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In my last data updates for this year, I looked first at , driven by a stronger-than-expected economy and inflation coming down, and then . In this post, I look at risk, a central theme in finance and investing, but one that is surprisingly misunderstood and misconstrued. In particular, there are wide variations in how risk is measured, and once measured, across companies and countries, and those variations can lead to differences in expected returns and hurdle rates, central to both corporate finance and investing judgments.

Risk Measures

? ? There is almost no conversation or discussion that you can have about business or investing, where risk is not a part of that discussion. That said, and notwithstanding decades of research and debate on the topic, there are still wide differences in how risk is defined and measured.

What is risk?

? ? I do believe that, in finance, we have significant advances in understanding what risk, I also think that as a discipline, finance has missed the mark on risk, in three ways. First, it has put too much emphasis on market-price driven measures of risk, where price volatility has become the default measure of risk, in spite of evidence indicating that a great deal of this volatility has nothing to do with fundamentals. Second, in our zeal to measure risk with numbers, we have lost sight of the reality that the effects of risk are as much on human psyche, as they are on economics. Third, by making investing a choice between good (higher returns) and bad (higher risk), a message is sent, perhaps?unwittingly, that risk is something to be avoided or hedged. ?It is perhaps to counter all of these that I start my session on risk with the Chinese symbol for crisis:

Chinese symbol for crisis = 룪C = Danger + Opportunity

I have been taken to task for using this symbol by native Chinese speakers pointing out mistakes in my symbols (and I have corrected them multiple times ?in response), but thinking of risk as a combination of danger and opportunity is, in my view, a perfect pairing, and this perspective offers two benefits. First, by linking the two at the hip, it sends the clear and very important signal that you cannot have one (opportunity), without exposing yourself to the other (danger), and that understanding alone would immunize individuals from financial scams that offer the best of both worlds - high returns with no risk. Second, it removes the negativity associated to risk, and brings home the truth that you build a great business, not by avoiding danger (risk), but by seeking out the right risks (where you have an advantage), and getting more than your share of opportunities.?

Breaking down risk

? ? One reason that we have trouble wrapping our heads around risk is that it has so many sources, and our capacity to deal with varies, as a consequence. When assessing risk in a project or a company, I find it useful to make a list of every risk that I see in the investment, big and small, but I then classify these risks into buckets, based upon type, with very different ways of dealing with and incorporating that risk into investment analysis. The table below provides a breakdown of those buckets, with economic uncertainty contrasted with estimation uncertainty, micro risk separated from macro risks and discrete risks distinguished from continuous risks:

While risk breakdowns may seem like an abstraction, they do open the door to healthier practices in risk analysis, including the following:Know when to stop: In a world, where data is plentiful and analytical tools are accessible, it is easy to put off a decision or a final analysis, with the excuse that you need to ?collect more information. That is understandable, but digger deeper into the data and doing more analysis will lead to better estimates, only if the risk that you are looking at is estimation risk. In my experience, much of the risk that we face when valuing companies or analyzing investments is economic uncertainty, impervious to more data and analysis. It is therefore healthy to know when to stop researching, accepting that your analysis is always a work-in-progress and that decisions have to be made in the face of uncertainty.Don't overthink the discount rate: One of my contentions of discount rates is that they cannot become receptacles for all your hopes and fears. Analysts often try to bring company-specific components, i.e, micro uncertainties, into discount rates, and in the process, they end up incorporating risk that investors can eliminate, often at no cost. Separating the risks that do affect discount rates from the risks that do not, make the discount rate estimation simpler and more precise.Use more probabilistic & statistical tools: The best tools for bringing in discrete risk are probabilistic, i.e., decision trees and scenario analysis, and using them in that context may open the door to other statistical tools, many of which are tailor-made for ?the problems that we face routinely in finance, and are underutilized.

Measuring risk

? The financial thinking on risk, at least in its current form, had its origins in the 1950s, when Harry Markowitz uncovered the simple truth that the risk of an investment is not the risk of it standing alone, but the risk it adds to an investor's portfolio. He followed up by showing that holding diversified portfolios can deliver much higher returns, for given levels of risk, for all investors. That insight gave rise not only to modern portfolio theory, but it also laid the foundations for how we measure and deal with risk in finance. In fact, almost every risk and return model in finance is built on pairing two assumptions, the first being that the marginal investors in a company or business are diversified and the second being that investors convey their risk concerns through market prices:

By building on the assumptions that the investors pricing a business are diversified, and make prices capture that risk, modern portfolio theory has exposed itself to criticism from those who disagree with one or both of these assumptions. Thus, there are value investors, whose primary disagreement is on the use of pricing measures for risk, arguing that risk has to come from numbers that drive intrinsic value - earnings and cash flows. There are other investors who are at peace with price-based risk measures , but disagree with the "diversified marginal investor" assumption, and they are more intent on finding risk measures that incorporate total risk, not just risk that cannot be diversified away. I do believe that the critiques of both groups have legitimate basis, and while I don't feel as strongly as they do, I can offer modifications of risk measures to counter the critiques;

For investors who do not trust market prices, you cannot create risk analogs that look at accounting earnings or cash flows, and for those who believe that the diversified investor assumption is an overreach, you can adapt risk measures to capture all risk, not just market risk. In short, if you don't like betas and have disdain for modern portfolio theory, your choice should not be to abandon risk measurement all together, but to come up with an alternative risk measure that is more in sync with your view of the world.?

Risk Differences across Companies

? ? With that long lead-in on risk, we are positioned to take a look at how risk played out, at the company level, in 2024. Using the construct from the last section, I will start by looking at price-based risk measures and then move on to intrinsic risk measures in the second section.

a. Price-based Risk Measures

? ? My data universe includes all publicly traded companies, and since they are publicly traded, computing price-based risk measures is straight forward. That said, it should be noted that liquidity ?varies widely across these companies, with some located in markets where trading is rare and others in markets, with huge trading volumes. With that caveat in mind, I computed three risk-based measures - a simplistic measure of range, where I look at the distance between the high and low prices, and scale it to the mid-point, the?standard deviation in stock prices, a conventional measure of volatility and beta, a measure of that portion of a company's risk that is market-driven.?

I use the data through the end of 2023 to compute all three measures for every company, and in my first breakdown, I look at these risk measures, by sector (globally):

Utilities are the safest or close to the safest , on all three price-based measures, but there are divergences on the other risk measures. Technology companies have the highest betas, but health care has the riskiest companies, on standard deviation and the price range measure. ?Looking across geographies, you can see the variations in price-based risk measures across the world:

There are two effects at play here. The first is liquidity, with markets with less trading and liquidity exhibiting low price-based risk scores across the board. The second is that some geographies have sector concentrations that affect their pricing risk scores; the preponderance of natural resource and mining companies in Australia and Canada, for instance, explain the high standard deviations in 2023.?? ?Finally, I brought in my corporate life cycle perspective to the risk question, and looked at price-based risk measures by corporate age, with the youngest companies in the first decile and the oldest ones in the top decile (with a separate grouping for companies that don't have a founding year in the database):On both the price range and standard deviation measures, not surprisingly, younger firms are riskier than older ones, but on the beta measure, there is no relationship. That may sound like a contradiction, but it does reflect the divide between measures of total risk (like the price range and standard deviation) and measures of just market risk (like the beta). Much of the risk in young companies is company-specific, and for those investors who hold concentrated portfolios of these companies, that risk will translate into higher risk-adjusted required returns, but for investors who hold broader and more diversified portfolios, younger companies are similar to older companies, in terms of risk.

b. Intrinsic Risk Measures

? ? As you can see in the last section, price-based risk measures have their advantages, including being constantly updated, but they do have their limits, especially when liquidity is low or when market prices are not trustworthy. In this section, I will look at three measures of intrinsic risk - whether a company is making or losing money, with the latter being riskier, the variability in earnings, with less stable earnings translating to higher risk, and the debt load of companies, with more debt and debt charges conferring more risk on companies.?

? ? I begin by computing ?these intrinsic risk measures across sectors, with the coefficient of variation on both net income and operating income standing in for earnings variability; the coefficient of variation is computed by dividing the standard deviation in earnings over the last ten years, divided by the average earnings over those ten years.?

Globally, health care has the highest percentage of money-losing companies and utilities have the lowest. In 2023, energy companies have the most volatile earnings (net income and operating income) and real estate companies have the most onerous debt loads. Looking at the intrinsic risk measures for sub-regions across the world, here is what I see:

Again, Australia and Canada have the highest percentage of money losing companies in the world and Japan has the lowest, Indian companies have the highest earnings variability and Chinese companies carry the largest debt load, in terms of debt as a multiple of EBITDA. In the last table, I look at the intrinsic risk measures, broken down by company age:

Not surprisingly, there are more money losing young companies than older ones, and these young companies also have more volatile earnings. On debt load, though, there is no discernible pattern in debt load across age deciles, though the youngest companies do have the lowest interest coverage ratios (and thus are exposed to the most danger, if earnings drop).

Risk Differences across Countries

? ? In this final section, I will look risk differences across countries, both in terms of why risk varies across, as well as how these variations play out as equity risk premiums. There are many reasons why risk exposures vary across countries, but I have tried to capture them all in the picture below (which I have used before in my country risk posts and in ):

Put simply, there are four broad groups of risks that lead to divergent country risk exposures; political structure, which can cause public policy volatility, corruption, which operates as an unofficial tax on income, war and violence, which can create physical risks that have economic consequences and protections for legal and property rights, without which businesses quickly lose value.?

? ? While it is easy to understand why risk varies across countries, it is more difficult to measure that risk, and even more so, to convert those risk differences into risk premiums. Ratings agencies like Moody's and S&P provide a measure of the default risk in countries with sovereign?ratings, and I build on those ratings to estimate country and equity risk premiums, by country. The figure below summarizes the numbers used to compute these numbers at the start of 2024:

The starting point for estimating equity risk premiums, for all of the countries, is the implied ?equity risk premium of 4.60% that I computed at the start of 2024, and talked about in . All countries that are rated Aaa (Moody's) are assigned 4.60% as equity risk premiums, but for lower-rated countries, there is an additional premium, reflecting their higher risk:

You will notice that there are countries, like North Korea, Russia and Syria, that are unrated but still have equity risk premiums, and for these countries, the equity risk premiums estimate is based upon a country risk score from . If you are interested, you can review the process that I use in far more detail that I update every year on country risk.

Risk and Investing

? ? The discussion in the last few posts, starting with equity risk premium in , and interest rates and default spreads in , leading into risk measures that differrentiate across companies and countries in this one, all lead in to a final computation of the costs of equity and capital for companies. That may sound like a corporate finance abstraction, but the cost of capital is a pivotal number that can alter whether and how much companies invest, as well as in what they invest, how they fund their investments (debt or equity) and how much they return to owners as dividends or buybacks. For investors looking at these companies, it becomes a number that they use to estimate intrinsic values and make judgments on whether to buy or sell stocks:

The multiple uses for the cost of capital are what led me to label it "the Swiss Army knife of finance" and if you are interested, you can keep a get a deeper assessment by

? ? Using the updated numbers for the risk free rate (in US dollars), the equity risk premiums (for the US and the rest of the world) and the default spreads for debt in different ratings classes, I computed the cost of capital for the 47,698 companies in my data universe, at the start of 2024. In the graph below, I provide a distribution of corporate costs of capital, for US and global companies, in US dollars:? ?

If your frame of reference is another currency, be it the Euro or the Indian rupee, adding the differential inflation to these numbers will give you the ranges in that currency. At the start of 2023, the median cost of capital, in US dollars, is 7.9% (8.7%) for a US (global) company, lower than the 9.6 (10.6%) at the start of 2024, for US (global) stocks, entirely because of declines in the price of risk (equity risk premiums and default spreads), but the 2024 costs of capital are higher than the historic lows of 5.8% (6.3%) for US (Global) stocks at the start of 2022. In short, if you are a company or an investor who works with fixed hurdle rates over time, you may be using a rationale that you are just normalizing, but you have about as much chance of being right as a broken clock.

What's coming?

? ? Since this post has been about risk, it is a given that things will change over the course of the year. If your question is how you prepare for that change, one answer is to be dynamic and adaptable, not only reworking hurdle rates as you go through the year, but also building in escape hatches and reversibility even into long term decisions. In case things don't go the way you expected them to, and you feel the urge to complain about uncertainty, I urge you to revisit the Chinese symbol for risk. We live in dangerous times, but embedded in those dangers are opportunities. If?you can gain an edge on the rest of the market in assessing and dealing with some of these dangers, you have a pathway to success. I am not suggesting that this is easy to do, or that success is guaranteed, but if investment is a game of odds, this can help tilt them in your favor.

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Datasets

Cost of Capital, by Industry - Start of 2024 ( & )Data Update Posts for 2024

In my last post, I looked at equities in 2023, and argued that while they did well during 2023, the bounce back were uneven, with a few big winning companies and sectors, and a significant number of companies not partaking in the recovery. In this post, I look at interest rates, both in the government and corporate markets, and note that while there was little change in levels, especially at the long end of the maturity spectrum, that lack of change called into question conventional market wisdom about interest rates, and in particular, the notions that the Fed sets interest rates and that an inverted yield curve is a surefire predictor of a recession. As we start 2024, the interest rate prognosticators who misread the bond markets so badly in 2023 ?are back to making their 2024 forecasts, and they show no evidence of having learned any lessons from the last year.

Government Bond/Bill Rates in 2023

? ? I will start by looking at government bond rates across the world, with the emphasis on US treasuries, which suffered their worst year in history in 2022, down close to 20% for the year, as interest rates surged. That same phenomenon played out in other currencies, as government bond rates rose in Europe and Asia during the year, ravaging bond markets globally.

US Treasuries?

? ? Investors in US treasuries, especially in the longer maturities, came into 2023, bruised and beaten rising inflation and interest rates. The consensus view at the start of the year was that US treasury rates would continue to rise, with the rationale being that the Federal Reserve was still focused on knocking inflation down, and would raise rates during the yearl. Implicit in this view was the belief that it was the Fed that had created bond market carnage in 2022, and in , I took issue with this contention, arguing that it was inflation that was the culprit.

1. A Ride to Nowhere - US Treasury Rates in 2023

? ? It was undoubtedly a relief for bond market investors to see US treasury markets?settle down in 2023, though there were bouts of volatility, during the course of the year. ?The graph below looks at US treasury rates, for maturities ranging from 3 months to 30 years, during the course of 2022 and 2023:

As you can see, while treasury rates, across maturities, jumped dramatically in 2022, their behavior diverged in 2023. At the short end of the spectrum, the three-month treasury bill rate rose from 4.42% to 5.40% during the year, but the 2-year rate decreased slightly from 4.41% to 4.23%, the ten-year rate stayed unchanged at 3.88% and the thirty-year rate barely budged, going from 3.76% to 4.03%. The fact that the treasury bond rate was 3.88% at both the start and the end of the year effectively also meant that the return on a ten-year treasury bond during 2023 was just the coupon rate of 3.88% (and no price change).?

2. The Fed Effect: Where's the beef?

? ?I noted at the start of this post that the stock answer than most analysts and investors, when asked why treasury rates rose or fell during much of the last decade has been "The Fed did it". Not only is that lazy rationalization, but it is just not true, and for many reasons. First, the only rate that the Fed actually controls is the Fed funds rate, and it is true that the Fed has been actively raising that rate in the last two years, as you can see in the graph below:? ?

In 2022, the Fed raised the Fed funds rate seven times, with the rate rising from close to zero (lower limit of zero and an upper limit of 0.25%) to 4.25-4.50%, by the end of the year. During 2023, the Fed continued to raise rates, albeit at a slower rate, with four 0.25% raises.?? ?Second, the argument that the Fed's Fed Funds rate actions have triggered increases in interest rates in the last two years becomes shaky, when you take a closer look at the data. In the table below, I look at all of the Fed Fund hikes in the last two years, looking at the changes in 3-month, 2-year and 10-year rates leading into the Fed actions. ?Thus, the Fed raised the Fed Funds rate on June 16, 2022 by 0.75%, to 1.75%, but the 3-month treasury bill rate had already risen by 0.74% in the weeks prior to the Fed hike, ?to 1.59%.?


In fact, treasury bill rates consistently rise ahead of the Fed's actions over the two years. This may be my biases talking, but to me, it looks like it is the market that is leading the Fed, rather than the other way around.?? ? Third, even if you are a believer that the Fed has a strong influence on rates, that effect is strongest on the shortest term rates and decays as you get to longer maturities. In 2023, for instance, for all of the stories about FOMC meeting snd the Fed raising rates, the two-year treasury declined and the ten-year did not budge.?To understand what causes long term interest rates to move, I went back to my interest rate basics, and in particular, the Fisher equation breakdown of a nominal interest rate (like the US ten-year treasury rate) into expected inflation and an expected real interest rate:

Nominal Interest Rate = Expected Inflation + Expected real interest rate

If you are willing to assume that the expected real interest rate should converge on the growth rate in the real economy in the long term, you can estimate what I call an intrinsic riskfree rate:

Intrinsic Riskfree Rate = Expected Inflation + Expected real growth rate in economy

In the graph below, I take first shot at estimating this intrinsic riskfree rate, by adding the actual inflation rate each year to the real GDP growth rate in that year, for the US:

I will not oversell this graph, since my assumption about real growth equating to real interest rates is up for debate, and I am using actual inflation and growth, rather than expectations. That said, it is remarkable how well the equation does at explaining the movements in the ten-year US treasury bond rate over time. The rise treasury bond rates in the 1970s can be clearly traced to higher inflation, and the low treasury bond rates of the last decade had far more to do with low inflation and growth, than with the Fed. In 2023, the story of the year was that inflation tapered off during the course of the year, setting to rest fears that it would stay at the elevated levels of 2022. That explains why US treasury rates stayed unchanged, even when the Fed raised the Fed Funds rate, though the 3-month rate remains a testimonial to the Fed's power to affect short term rates.?

3. Yield Curves and Economic Growth

?? ?It is undeniable that the slope of the yield curve, in the US, has been correlated with economic growth, with more upward sloping yield curves presaging higher real growth, for much of the last century. In an extension of this empirical reality, an inversion of the yield curve, with short term rates exceed long term rates, has become a sign of an impending recession. In a , I argued that if ?the slope of the yield curve is a signal, it is one with a great deal of noise (error in prediction). If you are a skeptic about the inverted yield curves as a recession-predictor, that skepticism was strengthened in 2022 and 2023:

As you can see, the yield curve has been inverted for all of 2023, in all of its variations (the difference between the ten-year and two-year rates, the difference between the two-year rate and the 3-month rate and the difference between the ten-year rate and the 3-month T.Bill rate). At the same time, not only has a recession not made its presence felt, but the economy showed signs of strengthening towards the end of the year. It is entirely possible that there will be a recession in 2024 or even in 2025, but what good is a signal that is two or three years ahead of what it is signaling??

