Aswath Damodaran's Blog, page 14

February 10, 2020

Data Update 3 for 2020: The Price of Risk!

When investing, risk is a given and if you choose to avoid it, at any cost, you will and in the last decade, you have borne a staggering cost in terms of returns unearned. At the other extreme, seeking out risk for the sake of taking risk is more suited to casinos than to financial markets, and as in casinos, the end game is almost always disastrous. The middle ground on risk is to accept that it is part and parcel of investing, to try to gauge how exposed you are to it and to make sure that your expected return is high enough to compensate you for taking that risk. Put simply, you are charging a price to take risk, and that price will reflect not only your history and experiences as an investor, but how risk averse you are, as an individual. In this post, rather than focus on your or my price of risk. I want to talk about the market price of risk, as assessed by all investors, and how that price changed in 2019.

The Price of Risk
There are almost as many definitions of risk, as there are investors, but I find many of them wanting. There is, of course, the definition of risk as uncertainty, a circular play on words, since it just replaces one nebulous word (risk) with another. There is the definition of risk as encompassing all the bad outcomes you can have on an investment, which by making risk into a negative and something to be avoided, leads you right into the arms of those selling your protection against it (in the form of hedging). In finance, we have become so used to measuring risk in statistical terms (standard deviation, variance, covariance etc.) that we have taken to defining risk with these measures, an arid and antiseptic view of risk. 听The truth is that risk, at least in business, is neither a good nor a bad, but a given. It is a combination of danger (the likelihood that bad things will happen to you) and opportunity (often emerging from exposing yourself to danger, and I think that the Chinese symbol for crisis captures its essence perfectly:(I know! I know! I have been corrected and recorrected on both the symbols and the definition by people who know far more Chinese than I do, which is pretty much everyone in the world鈥� So, please cut me some slack!) It is this definition of risk that allows us to frame the risk/return trade off that lies at the heart of investing. While you can choose a pathway of taking no risk and earning guaranteed returns, those returns in today鈥檚 markets would be close to zero in the United States and Europe. If you want to earn higher returns, you have no choice but to expose yourself to risk, and when you do, the key question becomes whether you are being compensated sufficiently for taking that risk.听When you invest in fixed income securities (bonds), your compensation takes the form of a default spread, i.e., what you charge over and above the risk free rate to invest in that bond.路 When you invest in equities, the payoff to taking risk comes in the form of an equity risk premium, i.e., the premium you demand over and above the risk free rate for investing in equities as an asset class.Both the default spread and the equity risk premium are market-set numbers and are driven by demand and supply. The default spread is a function of what investors believe is the likelihood that borrowers will fail to make their contractually obligated payments, and it will rise and fall with the economy. The equity risk premium is a more complex number and I think of it as the receptacle for everything from changes in investor risk aversion to perceptions of economic growth and stability to corporate choices on leverage and cash return to global flash points (war, health scares etc.).
The Default SpreadThe default spread is the premium that investors demand on a bond to compensate for default risk, and not surprisingly, it varies across bond issuers, with safer (riskier) borrowers being charged less (more) to borrow money. One assessment of corporate default risk is a bond rating, a measure of default risk computed by ratings agencies. While ratings agencies have been criticized for bias and delay, these bond ratings are still widely used, and are a convenient proxy not only for measuring default risk, but also for estimating default spreads. In the graph below, I have listed the default spreads at the start of 2020 and compared them to default spreads that I had estimated at the start of 2019, by ratings class:厂辞耻谤肠别:听The first conclusion, and a completely unsurprising one, is that companies that are lower rated (and thus perceived to have more default risk) have larger default spreads than companies that are highly rated; a BBB (Baa) rated bond, at the cusp of investment grade and junk bonds, for instance, saw its default spread drop from 2.00% at the start of 2019 to 1.56% at the start of 2020. To get some longer-term perspective on how much default spreads change over time, the default spread on the investment grade (BBB, Baa) rated bond is graphed below from 1980 to 2019:Source: At the risk of stating the obvious, the default spreads on bonds change over time, decreasing when times are good and investors are sanguine, and increasing during economic downturns and market crises.
The US Equity Risk PremiumIn my last data update post, where I looked at markets over the last decade, I also posted a table that reported historical equity risk premiums, i.e., the premiums earned by stocks over treasury bills and bonds over long periods, ranging from a decade to 92 years.听Source: There are many practitioners, who use these historical equity risk premiums as the best estimates for what you will earn in the future, using mean reversion as their basic argument. I have already made clear my problems with using a backward-looking number with a large estimation error (see the standard errors in the table above) as an expectation for the future, but it cuts against the very essence of an equity risk premium as a number that should be dynamic and constantly changing, as new information comes into markets. For almost three decades, I have computed an implied equity risk premium, a forward-looking value computed by looking at what investors are paying for stocks today, and the expected cash flows on those stocks. Specifically, I take an approach that is used with bonds to compute a yield to maturity to stocks, computing an IRR for stocks and then subtracting out the risk free rate. At the start of 2020, the implied equity risk premium for the S&P 500 was 5.20% and the calculations are in the graph below:
Since I have been computing this number at the start of each month, since September 2008, I can look at how this number moved in the twelve months of 2019:During the course of the year, the implied equity risk premium has increased from 5.96% to 5.20%, driven down by increasing stock prices and lower interest rates.
I am fascinated by the implied equity risk premium because it captures the market鈥檚 current standing in one number and frames debates about the overall market. A contention that markets are overvalued, or in a bubble, is equivalent to claiming that the equity risk premium is too low, relative to what you believe is a reasonable value. In contrast, a bullish assessment of the entire equity market can be viewed as a statement about equity risk premiums being too high, again relative to reasonable values. But what is a reasonable value? I have no idea, since I am not a market timer, but to help you make your own assessment, I have reproduced the implied equity risk premium for the S&P 500 going back to 1960:You could use the computed averages embedded in the graph as your basis for reasonable, and using that comparison, the market looks closer to under than overpriced, since the ERP on January 1, 2020 was 5.20%, higher than the average for the last 60 years (4.20%) or the last 20 years (4.86%). Even with a 10-year average, the market is only very mildly overpriced. It is true that the current implied ERP of 5.20% is being earned on a riskfree rate of 1.92%, low by historical standards, yielding an expected return of 7.12% and that may be too low for some. I will let you make your own assessment, but this is a healthier one that just looking at PE ratios (Shiller, trailing, forward) or other market metrics.
A Real Estate Risk Premium?If default spreads measure the price of risk in bond markets and equity risk premiums measure the risk for investing in stocks, what is the price of risk of investing in other asset classes? It may be more difficult to assess what this value is in other risky markets, but it exists without a doubt, and one way of evaluating how much of your portfolio to allocate to these asset classes is to compare their risk premiums to the risk premiums of bonds and stocks. To get a sense of how this would play out, consider the real estate market, perhaps the biggest asset class outside of stocks and bonds. Investors in commercial real estate attach prices to properties, based upon their expectations of income from the properties and capitalization rates. Thus, a property with expected income of $10 million and a capitalization rate of 8% will be valued at $125 million = $10/.08. Since the capitalization rate is effectively a measure of expected return on real estate, subtracting out the risk free rate should yield a measure of the risk premium in real estate.听Risk Premium for Real Estate = Cap Rate 鈥� Risk free rateIn the graph below, I have estimated the real estate risk premium and provided a comparison to the equity risk premium and default spread, over time:
Note that the real estate risk premium in the 1980s was not only well below the equity risk premium and the default spread, it was sometimes negative. While that may strike you as odd, it makes sense if you think of real estate as an asset class that is not only uncorrelated with financial asset returns but also provides insurance against inflation. As real estate was securitized in the 1990s and fears of inflation receded, the real estate risk premium has started behaving like the risk premiums in stock and bond markets, and the rising correlation between them reflects that co-movement. Put simply, we live in a world, where the real estate you own (often your house or apartment) will tend to move with, rather than against, your financial assets, and in the next market crisis, as the stocks and bonds that you own plummet in value, you should expect the value of your house to drop as well!
ConclusionThe debate about equity risk premiums is not an abstract one, since which side of the debate you come down upon (whether risk premiums today are too high or low) is going to drive your asset allocation judgments. If you are a bear, you believe that equity risk premiums should be higher, either for fundamental reasons or by instinct, and you should put less of your wealth into stocks than you normally would, given your age, liquidity needs and risk aversion. The challenge that you will face is in deciding where you will invest your money until you think that the ERP becomes more reasonable, since bonds are likely to also be overpriced (according to your view of the world) and real assets will often be no better. If you are a market bull, your story has to be one of equity risk premiums declining in the future, perhaps because you believe in your own version of mean reversion or because of continued economic growth. For both market bulls and bears, the perils with then bringing these views into every valuation that you do is that every company you value will then jointly both your views about the company and the overall market. It is for this reason that I think it makes sense to revert back to a market neutral view, when valuing individual companies, even if you have strong market views. Since my market timing skills are non-existent, I prefer to stay market neutral, and stick to valuing companies using the prevailing equity risk premiums.听
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Published on February 10, 2020 19:04

February 6, 2020

A Do-it-yourself (DIY) Valuation of Tesla: Of Investment Regrets and Disagreements!

I was hoping to move on from Tesla to my data update posts, but my last post on Tesla drew some attention, in good and bad ways, partly because of its timing. Right after I sold my shares for $640, last week (January 30), the stock took off, climbing to more than $900/share in the matter of days. As always, there were people on both sides of the great Tesla divide commenting on my valuation, with bears accusing me of wearing rose-colored glasses and making unrealistically optimistic assumptions, and bulls pointing to inputs that they felt under estimated the company鈥檚 potential. I wish that I had been clearer in my writing that the numbers that I was using did not represent 鈥渢he鈥� valuation of Tesla but that this was 鈥渕y鈥� valuation of the company, and that I not only expect disagreement, but I think it is part and parcel of a healthy market. Rather than leave that view as an abstraction, I thought I would revisit the valuation and present it in a different format, one in which you can choose your story for Tesla and estimate the value for yourself.
The Key Levers of ValueIn my earlier post, I valued Tesla and presented my valuation in a picture, where I connected the story that I was telling about the company to my estimated value per share of roughly $427 per share:If you find the numbers off putting or overwhelming, the value is determined by four key levers:The Growth Lever: The revenue growth rate controls how much and how quickly the firm will be able to grow its revenues from autos, software, solar panels and anything else that you believe the company will be selling. Rather than focus on the growth rate, I would suggest looking at the estimated revenues in 2030 (ten years out). In my Tesla story (valuation), I have estimated revenues of $125 billion in 2030, a five-fold increase over the 2019 revenues.The Profitability Lever: The target (pre-tax) operating margin determines how profitable you think the company will be, once its growth days start to scale down. Since these are operating margins, not gross or net margins, they are after all operating expenses (cost of goods sold, SG&A etc.) but before any financial expenses (interest expenses). In keeping with my view that R&D is really a capital expense, I capitalize R&D, which improves Tesla鈥檚 profitability, and target an operating margin of 12% by 2025.The Investment Efficiency Lever: To grow, companies have to invest in production capacity and the sales to invested capital听drives how efficiently investment is done, with higher sales to capital ratios reflecting more efficiency. With Tesla, I assume that every dollar of investment (in new factories, technology and new R&D) in the first 5 years generates $3 in revenues, as it utilizes excess capacity in the early years, and that this efficiency drops back by a third, as capacity constraints hit.The Risk lever: There are two inputs in this valuation that incorporate risk. The first is the cost of capital that I start the valuation with, a reflection of risk as seen through the eyes of a diversified investor in the company. The second is the likelihood of failure听(or distress), where the company has to liquidate assets and lose the additional value that it could have generated as a going concern. With Tesla, I set this cost of capital at 7% and assume that given its marginal profitability and significant debt load, the chance of failure is 10%.The value per share of $427 comes out of these assumptions and is driving my investment decisions. Since this is my story and valuation, I expect and welcome disagreement on any and all of these inputs. After all, I don鈥檛 have a crystal ball to forecast the future or a monopoly on the right estimates
A DIY Valuation of TeslaIn the rest of this post, rather than force my story on your, I would like you to make your choices on the growth, profitability, investment and risk dimensions future for Tesla, and just in case you need some help, I will offer data perspective, on each of those choices.听
The Growth Lever To make your judgment on how much revenue Tesla will have in a decade, it may help to take a look at the overall auto business. In 2019, the collective revenues of all publicly traded auto companies in the world was about $2.46 trillion and the the compounded average growth rate in those revenues over the last decade has been about 3.5%:Source data: S&P Capital IQPut simply, this is a big market, but the overall market is in slow growth. To provide some perspective on what the bigger auto companies generate in revenues, I have listed the 20 largest auto companies, in terms of revenues in the table below:Source data: S&P Capital IQTesla does make the list, coming in at the very bottom of the list, and its compounded annual growth rate between 2010 and 2019 stands out, partly the base revenues for the company, in 2010, were tiny. Since one of the Tesla stories told by optimistic is that it is a tech company, It may help in your estimation to see what large tech companies look like, and to make this assessment, I decided to focus on the giants on top of the tech heap in the FAANG stocks, with Microsoft thrown in for full measure:Note that while the tech companies are substantially more profitable than the auto companies, in terms of margins and dollar operating income, their revenues tend to be more muted, reflecting the pricing of their products and services. Apple, the largest market cap company in the world, had revenues of $ 260 billion in 2019, and Microsoft, the largest software company in the world, by far, had revenues of $129 billion, and both companies lagged Toyota and Volkswagen, on total revenues.

With this background, I think that you have the ammunition you need to make your own revenue judgments for Tesla in a decade, differentiating your story from mine, where revenues in 2030 for Tesla are roughly $125 billion. So, with no further ado, here are your choices (pick one):Since Tesla鈥檚 revenue stream includes not just autos but also software, batteries and solar panels, your story may augment revenues to reflect these, but remember that these streams cannot deliver the same revenue heft as selling cars, though they may be more profitable.听
The Profitability LeverTo make your judgment on operating profitability, take a look at both the largest auto company tables and the one for FAANG stocks in the last section. There is not a single large auto company with double digit margins, and across all auto companies listed publicly, the profit picture is even more bleak:Source: S&P Capital IQThe picture is brighter for the FAANG stocks, where the aggregate operating margin across all five stocks is 19.87%, well above auto industry averages. That margin, though, is delivered on smaller revenues and with business models where production costs are a smaller fraction of selling prices. The marginal cost of producing an extra unit for Microsoft is close to zero on both its Office and Cloud business, and even for Apple, which derives a large chunk of its revenues from the iPhone, the cost of making the iPhone is about about 40% of the price it charges.听
This information should provide a basis for you to make a choice on a target operating margin for Tesla in the future, keeping in mind that its current operating margin is miniscule and barely positive.听As you make this choice, it is important that you tie it back to your earlier growth story. While Tesla sales of software/tech will have higher margins, it the auto sales that are responsible for the bulking up of revenues over time. Thus, if your argument is that Tesla will become predominantly a soft services company, you can give it higher margins, but your revenue expectations may have to be reduced.
The Investment Efficiency LeverThe investment efficiency lever is one of the trickiest to navigate. Again, the place to start is with automobile companies, and the table below presents the distribution of sales to invested capital across all auto firms, at the start of 2020.
Looking across global auto companies, the median company generates $1.37 in sales for every dollar of capital invested, and at the 75th percentile, the more capital-efficient auto companies generate $2.42 in revenues for every dollar of capital invested. In fact, my estimate of $3 in revenues for every dollar of capital invested reflects an optimistic view of Tesla鈥檚 capacity to bring technological innovation to its production processes, and reduce the capital needed to fund those processes. Since Tesla, in 2019, generates $1.32 in revenue for every dollar of capital invested, my estimate is more aspirational than based on observable efficiencies, right now. Tesla bulls will counter with the tech company story, and to help the estimation process, I estimated the sales to invested capital at tech firms generally, just software firms and finally at just the FAANG stocks. None of these groups had sales to invested capital that were higher than my estimate. With that data to provide perspective, it is time to make your own judgment on investment efficiency:This choice will drive not only how much Tesla will have to reinvest to grow, but the extent to which it will be dependent on external capital for that growth.

