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Happy New Year, and I hope that 2022 brings you good tidings! To start the year, ÌýI returned to a ritual that I have practiced for thirty years, and that is to take a look at not just market changes over the last year, but also to get measures of the financial standing and practices of companies around the world. Those measures took a beating in 2020, as COVID decimated the earnings of companies in many sectors and regions of the world, and while 2021 was a return to some degree of normalcy, there is still damage that has to be worked through. This post will be one of a series, where I will put different aspects of financial data under the microscope, to get a sense of how companies are adapting (or not) to a changing world.

The Moneyball Question

When I first started posting data on my website for public consumption, it was designed to encourage corporate financial analysts and investors alike to use more data in their decision making. In making that pitch, I drew on one of my favorite movies, Moneyball, which told the story of Billy Beane (played by Brad Pitt), the general manager of the Oakland As, revolutionized baseball by using data as an antidote to the gut feeling and intuition of old-time baseball scouts.

In the years since Beane tried it with baseball, Moneyball has decisively won the battle for sporting executives' minds, as sport after sport has adopted its adage of trusting the data, with basketball, football, soccer and even cricket adopting sabermetrics, as this sporting spin off on data science is called. Not surprisingly, Moneyball has found its way into business and investing as well. ÌýIn the last decade, as tech companies have expanded their reach into our personal lives, collecting information on choices and decisions that used to private, big data has become not just a buzzword, but also a justification for investing billions in companies/projects that have no discernible pathway to profitability, but offer access to data. ÌýAlong the way, we have all also bought into the notion of crowd wisdom, where aggregating the choices of tens of thousands of choice-makers, no matter how naive, yields a consensus that beats expert opinion. After all, we get our restaurant choices from Yelp reviews, our movie recommendations from Rotten Tomatoes, and we have even built crypto currencies around the notion of crowd-checking transactions.