Other Currencies

? ? The rise in interest rates that I chronicled for the United States played out in other currencies, as well. While not all governments issue local-currency bonds, and only a subset of these are widely traded, there ?is information nevertheless in a comparison of these traded government bond rates across time:

Note that these are all local-currency ten-year bonds issued by the governments in question, with the German Euro bond rate standing in as the Euro government bond rate. Note also that during 2022 and 2023, the movements in these government bond rates mimic the US treasuries, rising strongly in 2022 and declining or staying stable in 2023.? ? These government bond rates become the basis for estimating risk-free rates in these currencies, ?essential inputs if you are valuing your company or doing a?local-currency project analysis; to value a company in Indian rupees, you need a rupee riskfree rate, and to do a project analysis in Japanese yen, a riskfree rate in yen is necessary. While there are some who use these government bond rates as riskfree rates, it is worth remembering that governments can and sometimes do default, even on local currency bonds, and that these government bond rates contain a spread for default risk. I use the sovereign ratings for countries to estimate and clean up for that default risk, and estimate the riskfree rates in different currencies at the start of 2024:

Unlike the start of 2022, when five currencies (including the Euro) had negative riskfree rates, there are only two currencies in that column at the start of 2024; the Japanese yen, a habitual member of the low or negative interest rate club, and the Vietnamese Dong, where the result may be an artifact of an artificially low government bond rate (lightly traded). Understanding that riskfree rates vary across currencies primarily because of difference in inflation expectations is the first step to sanity in dealing with currencies in corporate finance and valuation.

Corporate Borrowing

? ? As riskfree rates fluctuate, they affect the rates at which private businesses can borrow money. Since no company or business can print money to pay off its debt, there is always default risk, when you lend to a company, and to protect yourself as a lender, it behooves you to charge a default or credit?spread to cover that risk:

Cost of borrowing for a company = Risk free Rate + Default Spread

The question, when faced with estimating the cost of debt or borrowing for a company, is working out what that spread should be for the company in question. Many US companies have their default risk assessed by ratings agencies (Moody's, S&P, Fitch), and ?this practice is spreading to other markets as well. The bond rating for a company then becomes a proxy for its default risk, and the default spread then becomes the typical spread that investors are charging for bonds with that rating. In the graph below, I look at the path followed by bonds in different ratings classes - AAA, AA, A, BBB, BB, B and CCC & below - in 2022 and 2023:

As with US treasuries, the default spread behaved very differently in 2023, as opposed to 2022. In 2022, the spreads rose strongly across ratings classes, and more so for the lowest ratings, over the course of the year. During 2023, default spreads reversed course, declining across the ratings classes, with larger drops again in the lowest ratings classes.? ? One perspective that may help make sense of default spread changes over time is to think of the default spread as the price of risk in the bond market, with changes reflecting the ebbs and flows in fear in the market. In my last data update, I measured the price of risk in the equity market in the form on an implied equity risk premium, and chronicled how it rose sharply in 2022 and dropped in 2023, paralleling the?movements in default spreads. The fact that fear and risk premiums in equity and bond markets move in tandem should come as no surprise, and the graph below looks at the equity risk premiums and default spreads on one rating (Baa) between 1928 and 2023: For the most part, equity risk premiums and default spreads move together, but there have been periods where the two have diverged; the late 1990s, where equity risk premiums plummeted while default spreads stayed high, preceding the dot-com crash in 2001, and the the 2003-2007 time periods, where default spreads dropped but equity risk premiums stayed elevated, ahead of the 2008 market crisis. Consequently, it is comforting that the relationship between the equity risk premium and the default spread at the start of 2024 is close to historic norms and that they have moved largely together for the last two years.

Looking to 2024

? ? If there are lessons that can be learned from interest rate movements in 2022 and 2023, it is that notwithstanding all of the happy talk of the Fed cutting rates in the year to come, it is inflation that will again determine what will happen to interest rates, especially at the longer maturities, in 2024.?If inflation continues its downward path, it is likely that we will see longer-term rates drift downwards, though it would have to be accompanied by significant weakening in the economy for rates to approach levels that we became used to, during the last decade. If inflation persists or rises, interest rates will rise, no matter what the Fed does.?

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DataData Update Posts for 2024

Heading into 2023, US equities looked like they were heading into a sea of troubles, with inflation out of control and a recession on the horizon. While stocks had their ups and downs during the year, they ended the year strong, and recouped, at least in the aggregate, most of the losses from 2022. That positive result notwithstanding, the recovery was uneven, with a big chunk of the increase in market capitalization coming from seven companies (Facebook, Amazon, Apple, Microsoft, Alphabet, NVidia and Tesla) and wide divergences in performance across stocks, in performance. As we move into 2024, it looks like expectations have been reset, with most forecasters now expecting the economy to glide in for a soft landing and interest rates to decline, and while that may seem like good news, it will represent a challenge for equity market investors.
Looking Back? ? Almost a year ago, I about what 2023 held for stocks, and it reflected the dark mood in markets, and in the face of investor gloom, looked at how the expectations game would play out for equities. In that post, I noted that if inflation subsided quickly, and the economy stayed out of a recession, stocks had upside, and that is the scenario that played out in 2023. ?Stocks ended the year well, with November and December both delivering strong up movements, and while this left investors feeling good about the year, it was a rocky year. In the graph below, I look at the monthly levels on the index and price returns, by month:
On a month-to-month basis, stocks started the year well and had a good first half, before entering a tough third quarter where they gave back most of those gains. Over the course of the year, the S&P 500 rose from 3840 to 4770, an increase of 24.23% for the year, which when added to the dividend yield of 1.83% translated into a return of 26.06% for the year:To get historical context, I compared the returns in 2023 to annual returns on the S&P 500 going back to 1928:
It was a good year, ranking 24th out of the 95 years of data that I have in my dataset, a relief after the -18.04% return in 2022.?? ? The solid comeback in stocks, though, came with caveats. The first is that it was an uneven recovery, if you break stocks down be sector, which I have, for both US and global stocks, in the table below:?


As you can see, technology was the biggest winner of the year, up almost 58% (44%) for US (global) stocks, with communication services and consumer discretionary as the next best performers. Energy, one of the few survivors of the 2022 market sell-off, had a bad year, as did utilities and consumer staples.?Breaking equities down by?sub-region, and looking across the globe, I computed the change in aggregate market capitalization, by region:
While US stocks accounted for about $9.5 trillion of the $14 trillion increase in equity market capitalization across the world, two regions did even better, at least on a percentage basis. The first was Eastern Europe and Russia, coming back from a massive sell-off in the prior two years and the other was India, which saw an increase of $1 trillion in market cap, and a 31.3% increase in market capitalization.
Looking forward? ? While there is comfort in looking backwards, slicing and dicing data in the hope of getting clues for the future, investing is about the future. Much as we like to believe that history repeats itself, and find patterns even when they do not exist, the nature of markets makes them difficult to forecast, precisely because they are driven not by what actually happens to the economy, inflation and other fundamentals, but by how these results compare to expectations. Going into 2024, investors are clearly in a better mood about what is to come this year, than they were a year ago, but they are pricing in that better mood. To capture the market's mood, I back out the expected return (and equity risk premium) that investors are pricing in, through an implied equity risk premium:
Put simply, the expected return is an internal rate of return derived from the pricing of stocks, and the expected cash flows from holding them, and is akin to a yield to maturity on bonds.?? ? To see how expectations and pricing have changed over the course of the year, I compare the implied equity risk premium (ERP) from the start of 2023 with the same number at the start of 2024 & At the start of 2023, in the midst of the market's pessimism of what the coming years would deliver, stocks were priced to earn a 9.82% annual return and a 5.94% equity risk premium. In contrast, at the start of 2024, the lifting of fear has led to higher prices, a more upbeat forecast of earnings and an expected return of 8.48% and an equity risk premium of 4.60%. I do compute this expected return and the equity risk premium at the start of each month, and the last 24 months have been a roller coaster ride:

While equity risk premiums and expected returns rose strongly in 2022, registering the largest single-year increase in history, they declined over 2023, as hope has gained an upper hand over fear.? ? To the question of whether 8.48% is a reasonable expectation for an annual return for US stocks, and 4.60% a sufficient equity risk?premium, I looked at the historical estimates for these numbers going back to 1960:While stocks had expected returns exceeding 10% for much of the 1970s and 1980s, the culprit was high interest rates, and as interest rates have declined in this century, expected returns have come down as well. The post-2008 time period also was a period of historically low interest rates, and expected returns bottomed out in 2021, before rising again in 2022. ?In the table below, I look at the expected returns and equity risk premiums at the start of 2022, 2023 and 2024 against the distribution of the corresponding variables between 1960 and 2024:
It is comforting, if you are an equity investor, to see that the expected returns are only slightly lower than the median value over the longer period, and the equity risk premium is above historical norms.? ? Needless to say, there are other metrics, measuring the cheapness or expensiveness of equities, that investors may?find more troubling. In particular, the earnings yield (the inverse of the PE ratio) for US equities will give investors pause:


Note that the EP ratio, after a surge last year, has dropped back towards 2022 levels, with the caveat being that treasury bond rates are much higher now than they were then, an attractive alternative to equities that did not exist two years ago.
Taking a Stand? ?I am not a market timer, but I do value the market at regular intervals, more to get a measure of what the market is pricing in, than to forecast future movements. In valuing the index, I follow the intrinsic value rulebook, where the value is determined by expectations of cash flows in the future, discounted back to adjust their risk.?To get expected cash flows, I start with expectations of earnings from the equities that comprise the index. For the S&P 500, the most widely followed equity index, I use the consensus estimates of aggregate earnings for 2024 and 2025, from analysts. I know that mistrust of analysts runs high, and the perception that they are cheerleaders for individual companies is often well founded, but I will stick with these forecasts for a simple reason. Having tracked analyst forecasts for four decades,I have found that analyst estimates of aggregated earnings for the index are unbiased, with analysts under estimating earnings in almost as many years as they over estimate them.?The cash flows to equity investors, especially in the United States, have increasingly taken the form of buybacks, not just supplementing but supplanting dividends. In 2023, dividends and buybacks on the S&P 500 index amounted to $1.367 trillion, 164.25 in index units, with 57.6% of these cash flows coming from buybacks. As a percent of earnings, the cumulative cash returned represented 74.8% of earnings in that year, representing a decline from payout ratios during this century (2000-2022); the median payout ratio for this period was 83%.With these earnings and cash flows as starting points, and assuming that the treasury bond rate of 3.88% is a fair interest rate, I value the S&P 500: Note that I forecast earnings beyond 2025, by assuming that growth scales down to the growth rate of the economy, estimated to be roughly equal to the riskfree rate. Unlike early in 2023, when stocks looked slightly under valued, with consensus earnings numbers and prevailing rates, stocks look over valued by about 9.2%, with a similar structure today.? ? As with any market valuation, there are risks embedded in this value. First, the consensus view that the economy will come in for a soft landing may be wrong, with a recession or a stronger recovery both in the cards; the earnings numbers will be lower than analyst estimates in a recession and higher with a stronger economy. Second, while the market is building in expectations of interest rates declining in 2024, a significant portion of that optimism comes from a delusion that the Fed can raise or lower rates at well. After all, the treasury bond rate, a much stronger driver of equity values than short term treasury rates, remained unchanged in 2023, even as the Fed repeatedly raised the Fed Fund rates, and it is very likely that the future path of the treasury bond rate will depend more on the vagaries of inflation than on the whims of Jerome Powell. In the graph below, I look at the fair index level as a function of assumptions about earnings surprises and interest rates:
Note that I report the fair index values currently, and to convert them into target levels for the index a year from now, you have to take the future value of the index, using the expected return on stocks (net of dividend yield). For instance, to get the expected index level at the end of 2024, if rates stay at around 4% and earnings come in 10% ?above expectations, is as follows:Fair value of the index in current terms = 5202Expected annual return on equities = T.Bond rate + ERP = 4% + 5% = 9%Expected price appreciation on equities = Expected annual return - Dividend yield = 9% - 1.5% = 7.5%Expected index level on 12/31/2024 (r =4%, Earnings 10% above expected) = 5202 (1.075) = 5592As you can see, you would need earnings to come in above expectations, for the current index level (4750 on January 16) to be justified, with lower interest rates providing an assist. While what-if tables like the one above are useful tools for dealing with uncertainties, a more complete assessment of uncertainty requires that I be explicit about the uncertainties I face on each input, resulting in a simulation:

Not surprisingly, with uncertainties built in, the fair value of the index has a wide range, but using the first and ninth decile, a reasonable range for the fair value would 3670 - 5200, and at the January 16 closing level of 4750, there is about a ?70% chance that the market is over valued.? ? I am sure that you will disagree with one or more of the inputs that I have used to value the index, and I welcome that disagreement. Rather than point out to me the error of my ways, please , and you should be able to replace my assumptions about earnings, cash payout and interest rates, and arrive at your own estimates of index value.?

Caveat emptor!? ? Before you take my market prognostications at face value, please consider my open disclosure that I am a terrible market timer and try to avoid it in my investing. In short, I do not plan to act on my ?market valuation by buying puts on the index, or scaling down by portfolio's equity exposure. If you are wondering why I bother valuing the index, there are two reasons. First, there are times in the past, when the overvaluation of the market is so large that it operates as a red flag on investing in equities, as an asset class, in general. That signal?worked in early 2000 but did not in early 2008, and it is thus a noisy one. Second, and more generally, though, valuing the market allows you to make sense of, and tolerance for, bullish and bearish views on the market that may diverge from your own views. ?Thus, investors and analysts who believe that rates will continue to decline, with a strong economy delivering higher-than-expected earnings, will see significant upside in this market, just as investors and analysts who believe that stubbornly higher inflation will cause rates to rise, and that earnings will come in well below expectations will be more likely to be part of the doomsday crowd. Just as in 2023, there will ?be times in 2024 when one side or the other will think that it has decisively won the argument, just to see a reversal in the next period.
YouTube Video
DatasetsSpreadsheets

Continuing an annual ritual of long standing, ahead of starting my spring teaching at NYU starting in a couple of weeks, I would like to invite you, if you are interested, to come along for the ride. I know! I know! Most of you are not enrolled at NYU, paying nosebleed prices, and that is prerequisite to be in the classroom, but thanks to technology and a loose reading of the rules that constrain me, you can get a close approximation of the classroom experience, wherever you are in the world, with broadband being your only constraint.

My Teaching Journey

? ?I am a product of my life experiences, and at the risk of boring you, I would like to give you a short history of the lucky breaks and choices that have led me to where I am today. I came to the United States in 1979, and having lived here much of my life, I feel nothing but gratitude for the kindness and opportunities that this country has offered me. I started in the MBA program at University of California at Los Angeles (UCLA) in 1979, at the tail-end of its basketball glory days, fully expecting to move on to a career in consulting or investment banking, when I was done. To ease my financial constraints, I became a teaching assistant in the second year of my MBA program, and in what I can only describe as a moment of grace, I realized that teaching was what I wanted to do with the rest of my life.?

? ? Recognizing the need for a doctorate as an entree into college teaching, I stayed on at UCLA to get my Phd. In 1984, I moved on to the University of California at Berkeley, as a visiting lecturer, teaching?anything that needed to be taught. The six classes that I prepped for in those two years ranged from banking to investments to corporate finance, and while I have never worked harder, much of what I teach today came out of those classes.?In 1986, I joined New York University's business school as an assistant professor, and asked to teach Security Analysis, a class made legendary by Ben Graham, who taught it at Columbia University in the 1950s. By 1986,?though, it was showing its age, more a collection of topics about institutions and types of securities, than a cohesive class. I balked at teaching this motley collection of?topics and wanted to teach a class on valuation, but I was told that there was not enough stuff in valuation to fill a class. I learned early in my academic life that if you want to get anything done in an academic setting, it is better to do it subversively than it is to ask (and get) official permission. In the fall of 1986, I taught a valuation class in my security analyst slot, and with no cameras in the classroom or complaints from students, no one was any wiser. In spring 2024, I will be teaching valuation again to the MBAS, for the 59th time, and I have an identical class that I will delivering to undergraduates during the semester.?

? ? The very first class that I taught at Berkeley in 1984 was an introductory corporate finance class (BA 130, for those who are from Berkeley and remember the class codes) and I have continued to teach that class as well to the MBAs at Stern, usually in the first year of the program. Since many MBAs consider taking both my corporate finance and valuation classes, I am asked what the difference is between the classes, and my explanation is that in corporate finance, we look at first principles in finance from the inside of?businesses, as owners or managers, whereas in valuation, you look at those same principles, as investors or potential investors in these companies, from the outside in. In the years that I have taught these two classes, I find myself using my corporate finance framework constantly, when valuing companies, and bringing my understanding of valuation into play, when examining how companies should make investing, financing and dividend decisions.

? ? In the 1990s, I was asked to pinch hit for a colleague and manage a semester-long class of sessions with outside speakers, all of whom were successful investors and portfolio managers. As I watched these investors come in and pitch their ideas about how markets worked and the best way to beat these markets to the students in the class, I noticed that while the speakers all shared success, they had very different perspectives about markets and divergent investment philosophies. At the end of that class, I put together a class on investment philosophies, not with the intent of picking the best one, but instead offering the entire menu, so that students could decide for themselves whether they wanted to be technical analysts, momentum trades, value investors, venture capitalists of market timers.?

Pre-Season Prep

? ? If you are new to finance or valuation, and especially if you have a non-quantitative background (a liberal arts major, a job in strategy or marketing, for example), I don't blame you for feeling intimidated at the prospect of taking a corporate finance, valuation or investment philosophies class. Investment bankers, consultants and portfolio managers often speak in a language that is foreign to those not in the space, and create an aura of mystery and layers of complexity around what they do. In my view, much of this is smoke and mirrors, and there is nothing in finance that is beyond your reach, if you are willing to use common sense and commit to doing a little bit of work that is outside your comfort zone. In particular, there are three disciplines that can help you in any finance class or analysis, and the payoff to spending time on each of them is significant.

1. The Language of Finance: Much as I take issue with the rigidity of accounting rules and the incapacity of accounting to be imaginative, the data that we use in finance is expressed in accounting terms. If you really don't understand the difference between operating earnings and net income, or know what accounting balance sheets can (and cannot) measure, you will have trouble doing any type of corporate financial analysis or valuation. That said, accounting classes are not only overkill but they also actively create perspectives that can get in the way of sensible financial analysis. A few years ago, I created , reflecting my selfish interests in accounting data, and you can find this online, if your accounting is rusty:

If you are an accountant or have an accounting degree, you may find my treatment of accounting rules to be sacrilegious, but I have a very different end game.
2. The Building Blocks of Finance: Over the decades, finance has become specialized, but it is astonishing how much of finance is still build around basic building blocks. Since many of the students in my NYU finance classes come in with a foundational class in finance already under their belt, I used to take it for granted that they had mastered those building blocks. Over time, I have learned that this is not always true, and I have a , which includes discussions of ?what risk is, and how to measure it, the time value of money and the basic macroeconomic drivers of interest rates and exchange rates.
If you are well versed in these areas already, you should skip this class and move on, but it cannot hurt to refresh the basics.
3. The Data Wranglers: We live in the age of big data, and as I watch those marketing big data make tall claims about what it can do for businesses, It is worth remembering that finance discovered the power of data decades ago, and that its effects on practice have been mixed. In particular, we have discovered that having more financial data does not always lead to better decisions and that our behavioral quirks can lead us to skew and ignore data. It is for that reason that I find myself turning more and more to statistics, a discipline designed to take large amounts of contradictory data and make sense of that data. Again, I have a short course that I put together that needed in finance, from summary statistics (averages, medians) to measures of relationships (correlations, covariances) to predictive and analytics tools (regressions, simulations):? ??

