that you have seen in much of the rest of the developed world.
Disruption goes macro ÌýÌý ÌýÌýÌý ÌýFor much of its history, disruption has been restricted to the business space and it has had only limited success when directed at systemic inefficiencies in less business-driven settings. Health care clearly meets all of the criteria for a good disruption target, consuming 20% of US GDP, with a host of unhappy constituencies (doctors, patients, hospitals and payers). However, attempts at disruption, whether it be from Mark Cuban’s pharmaceutical start-up or from Google and Amazon’s health care endeavors, have largely left the system intact. I have described education, at the school and college level, as deserving of disruption for more than two decades, but notwithstanding tries at online education, not much has changed at universities (yet).ÌýÌý ÌýCan entire governments be disrupted? After all, it is hard to find anyone who would describe government organizations and systems as efficient, and the list of unhappy players is a mile long. The pioneers of government disruption have been in Latin America, with El Salvador and Argentina being their venues. Nayib Bukele, in El Salvador, and Javier Milei, in Argentina, have not just pushed back against the norms, but have reveled in doing so, and they were undoubtedly aided by the fact that the governments in both countries were so broken that many of their citizenry viewed any change as improvement. As we watch Elon Musk and DOGE move at hyper speed (by government standards), break age-old systems and push rules and laws to breaking point, I see the disruption playbook at play, and I am torn between two opposing perspectives. On the one hand, it is clear the US government has been broken for decades and tinkering at its edges (which is what every administration has done for the last forty years) has accomplished little to reduce the dysfunctionality of the system (and the deficits and debt that it creates). On the other, though, disrupting the US government is not the same as disrupting a business, since there are millions of vulnerable people (social security, Medicare and veteran care) whose lives rest on government checks, and a break in that process that is not fixed quickly could be catastrophic. There is a middle ground here, and unless DOGE finds it quickly, this disruption story will have lots of casualties.
Market and Micro EffectsÌýÌý ÌýAs I have wrestled with the barrage of news stories in the last few weeks, many with large consequences for economies and markets, I keep going back to what this means for my micro pursuits, i.e., analyzing how companies make decisions on investing, financing and dividends and what the values of these companies are. It is still early in that process, and there is much that I still don’t know the answer to, but here the ways I see this playing out.
In markets Ìý Ìý There are two key inputs that are market-driven which affect the values of every company. The first is interest rates, across the maturity spectrum, since their gyrations will play out across the market. In the graph below, I look at US treasury rates and how they have moved since the Trump election in early November:

The ten-year US treasury rate has declined from 4.55% on Election Day (November 5) Ìýto 4.27% on March 13, 2025, but since that treasury rate is driven of expectations about inflation and real economic growth, Trump supporters will attribute the decline to markets anticipating a drop in inflation in a Trump administration and Trump critics suggesting that the rate drop is an indicator of a slowing Ìýeconomy and perhaps even a recession. The yield curve has flattened out, with the 10-year rate staying higher than the 2-year rate, pushing that very flawed signal of economic recession into neutral territory.ÌýÌý Ìý The other number that I track is the equity risk premium, which at least in my telling, is a forward-looking number backed out of the market and the receptacle for the greed and fear in markets. ÌýIn the table below, I show my estimates of the implied equity risk premium for the S&P 500 at the start of every month, since January 2024, and on March 14, 2025.

The equity risk premium at the start of March was at 4.35%, surprisingly close to the 4.28% on Election Day, but that number has jumped to 4.68% in the first two weeks of March, indicating that uncertainty about tariffs and the economy is undercutting the resilience that the market has shown so far this year. In my view, the pathway that the equity risk premium takes for the rest of the year will be the key driver in whether equities level off, continue to decline or make a comeback. If equity risk premiums continue to march upwards, driven by increased uncertainty and the potential for trade wars, stock prices will drop, even if the economy escapes a recession, and adding a recession, with the damage it will create to expected earnings, will only make it worse. In ÌýI looked at US equities, and valued the S&P 500 at 5262, putting it about 12% below the index level (5882) at the start of the year. Even with the drawdown in prices that we have seen through March 10, the index remains above my estimated value, and while that value reflected what I saw at the start of the year, what has happened in the last few weeks has lowered the fair value, not raised it.
In companies Ìý Ìý Changes in interest rates and risk premiums will affect the valuations of all companies, but assuming that the tariff announcements and government spending cuts will play out over the foreseeable future, there will be disparate effects across companies. I will draw on a familiar structure, where I trace the value of a company to its key drivers:By narrowing our focus to the drivers of value, we can look at how company exposure to trade wars and DOGE will play out:1. Revenue growth: On the revenue growth front, companies that derive most or all of their revenues domestically will benefit and companies that are dependent on foreign sales will be hurt by tariff wars. To assess how that exposure varies across sectors, I look at the percentage of revenues s in each Ìýsector that companies in the S&P 500 get from foreign markets:Based on revenues in 2023Collectively, about 28% of the revenues, in 2023, of the companies in the S&P 500 came from foreign markets, but technology companies are most exposed (with 59% of revenues coming from outside the country) and utilities least exposed (just 2%) Ìýto foreign revenue exposure. It is also worth noting that the larger market cap companies of the S&P 500 have a higher foreign market revenue exposure than smaller market cap companies.ÌýOn the DOGE front, the attempts to cut costs are likely tol hit healthy care and defense, the two businesses that are most dependent on the government spending, most directly, with green energy, a more recent entrant into the government spending sweepstakes, also on the cutting block.2. Operating Ìýmargins: A company that gets all of its revenues from the domestic markets can still be exposed to trade wars, if its production or supply chains is set in other countries. The data on this front is far less visible or reported than revenue data and will require more company-level research. It is also likely that if the attempts to bring production back to the United States come to fruition, wages for US workers will increase, at least in the longer term, pushing up costs for companies. In short, a tariff war Ìýwill lower the operating margins for many firms, with the size of the decline depending on their revenues,Ìý3. Reinvestment: To the extent that companies are altering their decisions on where to build their next manufacturing facilities, as a result of tariff fears or in hope of government largesse, there should be an effect on reinvest, with an increase in reinvestment (lower sales to capital ratios) at businesses where this move will create investment costs. Looking across businesses, this effect is likely to be more intense at manufacturing companies, where moving production is more expensive and difficult to do, that at technology or service firms.4. Failure risk: Since 2008, the US government has implicitly, if not explicitly, made clear its preference for stepping in to help firms from failing, especially if they were larger and the cost of failure was perceived as high. It is not clear what the Trump administration's views are on bailing out companies in trouble, but may initial read is that government is less likely to jump in as a capital provider of last resort.ÌýÌý Ìý There is another way in which you can reframe how the shifts in politics and economics will play out in valuation. I have and that to value a company, you have a start with a business story for the company, check to make sure that it is and connect the story to valuation inputs (revenue growth, margins, reinvestment and risk). Staying with that structure, I have also posited that the value of a company can sometimes be affected by its political connections or by the government acting as an ally or an adversary, making the government a key player in the company's story. While that feature is not uncommon in many emerging market companies, when analyzing US and European companies, we had the luxury, historically, of keeping governments out of company stories, other than in their roles of tax collectors and regulators. That time may well have passed, and it is entirely possible that when valuing US companies now, you have to bring the government into the story, and in some cases, a company's political connections can make or break the story. ÌýÌýÌýThe company where you are seeing the interplay between economics and politics play out most visibly right now is Tesla, a company that has had a rollercoaster history with the market. In 2024, its stock soared, especially so after the election, but it has now given up almost of its gains, almost entirely because of itsÌý(or more precisely, Elon Musk's) political connections. I revisited my Tesla valuation from January 2024, when I valued the stock at $182, triggering a buy in my portfolio when the stock price dropped to $170. In the intervening year, there were three developments that have affected the Tesla narrative:A rethiinking the "electric cars are inevitable" story: For the last few years, it has become conventional wisdom that electric cars will eventually displace gas cars, and the question has been more about when that would happen, rather than whether. In 2024, you saw , as hybrids made a comeback, and the environmental consequences of having millions of electric cars on the road came into focus. To the extent that Tesla's value has come from an assumption that the electric car market will be huge, this affects end revenues and value.The rise of BYD as a competitor for electric cars: Since its founding, Tesla has dominated the electric car business, and legacy car makers have struggled to keep up with it. in 2024, BYD, the Chinese electric car company, , and it is clearly beating Tesla not just in China, but in most Asian markets and even in Europe, with lower prices and more choices. Put simply, it feels like Tesla has its first real competitor in the electric car business.The politicization of the Tesla story: There has been a backlash building from those who do not like Musk's political stances and it is spilling over into Tesla's sales, and the United States. As long as Musk remains at the center of the news cycle, this is likely to continue, and there is the added concern, even for Tesla shareholders who agree with Musk's politics, that he is too distracted now to provide direction to the company.ÌýThese developments have made me more wary than I was last year on the end game for Tesla. While I do believe that Tesla will be one of the lead players in the electric car market, the pathway to a dominant market share of the electric car market has become rockier, and it seems likely that the electric car market will bifurcate into a lower-priced and a premium market, with BYD leading in the first (lower priced) market, especially in much of Asia, and Tesla holding its own in the premium car market, with a clear advantage in the United States. I remain skeptical that any of the legacy auto companies, notwithstanding the money that they have spend on electric cars and the quality of these cars, will challenge the newcomers on this turf. My updated valuation for Tesla is below:

My estimate of value for Tesla stands at about $150 a share, about $30 less than my value last year, and about $70 below its stock price. As an investor, I have been wary of taking a position in BYD, because of its Chinese origins and the presence of Beijing as a player in its story, but given that Tesla is now a political play, it may be time to open the door to the BYD investment, but that will have to wait for another post.
The Bottom LineÌý Ìý While it is easy to blame market uncertainty on Trump, tariffs and trade wars for the moment, the truth is that the forces that have led us here have been building for years, both in our political and economic arenas. In short, even if the tariffs cease to be front page news, and the fears of an immediate trade war ease, the underlying forces of anti-globalization that gave rise to them will continue to play out in global commerce and markets. For investors, that will require a shift away from the large cap technology companies that have been the market leaders in the last two decades back to smaller cap companies with a more domestic focus. It will also require an acceptance of the reality that politics and macroeconomic factors will play a larger role in your company assessments, and create a bigger wild card on whether investments in these companies will pay off.
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posted by Aswath Damodaran on March, 16 ]]>
/author_blog_posts/25564134-data-update-9-for-2025-dividends-and-buybacks---inertia-and-me-tooism Wed, 05 Mar 2025 12:14:00 -0800 <![CDATA[Data Update 9 for 2025: Dividends and Buybacks - Inertia and Me-tooism!]]> /author_blog_posts/25564134-data-update-9-for-2025-dividends-and-buybacks---inertia-and-me-tooism The Cash Return Decision
Ìý ÌýÌýThe decision of whether to return cash, and how much to return, should, at least in principle, be the simplest of the three corporate finance decisions, since it does not involve the estimation uncertainties that go with investment decisions and the angst of trading of tax benefits against default risk implicit in financing decisions. In practice, though, there is probably more dysfunctionality in the cash return decision, than the other two, partly driven by deeply held, and often misguided views, of what returning cash to shareholders does or does not do to a business, and partly by the psychology that returning cash to shareholders is an admission that a company's growth days are numbered. In this section, I will start with a utopian vision, where I examine how cash return decisions should play out in a business and follow up with the reality, where bad dividend/cash return decisions can drive a business over a cliff.Ìý
The Utopian Version
Ìý Ìý If, as I asserted, equity investors have a claim the cash flows left over after all needs (from taxes to debt payments to reinvestment needs) are met, dividends should represent the end effect of all of those choices. In fact, in the utopian world where dividends are residual cash flows, here is the sequence you should expect to see at businesses:
In a residual dividend version of the world, companies will start with their cash flows from operations, supplement them with the debt that they think is right for them, invest that cash in good projects and the cash that is left over after all these needs have been met is available for cash return. Some of that cash will be held back in the company as a cash balance, but the balance can be returned either as dividends or in buybacks. If companies following this sequence to determine, here are the implications:The cash returned should not only vary from year to year, with more (less) cash available for return in good (bad) years), but also across firms, as firms that struggle on profitability or have large reinvestment needs might find that not only do they not have any cash to return, but that they might have to raise fresh capital from equity investors to keep going.ÌýIt also follows that the investment, financing, and dividend decisions, at most firms, are interconnected, since for any given set of investments, borrowing more money will free up more cash flows to return to shareholders, and for any given financing, investing more back into the business will leave less in returnable cash flows.ÌýÌý Ìý Seen through this structure, you can compute potential dividends simply by looking for each of the cash flow elements along the way, starting with an add back of depreciation and non-cash charges to net income, and then netting out investment needs (capital expenditures, working capital, acquisitions) as well as cash flow from debt (new debt) and to debt (principal repayments).Ìý
While this measure of potential dividend has a fanciful name (free cash flow to equity), it is not only just a measure of cash left in the till at the end of the year, after all cash needs have been met, but one that is easy to compute, since every items on the list above should be in the statement of cash flows.Ìý Ìý As with almost every other aspect of corporate finance, a company's capacity to return cash, i.e., pay potential dividends will vary as it moves through the corporate life cycle, and the graph below traces the path:

There are no surprises here, but it does illustrate how a business transitions from being a young company with negative free cash flows to equity (and thus dependent on equity issuances) to stay alive to one that has the capacity to start returning cash as it moves through the growth cycle before becoming a cash cow in maturity.
The Dysfunctional Version Ìý Ìý In practice, though, there is no other aspect of corporate finance that is more dysfunctional than the cash return or dividend decision, partly because the latter (dividends) has acquired characteristics that get in the way of adopting a rational policy. In the early years of equity markets, in the late 1800s, Ìýcompanies wooed investors who were used to investing in bonds with fixed coupons, by promising them predictable dividends as an alternative to the coupons. That practice has become embedded into companies, and dividends continue to be sticky, as can be seen by the number of companies that do not change dividends each year in the graph below:
While this graph is only of US companies, companies around the world have adopted variants of this sticky dividend policy, with the stickiness in absolute dividends (per share) in much of the world, and in payout ratios in Latin America. Put simply, at most companies, dividends this year will be equal to dividends last year, and if there is a change, it is more likely to be an increase than a decrease.Ìý Ìý This stickiness in dividends has created several consequences for firms. First, firms are cautious in initiating dividends, doing so only when they feel secure in their capacity to keep generate earnings. Second, since the punishment for deviating from stickiness is far worse, when you cut dividends, far more firms increase dividends than decrease them. Finally, there are companies that start paying sizable dividends, find their businesses deteriorate under them and cannot bring themselves to cut dividends. For these firms, dividends become the driving force, determining financing and investment decisions, rather than being determined by them.
This is, of course, dangerous to firm health, but given a choice between the pain of announcing a dividend suspension (or cut) and being punished by the market and covering up operating problems by continuing to pay dividends, many managers choose the latter, laying th e pathway to dividend madness.

Dividends versus Buybacks

Ìý ÌýÌýÌýAs for the choice of how to return that cash, i.e., whether to pay dividends or buy back stock, the basics are simple. Both actions (dividends and buybacks) have exactly the same effect on a company’s business picture, reducing the cash held by the business and the equity (book and market) in the business. It is true that the investors who receive these cash flows may face different tax consequences and that while neither action can create value, buybacks have the potential to transfer wealth from one group of shareholders (either the ones that sell back or the ones who hold on) to the other, if the buyback price is set too low or too high.ÌýÌý Ìý

ÌýÌý ÌýIt is undeniable that companies, especially in the United States, have shifted away from a policy of returning cash almost entirely in dividends until the early 1980s to one where the bulk of the cash is returned in buybacks. In the chart below, I show this shift by looking at the aggregated dividends and buybacks across S&P 500 companies from the mid-1980s to 2024:




While there are a number of reasons that you can point to for this shift, including tax benefits to investors, the rise of management options and shifting tastes among institutional investors, the primary reason, in my view, is that sticky dividends have outlived their usefulness, in a business age, where fewer and fewer companies feel secure about their earning power. Buybacks, in effect, are flexible dividends, since companies, when faced with headwinds, quickly reduce or cancel buybacks, while continuing to pay dividends: In the table below, I look at the differences between dividends and buybacks:

If earnings variability and unpredictability explains the shifting away from dividends, it stands to reason that this will not just be a US phenomenon, and that you will see buybacks increase across the world. In the next section, we will see if this is happening.

Ìý Ìý There are so many misconceptions about buybacks that I that looks in detail at those reasons. I do want to reemphasize one of the delusions that both buyback supporters and opponents use, i.e., that buybacks create or destroy value. Thus, buyback supporters argue that a company that is buying back its own shares at a price lower than its underlying value, is effectively taking an investment with a positive net present value, and is thus creating value. That is not true, since that action just transfers value from shareholders who sell back (at the too low a price) to the shareholders who hold on to their shares. Similarly, buyback opponents note that many companies buy back their shares, when their stock prices hit new highs, and thus risk paying too high a price, relative to value, thus destroying value. This too is false, since paying too much for shares also is a wealth transfer, this time from those who remain shareholders in the firm to those who sell back their shares.Ìý

Cash Return in 2024

Ìý Ìý Given the push and pull between dividends as a residual cash flow, and the dysfunctional factors that cause companies to deviate from this end game, it is worth examining how much companies did return to their shareholders in 2024, across sectors and regions, to see which forces wins out.

Cash Return in 2024

Ìý Ìý Let's start with the headline numbers. In 2024, companies across the globe returned $4.09 trillion in cash to their shareholders, with $2.56 trillion in dividends and $1.53 trillion taking the form of stock buybacks. If you are wondering how the market can withstand this much cash being withdrawn, it is worth emphasizing an obvious, but oft overlooked fact, which is that the bulk of this cash found its way back into the market, albeit into other companies. In fact, a healthy market is built on cash being returned by some businesses (older, lower growth) and being plowed back into growth businesses that need that capital.

Ìý Ìý That lead in should be considered when you look at cash returned by companies, broken down by sector, in the table below, with the numbers reported both in US dollars and scaled to the earnings at theseÌýcompanies:

To make the assessment, I first classified firms into money making and money losing, and aggregated the dividends and buybacks for each group, within each sector. ÌýNot surprisingly, the bulk of the cash bering returned is from money making firms, but the percentages of firms that are money making does vary widely across sectors. Utilities and financials have the highest percentage of money makers on the list, and financial service firms were the largest dividend payers, paying $620.3 billion in dividends in 2024, followed by energy ($346.2 billion) and industrial ($305.3 billion). Scaled to net income, dividend payout ratios were highest in the energy sector and technology companies had the lowest payout ratios. Technology companies, with $280.4 billion, led the sectors in buybacks, and almost 58% of the cash returned at money making companies in the sector took that form.Ìý

Ìý ÌýBreaking down global companies by region gives us a measure of variation on cash return across the world, both in magnitude and in the type of cash return:


It should come as no surprise that the United States accounted for a large segment (more than $1.5 trillion) of cash returned by all companies, driven partly by a mature economy and partly by a more activist investor base, and that a preponderance of this cash (almost 60%) takes the form of buybacks. Indian companies return the lowest percentage (31.1%) of their earnings as cash to shareholders, with the benign explanation being that they are reinvesting for growth and the not-so-benign reason being poor corporate governance. After all, in publicly traded companies, managers have the discretion to decide how much cash to return to shareholders, and in the absence of shareholder pressure, they, not surprisingly, hold on to cash, even if they do not have no need for it. It is also interesting that buybacks seems to be making inroads in other paths of the world, with even Chinese companies joining the party.