Don't get me wrong! I was a believer in big data and crowd wisdom, well before those terms were even invented. After all, I have lived much of my professional life in financial markets, where we have always had access to lots of data and market prices are set by crowds of investors. That said, it is my experience with markets that has also made me skeptical about the over selling of both notions, since we have an entire branch of finance (behavioral finance/economics) that has developed to explain how more data does not always lead to better decisions and why crowds can often be collectively wrong. As you use my data, I would suggest four caveats to keep in mind, if you find yourself trusting the data too much:More data is not always better than less data: In a , I argued that we as investors and analysts) were drowning in data, and that data overload is now a more more imminent danger than not have enough data. I argued that disclosure requirements needed to be refined and that a key skill that analysts will need for the future is the capacity to differentiate between data and information, and materiality from distraction.Data does not always provide direction: As you work with data, you discover that its messages are almost always muddled, and that estimates always come with ranges and standard errors. In short, the key discipline that you need to tame and use data is statistics, and it is one reason that I created my own quirky version of a statistics class on my website.Mean Reversion works, until it does not: Much of investing over the last century in the US has been built on betting on mean reversion, i.e. that things revert back to historical norms, sooner rather than later. After all, the key driver of investment success from investing in low PE ratio stocks comes from their reverting back towards the average PE, and the biggest driver of the Shiller PE as a market timing device is the idea that there is a normal range for PE ratios. While mean reversion is a strong force in stable markets, as the US was for much of the last century, it breaks down when there are structural changes in markets and economies, as I argued in this post.ÌýThe consensus can be wrong: A few months ago, I made the mistake of watching Moneyheist, a show on Netflix, based upon its , and as I wasted hours on this abysmal show, I got a reminder that crowds can be wrong, and sometimes woefully so. As you look at the industry averages I report on corporate finance statistics, from debt ratios to dividend yields, remember that just because every company in a sector borrows a lot, it does not mean that high debt ratios make sense, and if you are using my industry averages on pricing multiples, the fact that investors are paying high multiples of revenues for cloud companies does not imply that the high pricing is justified.In short, and at the risk of stating the obvious, having access to data is a benefit but it is not a panacea to every problem. Sometimes, less is more!
The Company Sample for 2022When I first started my data collection and analysis in 1990, data was difficult to come by, and when available, it was expensive. Without hundreds of thousands of dollars to spend on databases, I started my journey spending about a thousand dollars a year, already hitting budget constraints, subscribing to a Value Line database that was mailed to me on a CD every year. That database covered just 1700 US companies, and reported on a limited list of variables on each, which I sliced and diced to report on about a dozen variables, broken down by industry. Times have changed, and I now have access to extraordinarily detailed data on almost all publicly traded global companies. I am grateful to all the services that provide me with raw data, but I am cognizant that they are businesses that make money from selling data, and I try not to undercut them, or act as a competitor. That is why almost every variable that you will see me reporting on my website represents a computation or estimate of mine, albeit with raw data from a provider, rather than a regurgitation of data from a service. It is also why I report only aggregated data on industries, rather than company-level data.
Regional BreakdownMy data sample for 2022 includes every publicly traded firm that is traded anywhere in the world, with a market capitalization that exceeds zero. That broad sweep yields a total of 47,606 firms, spread across 135 countries and every continent in the world:
The largest slice is Small Asia, where small has to be read in relative terms, since it includes all of Asia, except for India, China and Japan, with 9,408 firms. It is followed by the United States, with 7,229 firms, and then China (including Hong Kong listings), with 7.043 firms. Since many of these firms have small market capitalizations, with some trading at market caps of well below $10 million, the chart below looks at the breakdown of the sample in market capitalization:
The market capitalization breakdown changes the calculus, with the US dominating with $52 trillion in collective market cap, more than 40% of the overall global value, followed by China with $19 trillion in aggregate market capitalization.Ìý
Sector/Industry BreakdownThe most useful way to categorize these 47,606 companies is by industry groupings, but that process does raise thorny questions about what industry groupings to use, and where to put firms that are not easily classifiable. To illustrate, what business would you put Apple, a company that was categorized (rightly) as a computer hardware company 40 years ago, but that now gets more than 60% of its revenues and profits from the iPhone, a telecommunication device that is also a hub for entertainment and services? I started my classification with a very broad grouping, based upon S&P's sector classes:This should not come as a surprise, especially given their success in markets over the last decade, but technology is the largest sector, accounting for 19.22% of global market capitalization, though industrials account for the largest number of publicly traded firms. One sector to note is energy, which at 4.86% of global market capitalization at the start of 2022, has seen its share of the market drop by roughly half over the last decade. Addressing the legitimate critique that sector classifications are too broad, I created 94 industry groupings for the companies, drawing on the original classifications that I used for my Value Line data thirty years ago (to allow for historical comparisons) and S&P's industry list. The table below lists my industry groups, with the number of companies in each one:I am sure that some of you will find even these industry groupings to be over-broad, but I had to make a compromise between having too many groupings, with not enough firms in each one, and too few. It also required that I make judgment calls on where to put individual firms, and some of those calls are debatable, but I feel comfortable that my final groups are representative.
The Data VariablesWhen I first started reporting data, I had only a dozen variables in my datasets. Over time, that list has grown, and now includes more than a hundred variables. A few of these variables are macro variables, but only those that I find useful in corporate finance and valuation, and not easily accessible in public data bases. Most of the variables that I report are micro variables, relating to company choices on investing, financing and dividend policies, or to data that may be needed to value these companies.
Macro DataIf your end game is obtaining macroeconomic data, there are plenty of free databases that provide this information today. My favorite is the one maintained by the , which contains historical data on almost every macroeconomic variable, at least for the US. Rather than replicate that data, my macroeconomic datasets relate to four key variables that I use in corporate finance and valuation.Risk Premiums: You cannot make informed financial decisions, without having measures of the price of risk in markets, and I report my estimates for these values for both debt and equity markets. For debt markets, it takes the form of default spreads, and I report the latest estimates of these corporate bond spreads at this link. In the equity market, the price of risk (equity risk premium) is more difficult to observe, and I start by reporting on the conventional estimate of this measure by looking at historical returns (going back to 1928) on stocks, bonds, bills and real estate at this link. I offer an alternative forward-looking and more dynamic measure of this premium in an implied premium, with the start of 2022 estimate here and the historical values (going back to 1960) of this implied premium here.Risk free Rates: While the US treasury bond rate is widely reported, I contrast its actual value with what I call an intrinsic measure of the rate, computed by adding the inflation rate to real growth each year at this link.ÌýCurrency and Country Risk: Since valuation often requires comfort with moving across currencies, I provide estimates of risk free rates in different currencies at this link. I extend my equity risk premium approach to cover other countries, using sovereign default spreads as my starting point, at this link.Tax Rates: Since the old saying about death and taxes is true, I report on marginal tax rates in different countries at this link, and while I would love to claim that I did the hard work, the credit belongs to KPMG for keeping this data updated over time.I do update my equity risk premiums for the US at the start of every month , and the country equity risk premiums once every six months.Ìý