If you are a statistics maven, you will undoubtedly find my discussion of statistical topics to be simplistic and naive, but if you are not, I hope that this revisiting of statistical concepts helps.

Learning Choices

? ? If I have not already talked you out of taking my classes, and you are still interested, the classes exist in multiple formats, and you can make your choice, based upon time?available, preferences and end games.

The Classes

? ? In the first section of this post, I described the history of the three classes that I teach - the corporate finance class that I first taught at Berkeley in 1984 and have taught every year since, the valuation class that I sneaked in, as a replacement for security analysis, into my NYU classroom in 1986, and my investment philosophies class, born out of my experience listening to great investors talk about how they make money.?

? ? ?I describe my corporate finance class as an applied, big-picture class.?It is a big-picture class because it is really a class about how to run a business, from a financial principles perspective, and every decision that a business makes is ultimately a corporate finance decision. The class tries to answer three core questions that every business, small or large, public or private, faces - the investment question (of whether and how much to invest in new projects/assets, the financing question of how much to borrow and in what form and the dividend question of how much cash to return to shareholders, if at all:

??

It is an applied class, because I answer each of these questions for a mix of companies that range the spectrum from large to small, developed to emerging market and from public to private - Disney, Vale, Tara Motors, Baidu, Deutsche Bank and a privately owned bookstore in New York Since these are real businesses exposed to changes in real time, there will be surprises that they deliver during the next few months that will become fodder for discussion.?

?? ?The corporate finance class ends with a valuation segment, where I link the decisions that companies make on the investing, financing and dividend dimension to value. I pick up on that segment in the valuation class, which I describe grandiosely as a class about valuing and pricing just about anything and from any perspective:

Rather than use case studies and abstractions, this class is built around valuing businesses in real time, and the companies that hit the news during the course of the next few months will find their way into my classroom versions of the valuation class. While it is offered to both undergraduates and MBAs, the class is identical in terms of content, and you can pick either to follow.? ? The investment philosophies class covers the spectrum of investment philosophies, and I have classified them in the picture below, based upon whether they are built around value or pricing. If you find that contrast mystifying, tune in to the class, and I will clarify:

The end game with this class is not to sell you on the best investment philosophy, but the one that best fits you, based upon what you bring to the game.

Class Format

? ? My classes are available in three formats. The first is the classroom format, where you can watch recordings of my undergraduate and MBA classes at Stern this semesters, shortly after they are delivered in real time. In that format, you will also have access to all of the materials that I use in the classroom, including lectures notes and exams/quizzes, and if you really want to get close to classroom-experience, you can ?do the project that everyone in class is required to do. You will not get credit or a grade, and you are not enrolled the class, but you don't have to pay tuition. The second is a free online version that I have created for each class, with the lectures shrunk (in substance and time) to be more attuned to an online audience. You can , and as with the classroom classes, be able to download lecture notes and quizzes. The third is an online and paid version offered by NYU, where there are professional recordings of the online lectures, administered and grades quizzes and exams and virtual office hours. You will get an official certificate of course completion with this class, but NYU will extract its (financial) pound of flesh in the form of a tuition payment.

table.tableizer-table { font-size: 12px; border: 1px solid #CCC; font-family: Arial, Helvetica, sans-serif; } .tableizer-table td { padding: 4px; margin: 3px; border: 1px solid #CCC; } .tableizer-table th { background-color: #104E8B; color: #FFF; font-weight: bold; }Class FormatCostCreditTimingSessionsMaterialPersonal Interaction $0 NoneTaught Jan - May 2024, but flexible on your partTwenty six 80-minute recorded sessions (MBA) or twenty eight 75-minute sessons (Undergraduate)Lecture notes, additional material, quizzes/exams and final project None, unless you are an NYU student in the class $0 NoneFlexible26-36 online 10-20 minutes recorded sessionsLecture notes, post-class testsNone Online (NYU Certificate)$2,200 CertificationJan - May 202426-36 online 10-20 minutes recorded sessionsLecture notes, post-class tests, quizzes/exams, projectOne live virtual office hour every two weeks.

I want to emphasize that if you decide to follow the classroom or online versions of the class, it is entirely informal and that it has nothing to do with NYU. There is no registration, recording or access to NYU resources that come with taking these classes. ?If you take the certificate class, you will have a more formal relationship with NYU.?

?? ?In choosing between these alternatives (and I really am completely okay with any choice you make), here are some things to consider:

Financial constraints: If you are budget-constrained, your choice is a simple one. Since my NYU certificate classes are available, with almost nothing held back, for free on my webpage, why pay for these classes? The corollary to this proposition, however, is if you do choose to take the certificate class, please recognize that NYU sets the prices and complaining to me that the price is too high accomplishes nothing.Time constraints: You have lives to live, work to do and families that you want to spend time with, and adding one of my classes to the list of things to do will eat into your time. The NYU certificate classes run on a semester clock, and if it looks like you will be busy for the next few months, you may find yourself unable to finish the class. Unlike some university-offered certificate classes, I do require those who take these certificate classes show me through a project and exams that they understand the material, and I don't give free passes. The two free versions (classroom and free online) do not operate on a calendar. In short, you can start with the regular class in January 2024 and stretch out the class over 12 months or 18 months, if you want to.End game: Much as we all like to buy into the notion that learning is what matters, the truth is that some of you may want to use proof of that learning as a ticket to improve your standing in life (get a different job, move up in the ranks). With the free versions, you may very well learn just as much as those taking the class in the classroom, but you will get no credit for the class. Of course, you will get the certificate if you take the NYU certificate version, but NYU will extract its pound of flesh.Updating: You will ?be watching recorded lectures in all three versions of the class, but the timing of these recordings will be different. With the classroom format, you will get an updated 2024 version and in real time, but with the online versions (free and certificate), the sessions will reflect when they were recorded. While my framework and fundamentals remain the same, the examples I will be using will reflect this updating (or lack of it).Personal preferences: The online sessions (free and certificate) are shorter (10-20 minutes) and thus more easily amenable to online consumption. Watching an 80-minute session online is not easy, especially in a world of TikTok and short YouTube videos. You may want to try both formats, before you decide.The links to all of the classes in their different formats is below: table.tableizer-table { font-size: 12px; border: 1px solid #CCC; font-family: Arial, Helvetica, sans-serif; } .tableizer-table td { padding: 4px; margin: 3px; border: 1px solid #CCC; } .tableizer-table th { background-color: #104E8B; color: #FFF; font-weight: bold; }ClassLink Accounting 101 Foundations of Finance Statistics Corporate Finance (MBA) Corporate Finance (Online Free) Corporate Finance (NYU Certificate) Valuation (MBA) Valuation (Undergrads) Valuation (Online Free)https://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcastvalonline.htm Valuation (NYU Certificate) Inv Philosophies(Online Free) Inv Philosophies (NYU Certificate)

Note that the certificate classes for the spring 2024 will be open for enrollment only until Sunday, January 14, 2024, and that the corporate finance certificate class is available only in the fall.

Sequencing

? ? I like all the classes I teach, and if you asked which one you should take, I would be unable to answer, partly because it depends on what you plan to do in the future. If your question is about sequence, i.e., which classes should be taken first, that too will depend on what your background is and your end game. To help you make these choices, I put together a flow chart:

In fact, you may short circuit this sequencing and take only a portion of a class. Thus, if you are involved in banking or project financing, you may choose to take only the capital structure part of the corporate finance class, and if you are a trader, your focus may be on the pricing portion of the valuation class.?

The Joy of Learning

? ? As I?watch?young children experience the joy of learning, it reinforces my belief that human beings love to learn and that the tragedy of education systems is that they seem to be designed to destroy that love. It would be hubris on my part to claim that I will make you rediscover that love, but I do know that one reason I teach is to expose people to how much I enjoy learning new things or relearning old lessons. I hope that you can see that joy and that some of it rubs off on you!?

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?? ?In January 1993, I was valuing a retail company, and I found myself wondering what a reasonable margin was for a firm operating in the retail business. In pursuit of an answer to that question, I used company-specific data from Value Line, one of the earliest entrants into the investment data business, to compute an industry average. The numbers that I computed opened my eyes to how much perspective on the high, low, and typical values, i.e., the distribution of margins, helped in valuing the company, and how little information there was available, at least at that time, on this dimension. That year, I computed these industry-level statistics for five variables that I found myself using repeatedly in my valuations, and once I had them, I could not think of a good reason to keep them secret. After all, I had no plans on becoming a data service, and making them available to others cost me absolutely nothing. In fact, that year, my sharing was limited to the students in my classes, but in the years following, as the internet became an integral part of our lives, I extended that sharing to anyone who happened to stumble upon my website. That process has become a start-of-the-year ritual, and as data has become more accessible and my data analysis tools more powerful, those five variables have expanded out to more than two hundred variables, and my reach has extended from the US stocks that Value Line followed to all publicly traded companies across the globe on much more wide-reaching databases. Along the way, more people than I ever imagined have found my data of use, and while I still have no desire to be a data service, I have an obligation to be transparent about my data analysis processes. I have also developed a practice in the last decade of spending much of January exploring what the data tells us, and does not tell us, about the investing, financing and dividend choices that companies made during the most recent year. In this, the first of the data posts for this year, I will describe my data, in terms of geographic spread and industrial breakdown, the variables that I estimate and report on, the choices I make when I analyze data, as well as caveats on best uses and biggest misuses of the data.?
The Sample
? ? While there are numerous services, including many free ones, that report data statistics, broken down by geography and industry, many look at only subsamples (companies in the most widely used indices, large market cap companies, only liquid markets), often with sensible rationale ¨C that these companies carry the largest weight in markets or have the most reliable information on them. Early in my estimation life, I decided that while this rationale made sense, the sampling, no matter how well intentioned, created sampling bias. Thus, looking at only the companies in the S&P 500 may give you more reliable data, with fewer missing observations, but your results will reflect what large market cap companies in any sector or industry do, rather than what is typical for that industry.
?? ?Since I am lucky enough to have access to databases that carry data on all publicly traded stocks, I choose all publicly traded companies, with a market price that exceeds zero, as my universe, for computing all statistics. In January 2024, that universe had 47,698 companies, spread out across all of the sectors in the numbers and market capitalizations that you see below:

Geographically, these companies are incorporated in 134 countries, and while you can download the number of companies listed, by country, in a dataset at the end of this post, I break the companies down by region into six broad groupings ¨C United States, Europe (including both EU and non-EU countries, but with a few East European countries excluded), Asia excluding Japan, Japan, Australia & Canada (as a combined group) and Emerging Markets (which include all countries not in the other groupings), and the pie chart below provides a picture of the number of firms and market capitalizations of each grouping:

Before you take issue with my categorization, and I am sure that there are countries or at least one country (your own) that I have miscategorized, I have three points to make, representing a combination of mea culpas and explanations. First, these categorizations were created close to twenty years ago, when I first started looking a global data, and many countries that were emerging markets then have developed into more mature markets now. Thus, while much of Eastern Europe was in the emerging market grouping when I started, I have moved those countries that have either adopted the Euro or grown their economies strongly into the Europe grouping. Second, I use these groupings to compute industry averages, by grouping, as well as global averages, and nothing stops you from using the average of a different grouping in your valuation. Thus, if you are from Malaysia, and you believe strongly that Malaysia is more developed than emerging market, you should look at the global averages, instead of the emerging market average. Third, the emerging market grouping is now a large and unwieldy one, including most of Asia (other than Japan), Africa, the Middle East, portions of Eastern Europe and Russia and Latin America. Consequently, I do report industry averages for the two fastest growing emerging markets in India and China.
The Variables
?? ?As I mentioned at the start of this post, this entire exercise of collecting and analyzing data is a selfish one, insofar as I compute the data variables that I find useful when doing corporate financial analysis, valuation, or investment analysis. I also have quirks in how I compute widely used statistics like accounting returns on capital or debt ratios, and I will stay with those quirks, no matter what the accounting rule writers say. Thus, I have treated leases as debt in computing debt ratios all through the decades that I have been computing this statistic, even though accounting rules did not do so until 2019, and capitalized R&D, even though accounting has not made that judgment yet.??? ?In my corporate finance class, I describe all decisions that companies make as falling into one of three buckets ¨C investing decisions, financing decision and dividend decisions. My data breakdown reflects this structure, and here are some of the key variables that I compute industry averages for on my site:
table.tableizer-table { font-size: 12px; border: 1px solid #CCC; font-family: Arial, Helvetica, sans-serif; } .tableizer-table td { padding: 4px; margin: 3px; border: 1px solid #CCC; } .tableizer-table th { background-color: #104E8B; color: #FFF; font-weight: bold; }?Corporate Governance & Descriptive??? ??1.??? ??2.??? ??3. ??? ?????? Investing Principle?Financing Principle?Dividend Principle? Hurdle RateProject ReturnsFinancing MixFinancing TypeCash ReturnDividends/Buybacks 1. 1. 1. 1.1. 1. 2. 2. 2. 2.2. ? 3. 3. 3??? 4. 4. ?4. ??? ?5. ???Many of these corporate finance variables, such as the costs of equity and capital, debt ratios and accounting returns also find their way into my valuations, but I add a few variables that are more attuned to my valuation and pricing data needs as well.
table.tableizer-table { font-size: 12px; border: 1px solid #CCC; font-family: Arial, Helvetica, sans-serif; } .tableizer-table td { padding: 4px; margin: 3px; border: 1px solid #CCC; } .tableizer-table th { background-color: #104E8B; color: #FFF; font-weight: bold; }Valuation?Pricing Growth & ReinvestmentProfitabilityRiskMultiples 1.1. 1. 1. 2. 2. 2. 2. 3.
?3. 4.??4. s 5. ??? 6. ??Thus, I compute pricing multiples based on revenues (EV to Sales, Price to Sales), earnings (PE, PEG), book value (PBV, EV to Invested Capital) or cash flow proxies (EV to EBITDA). In recent years, I have also added employee statistics (number of employees and stock-based compensation) and measures of goodwill (not because it provides valuable information but because of its potential to cause damage to your analysis).??? ?My data is primarily micro-focused, since there are other services that are much better positioned to provide macro data (on inflation, interest rates, exchange rates etc.). My favorite remains the Federal Reserve data site in St. Louis (, and one of the great free data resources in the world), but there are a few macro data items that I estimate, primarily because they are not as easily available, or if available, are exposed to estimation choices. Thus, I report , mostly because data services seem to focus on individual asset classes and partly because I want to make sure that returns are computed the way I want them to be. I also have (forward-looking and dynamic estimate of what investors are pricing stocks to earn in the future) for the S&P 500 going back annually to 1960 and monthly to 2008, and equity risk premiums for countries.?
The Industry Groupings?? ?I am aware that there are industry groupings that are widely used, including industry codes (SIC and NAICS), I have steered away from these in creating my industry groupings for a few reasons. First, I wanted to create industry groupings that were intuitive to use for analysts looking for peer groups, when analyzing companies. Second, I wanted to maintain a balance in the number of groupings - having too few will make it difficult to differentiate across businesses and having too many will create groupings with too few firms for some parts of the world. The sweet spot, as I see it, is around a hundred industry groupings, and I get pretty close with 95 industry groupings; the table below lists the number of firms within each in my data:
No matter how carefully you create these groupings, you will still face questions about where individual companies fall, especially when each company can be assigned to one industry group. Is Apple a personal computer company, an entertainment company or wireless telecom company? While you can allow it to be in all three, when analyzing the companies, for purposes of computing industry averages, I had to assign each company to a single grouping. If you are interested in seeing which companies fall within each group, you can find it by clicking . (Be patient. This is a large dataset and can take a while to download)?
Data Timing & Currency Effects?? ?In computing the statistics for each of the variables, I have one overriding objective, which is to make sure that they reflect the most updated data that I have at the time that I compute them, which is usually the first week of January. That does lead to what some of you may view as timing contradictions, since any statistic based upon market data (costs of equity and capital, equity risk premiums, risk free rates) is updated to the date that I do the analysis (usually the values at the close of the last trading day of the prior year ¨C Dec 31, 2023, for 2024 numbers), but any statistic that uses accounting numbers (revenues, earnings etc.) will reflect the most recent quarterly accounting filing. Thus, when computing my accounting return on equity in January 2024, I will be dividing the earnings from the four quarters ending in September 2023 (trailing twelve month) by the book value of equity at the end of September 2022. Since this is reflecting of what investors in the market have access to at the start of 2024, it fulfils my objective of being the most updated data, notwithstanding the timing mismatch.?? ?There are two perils with computing statistics across companies in different markets. The first is differences in accounting standards, and there is little that I can do about that other than point out that these differences have narrowed over time. The other is the presence of multiple currencies, with companies in different countries reporting their financials in different currencies. The global database that I use for my raw data, S&P Capital IQ, gives me the option of getting all of the data in US dollars, and that allows for aggregation across global companies. In addition, most of the statistics I report are ratios rather than absolute values, and are thus amenable to averaging across multiple countries.
Statistical Choices?? ?In the interests of transparency, it is worth noting that there are data items where the reporting standards either don¡¯t require disclosure in some parts of the world (stock-based compensation) or disclosure is voluntary (employee numbers). When confronted with missing data, I do not throw the entire company out of my sample, but I report the statistics only across companies that report that data.?? ?In all the years that I have computed industry statistics, I have struggled with how best to estimate a number that is representative of the industry. As you will see, when we take a closer look at individual data items in later posts, the simple average, which is the workhorse statistic that most services report for variables, is often a poor measure of what is typical in an industry, either because the variable cannot be computed for many of the companies in the industry, or because, even when computed, it can take on outlier values. Consider the PE ratio, for example, and assume that you trying to measure a representative PE ratio for software companies. If you follow the averaging path, you will compute the PE ratio for each software company and then take a simple average. In doing so, you will run into two problems.?First, when earnings are negative, the PE ratio is not meaningful, and if that happens for a large number of firms in your industry group, the average you estimate is biased, because it is only for the subset of money-making companies in the industry.?Second, since PE ratios cannot be lower than zero but are unconstrained on the upside, you will find the average that you compute to be skewed upwards by the outliers.?Having toyed with alternative approaches, the one that I find offers the best balance is the aggregated ratio. In short, to compute the PE ratio for software companies, I add up the market capitalization of all software companies, including money-losers, and divide by the aggregated earnings across these companies, against including losses. The resulting value uses all of the companies in the sample, reducing sampling bias, and is closer to a weighted average, alleviating the outlier effect. For a few variables, I do report the conventional average and median, just for comparison.?
Using the data?? ?As I noted earlier, the datasets that I report are designed for my use, in corporate financial analysis and valuation that I do in real time. Thus, I plan to use the 2024 data that you see, when I value companies or do corporate financial analysis during the year, and if you are a practitioner doing something similar, it should work for you. You can find this , organized to reflect the categories.??? ?That said, there are some of you who are not doing your analysis in real time, either because you are in the appraisal business and must value your company as of the start of 2020 or 2021, or a researcher looking at changes over time. I do maintain the on my webpage, and if you click on the relevant data, you can get the throwback data from prior years.?? ?There are two uses that my data is put to where you are on your own. The first is in legal disputes, where one or both sides of the dispute seem to latch on to data on my site to make their (opposing) cases. While I clearly cannot stop that from happening, please keep me out of those fights, since there is a reason I don¡¯t do expert witness of legal appraisal work; courts are the graveyards for good sense in valuation. The other is in advocacy work, where data from my site is often selectively used to advance a political or business argument. My dataset on what companies pay as tax rates seems to be a favored destination, and I have seen statistics from it used to advance arguments that US companies pay too much or too little in taxes.??? ?Finally, my datasets do not carry company-specific data, since my raw data providers (fairly) constrain me from sharing that data. Thus, if you want to find the cost of capital for Unilever or a return on capital for Apple, you will not find it on my site, but that data is available online already, or can be computed from the financial releases from these companies.
A Sharing Request?? ?I will end this post with words that I have used before in these introductory data posts. If you do use the data, you don¡¯t have to thank me, or even acknowledge my contribution. Use it sensibly, take ownership of your analysis (don¡¯t blame my data for your value being too high or low) and pass on knowledge. It is one of the few things that you can share freely and become richer as you share more. Also, as with any large data exercise, I am sure that there are mistakes that have found their way into the data, and if you find them, let me know, and I will fix them as quickly as I can!
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Links to my dataData Update Posts for 2024

Data Update 1 for 2024: The data speaks, but what does it say?