FCFE and Cash Return

Ìý Ìý While it is conventional practice to scale dividends to net income, to arrive at payout ratios, we did note, in the earlier section, that you can compute potential dividends from financial statements, Here again, I will start with the headline numbers again.ÌýIn 2024, companies around the world collectively generated $1.66 trillion in free cash flows to equity:

As you can see in the figure, companies started with net income of $6,324 billion, reinvested $4,582 billion in capital expenditures and debt repayments exceeded debt issuances by $90 billion to arrive at the free cash flow to equity of $1.66 trillion. That said, companies managed to pay out $2,555 billion in dividends and bought back $1,525 billion in stock, a total cash return of almost $4.1 trillion.

Ìý Ìý As the aggregate numbers indicate, there are many companies with cash return that does not sync with potential dividends or earnings. In the picture below, we highlight four groups of companies, with the first two focused on dividends, relative to earnings, and the other two structured around cash returned relative to free cash flows to equity, where we look at mismatches.


Let's start with the net income/dividend match up. Across every region of the world, 17.5% of money losing companies continue to pay dividends, just as 31% of money-making companies choose not to pay dividends. Using the free cash flows to equity to divide companies, 38% of companies with positive FCFE choose not to return any cash to their shareholder while 48% of firms with negative FCFE continue to pay dividends. While all of these firms claim to have good reasons for their choices, and I have listed some of them, dividend dysfunction is alive and well in the data.

Ìý Ìý I argued earlier in this post that cash return policy varies as companies go through the life cycle, and to see if that holds, we broke down global companies into deciles, based upon corporate age, from youngest to oldest, and looked at the prevalence of dividends and buybacks in each group:

As you can see, a far higher percent of the youngest companies are money-losing and have negative FCFE, and it is thus not surprising that they have the lowest percentage of firms that pay dividends or buy back stock. As companies age, the likelihood of positive earnings and cash flows increases, as does the likelihood of dividend payments and stock buybacks.
ConclusionÌýÌý ÌýWhile dividends are often described as residual cash flows, they have evolved over time to take on a more weighty meaning, and many companies have adopted dividend policies that are at odds with their capacity to return cash.ÌýThere are two forces that feed this dividend dysfunction. The first is inertia, where once a company initiates a dividend policy, it is reluctant to back away from it, even though circumstances change. The second is me-tooism, where companies adopt cash return policies to match Ìýtheir peer groups, paying dividends because other companies are also paying dividends, or buying back stock for the same reasons.ÌýThese factors explain so much of what we see in companies and markets, but they are particularly effective in explaining the current cash return policies of companies.
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Data Updates for 2025
Data LinksDividend fundamentals, by industry (, , , , , , Cash return and FCFE, by industry (,Ìý,Ìý,Ìý,Ìý,Ìý,Ìý

posted by Aswath Damodaran on March, 06 ]]>
/author_blog_posts/25535459-data-update-8-for-2025-debt-taxes-and-default---an-unholy-trifecta Sun, 23 Feb 2025 17:05:00 -0800 <![CDATA[Data Update 8 for 2025: Debt, Taxes and Default - An Unholy Trifecta!]]> /author_blog_posts/25535459-data-update-8-for-2025-debt-taxes-and-default---an-unholy-trifecta The Debt Trade off Ìý Ìý As a prelude to examining the debt and equity tradeoff, it is best to first nail down what distinguishes the two sources of capital. There are many who trust accountants to do this for them, using whatever is listed as debt on the balance sheet as debt, but that can be a mistake, since accounting has been guilty of mis-categorizing and missing key parts of debt. To me, the key distinction between debt and equity lies in the nature of the claims that its holders have on cash flows from the business. Debt entitles its holders to contractual claims on cash flows, with interest and principal payments being the most common forms, whereas equity gives its holders a claim on whatever is left over (residual claims). The latter (equity investors) take the lead in how the business is run, by getting a say in choosing who manages the business and how it is run, while lenders act, for the most part, as a restraining influence.
Using this distinction, all interest-bearing debt, short term and long term, clears meets the criteria for debt, but for almost a century, leases, which also clearly meet the criteria (contractually set, limited role in management) of debt, were left off the books by accountants. It was only in 2019 that the accounting rule-writers (IFRS and GAAP) finally did the right thing, albeit with a myriad of rules and exceptions.ÌýÌýÌý ÌýEvery business, small or large, private or public and anywhere in the world, faces a question of whether to borrow money, and if so, how much, and in many businesses, that choice is driven by illusory benefits and costs. Under the illusory benefits of debt, I would include the following:Borrowing increases the return on equity, and is thus good: Having spent much of the last few decades in New York, I have had my share of interactions with real estate developers and private equity investors, who are active and heavy users of debt in funding their deals. One reason that I have heard from some of them is that using debt allows them to earn higher returns on equity, and that it is therefore a better funding source than equity. The first part of the statement, i.e., that borrowing money increases the expected return on equity in an investment, is true, for the most part, since you have to contribute less equity to get the deal done, and the net income you generate, even after interest payments, will be a higher percentage of the equity invested. It is the second part of the statement that I would take issue with, since the higher return on equity, that comes with more debt, will be accompanied by a higher cost of equity, because of the use of that debt. In short, I would be very skeptical of any analysis that claims to turn a neutral or bad project, funded entirely with equity, into a good one, with the use of debt, especially when tax benefits are kept out of the analysis.The cost of debt is lower than the cost of equity: If you review , and go through my cost of capital calculation, there is one inescapable conclusion. At every level of debt, the cost of equity is generally much higher than the cost of debt for a simple reason. As the last claimants in line, equity investors have to demand a higher expected return than lenders to break even. That leads some to conclude, wrongly, that debt is cheaper than equity and more debt will lower the cost of capital. (I will explain why later in the post.)Under the illusory costs of debt, here are some that come to mind:Debt will reduce profits (net income): On an absolute basis, a business will become less profitable, if profits are defined as net income, if it borrows more money. That additional debt will give rise to interest expenses and lower net income. The problem with using this rationale for not borrowing money is that it misses the other side of debt usage, where using more debt reduces the equity that you will have to invest.Debt will lower bond ratings: For companies that have bond ratings, many decisions that relate to use of debt will take into account what that added debt will do to the company’s rating. When companies borrow more money, it may seem obvious that default risk has increased and that ratings should drop, because that debt comes with contractual commitments. However, remember that the added debt is going into investments (projects, joint ventures, acquisitions), and these investments will generate earnings and cash flows. When the debt is within reasonable bounds (scaling up with the company), a company can borrow money, and not lower its ratings. Even if bond ratings drop, a business may be worth more, at that lower rating, if the tax benefits from the debt offset the higher default risk.Equity is cheaper than debt:ÌýThere are businesspeople (including some CFOs) who argue that debt is cheaper than equity, basing that conclusion on a comparison of the explicit costs associated with each â€� interest payments on debt and dividends on equity. By that measure, equity is free at companies that pay no dividends, an absurd conclusion, since investors in equity anticipate and build in an expectation of price appreciation. Equity has a cost, with the expected price appreciation being implicit, but it is more expensive than debt.The picture below captures these illusory benefits and costs:
If the above listed are illusory reasons for borrowing or not borrowing, what are the real reasons for companies borrowing money or not borrowing? The two primary benefits of borrowing are listed below:Tax Benefits of Debt: The interest expenses that you have on debt are tax deductible in much of the world, and that allows companies that borrow money to effectively lower their cost of borrowing:Ìý
ÌýÌý ÌýAfter-tax cost of debt = Interest rate on debt (1 â€� tax rate)Ìý
In dollar terms, the effect is similar; a firm with a 25% tax rate and $100 million in interest expenses will get a tax benefit of $25 million, from that payment.ÌýÌý

Debt as a disciplinary mechanism: In some businesses, especially mature ones with lots of earnings and cash flows, managers can become sloppy in capital allocation and investment decisions, since their mistakes can be covered up by the substantial earnings. Forcing these companies to borrow money, can make managers more disciplined in project choices, since poor projects can trigger default (and pain for managers).

These have to be weighted off against two key costs:Expected bankruptcy costs: As companies borrow money, the probability that they will be unable to make their contractual payments on debt will always increase, albeit at very different rtes across companies, and across time, and the expected bankruptcy cost is the product of this probability of default and the cost of bankruptcy, including both direct costs (legal and deadweight) and indirect costs (arising from the perception that the business is in trouble).Agency costs: Equity investors and lenders both provide capital to the business, but the nature of their claims (contractual and fixed for debt versus residual for equity) creates very different incentives for the two groups. In short, what equity investors do in their best interests (taking risky projects, borrow more money or pay dividends) may make lenders worse off. As a consequence, when lending money, lenders write in covenants and restrictions on the borrowing businesses, and those constraints will cause costs (ranging from legal and monitoring costs to investments left untaken).The real trade off on debt is summarized in the picture below:
While the choices that businesses make on debt and equity should be structured around expected tax benefits (debt’s biggest plus) and expected bankruptcy costs (debt’s biggest minus), businesses around the world are affected by frictions, some imposed by the markets that they operate in, and some self-imposed. The biggest frictional reasons for borrowing are listed below:Bankruptcy protections (from courts and governments): If governments or courts step in to protect borrowers, the former with bailouts, and the latter with judgments that consistently favor borrowers, they are nullifying the effect of expected bankruptcy costs in restraining companies from borrowing too much. Consequently, companies in these environments will borrow much more than they should.Subsidized Debt: If lenders or governments lend money to firms at below-market reasons for reasons of virtue (green bonds and lending) or for political/economic reasons (governments lending to companies that choose to keep their manufacturing within the domestic economy), it is likely that companies will borrow much more than they would have without these debt subsidies.Corporate control: There are companies that choose to borrow money, even though debt may not be the right choice for them, because the inside investors in these companies (family groups, founders) do not want to raise fresh equity from the market, concerned that the new shares issued will reduce their power to control the firm.ÌýThe biggest frictional reasons for holding back on borrowing include:Debt covenants: To the extent that debt comes with restrictions, a market where lender restrictions are more onerous in terms of the limits that they put on what borrowers can or cannot do will lead to a subset of companies that value flexibility borrowing less.Overpriced equity: To the extent that markets may become over exuberant about a company's prospects, and price its equity too highly, they also create incentives for these firms to overuse equity (and underutilize debt).ÌýRegulatory constraints: There are some businesses where governments and regulators may restrict how much companies operating in them can borrow, with some of these restrictions reflecting concerns about systemic costs from over leverage and others coming from non-economic sources (religious, political).The debt equity trade off, in frictional terms, is in the picture below:

As you look through these trade offs, real or frictional, you are probably wondering how you would put them into practice, with a real company, when you are asked to estimate how much it should be borrow, with more specificity. That is where the cost of capital, the Swiss Army Knife of finance that I wrote about in , comes into play as a debt optimizing tool. Since the cost of capital is the discount rate that you use to discount cash flows back to get to a value, a lower cost of capital, other things remaining equal, should yield a higher value, and minimizing the cost of capital should maximize firm. With this in place, the “optimal� debt mix of a business is the one that leads to the lowest cost of capital:
You will notice that as you borrow more money, replacing more expensive equity with cheaper debt, you are also increasing the costs of debt and equity, leading to a trade off that can sometimes lower the cost of capital and sometimes increase it. This process of optimizing the debt ratio to minimize the cost of capital is straight forward, and if you are interested, will help you do this for any company.
Measuring the Debt BurdenÌýÌý ÌýWith that tradeoff in place, we are ready to examine how it played out in 2024, by looking at how much companies around the world borrowed to fund their operations. We can start with dollar value debt, with two broad measures â€� gross debt, representing all interest-bearing debt and lease debt, and net debt, which nets cash and marketable securities from gross debt. In 2024, here are the gross and net debt values for global companies, broken down by sector and sub-region:
The problem with dollar debt is that absolute values can be difficult to compare across sectors and markets with very different values, I will look at scaled versions of debt, first to total capital (debt plus equity) and then then to rough measures of cash flows (EBITDA) and earnings (EBIT). The picture below lists the scaled versions of debt:Debt to Capital: The first measure of debt is as a proportion of total capital (debt plus equity), and it is this version that you use to compute the cost of capital. The ratio, though, can be very different when you use book values for debt and equity then when market values are used. The table below computes debt to capital ratios, in book and market terms, by sector and sub-region:ÌýI would begin by separating the financial sector from the rest of the market, since debt to banks is raw material, not a source of capital. Breaking down the remaining sectors, real estate and utilities are the heaviest users of debt, and technology and health care the lightest. Across regions, and looking just at non-financial firms, the US has the highest debt ratio, in book value terms, but among the lowest in market value terms. Note that the divergence between book and market debt ratios in the last two columns varies widely across sectors and regions.Debt to EBITDA: Since debt payments are contractually set, looking at how much debt is due relative to measure of operating cash flow making sense, and that ratio of debt to EBITDA provides a measure of that capacity, with higher (lower) numbers indicating more (less) financial strain from debt.Interest coverage ratio: Interest expenses on debt are a portion of the contractual debt payments, but they represent the portion that is due on a periodic basis, and to measure that capacity, I look at how much a business generates as earnings before interest and taxes (operating income), relative to interest expenses. In the table below, I look at debt to EBITDA and interest coverage ratios, by region and sector:ÌýThe results in this table largely reaffirm our findings with the debt to capital ratio. Reda estate and utilities continue to look highly levered, and technology carries the least debt burden. Across regions, the debt burden in the US, stated as a multiple of EBITDA or looking at interest coverage ratios, puts it at or below the global averages, whereas China has the highest debt burden, relative to EBITDA.The Drivers and Consequences of DebtÌýÌý ÌýAs you look at differences in the use of debt across regions and sectors, it is worth examining how much of these differences can be explained by the core fundamentals that drive the debt choice â€� the tax benefits of debt and the bankruptcy cost.ÌýThe tax benefit of debt is the easier half of this equation, since it is directly affected by the marginal tax rate, with a higher marginal tax rate creating a greater tax benefit for debt, and a greater incentive to borrow more. Drawing on a that lists marginal tax rates by country, I create a heat map:
The country with the biggest changes in corporate tax policy in the world, for much of the last decade, has been the United States, where the federal corporate tax rate, which at 35%, was one of the highest in the world prior to 2017, saw a drop to 21% in 2017, as part of the first Trump tax reform. With state and local taxes added on, the US, at the start of 2025, had a marginal corporate tax rate of 25%, almost perfectly in line with a global norm. The 2017 tax code, though, will sunset at the end of 2025, and corporate tax rates will revert to their old levels, but the Trump presidential win has not only increased the odds that the 2017 tax law changes will be extended for another decade, but opened up the possibility that corporate tax rates may decline further, at least for a subset of companies.
ÌýÌý ÌýÌýÌý ÌýAn interesting question, largely unanswered or answered incompletely, is whether the US tax code change in 2017 changed how much US companies borrowed, since the lowering of tax rates should have lowered the tax benefits of borrowing. In the table below, I look at dollar debt due at US companies every year from 2015 to 2024, and the debt to EBITDA multiples each year:



As you can see, the tax reform act has had only a marginal effect on US corporate leverage, albeit in the right direction. While the dollar debt at US companies has continued to rise, even after marginal tax rates in the US declines, the scaled version of debt (debt to capital ratio and debt to EBITDA have both decreased).



The most commonly used measure of default riskÌýis corporate bond ratings, since ratings agencies respond (belatedly) to concerns about default risk by downgrading companies. The graph below, drawing on data from S&P< looks at the distribution of bond ratings, from S&P, of rated companies, across the globe, and in the table below, we look at the breakdown by sector:Ìý
The ratings are intended to measure the likelihood of default, and it is instructive to look at actual default rates over time. In the graph below, we look at default rates in 2024, in a historical context:


As you can see in the graph, default rates are low in most periods, but, not surprisingly, spike during recessions and crises. With only 145 corporate defaults, 2024 was a relatively quiet year, since that number was slightly lower than the 153 defaults in 2023, and the default rate dropped slightly (from 3.6% to3.5%) during the year.Ìý

The default spread is a price of risk in the bond market, and if you recall, I estimated the . To the extent that the price of risk in both the equity and debt markets are driven by the endless tussle between greed and fear, you would expect them to move together much of the time, and as you can see in the graph below, I look at the implied equity risk premium and the default spread on a Baa rated bond:
In 2024, the default spread for a Baa rated dropped from 1.61% to 1.42%, paralleling a similar drop in the implied equity risk premium from 4.60% to 4.33%.Ìý
Debt DesignÌýÌý ÌýThere was a time when businesses did not have much choice, when it came to borrowing, and had to take whatever limited choices that banks offered. In the United States, corporate bond markets opened up choices for US companies, and in the last three decades, the rest of the world has started to get access to domestic bond markets. Since corporate bonds lend themselves better than bank loans to customization, it should come as no surprise now that many companies in the world have literally dozens of choices, in terms of maturity, coupon (fixed or floating), equity kickers (conversion options) and variants on what index the coupon payment is tied to. While these choices can be overwhelming for some companies, who then trust bankers to tell them what to do, the truth is that the first principles of debt design are simple. The best debt for a business is one that matches the assets it is being used to fund, with long term assets funded with long term debt, euro assets financed with euro debt, and with coupon payments tied to variables that also affect cash flows.Ìý
There is data on debt design, though not all companies are as forthcoming about how their debt is structured. In the table below, I look at broad breakdowns â€� conventional and lease debt, long term and short debt, by sector and sub-region again:The US leads the world in the use of lease debt and in corporate bonds, with higher percentages of total debt coming from those sources. However, floating rate debt is more widely used in emerging markets, where lenders, having been burned by high and volatile inflation, are more likely to tie lending rates to current conditions.ÌýÌý ÌýWhile making assessments of debt mismatch requires more company-level analysis, I would not be surprised if inertia (sticking with the same type of debt that you have always uses) and outsourcing (where companies let bankers pick) has left many companies with debt that does not match their assets. These companies then have to go to derivatives markets and hedge that mismatch with futures and options, creating more costs for themselves, but fees and benefits again for those who sell these hedging products.
Bottom LineÌý Ìý When interest rates in the United States and Europe rose strongly in 2022, from decade-long lows, there were two big questions about debt that loomed. The first was whether companies would pull back from borrowing, with the higher rates, leading to a drop in aggregate debt. The other was whether there would be a surge in default rates, as companies struggled to generate enough income to cover their higher interest expenses. While it is still early, the data in 2023 and 2024 provide tentative answers to these questions, with the findings that there has not been a noticeable decrease in debt levels, at least in the aggregate, and that while the number of defaults has increased, default rates remain below the highs that you see during recessions and crises. The key test for companies will remain the economy, and the question of whether firms have over borrowed will be a Ìýglobal economic slowdown or recession.