Micro DataI am not interested in reported financial ratios, just for the sake of reporting them, and my focus is therefore on those statistics that I use in corporate finance and valuation. You may find my choices to be off putting, but you could combine my reported data to create your own. For example, I believe that return on assets, an accounting ratio obtained by dividing net income by total assets, is an inconsistent abomination, leading to absurd conclusions, and I refuse to report it, but I do report returns on invested capital and equity.Ìý
Rather than just list out the variables that I provide data on, I have classified them into groups in the table below:
With each of these variables, I report industry averages for all companies globally, as well as regional averages for five groups: (a) US, (b) EU, UK and Switzerland, (c) Emerging Markets, (d) Japan and (e) Australia, NZ and Canada. Since the emerging market grouping is so large (representing more than half my sample) and diverse (across every continent), I break out India and China as separate sub-groups. You can find the data to download on my website, .
Data Timing and TimelinessAlmost all of the data that you will see in my updates reflects data that I have collected in the last week (January 1, 2022- January 8, 2022. ÌýThat said, there will be difference in timeliness on different data variables, largely based upon whether the data comes from the market or from financial statements.ÌýFor data that comes from the market, such as market capitalization and costs of capital, the current data is as of January 1, 2022.For data that comes from financial statements, the numbers that I use come from the most recent filings, which for most companies will be data through September 30, 2021.ÌýThus, my trailing PE ratio for January 1, 2022, is computed by dividing the market capitalization on January 1, 2022, by the earnings in the twelve months ending in September 2021. While that may seem inconsistent, it is consistent with the reality that you, as an investor or analyst, use the most current data that you can get for each variable. As we go through the year, both the market and the accounting numbers will change, and a full-fledged data service would recompute and update the numbers. I am not, and have no desire to be, a data service, and will not be updating until the start of 2023. Thus, there are two potential dangers in using my data later in the year, with the first emerging if the market sees a steep shift, up or down, which will alter all of the pricing multiples, and the second occurring in sectors that are either transforming quickly (disrupted sectors) or are commodity-based (where changes in commodity prices can alter financials quickly).
Estimation ChoicesWhen I embarked on the task of estimating industry averages, I must confess that I did not think much of the mechanics of how to compute those averages, assuming that all I would have to do is take the mean of a series of numbers. I realized very quickly that computing industry averages for pricing and accounting ratios was not that simple. To illustrate why, I present you with a slice of my table of PE ratios, by industry grouping, for US firms, the start of 2022:Take the broadcasting group, just as an illustration, where there were 29 firms in my US sample. The three columns with PE ratios (current, trailing and forward) represent simple averages, but these case be skewed for two reasons. The first is the presence of outliers, since PE ratios can be absurdly high numbers (as is the case with auto & truck companies), and can pull the averages up. The second is the bias created by removing firms with negative earnings, and thus no meaningful PE ratio, from the sample. The last two columns represent my attempts to get around these problems. In the second to last column, I compute an aggregated PE ratio, by taking the total market capitalization of all firms in the group and dividing by the total earnings of all firms in the group, including money losers. In effect, this computes a number that is close to a weighted average that includes all firms in the group, but if a lot of firms are money-losers, this estimate of the PE ratio will be high. To see that effect, I compute an aggregated PE ratio, using only money-making firms, in the last column. You may look at the range of values for PE ratios, from 7.05 to 24.99 for broadcasting firms, and decide that I am trying to confuse the issue, but I am not. It is the basis for why I take all arguments that are based upon average PE ratios with a grain of salt, since the average that an analyst uses will reflect the biases they bring to their sales pitches.Ìý
The other issue that I had to confront, especially because my large sample includes many small companies, listed and traded in markets with information disclosure holes, is whether to restrict my sample to markets like the US and Europe, where information is more dependable and complete, or to stay with my larger sample. The problem with doing the former is that you create bias in your statistics by removing smaller and risker firms from your sample, and I chose to have my cake and eat it too, by keeping all publicly traded firms in my global sample, but also reporting the averages for US and European firms separately.
Using the DataI report the data on my website, because I want it to be used. So, if you decide that some Ìýof the data is useful to you, in your investing or analysis, you are welcome to use it, and you don't have to ask for permission. If you find errors in the data, please let me know, and I will fix it. If you are looking for a variable that I do not compute, or need an average for a region that I don't report separately on (say Brazil or Indonesia), please understand that I cannot meet customized data requests. I am a solo operator, with other fish to fry, and there is no team at my disposal. As I , this data is meant for real time analysis for those in corporate finance and valuation. It is not designed to be a research database, though I do have going back in time, and you may be able to create a database of your own. If you do use the data, I would ask only three things of you:Understand the data: I have tried my best to describe how I compute my numbers in the spreadsheets that contain the data, in worksheets titled "Variables and FAQ". On some of the variables, especially on equity risk premiums, you may want to read the papers that I have, where I explain my reasoning, or watch my classes on them. Whatever you do, and this is general advice, never use data from an external source (including mine), if you do not understand how the data is computed.Take ownership: If you decide to use any of my data, especially in corporate financial analysis and valuation, please recognize that it is still your analysis or valuation.ÌýDon't bring me into your disagreements, especially in legal settings: If you are in disagreement with a colleague, a client or an adversary, I am okay with you using data from my website to buttress your arguments, but please do not bring me in personally into your disputes. This applies in spades, if you are in a legal setting, since I believe that courts are where valuation first principles go to die.ConclusionI would love to tell you that I am driven by altruistic motives in sharing my data, and push for sainthood, but I am not. ÌýI would have produced all of the data that you see anyway, because I will need it for my work, both in teaching and in practice, all year. Having produced the data, it seems churlish to not share it, especially since it costs me absolutely nothing to do so. If there is a hidden agenda here, it is that I think that in spite of advances over the last few decades, the investing world still has imbalances, especially on data access, and I would like it make a little flatter. Thus, if you find the data useful, I am glad, and rather than thank me, please pass on the sharing.Ìý
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At the start of every semester for as long as I can remember, I have invited people to sit in informally on my classes at NYU or take the shorter online versions on my website. After thirty six years of teaching, you would think I would be jaded, but I am not. As we get ready for the spring, I am excited, perhaps more so than usual, because I hope to finally be in a real classroom, instead of online, for my classes.Ìý