?? ?Can one person make a difference to the value of a business? Of course, and with small businesses, especially those built around personal services (a doctor or plumber¡¯s practice), it is part of the valuation process, where the key person is valued or at least priced and incorporated into valuation. While that effect tends to fade as businesses get larger, the tumult at Open AI, where the board dismissed Sam Altman as CEO, and then faced with an enterprise-wide meltdown, as capital providers and employees threatened to quit, illustrates that even at larger entities, a person or a few people can make a value difference. In fact, at Tesla, a company that I have valued at regular intervals over the last decade, the question of what Elon Musk adds or detracts from value has become more significant over time, rather than fading. Finally, Charlie Munger's passing at the age of ninety-nine brought to a close one of the most storied key person teams of all time at Berkshire Hathaway, and generations of investors who had attached a premium to the company because of that team's presence mourned.
Key Person: Who, what and why??? ?While it is often assumed that key people, at least from a value perspective, are at the top of the organization, usually founders and top management, we will begin this section by expanding the key person definition to include anyone in an organization, and sometimes even outside it. We will then follow up with a framework for thinking about how key people can affect the value of a business, with practical suggestions on valuing and pricing key people. We will end with a discussion of how enterprises try, with mixed effects, to build protections against the loss of key personnel.
Who is a key person??? ?In the Open AI, Tesla and Berkshire Hathaway cases, it is persons at the top of the organization that have been identified as key value drivers, but the key people in an organization can be at every level, with differing value effects.?It starts of course with founders who create organizations and lead them through their early years, partly because they represent their companies to the rest of the world, but more because they mold these companies, at least in their formative years. It is worth noting that while some reach legendary status, sharing their names with the organization (like Ford and HP), others are unceremoniously pushed aside, because they were viewed, rightly or wrongly, as unfit to lead their own creations.?Staying at the top, CEOs for companies often become entwined with their companies, especially as their tenure lengthens. From Alfred Sloan at General Motors to Jack Welch at General Electric to Steve Jobs at Apple, there is a history of CEOs being tagged as superstars (and indispensable to the organizations that they head), in successful companies. By the same token, as with founders, the failures of businesses often rub off on the people heading them, fairly or unfairly.As you move down the organization, there can be key players in almost every aspect of business, with scientists at pharmaceutical companies who come up with pathbreaking discoveries that become the basis for blockbuster drugs or design specialists like Jon Ive at Apple, whose styling for Apple¡¯s devices was viewed as a critical component of the company's success. ?The skills they bring can be unique, or at least very difficult to replace, making them indispensable to the organization's success.In businesses driven by selling, a master-salesperson or dealmaker can become a central driver of its value, bringing in a clientele that is more attached to the sales personnel than they are to the organization providing the product or service. In businesses like banking, consulting or the law, rainmakers can represent a significant portion of value, and their departure can be not just damaging but catastrophic.In people-oriented businesses, especially in service, a manager or?employee that cultivates strong relationships with customers, suppliers and other employees, can be a key person, with the loss of that person leading to not just lost sales, as clients flee, but create ripple effects across the organization.In some businesses, the key person may not work for the organization but contribute a significant amount to its value as a spokesperson or product brander. In sports and entertainment, for instance, business can gain value from having a celebrity representing them in a paid or unpaid capacity. In my valuation of Birkenstock for their IPO, just a few weeks ago, I noted the value added to the company by Kate Moss or Steve Jobs wearing their sandals. Over the decades, a significant part of Nike¡¯s value has been gained and sometimes lost from the celebrities who have attached their names to its shoes.In short, the key person or people in an organization can range the spectrum, with the only thing in common being a ¡°significant effect¡± on value or price.
Key Person(s): Value effects?? ?Given my obsession with value, it should come as no surprise that my discussion of key people begins by looking at the many ways that they can affect value. As I identify the multiple key person value drives, note that not all key people affect all value drivers, and the value effects can also vary not only widely across key people, but for the same key person, across time. At the risk of being labeled as a one-trick pony, I will use my intrinsic value framework, and by extension, the It Proposition, where if it does not affect cash flow or risk, it cannot affect value, to lay out the different effects a key person can have on value:
For personnel at the top, and I include founders and CEOs, the effect on value comes from setting the business narrative, i.e., the story that animates the numbers (revenue growth, profit margins, capital intensity and risk) that drives value., and that effect, as I have noted in my earlier discussions of narrative and numbers, can be all encompassing. The effects of people lower down in the organization tend to be more focused on one or two inputs, rather than across the board, but that does not preclude the effect from being substantial. A salesperson who accounts for half the sales of a business and most of its new customers will influence value, through revenues and revenue growth, whereas an operations manager who is a supply chain wizard can have a large impact on profit margins. ?As someone who teaches corporate finance, I have always tried to pass on the message, especially to those who are headed to finance jobs at companies or investment banks, that of all of the players in an organization, finance people are among the most replaceable, and thus least likely to be key people. It is perhaps the reason that you are less likely to see a company¡¯s value implode even when a well-regarded CFO leaves, though there are exceptions, especially with distressed or declining companies, where financial legerdemain can make the difference between survival and failure.?? ?With this framework, valuing a key person or persons becomes a simple exercise, albeit one that may require complex assumption. To estimate key person value, there are three general approaches:1. Key person valuation: ?You value the company twice, once with the key persons included, with all that they bring to it¡¯s cash flows and value, and then again, without those key persons, reflecting the changes that will occur to value inputs:Value of key person(s) = Value of business with key person - Value of business without key personA key person whose effect on a business is identifiable and isolated to one of the dimensions of value will be easier to value than one whose effects are disparate and difficult to isolate. Thus, valuing a key salesperson is easier than valuing a key CEO, since the former's effects are only on sales and can be traced to that person's efforts, whereas the effect of a CEO can be on every dimension of value and difficult to separate from the efforts of others in the organization.
2. Replacement Cost: In some cases, the value of a key person can be computed by estimating the cost of replacing that person. Thus, key people with specific and replicable skills, such as skilled scientists or engineers, may be easier to value than key people, with fuzzier skill sets, such as strong connections and people skills. However, finding replacements for people with unique or blended skills can be more difficult, since they may not exist.3. Insurance cost: Finally, there are some key people in an organization who can be insured, where insurance companies, in return for premium payments, will pay out an amount to compensate for the losses of these key people. For companies that buy insurance, the key person value then become monetized as a cost, reducing the value of these companies when the key person is present, while increasing its value, when it loses that person.?? ?The key person valuation approach, while general, can not only yield different values for key people, but also generate a value effect that is negative for a key person whose influence has become malignant. ?The framework can also help explain how the value of a key person can evolve over time, from a significant positive at one stage of an organization to neutral later or even a large negative, explaining why some key people get pushed out of organizations, including those that they may have founded.?
Key Person(s): Pricing effects?? ?It is true that markets are pricing mechanisms, not instruments for reflecting value, at least in the short term, and it should come as no surprise then that the effects of a key person are captured in pricing premiums or discounts, sometime arbitrary, and sometimes based upon data. In this section, I will start with the practices used by appraisers to try to adjust the pricing of businesses for the presence or potential loss of a key person and then move on to how markets react to the loss of key personnel at publicly traded companies.?? ?In appraisal practice, the effect of the potential loss of an owner, founder or other key person in a business that you are acquiring is usually captured with a key person discount, where you price the business first, based upon its existing financials, and then reduce that pricing by 15%, 20% or more to reflect the absence of the key person. Shannon Pratt, in his widely used work on valuing private companies, suggested a key person discount of between 10%-25%, though he left the number almost entirely to appraiser discretion. In addition, the nature of private company appraisal, where valuations are done for tax or legal purposes, has also meant that the acceptable levels of discount for key people have been determined more by courts, in their rulings on these valuations, than by first principles.?? ?In public companies, the market reaction to the loss of key personnel can be an indication of how much investors priced the presence of those personnel. Empirically, the research in this area is deepest on CEO departures, with the market reaction to those departures broken down by cause into Acts of God (death), firing or retirement.?CEO Deaths: In the , the imperious CEO of the company causes the stock price of Waystar Royco, his family-controlled company, to drop precipitously. While that was fiction, and perhaps exaggerated for dramatic effect, there is research that looks at the market reaction to the deaths of CEOs of publicly traded companies, albeit with mixed results. A ?between 1950 and 2009?finds that in almost half of all of these cases, the stock price increases on the death of a CEO, and unsurprisingly, the reactions tended to be negative with under-performing CEOs and positive with highly regarded ones. Interestingly, this study also finds that the impact of CEOs, both positive and negative, was greater in the later time periods, than in earlier periods. A?documented that the stock price reaction to CEO deaths was greater for longer-tenured CEOs in badly performing firms, strengthening the negative value effect argument.CEO (forced) replacements: CEOs are most likely to be replaced in companies, where their policies are at odds with those that their shareholders desire, but given the powers of incumbency, change may require the presence of a large and vocal shareholder (activist), pushing for change. To the extent that shareholders have good reasons to be disgruntled, the companies can be viewed as case studies for key-person negative value, where the top manager is reducing value with his or her actions. Research on what happens to stock prices and company performance after forced replacements with stock prices rising on the firing, and improved performance following, under a new CEO.CEO retirements: If CEO deaths represent unexpected losses of key people, and CEO dismissals represent the subset of firms where CEOs are more likely to be value-reducing key people, it stands to reason that CEO retirements should be more of a mixed bag. Research backs up this hypothesis, with the average stock price reaction to voluntary CEO departures being close to zero, with a mildly negative reaction to age-related departures. It is worth noting that market reactions tend to be much more positive, when CEOs are replaced by outsiders than by someone from within the firm, suggesting that shareholders see value in changing the way these businesses are run.The positive reaction, at least on average, to CEO firing is understandable since CEOs usually get replaced by boards only after extended periods of poor performance at companies or personal scandal, and investors are pricing in the expectation that change is likely to be positive. The positive reaction to some CEO deaths is macabre, but it does reflect the reality that they are more likely to occur in organizations that are badly in need of fresh insights.?? ? There are a few case studies that look at how the market reacts to a company signing or losing a key celebrity spokesperson or product endorser, especially when that loss is unexpected. Thus, when Tiger Woods, who operated as a spokesperson or product endorser for five companies (Accenture, Nike, Gillette, Electronic Arts and Gatorade), had personal troubles that were made public, . That should come as little surprise, since Tiger Wood's product endorsements, prior to this incident, had added significant value to these companies, with o, after the endorsement.??In an earlier episode, Nike also lost billions in market capitalizations, when Michael Jordan, an NBA superstar whose name-branded footwear (Air Jordan) had become a game changer for Nike, , that he would be retiring from basketball, to play baseball. Finally, and this is perhaps a reach at this point, the biggest story coming out of the National Football League (NFL) this year has been the Taylor Swift-Travis Kielce romance, which in addition to creating tabloid headlines, has , especially among women. Is it possible that the person who adds the most value to the NFL this year is not Patrick Mahomes (its highest profile quarterback) or Roger Goodell (its commissioner), but a pop star? Time will tell, but it is not an implausible claim.
Managing Key Person ValueA business that has significant positive value exposure to a key person can try to mitigate that risk, albeit with limits. The actions taken can vary depending on the key person involved, with more effective protections against losses that are easily identifiable.Insurance: Smaller businesses that are dependent on a person or persons for a significant portion of their revenues and profits can buy insurance against losing them, with the insurance premia reflecting the expected value loss. To the extent that the insurance actuaries who assess the premiums are good at their jobs, companies buying key person insurance even out their earnings, trading lower earnings (because of the premiums paid) in periods when the key person is still present for higher earnings, when they are absent. It is also true that key person insurance is easier to price and buy, when the effects of a key person are separable and identifiable, as is the case of a master salesperson with a track record, than when the effects are diffuse, as is the case for a star CEO who sets narrative.No-compete clauses: One of the concerns that businesses have with key people is not just the loss of value from their departure, but that these key people can take client lists, trade secrets or product ideas to a competitor. It is for this reason that companies put in no-compete clauses into employment contracts, but the degree of protection will depend on what the key person takes with them, when they leave. No-compete clauses can prevent a key person from taking a client list or soliciting clients at a direct competitor, but will offer little protection when the skills that the person possesses are more diffuse.Overlapping tenure: As we noted earlier, it is routine, when pricing smaller, personal service businesses to attach a significant discount to the pricing of those businesses, on the expectation that a portion of the client base is loyal to the old owner, not the business. Since this reduces the sales proceeds to the old owner, there is an incentive to reduce the key person discount, and one practice that may help is for the old owner to stay on in an official or unofficial capacity, even after the business has been sold, to smooth the transition.Team building: To the extent that key people can build teams that reflect and magnify their skills, they are reducing their key person value to the business. That team building includes hiring the ¡°right¡¯ people and not just offering them on-the-job training and guidance, but also the autonomy to make decisions on their own. In short, key people who refuse to delegate authority and insist on micro-management will not build teams that can do what they do.Succession planning: For key people at the top of organizations, the importance of succession planning is preached widely, but practiced infrequently. A good succession plan starts of course by finding the person with the qualities that you believe are necessary to replicate what the key person does, but being willing to share knowledge and power, ahead of the transfer of power.As you can see, some of the actions that reduce key people value must come from those key people, and that may seem odd. After all, why would anyone want to make themselves less valuable to an organization? The truth is that from the organization's perspective, the most valuable key people find ways to make themselves more dispensable and less valuable over time by finding successors and building teams who can replicate what they can do. That may be at odds with the key person's interests, leading to a trade off a lower value added from being key people for a much higher value for the organization, and if they own a large enough stake in the latter, can end with being better off financially at the end. I have been open about my loyalty to Apple over the decades, but even as an Apple loyalists, I admire Bill Gates for building a management team that he trusted enough, at Microsoft, to step down as CEO in 2000, and while I cringe at Jeff Bezos becoming tabloid fodder, he too has built a company, in Amazon, that will outlast him.?
Determinants of Key Person Value
?? ?If key person value varies across businesses and across time, it is worth examining the forces that determine that value effect, looking for both management and investment lessons. In particular, key people will tend to matter more at smaller enterprises than at larger ones, more at younger firms than at mature businesses, more at businesses that are driven by micro factors than one driven by macro forces and more at firms with shifting and transitory moats than firms with long-standing competitive advantages.
Company size?? ?In general, the value of a key person or persons should decrease as an organization increases in size. The value added by a superstar trader will be greater if he or she works at a ten-person trading group than if they work at a large investment bank. There are clearly exceptions to this rule, with Tesla being the most visible example, but at the largest companies, with hundreds or even thousands of employees, and multiple products and clients, it becomes more and more difficult for a single person or even a group of people to make a significant difference.?
Stage in Corporate Life Cycle?? ?I have written about how companies, like human beings, are born, mature, age and die, and have used the corporate life cycle as a framework to talk about corporate financial and investment choices. I also believe it provides insight into the key person value discussion:As you can see, early in the life cycle, where the corporate narrative drives value, a single person, usually a founder, can make or break the business, with his or her capacity to set narrative and inspire loyalty (from employees and investors). As a business ages, CEOs matter less, as the business takes form, and scales up, and less of its value comes from ?future growth. At mature companies, CEOs often are custodians of value in assets in place, playing defense against competitors, and while they have value, their potential for value-added becomes smaller. ?At a company facing decline, the value of a key person at the top ticks up again, partly in the hope that this person can resurrect the company and partly because a CEO for a declining company who doubles down on bad growth choices can destroy value over short periods. The research provides support, with evidence that CEO deaths at young companies more likely to evoke large negative stock price reactions.??? ?This life-cycle driven view of the value of to management may provide some perspective into the key person effects at both Open AI and Tesla.At OpenAI, for better or worse, it is Sam Altman who has been the face of the company, laying out the narrative for the future of AI, and Open AI remains a young company, notwithstanding its large estimated value. While the board of directors felt that Altman was on a dangerous path, the capital providers, which included not only venture capitalists, but Microsoft as a joint-venture investor, were clearly swayed not in agreement, and Open AI¡¯s employees were loyal to him. In short, once Open AI decided to open the door to eventually being not just a money-making business, but one worth $80 billion or more, Altman became the key person at the company, as Open AI¡¯s board discovered very quickly, and to its dismay.With Tesla, the story is more complicated, but this company has always revolved around Elon Musk. As a young company, where investors and legacy auto companies viewed it as foolhardy in its pursuit of electric cars, Musk's vision and drive was indispensable to its growth and success. As Tesla has brought the rest of the auto business around to its narrative, and become not just a successful company, but one worth a trillion dollars or more at its peak, Musk has remained the center of the story, in good and bad ways. His vision continues to animate the company¡¯s thinking on everything from the Cybertruck to robo-taxis, but his capacity for distraction has also sometimes hijacked that narrative. Thus, the debate of whether Musk, as a key person, is adding or detracting from Tesla¡¯s value has been joined, and while I remain convinced that he remains a net positive, since I cannot imagine Tesla without him, there are many who disagree with me. At the same time, Musk is mortal and it remains an open question whether he is willing to make himself dispensable, by not only building a management teams that can run the company without him, but also a successor that he is willing to share power and the limelight.In general, the life cycle framework explains why good venture capitalists often spend so much time assessing founder qualities and why public market investors, especially those who focus on mature companies, can base their investments on just financial track records.
Micro versus Macro?? ?There are some companies where value comes more from company-specific decisions on products/services to offer, markets to enter and pricing decisions, and others, where the value comes more from macro variables. A media company, like Disney, where movie or television offerings constantly have to adjust to reflect changing demand and in response to competition, would be an example of the former, whereas an oil company, where it is the oil price that is the key determinant of revenues and earnings, would be an example of the latter.?? ?In general, you are far more likely to find key people, who can add or take away from value at the former (micro companies) than at the latter (macro companies). Consider the heated arguments that you are hearing about Bob Iger and his return to the CEO position at Disney, with Nelson Peltz in the mix, arguing for change. While some of the forces affecting Disney are across entertainment companies, as I noted in this post, I also argued that whether Disney ends up as one of the winners in this space will depend on management decisions on which businesses to growth, which ones to shrink or spin off and how they are run. With Royal Dutch, it is true that canny management can add to oil reserves, by buying them when oil prices are low, but for the most part, much of what happens to it is impervious to who runs the company.?
Business Moats?? ?Business moats refer to competitive advantages that companies have over their competitors that allow them to not just grow and be profitable, but to create value by earning well above their cost of capital. That said, moats can range the spectrum, both in terms of sources (cheap raw material, brand names, patents) as well as sustainability (some last for decades and others are transitory). Some moats are inherited by management, and others are earned, and some are high maintenance and others require little care.?? ?In general, there will be less key person value at companies with inherited moats that are sustainable and need little care, and more key person value at companies where moats need to be recreated and maintained. To illustrate, consider two companies at opposite ends of the spectrum. At one end, Aramco, one of the most valuable companies in the world, derives almost all of its value from its control of the Saudi oil sands, allowing it to extract oil at a traction of the cost faced by other oil companies, and it is unlikely that there is any person or group of people in the organizational that could affect its value very much. At the other end, an entertainment software company like Take-Two Interactive is only as good as its latest game or product, and success can be fleeting. It should come as no surprise that there are far more key people, both value-adders and value-destroyers, in these businesses than in most others.?
Implications? ? The notion that a key person or persons can add or detract from the value of an organization is neither surprising nor unexpected, but having a structured framework for examining the value effects can yield interesting implications.