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Data Updates for 2025Data LinksDebt fundamentals, by industry (, , , , , & )Debt details, by industry (,Ìý,Ìý,Ìý,Ìý,ÌýÌý&Ìý)


posted by Aswath Damodaran on February, 24 ]]>
/author_blog_posts/25521826-return-on-equity-earnings-yield-and-market-efficiency-back-to-basics Tue, 18 Feb 2025 11:53:00 -0800 <![CDATA[Return on Equity, Earnings Yield and Market Efficiency: Back to Basics!]]> /author_blog_posts/25521826-return-on-equity-earnings-yield-and-market-efficiency-back-to-basics comparison of accounting returns on equity (capital) to costs of equity (capital) can yield a measure of excess returns. The second was a comment that I made on a LinkedIn post that had built on my implied equity premium approach to the Indian market but had run into a roadblock because of an assumption that, in an efficient market, the return on equity would equate to the cost of equity. I pointed to the flaw in the logic, but the comments thereafter suggested such deep confusion about what returns on equity or capital measure, and what comprises an efficient market, that I think it does make sense to go back to basics and see if some of the confusion can be cleared up.
The Lead In: Business FormationÌý Ìý To keep this example as stripped of complexity as I can, at least to begin, I will start with two entrepreneurs who invest $60 million apiece to start new businesses, albeit with very different economics:The first entrepreneur starts business A, with a $60 million investment up front, and that business is expected to generate $15 million in net income every year in perpetuity.The second entrepreneur starts business B, again with a $60 million investment up front, and that investment is expected to generate $3 million every year in perpetuity.With these characteristics, the accounting balance sheets for these companies will be identical right after they start up, and the book value of equity will be $60 million in each company.Ìý
The return on equity is an entirely accounting concept, and it can be computed by dividing the net income of each of the two businesses by the book value of equity:Return on equity for Business A Ìý= Net income for Business A / Book Value of Equity for Business A = 15/60 = 25%Return on equity for Business B Ìý= Net income for ÌýBusiness B / Book Value of Equity for Business B = 3/60 = 5%Assume that both these businesses have the same underlying business risk that translates into a cost of equity of 10%, giving the two businesses the following excess returns:Excess Return for Business A = Return on equity for Business A â€� Cost of equity for Business A = 25% -10% = 15%Excess Return for Business B = Return on equity for Business B â€� Cost of equity for Business B = 5% -10% = -5%In the language of my last post, the first business is a good one, because it creates value by earning more than your money would have earned elsewhere on an investment of equivalent risk, and the second is a bad one, because it does not.Ìý Ìý The return on equity may be an equation that comes from accounting statements, but in keeping with my argument that every number needs a narrative, each of these numbers has a narrative, often left implicit, that should be made explicit.On business A, the story has to be one of strong barriers to entry that allow it to sustain its excess returns in perpetuity, and those could include anything from a superlative brand name to patent protection to exclusive access to a natural resource. In the absence of these competitive advantages, these excess returns would have faded very quickly over time.On business B, you have a challenge, since it does seem irrational that an entrepreneur would enter a bad business, and while that irrationality cannot be ruled out (perhaps the entrepreneur thinks that earning any profit makes for a good business), the reality is that outside events can wreak havoc on the bet paid plans of businesses. For instance, it is possible that the entrepreneur’s initial expectations were that he or she would earn much more than 5%, but a competitor launching a much better product or a regulatory change could have changed those expectations.In sum, the return on equity and its more expansive variant, the return on invested capital, measure what a company is making on the capital it has invested in business, and is a measure of business quality.
The Market Launch Ìý Ìý Assume now that the owners of both businesses (A and B) list their businesses in the market, disclosing what they expect to generate as net income in perpetuity. Investors in equity markets will now get a chance to price the two companies, and if markets are efficient, they will arrive at the following:Thus, a discerning (efficient) market would value business A, with $15 million in net income in perpetuity at $150 million, while valuing business B, with $3 million in net income in perpetuity, at $30 million. If you are wondering why you would discount net income, rather than cash flow, the unique features of these investments (constant net income, no growth and forever lives) makes net income equal to cash flow.Ìý Ìý Even with this very simplistic example, there are useful implications. The first is that if markets are efficient, the price to book ratios will reflect the quality of these companies. In this example, for instance, business A, with a market value of equity of $150 million and a book value of equity of $60 million, will trade at 2.50 times book value, whereas company B with a market value of equity of $30 million and a book value of equity of $60 million will trade at half of book value. Both companies would be fairly valued, though the first trades at well above book value and the second at well below, thus explaining why a lazy variant of value investing, built almost entirely on buying stocks that trade at low price to book ratio,, will lead you to holding bad businesses, not undervalued ones.Ìý Ìý As I noted at the start of this post, it was motivated by trying to clear up a fundamental misunderstanding of what return on equity measures. In fact, the working definition that some commenters used for return on equity was obtained by dividing the net income by the market value of equity. That is not return on equity, but an earnings to price ratio, i.e., the earnings yield, and in these examples, with no growth and perpetual (constant) net income, that earnings yield will be equal to the cost of equity in an efficient market.
Extending the Discussion Ìý Ìý One of the advantages of this very simple illustration is that it now can be used as a launching pad for casting light on some of the most interesting questions in investing:Good companies versus Good Investments: I have written about the contrast between a good company and a good investment, and this example provides an easy way to illustrate the difference. Looking at companies A and B, there is absolutely no debating the fact that company A is better company, with sustainable moats and high returns on equity (25%), than company B, which struggles to make money (return on equity of 5%), and clearly is in a bad business. However, which of these two companies is the better investment rests entirely on how the market prices them:
As you can see, the good company (A) can be a good, bad or neutral investment, depending on whether its is priced at less than, greater than or equal to its fair value ($150 million) and the same can be said about the bad company (B), with the price relative to its fair value ($30 million). At fair value, both become neutral investments, generating returns to shareholders that match their cost of equity.The Weakest Link in Excess Returns: The excess return is computed as the difference between return on equity and the cost of equity, and while it is true that different risk and return models and differences in risk parameters (relative risk measures and equity risk premiums) can cause variations in cost of equity calculations, the return on equity is the weaker link in this comparison. To understand some of the ways the return on equity can be skewed, consider the following variants on the simple example in this case:Accounting inconsistencies: As an entirely accounting number, the return on equity is exposed to accounting inconsistencies and miscategorization. To illustrate with our simple example, assume that half the money invested in business A is in R&D, which accountants expense, instead of capitalizing. That business will report a loss of $15 million (with the R&D expense of $30 million more than wiping out the profit of $15 million) in the first year on book capital of $30 million (the portion of the capital invested that is not R&D), but in the years following, it will report a return on capital of 50.00% (since net income will revert back to $15 million, and equity will stay at $30 million). Carrying this through to the real world, you should not be surprised to see technology and pharmaceutical companies, the two biggest spenders on R&D, report much higher accounting returns than they are actually earning on their investments..Aging assets: In our example, we looked at firms an instant after the upfront investment was made, when the book value of investment measures what was paid for the assets acquired. As assets age, two tensions appear that can throw off book value, the first being inflation, which if not adjusted for, will result in the book value being understated, and accounting returns overstated. The other is accounting depreciation, which often has little to do with economic depreciation (value lost from aging), and subject to gaming. Extrapolating, projects and companies with older assets will tend to have overstated accounting returns, as inflation and depreciation lay waste to book values. In fact, with an aging company, and adding in stock buybacks, the book value of equity can become negative (and is negative for about 10% of the companies in my company data sample).Fair Value Accounting: For the last few decades, the notion of fair value accounting has been a fever dream for accounting rule writers, and those rules, albeit in patchwork form, have found their way into corporate balance sheets. In my view, fair value accounting is pointless, and I can use my simple example to illustrate why. If you marked the assets of both company A and company B to market, you would end with book values of $150 million and $30 million for the two companies and returns on equity of 10% for both firms. In short, if fair value accounting does what it is supposed to do, every firm in the market will earn a return on equity (capital) equal to the cost of equity (capital), rendering it useless as a metric for separating good and bad businesses. If fair value accounting fails at what it is supposed to do, which is the more likely scenario, you will end up with book values of equity that measure neither original capital invested nor current market value, and returns on equity and capital that become noise.Growth enters the equation: For companies A and B, in this example, we assumed that the net income was constant, i.e., there is no growth. Introducing growth into the equation changes none of the conclusions that we have drawn so far, but it makes reading both the return on equity and the earnings yield much messier. To see why, assume that company A in the example continues to have no growth, but company B expects to see compounded annual growth of 50% a year in its net income of $3 million for the next decade. We can no longer consign company B to the bad business pile as easily, and the current earnings to price ratio for that company will no longer be equal to the cost of equity, even if markets are efficient. Incorporating growth into the analysis will also mean that net income is not equal to cash flow, since some or a large portion of that net income will have to get reinvested back to deliver the growth. In fact, this is the argument that I used in Ìýto explain why comparing the earnings yield to the treasury bond rate is unlikely to yield a complete assessment of whether stocks are under or over valued, since it ignores growth and reinvestment entirely.Exiting bad businesses: This example also helps to bring home why it is so difficult for companies in bad businesses to fix their "badness" or exit their businesses. In the case of company B, for instance, telling the manager to find projects that earn more than 10% is advice that can be freely dished out, but how exactly do you invent good projects in a business that has turned bad? While exiting the business seems to be a better choice, that presupposes that you will get your capital ($60 million) back when you do, but in the real world, potential buyers will discount that value. In fact, if you divest or sell the bad business for less than $30 million, you are actually worse off than staying in the business and continuing to generate $3 million a year in perpetuity, which has a $30 million value. In the real world, most companies in bad businesses hire new CEOs, restructure their businesses and enter new businesses in a desperate attempt to become good businesses, and enrich consultants and bankers, but not their own shareholders, along the way. Conclusion Ìý Ìý Many of the comments on my seventh data update, and on my explanation about why ÌýROE and cost of equity don’t have to be equal in an efficient market, came from people with degrees and certifications in finance, and quite a few of the commenters had “finance professionalâ€� listed in their profile. Rather than take issue with them, I would argue that this misunderstanding of basics is a damning indictment of how these concepts and topics are taught in the classroom, and since I may very well be one of the culprits, one reason that I wrote this post is to remind myself that I have to revisit the basics, before making ambitious leaps into corporate financial analysis and valuation. For those of you who are not finance professionals, but rely on them for advice, I hope this is a cautionary note on taking these professionals (consultants, appraisers, bankers) at their word. Some of them throw buzzwords and metrics around, with little understanding of what they mean and how they are related, and it is caveat emptor.
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posted by Aswath Damodaran on February, 19 ]]>
/author_blog_posts/25505479-data-update-7-for-2025-the-end-game-in-business Wed, 12 Feb 2025 06:52:00 -0800 <![CDATA[Data Update 7 for 2025: The End Game in Business!]]> /author_blog_posts/25505479-data-update-7-for-2025-the-end-game-in-business I am in the third week of the corporate finance class that I teach at NYU Stern, and my students have been lulled into a false sense of complacency about what's coming, since I have not used a single metric or number in my class yet. In fact, we have spent almost four sessions (that is 15% of the overall class) talking about the end game in business. In an age when ESG, sustainability and stakeholder wealth maximization have all tried to elbow their way to the front of the line, all laying claim to being what business should be about, I have burnished my "moral troglodyte" standing by sticking with my belief that the end game in business is to maximize value, with earnings and cash flows driving that value, and that businesses that are profitable and value creating are in a much better position to do good, if they choose to try. In this post, I will focus on how companies around the world, and in different sectors, performed on their end game of delivering profits, by first focusing on profitability differences across businesses, then converting profitability into returns, and comparing these returns to the hurdle rates that I talked about in .