The Risk LeverThe first component in the risk lever is the cost of capital, and to provide a sense of what costs of capital look like around the world at the start of 2020, let me start with a cost of capital distribution for all publicly traded companies:Note that the median cost of capital across all firms globally is 7.58%, and that 50% of all publicly traded firms have costs of capital that fall between 6.27% and 8.71%. It is true that costs of capital vary across different industries, and while you can , the median cost of capital for auto firms is 6.94% and for tech firms, it is 8.86%. While I used 7% as my cost of capital, you may disagree and here are your choices:The other component of risk is failure, where the company faces the risk of having its life truncated, either because it runs out of cash or because of debt payments coming due. While the rise in stock price has reduced its vulnerability for the moment, those who see more losses in the future and continued borrowing to fund investment may attach a higher probability of default than the 10% that I use, whereas those who believe Elon鈥檚 claims that Tesla has entered an era of positive earnings and cash flows, may decide that Tesla has no risk of failure any more:

The ValuationI have created a front end for my that allows the choices you made to drive the valuation. Running through the different combinations for the four variables, I have too many to list individually, but consider a subset in this table:Broadly speaking, there are four broad stories that I have valued here:The Big Auto Story: If your story is that Tesla will emerge from its growth period as one of the largest auto companies in the world (revenues of $100- $300 billion in year 10), with top-tier auto company margins (7.42%), investment efficiency (2.42) and cost of capital (6.94%), the value per share ranges from $106/share (with BMW like revenues) to $227/share (with Daimler-like revenues) to $333/share (with VW/Toyota like revenues).The Techy Auto Company Story: An alternate story is that Tesla is an auto/software/services company with tech company characteristics, giving it higher margins (10.25%) and a higher cost of capital (8.86%). With this story, the听value per share ranges from $111/share (with BMW like revenues) to $212/share (with Daimler-like revenues) to $298/share (with VW/Toyota like revenues). Put simply, the higher risk nullifies the benefits of higher profitability.The FAANGy Auto Company: In this variant of the tech story, Tesla not only develops a tech twist, but becomes as successful as the most successful tech companies (I use the FAANG stocks + Microsoft). 听In this story, the margins approach 18.97% and with a tech cost of capital, the value per share ranges from $459/share (with BMW like revenues) to $855/share (with Daimler-like revenues) to $2,106/share (with VW/Toyota like revenues).The Make-your-best Company: In this variant, I give Tesla the best possible outcomes on each variable, revenues like VW/Toyota, margins like pure software companies (21.24%), a sales to capital ratio that is higher than any of the sector averages (4.00) and a cost of capital of an auto company (6.94%), and arrive at a value per share of $2106.For some of you, the fact that there is a value here that justifies whatever your Tesla status is right now (long, short or just watching) should not be the end of your analysis. Each of these stories may be possible, but the tests you have to run, and I will prejudge your conclusions, is whether they are plausible. With each story, there are key questions that need answering:

With the big auto stories, the key question will be whether Tesla can climb to the very top of the heap in terms of revenues, generally reserved for mass market companies, while earning operating margins that are usually reserved for smaller luxury auto companies?With the techy auto stories, the key question becomes whether a company that derives the bulk of its revenues from selling cars be profitable and reinvest like a tech company?听With the FAANGy stories, the investment question becomes whether you should up front for a company on the expectation that it will be an exceptional company. It very well might make it to the top of the heap, but if it does not, you are set up for disappointment.With the MYB story, you are approaching the most dangerous place in valuation, where you pick and choose each assumption, without considering the ones you have already made. Put simply, is it even possible to build a company that generates revenues like Toyota, earns margins like Microsoft and invests more efficiently than any manufacturing company in history has ever done, while still preserving the low cost of capital of an auto company?ConclusionIn the week since I sold Tesla at $640, the stock has gone on a wild ride, rising above $900 in two trading days. Not surprisingly, quite a few of you have asked me whether I have any regrets about selling too early. You may not believe me, but I don't. I made my decision to buy, based on my story and valuation for Tesla, and my decision to sell, for the same reason, because I am an investor who believes in value, and acting on it. If I abandon that philosophy to play the momentum game, a game that I am not good at and don鈥檛 really play well, I may make a bit more money, but at what cost? 听 On a different note, I have to confess that one reason that I write about Tesla reluctantly is the vitriol that seems to be part of any discussion of the stock. In a world where we face unbridgeable divides on politics, religion and culture, do we need to add investing to the mix? 听If you stayed with your Tesla investment, I wish you the best, and I hope that you are holding on for the right reasons, either because you believe that its value is much higher or because you are playing the pricing game. If you sold short and lost money, I get no joy out of your losses and no inclination to do a celebratory dance. For the moment, you may have lost, but having watched this stock for as long as I have, that can change in a minute. As far as I am concerned, Tesla is a fascinating company, but it is just an investment, not a matter of life or death, and definitely not worth losing sleep, and friends, over.

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Published on February 06, 2020 17:03

January 30, 2020

An Ode to Luck: Revisiting my Tesla Valuation

When investing, I am often my own biggest adversary, handicapped by the preconceptions and priors that I bring into analysis and decision making, and no company epitomizes the dangers of bias more than Tesla. It is a company where there is no middle ground, with the optimists believing that there is no limit to its potential and the pessimists convinced that it is a time bomb, destined to implode. I have tried, without much luck, to navigate the middle ground in my valuations of the company and have been found wanting by both sides. For much of Tesla鈥檚 life, I have pointed to its promise but argued that it was too richly priced to be a good investment, and during that period, Tesla bulls accused me of working for the short sellers. They did not believe me when I argued that you could like a company for its vision and potential, and not like it as an investment. When I bought Tesla in June 2019, arguing that the price had dropped enough (to $180) to make it a good investment, they became my allies, but that decision led to a backlash from Tesla bears, who labeled me a traitor for abandoning my position, again not accepting my argument that at the right price, I would buy any company. I would love to chalk it to my expert timing, but luck was on my side, the momentum shifted right after I bought, and the stock has not stopped rising since. When Tesla鈥檚 earnings reported its earnings yesterday (January 29th), the stock was trading at $581, before jumping to $650 in after-market trading. It is time to revisit my valuation and reassess my holding!
Tesla in听June 2019: A Story Stock loses its story!It was in June 2019 just over seven months ago, when the sky was full of dark clouds for Tesla, as a collection of wounds, some internal and others external had pushed the stock price down more than 40% in a few months, that I took a look at the company and valued it at just over $190 per share:In arriving at this value, I told a story of a company that would grow to deliver $100 billion in revenues in a decade, while also earning a 10% pre-tax operating margin. One concern that I had at the time was that the debt load for the company, in conjunction with operating losses and a loss of access to new capital, would expose the company to a risk of default; I estimated a 20% probability that Tesla would not survive. 听At the time that I wrote the post, I posted a limit order to buy the stock at a $180 stock price, and when it executed a short while later, 听some of you pointed out that I was not giving myself much margin of safety. I argued that the distribution of Tesla value outcomes gave me a much larger chance of upside than downside. At the time of the investment, I also described the company as a corporate teenager, with lots of potential but a frustrating practice of risking it all for distractions.
A Story Update, through January 2020When I bought Tesla, I had no indication that it had hit bottom. In fact, given how strongly momentum and mood had shifted against the stock, I expected to lose money first, before any recovery would kick in, and I certainly did not expect a swift return on my investment. The market, of course, had its own plans for Tesla and the stock鈥檚 performance since the time I bought it is in the graph below:
One of my concerns, as an investor, is that I can sometimes mistake dumb luck for skill, but in this case, I 听am operating under illusions. The timing on this investment was pure luck, but I am not complaining. What happened to cause the turnaround. There were three factors that fed into the upward spiral in the stock price:Return to growth: In the middle of 2019, Tesla鈥檚 growth seemed to have run out of steam and there were some who believed that its best days were behind it. In the two quarters since, Tesla has shown signs of growth, albeit not at the breakneck pace that you saw it grow, earlier in its life.Operating improvements: One of Tesla鈥檚 weaknesses has been an inability to deliver on time and maintain anything resembling an efficient supply chain. In the second half of 2019, Tesla seemed to be paying attention to its weakest link, focusing on producing and delivering cars, without drama, and even running ahead of schedule on new capacity that it was adding in Shanghai.Radio Silence: I know that this will sound petty to Musk fans, but Elon Musk has always been a mixed blessing for the company. While his vision has been central to building the company, he has also made it a practice of creating diversions that take people鈥檚 attention away from the story line. He has also had a history of pre-empting operating decisions with rash missives (pricing the Tesla 3 at $35,000 and producing 5,000 cars/week) that led to operating and credibility problems for the company. Musk has been quieter and more focused of late, and the last six months have been blessedly free of distractions, allowing investors to focus on the Tesla story.In earlier posts, I have drawn a distinction between the value of a stock and its price, noting that traders play the pricing game (trying to gauge momentum and shifts) and investors play the value game, where they invest based upon value, hoping for price convergence. While price and value are driven by different factors, in the case of Tesla, there is a feedback effect from price to value because of (a) its high debt obligations and (b) its need for more capital to fund its growth. As stock prices rise, the debt obligation becomes less onerous for two reasons. First, some of it is convertible debt, at high enough stock prices, it gets converted to equity. Second, Tesla鈥檚 capacity to raise new equity at high stock prices gives it a fall back that it can use, if it chooses to pay down debt. By the same token, the number of shares that Tesla will need to issue to cover its funding needs, as it grows, will decrease as the stock price rises, reducing their dilution effect on value.
Valuing Tesla in January 2020There have been three earnings reports from Tesla since my June 2019 report, and the table below shows how the base year numbers have shifted, as a consequence: & The base revenues have increased by about 9%, and operating margins continued to get less negative (turning positive in the last quarter of the year), as long-promised economies of scale finally manifested themselves. In the table below, I highlight the changes that I have made in key inputs relating to growth, profitability and reinvestment.听Specifically, here is what I changed:Higher end revenues: My revenue growth rate, while only marginally higher than the growth rate I used in June 2019, delivers revenues of just above $125 billion in 2030, about 25% higher than the end revenues that I forecast a year ago. Since this will require that Tesla sell more than 2 million cars in 2030, I am not making this assumption lightly.Higher margins: My target pre-tax operating margin has also been pushed up from 10% to 12%, reflecting the improvements in margins that the company has already delivered and an expectation that the company will continue to work on a more efficient production model than conventional automakers.听More efficient reinvestment: My reinvestment assumptions for the long term resemble those that I made in June, with every dollar in invested capital delivering $2 in revenues, as the company adds capacity. In the near term, though, I assume less reinvestment, assuming $3 in revenues for every new dollar of capital invested, since Tesla contends in its January 2020 earnings call to have capacity online to produce 640,000 cars, enough to cover growth for the next year or two.If you are surprised about the lower cost of capital in January 2020, that drop has little to do with Tesla and more to do with changes in the market. First, the US treasury bond rate has dropped to 1.75% from 2.26% in June 2019, creating a lower base for both the costs of equity and debt for the company. Second, while Tesla鈥檚 bond rating has not improved dramatically, default spreads on bonds have dropped over the course of the year. Finally, the price feedback effect has silenced talk about imminent default, but I understand that a momentum shift and a lower stock price can rekindle it, and I have halved the probability of default. With this more upbeat story, the value that I get per share for Tesla is $427, and the details are shown below:If your criticism of this valuation is that I am letting the good times in the stock feed into my intrinsic value estimate, I am guilty as charged, but I have never been able to completely ignore what markets are doing, when doing intrinsic value. To see how each assumption that I have altered feeds into the value, I broke down the value change into constituent pieces.
The biggest increase in value comes from increasing the margin, accounting for a little bit more than half of the value change, followed by higher revenue growth and then by lower costs of capital. Note that the firm鈥檚 debt load magnifies the effects of changes in the value of operating assets on equity value, and the options that had dropped in value with the stock price in June 2019, are reasserting their role as a drain on value. If there is a lesson that I would take away from this table, it is that the key debate that we should be having on Tesla is not about whether it can grow. Given the size of the auto market, and the shift towards electric cars, the growth is both possible and plausible. It is about the margins that Tesla can command, once it becomes a mature company, which in turn requires an assessment of what the auto market will look like a decade from now. If you believe that an electric car is an automobile first, and electric next, it will be difficult to reach and sustain double-digit operating margins, if you are not a niche auto company. If, in contrast, your view is that the electric car market will be viewed as an electronic or tech product, you may be able to justify higher margins.
What now?In the interests of transparency, I should start with a confession. I went into this valuation wanting to hold on to Tesla for a little while longer, partly because it has done so well for me (and it tough to let winners go, when they are still winning) but mostly because at a 7-month holding period, selling it now will expose me to a fairly hefty tax liability; short-term capital gains (less than a one-year holding period) are taxed at my ordinary tax rate and long term capital gains (greater than a year holding period) are taxed at a 20% lower rate. This desire to derive a higher value for Tesla (to justify continuing to hold it) may be driving the optimism in my assumptions in the last section, but even with those optimistic assumptions, my value per share of $427 was well below the closing price of $581 at the end of trading and even further below the $650 that Tesla was trading at after the earnings release. Could tweaking the assumptions give me a value higher than the price? Of course! I could raise my end year revenues to $200 billion ( plausible in a market this size) and give Tesla an 18% operating margin (perhaps by calling it a tech company) and arrive at a value of $ 1,168 per share, but that to me is pushing the limits of possibility, and one reason why I hold back on simple what-if analyses. A Monte Carlo simulation allows for a more complete assessment of uncertainty and in the table below, I vary four key assumptions (revenue growth, target margin, reinvestment efficiency and cost of capital) to arrive at a value distribution for Tesla:At the price of $650/share, post-earnings report, Tesla is close to the 90th percentile of my value distribution. While it possible that Tesla could be worth more than $650, it is neither plausible nor probable, at least based on my assumptions.
A Post ScriptHolding on to the hope that I could defer my sale of Tesla until June (to qualify for long term capital gains), I looked at buying puts to protect my capital gains, but that pathway is an expensive one at Tesla, given how much volatility is priced into the options. Reluctantly, I 听sold my Tesla holdings at $640 this morning, and as with my buy order in June, I don鈥檛 expect immediate or even near-term gratification. The momentum is strong, and the mood is delirious, implying that Tesla鈥檚 stock price could continue to go up. That said, I am not tempted to stay longer, though, because I came to play the investing game, not the trading game, and gauging momentum is not a skill set that I possess. I will miss the excitement of having Tesla in my portfolio, but I have a feeling that this is more a separation than a permanent parting, and that at the right price, Tesla will return to my portfolio in the future.听
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Published on January 30, 2020 11:31