Spring is here, and the classroom beckons!

Ìý Ìý I have always , first and foremost, but like many of you, COVID has been a disruptor. For much of the last two years, rather than teach my classes in a classroom, IÌýtaught my classes fromÌýmy home office, making a few low-cost, low-tech investments to improve my set up.Ìý

I know that many of us, especially as we age, take the dystopian view that technology has hurt more than helped, and while I share the concern about the damage that social media has wrought on society, I remain thankful for the good that has come from technological advances. The combination of speedy internet access and delivery platforms (Zoom, Teams, Skype, Blue Jeans etc.) allowed me to deliver my classes from home, with some help. With aÌý, a and my in sidecar mode, I could see everyone in my class, albeit with some work; with Zoom, the limit was 48 students at a time. My Ìýand my , took care of my audio needs, and my supplemented my computer's camera to cover my video requirements, with two extra spotlights for late evening sessions, when natural light failed. To top it all off, and this was priceless, I could see the Pacific Ocean, out of my window, especially when I was able to teach standing, using my to elevate my monitor. (If you are wondering why I have been so specific about my accessories, it is not because I receive sponsorship payments from any of these companies, but because it may help you replicate my set up, other than the view of the Pacific, if you are teaching or working from home. If you have a bigger budget, I would try to , who described his astounding set up for teaching last year.)