Profitability - Absolute and Relative

Ìý Ìý While we may all agree with the proverbial bottom line being profits, there seems to be no consensus on how best to measure profitability, either from an accounting or an economic perspective. In this section, I will begin with a simplistic breakdown of the income statement, the financial statement that is supposed to tell us how much a business generated in profits in during a period, and use it as an (imperfect) tool to understand the business economics.Ìý

Ìý Ìý While accountants remain focused on balance sheets, with a fixation of bringing intangibles on to the balance and marking everything up to the market, much of the information that we need to assess the value of a business comes from income and cash flow statements. I am not an accountant, but I do rely on accounting statements for the raw data that I use in corporate finance and valuation. I have tried my hand at financial statement analysis, as practiced by accountants, and discovered that for the most part, the analysis creates more confusions than clarity, as a multiplicity of ratios pull you in different directions. It is for that reason that I createdÌý, that you can find on my webpage.

Ìý Ìý During the course of the class, I assess the income statement, in its most general form, by looking at the multiple measures of earnings at different phases of the statement:


Which of these represents the bottom line for businesses? If you are aÌýshareholder in a company, i.e., an equity investor, the measure that best reflects the profits the company made on the equity you invested in them is the earnings per share. That said, there is information in the measures of earnings as you climb the income statement, and there are reasons why as you move up the income statement, the growth rates you Ìýobserve may Ìýbe different:

To get from net income to earnings per share, you bring in share count, and actions taken by companies that alter that share count will have effects. Thus, a company that issues new shares to fund its growth may see net income growth, but its earnings per share growth will lag, as the share count increases. Conversely, a company that buys back shares will see share count drop, and earnings per share growth will outpace net income growth.To get from operating income to net income, you have multiple variables to control for. The first Ìýis taxes, and incorporating its effect will generally lead to lower net income, and the tax rate that you pay to get from pretax profit to net income is the effective tax rate. To the extent that you have cash on your balance, you will generate interest income which adds on to net income, but interest expenses on debt will reduce income, with the net effect being positive for companies with large cash balance, relative to the debt that they owe, and negative for firms with large net debt outstanding. There is also the twist of small (minority) holdings in other companies and the income you generate from those holdings that affect net income.To get from gross income to operating income, you have to bring in operating expenses that are not directly tied to sales. Thus, if you have substantial general and administrative costs or incur large selling and advertising costs or if you spend money on R&D (which accountants mistakenly still treat as operating expenses), your operating income will be lower than your gross income.Finally, to get from revenues to gross income, you net out the expenses incurred on producing the goods/services that you sell, with these expenses often bundled into a "cost of goods sold" categorization. While depreciation of capital investments made is usually separated out from costs of goods sold, and shown as an operating cost, there are some companies, where it is bundled into costs of goods sold.ÌýIn many cases, the only statement where you will see depreciation and amortization as a line item is the statement of cash flows.

With that template in place, the place to start the assessment of corporate profitability is to to look at how much companies generated in each of the different earnings metrics around the world in 2024, broken down by sector:


For the financial services sector, note that I have left revenues, gross profit, EBITDA and operating profit as not applicable, because of their unique structure, where debt is raw material and revenue is tough to nail down. (Conventional banks often start their income statements with net interest income, which is interest expense on their debt/deposits netted out against net income, making it closer to nough to categorize and compare to non-financial firms). I have also computed the percentage of firms globally that reported positive profits, a minimalist test on profitability in 2024, and there are interesting findings (albeit some not surprising) in this table:On a net profit basis, there is no contest for the sector that delivers the most net income. It is financials by a wide margin, accounting for a third of the net profits generated by all firms globally in 2024. In fact, technology, which is the sector with the highest market cap in 2024, is third on the list, with industrials taking second place.As you move from down the income statement, the percentage of firms that report negative earnings decreases. Across the globe, close to 84% of firms had positive gross profits, but that drops to 67% with EBITDA, 62% percent with operating income and 61% with net income.ÌýAcross sectors, health care has the highest percentage of money-losing companies, on every single metric, followed by materials and communication services, whereas utilities had the highest percentage of money makers.While looking at dollar profits yields intriguing results, comparing them across sectors or regions is difficult to do, because they are in absolute terms, and the scale of businesses vary widely. The simple fix for that is to measure profitability relative to revenues, yielding profit margins - gross margins for gross profits, operating margins with operating profits and net margins with net profits. At the risk of stating these margins, not only are these margins not interchangeable, but they each convey information that is useful in understanding the economics of a business:
As you can see, each of the margins provides insight (noisy, but still useful) about different aspects of a business model.Ìý Ìý With gross margins, you are getting a measure of unit economics, i.e., the cost of producing the next unit of sale. Thus, for a software company, this cost is low or even zero, but for a manufacturing company, no matter how efficient, the cost will be higher. Even within businesses that look similar, subtle differences in business models can translate into different unit economics. For Netflix, adding a subscriber entails very little in additional cost, but for Spotify, a company that pays for the music based on what customers listen to, by the stream, the additional subscriber will come with additional cost. Just to get a big picture perspective on unit economics, I ranked industries based upon gross margin and arrived at the following list of the ten industries with the highest gross margins and the ten with the lowest:
With the caveat that accounting choices can affect these margins, you can see that the rankings do make intuitive sense. The list of industry groups that have the highest margins are disproportionately in technology, though infrastructure firms (oil and gas, green energy, telecom) also make the list since their investment is up front and not per added product sold. The list of industry group with the lowest margins are heavily tilted towards manufacturing and retail, the former because of the costs of making their products and the latter because of their intermediary status.ÌýÌý Ìý With operating margins, you are getting a handle on economies of scale.ÌýWhile every companies claims economies of scale as a rationale for why margins should increase as they get larger, the truth is more nuanced. Economies of scale will be a contributor to improving margins only if a company has significant operating expenses (SG&A, Marketing) that grow at a rate lower than revenues. To measure the potential for economies of scale, I looked at the difference between gross and operating margins, across industries, with the rationale that companies with a large difference have a greater potential for economies of scale.
Many of the industry groups in the lowest difference (between gross and operating margin) list were also on the low gross margin list, and the implication is not upbeat. When valuing or analyzing these firms, not only should you expect low margins, but those margins will not magically improve, just because a firm becomes bigger.Ìý Ìý The EBITDA margin is an intermediate stop, and it serves two purposes. If provides a ranking based upon operating cash flow, rather than operating earnings, and for businesses that have significant depreciation, that difference can be substantial. It is also a rough measure of capital intensity Ìýsince to generate large depreciation/amortization, these companies also had to have substantial cap ex. Using the difference between EBITDA and operating margin as a measure of capital intensity, the following table lists the industries with the most and least capital intensity:
Profit margins by industry:Ìý,Ìý,Ìý,Ìý,Ìý,ÌýandÌý
Again, there are few surprises on this list, including the presence of biotech at the top of the most capital intensive list, but that is due to the significant amortization line items on their balance sheets, perhaps from writing off failed R&D, and real estate on the top of the least capitalÌýintensive list, but the real estate segment in question is for real estate operations, not ownership.Ìý Ìý The net margin, in many ways, is the least informative of the profit margins, because there are so many wild cards at play, starting with differences in taxes (higher taxes lower net income), financial leverage (more leverage reduces net margins), cash holdings (interest from higher cash balances increases net income) and cross holdings (with varying effects depending on how they are accounted for, and whether they make or lose money). Ranking companies based upon net margin may measure everything from differences in financial leverage (more net debt should lead to lower margins) to extent of cross holdings and non-operating investments (more of these investments can lead to higher margins).