Aging of key person(s)? ? There are many reasons that key persons leave companies, and while companies can try to stave them off by taking actions to protect key people, there is one reason - aging and death - which are inexorable and inevitable. As key people, especially at the top of an organization age, investors should start factoring in not just their eventual departures, but a decline in effectiveness, as they get older. Speaking of key people in large companies, Berkshire Hathaway has a had a special status, an insurance company with the best portfolio managers in the world in Warren Buffett and Charlie Munger. Well before Munger's passing, Buffett and Munger had bowed to advancing age and had ?passed the baton on to Ted Weschler and Todd Combs. While Buffett undoubtedly still has a say in investment choices, it is also clear that he has a far lesser role than he used ro, which may explain Berkshire's , a company that has a snowball's chance in hell of getting through a Buffett-Munger investment screening.
? ? Are markets building in the recognition that Berkshire Hathaway's future will be in the hands of someone other than the two legendary leaders? I think so, and one way to see how markets have adjusted expectations is by comparing the price to book ratio that Berkshire Hathaway trades at relative to a typical insurance company:

In the last decade, as you can see, Berkshire Hathaway's price to book has drifted down, and relative to insurance companies in the aggregate, the Buffett-Munger premium has largely dissipated, suggesting that while Combs and Weschler are well-regarded stock pickers, they cannot replace Buffett and Munger. That may explain why Berkshire's stock price was unaffected by Munger's passing.
Industry Structure? ? As we shift away from a twentieth century economy, where manufacturing and financial service companies dominated, to one where technology and service companies are atop the largest company list, we are also moving into a period where value will come as much from key people in the organization as it does from physical assets. It follows that companies will invest more in human capital to preserve their value, and here, as in much of the new economy, accounting is missing the boat. While there have been attempts to increase corporate disclosure about human capital, the impetus seems to be coming more from diversity advocates than from value appraisers. If human capital is to be treated as a source of value, what companies spend in recruitment, training and nurturing employee loyalty is more capital expenditure than operating expense, and as with any other investment, these expenses have to be judged by the consequences in terms of employee turnover and key person losses.
Compensation?? ?To the extent that key people deliver more value to companies, it stands to reason that they will try to claim some or all of that added value for themselves. In organizations where they are valuable key people, you should expect to see much greater differences in compensation across employees, with the most valued key people being paid large multiples of what the typical employee earns. In addition, to encourage these key people to make themselves less key, by building teams and grooming successors, you would expect the pay to be more in the form on equity (restricted stock or options) than in cash.While that may strike you as inequitable or unfair, it reflects the economics of businesses, and legislating compensation limits will either cause key people to move on or to find loopholes in the laws.??? ?Lest I be viewed as an apologist for monstrously large top management compensation packages, ?the key person framework can be a useful in holding to account boards of directors that grant absurdly high compensation packages to top managers in companies, where their presence adds little value. Thus, I don¡¯t see why you would pay tens of millions of dollars to the CEOs of Target (a mature to declining retail company, no matter who runs it), Royal Dutch (an almost pure oil play) or Coca Cola ( where the management is endowed with a brand name that they had little role in creating). This may be a bit unfair, but I would wager that an AI-generated CEO could replace the CEOs of half or more of the S&P 500 companies, and no one would notice the difference.
In conclusion? ? There are many canards about intrinsic valuation that are in wide circulation, and one is that intrinsic valuations do not reflect the value of people in a company. That is not true,?since intrinsic valuations, done right, should incorporate the value of a key person or people in a business, reflecting that value in cash flows, growth or risk inputs. That said, intrinsic value is built, not on nostalgia or emotion, but ?on the cold realities that key people can sometimes destroy value, that a key person in a company can go from being a value creator to a value destroyer over time and that key people, in particular, and human capital, in general, will matter less in some companies (more mature, manufacturing and with long-standing competitive advantages) than in other companies (younger, service-oriented and with transitory and changing moats.?
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I was planning to start this post by telling you that Tesla was back in the news, but that would be misleading, since Tesla never leaves the news. Some of that attention comes from the company's products and innovations, but much of it comes from having Elon Musk as a CEO, a man who makes himself the center of every news cycle. That attention has worked in the company's favor over much of its lifetime, as it has gone from a start-up to one of the largest market cap companies in the world, disrupting multiple businesses in the process. At regular intervals, though, the company steps on its own story line, creating confusion and distractions, and during these periods, its stock price is quick to give up gains, and that has been the case for the last few weeks. As the price dropped below $200 today (October 30,2023), I decided that it was time for me to revisit and revalue the company, taking into account the news, financial and other, that has come out since my last valuation in January 2023, and to understand the dueling stories that are emerging about the company.

My Tesla History

? ? When I write and teach valuation, I describe it as a craft, and there are very few companies that I enjoy practicing that craft more than I do with Tesla. Along the way, I have been wrong often on the company, and if you are one of those who only reads valuations by people who get it right all the time, you should skip the rest of this post, because I will cheerfully admit that I will be wrong again, though I don't know in which direction. My , when it was a nascent automobile firm, selling less than 25,000 cars a year, and viewed by the rest of the automobile sector with a mix of disdain and?curiosity. I valued it as a luxury automobile firm that would succeed in that mission, giving it Audi-level revenues in 2023 of about $65 billion, and operating margins of 12.50% that year (reflecting luxury auto margins). To deliver this growth, I did assume that Tesla would have to invest large amounts of capital in capacity, and that this would create a significant drag on value, resulting in a equity value of just under $10 billion.

? ? In subsequent valuations, I modified and adapted this story to reflect lessons that I learned about Tesla, along the way. First, I learned that the company was capable of generating growth much more efficiently, and more flexibly, than other auto companies, reducing the capital investment needed for growth. Second, I noticed that Tesla customers?were almost fanatically attached to the company's products, and were willing to evangelize about it, yielding a brand loyalty that legacy auto companies could only dream about. Third, in a world where many companies are run by CEO who are, at best, operating automatons, and at worst, evidence of the Peter Principle at play, where incompetence rises to the top, Tesla had a CEO whose primary problem was too much vision, rather than too little. In valuation terms, that results in a company whose value shifts with narrative changes, creating not only wide swings in value, but vast divergences in opinion on value. In 2016, you had for the company and listed some of the possible choices in a picture:

I translated these stories into inputs on revenue growth, profit margins and reinvestment, to arrive at a template of values:Note that is multiple stock splits ago, and the prices per share here are not comparable to the share price today, but the overall lessons contained in this table still apply. First, when you see significant disagreements about what Tesla is worth, those differences come from divergent stories, not disagreements about numbers. Second, every news story or financial disclosure about Tesla has to be used to evaluate how the company's narrative is changing, creating multiplier effects that create disproportionate value changes.? ? Along the way, Tesla (or more precisely, Elon Musk) has made choices that could be, at best, described as puzzling, and, at worst, as perilous for the company's long term health, from , when equity would have been a much better choice, to setting arbitrary targets on production (remember the for the company in 2018) and cash flows () that pushed the company into a corner. If you add to that the self-inflicted wounds including Musk tweeting out that he had a deal to , in 2018, it is not surprising that the stock has had periods of trauma. It was after one of these downturns in 2019, when the stock hit $180 (with a market cap of $32 billion), that , albeit labeling it as my corporate teenager, an investment that would frustrate me because it would get in the way of its own potential.?? ? I profited mightily on that investment, but I , when Tesla's market capitalization hit $150 billion, and just before COVID put the company on a new price orbit. In fact, I, when its market capitalization hit a trillion, marveling at its rise, but also noting that it was priced to deliver such wondrous results ($600-$800 billion in revenues, with 20%+ margins) that I was uncomfortable going along:
In 2022, the stock came back to earth with a vengeance, losing more than 65% of its equity value, leaving the stock (on a post-split basis) trading at close to $100 a share at the end of the year. Three weeks later, i.e., at the start of 2023, , allowing for uncertainties in my estimate of revenues and margins to deliver a median value per share of $153, with significant variation in potential outcomes:

I was about a week late on my valuation, since the stock price had already broken through this value by the time I finished it, leaving my portfolio Tesla-free, in 2023.

Tesla Update

? ? My last Tesla valuation is less than ten months old, and while that is not long in calendar time, with Tesla, it feels like an eternity, with this stock. As a lead in to updating the company¡¯s valuation, it makes sense to start with the stock price, the market¡¯s barometer for the company's health. The stock, which ?started the year in a swoon, recovered quickly in the first half of the year, peaking around mid-year at close to $300 a share.?

The last four months have tested the stock, and it has given back a significant portion of its gains this year, with the stock dropping below $200 on October 30, 2023. Since earnings reports are often viewed as the catalysts for momentum shifts, I have highlighted the four earnings reports during the course of 2023, with a comparison of earnings per share reported, relative to expectations. The first earnings report, in January 2023, has been the only one where the company beat expectations, and it matched expectations in the April report, and fallen behind in the July and October reports.?

? ? The earnings per share focus misses much of Tesla¡¯s story, and it is instructive to dig deeper into the income statement and examine how the company has performed on broader operating metrics:

In the twelve months, ending September 2023, Tesla reported operating income of $10.7 billion on revenues of $95.9 billion; that puts their revenues well ahead of my 2013 projection of $65 billion, albeit with an operating margin of 11.18%, lagging my estimate of 12.5%. ?That makes Tesla the eleventh largest automobile company in the world, in revenue terms, and the seventh most profitable on the list, making it more and more difficult for naysayers to argue that it is a fad that will pass. Breaking down the news in the financials by business grouping, here is what the reports reveal:

Auto business: Tesla's auto business saw revenue growth slow down from the torrid pace that it posted between 2020 and 2022, with third quarter year-on-year revenue growth dropping to single digits, but given the flat sales in the auto sector and a sluggish electric car market, it remains a stand-out. The more disappointing number, at least for those who were expecting pathways to software-company like margins for the company, was the decline in profit margins on automobiles from 2022 levels, though ?the 17.42% gross margin in the third quarter, while disappointing for Tesla, would have been cause for celebration at almost any of its competitors.Energy business: Tesla's energy business, which was grounded by its acquisition of Solar City in 2016, has had a strong year, rising from 4.8% of the company's revenues in 2022 to 6.2% in the twelve months ending September 2023. In conjunction, the profitability of the business also surged in the last twelve months, and while some of this increase will average out, some of it can be attributed to a shift in emphasis to storage solutions (battery packs and other) from energy generation.In short, Tesla's financial reports, are an illustration of how much expectations can play a role in how markets react to the news in them. The post-COVID surge in Tesla's revenues and profitability led to unrealistically high expectations of what the company can do in this decade, and the numbers, especially in the last two quarters, have acted as a reality check.? ? As a story stock, Tesla is affected as much by news stories about the company and its CEO, as it is by financials, and there are three big story lines about the company that bear on its value today:
Price Cuts: During the course of 2023, Tesla has repeatedly , with the most recent ones coming earlier this month, The $1,250 reduction in the Model 3 should see its price drop to about $39,000, making it competitive, even on a purely price basis, in the mass auto market in the United States. Some of this price cutting is tactical and in response to competition, current or forecast, but some of it may reflect a shift in the company's business model.Full Self Driving (FSD): Tesla, as a company, has to the forefront of its story, though there remains a divide in how far ahead Tesla is of its competition, and the long term prospects for automated driving. Its novelty and news value has made it a central theme of debate, with Tesla fans and critics using its successes and failures as grist for their social media postings. While an autopilot feature is packaged as a standard feature with Teslas, ?it offers ?FSD software, which is still , offers an enhanced autopilot model, albeit at a price of $12,000. The FSD news stories have also reignited talk of a robotaxi business for Tesla, with leaks from the company of a $25,000 vehicle specifically aimed at that business.Cybertruck: After years of waiting, the Tesla Cybertruck is here, and it too has garnered outsized attention, partly because of its and partly because it is Tesla's entree into a market, where traditional auto companies still dominate. While there is still debate about whether this product will be a niche offering or one that changes the trucking market, it has undoubtedly drawn attention to the company. In fact, the company'srecords more than two millions reservations (with deposits), though if history is a guide, the actual sales will fall well short of these numbers.This being Tesla, there are dozens of other stories about the company, but that is par for the course. We will focus on these three stories because they have the potential to upend or alter the Tesla narrative, and by extension, its value.

Story and Valuation: Revisit and Revaluation

? ? In my Tesla valuations through the start of 2023, I have valued Tesla as an automobile company, with the other businesses captured in top line numbers, rather than broken out individually. That does not mean that they are adding significantly to value, but that the value addition is buried in an input to value, rather than estimated standing alone. In my early 2023 valuation, I estimated an operating margin of 16% for Tesla, well above auto industry averages, because I believed that software and or the robotaxi businesses, in addition to delivering additional revenues, would augment operating margins, since they are high-margin businesses.?? ??

?? ?The news stories about Tesla this year have made me reassess that point of view, since they feed into the narrative that Tesla not only believes that the software and robotaxi businesses have significant value potential as stand-alone businesses, but it is acting accordingly. To see why, let me take each of the three news story lines and work them into my Tesla narrative:

Cybertrucks: The easiest news items to weave into the Tesla narrative is the Cybertruck effect. If the advance orders are an indication of pent-up demand and the Cybertruck represents an extension into a hitherto untapped market, it does increase Tesla's revenue growth potential. There are two potential negatives to consider, and Musk referenced them during the course of the most recent earnings call. The first is that, even with clever design choices, at their rumored pricing, the margins on these trucks will be lower than on higher-end offerings. The other is that the Cybertruck?may very well require dedicated production facilities, ?pushing up reinvestment needs. If Cybertruck sales are brisk, and the demand is strong, the positives will outweigh the negatives, but if the buzz fades, and it becomes a niche product, it may very well prove a distraction that reduces value. The value added by Cybertrucks will also depend, in part, on who buys them, with Tesla gaining more if the sales comes from truck buyers, coming from other companies, than it will if the sales comes from Tesla car buyers, which will cannibalize their own sales.FSD: As I look at the competing arguments about Tesla's FSD research, it seems clear to me that both sides have a point. On the plus side, Tesla is clearly further along this road than any other company, not only from a technological standpoint, but also from business model and marketing?standpoints. While I do not believe that charging $12,000 for FSD as an add-on will create a big market, lowering that price will open the door not only to software sales to Tesla drivers, but perhaps even to other carmakers. In addition, it seems clear to me that the Tesla robotaxi business has now moved from possible to plausible on my scale, and thus merits being taken seriously. On the minus side, I do agree that the world is not quite ready for driverless cars, on scale, and that rushing the product to market can be catastrophic.?Price cuts: The Tesla price cuts have led to a divide among Tesla bulls, with some pointing to it as the reason for Tesla's recent pricing travails and others viewing it as a masterstroke advancing it on its mission of global domination. To decide which side has the more realistic perspective, I decided to take a look at how price cuts play out in value for a generic company. The first order effect of a price cut is negative, since lowering prices will lower margins and profits, and it is easy to compute. It is the second order effects that are tricky, and I list the possibilities in the figure below, with value consequences:
In short, price cuts can, and often will, change the number of units sold, perhaps offsetting some of the downside to price cut (tactical), make it more difficult for competitors to keep up or enter your business (strategic) and expand the potential for side or supplemental businesses to thrive (synergistic). This figure explains the divide on the Tesla price cuts, with the pessimists arguing that electric car demand is too inelastic for volume increases that will compensate for the lower margins, and the optimists arguing that the value losses from lower margins will be more than offset by a long-term increase in Tesla's market share, and increase the value from their software and robotaxi businesses.

To bring these stories into play, I break Tesla down into four businesses - the auto business, the energy business, the software business and the robotaxi business. I do know that there will be Tesla optimists who will argue that there are other businesses that Tesla can enter, including insurance and robots, but for the moment, I think that the company has its hands full. I look out the landscape for these businesses in the picture below, looking at the potential size and profitability of the market for each of these businesses, as well as Tesla's standing in each.