January 27, 2020

Data Update 2 for 2020: Retrospective on a Disruptive Decade

My data updates usually look at the data for the most recent year and what I learn from them, but 2020 also marks the end of a decade. In this post, I look back at markets over the period, a testing period for many active investors, and particularly so for value investors, who found that even as financial assets posted solid returns, what they thought were tried and true approaches to "beating the market" seemed to lose their power. In addition, trust in mean reversion, i.e., that things would go back to historic norms was shaken as interest rates remained low for much of the period and PE ratios rose above historical averages and continued to rise, rather than fall back.听
1. It was a great year, and a very good decade, for equities, and a very good year for bonds!While investing should always be forward-looking, there is a benefit to pausing and looking backwards. If you had US stocks in your portfolio, 2019 was a very good year. The S&P 500 started the year at 2506.85 and ended the year at 3230.78, an increase of 28.88%, and with dividends added, the return for the year was 31.22%. To get a sense of how this year measures up against other good years, I compared it to the annual returns from 1927 to 2019 in this graph:Over the 92 years that are in this historical assessment, 2019 ranked as the sixteenth best year and second only to 2013 (annual return of 32.15%) in this century. While stocks have garnered the bulk of the attention for having a good year, bonds were not slackers in the returns game. In 2019, the ten-year US treasury bond returned 9.64% and ten-year Baa corporate bonds weighing in with a 15.33% return. That may surprise some, given how low interest rates have been, but the bulk of these returns came from price appreciation, as the US treasury bond rate declined from 2.69% to 1.92%, and the corporate bonds also benefited from a decline in default spreads (the price of risk in the bond market) during the year. The year also capped off a decade of gains for stocks, with the S&P almost tripling from 1115.10 on January 1, 2010 to 3230.78 on January 1, 2020, and with dividends included and reinvested, the cumulated return for the decade is 252.96%. To put these returns in perspective, I have compared this cumulated return to the eight full decades that I have data for in the table below, in conjunction with the cumulated returns for treasury and corporate bonds over each decade:While 2010-19 represented a bounce back for stocks from a dismal 2000-09 time period, with the 2008 crisis ravaging returns, it falls behind three other decades of even higher returns (1950-59, 1980-89 and 1990-1999). It was a middling decade for both treasury and corporate bonds, with cumulated returns running ahead of the three decades spanning 1940 to 1969 but falling behind the other decades, in terms of returns delivered. Treasury bills delivered their worst decade of returns, since the 1940s, with the cumulated return amounting to 5.25%. I don鈥檛 want to overanalyze historical data, but there are interesting nuggets of information in the data:a. Historical Risk Premium: The US historical data has been used by many analysts in corporate finance and valuation as the basis for computing historical risk premiums and in the table below, I compute the risk premiums that investors would have earned in this market, investing in stocks as opposed to treasury bills and bonds, over different time periods, and with different averaging approaches:
If you go with the geometric average premium from 1927-2019 as your predictor for the equity risk premium in 2020, US stocks should earn about 4.83% more than US treasury bonds for the year:Expected return on stocks in 2020 = T.Bond Rate + Historical ERP听= 1.92% + 4.83% = 6.75%Since a portion of this return will come from dividends, the expected price appreciation in stocks is the difference:Expected price appreciation on stocks = Expected Return - Dividend yield听= 6.75%- 1.82% = 4.93%I am not a fan of historical premiums, not only because they represent almost an almost slavish faith in mean reversion but also because they are noisy; the standard errors in the historical premiums are highlighted in red and you can see that even with 92 years of data, the standard error in the risk premium is 2.20% and that with 10 or 20 years of data, the risk premium estimate is drowned out by estimation error.b. Asset Allocation: The fact that stocks have beaten treasury and corporate bonds by wide margins over the entire history is often the sales pitch used to push investors to allocate more of their savings to stocks, with the argument being that stocks always win in the long term. The data should yield cautionary notes:First, in three decades out of the nine in the table, stocks under-performed treasury bonds and treasury bills, and if your response is that ten years is not a long enough time period, you may want to check the actuarial tables.听Second, there is a selection bias in our use of the US markets for computing the historical premium. Looking across the globe, the US was one of the most successful equity markets of the last century and using it may be skewing our results upwards. Put bluntly, if you had invested in the Nikkei at the height of its climb in the 1980s, you would still be struggling to get back the money you lost, when the Japanese markets collapsed.c. Market Timing: It is human nature to try to time markets, and some investors make it the central focus of their investment philosophies. I will not try to litigate the good sense of doing so in this post, but the historical return data gives us a sense of both the upside and the downside of doing so. In terms of pluses, an investor who was able to avoid the doomed decades (when stocks earned less than T.Bills and T.Bonds) would be comfortably ahead of an investor who did not, if he or she stayed fully invested in the remaining decades. In terms of minuses, if the market timing investor failed to stay invested in stocks in the good decades, the opportunity costs would quickly overwhelm the benefits. Between 2010 and 2019, there were many investors who believed that a correction was around the corner, driven by their perception that interest rates were being kept artificially low by central banks and that they would revert to historic norms quickly. When that reversion did not occur, these investors paid a hefty price in returns foregone. All of the historical returns that I have reported in this section are nominal, and to the extent that you are interested in real returns, you may want to and check out the results. (Hint: Not much changes)
2. A Low Interest Rate DecadeIf there was a defining characteristic for the decade, it was that interest rates, both in the US and globally, dropped to levels not seen in decades. You can see this in the path of the US 10-year treasury bond rate in the graph below:Since the drop in rates occurred after the 2008 crisis, and in the aftermath of concerted actions by central banks to bolster weak economies, it has become conventional wisdom that it is central banks that have kept rates artificially low, and that the ending of quantitative easing would cause rates to revert back to historical averages. As many of you who have been reading my posts know, I don't believe that central banks have the power to keep long term market-set rates low, if the fundamentals don't support low rates. In fact, one of my favorite graphs is one where I compare the 10-year treasury bond rate each year to the sum of the inflation rate and real GDP growth rate that year (intrinsic riskfree rate):As you can see, the main reason why rates have dropped in the US and Europe has been fundamental. As inflation has declined (and become deflation in some parts of the world) and real GDP growth has been anemic, intrinsic and actual risk free rates have dropped. To the extent that the difference between the two is a measure of central banking actions, it is true that the Fed鈥檚 actions kept actual rates lower than intrinsic rates more in the last decade than in prior years, but it is also true that even in the absence of central banking intervention, rates would not have reverted back to historical norms.听
3. It was a tech decade, and FAANG stocks stole the show!While it was a good decade for stocks, 听the gains varied across sectors. Using the S&P 500 again as the indicator, you can see the shift in value over the decade by looking at how the different sectors evolved over the decade, as a percent of the S&P 500:The most striking shift is in the energy sector, which dropped from 11.51% of the index to 4.60%, in market capitalization terms. Some of this drop is clearly due to the decline in oil prices during the decade, but some of it can be attributed to a general loss of faith in the future of fossil fuel and conventional energy companies. The biggest sector through the entire decade was technology but its increase in percentage terms seems modest at first sight, rising from 19.76% in 2009 to 21.97% in 2019, but that is because two of the biggest names in the sector, Google and Facebook, were moved to the communication services sector; if they had been left in technology, its share of the index would have risen to more than 30%. In fact, five companies (Facebook, Alphabet, Apple, Netflix and Google), representing the FAANG stocks, had a very good decade, with their collective market capitalization increasing by $3.4 trillion over the ten years:
Put in perspective, the FAANG stocks accounted for 22% of the increase in market capitalization of the S&P 500, and any portfolio that did not include any of these stocks for the entire decade would have had a tough time keeping up with the market, let alone beating it. (This is an approximation, since not all five FAANG stocks were part of the S&P 500 for the entire decade, with Facebook entering after its IPO in 2012 and Netflix being added to the index in 2014).
4. Mean Reversion or Structural ShiftOne of the perils of being in a market like the US, where rich historical data is available and easily accessible is that analysts and academics have pored over the data and not surprisingly found patterns that have very quickly become part of investment lore. Thus, we have been told that value beats growth, at least over long periods, and that small cap stocks earn a premium, and have converted these findings into investing strategies and valuation practices. While it is dangerous to use a decade鈥檚 results to abandon a long history, the last decade offered sobering counters to old investing nostrums.
a. Value versus GrowthThe basis for the belief that value beats growth is both intuitive and empirical. The intuitive argument is that value stocks are priced cheaper and hence need to do less to beat expectations and the empirical argument is that stocks that are classified as value stocks, defined as low price to book and low price to book stocks, have historically done better than growth stocks, defined as those trading at high price to book and high price earnings ratios. Looking at the annual returns on the lowest and highest PBV stocks in the United States, going back to 1927:The lowest price to book stocks have historically earned 5.22% more than the highest price to book stocks, if you look at 1927-2019. Broken down by decades, though, you can see that the assumption that value beats growth is not as easily justified:While there are some, especially in the old-time value crowd, that view the last decade as an aberration, the slide in the value premium has been occurring over a much longer period, suggesting that there are fundamental factors at play that are eating away at the premium. If you are a believer in value, as I am, there is a consolation prize here. Assuming that low PE stocks and low PBV stocks are good value is the laziest form of value investing, and it is perhaps not surprising that in a world where ETFs and index funds can be created to take advantage of these screens, there is no payoff to lazy value investing. I believe that good value investing requires creativity and out-of-the-box thinking, as well as a willingness to live with uncertainty, and even then, the payoff听
b. The Elusive Small Cap PremiumAnother accepted part of empirical wisdom about stocks not only in the US, but also globally, is that small cap stocks deliver higher returns, after adjusting for risk using conventional risk and return models, than large cap stocks.听Looking at the data from 1927 to 2019, it looks conclusively like small market cap stocks have earned substantially higher returns than larger cap stocks; relative to the overall market, small cap stocks have delivered about 4-4.5% higher returns, and conventional adjustments for risk don't dent this number significantly. Not only has this led some to put their faith in small cap investing but it has also led analysts to add a small cap premium to costs of equity, when valuing small companies. I have not only never used a small cap premium, when valuing companies, but I am skeptical about its existence, and wrote a post on why a few years ago. Again, updating the data by decades, here is what I see:As with the value premium, the size premium had a rough decade between 2010 and 2019, dropping close to zero, on a value weighted basis, and turning significantly negative, when returns are computed on a equally weighted basis. Again, the trend is longer term, as there has been little or no evidence of a small cap premium since 1980, in contrast to the dramatic premiums in prior decades. If you are investing in small cap stocks, expecting a premium, you will be disappointed, and if you are still adding small cap premiums to your discount rates, when valuing companies, you are about four decades behind the times.
5. New buzzwords were bornEvery decade has its buzzwords, words that not only become the focus for companies but are also money makers for consultants, and the last decade was no exception. At the risk of being accused of missing a few, there were two that stood out to me. The first was big data, driven partly by more extensive collection of information, especially online, and partly by tools that allowed this data to be accessed and analyzed. The other was crowd wisdom, where expert opinions were replaced by crowd judgments on a wide range of applications, from restaurant reviews to new (crypto) currencies.

a. Big DataEarlier in this post, I looked at the surge in value of the FAANG stocks, and how they contributed to shaping the market over the last decade. One common element that all five companies shared was that they were not only reaching tens of millions of users, but that they were also collecting information on these users, and then using that information to improve existing products/services and add new ones. Other companies, seeking to emulate their success, tried their hand at 鈥渂ig data鈥�, and it became a calling card for start-ups and young firms during the decade. While I agree that Netflix and Amazon, in particular, have turned big data into a weapon against competition, and Facebook鈥檚 entire advertising business is built on using personal data to focus advertising, I personally believe that like all buzz words, big data has been over sold. In particular, I noted, in a post from 2018 ,that for big data to create value,The data has to be exclusive: For data to be valuable, there has to be some exclusivity. Put simply, if everyone has it, no one has an advantage. Thus, the fact that you, as a business, can trace my location has little value when two dozen other applications and services on my iPhone are doing exactly the same thing.听The data has to be actionable: For value conversion to occur, the data that has been collected has to be usable in modifying and adapting the products and services you offer as a business.听Using these two-part test, you can see why Amazon and Netflix are standouts when it comes to big data, since the data they collect is exclusive (Netflix on your viewing habits/tastes and Amazon on your retail behavior) and is then used to tailor their offerings (Netflix with its original content investments and offerings and Amazon with its product nudging). Using the same two-part test, you can also see why the claims of big data payoffs at MoviePass and Bird Scooters makers never made sense.

b. Crowd WisdomOne consequence of the 2008 crisis was a loss in faith in both institutional authorities (central banks, governments, regulators) but also in experts, most of whom had been hopelessly wrong in the lead up to the crisis. It is therefore not surprising that you saw a move towards trusting crowds on answers to big questions right after the crisis. It is no coincidence that Satoshi Nakamoto (whoever he might be) posted the paper laying out the architecture of Bitcoin in November 2008, a proposal for a digital currency without a central bank or regulatory overlay, where transactions would be crowd-checked (by miners). While Bitcoin has been more successful as a speculative game than as a currency during the last decade, the block chains that it introduced have now found their way into a much wider range of businesses, threatening to replace institutional oversight (from banks, stock exchanges and other established entities) with cheaper alternatives. The crowd concept has expanded into almost every aspect of our lives, with Yelp ratings replacing restaurant reviewers in our choices of where to eat, Rotten Tomatoes supplanting movie critics in deciding what to watch and betting markets replacing polls in predicting election outcomes. I share the distrust of experts that many others have, but I also wary of crowd wisdom. After all, financial markets have been laboratories for observing how crowds behave for centuries, and we have found that while crowds are often much better at gauging the right answers than market gurus and experts, they are also prone to herding and collective bad choices. For those who have become too trusting of crowds, my recommendation is that they read 鈥淭he Madness of Crowds鈥�, an old manuscript that is still timely.
The decade to comeIt has been said that those who forget the past are destined to relive it, and that is one reason why we pore over historical track records, hoping to get insight for the future. But it has also been said that army generals who prepare too intensely to fight the last war will lose the next one, suggesting that reading too much into history can be dangerous. To me the biggest lesson of the last decade is to keep an open mind and to not take conventional wisdom as a given. I don鈥檛 know what the next decade will bring us, but I can guarantee you that it will not look like the last one or any of the prior ones, So, strap on your seat belts and get ready! It鈥檚 going to be a wild ride!