Accounting Returns

Ìý Ìý While scaling profits to revenues to get margins provides valuable information about business models and their efficacy, scaling profits to capital invested in a business is a useful tool for assessing the efficiency of capital allocation at the business., The two measures of profits from the previous section that are scaled to capital are operating income (before and after taxes) and net income, with the former measured against total invested capital (from equity and debt) and the latter against just equity capital.ÌýUsing a financial balance sheet structure again, here is what we get:


The achilles heel for accounting return measures is their almost total dependence on accounting numbers, with operating (net) income coming from income statements and invested capital (equity) from accounting balance sheets. Any systematic mistakes that accountants make (such as not treating leases as debt, which was the default until 2019, and treating R&D as an operating expense, which is still the case) will skew accounting returns. In addition, accounting decisions to write off an asset or take restructuring charges will make the calculation of invested capital more difficult. I laying out these and other challenges in computing accounting returns, and you are welcome to browse through it, if you want.ÌýÌý Ìý

ÌýÌý ÌýÌý ÌýIf you are willing to live with the limitations, the accounting returns become proxies for what a business earns on its equity (with return on equity) and as a business (with the cost of capital). Since the essence of creating value is that you need to earn more than your cost of capital, you can synthesize returns with the costs of equity and capital that I talked about in the last post, to get measures of excess returns:


I have the data to compute the accounting returns for the 48,000 publicly traded companies in my sample, though there are estimation choices that I had to make, when computing returns on equity and capital:
Thus, you will note that I have bypassed accounting rules and capitalized R&D and leases (even in countries where it is not required) to come up with my versions of earnings and invested capital. Having computed the return on capital (equity) for each company, I then compared that return to the cost of capital (equity) to get a measure of excess returns for the company. In the table below, I start by breaking companies down by sector, and looking at the statistics on excess returns, by sector:
Note that across all firms, only about 30% of firms earn a return on capital that exceeds the cost of capital. Removing money-losing firms, which have negative returns on capital from the sample, improves the statistic a little, but even across money making firms, roughly half of all firms earn less the the cost of capital.While the proportions of firms that earn returns that exceed the cost of equity (capital) vary across sectors, there is no sector where an overwhelming majority of firms earn excess returns.ÌýÌý ÌýI disaggregate the sectors into industry groups and rank them based upon excess returns in the table below, with the subtext being that industries that earn well above their cost of capital are value creators (good businesses) and those that earn below are value destroyers (bad businesses):Excess returns by industry:Ìý,Ìý,Ìý,Ìý,Ìý,ÌýÌýandÌý
There are some industry groups on this list that point to the weakness of using last year's earnings to get accounting return on capital. You will note that biotech drug companies post disastrously negative returns on capital but many of these firms are young firms, with some having little or no revenues, and their defense would be that the negative accounting returns reflect where they fall in the life cycle. Commodity companies cycle between the most negative and most returns lists, with earnings varying across the cycle; for these firms, using average return on capital over a longer period should provide more credible results.ÌýÌý ÌýFinally, I look at excess returns earned by non-financial service companies by sub-region, again to see if companies in some parts of the world are better positioned to create value than others:
As you can see, there is no part of the world that is immune from this problem, and only 29% of all firms globally earn more than their cost of capital. Even if you eliminate firms with negative earnings, the proportion of firms that earn more than their cost of capital is only 46.5%.Ìý
ImplicationsÌý Ìý I have been doing versions of this table every year for the last decade, and the results you see in this year's table, i.e., that 70% of global companies generate returns on equity (capital) that are less tan their hurdle rates, has remained roughly static for that period. ÌýMaking money is not enough for success: In many businesses, public or private, managers and even owners seem to think that making money (having a positive profit) represents success, not recognizing that the capital invested in these businesses could have been invested elsewhere to earn returns.ÌýCorporate governance is a necessity; Marty Lipton, a and critic of this things activist argued that activist investing was not necessary because most companies were well managed, and did not need prodding to make the right choices. The data in this post suggests otherwise, with most companies needing reminders from outside investors about the opportunity cost of capital.Companies are not fatted calves: In the last few years, two groups of people have targeted companies - politicians arguing that companies are price-gouging and the virtue crowd (ESG, sustainability and stakeholder wealth maximizers) pushing for companies to spend more on making the world a better place. Implicit in the arguments made by both groups is the assumption that companies are, at least collectively, are immensely profitable and that theyÌýcan afford to share some of those spoils with other stakeholders (cutting prices for customers with the first group and spending lavishly on advancing social agendas with the second). That may be true for a subset of firms, but for most companies, making money has only become more difficult over the decades, and making enough money to cover the cost of the capital that they raise to create their businesses is an even harder reach. Asking these already stretched companies to spend more money to make the world a better place will only add to the likelihood that they will snap, under the pressures.ÌýA few months ago, I was asked to give testimony to a Canadian legislative committee that was planning to force Canadian banks to lend less to fossil fuel companies and more to green energy firms, a terrible idea that seems to have found traction in some circles. If you isolate the Canadian banks in the sample, they collectively generated returns on equity of 8.1%, with two thirds of banks earning less than their costs of equity. Pressuring these banks to lend less to their best customers (in terms of credit worthiness) and more to their worst customers (green energy company are, for the most part, financial basket cases) is a recipe for pushing these banks into distress, and most of the costs of that distress will be borne not by shareholders, but by bank depositors.
YouTube Video

Data Updates for 2025Data LinksExcess returns by industry: , , , , , and Profit margins by industry: , , , , , and Paper Links

ÌýÌý Ìý



posted by Aswath Damodaran on February, 13 ]]>
/author_blog_posts/25494531-data-update-6-for-2025-from-macro-to-micro---the-hurdle-rate-question Sat, 08 Feb 2025 08:32:00 -0800 <![CDATA[Data Update 6 for 2025: From Macro to Micro - The Hurdle Rate Question!]]> /author_blog_posts/25494531-data-update-6-for-2025-from-macro-to-micro---the-hurdle-rate-question a rate of return that you determine as your required return for business and investment decisions. In this post, I will drill down to what it is that determines the hurdle rate for a business, bringing in what business it is in, how much debt it is burdened with and what geographies it operates in.
The Hurdle Rate - Intuition and UsesÌý Ìý You don't need to complete a corporate finance or valuation class to encounter hurdle rates in practice, usually taking the form of costs of equity and capital, but taking a finance class both deepens the acquaintance and ruins it. It deepens the acquaintance because you encounter hurdle rates in almost every aspect of finance, and it ruins it, by making these hurdle rates all about equations and models.ÌýA few years ago, I wrote , where I described the cost of capital as the Swiss Army knife of finance, because of its many uses.ÌýÌýÌý ÌýIn my corporate finance class, where I look at the first principles of finance that govern how you run a business, the cost of capital shows up in every aspect of corporate financial analysis:In business investing (capital budgeting and acquisition) decisions, it becomes a hurdle rate for investing, where you use it to decide whether and what to invest in, based on what you can earn on an investment, relative to the hurdle rate. In this role, the cost of capital is an opportunity cost, measuring returns you can earn on investments on equivalent risk.
In business financing decisions, the cost of capital becomes an optimizing tool, where businesses look for a mix of debt and equity that reduces the cost of capital, and where matching up the debt (in terms of currency and maturity) to the assets reduces default risk and the cost of capital. In this context, the cost of capital become a measure of the cost of funding a business:
In dividend decisions, i.e., the decisions of how much cash to return to owners and in what form (dividends or buybacks), the cost of capital is a divining rod. If the investments that a business is looking at earn less than the cost of capital, it is a trigger for returning more cash, and whether it should be in the form of dividends or buybacks is largely a function of what shareholders in that company prefer:The end game in corporate finance is maximizing value, and in my valuation class, where I look at businesses from the outside (as a potential investor), the cost of capital reappears again as the risk-adjusted discount rate that you use estimate the intrinsic value of a business.Ìý
Much of the confusion in applying cost of capital comes from not recognizing that it morphs, depending on where it is being used. An investor looking at a company, looking at valuing the company, may attach one cost of capital to value the company, but within a company, but within a company, it may start as a funding cost, as the company seeks capital to fund its business, but when looking at investment, it becomes an opportunity cost, reflecting the risk of the investment being considered.
The Hurdle Rate - Ingredients
Ìý Ìý If the cost of capital is a driver of so much of what we do in corporate finance and valuation, it stands to reason that we should be clear about the ingredients that go into it. Using one of my favored structures for understanding financial decision making, a financial balance sheet, a cost of capital is composed of the cost of equity and the cost of debt, and I try to capture the essence of what we are trying to estimate with each one in the picture below:




To go from abstractions about equity risk and default risk to actual costs, you have to break down the costs of equity and debt into parts, and I try to do so, in the picture below, with the factors that you underlie each piece:
As you can see, most of the items in these calculations should be familiar, if you have read my first five data posts, since they are macro variables, having nothing to do with individual companies. ÌýThe first is, of course, the riskfree rate, a number that varies across time (as you saw in post on US treasury rates inÌý) and across currencies (in my post on currencies in data update 5).ÌýThe second set of inputs are prices of risk, in both the equity and debt markets, with the former measured by equity risk premiums, and the latter by default spreads. In , I looked at equity risk premiums in the United States, and expanded that discussion to equity risk premiums in the rest of the world ). In , I looked at movements in corporate default spreads during 2024.There are three company-specific numbers that enter the calculation, all of which contribute to costs of capital varying across companies;Relative Equity Risk, i.e., a measure of how risky a company's equity is, relative to the average company's equity. While much of the discussion of this measure gets mired in the capital asset pricing model, and the supposed adequacies and inadequacies of beta, I think that too much is made of it, and that the model is adaptable enough to allow for other measures of relative risk.I am not a purist on this measure, and while I use betas in my computations, I am open to using alternate measures of relative equity risk.Corporate Default Risk, i.e, a measure of how much default risk there is in a company, with higher default risk translating into higher default spreads. For a fairly large subset of firms, a bond rating may stand in as this measure, but even in its absence, you have no choice but to estimate default risk. Adding to the estimation challenge is the fact that as a company borrows more money, it will play out in the default risk (increasing it), with consequences for both the cost of equity and debt (increasing both of those as well).Operating geographies: ÌýThe equity risk premium for a company does not come from where it is Ìýincorporated but from where it does business, both in terms of the production of its products and services and where it generates revenue. That said, the status quo in valuation in much of the world seems to be to base the equity risk premium entirely on the country of incorporation, and I vehemently disagree with that practice:Again, I am flexible in how operating risk exposure is measured, basing it entirely on revenues for consumer product and business service companies, entirely on production for natural resource companies and a mix of revenues and production for manufacturing companies.As you can see, the elements that go into a cost of capital are dynamic and subjective, in the sense that there can be differences in how one goes about estimating them, but they cannot be figments of your imagination.
The Hurdle Rate - Estimation in 2025Ìý Ìý With that long lead in, I will lay out the estimation choices I used to estimate the costs of equity, debt and capital for the close to 48,000 firms in my sample. In making these choices, I operated under the obvious constraint of the raw data that I had on individual companies and the ease with which I could convert that data into cost of capital inputs.Ìý
Riskfree rate: To allow for comparisons and consolidation across companies that operate in different currencies, I chose to estimate the costs of capital for all companies in US dollars, with the US ten-year treasury rate on January 1, 2025, as the riskfree rate.Equity Risk Premium: Much as I would have liked to compute the equity risk premium for every company, based upon its geographic operating exposure, the raw data did not lend itself easily to the computation. Consequently, I have used the equity risk premium of the country in which a company is headquartered to compute the equity risk premium for it.Relative Equity Risk: I stay with beta, notwithstanding the criticism of its effectiveness for two reasons. First, I use industry average betas, adjusted for leverage, rather than the company regression beta, because because the averages (I title them bottom up betas) are significantly better at explaining differences in returns across stocks. Second, and given my choice of industry average betas, none of the other relative risk measures come close, in terms of predictive ability. For individual companies, I do use the beta of their primary business as the beta of the company, because the raw data that I have does not allow for a breakdown into businesses.ÌýCorporate default risk: For the subset of the sample of companies with bond ratings, I use the S&P bond rating for the company to estimate the cost of debt. For the remaining companies, I use interest coverage ratios as a first measure to estimate synthetic ratings, and standard deviation in stock prices as back-up measure.Debt mix: I used the market capitalization to measure the market value of equity, and stayed with total debt (including lease debt) to estimate debt to capital and debt to equity ratiosThe picture below summarizes my choices:


There are clearly approximations that I used in computing these global costs of capital that I would not use if I were computing a cost of capital for valuing an individual company, but this approach yields values that can yield valuable insights, especially when aggregated and averaged across groups.
a. Sectors and IndustriesÌý Ìý The risks of operating a business will vary Ìýwidely across different sectors, and I will start by looking at the resulting differences in cost of capital, across sectors, for global companies:

There are few surprises here, with technology companies facing the highest costs of capital and financials the lowest, with the former pushed up by high operating risk and a resulting reliance on equity for capital, and the latter holding on because of regulatory protection.Ìý Ìý Broken down into industries, and ranking industries from highest to lowest costs of capital, here is the list that emerges:
The numbers in these tables may be what you would expect to see, but there are a couple of powerful lessons in there that businesses ignore at their own peril. The first is that even a casual perusal of differences in costs of capital across industries indicates that they are highest in businesses with high growth potential and lowest in mature or declining businesses, bringing home again the linkage between danger and opportunity. The second is that multi-business companies should understand that the cost of capital will vary across businesses, and using one corporate cost of capital for all of them is a recipe for cross subsidization and value destruction.
b. Small versus Larger firmsÌý Ìý In for this year, I took a brief look at the small cap premium, i.e, the premium that small cap stocks have historically earned over large cap stocks of equivalent risk, and commented on its disappearance over the last four decades. I heard from a few small cap investors, who argued that small cap stocks are riskier than large cap stocks, and should earn higher returns to compensate for that risk. Perhaps, but that has no bearing on whether there is a small cap premium, since the premium is a return earned over and above what you would expect to earn given risk, but I remained curious as to whether the conventional wisdom that small cap companies face higher hurdle rates is true. To answer this question,ÌýI examine the relationship between risk and market cap, breaking companies down into market cap deciles at the start of 2025, and estimating the cost of capital for companies within each decile:

The results are mixed. Looking at the median costs of capital, there is no detectable pattern in the cost of capital, and the companies in the bottom decile have a lower median cost of capital (8.88%) than the median company in the sample (9.06%). That said, the safest companies in Ìýlargest market cap decile have lower costs of capital than the safest companies in the smaller market capitalizations. As a generalization, if small companies are at a disadvantage when they compete against larger companies, that disadvantage is more likely to manifest in difficulties growing and a higher operating cost structure, not in a higher hurdle rate.
c. Global DistributionÌý Ìý In the final part of this analysis, I looked at the costs of capital of all publicly traded firms and played some Moneyball, looking at the distribution of costs of capital across all firms. In the graph below,I present the histogram of cost of capital, in US dollar terms, of all global companies at the start of 2025, with a breakdown of costs of capital, by region, below:



I find this table to be one of the most useful pieces of data that I possess and I use it in almost every aspect of corporate finance and valuation:Cost of capital calculation: The full cost of capital calculation is not complex, but it does require inputs about operating risk, leverage and default risk that can be hard to estimate or assess for young companies or companies with little history (operating and market). For those companies, I often use the distribution to estimate the cost of capital to use in valuing the company. Thus, when I valued Uber in June 2014, I used the cost of capital (12%) at the 90th percentile of US companies, in 2014, as Uber's cost of capital.ÌýNot only did that remove a time consuming task from my to-do list, but it also allowed me to focus on the much more important questions of Ìýrevenue growth and margins for a young company. Drawing on , where I talk about differences across currencies, this table can be easily modified into the currency of your choice, by adding differential inflation. Thus, if you are valuing an Indian IPO, in rupees, and you believe it is risky, at the start of 2025, adding an extra 2% (for the inflation differential between rupees and dollars in 2025) to the ninth decile of Indian costs of capital (12.08% in US dollars) will give you a 14.08% Indian rupee cost of capital.Fantasy hurdle rates: In my experience, many Ìýinvestors and companies make up hurdle rates, the former to value companies and the latter to use in investment analysis. These hurdle rates are either hopeful thinking on the part of investors who want to make that return or reflect inertia, where they were set in stone decades ago and have never been revisited. In the context of checking to see whether a valuation passes the 3P test (Is it possible? Is it plausible? Is it probable?), I do check the cost of capital used in the valuation. A valuation in January 2025, in US dollars, that uses a 15% cost of capital for a publicly traded company that is mature is fantasy (since it is in well in excess of the 90th percentile), and the rest of the valuation becomes moot.ÌýTime-varying hurdle rates: When valuing companies, I believe in maintaining consistency, and one of the places I would expect it to show up is in hurdle rates that change over time, as the company's story changes. Thus, if you are valuing a money-losing and high growth company, you would expect its cost of capital to be high, at the start of the valuation, but as you build in expectations of lower growth and profitability in future years, I would expect the hurdle rate to decrease (from close to the ninth decile in the table above towards the median).It is worth emphasizing that since my riskfree rate is always the current rate, and my equity risk premiums are implied, i.e., they are backed out from how stocks are priced, my estimates of costs of capital represent market prices for risk, not theoretical models. Thus, if looking at the table, you decide that a number (median for your region, 90th percentile in US) look too low or too high, your issues are with the market, not with me (or my assumptions).
TakeawaysÌý Ìý I am sorry that this post has gone on as long as it has, but to end, there are four takeaways from looking at the data:
Corporate hurdle rate: The notion that there is a corporate hurdle rate that can be used to assess investments across the company is a myth, and one with dangerous consequences. It plays out in all divisions in a multi-business company using the same (corporate) cost of capital and in acquisitions, where the acquiring firm's cost of capital is used to value the target firm. The consequences are predictable and damaging, since with this practice, safe businesses will subsidize risky businesses, and over time, making the company riskier and worse off over time.Reality check on hurdle rates: All too often, I have heard CFOs of companies, when confronted with a cost of capital calculated using market risk parameters and the company's risk profile, say that it looks too low, especially in the decade of low interest rates, or sometimes, too high, especially if they operate in an risky, high-interest rate environment. As I noted in the last section, making up hurdle rates (higher or lower than the market-conscious number) is almost never a good idea, since it violates the principle that you have live and operate in the world/market you are in, not the one you wished you were in.Hurdle rates are dynamic: In both corporate and investment settings, there is this almost desperate desire for stability in hurdle rates. I understand the pull of stability, since it is easier to run a business when hurdle rates are not volatile, but again, the market acts as a reality check. In a world of volatile interest rates and risk premia, using a cost of capital that is a constant is a sign of denial.Hurdle rates are not where business/valuation battles are won or lost: It is true that costs of capital are the D in a DCF, but they are not and should never be what makes or breaks a valuation. In my four decades of valuation, I have been badly mistaken many times, and the culprit almost always has been an error on forecasting growth, profitability or reinvestment (all of which lead into the cash flows), not the discount rate. In the same vein, I cannot think of a single great company that got to greatness because of its skill in finessing its cost of capital, and I know of plenty that are worth trillions of dollars, in spite of never having actively thought about how to optimize their costs of capital. It follows that if Ìýyou are spending the bulk of your time in a capital budgeting or a valuation, estimating discount rates and debating risk premiums or betas, you have lost the script. If you are valuing a mature US company at the start of 2025, and you are in a hurry (and who isn't?), you would be well served using a cost of capital of 8.35% (the median for US companies at the start of 2025) and spending your time assessing its growth and profit prospects, and coming back to tweak the cost of capital at the end, if you have the time.YouTube Video

Data Updates for 2025Data LinksCost of capital, by industry grouping: , , , , , )Paper links

posted by Aswath Damodaran on February, 09 ]]>