Note that the auto business is, by far, the largest in terms of revenue potential, but it lags the other business in profitability, especially the software and robotaxi businesses, where unit economics are favorable and margins much higher. Note also that estimates for the future in the robotaxi and auto software businesses are squishy, insofar as they are till nascent, and there is much that we do not know.My?Tesla story for each of these businesses is below, with revenue and profitability assumption, broken down ?by business:

With these stories in place, I estimate revenues, earnings and cash flows for the businesses, and in sum, for the company, and use these cash flows to estimate a value per share for the company:

In sum, the value per share that I get with Tesla's businesses broken down and allowing for divergent growth and profitability across businesses, is about $180 a share. That is higher than my estimate at the start of the year, with part of that increase coming from the higher profit potential in the side businesses, and expectations of a much larger end game in each one.?? ? Given that this value comes from four businesses, you can break down the value into each of those businesses, and I do so below:
Just as a note of caution, these businesses are all linked together, since the battery technology that drives the auto and energy businesses are shared, and FSD software sales will be tied to car sales. Consequently, you would not be able to spin off or sell these businesses, at least as these estimated values, but it does provide a sense of investors should watch for in this company. Thus, with a chunk of value tied to FSD, from software and robotaxis, any signs of progress (failure) on the FSD front will have consequences for value.

An Action Plan?? ?As you review my story and numbers, you will undoubtedly have very different views about Tesla going forward, and rather than tell me that you disagree with my views, which serves neither of us, please download the spreadsheet and make your own projections, by business. So, if you believe that I am massively underestimating the size of the robotaxi business, please do make your own judgment on how big it can get, with the caveat that making that business bigger will make your auto and software businesses smaller. After all, if everyone is taking robotaxis, the number of cars sold should drop off and existing car owners may be less likely to pay extra for a FSD package.?? ? At $197 a share, Tesla remains over valued, at least based on my story, but a stock that has dropped $54 in price in the last few weeks could very well drop another $20 in the next few. To capture that possibility, I have a limit buy at my estimated value of $180, with the acceptance that it may never hit that price in this iteration. For those of you who wonder why I don't have a margin of safety (MOS), I have argued that the MOS is a blunt instrument that is most useful when you are valuing mature companies where you face a luxury of riches (lots of under valued companies). Furthermore, as my January 2023 simulation of Tesla value reveals, this is a company with more upside than downside, and that make a fair-value investment one that I can live with. ?Put simply, the possibility of other businesses ?that Tesla can enter into adds optionality that I have not incorporated into my value, and that acts as icing on the cake.?? ?Obviously, and this will sound like the postscript from an email that you get from your investment banking friends, I am not offering this as investment advice. Unlike those investment banking email postscripts, I mean that from the heart and am not required by either regulators or lawyer to say it. I believe that investors have to take ownership of their investment decisions, and I would suggest that the only way for you to make your own judgment on Tesla is to frame your story, and value it based on that story. Of course, you are welcome to use, adapt or just ignore my spreadsheet in that process.

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Data and Spreadsheets

?? ? I have made no secret of my disdain for ESG, an , that has been a , including fund managers, consultants and academics. In response, I have been told that the problem is not with the idea of ESG, but in its measurement and application, and that impact investing is the solution to both market and society's problems. Impact investing, of course, is investing in businesses and assets based on the expectation of not just earning financial returns, but also creating positive change in society.?

?? ?It is human nature to want to make the world a better place, but does impact investing have the impact that it aims to create? That is the question that I hope to address in this post. In the course of the post, I will work with two presumptions. The first is that the problems for society that impact investing are aiming to address are real, whether it be climate change, poverty or wealth inequality. The second is that impact investors have good intentions, aiming to make a positive difference in the world. I understand that there will be some who feel that these presumptions are conceding too much, but I want to keep my focus on the mechanics and consequences of impact investing, rather than indulge in debates about society's problems or question investor motives.

Impact Investing: The What, The Why and the How!

? ? Impact?investments are investments made with the intent of generating benefits for society, alongside a financial return. That generic definition is not only broad enough to cover a wide range of impact investing actions and motives, but has also been with us since the beginning of time. Investors and business people have often considered social payoffs when making investments, though they have differed on the social outcomes that they seek, and the degree to which they are willing to sacrifice the bottom line to achieve those outcomes.??? In the last two decades, this age-old investing behavior has come under the umbrella of impact investing, with several books on how to do it right, academic research on how it is working (or not), and organizations dedicated to advancing its mission. ?The Global Impact Investing Network (GIIN), a non-profit that tracks the growth of this investing movement, estimated that more than $1.16 trillion was invested by impact investors in 2021, with a diverse range of investors:Global Impact Investing Network, 2022 Report
Not surprisingly, the balance between social impact and financial return desired by investors, varies across investor groups, with some more focused on the former and others the latter. In a survey of impact investors, GIIN elicited these responses on what types of returns ?investors expected to earn on their impact investments, broken down by groups:
Global Impact Investing Network, 2020 Report
Almost two thirds of impact investors believe that they can eat their cake and have it too, expecting to earn as much or more than a risk-adjusted return, even as they do good. That delusion running deepest among pension funds, insurance companies, for-profit fund managers and diversified financial investors, who also happen to account for 78% of all impact investing funds.?? ?If having a positive impact on society, while earning financial returns, is what characterizes impact investing, it can take one of three forms:Inclusionary Impact Investing: On the inclusionary path, impact investors seek out businesses or companies that are most likely to have a positive impact on whatever societal problem they are seeking to solve, and invest in these companies, often willing to pay higher prices than justified by the financial payoffs on the business.?Exclusionary Impact Investing: In the exclusionary segue, impact investors sell shares in businesses that they own, or refuse to buy shares in these businesses, if they are viewed as worsening the targeted societal problem.Evangelist Impact Investing: In the activist variant, impact investors buy stakes in businesses that they view as contributing to the societal problem, and then use that ownership stake to push for changes in operations and behavior, to reduce the negative social or environmental impact.The effect of impact investing in the inclusionary and exclusionary paths is through the stock price, with the buying (selling) in inclusionary (exclusionary) investing pushing stock prices up (down), which, in turn, decreases (increases) the costs of equity and capital at these firms. The changes in costs of funding then show up in investing decisions and growth choices at these companies, with good companies expanding and bad companies shrinking.?With evangelist impact investing, impact investors aim to get a critical mass of shareholders as allies in pushing for changes in how companies operate, shifting the company away from actions that create bad consequences for society to those that have neutral or good consequences.
As you can see, for impact investing to have an impact on society, a series of links have to work, and if any or all of them fail, there is the very real potential that impact investing can have perverse consequences.With inclusionary investing, there is the danger that you mis-identify the companies capable of doing good, and flood these companies with too much capital. Not only is capital invested in these companies wasted, but increases the barriers to better alternatives to doing good.?With exclusionary investing, pushing prices down below their "fair" values will allow investors who don¡¯t care about impact to earn higher returns, from owning these companies. More importantly, if it works at reducing investment from public companies in a "bad" business, it will open the door to private investors to fill the business void. ?With evangelist investing, an absence of allies among other shareholders will mean that your attempts to change the course of businesses will be largely unsuccessful. Even when you are successful in dissuading these companies from "bad" investments, but may not be able to stop them from returning the cash to shareholders as dividends and buybacks, rather than making "good" investments.In the table below, I look at the potential for perverse outcomes under each of three impact investing approaches, using climate change impact investing as my illustrative example:

The question of whether impact investing has beneficial or perverse effects is an empirical question, not a theoretical one, since your assumptions about market depth, investor behavior and business responses can lead you to different conclusion.? ? It is worth noting that impact investing may have no effect on stock prices or on corporate behavior, either because there?is too little money behind it, or because there is offsetting investing in the other direction. In those cases, impact investing is less about impacting society and more about alleviating the guilt and cleansing the consciences of the impact investors, and the only real impact will be on the returns that they earn on their portfolios.?

The Impact of Impact Investing: Climate Change

? ? While impact investing can be directed at any of society's ills, it is undeniable that its biggest focus in recent years has been on climate change, with hundreds of billions of dollars directed at reversing its effects. Climate change, in many ways, is also tailored to impact investing, since concerns about climate change are widely held and many of the businesses that are viewed as good or bad, from a climate change perspective, are publicly traded. As an empirical question, it is worth examining how impact investing has affected the market perceptions and pricing of green energy and fossil fuel companies, the operating decisions at these companies, and most critically, on the how we produce and consume energy.

Fund Flows

? ???? The biggest successes of ?climate change impact investing have been on the funding side. Not only has impact investing directed large amounts of capital towards green and alternative energy investments, but the movement has also succeeded in convincing many fund managers and endowments to divest themselves of their investments in fossil fuel companies.?

As concerns about climate change have risen, the money invested in alternative energy companies has expanded, with $5.4 trillion cumulatively invested in the last decade:

Source: BloombergNEF

Almost half of this investment in alternative energy sources has been in renewable energy, with electrified transport and electrified heat accounting for a large portion of the remaining investments.?

On the divestment side, the drumbeat against fossil fuel investing has had an effect, with many investment fund managers and endowments joining the divestiture movement:

By 2023, close to 1600 institutions, with more than $40 trillion of funds under their management, had announced or concluded their divestitures of investments in fossil fuel companies.

If impact investing were measured entirely on fund flows into green energy companies and out of fossil fuel companies, it has clearly succeeded.

Market Price (and Capitalization)

? ? It is undeniable that fund flows into or out of companies affects their stock prices, and if the numbers in the last section are even close to reality, you should have expected to see a surge in market prices at alternative energy companies, as a result of funds flowing into them, and a decline in market prices of fossil fuel companies, as fossil fuel divestment gathers steam.?

On the alternative energy front, as money has flowed into these companies, there has been a surge in enterprise value (equity and net debt) and market capitalization (equity value); I report both because impact investing can also take the form of green bonds, or debt, at these companies. The enterprise value of publicly traded alternative energy companies has risen from close to zero two decades ago to more than $700 billion in 2020, before losing steam in the last three years:

Adding in the value of private companies and start-ups in this space would undoubtedly push up the number further.?

On the fossil fuel front, the fossil fuel divestments have had an impact on market capitalizations, though there are signs that the effect is weakening:

In the last decade, when fossil fuel divestment surged, the percentage changes in market capitalization at fossil fuel companies lagged returns on the market, with fossil fuel companies reporting a compounded annual percentage increase of 4.49% a year..?The negative effect was strongest in the middle of the last decade, but market prices for fossil fuel companies have recovered strongly between 2020 and 2023.

It is worth noting that even after their surge in market cap in the last decade, alternative energy companies have a cumulated enterprise value of about $600 billion in September 2023, a fraction of the $8.5 trillion of cumulated enterprise value at fossil fuel companies.

Investor perceptions

?? ?Impact investing has always been about changing investor perceptions of energy companies, more than just prices. In fact, some impact investors have argued that their presence in the market and advocacy for alternative energy has led investors to change their views about fossil fuel companies, shifting from viewing them as profitable, cash-rich businesses with extended lives, to companies living on borrowed time, looking at decline and even demise. In intrinsic valuation terms, that shift should show up in the pricing, with lower value attached to the latter scenario than the former:

? ? On the green energy front, to see if investors perceptions of these companies have changed, ?I look at two the pricing metrics for green energy companies - the enterprise value to EBITDA and enterprise value to revenue multiples:

The numbers offer a mixed message on whether impact investing has changed investor perceptions, with EV to EBITDA multiples staying unchanged, between the 1998-2010 and 2011-2023 time periods, but EV as a multiple of revenues soaring from 2.62 in the 1998-2010 time period to 5.95 in the 2011-2023 time period. The fund flows into green energy are affecting pricing, though it remains an open question as to whether the pricing is getting too rich, as too much money chases too few opportunities.

?? ?Looking at fossil fuel firms, the poor performance in the last decade seems to support the notion that impact investing has changed how investors perceive fossil fuel companies, but there are some checks that need to be run to come that conclusion.?

Oil Price Effect: The market capitalization of oil companies is dependent on oil prices, as you can see in the figure below, where the collective market?capitalization of fossil fuel companies is graphed against the average oil price each year from 1970 to 2022; almost 70% of the variation in market capitalization over time explained by oil price movements.

To separate impact investing divestment effects from oil price effects, I estimated the predicted market capitalization of fossil fuel companies, given the oil price each year, using the statistical relationship between?market cap and oil prices in the twenty five years leading into the forecast year. (I regress market capitalization against average oil price from 1973 to 1997 to estimate the expected market cap in 1998, given the oil price in 1998, and so on, for every year from 1998 to 2023. Note that the only thing you can read these regressions is that market capitalization and oil prices move together, and that there is no way to draw conclusions about causation):

If divestitures are having a systematic effect on how markets are pricing fossil fuel companies, you should expect to see the actual market capitalizations trailing the?expected market capitalization, based on the oil price. That seems to be the case, albeit marginally, between 2011 and 2014, but not since then. In short, the divestiture effect on fossil fuel companies has faded over time, with other investors stepping in and buying shares in their companies, drawn by their earnings power.?

Pricing: If impact investing is changing investor perceptions about the future growth and termination risk at fossil fuel companies, it should show up in how these companies are priced, lowering the multiples of revenues or earnings that investors are willing to pay. In the chart below, I look at the pricing of fossil fuel companies over time, using EV to sales and EV to EBITDA as pricing metrics:?While the pricing metrics swing from year to year, that has always been true at oil companies, since earnings and revenues vary, with oil prices. However, if impact investing is having a systematic effect on how investors are pricing companies, there is little evidence of that in this chart.In sum, while it is possible to find individual investors who have become skeptical about the future for fossil fuel companies, that view is not reflective of the market consensus. I do believe that investors are pricing fossil fuel companies now, with the expectation of much lower growth in the future, than they used to, but that is coming as much from these companies returning more of their earnings as cash and reinvesting less than they used to, as it is from an expectation that the days of fossil fuel are numbered. Some impact investors will argue that this is because investors are short-term, but that is a double-edged sword, since it undercuts the very idea of using investing as the vehicle to create social and environmental change.

Operating Impact ? ? Impact investing, in addition to affecting pricing of green energy and fossil fuel companies, can also have effects on how fossil fuel companies perform and operate. On the profitability front, fossil fuel companies seem to have weathered the onslaught of climate change critics, with revenues and profit margins (EBITDA and operating) bouncing back from a slump between 2014 and 2018 to reach historic highs in 2022.?

A key development over the last decade, as profits have returned, is that fossil fuel companies are returning much of cash flows that they are generating to their shareholders in the form of dividends and buybacks, notwithstanding the pressure from activist impact investors that they reinvest that money in green energy projects:
In one development that impact investors may welcome, fossil fuel companies are collectively investing less in exploration for new fossil fuel reserves in the last decade than they did in prior ones:
If you couple this trend of exploring less with the divestitures of fossil fuel reserves, over the last decade, there is a basis for the argument that fossil fuel companies are reducing their fossil fuel presence, and some impact investing advocates may be tempted to declare victory. After all, if the objective is to reduce fossil fuel production, does it not advance your cause if less money is being spent exploring for coal, oil and gas? ??? ?Before claiming a win, though, there is a dark side to this retreat by public fossil-fuel companies, and that comes from private equity investors and privately-owned (or government-owned) oil companies stepping into the breach; many of the divestitures and sales of fossil fuel assets by publicly traded companies have been to private buyers, and the assets being divested are often among the dirtiest (from a climate-change perspective) of their holdings.. Over the last decade, some of private equity¡¯s biggest players , with the investments ranging the spectrum. ?Source: Pitchbook
While there was an uptick in investments in renewables in 2019 and 2020, the overwhelming majority of private equity investments during the decade were in fossil fuels. In the process, private equity firms like the Carlyle Group and KKR have become major holders of fossil fuel reserves, and there from buying abandoned and castoff oil wells from oil companies, pressured to sell by impact investors. While climate change advocates are quick to point to this public-to-private transition of fossil fuel assets as a flaw, they fail to recognize that it is is a natural side-effect of an approach that paints publicly traded fossil fuel firms as villains and shuns their investments, while continuing to be dependent on fossil fuels for meeting energy needs.?? ? On the activist front, there is evidence that impact investing's capacity to change oil company behavior is losing its potency. While fossil fuel companies were quick to give in to pressure?from impact investors?to de-carbonize, for much of the last decade, the Russian invasion of Ukraine seems to have been , laying bare how reliant the globe still is on fossil fuels for its energy needs. In the aftermath, the biggest fossil fuel companies have become bolder about their plans to stay in and grow their fossil fuel?investments, with?,?,?, and .?
Macro Impact ? ? The success or failure of impact investing, when it relates to climate change, ultimately comes from the changes it creates in how energy is produce and consumed, and it is on this front that the futility of the movement is most visible. While alternative energy sources have expanded their production, it has not been at the expense of oil consumption, which has barely budged over the last decade.
Fairly or unfairly, the pandemic seems to have done more to curb oil consumption than all of impact investing's efforts over the last decade, but the COVID effect, which saw oil consumption drop in 2020 has largely faded.? ? Taking a global and big-picture perspective of where we get our energy, a comparison of energy sources in 1971 and 2019 yields a picture of how little things have changed:
Fossil fuel, which accounted for 86.6% of energy production in 1971, was responsible for 80.9% of production in 2019, with almost all of that gain from coming from nuclear energy, which many impact investors viewed as an undesirable alternative energy source for much of the last decade. Focusing on energy production just in the US, the failure of impact investing to move the needle on energy production can be seen in stark terms:
Fossil fuels account for a higher percent of overall energy produced in the United States today than they did ten or fifteen years ago, with gains in solar, wind and hydropower being largely offset by reductions in nuclear energy.?If this is what passes for winning in impact investing, I would hate to see what losing looks like.?? ? I have tried out variants of this post with impact investing acquaintances, and there are three broad responses that they have to its findings (and three defenses for why we should keep trying):
Things would be worse without impact investing: It is impossible to test this hypothetical, but is it possible that our dependence on fossil fuels would be even greater, without impact investing making a difference? Of course, but that argument would be easier to make, if the trend lines were towards fossil fuels before impact investing, and moved away from fossil fuels after its rise. The data, though, suggests that the biggest shift away from fossil fuels occurred decades ago, well before impact investing was around, primarily from the rise of nuclear energy, and that impact investing's tunnel vision on alternative energy has actually made things worse.It takes time to create change: It is true that the energy business is an infrastructure business, requiring large investments up front and long gestation periods. It is possible that the effects of impact investing are just not being felt yet, and that they are likely to show up later this decade. This would undercut the urgency argument that impact investors have used to induce their clients to invest large amounts and doing it now, and if they had been more open about the time lag from the beginning, this argument would have more credibility today.Investing cannot offset consumption choices: If the argument is that impact investing cannot stymie climate change on its own, without changes in consumer behavior, I could not agree more, but changing behavior will be painful, both politically and economically. I would argue that impact investing, by offering the false promise of change on the cheap, has actually reduced the pressure on politicians and rule-makers to make hard decisions on taxes and production.Even conceding some truth in all three arguments, what?I see in the data is the essence of insanity, where impact investors keep throwing in more cash into green energy and more vitriol at fossil fuels, while the global dependence on fossil fuels increases.
Impact Investing: Investing for change? ?Much of what I have said about impact investing's quest to fight climate change can be said about the other societal problems that impact investors try to address. Poverty, sexism, racism and inequality have had impact investing dollars directed at them, albeit not on the same scale as climate change, but are we better off as a society on any of these dimensions? To the response that doing something is better than being doing nothing, I beg to differ, since acting in ways that create perverse outcomes can be worse than sitting still. ?To end this post on a hopeful note, I believe that impact investing can be rescued, albeit in a humbler, more modest form.?With your own money, pass the sleep test: If you are investing your own money, your investing should reflect your pocketbook as well as your conscience. After all, ?investors, when choosing what to invest in, and how much, have to pass the sleep test. If investing in Exxon Mobil or Altria leads you to lose sleep, because of guilt, you should avoid investing in these companies, no matter how good they look on a financial return basis.With other people's money, be transparent and accountable about impact: If you are investing other people¡¯s money, and aiming for impact, you need to be explicit on what the problem is that you are trying to solve, and get buy in from those who are investing with you. In addition, you should specify measurement metrics that you will use to evaluate whether you are having the impact that you promised.Be honest about trade offs: When investing your own or other people's money, you have to be honest with yourself not only about the impact that you are having, but about the trade offs implicit in impact investing. As someone who teaches at NYU, I believe that? will not only have no effect on climate change, but coming from an institution that has established a , it is an act of rank hypocrisy. It is also critical that those impact investors who expect to make risk-adjusted market returns or more, while advancing social good, recognize that being good comes with a cost.Less absolutism, more pragmatism: For those impact investors who cloak themselves in virtue, and act as if they command the moral high ground, just stop! Not only do you alienate the rest of the world, with your I-care-about-the-world-more-than-you attitude, but you eliminate any chances of learning from your own mistakes, and changing course, when your actions don't work.Harness the profit motive: I know that for some impact investors, the profit motive is a dirty concept, and the root reason for the social problems that impact investing is trying to address. While it is true that the pursuit of profits may underlie the problem that you are trying to solve, the power from harnessing the profit motive to solve problems is immense. Agree with his methods or not, Elon Musk, driven less by social change and more by the desire to create the most valuable company in the world, has done more to address climate change than all of impact investing put together.?I started this post with two presumptions, that the social problems being addressed by impact investors are real and that impact investors have good intentions, and if that is indeed the case, I think it is time that impact investors face the truth. After 15 years, and trillions invested in its name, impact investing, as practiced now, has made little progress on the social and environmental problems that it purports to solve. Is it not time to try something different?
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A few days ago, I , and noted that the reception that the stock gets will be a good barometer of where risk capital stands in the market, right now. After a buzzy open, when the stock jumped from its offering price of $30 a share to $42, the stock has quickly given up those gains and now trades at below to its offer price. In this post, I will look at another initial public offering, Birkenstock, that is likely to get more attention in the next few weeks, given that it is targeting to go public at a pricing of about?€8 billion, for its equity, in a few weeks. Rather than make this post all about valuing Birkenstock, and comparing that value to the proposed pricing, I would like to use the company to discuss how intangible assets get valued in an intrinsic valuation, and why much of the discussion of intangible valuation in accounting circles is a reflection of a mind-set on valuation that often misses its essence.