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January 13, 2020

Data Update 1 for 2020: Setting the table

Starting in the early 1990s, I have spent the first week or two of every new year playing my version of Moneyball, downloading raw market and accounting data on publicly traded companies and using that data to compute operating, pricing and risk metrics for them. This year, I got a later start than usual on January 6, but as the week draws to a close, the results of my data exploration are posted on my 听and will be the basis for a series of posts here over the next six weeks. As you look at the data, you will find that the choices I have made on how to classify companies and compute metrics affect my findings, and I will use this post to cast some light on those choices.
The DataRaw Data: We live in an age when accessing raw data is easy, albeit not always cheap, and the tools to analyze that data are also widely available. My raw data is drawn from a variety of sources, ranging from S&P Capital IQ to Bloomberg to the Federal Reserve, and there are two rules that I try to follow. The first is to be careful about attributing sources for the raw data, and the second is to not undercut my raw data providers by replicating their data on my site, if they have commercial interests.听Data Analysis: Broadly speaking, I would categorize my data updates into three groups. The first is macro data, where my ambitions tend to be modest, and the only numbers that I update are numbers that I need and use in my valuation and corporate financial analysis. The second is business data, where I consolidate the company-level data into industry groupings, and report statistics on how companies invest, finance their operations and return cash (dividends and buybacks). The third are my data archives, where you can look at trend lines in the statistics by accessing my statistics from prior years.听
A. Macro DataI am not a market timer or a macro economist, and my interests in macro data are therefore limited to numbers that I cannot easily look up, or access, on a public database. Thus, there is no point in my reporting exchange rates between major currencies, when you have , the Federal Reserve site , that I cannot praise more highly for its reach and its accessibility. I do report and update the following:Risk free rates in currencies: The way in which currencies are dealt with in valuation and corporate finance leaves us exposed to multiple problems, and I about both why risk free rates vary across currencies and why government bond rates are not always risk free. At the start of every year, I update my currency risk free rates, starting with the government bond rates, and then netting out default spreads and . As risk free rates in developed market currencies hit new lows, and central banks are blamed for the phenomenon, I also update an intrinsic measure of the US dollar risk free rate, obtained by adding the inflation rate to real GDP growth each year, and report the time series in.Equity Risk Premiums: The equity risk premium is the price of risk in equity markets and plays a key role in both corporate finance and valuation. The conventional approach to estimating this risk premium is to look at history, and to compare the returns that you would have earned investing in stocks, as opposed to investing in risk free investments. I update the historical risk premium for US stocks, by bringing in 2019 returns on stocks, treasury bonds and treasury bills ; my updated geometric average premium for stocks over US treasuries. I don't like the approach, both because it is backward looking and because the risk premium estimates are noisy, and . I estimate the i and report the in this dataset.听Corporate Default Spreads: Just as equity risk premiums measure the price of risk in equity markets, default spreads measure the price of risk in the debt markets. I break down bonds into bond rating classes (S&P and Moody's) and report my estimates of default spreads at the start of 2020 in 听(and it includes a way of estimating a bond rating for a firm that does not have one).Corporate Tax Rates: Ultimately, companies and investors count on after-tax income, though companies are adept at听keeping taxes paid low. While I will report the that companies actually pay in my corporate data, I am grateful to KPMG for听going through tax codes in different countries and compiling corporate tax rates, which I reproduce .Country Risk Premiums: As听companies expand their operations beyond domestic markets, we are faced with the challenge of bringing in the risk of foreign markets into our听corporate financial analyses and valuation. I have spent much of the last 25 years trying to come up with better ways of estimating risk premiums for countries, and I describe the process I use in At the start of 2020, I use my approach, flaws and all, to estimate equity risk premiums for 170 countries and report them .With macro data, it is generally good practice in both corporate finance and valuation to bring in the numbers as they are today, rather than have a strong directional view. So, uncomfortable though it may make you, you should be using today's risk free rates and risk premiums, rather than normalized values, when valuing companies or making investment assessments.
B. Micro Data
The sample: All data analysis is biased and the bias starts with the sampling approach used to arrive at the data set. My data sample includes all publicly traded companies, listed anywhere in the world, and the only criteria that I impose is that they have a market capitalization number available as of December 31, 2019. The resulting sample of 44,394 firms includes firms from 150 countries, some of which have very illiquid markets and questionable disclosure practices. Rather than remove these firms from my sample, which creates its own biases, I will keep them in my sample and deal with the consequences when I compute my statistics.
While this is a comprehensive sample, it is still biased because it includes just publicly listed companies. There are tens of thousands of private businesses that are part of the competitive landscape that are not included here, and the reason is pragmatic: most of these companies are not required to make public disclosures and there are few reliable databases that include data on these firms.听The Industry Groupings: While I do have a (very large) spreadsheet that has the data at the company level, I am afraid that my raw data providers do not allow me to share that data, even though it is entirely comprised of numbers that I estimate. I consolidate that data into 94 industry groupings, which are loosely based on the industry groupings I created from Value Line in the 1990s when I first started creating my datasets. To see my industry grouping and what companies fall into each one, If you are interested, you will find more in-depth descriptions of how I compute the statistics that I report both in the themselves as well as in .
The timing: I use a mix of market and accounting data and that creates a timing problem, since the accounting data is updated at the end of each quarter and the market data is updated continuously. Using the logic that I should be accessing the most updated data for every item, my January 1, 2020, updated has market data (for share prices, interest rates etc) as of December 31, 2019 and the accounting data as of the most recent financial statement (usually September 30, 2019 for most companies). I don't view this an inconsistent but a reflection of the reality that investors face.
C. Archived DataWhen I first started compiling my datasets, I did not expect them to be widely used, and certainly did not believe that they would be referenced over time. As I starting getting requests for datasets from earlier years, I decided that it would save both me and you a great deal of time to create . As you look at these archives, you will notice that not all datasets go back in time to the 1990s, reflecting first the expansion of my analysis from just US companies to global companies about 15 years ago and second the adding on of variables that I either did not or could not report in earlier years.
The Rationale
If you are wondering why I collect and analyze the data, let me make a confession, at the risk of sounding like a geek. I enjoy working with the data and more importantly, the data analysis is a gift that keeps on giving for the rest of the year, as I value companies and do corporate financial analysis.
It gives me perspective: In a world where we suffer from data overload, the week that I spend looking at the numbers gives me perspective not only on what comprises normal in corporate financial behavior, but also on the differences across sectors and geographies.听Possible, Plausible and Probable: I have long argued that the valuation of a company always starts with a story but that a critical part of the process of converting narrative to value is checking the story for possibility, plausibility and probability. Having the global data aggregated and analyzed can help significantly in making this assessment, since you can see the cross section of revenues and profit margins of companies in the business and see if your assessments are out of line, and if so, whether you have a justification.听Rules of thumb: In spite of all of the data that we now have available, investors and companies seem to still rely on rules of thumb devised in a different time and market. Thus, we are told that companies that trade at less than book value, or six times EBITDA, are cheap, and that the target or right debt ratio for a manufacturing company is 40%. Using the global data, we can back up or dispel these rules of thumb and perhaps replace them with more dynamic and meaningful decision rules.Fact-based opinions: Many market prognosticators and economists seem to have no qualms about making up stuff about investor and corporate behavior and stating them as facts. Thus, it has become conventional wisdom that US companies are paying less in taxes that companies operating elsewhere in the globe, and that they have borrowed immense amounts of cash over the last decade to buy back stock. Those "facts" are now driving political debate and may well lead to change in policy, but these are more opinions than facts, and the data can be arbiter.If you are wondering why I am sharing the data, let's get real. Nothing that I am doing is unique, and I have no secret data stashes. In short, anyone with access to data (and there are literally tens of thousands who do) can do the same analysis. I lose nothing by sharing, and I get immense karmic payoffs. So, please use whatever data you want, and in whatever context, and I hope that it saves you time and helps you in your decision making and analysis.听
The CaveatsThe last decade has seen big data and crowd wisdom sold as the answers to all of our problems, and as I listen to the sales pitches for both, I would offer a few cautionary notes, born out of spending much of my life time working with data:Data is not objective: The notion that using data makes you objective is nonsense. In fact, the most egregious biases are data-backed, as people with agendas pick and choose the data that confirms their priors. Just as an example, take a look at the data that I have in what US companies paid in taxes in 2019 in . I have reported a variety of tax rates, not with the intent to confuse, but to note how the numbers change, depending on how you compute them. 听If you believe, like some do, that US companies are shirking their tax obligations, you can point to average tax rate of 7.32% that I report for all US companies, and note that this is well below the federal corporate tax rate of 21%. However, someone on the other side of this debate can point to the 19.01% average tax rate across only money making companies (since only profits get taxed) as evidence that companies are paying their taxes.听Crowds are not always wise: One of the strongest forces in corporate finance is me-tooism, where companies decide how to invest, how much to borrow and what to pay in dividends by looking at what their peers do. In my datasets, I offer them guidance in this process, by reporting debt ratios and dividend payout ratios for sectors, as well as regional breakdowns. The implicit assumption is that what other companies do, on average, must be sensible, but that assumption is not always true. This warning is particularly relevant when you look at the pricing metrics (PE, EV to EBITDA etc.) that I report, by sector and by region. The market may be right, on average, but it can also over price or under price a sector, at times.I respect data, but I don't revere it. I don't believe that just having data will give me an advantage over other investors or make me a better investor, but harnessing that data with intuition and logic may give me a leg up (or at least I hope it does).

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Published on January 13, 2020 05:32

December 29, 2019

The Market is Huge! Revisiting the Big Market Delusion

For the high-profile IPOs that have reached the market in 2019, with apologies to Charles Dickens for stealing and mangling his words, it has been the best and the worst of years. On the one hand, you have seen companies like Uber and Slack, each less than a decade old, trading at market capitalizations in the tens of billions of dollars, while working on unformed business models and reporting losses. On the other, many of these new listings have not only had disappointing openings, but have seen their market prices drop in the months after. In September 2019, we did see an implosion in the value of WeWork, another company that started the listing process with lots of promise and a pricing to match, but melted down from a combination of self-inflicted wounds and public market scrutiny. While these companies were very different in their business models (or lack of them), they shared one thing in common. When asked to justify their high pricing, they all pointed to how big the potential markets for their products/services were, captured in their assessments of market size. Uber estimated its total accessible market (TAM) to be in excess of $ 6 trillion, Slack鈥檚 judgment was that it had 5 million plus prospective clients across the world and WeWork鈥檚 argument was that the commercial real estate market was massive. In short, they were telling big market stories, just as PC makers were in the 1980s, dot com firms in the 1990s and social media companies a decade later. In this post, we will start by conceding the allure of big markets, but argue that the allure can lead to delusional pricing. (This post is a not-so short summary of a paper that Brad Cornell and I have written on this topic. You can .)
The IngredientsThere is nothing more exciting for a nascent business than the perceived presence of a big market for its products and services, and the attraction is easy to understand. In the minds of entrepreneurs in these markets, big markets offer the promise of easily scalable revenues, which if coupled with profitability, can translate into large profits and high valuations. While this expectation is not unreasonable, overconfidence on the part of business founders and their capital providers can lead to unrealistic judgments of future profits, and overly high estimates for what they think their companies are worth, in what I will term the 鈥渂ig market delusion鈥�. That initial overpricing is a common feature of these markets, but results in an inevitable correction that brings the pricing back to earth. In fact, there are three pieces to this puzzle, and it is when they all come together that you see the most egregious manifestations of the delusion.Big Market: It is the promise of a big market that starts the process rolling, whether it be eCommerce in the 1990s, online advertising between 2010 and 2015, cannabis in 2018 or artificial intelligence today. In each case, the logic of impending change was impeccable, but the extrapolation that the change would lead create huge and profitable markets was made casually. That extrapolation was then used to justify high pricing for every company in the space, with little effort put into separating winners from losers and good from bad business models.听Overconfidence: Daniel Kahneman, whose pioneering work with Amos Tversky, gave rise to behavioral finance as a disciple described overconfidence as the mother of all behavioral biases, for three reasons. First, it is ubiquitous, since it seems to be present in an overwhelming proportion of human beings. Second, overconfidence gives teeth to, and augments, all other biases, such as anchoring and framing. Finally, there is reason believe that overconfidence is rooted in evolutionary biology and thus cannot be easily countered. The problem gets worse with big markets, because of a selection bias, since these markets attract entrepreneurs and venture capitalists, who tend to be among the most over confident amongst us. Big markets attract entrepreneurs, over confident that their offerings will be winners in these markets, and venture capitalists, over confident in their capacity to pick the winners.听Pricing Game: We will not bore you with another extended discourse on the difference between value and price, but suffice to say that young companies tend to be priced, not valued, and often on raw metrics (users, subscribers, revenues). As a consequence, there is no attempt made to flesh out the "huge market" argument, effectively removing any possibility that entrepreneurs or the venture capitalists funding them will be confronted with the implausibility of their assumptions.The end result is that young companies in big markets will operate in bubbles of overconfidence, leading them to over estimate their chances of succeeding, the revenues they will generate if they do and how much profit they can generate on these revenues:
This does not mean that every company in the big market space will be over priced, since a few will succeed and exploit the big market to full effect, but it does mean that the companies will be collectively over priced. As is always the case with markets, there will be a time of reckoning, where investors and managers will wake up to the reality that the big market is not big enough to accommodate all their growth dreams and there will be a correction. In the aftermath, there will be finger-wagging and talk of "never again", but the process will be repeated, albeit in a different form, with the next big market.
Case StudiesWe will not claim originality here, since the big market delusion has always been part of market landscapes, and big markets have always attracted overconfident start ups and investors, creating cycles of bubble and bust. In this section, we will highlight three high profile examples:

1. Internet Retail in 1999 The Big Market: As the internet developed and became accessible to the public in the 1990s, the promise of eCommerce attracted a wave of innovators, from Amazon in online retail in 1994 to Ebay in auctions in 1995, and that innovation was aided by the arrival of Netscape Navigator's browser, opening up the internet to retail consumers and PayPal, facilitating online payments.听New businesses were started to take advantage of this growing market with the entrepreneurs using the promise of big market potential to raise money from venture capitalists, who then attached sky-high prices to these companies. By the end of 1999, not only was venture capital flowing in record amounts to young ventures, but 39% of all venture capital was going into internet companies.The Pricing Delusion: The enthusiasm that entrepreneurs and venture capitalists were bringing to online retail companies seeped into public markets, and as public market interest climbed, many young companies found that they could bypass the traditional venture capital route to success and jump directly to public listings. Many of the online retail companies that were listed on public markets in the late 1990s had the characteristics of nascent businesses, with small revenues, unformed business models and large losses, but all of these shortcomings were overwhelmed by the perception of the size of the eCommerce market. In 1999 alone, there were 295 initial public offerings of internet stocks, representing more than 60% of all initial public offerings that year. One measure of the success of these dot.com stocks is that data services created indices to track them. The Bloomberg Internet index was initiated on December 31, 1998, with a hundred young internet companies in it, and it rose 250% in the following year, reaching a peak market capitalization of $2.9 trillion in early 2000. Because the collective revenues of these companies were a fraction of that value, and most of them were losing money, the only way you could justify these market capitalizations was with a combination of very high anticipated revenue growth accompanied by healthy profit margins in steady state, premised on successful entry into a big market.听The Correction:听The rise of internet stocks was dizzying, in terms of the speed of ascent, but its descent was even more precipitous. The date the bubble burst can be debated, but the NASDAQ, dominated in 2000 by young internet companies, peaked on March 10, 2000, and in the months after, the pricing unraveled as shown in the collapse of the Bloomberg Internet Index:The Bloomberg Internet IndexOf the dozens of publicly traded retail companies in existence in March 2000, more than two-thirds failed, as they ran out of cash (and capital access) and their business models imploded. Even those that survived, like Amazon, faced carnage, losing 90% of their value, and flirting with the possibility of shutting down.听
2. Online Advertising in 2015 & 2019 The Big Market: The same internet that gave birth to the dot com boom in the nineties also opened the door to digital advertising and while it was slow to find its footing, the arrival of search engines like Yahoo! and Google fueled its growth. 听The advent of social media altered the game even more, as businesses realized that not only were they more likely to reach customers on social media sites, but that social media companies also brought in data about their users that would allow for more focused and effective advertising. The net result of all these innovations was that digital advertising grew in the decade from 2005 to 2015, both in absolute numbers and as a percent of total advertising:

As digital advertising grew, firms that sought a piece of this space also entered the market and were generally rewarded with infusions of capital from both private and public market investors.The Pricing Delusion: In a ,听I looked at how the size of the online advertising market skewed the companies of companies in this market, by looking at publicly traded companies in the space and backing out from the market capitalizations what revenues would have to be in 2025, for investors to break even. To do this, I made assumptions about the rest of the variables required to conduct a DCF valuation (the cost of capital, target operating margin and sales to capital ratio) and held them fixed, while Ie varied the revenue growth rate until I arrived at the current market capitalization. With Facebook in August 2015, for instance, here is what I estimated:
Put simply, for Facebook's market capitalization in 2015 to be justified, its revenues would have to rise to $129,318 million in 2025, with 93% of those revenues coming form online advertising. Repeating this process for all publicly traded online ad companies in August 2015:Imputed Revenues in 2025 in millions of US $The total future revenues for all the companies on the list totals $523 billion. Note that this list is not comprehensive, because it excludes some smaller companies that also generate revenues from online advertising and the not-inconsiderable secondary revenues from online advertising, generated by firms in other businesses (such as Apple). It also does not include the online adverting revenues being impounded into the valuations of private businesses like Snapchat, that were waiting in the wings in 2015. Consequently, we are understating the imputed online advertising revenue that was being priced into the market at that time. In 2014, the total advertising market globally was about $545 billion, with $138 billion from digital (online) advertising. Even with optimistic assumptions about the growth in total advertising and the online advertising portion of it climbing to 50% of revenues, the total online advertising market in 2025 comes to $466 billion. The imputed revenues from the publicly traded companies in August 2015 alone exceeds that number, implying that the companies in were being overpriced relative to the market (online advertising) from which their revenues were derived.The Correction?听The online ad market has not had a precipitous fall from the heights of 2015, but it has matured. By 2019, not only had investors learned more about the publicly traded companies in the online advertising business, but online advertising matured. Using the same process that we used in 2015, we imputed revenues for 2029 using data up through November 2019. Those calculations are presented in the table below:
Imputed Revenues in 2029 in millions of US $There are signs that the market has moderated since 2015. First, the number of companies shrank, as some were acquired, some failed, and a few consolidated. Second, the market capitalizations had been recalibrated and starting revenues in 2019 are much greater than they were in 2015. As a result, the breakeven revenue in 2029 is $573 billion, only slightly higher than the imputed revenues from the 2015 calculation, despite being four years further into the future. This suggests that the market is starting to take account of the limits imposed by the size of the underlying market. Third, more of the companies on the list have had moments of reckoning with the market, where they have been asked to show pathways to profitability and not just growth numbers. Two examples are Snap and Twitter. For both companies the market capitalizations have languished because of the perception that their pathways to profitability are rocky. In short, if there is a correction occurring in this market, it seems to be happening in slow motion.
3. Cannabis in October 2018 The Big Market:听Until recently, cannabis, in any of its forms, was illegal in every state in the United States in most of the world, but that is changing rapidly. By October 2018, smoking marijuana recreationally and medical marijuana were both legal in nine states, and medical marijuana alone in another 20 states. Outside the United States, much of Europe has always taken a more sanguine view of cannabis, and on October 17, 2018, Canada became the second country (after Uruguay) to legalize the recreational use of the product. In conjunction with this development, new companies were entering the market, hoping to take advantage of what they saw as a 鈥渂ig鈥� market, and excited investors were rewarding them with large market capitalizations. 听The widespread view as of October 2018 was that the cannabis market would be a big one, in terms of users and revenues. There were concerns that many recreational cannabis users would continue to use the cheaper, illegal version over the regulated but more expensive one, and that US federal law would be slow to change its view on legality.听In spite of these caveats, there remained optimism about growth in this market, with the more conservative forecasters predicting that global revenues from marijuana sales will increase to $70 billion in 2024, triple the estimated sales in 2018, and the more daring ones predicting close to $150 billion in sales.The Pricing Delusion:听In October 2018, the cannabis market was young and evolving, with Canadian legalization drawing more firms into the business. While many of these firms were small, with little revenue and big operating losses, and most were privately owned, a few of these companies had public listings, primarily on the Canadian market. The table below lists the top ten cannabis companies as of October 14, 2018, with the market capitalizations of each one, in conjunction with each company鈥檚 operating numbers (revenues and operating income/losses, in millions of US $).Cannabis Stocks on Oct 14, 2018 ($ values in millions of US$)Note that the most valuable company on the list was Tilray with a market cap of over $13 billion. Tilray had gone public a few months prior, with revenues that barely register ($28 million) and nearly equal operating losses, but had made the news right after its IPO, with its stock price increasing ten-fold in the following weeks, before subsequently losing almost half of its value in the following weeks. Canopy Growth, the largest and most established company on the list, had the highest revenues at $68 million. More generally, all of them trade at astronomical multiples of book value, with a collective market cap in excess of $48 billion, more than 20 times collective revenues and 10 times book value. For each company, the high market capitalization relative to any measure of fundamental value was justified using the same rationale, namely that the cannabis market was big, allowing for huge potential growth.听The Correction: In the听of the cannabis market, the overreach on the part of both businesses and their investors caught up with them. By October 2019, the assumptions regarding growth and profitability were being universally scaled back, business models were being questioned, and investors were reassessing the pricing of these companies. The best way to see the adjustment is to look the performance of the major cannabis exchange-traded fund, ETFMG, over the period depicted in the figure below:Note that within a period of approximately one year, cannabis stocks lost more than 50% of their aggregate value. The damage cut across the board. Tilray and Canopy Growth, the two largest market capitalization companies in the October 2019 saw their market capitalizations decline by 80.7% and 38.6% respectively. Given that there was no significant shift in fundamentals, the apparent explanation is that investors came to realize that the 鈥渂ig market鈥� was not going to deliver the previously expected growth rates or the profitability for the expanding group of individual companies.
Common ElementsThe three examples that we listed are in very different businesses and have different market settings. That said, there are some common elements that you see in all three, and will in any big market setting:Big Market stories: In every big market delusion, there is one shared feature. When asked to justify the pricing of a company in the market, especially young companies with little to show in terms of fundamentals, entrepreneurs, managers and investors almost always point to macro potential, i.e., that the retail or advertising or cannabis markets were huge. The interesting aspect is that they rarely express the need to go beyond that justification, by explaining why the specific company they were recommending was positioned to take advantage of that growth. In recent years, the big markets have gone from just words to numbers, as young companies point to big total accessible markets (TAM), when seeking higher pricing, often adopting nonsensical notions of what accessible means to get to large numbers.听Blindness to competition: When the big market delusion is in force, entrepreneurs, managers and investors generally downplay existing competition, thus failing to factor in the reality that growth will have to be shared with both existing and potential new entrants. With cannabis stocks in late 2018, much of the pricing optimism was driven by the size of the potential market in the United States, assuming legalization, but very few entrepreneurs, managers and investors seemed to consider the likelihood that legalization would attract new players into the market and that illegal sources of supply would maintain their hold on the market.All about growth: When enthusiasm about growth is at its peak, companies focus on growth, often putting business models to the side or even ignoring them completely. That was true in all three of our case studies. With internet stocks, companies typically based their entire pricing pitch on how quickly they were growing. With social media companies, it took an even rawer form, with growth in users and subscribers being the calling cards for higher pricing. Investors, both private and public, not only went along with the pitch but at the expense of profits.Disconnect from fundamentals: If you combine a focus on growth as the basis for pricing with an absence of concern at these companies about business models, you get pricing that is disconnected from the fundamentals. In all three case studies presented in this paper, at the peak of the pricing run up, most of the stocks in each group had negative earnings (making earnings multiples not meaningful), little to show in assets (making book value multiples difficult to work with) and traded at huge multiples of revenues. Put simply, the pricing losing its moorings in value, but investors who look at only multiples miss the disconnect.The one area where the three case studies diverge is in how the pricing delusion corrects itself. There are also differences in how these markets correct. For instance, the dot com bubble to hit a wall in March 2000 and burst in a few months, as public markets corrected first, followed by private markets, but the question of why it happened at the time that it did remains a mystery. The online advertising run-up has moderated much more gradually over a few years, and if that trend continues, the correction in this market may be smooth enough that investors will not call it a correction. With cannabis stocks, the rise and fall were both precipitous, with the stocks tripling over a few months and losing that rise in the next few months.
Implications
If the big market delusion is a feature of big markets, destined to repeat over time, it behooves us as entrepreneurs, managers, investors and regulators to recognize that reality and modify our behavior.
1. Entrepreneurs and Venture Capitalists
The obvious advice that can be offered to entrepreneurs and venture capitalists, to counter the big market delusion, is to be less over confident, but given that it is not only part of their make up but the driver for exploiting the big market, it will have little effect. Our suggestions are more modest. First, testing out the plausibility of your market size assumptions and the viability of the business model you plan to use to exploit the market on people, whose opinion you value but don't operate in your bubble, is a sensible first step. Second, when you get results from your initial business forays that run counter to what you expected to see, don't be quick to rationalize them away as aberrations. By keeping the feedback loop open, you may be able to improve your business model and adjust your expectations sooner, to reflect reality. Third, build in safety buffers into your model, allowing you to keep operating even if capital dries up (as it inevitably will when the correction arrives), by accumulating cash and avoiding cost commitments that lock you in, like debt and long term cost contracts. Finally, while you may be intent on delivering the metrics that are priced highly, such as users or subscribers, pay attention to building a business model that will work at delivering profits, and if forced to pick between the two objectives, pick the latter.

2.Public Market Investors
The big market delusion almost never stays confined to private markets and sooner or later, the companies in the space list on public markets and are often priced in these markets, at least initially, like they were in private markets. While a risk averse investor may feel it prudent to entirely avoid these stocks, there are opportunities that can be exploited:Momentum investors/traders: The big market delusion is one explanation for the momentum of young, growth stocks. When fascination with a big market like 鈥渢ransportation鈥� takes hold, it can produce momentum in the prices of innovative companies in that space such as Uber and Lyft, and significant profits along the way. The risk, of course, is that the big market delusion fades and the market corrects as has happened in the case of both Uber and Lyft. As we have emphasized, however, there appears to be no way to time such corrections.听Value investors: 听The 听obvious advice is to avoid young, growth stocks whose value is based on big market stories. But that carries its own risk. In the twelve year stretch beginning in 2007, growth stocks have dramatically outperformed value stocks. As one example, during this period the Russell 1000 growth index outperformed the Russell 1000 value index by an astonishing 4.3% per year. That outperformance was driven in part by stories regarding how technology companies were going to disrupt or invent big markets from housing to entertainment to automobiles. There is a riskier, higher payoff, strategy. Since the big market delusion leads to a collective over pricing, value investors can bet against a basket of stocks (sell short on an ETF like the ETFMG) and hope that the correction occurs soon enough to reap rewards.In sum, though, young companies make markets interesting and by making them interesting, they increase liquidity and trading.听3. Governments and Market Regulators听In the aftermath of every correction, there are many who look back at the bubble as an example of irrational exuberance. A few have gone further and argued that such episodes are bad for markets, and suggested fixes, some disclosure-related and some putting restrictions on investors and companies. In fact, in the aftermath of every bursting bubble, you hear talk of how more disclosure and regulations will prevent the next bubble. After three centuries of futility, where the regulations passed in response to one bubble often are at the heart of the next one, you would think that we would learn, but we don't. In fact, over confidence will overwhelm almost every regulatory and disclosure barrier that you can throw up. We also believe that these critics are missing the point. Not only are bubbles part and parcel of markets, they are not necessarily a negative. The dot com bubble changed the way we live, altering not only how we shop but how we travel, plan and communicate with each other. What is more, some of the best performing companies of the last two decades emerged from the debris. Amazon.com, a poster child for dot com excess, survived the collapse and has become a company with a trillion-dollar market capitalization. 听Our policy advice to politicians, regulators and investors then is to stop trying to make bubbles go away. In our view, requiring more disclosure, regulating trading and legislating moderation are never going to stop human beings from overreaching. The enthusiasm for big markets may lead to added price volatility, but it is also a spur for innovation, and the benefits of that innovation, in our view, outweigh the costs of the volatility. We would choose the chaos of bubbles, and the change that they create, over a world run by actuaries, where we would still be living in caves, weighing the probabilities of whether fire is a good invention or not.
Conclusion
Overconfident in their own abilities, entrepreneurs and venture capitalists are naturally drawn to big markets which offer companies the possibility of huge valuations if they can effectively exploit them. And there are always examples of a few immense successes, like Amazon, to fuel the fire. This leads to a big market delusion, resulting in too many new companies being founded to take advantage of big markets, each company being overpriced by its cluster of founders and venture capitalists. This overconfidence then feeds into public markets, where investors get their cues on price and relevant metrics from private market investors, leading to inflated values in those markets. This results in eventual corrections as the evidence accumulates that growth has to be shared and profitability may be difficult to achieve in a competitive environment. This post is a long one, but if you find it interesting, . As always, your feedback is appreciated!
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Published on December 29, 2019 20:12

December 19, 2019

A Teaching Manifesto: An Invitation to my Spring 2020 classes

If you have been reading my blog for long enough, you should have seen this post coming. Every semester that I teach, and it has only been in the spring in the last few years, I issue an invitation to anyone interested to attend my classes online. While I cannot offer you credit for taking the class or much direct personal help, you can watch my sessions online (albeit not live), review the slides that I use and access the post class material, and it is free. If you are interested in a certificate version of the class, NYU offers that option, but it does so for a fee. You can decide what works for you, and whatever your decision is, I hope that you enjoy the material and learn from it, in that order.
The Structure
I will be teaching three classes in Spring 2020 at the Stern School of Business (NYU), a corporate finance class to the MBAs and two identical valuation classes, one to the MBAs and one for undergraduates. If you decide to take one of the MBA classes, the first session will be on February 3, 2020, and there will be classes every Monday and Wednesday until May 11, 2020, with the week of March 15-22 being spring break. In total, there will be 26 sessions, each session lasting 80 minutes. The undergraduate classes start a week earlier, on January 27, and go through May 11, comprising 28 sessions of 75 minutes apiece.听The Spring 2020 Classses: With all three classes, the sessions will be recorded and converted into streams, accessible on my website and downloadable, as well as YouTube videos, with each class having its own playlist. In addition, the classes will also be carried on iTunes U, with material and slides, accessible from the site. The session videos will usually be accessible about 3-4 hours after class is done and you can either take the class in real time, watching the sessions in the week that they are taught, or in bunches, when you have the time to spend to watch the sessions; the recordings will stay online for at least a couple of years after the class ends. There will be no need for passwords, since the session videos will be unprotected on all of the platforms.听The (Free) Online Version: During the two decades that I have been offering this online option, I have noticed that many people who start the class with the intent of finishing it give up for one of two reasons. The first is that watching an 80-minute video on a TV or tablet is a lot more difficult than watching it live in class, straining both your patience and your attention. The second is that watching these full-length videos is a huge time commitment and life gets in the way. It is to counter these problems that I created 12-15 minute versions of the each session for online versions of the classes. These听online classes, recorded in 2014 and 2015, is also available on my website and through YouTube, and should perhaps be more doable than the full class version.The NYU Certificate Version: For most of the last 20 years, I have been asked why I don鈥檛 offer certificates of completion for my own classes and I have had three answers. The first is that, as a solo act, I don鈥檛 have the bandwidth to grade and certify the 20,000 people who take the classes each semester. The second is that certification requires regulatory permission, a bureaucratic process in New York State that I have neither the stomach nor the inclination to go through. The third is, and it is perhaps the most critical, is that I am lazy and I really don't want to add this to my to-do list. One solution would be to offer the classes through platforms like Coursera, but those platforms work with universities, not individual faculty, and NYU has no agreements with any of these platforms. About three years ago, when NYU approached me with a request to create online certificate classes, I agreed, with one condition: that the free online versions of these classes would continue to be offered. With those terms agreed to, there are now NYU Certificate versions of each of the online classes, with much of the same content, but with four add ons. First, each participant will have to take quizzes and a final exam, multiple choice and auto-graded, that will be scored and recorded. Second, each participant will have to complete and turn in a real-world project, showing that they can apply the principles of the class on a company of their choice, to be graded by me. Third, I will have live Zoom sessions every other week for class participants, where you can join and ask questions about the material. Finally, at the end of the class, assuming that the scores on the exams and project meet thresholds, you will get a certificate, if you pass the class, or a certificate with honors, if you pass it with flying colors. The Classes I have absolutely no desire to waste your time and your energy by trying to get you to take classes that you either have no interest in, or feel will serve no good purpose for you. In this section, I will 听provide a short description of each class, and provide links to the different options for taking each class.
I. Corporate Finance
Class description : I don鈥檛 like to play favorites, but corporate finance is my favorite class, a big picture class about the first principles of finance that govern how to run a business. I will not be egotistical enough to claim that you cannot run a business without taking this class, since there are many incredibly successful business-people who do, but I do believe that you cannot run a business without paying heed to the first principles. I teach this class as a narrative, staring with the question of what the objective of a business should be and then using that objective to determine how best to allocate and invest scarce resources (the investment decision), how to fund the business (the financing decision) and how much cash to take out and how much to leave in the business (the dividend decision). I end the class, by looking at how all of these decisions are connected to value.
Chapters: Applied Corporate Finance Book, Sessions: Class sessionI am not a believer in theory, for the sake of theory, and everything that we do in this class will be applied to real companies, and I will use six companies (Disney, Vale, Tata Motors, Deutsche Bank, Baidu and a small private bookstore called Bookscape) as lab experiements that run through the entire class.

I say, only half-jokingly, that everything in business is corporate finance, from the question of whether shareholder or stakeholder interests should have top billing at companies, to why companies borrow money and whether the shift to stock buybacks that we are seeing at US companies is good or bad for the economy. Since each of these questions has a political component, and have now entered the political domain, I am sure that the upcoming presidential election in the US will create some heat, if not light, around how they are answered.
For whom?
As I admitted up front, I believe that having a solid corporate finance perspective can be helpful to everyone. I have taught this class to diverse groups, from CEOs to banking analysts, from VCs to startup founders, from high schoolers to senior citizens, and while the content does not change, what people take away from the class is different. For bankers and analysts, it may be the tools and techniques that have the most staying power, whereas for strategists and founders, it is the big picture that sticks. So, in the words of the old English calling, "Come ye, come all", take what you find useful, abandon what you don't and have fun while you do this.
Links to Offerings
1. Spring 2020 Corporate Finance MBA class (Free)听(Download the iTunes U app and use enroll code of听FLJ-MLN-XZL)2. Online Corporate Finance Class (Free)
听(Download the iTunes U app and use enroll code of听HAS-CCR-FRA)3. NYU Certificate Class on Corporate Finance (It will cost you...)
II. Valuation
Class description: Some time in the last decade, I was tagged as the Dean of Valuation, and I still cringe when I hear those words for two reasons. First, it suggests that valuation is a deep and complex subject that requires intense study to get good at. Second, it also suggests that I somehow have mastered the topic. If nothing else, this class that I first taught in 1987 at NYU, and have taught pretty much every year since, dispenses with both delusions. I emphasize that valuation, at its core, is simple and that practitioner, academics and analysts often choose to make it complex, sometimes to make their services seem indispensable, and sometimes because they lose the forest for the trees. Second, I describe valuation as a craft that you learn by doing, not by reading or watching other people talk about it, and that I am still working on the craft. In fact, the more I learn, the more I realize that I have more work to do. 听This is a class about valuing just about anything, from an infrastructure project to a small private business to a multinational conglomerate, and it also looks at value from different perspectives, from that of a passive investor seeking to buy a stake or shares in a company to a PE or VC investor taking a larger stake to an acquirer interested in buying the whole company.听
Finally, I lay out my rationale for differentiating between value and price, and why pricing an asset can give you a very different number than valuing that asset, and why much of what passes for valuation in the real world is really pricing.听
Along the way, I emphasize how little has changed in valuation over the centuries, even as we get access to more data and more complex models, while also bringing in new tools that have enriched us, from option pricing models to value real options (young biotech companies, natural resource firms) to statistical add-ons (decision trees, Monte Carlo simulations, regressions).听
For whom?
Do you need to be able to do valuation to live a happy and fulfilling life? Of course not, but it is a skill worth having as a business owner, consultant, investor or just bystander. With that broad audience in mind, I don't teach this class to prepare people for equity research or financial analysis jobs, but to get a handle on what it is that drives value, in general, and how to detect BS, often spouted in its context. Don't get me wrong! I want you to be able to value or price just about anything by the end of this class, from Bitcoin to WeWork, but don't take yourself too seriously, as you do so.
Links to Offerings 1a. Spring 2020 Valuation MBA class (Free)听(Download the iTunes U app and use enroll code of听FSN-WWJ-RAH)1b. Spring 2020 Valuation听Undergraduate听class (Free)听(Download the iTunes U app and use enroll code of ENT-ZXA-JYL)2. Online Valuation Class (Free)听(Download the iTunes U app and use enroll code of听K7X-VD9-5KE)3. NYU Certificate Class on Valuation (Paid)
III. Investment Philosophies
Class description: This is my orphan class, a class that I have had the material to teach but never taught in a regular classroom. It had its origins in an couple of observations that puzzled me. The first was that, if you look at the pantheon of successful investors over time, it is not only a short one, but a diverse grouping, including those from the old time value school (Ben Graham, Warren Buffett), growth success stories (Peter Lynch and VC), macro and market timers (George Soros), quant players (Jim Simon) and even chartists. The second was that the millions who claim to follow these legends, by reading everything ever written by or about them and listening to their advice, don鈥檛 seem to replicate their success. That led me to conclude that there could be no one 鈥榖est鈥� Investment philosophy across all investors but there could be one that is best for you, given your personal makeup and characteristics, and that if you are seeking investment nirvana, the person that you most need to understand is not Buffett or Lynch, but you. 听In this class, having laid the foundations for understanding risk, transactions cost and market efficiency (and inefficiency), I look at the entire spectrum of investment philosophies, from charting/technical analysis to value investing in all its forms (passive, activist, contrarian) to growth investing (from small cap to venture capital) to market timing. With each one, I look at the core drivers (beliefs and assumptions) of the philosophy, the historical evidence on what works and does not work and end by looking at what an investor needs to bring to the table, to succeed with each one.
I will try (and not always succeed) to keep my biases out of the discussion, but I will also be open about where my search for an investment philosophy has brought me. By the end of the class, it is not my intent to make you follow my path but to help you find your own.
For whom?
This is a class for investors, not portfolio managers or analysts, and since we are all investors in one way or the other, I try to make it general. That said, if your intent is to take a class that will provide easy pathways to making money, or an affirmation of the "best" investment philosophy, this is not the class for you. My objective in this class is not to provide prescriptive advice, but to instead provide a menu of choices, with enough information to help you can make the choice that is best for you. Along the way, you will see how difficult it is to beat the market, why almost every investment strategy that sounds too good to be true is built on sand, and why imitating great investors is not a great way to make money.

Links to Offerings
1. Online Investment Philosophies Class (Free)听(Download the iTunes U app and use enroll code of听J6Z-AD7-NX3)2. NYU Certificate Class on Valuation (Paid)NYU Entry Page (Coming soon)ConclusionI have to confess that I don't subscribe to the ancient Guru/Sishya relationship in teaching, where the Guru (teacher) is an all-knowing individual who imparts his or her fountain of wisdom to a receptive and usually subservient follower. I have always believed that every person who takes my class, no matter how much of a novice in finance, already knows everything that needs to be known about valuation, corporate finance and investments, and it is my job, as a teacher, to make him or her aware of this knowledge. Put simply, I can provide some structure for you to organize what you already know, and tools that may help you put that knowledge into practice, but I am incapable of profundity. I hope that you do give one (or more) of my classes a shot and I hope that you both enjoy the experience and get a chance to try it out on real companies in real time.

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Published on December 19, 2019 13:30

November 19, 2019

Regime Change and Value: A Follow up Post on Aramco

In from a couple of days ago, I valued Aramco at about $1.65 trillion, but I qualified that valuation by noting that this was the value before adjusting for regime change concerns. That comment seems to have been lost in the reading, and it is perhaps because (a) I made it at the end of the valuation and (b) because the adjustment I made for it seemed completely arbitrary, knocking off about 10% off the value. Since this is a issue that is increasingly relevant in a world, where political disruptions seem to be the order of the day in many parts of the world, I thought that a post dedicated to just regime changes and how they affect value might be in order, and Aramco would offer an exceptionally good lab experiment.
Going Concern and Truncation RisksRisk is part and parcel of investing. That said, risk came come from many sources and not all risk is created equal, to investors. In fact, modern finance was born from the insight that for a diversified investor, it is only risk that you cannot diversify away, i.e., macroeconomic risk exposure, that affects value. In this section, I want to examine another stratification of risk into going concern and truncation risk that is talked about much less, but could matter even more to value.
DCF Valuation: A Going Concern Judgment The intrinsic value of a company has always been a function of its expected cash flows, its growth and how risky the cash flows are, but in recent decades a combination of access to data and baby steps in bringing economic models into valuation has resulted in the development of discounted cashflow valuation as a tool to estimate intrinsic value. Put simply, the discounted cash flow value of an asset is:
Extended to a publicly traded company, with a potential life in perpetuity, this value can be written as:
If you are a reader of , it should come as no mystery to you that I not only use DCF models to value companies, but that I believe that people under estimate how adaptable it is, usable in valuing everything from start ups to infrastructure projects. 听There is, however, one significant limitation with DCF models that neither its proponents nor its critics seem be aware of, and it needs to be addressed. Specifically, a DCF is an approach for valuing going concerns, and every aspect of it is built around that presumption. Thus, you estimate expected cash flows each year for the firm, as a going concern, and your discount rate reflects the risk that you see in the company as a going concern. In fact, it is this going concern assumption that allows us to assume that cash flows continue for the long term, sometimes forever, and attach a terminal value to these cash flows.
Truncation Risks If you accept the premise that a DCF is a going concern value, you are probably wondering what other risks there may be in investing that are being missed in a DCF valuation. The risks that I believe are either ignored or incorrectly incorporated into value are truncation risks. The simplest way of illustrating the difference between going concern and truncation risks is by picking a year in your cash flow estimation, say year 3. With going concern risk, you are worried about the actual cash flows in year 3 being different from your expectations, but with truncation risk, you are worried about whether there will be a year 3 for your company.听
So, what types of risk will fall into the truncation risk category? Looking at the corporate life cycle, you will see truncation risk become not just significant, but is perhaps the dominant risk that you worry about, age both ends of the life cycle. With start ups and young companies, it is survival risk that is front and center, given that approximately two thirds of start ups never make it to becoming viable businesses. With declining and aging companies, especially laden with debt, it is distress risk, where the company unable to meet its contractual obligations, shutters its doors and liquidates it assets. Looking at political risk, truncation risk can come in many forms, starting with nationalization risk, where a government takes over your business and pays you nothing in some cases and less than fair value in the rest, but extending to other expropriation risks, where you still are allowed to hold equity, but in a much less valuable concern.
Since truncation risk is more the rule than the exception, and it is the dominant risk in some companies, you would think that investors and analysts valuing these companies will have devised sensible ways of incorporating the risk, but you would be wrong.
The most common approach to dealing with truncation risk is for analysts to hike up the discount rate, using the alluring argument that if there is more risk, you would demand a higher return. The problem, though, is that this higher discount rate still goes into a DCF where expected cash flows continue in perpetuity, creating an internal contradiction, where you increase the discount rate for truncation risk but you do nothing to the cash flows. In addition, the discount rate that these analysts use are made up, higher just for the sake of being higher, with no rationale for the adjustment. With venture capitalists, this shows up as absurdly high target rates of 40%, 50% or 60%, fiction in a world where these VCs actually deliver returns . Discount rates are blunt instruments and are incapable of carrying the burden of truncation risk, and should not be made to do so.Some analysts take the more sensible approach of scenario analysis, allowing for good and bad scenarios (including failure or nationalization) but never close the loop by attaching probabilities to the scenarios. Instead, they leave behind ranges for the value that are so wide as to be useless for decision making purposes.听My suggestion is that you use a decision tree approach, where you not only allow for different scenarios, but you make these scenarios cover all possibilities and then attach a probability to each one. In the case of a start up, then, your two possible outcomes will be that the company will make it as a going concern and that it will not, and you will follow through with a DCF, with a going concern discount rate, yielding the value for the going concern outcome, and a liquidation providing your judgment for what the company will be worth, in the failure scenario:
Since you have probabilities for each outcome, you can compute an expected value. If you do this, you should expect to see discount rates for companies prone to failure (young start ups and declining firms) be drawn from the , but the adjustment for failure will be in the post-DCF adjustments. Put more simply, you should see 12-15% as costs of capital for even the riskiest start-ups, in a DCF, never 40-50%, but your post value adjustments for failure and its consequences will still take their toll.
The Aramco Valuation: Bringing in Truncation Risk听In my last post, I valued Aramco in a DCF, using three measures of cash flows from dividends to potential dividends to free cash flows to the firm and arrived at values that were surprisingly close to each other, centered around $1.65 trillion, for the equity. Note, though, that these are going concern values, and reflect the expectation that while there may be year to year changes in cash flows, as oil prices changes, management recalibrate and the government tweaks tax and royalty rates, the company will be a going concern and that it will not suffer catastrophic damage to its core asset of low-cost oil reserves. For many investors in Aramco, the prime concern may be less on these fronts and more on whether the House of Saud, as the backer of the promises that Aramco is making its investors, will survive intact for the next few decades.
DCF Valuation: Going Concern Risk Reviewing my discounted cash flow valuations of Aramco, you will notice that I began with a risk free rate in US dollars, because my currency choice was that currency. I then adjusted for risk, using a beta for Aramco, based upon REITs/royalty trusts for the promised dividend model and integrated oil companies for the potential dividends/free cash flow models, and an equity risk premium for Saudi Arabia of only 6.23%, with a country risk premium of 0.79% estimated for the country added to the mature market premium estimated for the US. The end result is that I had costs of equity ranging from 4.82% for promised dividends to 8.15% for cash flows.
The biggest push back I have had on my valuations is that the cost of equity seems low for a country like Saudi Arabia, and my response is that you are right, if you consider all of the risk in investing in a Saudi equity. However, much of the risk that you are contemplating in Saudi Arabia is political risk, or put more bluntly, the risk of regime change in the country, that could have dramatic effects on value. In fact, if you remove that risk from consideration and look at the remaining risk, Aramco is a remarkably safe investment, with the safety coming from its access to huge oil reserves and mind-boggling profits and cash flows. The DCF values that I have estimated, centered around $1.65 trillion, are therefore values before adjusting for the risk of regime change.
Regime Change Concerns If you invest in Aramco, you clearly have an interests in who rules and runs the country, since every aspect of your valuation is dependent on that assumption. If the House of Saud continues to rule, I believe that the company will be the cash cow that I project it to be in my DCF and the values that I estimated hold. If the Arab spring comes to Riyadh and there is a regime change, the foundations of my value can either crack or be completely swept away, with cash flows, growth and risk all up for re-estimation. In fact, to complete my valuation, I need to bring both the probability of regime change and the consequences into my final valuation:
Consider the most extreme case. If you believe that regime change in imminent and certain, and that the change will be extreme (with equity being expropriated and Aramco being brought back entirely into the hands of the state), my expected value for equity becomes zero:
If at the other extreme, you either believe that regime change will never happen, or even if it does, the new regime will not want to hurt the goose that lays the golden eggs and leaves existing terms in place, the value effect of considering regime change will be zero. The truth lies between the extremes, though where it lies is open for debate. I believe that there remains a non-trivial chance (perhaps as high as 20%) that there will be a regime change over the long term and that if there is one, there will be changes that reduce, but not extinguish, my claim, as an equity investor, on the cash flows.听
That, in an entirely subjective nutshell, is why I think Aramco's equity value is closer to $1.5 trillion than $1.7 trillion. 听As with all my other valuations, I understand that your judgments on Aramco will be different from mine, but I think that the disagreements we have are not so much on the going concern estimates of cash flows and risk but on the likelihood and consequences of regime change.听
Democracies versus AutocraciesI am not a political scientist, but I have always been fascinated by the question of how political structure and economic value are intertwined. Specifically, would you attach more value to a company or project operating in a democracy or in an autocracy? The approach that I have described in this post to deal with going concern and regime change risk allows me one way of trying too answer the question.听Democracies are messy institutions, where governments change and policies morph, because voters change their minds. Put simply, a democracy generally cannot offer any business iron clad guarantees about regulations not changing or tax rates remaining stable, because the government that offers those promises first has to get them approved by legislatures, often can be checked by legal institutions and, most critically, can be voted out of office. Consequently, companies operating in democracies will always complain more about the rules constantly changing, and how those changing rules affect cash flows, growth and risk.听Autocracies offer more stability, since autocrats don't have to get policies approved by legislators, often are unchecked by legal institutions and don't have to worry about how their decision poll with voters. Companies operating in autocracies can be promise rules that are fixed, regulations that don't change and tax rates that will stay constant. The catch, though, is that autocracies seldom transition smoothly, and when change comes, it is often unexpected and wrenching.In valuation terms, democracies create more going concern risk and autocracies create more worries about regime change. The former will show up as higher discount rates in a DCF valuation and the latter as post-DCF adjustments. While I prefer democracies to autocracies, there is no way, a priori, that you can argue that democracies are always better than autocracies or vice versa, at least when it comes to value, and here is why:The going concern risk that is added by being in a democracy will depend on how the democracy works. If you have a democracy, where the opposing parties tend to agree on basic economic principles and disagree on the margins, the going concern risk added will be small. In the United States, in the second half of the last century, both parties (Republicans and Democrats) agreed on the fundamentals of the economy, though one party may have been more favorable on some issues, for business, and less favorable on other issues. In contrast, if you have a democracy, where governments are unstable and the opposing parties have widely different views on the very fundamentals of how an economy should be structured, the effect on going concern risk will be much higher.听The regime change risk in an autocracy will vary in how the autocracy is structured and how transitions happen. Autocracies structured around a person are inherently more unstable than autocracies built around a party or ideology, and transitions are more likely to be violent if the military is involved in regime change, in either direction. In addition, violent regime changes feed on themselves, with memories of past violent meted out to a group driving the violence that it metes out, when its turn comes.In summary, when you are trying to decide on whether a business is worth more in a democracy than in a dictatorship, you are being asked to trade off more continuous, going concern risk in the former for the more stable environment of the latter, but with more discontinuous risk. I have deliberately stayed away from using specific country examples in this section, because this argument is more emotion than intellect, but you can fill your own contrasts of countries, and make your own judgments.听
ConclusionI have often described valuation as a craft, where mastery is an elusive goal and the key to getting better is working at doing more valuation. I am glad that I valued Aramco, because it is an unconventional investment, a company where I have to worry more about political risks than economic ones. The techniques I develop on Aramco will serve me well, not only when I value Latin American companies, as that continent seems to be entering one of its phases of disquiet, but when I value developed market companies, as Europe and the US seem to be developing emerging market traits.

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Published on November 19, 2019 15:16

November 18, 2019

A coming out party for the world's most valuable company: Aramco's long awaited IPO!

In a year full of interesting initial public offerings, many of which I have looked at in this blog, it is fitting that the last IPO I value this year will be the most unique, a company that after its offering is likely to be the most valuable company in the world, the instant it is listed. I am talking about Aramco, the Saudi Arabian oil colossus, which after many false starts, filed a prospectus on November 10 and that document, a behemoth weighing in at 658 pages, has triggered the listing clock.