The Value of Intangible Assets

? ? Accounting has historically done a poor job dealing with intangible assets, and as the economy has transitioned away from a manufacturing-dominated twentieth century to the technology and services focused economy of the twenty first century, that failure has become more apparent. The resulting debate among accountants about how to bring intangibles on to the books has spilled over into valuation practice, and many appraisers and analysts are wrongly, in my view, letting the accounting debate affect how they value companies.? ??

The Rise of Intangibles

? ? While the debate about intangibles, and how best to value them, is relatively recent, it is unquestionable that intangibles have been a part of valuation, and the investment process, through history. An analyst valuing General Motors in the 1920s was probably attaching a premium to the company, because it was headed by Alfred Sloan, viewed then a visionary leader, just as an investor pricing GE in the 1980s was arguing for a higher pricing, because Jack Welch was engineering a rebirth of the company. Even a cursory examination of the the?, the stocks that drove US equities upwards in the early 1970s, reveals companies like Coca Cola and Gilette, where brand name was a significant contributor to value, as well as pharmaceutical companies like Bristol-Myers and Pfizer, which derived a large portion of their value from patents. In fact, IBM and Hewlett Packard, pioneers of the tech sector, were priced higher during that period, because of their technological strengths and other intangibles. ?Within the investment community, there has always been a clear recognition of the importance of intangibles in driving investment value. In fact, among old-time value investors, especially in the Warren Buffet camp, the importance of having "good management' and moats (competitive advantages, many of which are intangible) represented an acceptance of to how critical it is that we incorporate these intangible benefits into investment decisions.

? ?With that said, it is clear that the debate about intangibles has become more intense in the last two decades. One reason is the perception that intangibles now represent a greater percent of value at companies and are a significant factor in more of the companies?that we invest in, than in the past. While I have seen claims that intangibles now account for sixty, seventy or even ninety percent of value, I take these contentions with a grain of salt, since the definition of "intangible" is elastic, and some stretch it to breaking point, and the measures of value used are questionable. ?A more tangible way to see why intangibles have become a hot topic of discussion is to?look at the evolution of the top ten companies in the world, in market capitalization, over time:

In 1980, IBM was the largest market cap company in the world, but eight of the top ten companies were oil or manufacturing companies. With each decade, you can see the effect of regional and sector performance in the previous decade; the 1990 list is dominated by Japanese stocks, reflecting the rise of Japanese equities in the 1980s, and the 2000 list by technology and communication companies, benefiting from the dot-com boom. Looking at the top ten companies in 2020 and 2023, you see the dominance of technology companies, many of which sell products that you cannot see, often in production facilities that are just as invisible.? ?The other development that has pushed the intangible discussion to the forefront is a sea change in the characteristics of companies entering public markets. While companies that were listed for much of the twentieth century waited until they had established business models to go public, the dot-com boom saw the listing of young companies with growth potential but unformed business models (translating into operating?losses), and that trend has continued and accelerated in this century. The graph below looks at the revenues and profitability of companies that go public each year, from 1980 to 2020:

As you can see, the percent of money-making companies going public has dropped from more than 90% in the 1980s to less than 20% in 2020, but at the same time, while also reporting much higher revenues, reporting the push by private companies to scale up quickly. In valuing these companies, investors and analysts face a challenge, insofar as much of the values of these firms came from expectations of what they would do in the future, rather than investments that they have already made. I capture this effect in what I call a financial balance sheet:

While you can value assets-in-place, using historical data and the information in financial statements, in assessing the value of growth assets, you are making your best assessments of investments that these companies will make in the future, and these investments are formless, at least at the moment.?

The Accounting Challenge with Intangibles

? ? The intangible debate is most intense in the accounting community, with both practitioners and academics arguing about whether intangibles should be "valued", and if so, how to bring that value into financial statements. To see why the accounting consequences are likely to be dramatic, consider how these choices will play out in the balance sheet, the accountants' attempt to encapsulate what a business owns, what it owes and how much its equity is worth.?

There are inconsistencies in how accountants measure different classes of assets, and I incorporate them into my picture above, leaving the intangible assets section as the unknown: Any changes in accounting rules on measuring the value of intangibles, and bringing them on the balance sheet, will also play out as changes on the other side of the balance sheet, primarily as changes in the value of assessed or book equity. Put simply, if accountants decide to bring intangible assets like brand name, management quality and patent protection into asset value will increase the value of book equity, at least as accountants measure it, in that company.? ? In their attempt to bring intangible assets on to balance sheets, accountants face a barrier of their own creation, emanating from how they treat the expenditures incurred in building up these assets. To understand why, consider how fixed assets (such as plant and equipment and equipment) become part of the balance sheet. The expenditures associated with acquiring these fixed assets are treated as capital expenditures, separate from operating expenses, and only the portion of that expenditure (depreciation or amortization) that is assumed to be related to the current year's operations is treated as an operating?expense. The unamortized or un-depreciated portions of these capital expenses are what we see as assets on balance sheets. ?The expenses that result in intangible asset acquisitions are, for the most part, not treated consistently, with brand name advertising, R&D expenses and investments in recruiting/training, the expenses associated with building up brand name, patent protection and human capital, respectively, being treated as operating, rather than capital, expenses. As a consequence of this mistreatment, I have argued that not only are the biggest assets, mostly intangible, at some companies kept off the balance sheet, but their earnings are misstated:

There are ways in which accounting can fix this inconsistency, but it will result in an overhaul of all of the financial statements, and companies and investors balk at wholesale revamping of accounting numbers (EBITDA, earnings per share, book value) that they have relied on to price these firms.? ? So, how far has accounting come in bringing intangible assets on to balance sheets? One way to measure progress on this issue is to look at the portion of the book value of equity at US companies that comes from tangible assets, in the chart below:

Looking across all US firms from 1980 to 2022, the portion of book value of equity that comes tangible assets has dropped from more than 70% in 1998 to about 30% in 2022. That would suggest that intangible assets are being valued and incorporated into balance sheets much more now than in the past. Before you come to that conclusion, though, you may want to consider the breakdown of the intangible assets on accounting balance sheets, which I do in the graph below:

Over the last 25 years, as intangible assets have risen in value, goodwill has been, by far, the biggest single component of that value, accounting for about 60% of all intangibles on US corporate balance sheets; the jump in 2001 came from a change in accounting rules on acquisitions, when pooling was banned and companies were forced to recognize goodwill on all acquisitions. So what?t, intangible or not, but more a plug variable, signifying the difference between the price paid to acquire a target company and its book value, with adjustments for fairness, and designed to make balance sheets balance. Thus, much of the talk about intangibles in accounting has been just that, talk, with little of real consequence for balance sheets.?? ? There is another measure that you can use to see the futility, at least so far, of accounting attempts to value intangibles. In the graph below, I look at the aggregated market capitalization of companies, in 2022, which should incorporate the pricing of intangibles by the market, and compare that value to book value (tangible and intangible), by sector, reflecting accounting attempts to value these same intangibles.

The sectors where you would expect intangible assets to be the largest portion of value are consumer products (brand name) and technology (R&D and patents). These are also the sectors with the lowest book values, relative to market value, suggesting that whatever accountants are doing to bring in intangibles in these companies into book value is not having a tangible effect on the numbers.?? ? In sum, the accounting obsession with intangibles, and how best to deal with them, has not translated into material changes on balance sheets, at least with GAAP in the United States. It is true that IFRS has moved faster in bringing intangible assets on to balance sheets, albeit not always in the most sensible ways, but even with those rules in place, progress on bringing?intangible assets onto balance sheets has been slow. To be frank, I don't think accounting rule writers will be able to handle intangibles in a sensible way, and the barriers lie not in rules or models, but in the accounting mindset. Accounting is backward-looking and rule-driven, making it ill equipped to value intangibles, where you have no choice, but to be forward looking, and principle-driven.?

The Intrinsic Value of Intangibles

? ? I have been teaching and writing about valuation for close to four decades now, and I have often been accused of giving short shrift to intangible assets, because I don't have a session dedicated to valuing intangibles, in my valuation class, and I don't have entire books, or even chapters of my books, on the topic. While it may seem like I am in denial, given how much value companies derive from assets you cannot see, I have never felt the need to create new models, or even modify existing models, to bring in intangibles. In this section, I will explain why and make the argument that if you do intrinsic valuation right, intangibles should be, with imagination and very little modification of existing models, already in your intrinsic value.

?? ?To understand intrinsic value, it is worth starting with the simple equation that animates the estimation of value, for an asset with n years of cash flows:

Thus, the intrinsic value of an asset is the present value of the expected cash flows on it, over its lifetime. When valuing a business, where cash flows could last for much longer (perhaps even forever), this equation can be adapted:

In this equation, for anything, tangible or not, has to show up in either the expected cash flows or in the risk (and the resulting discount rate);?that is?my "IT" proposition. This proposition?has stood me in good stead, in assessing the effect on value of just about everything, from macro variables like??to buzzwords like?. ? ??

?? ?Using this framework for assessing intangible assets, from brand name to quality management, you can see that their effect on value has to come from either higher expected cash flows or lower risk (discount rates).? To provide more structure to this discussion, I reframe the value equation in terms of inputs that valuation analysts should be familiar with - revenue growth, operating margins and reinvestment, driving cash flows, and equity and debt risk, determining discount rates and failure risk.?
In the picture, I have highlight some of the key intangibles and which inputs are mostly?likely to be affected by their presence.?It is the operating margin where brand name, and the associated pricing power, is likely have its biggest effect, though it can have secondary effects on revenue growth and even the cost of capital.?Good management, another highly touted intangible, will manifest in a business being able to deliver higher revenue growth, but also show up in margins and reinvestment; the essence of superior management is being able to find growth, when it is scarce, while maintaining profitability and not reinvesting too much.?Connections to governments and regulators, an intangible that is seldom made explicit, can affect value by reducing failure risk and the cost of debt, while increasing growth and or profitability, as the company gets favorable treatment on bids for contracts.This is not a comprehensive list, but the framework applies to any intangible that you believe may have an effect on value. This approach to intangibles also allows you to separate valuable intangibles from wannabe intangibles, with the latter, no matter how widely sold, having little or no effect on value. Thus, a company that claims that it has a valuable brand name, while delivering operating margins well below the industry average, really does not, and the effect of ESG on value, no matter what its advocates claim, is non-existent.? ?It is true that this approach to ?valuing intangibles works best for a company with a single intangible, whether it be brand name or customer loyalty, where the effect is isolated to one of the value drivers. It becomes more difficult to use for companies, like Apple, with multiple intangibles (brand name, styling, operating system, user platform). While you can still value Apple in the aggregate, breaking out how much of that value comes from each of the intangibles will be difficult, but as an investor, why does it matter??

The Birkenstock IPO: A Footwear company with intangibles

? ? If you have found this discussion of intangibles abstract, I don't blame you, and I will try to remedy that by applying my intrinsic value framework to value Birkenstock, just ahead of its initial public offering. As a?company with multiple intangible components in its story, it is well suited to the exercise, and I will try to not only estimate the value of the company with the intangibles incorporated into the numbers, but also break down the value of each of its intangibles.

The Lead In

? ? Birkenstock is primarily a footwear company, and to get perspective on growth, profitability and reinvestment in the sector, I looked at all publicly traded footwear companies across the globe. the table below summarizes key valuation metrics for the 86 listed footwear companies that were listed as of September 2023.

In the aggregate, the metrics for footwear companies are indicative of an unattractive business, with more than half the listed companies seeing revenues shrink in the decade, leading into 2022 and more than quarter reporting operating losses. However, many of these companies are small companies, with a median revenue at $170 million, struggling to stay afloat in a competitive product market. Since Birkenstock generated revenues of $1.4 billion in the twelve months leading into its initial public offering, with an expectation of more growth in the future, I zeroed in on the twelve largest companies in the apparel and footwear sector, in ?market capitalization, and looked at their operating metrics:

As you can see, these companies look very different from the sector aggregates, with solid revenue growth (median compounded growth rate of 8.66% a year, for the last decade) and exceptional operating margins (gross margins close to 70% and operating margins of 24%). Each of the companies also has a recognizable or many recognizable brand names, with LVMH and Hermes topping the list. In this business, at least, brand name seems to be dividing line between success and mediocrity, and having a well-recognized brand name contributes to growth and profitability. It is this grouping that I will draw on more, as I look valuing Birkenstock.

Birkenstock's History

? ? In my work on corporate life cycles, I talk about how companies age, and how importance it is that they act accordingly. Generally, as a company moves across the life cycle, revenue growth eases, margins level off and there is less reinvestment. As a business that has been around for almost 250 years, Birkenstock should be a mature or even old company, but it has found a new lease on life in the last decade.?

?? ?Birkenstock was founded in 1774 by Johann Adam Birkenstock,?a Germany cobbler, and it stayed a family business for much of its life. In the decades following its founding, the company modified and adapted its footwear offerings, catering to wealthy Europeans in the growing German spa culture in the 1800s, and modifying its product line, adding flexible insoles in 1896 and pioneering arch supports in 1902. During the 1920s and 1930s, the company carved out a market around comfort and foot care, partnering with physicians and podiatrists, offering solutions for customers with foot pain. In 1963, the company introduced its first fitness sandal, the Madrid, and sandals now represent the heart of Birkenstock's product line.?

?? ?Along the way, serendipity played a role in the company's expansion. In 1966, a Californian named Margot Fraser, when visiting her native Germany, discovered that Birkenstocks helped her tired and hurting feet, and she convinced Karl Birkenstock to try selling the company's sandals in California. It is said that Karl advanced her credit, and helped her persuade reluctant California?retailers to carry the ?company¡¯s unconventional footwear in their stores. That proved timely, since people protesting against the war and society's ills latched on to these sandals, making them them symbolic footwear for the rebellious. in the 1990s, the brand had a rebirth, when a very young Kate Moss wore it for a cover story, and it became a hot brand, especially on college campuses. Today, Birkenstock gets more than 50% of its revenues in the United States, with multiple celebrities among its customers. The company's prospectus does a good job painting a picture of both the product offerings and customer base, leading into the IPO, and I have captured those statistics in the picture below:

Unlike some in its designer and brand name peers, the company¡¯s products are not exorbitantly over priced and the company¡¯s best seller, the Arizona, sells for close to $100. While the company sells more shoes to women than men, it sells footwear to a surprisingly diverse customer base, in terms of income, with 20% of its sales coming from customers who earn less than $50,000 a year, and in terms of age, with almost 40% of its revenues coming from Gen X and Gen Z members.

?? ?For much of its history, Birkenstock was run as a family business, capital constrained and with limited growth ambitions, perhaps explaining its long life. The turning point for the company, to get to its current form, occurred in 2012, when the family, facing internal strife, turned control of the company over to outside managers, choosing Markus Bensberg, a company veteran, and Oliver Reichert, a consultant, as co-CEOs of the company. Reichert, in particular, was a controversial pick since he was not only an outsider, but one with little experience in the shoe business, but the choice proved to be inspired. With an assist again from serendipity, when Phoebe Philo exhibited a black mink-lined Arizona on a Paris catwalk in 2012, leading to collaborations with high-end designers like Dior, the company has found a new life as a growth company, with revenues rising from?€200 million ?in 2012 to more than?€1.4 billion ?in the twelve months leading into the IPO, representing an 18.2% compounded annual growth rate over the decade:

?(October 4 filing)

The surge in revenues has been particularly pronounced since 2020, the COVID year, with different theories on why the pandemic increased demand for the product; one is that people working from home chose the comfort of Birkenstocks over uncomfortable work shoes.?The company's growth has come with solid profitability, and the table below shows key profit metrics over the last three?years:

?(October 4 filing)

Note that the company's operating and gross margins, at least in the last two years, match up well with the operating margins of the large, brand name apparel & footwear companies that we highlighted in the last section. It may be early to value brand name, but the company certainly has been delivering margins that put it in the brand name group.