Aramco: History and Set Up
Aramco鈥檚 beginnings trace back to 1933, when Standard Oil of California discovered oil in the desert sands of Saudi Arabia. Shortly thereafter, Texaco and Chevron formed the Arabian American Oil Company (Aramco) to develop oil fields in the country and the company also built the Trans-Arabian pipeline to deliver oil to the Mediterranean Sea. In 1960, the oil producing countries, then primarily concentrated in the Middle East, created OPEC and in the early 1970s, the price of oil rose rapidly, almost quadrupling in 1973. The Saudi Government which had been gradually buying Aramco鈥檚 assets, nationalized the company in 1980 and effectively gave it full power over all Saudi reserves and production. The company was renamed Saudi Aramco in 1988.
To understand why Aramco has a shot at becoming the most valuable company in the world, all you have to do is look at its oil reserves. In 2018, it was estimated that Aramco had in excess of 330 billion barrels of oil and gas in its reserves, a quarter of all of the world鈥檚 reserves, and almost ten times those of Exxon Mobil, the current leader in market cap, among oil companies. To add to the allure, oil in Saudi Arabia is close to the surface and cheap to extract, making it the most profitable place on oil to own reserves, with production costs low enough to break even at $20-$25 a barrel, well below the $40-$50 break even price that many other conventional oil producers face, and even further below the new entrants into the game. This edge in both quantity and costs plays out in the numbers, and Aramco produced 13.6 million barrels of oil & gas every day in 2018, and reported revenues of $355 billion for the year, on which it generated operating income of $212 billion and net income of $111 billion. In short, if your complaint about the IPOs that you saw this year was that they had little to show in terms of revenues and did not have money-making business models, this company is your antidote.
Aramco, Saudi Arabia and the House of Saud!
The numbers that are laid out in the annual report are impressive, painting a picture of the most profitable company in the world, with almost unassailable competitive advantages, investors need to be clear that even after its listing, Aramco will not be a conventional company, and in fact, it will never be one. The reason is simple. Saudi Arabia is one of the wealthier countries in the world, on a per capital basis, and one of the 20 largest economies, in terms of GDP, but it derives almost 80% of that GDP from oil. Thus, a company that controls those oil spigots is a stand in for the entire country, and over the last few decades, it should not surprise you to learn that the Saudi budget has been largely dependent on the cash flows it collects from Aramco, in royalties and taxes, and that Aramco has also invested extensively in social service projects all over the country. The overlap between company and country becomes even trickier when you bring in the Saudi royal family, and its close to absolute control of the country, which also means that Aramco鈥檚 fortunes are tied to the royal family鈥檚 fortunes. It is true that there will still be oil under the ground, even if there is a change in regime in Saudi Arabia, but the terms laid out in the prospectus reflect the royal family鈥檚 promises and may very well be revisited if control changed. Should this overlap between company, country and family have an effect on how you view Aramco? I don鈥檛 see how it cannot and it will play out in many dimensions:Corporate governance: After the IPO, the company will have all the trappings of a publicly traded company, from a board of directors to annual meetings to the rituals of financial disclosure. These formalities, though, should not obscure the fact that there is no way that this company can or ever will be controlled by shareholders. The Saudi government is open about this, stating in its prospectus that 鈥渢he Government will continue to own a controlling interest in the Company after the Offering and will be able to control matters requiring shareholder approval. The Government will have veto power with respect to any shareholder action or approval requiring a majority vote, except where it is required by relevant rules for the government.鈥� While one reason is that the majority control will remain with the government, it is that it would be difficult to visualize and perhaps to dangerous to even consider allowing a company that is a proxy for the country to be exposed to corporate control costs. After all, a hostile acquisition of the company would then be the equivalent of an invasion of the country. The bottom line is that if you invest in Aramco, you should recognize that you are more capital provider than shareholder and that you will have little or no say in corporate decision making.Country risk: Aramco has a few holdings and joint ventures outside Saudi Arabia, but this company is not only almost entirely dependent on Saudi Arabia but its corporate mission will keep it so. Put differently, a conventional oil company that finds itself overdependent on a specific country for its production can try to reduce this risk by exploring for oil or buying reserves in other countries, but Aramco will be limited in doing this, because of its national status.Political risk: For decades, the Middle East has had more than its fair share of turmoil, terrorism and war, and while Saudi Arabia has been a relatively untouched part, it too is being drawn into the problem. The drone attack on its facilities in Shaybah in August 2019, which not only caused a 54% reduction in oil production, but also cost billions of dollars to the company was just a reminder of how difficult it is to try to be oasis. On an even larger scale, the last decade has seen regime changes in many countries in the Middle East, with some occurring in countries, where the ruling class was viewed as insulated. The Saudi political order seems settled for the moment, with the royal family firmly in control, but that too can change, and quickly.In short, this is not a conventional company, where shareholders gather at annual meetings, elect boards of directors and the corporate mission is to do whatever is necessary to increase shareholder well being, and it never will be one. For some, that feature alone may be sufficient to take the company off their potential investment list. For others, it will be something that needs to be factored into the pricing and value, but at the right price or value, presumably with a discount built in for the country and political risk overlay, the company can still be a good investment.
IPO Twists
Before we price and value Aramco, there are a few twists to this IPO that should be clarified, since they may affect how much you are willing to pay. The prospectus, filed on November 10, sheds some light:Dividends: In the ending on September 30, 2019, Aramco paid out an ordinary dividend of $13.4 billion, entirely to the Saudi Government, and it plans to pay an additional interim dividend of at least $9.5 billion to the government, prior to the offering. The company commits to paying at least $75 billion in dividends in 2020, with holders of shares issued in the IPO getting their share, and to maintaining these dividends through 2024. Beyond 2024, dividends will revert back to their normal discretionary status, with the board of directors determining the appropriate amount. As an aside, the dividends to non-government shareholders will be paid in Saudi Riyal and to the government in US dollars.IPO Proceeds: The prospectus does not specify how many shares will be offered in the initial offering, but it is not expected to be more than a couple of percent of the company. None of the proceeds from the IPO will remain in Aramco. The government will redirect the proceeds elsewhere, in pursuit of its policy of making Saudi Arabia into an economy less dependent on oil.Trading constraints: Once the offering is complete, the shares will be listed on the Saudi stock exchange and its size will make it the dominant listing overnight, while also subjecting it to the trading restrictions of the exchange, including a limit of a 10% movement in the stock price in a day; trading will be stopped if it hits this limit.Inducements for Saudi domestic investors: In an attempt to get more domestic investors to hold the stock, the Saudi government will give one bonus share, for every ten shares bought and held for six months, by a Saudi investor, with a cap at a hundred bonus shares.Royalties & Taxes: In my view, it is this detail that has been responsible for the delay in the IPO process and it is easy to see why. For all of its life, Aramco has been the cash machine that keeps Saudi Arabia running, and the cash flows extracted from the company, whether they were titled royalties, taxes or dividends, were driven by Saudi budget considerations, rather than corporate interests. Investors were wary of buying into a company, where the tax rate and the royalties were fuzzy or unspecified and the prospectus lays out the following. First, 听the corporate tax rate will be 20% on downstream taxable income, though tax rates on different income streams can be different. The Saudi government also imposes a Zakat, a levy of 2.5% on assessed income, thus augmenting the tax rate. In sum, these tax rate changes were already in effect in 2018, and the company paid almost 48% of its taxable income in taxes that year. Second, the royalties on oil were reset ahead of the IPO and will vary, depending on the oil price, starting at 40% if oil prices are less than $70/barrel, increasing to 45% if they fell between $70 and $100, and becoming 80% if the oil price exceeds $100/barrel. A Pricing of Aramco
The initial attempts by the Saudi government to take Aramco public, as long as two years ago, came with an expectation that the company would be 鈥渧alued鈥� at $2 trillion or more. Since the IPO announcement a few weeks ago, much has been made about the fact that there seem to be wide divergences in how much bankers seem to think Aramco is worth, with numbers ranging from $1.2 billion to $2.3 trillion. Before we take a deep dive into how the initial assessments of value were made and why there might be differences, I think that we should be clear eyed about these numbers. Most of these numbers are not valuations, based upon an assessment of business models, risk and profitability, but instead represent pricing of Aramco, where assessment of price being made by looking at how the market is pricing publicly traded oil companies, relative to a metric, and extending that to Aramco, adjusting (subjectively) for its unique set up in terms of corporate governance, country risk and political risk. In the table below, I look at integrated oil companies, with market caps in excess of $10 billion, in October 2019, and how the market is pricing them relative to a range of metrics, from barrels of oil in reserve, to oil produced, to more conventional financial measures (revenues, earnings, cash flows):
The median oil company equity trades at about 13 times earnings, and was a business, at about the value of its annual revenues, and the market seems to be paying about $23 for every barrel of proven reserves of oil (or equivalent). In the table below, I have priced Aramco, using all of the metrics, and at the median and both the first and third quartiles:
You can already see that if you are looking at how to price Aramco, the metric on which you base it on will make a very large difference:听If you price Aramco based on its revenues of $356 billion or on its book value of equity of $271 billion, its value looks comparable or slightly higher than the value of Exxon Mobil and Royal Dutch, the largest of the integrated oil companies.听That pricing, though, is missing Aramco鈥檚 immense cost advantage, which allows it to generate much higher earnings from the same revenues. Thus, when you base the pricing on Aramco鈥檚 EBITDA of $224 billion, you can see the pricing rise to above a trillion and if you shift to Aramco鈥檚 net income of $111 billion, the pricing approaches $1.5 trillion.听The pricing is highest when you focus on Aramco鈥檚 most valuable edge, its control of the Saudi oil reserves and its capacity to produce more oil than any other oil company in the world. If you base the pricing on the 10.3 billion barrels of oil that Aramco produced in 2018, Aramco should be priced above $1.5 trillion and perhaps even closer to $2 trillion. If you base the pricing on the 265.9 billion barrels of proven reserves that Aramco controls for the next 40 years, Aramco鈥檚 pricing rises to sky high levels.If you are a potential investor, the pricing range in this table may seem so large, as to make it useless, but it can still provide some useful guidelines. First, you should not be surprised to see the roadshows center on Aramco鈥檚 strongest suits, using its huge net income (and PE ratios) as the opening argument to set a base for its pricing, and then using its reserves as a reason to augment that pricing. Second, there is a huge discount on the pricing, if just reserves are used as the basis for pricing, but there are two good reasons why that high pricing will be a reach:Production limits: Aramco not only does not own its reserves in perpetuity, with the rights reverting back to the Saudi government after 40 years, with the possibility of a 20-year extension, if the government decides to grant it, but it is also restricted in how much oil it can extract from those reserves to a maximum of 12 billion barrels a year.Governance and Risk: We noted, earlier, that Aramco鈥檚 flaws: the government鈥檚 absolute control of it, the country risk created by its dependence on domestic production and the political risk emanating from the possibility of regime change. To see how this can affect pricing, consider how the five companies on the integrated oil peer group that are Russian (with Gazprom, Rosneft and Lukoil being the biggest) are priced, relative to the global average:Russian oil companies are discounted by 50% or more, relative to their peer group, and while Saudi Arabia does not have the same degree of exposure, the market will mete out some punishment.
A Valuation of AramcoThe value of Aramco, like that of any company in any sector, is a function of its cash flows, growth and risk. In fact, the story that underlies the Aramco valuation is that of a mature company, with large cash flows and concentrated country risk. That said, the structuring of the company and the desire of the Saudi government to use its cash flows to diversify the economy play a role in value.听
General Assumptions
While I will offer three different approaches to valuing Aramco, they will all be built on a few common components.

First, I will do my valuation in US dollars, rather than Saudi Riyals, since as a commodity company, revenues are in dollars and the company reports its financials in US dollars (as well as Riyal). This will also allow me to evade tricky issues related to the Saudi Riyal being pegged to the US dollar though the reverberations from the peg unraveling will be felt in the operating numbers.听Second, I will use an expected inflation rate of 1.00% in US dollars, representing a rough approximation of the difference between the US treasury bond rate and the US TIPs rate. Third, I will use the equity risk premium of 6.23% for Saudi Arabia, representing about a 0.79% premium over my estimate of a mature market premium of 5.44% at the start of November 2019.听Finally, rather than use the standard perpetual growth model, where cash flows continue forever, I will use a 50-year growth period, representing the fact that the company's primary asset, its oil reserves, are not infinite and will run out at some point in time, even if additional reserves are discovered. In fact, at the current production level, the existing reserves will be exhausted in about 35 years.
Valuation: Promised Dividends
While the dividend discount model is far too restrictive in its assumptions about payout to be used to value most companies, Aramco may be the exception, especially given the promise in the prospectus to pay out at least $75 billion in dividends every year from 2020 and 2024, and the expectation that these dividends will continue and grow after that. There is one additional factor that makes Aramco a good candidate for the dividend discount model and that is the absolute powerlessness that stockholders will have at the company to change how much it returns to shareholders. To complete my valuation of Aramco using the promised dividends, I will make two additional assumptions:

Growth rate: I will assume a long term growth rate in dividends set equal the inflation rate, and since this valuation is in US dollars, that inflation rate will be 1%.Discount rate: Rather than use a discount rate reflecting the risk of an oil company, I will be one that is closer to that demanded by investors in REITs and oil royalty trusts, investments where the bulk of the returns will be in dividends and those dividends are backed up by asset cash flows.The valuation picture is below:
Based upon my assumptions, the value of Aramco is about $1.63 trillion. Seen through these lens, this stock is a dressed-up bond, where dividends will remain the primary form of return and there will be little price appreciation.
Valuation: Potential Dividends
The reason that dividend discount models often fail is because they look at the actual dividends paid and don鈥檛 factor in the reality that some companies pay out more than they can afford to do in dividends, in which case they are unsustainable and will fall under that weight, and some companies pay too little, in which case the cash that is paid out accumulates in the firm as a cash balance, and equity investors get a stake in it. While I noted that Aramco has signaled that it will pay at least $75 billion in dividends over the next five years, it has not indicated that it will cease investing and with potential dividends, you value the company based upon its capacity to pay dividends, rather than actual dividends. 听In computing the potential dividends, I assumed that the company would be able to grow earnings at 1.80% a year, and be able to do so by continuing to generate sky high returns on equity (its 2018 return on equity was about 41%). However, the shift from promised dividends to potential dividends will also expose investors to more of the risk in an integrated oil company and I adjust the cost of equity accordingly:
The value of equity, using potential dividends, is $1.65 trillion, reflecting not only Aramco鈥檚 capacity to pay much higher dividends than promised but also the higher risk in these cash flows.
Valuation: As a BusinessWhen you value a business, you effectively allow for the options that the firm has to make changes to how much and where it invests, how it finances it business and how much it pays in dividends. One reason that this may provide only limited benefits in the Aramco case is that the company is significantly constrained, both because of its ownership and governance structure as well as its mission, on all three dimensions. Thus, it is likely that Aramco will remain predominantly a fossil fuel company, tethered to its roots in Saudi Arabia, is unlikely to alter its policy of being predominantly equity funded and its dividend policy is sticky even at as it starts life as a public company. 听Following through with these assumptions, I assumed that the debt ratio for Aramco will stay low at 1.80% of overall capital, as will the cost of debt at 2.70%, in US dollar terms, based upon its bond rating. To get the reinvestment, I switch to using the return on capital of 44.61% that the company generated in 2018, as my base:
Adding the cash and cross holdings and then subtracting out the debt and minority interests in the company yields an equity value of $1.67 trillion, that is close to what we obtained with the FCFE model, but that should not be surprising, given that the company has so little debt in its capital structure.
Final Valuation Adjustments
In summary, what is surprising about the valuations of Aramco, using the three approaches, is how close they are in their final assessments, all yielding values around $1.65 trillion. That said, there are three additional considerations that none of these models have factored in.

Political Risk: While these models adjust for country risk in Saudi Arabia, I have used the default spread of the country as a proxy, but that misses the risk of regime change, a discontinuous risk that will have very large and potentially catastrophic effects on value. While you may believe that this risk is low, it is definitely not zero.听Upside limits: When you invest in any large integrated oil company, you are making a bet on oil prices, with the expectation that higher oil prices will deliver higher income and higher value. While that assumption still holds for Aramco, the royalty structure that the Saudi government has created, where the royalty rate will climb from 40% at current oil prices to 45% if they rise above $ 70 and 80% if they rise above $100/barrel will mean that your share of gains, as an equity investor, on the upside will be capped, dampening the value today.Price setter/taker: While the largest publicly traded oil companies in the world are still price takers, Aramco has more influence on the oil price than any of them, as a result of Saudi Arabia's role in the oil market. Put simply, while the power of the Saudi government to set oil prices has decreased from the 1970s, it does continue to wield more influence than any other entity in this process.The first two factors are clear negatives and should lead you to mark down the value of Aramco, but 听the third factor may help provide some downside protection. Overall, I would expect the value of equity in Aramco to be closer to $1.5 trillion, after these adjustments are made. (I am assuming a small chance of regime change, but if you attach a much higher probability, the drop off in value will be much higher).
Aramco: To invest or not to?
Over the weekend, we got a little more clarity on the IPO details, with a rumored pricing of $1.7 trillion for the company's equity and a planned offering of 1.5% of the outstanding shares. That price is within shouting distance of my valuation, and my guess is that given the small size of the offering (at least on a percentage basis), it will attract enough investors to be fully subscribed. At this pricing, I think that the company will be more attractive to domestic than international investors, with Saudi investors, in particular, induced to invest by the company's standing in the country. It will be a solid investment, as long as investors recognize what they are getting is more bond than stock, with dividends representing the primary return and limited price appreciation. They will have no say in how the company is run, and if they don't like the way it is run, they will have to vote with their feet. If they are worried about risk, the research they should do is more political than economic, with the primary concerns about regime stability. The one concern that you should have, if you are a Saudi investor, with your human capital and real estate already tied to Saudi Arabia's (and oil's) well being, investing your wealth in Aramco will be doubling down on that dependence.
In case you care about my investment judgment, Aramco is not a stock for me for two reasons. First, I am lucky enough not to be dependent on cash flows from my investment portfolio to meet personal liquidity needs, and have no desire to receive large dividends, just for the sake of reaching them, since they just create concurrent tax burdens. Second, if I were tempted to invest in the company as a play on oil prices, the rising royalty rates, as oil prices go up, imply that my upside will be limited at Aramco. 听Finally, it is worth noting that this company will be the ultimate politically incorrect investment, operating both as a long term bet on oil, in a world where people are as dependent as ever on fossil fuels, but seem to be repelled by those who produce it, and as a bet on Saudi royalty, an unpopular institution in many circles. As a consequence, I am willing to bet that not too many college endowments in the United States will be investing in Aramco, and even conventional fund managers may avoid the stock, just to minimize backlash. I don't much care for political correctness nor for investors who seem to believe that the primary purpose of investing is virtue signaling, and I must confess that I am tempted to buy Aramco just to see their heads explode. However, that would be both petty and self-defeating, and I will stay an observer on Aramco, rather than an investor.
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Published on November 18, 2019 13:26

November 15, 2019

The Softbank-WeWork End Game: Savior Economics or Sunk Cost Problem?

Since , where I valued the company ahead of its then imminent offering, much has happened. The company鈥檚 IPO collapsed under the weight of its own pricing contradictions, and after a near-death experience, Softbank emerged as the savior, investing an additional $ 8 billion in the company, and taking a much larger stake in its equity. As the WeWork story continues to unfold, I am finding myself more interested in Softbank than in WeWork, largely because it鈥檚 actions cut to the heart of so many questions in investing, from how sunk costs can affect investing decisions, to the feedback effects from mark-to-market accounting, and finally on the larger question of whether smart money is really smart or just lucky.
WeWork: The IPO Aftermath
It has been only a few weeks since I valued WeWork for its IPO, but it seems much longer, simply because of how much has changed since then. As a reminder, . I also argued that this was a company on a knife鈥檚 edge, a growth machine with immense operating and financial leverage, where misstep could very quickly tip them into bankruptcy, with a table illustrating how quickly the equity slips into negative territory, if the operating assumptions change:Soon after my post, the ground shifted under WeWork, as a combination of arrogance (on the part of VCs, bankers and founders) and business model risks caught up with the company, and the IPO was delayed, albeit reluctantly by the company. That action, though, left the company in a cash crunch, since it had been counting on the IPO to bring in $3 billion in capital to cover its near-term needs. In conjunction with a loss of trust in the top management of the company, created a vicious cycle with the very real possibility that the company would implode. As WeWork sought rescue packages, , with three components to it:Equity Buyout: A tender offer of $3 billion in equity to buy out of existing stockholders in the firm to increase its share of the equity ownership to 80%. In an odd twist, Softbank contended that, after the financing, 鈥�it will not hold a majority of the voting rights鈥� and does not control the company鈥� WeWork will not be a subsidiary of Softbank. WeWork will be an associate of Softbank鈥�. I am not sure whether this is a true confession of lack of control or a ploy to keep from consolidating WeWork (and its debt load) into Softbank's financials.Added Capital: Softbank would provide fresh debt financing of $5 billion ($1.1 billion in secured notes, $2.2 billion in unsecured notes and $1.75 billion as a line of credit) and an acceleration of a $1.5 billion equity investment it had been planning to make into WeWork in 2020, giving WeWork respite, at least in the short term, from its cash constraints.Neutering Adam Neumann (at a cost): The offer also includes a severing of Adam Neumann鈥檚 leadership of the company, in return for which he will receive $1 billion in cash, $500 million as a loan to repay a JP Morgan credit line and $185 million for a four-year position as a consultant. I assume that the consulting fee is more akin to a restraining order, preventing him from coming within sighting distance of any WeWork office or building.Since that deal was put together, the storyline has shifted, with Softbank now playing the lead role in this morality play, with multiple questions emerging:What motivated Softbank to invest so much more in a company where it had already lost billions? Some are arguing that Softbank had no choice, given the magnitude of what they had invested in WeWork, and others are countering that they were throwing good money after bad.听With mark-to-market rules in effect at Softbank, how will accountants reflect the WeWork disaster on Softbank鈥檚 books? I think that fair-value accounting is neither fair nor is it about value, but the WeWork write down that Softbank had to take is a good time to discuss how fair-value accounting can have a feedback effect on corporate decision making.Is Masa Son a visionary genius or an egomaniac in need of checks and balances? A year ago, there were many who viewed Masa Son, with his 300-year plans and access to hundreds of billions of dollars in capital, was a man ahead of his time, epitomizing smart money. Today, the consensus view seems to be that he is an impulsive and emotional investor, not to be trusted in his investment judgments. The truth, as is often the case, lies somewhere in the middle.Since Softbank is a holding company, deriving a chunk of its value from its perceived ability to find start-ups and young companies and convert them into big wins, how will its value change as a result of its WeWork missteps? To answer this question, I will look at how Softbank鈥檚 market capitalization has changed over time, especially around the WeWork fiasco, and examine the consequences for its Vision fund plans. Sunk Cost or Corporate Rescue!
In the years that WeWork was a private company, Softbank was, by far, the largest investor in the company. In August 2019, when the IPO was first announced, Softbank had not only been its largest capital provider, investing $7.5 billion in the company, but had also supplied the most recent round of capital, at a pricing of $47 billion. That lead-in, though, raises questions about the motives behind its decision to invest an extra $ 8 billion to keep WeWork afloat.听It鈥檚 a corporate rescue: There are some who would argue that Softbank had no choice, since without an infusion of capital, WeWork was on a pathway to being worth nothing and that by investing its capital, Softbank would avoid that worst-case scenario. In fact, if you believe Softbank, with the infusion, WeWork has a pre-money value of $8 billion, with the infusion, and while that is a steep write down from the $47 billion pricing, it is still better than nothing.听Good money chasing bad: The sunk cost principle, put simply, states that when you make an investment decision, your choice should be driven by its incremental effects and not by how much you have already expended leading up to that decision. In practice, though, , trying to make up for past mistakes by making new ones. In the context of Softbank鈥檚 new WeWork investment, this would imply that Softbank is investing $ 8 billion in WeWork, not because it believes that it can generate more than amount in incremental value from future cash flows, but because it had invested $7.5 billion in the past.So, how do you resolve this question? As I see it, the Softbank rescue of WeWork may have helped it avoid a near term liquidity meltdown, but it has not addressed any of the underlying issues that I noted with the company鈥檚 business model. In fact, it has taken a highly levered company whose only pathway to survival was exponential growth and made it an even more levered company with constrained growth. In fact, Softbank has been remarkably vague about the economic rationale for the added investment and their story does not hold up to scrutiny. I do realize that Masa Son claims that 鈥�(t)he logic is simple. Time will resolve鈥�.鈥�.鈥�.鈥塧nd we will see a sharp V-shaped recovery,鈥� in WeWork, but I don鈥檛 see the logic, time alone cannot resolve a $30 billion debt problem and there are enough costs in non-core businesses to cut to yield a quick recovery. At least from my perspective, Softbank鈥檚 investment in WeWork is good money chasing bad, a classic example of how sunk costs can skew decisions. To those who would counter that Softbank has a lot of money to lose and smart people working for it, note that the more money you have to lose and the smarter people think they are, the more difficult it becomes to admit to past mistakes, exacerbating the sunk cost problem. In fact, now that Softbank will have more than $15 billion invested in WeWork, they have made the sunk cost problem worse, going forward.
Accounting Fair Value
I understand the allure of fair value accounting to accountants. It provides them with a way to update the balance sheet, to reflect real world changes and developments, and make it more useful to investors. The fact that it also creates employment for accountants all over the world is a bonus, at least from their perspective. I think that the accounting response to Softbank鈥檚 WeWork mistake illustrates why fair value accounting is an oxymoron, more likely to do damage than good:It is price accounting, not value accounting: In Softbank鈥檚 latest earnings report, we saw the first installment of accounting pain from the WeWork mistake, with and reporting a hefty loss for the quarter. The reason for the write-down, though, was not a reassessment of WeWork鈥檚 value, but a reaction to the drop in the pricing of the company鈥檚 equity from the $47 billion before the IPO to $8 billion after the IPO implosion.听With Softbank supplying the pricing: If you are dubious about the use of pricing in accounting revaluations, you should even more skeptical in this case, since Softbank was setting the pricing, at both the $47 billion pre-IPO, and the $8 billion, post-collapse. As I noted in the last section, there is nothing tangible that I can see in any of Softbank鈥檚 numerous press releases to back these numbers. In fact, if WeWork had not been exposed in its public offering, my guess is that Softbank would have probably invested more capital in the company, marked up the pricing to some number higher than $47 billion and that we would not be having this conversation.Too little, too late: As is always the case with accounting write-downs and impairments, there was very little news in the announcement. In fact, given that the write down was based upon pricing, not value, the market knew that a write off was coming and approximately how much the write off would be, which explains why even multi-billion write offs and impairments usually have no price effect, when announced. Incidentally, the accountants will offer you intrinsic valuations (DCF) to back up their assessments, but I would not attach to much weight to them, since they are , where the analysts decide, based on the pricing, what they would like to get as value, and then reverse engineer the inputs to deliver that number.With dangerous feedback effects: If all fair value accounting did was create these write downs and impairments that don鈥檛 faze investors, I could live with the consequences and treat the costs incurred in the process as a jobs plan for accountants. Unfortunately, companies still seem to think that these accounting charges are news that moves markets and take actions to minimize them. In fact, a cynic might argue that one motivation for Softbank鈥檚 rescue of WeWork was to minimize the write down from its mistake.听I am not a fan of fair value accounting, partly because it is a delayed reaction to a pricing change and is not a value reassessment, and partly because companies are often tempted to take costly actions to make their accounting numbers look better.听
Smart Money, Stupid Money!
I hope that this entire episode will put to rest the notion of smart money, i.e., that there are investors who have access to more information than we do, have better analytical tools than the rest of us and use those advantages to make more money than the rest of us. In fact, it is this proposition that leads us to assume that anyone who makes a lot of money must be smart, and by that measure, Masa Son would have been classified as a smart investor, and wealthy investors funneled billions of dollars into Softbank Vision funds, on that basis. I am not going to argue that the WeWork misadventure makes Masa Son a stupid investor, but it does expose the fact that he is human, capable of letting his ego get ahead of good sense and that at least some of his success over time has to be attributed being in the right place at the right time.听
So, if investors cannot be classified into smart and stupid, what is a better break down? One would be to group them into lucky and unlucky investors, but that implies a complete surrender to the forces of randomness that I am not yet willing to make. I think that investors are better grouped into humble and arrogant, with humble investors recognizing that success, when it comes, is as much a function of luck as it is of skill, and failure, when it too arrives, is part of investing and an occasion for learning. Arrogant investors claim every investing win as a sign of their skill and view every loss as an affront, doubling down on their mistakes. If I had to pick someone to manage my money, the quality that I would value the most in making that choice is humility, since humble investors are less likely to overpromise and overcommit. I think of the very act of demanding obscene fees for investment services is an act of arrogance, one reason that I find it difficult to understand why hedge funds are allowed to get away with taking 2% of your wealth and 20% of your upside.
Leading into the WeWork IPO, the question of where Masa Son fell on the humility continuum was easy to answer. Anyone who makes three hundred year plans and things that bigger is always better has a God complex, and success feeds that arrogance. I would like to believe that the WeWork setback has chastened Mr. Son, and in his remarks to shareholders this week, he said the right things, stating that he had 鈥渕ade a bad investment decision, and was deeply remorseful鈥�, speaking of WeWork. However, he then undercut his message by not only claiming that the pathway to profit for WeWork would be simple (it is not) but also asserting that his Vision fund was still better than other venture capitalists in seeking out and finding promising companies. in my view, 听Masa Son needs a few more reminders about humility from the market, since neither his words nor his actions indicate that he has learned any lessons.听
Softbank: The WeWork Effect
WeWork may have been Masa Son鈥檚 mistake, but the vehicle that he used to make the investment was Softbank, through the company and its Vision fund. As WeWork has unraveled, it is not surprising that Softbank has taken a significant hit in the market.听
Note that Softbank has lost more than $15 billion in value since August 14, when the WeWork IPO was announced, and much of that loss can be attributed to the unraveling of the IPO, and how investor perceptions of Masa Son鈥檚 investing skills have changed since.

The knocking down of Softbank鈥檚 value by the market may strike some of you as excessive, but there is reason that Softbank鈥檚 WeWork investment has ripple effects. Softbank may be built around a telecom company, but like Berkshire Hathaway, the company that Masa Son is rumored to admire and aspire to be, it is a holding company for investments in other companies. In fact, its most valuable holding remains an early investment in Alibaba, now worth tens of billions dollars. While Alibaba is publicly traded and its pricing is observable, many of Softbank鈥檚 most recent investments have been in young, private companies like WeWork. With these investments, the pricing attached to them by Softbank, in its financials, comes from recent VC funding rounds and their valuations reflect trust in Softbank鈥檚 capacity to pick winners and the WeWork meltdown hurts on both counts. First, investors are more wary about trusting VC pricing, especially if Softbank has been a lead investor in funding rounds, since that is how you arrived at the $47 billion pricing for WeWork in the first place. Second, the notion of Masa Son as an investing savant, skilled at picking the winners of the disruption game, has been damaged, at least for the moment and perhaps irreparably. The easiest way to measure how investor perceptions have changed is to compare the market capitalization of Softbank to its book value, a significant proportion of which reflects its holdings, marked to market:
Investors have been wary of Softbank鈥檚 investing skills, even before the WeWork IPO, but the write offs on Uber and WeWork has made them even more skeptical, as the price to book ratio continues its march towards parity, with the market capitalization at 123% of the book value of equity in November 2019. In fact, if you focus just on Softbank鈥檚 non-consolidated holdings, public and private, note that the market capitalization of Softbank now stands at 73% of the value of just these holdings, most of which are marked to market. Put simply, when you buy Softbank, you are getting Uber and Alibaba at a discount on their traded market prices, but before you put your money down on what looks like a great deal, there are two considerations that may affect your decision. The first is that the company has a vast amount of debt on its balance sheet that has to be serviced, potentially putting your equity at risk, and the second is that you are getting Softbank (and Masa Son) as the custodian of the investments. If you have lost faith in (in people and in companies), you may view the 27% discount that the market is attaching to Softbank鈥檚 holdings as entirely justifiable and steer away from the stock. In contrast, if you feel that WeWork was an aberration in an otherwise stellar investment picking record, you should load up on Softbank stock. As for me, I don鈥檛 plan to own Softbank! I don't like grandiosity and Masa Son seems to have been soaked in it.

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Published on November 15, 2019 05:14

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Aswath Damodaran's Blog

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Aswath Damodaran isn't a 欧宝娱乐 Author (yet), but they do have a blog, so here are some recent posts imported from their feed.