? ? The strong growth since 2020 provide a strong basis for why the company is planning its public offering now, but there is another factor that may explain the timing. In 2021, the family sold a majority stake in the firm to L. Catterton, an LVMH-backed private equity firm, at an estimated value in excess of?€. That deal was funded substantially with debt, leaving a debt overhang of close to?€2?billion, in 2023; the prospectus states that all of of the company's proceeds from the offering will be used to pay down this debt. That said, the pricing for the offering has increased since news of it was first floated in July, with?€ ?increasing?to?€ and to. The company has picked up anchor investors along the way, with the Norwegian sovereign fund planning to buy?€300 million ?of the initial offering.

Birkenstock's Intangibles

? ? Birkenstock is a good vehicle for identifying and valuing intangibles, since it has so many of them, with some more sustainable and more valuable than others:? ??

Brand Name: It is undeniable that Birkenstock not only has a brand name, in terms of recognition and visibility, but has the pricing power and operating margins to back up that brand name. However, as is often the case, the building blocks that gave rise to the brand name are complex and varied. The first is the uniqueness of the footwear makes the company stand out, with people people either hating its offerings (ugly, clunky, clog) or loving it. Unlike many footwear companies that attempt to copy the hottest styles, Birkenstock marches to its own drummer. The second is that the company's focus on comfort and foot health, in designing footwear, as well as the use of quality ingredients, is matched by actions. In fact, one reason that the company makes almost all of its shoes still in Germany, rather than offshoring or outsourcing, is to preserve quality, and sticks with time-tested and quality ingredients, is to preserve this reputation. The third is that unlike some of the companies on the big brand name list, Birkenstock's are not exorbitantly over priced, and has a diverse (in terms of income and age) customer base. In short, its brand name seems to have held up well over the generations.Celebrity Customer Base: As I noted earlier, especially as Birkenstocks entered the US market, they attracted a celebrity clientele, and that has continued through today. Birkenstock attracts celebrities in different age groups, from Gwyneth Paltrow & Heidi Klum to Paris Jackson & Kendall Jenner, and more impressively, it does so without paying them sponsorship fees. If the best advertising is unsolicited, Birkenstock clearly has mastered the game.?Good Management: I tend be skeptical about claims of management genius, having discovered that even the most highly regarded CEOs come with blind spots, but Birkenstock seems to have struck gold with Oliver Reichert. Not only has he steered the company towards high growth, but he has done so without upsetting the balance that lies behind its brand name. In fact, while Birkenstock has entered into collaborative arrangements with other high profile brand names like Dior and Manolo Blank, Reichert has also turned down lucrative offers to collaborate with designers that he feels undermine Birkenstock's image.?The Barbie Buzz: For a company that has benefited from serendipitous events, from Margot Fraser's introduction of its footwear to Americans in 1966 to Phoebe Philo's sandals on the Paris catwalk in 2012, the most serendipitous event, at least in terms of its IPO, may have been the release of the Barbie movie, this summer. Margot Robbie's which has been the blockbuster hit of the year, hyper charged the demand for the company's footwear. It is true that buzzes fade, but not before they create a revenue bump and perhaps even increase the customer base for the long term.For the moment, these intangibles are qualitative and fuzzy, but in the next section, I will try to bring them into my valuation inputs.

Birkenstock Valuation

? ? My?Birkenstock valuation is built around an upbeat story of continued high growth and sustained operating margins, with the details below:

Revenue Growth: The company is coming into the IPO, with the wind at its back, having delivered a compounded annual growth rate of 18.2% in revenues in the decade leading into the offering. That said, its revenues now are?€1.4 billion, rather than the?€200 million they were in 2012, and growth rates will come down to reflect the larger scale. While the average CAGR in revenues for big brand apparel & footwear firms has been 8.66%, I believe that Oliver Reichert and the management team that runs Birkenstock will continue their successful history of opportunistic growth, and be able to triple revenues over the next decade. This will be accomplished with an assist from the Barbie Buzz in year 1 (pushing the growth rate to 25% over the next year) and a compounded growth rate of 15% a year in the following four years.Profitability: Birkenstock has had a history of strong operating margins, driven by its brand name and visibility. In the twelve months leading into the IPO, the company reported a pre-tax operating margin of 22.3%, and its margins over the last decade have hovered around 20%. I believe that the strength of the brand name will sustain and perhaps even slightly increase operating margins for the company, with the margin increasing to 23%, over the next ?year, and to 25% over the following four years.Reinvestment: Birkenstock has been circumspect in investing for growth, over its history, showing reluctance to move away from its reliance on its German workforce, and in making acquisitions. It has also not been a big spender on brand advertising, using its celebrity clientele as a key component of building and growing its brand I believe that the celebrity clientele effect will allow the company to continue on its path of efficient growth, delivering?€2.62 for every euro invested, matching the third quartile of big brand apparel firms.Risk: The Catterton acquisition of a majority stake in Birkenstock in 2021 was funded with a significant amount of debt, but the proceeds from the offering are expected to be utilized in paying down debt. The company should emerge from the offering with a debt load on par with other brand name apparel & footwear companies, and the concentration of its production in Germany will reduce exposure to supply chain and country risk.IPO Proceeds: News stories suggest that Birkenstock is planning to offer about 21.5 million shares to the public, and use the proceeds (estimated to be?€1 billion, at the?€45 offering price) to pay down debt. In conjunction, Catterton plans to sell about the same number of shares at the offering as well, reducing its stake in the company, and cashing out on what should be a big win for the private equity player.To see how these inputs play out in value, I have brought them together in the (dense) valuation picture below. With each of the inputs, I have highlighted both the numbers that I am using, as well as highlighting how much intangibles contribute to each input:

The value that I estimate for Birkenstock, with my inputs on growth, profitability and risk, is about?€8.38 billion, about 10% less than the rumored offering pricing, but still well within shouting distance of that number. In case you are tempted to use the company's many intangibles as the explanation for the difference, note that I have already incorporated them into my inputs and value. To make explicit that effect, I have isolated each intangible and its effect on value in the table below:

To value each intangible, I toggle the input that reflects the intangible on and off to determine how much it changes value. The intangible that has the biggest effect on value is brand name, followed by the strength of the management team, with the Barbie Buzz and Celebrity Effects lagging. Another way of visualizing how these intangibles play into value is to build up to estimated value of equity of?€8.38 billion in pieces:

These value judgments are based upon my estimates, and they are, of course, open for debate. For instance, you might argue that the effect of good management on revenue growth is more or less than my estimate, or even that the effects spill over into other inputs (cost of capital, margins and reinvestment), but that is a healthy debate to have.?

Pricing Factors

? ? It is undeniable that the Birkenstock IPO will be priced, not valued, and the question of how the stock will do is just as much dependent, perhaps more so, on market mood and momentum, as it is on the fundamentals highlighted in the valuation.?

Looking at news about the company, the timing works well, since the company is coming into the market on a wave of good publicity. Almost every news story that I have read about the company paints a positive picture of it, with laudatory mentions of Oliver Reichert and the company's products, intermixed with pictures of not only Barbie's pink Birkenstock but a host of other celebrities.It is the market mood that is working against the company, at least at the moment that I am writing this post (October 6, 2023). As I wrote in just a few days ago, the market mood has soured, with the optimism that we had dodged the bullet that was so widely prevalent just a few weeks ago replaced with the pessimism that dark days lie ahead for the global economy and markets.At its offering pricing of?€9.2 billion ?(€45 to?€50 per share), the company and its bankers seem to be betting that the good vibes about the company will outweigh the bad vibes in the market, but that is gamble. ?As someone who has tried and rejected the Arizona sandal, I am unlikely to be a customer for Birkenstock footwear, but this is a company with a truly unique brand name and a management team that understands the delicate balance between utilizing a brand name well and overdoing it. It is, in my view, a reach at?€45 or?€50 per share, but if the market turns sour, and the stock drops to below?€40, I would be a buyer.
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As we enter the last quarter of 2023, it has been a roller coaster of a year. We started the year with significant uncertainty about whether the surge in inflation seen in 2022 would persist as well as about whether the economy was headed into a recession. In the first half of the year, we had positive surprises on both fronts, as inflation dropped after than expected and the economy stayed resilient, allowing for a comeback on stocks, which I wrote about . That recovery notwithstanding, uncertainties about inflation and the economy remained unresolved, and those uncertainties became part of the market story in the third quarter of 2023. In July and the first half of August of 2023, it looked like the market consensus was solidifying around a soft-landing story, with no recession and inflation under control, but that narrative developed cracks in the second half of the quarter, with markets giving back gains. In this post, I will look at how markets did during the third quarter of 2023, and use that performance as the basis for examining risk capital's presence (or absence) in markets.?

The Markets in the Third Quarter

? Coming off a year of rising rates in 2022, interest rates have continued to command center stage in 2023. While the rise in treasury rates has been less dramatic this year, rates have continued to rise across the term structure:

US Treasury
While short term rates rose sharply in the first half of the year, and long term rates stabilized, the third quarter has sen a reversal, with short term rates now stabilizing and long term rates rising. At the start of October, the ten-year and thirty-year rates were both approaching 15-year highs, with the 10-year treasury at 4.59% and the 30-year treasury rate at 4.73%. As a consequence, the yield curve which has been downward sloping for all of the last year, became less so, which may have significance for those who view this metric as an impeccable predictor of recessions, but I am not one of those.? ? Moving on to stocks, the strength that stocks exhibited in the first half of this year, continued for the first few weeks of the third quarter, with stocks peaking in mid-August, but giving back all of those gains and more in the last few weeks of the third quarter of 2023:
As you can see, it has been a divergent market, looking at performance during 2023. In spite of losing 3.65% of their value in the third quarter of 2023, large cap stocks are still ahead 12.13% for the year, but small cap stocks are now back to where they were at the start of 2023. The NASDAQ also gave back gains in the third quarter, but is up 27.27% for the year, but those gaudy numbers obscure a sobering reality. ?Seven companies (NVIDIA, Apple, Microsoft, Alphabet, Meta, Amazon and Tesla) account for $3.7 trillion of the increase in market cap in 2023, and removing them from the S&P 500 and NASDAQ removes much of the increase in value you see in both indices.?? ? Breaking global equities down by sector, and looking at the changes in 2023, both for the entire year as well as just the third quarter, we arrive at the following:

?In keeping with our findings from contrasting the NASDAQ to other US indices, technology has been the best performing sector for 2023, followed by consumer discretionary and communication services. However, also in keeping with our findings on divergence across stocks, five of the eleven sectors have decreased in value in 2023, with real estate and utilities the worst performing sectors. Some of these differences across sectors reflect reversals from the damage done in 2022, but some of it is reflective of the disparate impact of inflation and higher rates across companies

? ? Finally. I looked at global equities, broken down by region of the world, and in US dollars, to allow for direct comparison:

India is the only region of the world to post positive returns, in US dollar terms, in the third quarter, and is the best performing market of the year, running just ahead of the US; note again that of the $5.2 trillion increase in value US equities, the seven companies that we listed earlier accounted for $3.7 billion. Latin America had a brutal third quarter, and is the worst performing region in the world, for the year-to-date, followed by China. If you are an equity investor, your portfolio standing at this point of 2023 and your returns for the year will be largely determined by whether you had any money invested in the "soaring seven" stocks, as well as the sector and regional skews in your investments.

Price of Risk

? ? The drop in stock and bond prices in the third quarter of 2023 can partly be attributed to rising interest rates, but how much of that drop is due to the price of risk changing? Put simply, higher risk premiums translate into lower asset prices, and it is conceivable that political and macroeconomic factors have contributed to more risk in markets. To answer this question, I started with the corporate bond market, where default spreads capture the price of risk, and looked at the movement of default spreads across ratings classes in 2023:

As you can see, bond default spreads, after surging in 2022, had a quiet third quarter, decreasing slightly across all ratings classes. Looking across the year to date, there has been little movement in the ?higher ratings classes, but default spreads have dropped substantially during2023, for lower rated bonds.? ? In the equity market, I fall back on my estimates of implied equity risk premiums, which I report at the , and you can see the path that these premiums have taken during the course of the last two years below:
The equity risk premium declined in the first half of the year, from 5.94% on January 1, 2023, to 5.00% on July 1, 2023, but have been relatively stable in the third quarter, albeit on top of higher risk free rates. Thus, the equity risk premium of 4.84% on October 1, 2023, when added to the ten-year T.Bond rate of 4.58% on that day yields an expected return on equity of 9.42%, up from 8.81% on July 1, 2023.?Put simply, notwithstanding the ups and downs in stock prices and interest rates in the third quarter of 2023, there is little evidence that changes in the pricing of risk had much to do with the volatility. Much of the change in stock and corporate bond prices in the third quarter has come from rising interest rates, not a heightened fear factor.
Risk Capital

? ? In a p, I noted a dramatic shift in risk capital, i.e., the capital invested in the riskiest investments in every asset class - young, money-losing stocks in equities, high-yield bonds in the?corporate bond market and seed capital, in venture capital. After a decade of excess, where risk capital was not just abundant, but overly so, risk capital retreated to the sidelines, creating ripple effects in private and public equity markets. In making that case, I drew on three metrics for measuring risk capital - the number of initial public offerings, the amount of venture capital investment and original issuances of high yield bonds, and I decided that it is time to revisit those metrics, to see if risk capital is finding its way back into markets.

? ? With IPOs, there have been positive developments in recent weeks, with a few high-profile IPOs (Instacart, ARM and Klaviyo) hitting the market, suggesting a loosening up of risk capital. To get a broader perspective, though, I took a look a the number of IPOs, as well as proceeds raised, in 2023, with the intent of detecting shifts:

The good news is that there has been some recovery from the last quarter of 2022, where there were almost no IPOs, but the bad news (for those in the IPO ecosystem) is that this is still a stilted recovery, with numbers well below what we observed for much of the last decade. In addition, it should be noted that the companies that have gone public in the last few weeks have had rough going, post-issuance, in spite of being priced conservatively (relative to what they would have been priced at two years ago).? ? Turning to venture capital financing, we look at both the dollar value of venture capital investing, as well as the breakdown into angel, early stage and late?stage funding:The drop off in venture capital investing that we saw in the second half of 2022 has clearly continued into 2023, with the second quarter funding down from the first. I have long argued that venture capital pricing is tied to IPO and young company pricing in public markets, and given that those are still languishing, venture capital is holding back. In short, if you are a venture capitalist or a company founder, battered by down rounds and withheld capital, the end is not in sight yet.? ? Finally, companies that have ?ratings below investment?grade need access to risk capital, to make original issuances of bonds. In the chart below, I look at corporate bond issuances in 2023:
The good news is that corporations are back to issuing bonds, perhaps recognizing that waiting for rates to come down is futile. However, the portion of these issuances that are high-yield bonds has stayed low for the last six quarters, suggesting that the market for these bonds is still sluggish.?? ? Looking across the risk capital metrics, notwithstanding the recovery we have seen in equities this year, it looks like risk capital is still on the side lines, perhaps because that recovery is concentrated in large and money-making companies. Until you start see stock market gains widen and include smaller, money-losing companies, it is unlikely that we will see bounce backs in the venture capital and high-yield bond markets. Even when that recovery comes, I believe that we will not return to the excesses of the last decade, and that is, in my view, a good development.

What now?

? ? Entering the last quarter of 2023, it is striking how little the terrain has shifted over the last nine months. The two big uncertainties that I highlighted at the start of the year - whether inflation would persist or subside and whether there would be a recession - remain unresolved. If anything, the failed prognostications of economists and market gurus on both of these macro questions has left us with even less faith in their forecasts, and more adrift about what's coming down the pike. On the economy, the consensus view at the start of 2023 was that we were heading into a recession, with the only questions being when it would kick in, and how deep it would be. One reason for market outperformance this year has been the performance of the economy, which has managed to not only avoid a recession but also deliver strong employment numbers:

It is true that if you squint at this graph long enough, you may see signs of slowing down, but there are few indicators of a recession. This data may explain why economists have become more optimistic about the future, over the course of 2023, as can be seen in their estimates of the probability of a recession:?

The economists polled in this survey have reduced their likelihood of a recession from more than 60% to about 40%, with the steepest drop off occurring in the last two months. ? ? ?

?? ?On inflation, we started the year with the consensus view that inflation would come down, but only because of economic weakness. The positive surprise for markets in 2023 is that inflation has come down, without a recession yet in sight:

The drop off in inflation ?in the first half of 2023 was steep, both in actual numbers (CPI and PPI) and in expectations (from surveys of consumers and the treasury market). While the third quarter saw of leveling off in those gains, it is clear that inflation has dropped over the course of the year, albeit to levels that still remain about Fed targets. If you are one of those who argued that inflation was transitory, this year is not a vindication, since prices, even if they level off, will be about 20% higher than they were two years ago. There is work to be done on the inflation front, and declaring premature victory can be dangerous.

Valuing Equities

? ? In response to what this means for the market, I have to start with a confession, which is that I am not a market timer, making it very unlikely that I will find the market to be mis-valued by a large magnitude. In keeping with a practice that I have used before (see my start-of-the year and mid-year valuations), I valued the S&P 500, given current market interest rates and consensus estimates of earnings for the future:

As you can see, with the 10-year treasury bond rate at 4.58% and the earnings estimates from analysts for 2023, 2024 and 2025, I estimate an intrinsic value of the index of 4147, about 3.4% below the actual index level of 4288, making it close to fairly valued.??? ?My assessment is a bit of a cop-out, since they are built on current interest rate levels and consensus earnings estimates. To the extent that your views about inflation and the economy diverge from that consensus can cause you to arrive at a different value. I have tried to capture four scenarios in the picture below, with a contrast to the market consensus scenario above, and computed intrinsic value under each one:
As you can see, your views on inflation (stubborn or subsides) and the economy (soft landing or recession) will lead you to very different estimates of intrinsic value, and judgments about under or over valuation.??? ?Since I am incapable of forecasting inflation and economic growth, I fall back on another tool in my arsenal, a Monte Carlo simulation, where I allow three key variables (risk free rate, equity risk premium, earnings in 2024 & 2025) to vary, and estimate the effect on index value:
The median value across 10,000 simulations is 4199. 2.1% below the index value of 4288, confirming my base case conclusion. If there is a concern here for equity investors, it is that there is more downside than upside, across the simulation, and that should be a factor in asset allocation decisions. It can also explain not only why there is reluctance on the part of investors to jump on the bandwagon, but also the presence of high-profile investors, short selling the entire equity market.?
Conclusion? ? As I was writing this post, I am reminded of one of my favorite movies, , where Bill Murray is a weatherman who wakes up and relives the same day over and over again. We started the year, talking about inflation and a possible recession, and we keep returning to that conversation repeatedly. You may want to move on, but it is unlikely that either uncertainty will be resolved in the near future. In the meantime, the market will continue swinging between wild optimism (where inflation is no longer viewed as a threat and the economy has a soft landing) and extreme pessimism (where inflation comes back with a bang and the economy falls into a?recession). The truth, as is often the case, will fall somewhere in the middle, but it will not be easy to find.
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