ÌýÌýÌý ÌýIn these last two years, I have learned a lot about online teaching and I hope that learning makes me a better teacher, both online and in the classroom.Ìý

First, with today's technology, online classes get scarily close to physically being in aÌýclassroom, a reminder to me, and teachers all over the world, that unless we offer something unique in a classroom setting, disruption is coming for the teaching business.ÌýSecond, I learned there is some learning that is better delivered online, than in a physical setting, and I believe that there are some topics that I will continue to deliver online, even after this virus passes on.ÌýThird, while I still loved teaching online, I desperately missed the feeling of being in an actual classroom, looking at a collection of faces, some with eyes closed, some bored and some waiting to ask a question. After all, every teacher is a repressed actor, and actors draw their energy from their audiences, and I have been missing mine!

Each semester, I step into a classroom wanting to teach the “best� class that I ever have, perhaps even the perfect class, knowing fully well that I will fall short, in practice, because there will be things to improve.

Classes

Ìý Ìý I am a dabbler, not a specialist, and my teaching reflects that predisposition. During my teaching lifetime, I have taught a wide swath of classes, ranging from banking to equity instruments, but in the last twenty years, my focus has been on three classes, corporate finance, valuation and investment philosophies, with the last one taught only online. My classroom teaching at Stern has been mostly corporate finance and valuation, to both MBAs and undergraduates. With MBAs, the corporate finance class has been a first year elective and the valuation has been an elective in the second year, and with undergraduates, I have alternated between the two classes across the years. I have added shorter online versions of each class, offered on , at no cost, but with no credit. Starting a fewÌýyears ago, Stern has offered certificate versions of each of the three classes, albeit at a price, but with more structure (quizzes, exams, projects) and a certificate, if you make it through.Ìý

Pre-Game Prep

Ìý Ìý In all of my regular classes, I have drawn on the assumption that my students come in with an exposure and understanding of three areas, accounting (more in the context of being able to read financial statements than theÌýmechanics of debit and credit), basics of finance (especially the time value of money and anÌýunderstanding of markets) and statistics (how to make sense of data). Being a control freak, I have created my own versions of what I would like my students to know in each of these disciplines, and you can find myÌýversions on my website. WithÌýeach of my classes, I am sure that purists in each of these areas would blanch not just at myÌýchoice of topicsÌýthat matter, but also at myÌýsloppiness in description, but I will let you be the judge of content.

Ìý Ìý The place to start is withÌýaccounting. Much as I abuse accountants in my classroom, I also recognizeÌýthat almost all of the raw material we use in corporate finance and valuation comes from accounting statements.ÌýPut simply, if youÌýcannot tell the difference betweenÌýoperating and net income, or what to consider as debt, you will be lost inÌýany type of financial analysis. In my eleven-session (with each session lasting 15-20Ìýminutes) accounting class, I cover the material that I draw on in my finance classes:

Once you have the accounting basics under your belt, you can turn to the basics of finance. The time value of money is at the heart of almost everything in finance, and understanding the mechanics and intuition of present value is a bedrock on financial analysis. In my introductory finance class, I cover the time value of money, and how risk plays out in that computation, as well as look at three macro variables that we encounter repeatedly in financial analyses - inflation, interest rates and exchange rates.

Finally, we live in the age of data, and it is surprising that we use that data so little, and when we do, so badly. If the role of statistics is to make sense of large and contradictory data, it is a critical skill in every discipline, and especially one, with as many numbers as finance. With the full disclosure that I am a statistical novice, I put together a statistics class, purely as a user of its many tools, and in 13 sessions, ÌýI cover everything from descriptive statistics to multiple regressions and simulations.


If you are well versed in accounting, statistics and the basics of finance, you may find the material in these classes simplistic, but it never hurts to reinforce existing concepts.

The Game

Ìý Ìý If you have the pre-game behind you, it is time to turn to the main attractions (or tortures, depending on your perspective), and I will present them in the sequence that I think it makes the most sense to take them, if you want to torture yourself by taking all three.Ìý

a. Corporate Finance

ÌýÌý ÌýIf you have taken a corporate finance class in your past life, you may be surprised by what I cover, and what I do not, in my corporate finance class. My version of the class should have a different name, since it is not just about corporations and I am not sure that it is all about finance either. It covers the first financial principles that govern how to run a business, and as a consequence, it has the broadest reach and the deepest impact of any of my classes. Whether you are an entrepreneur, starting on the long process of converting an idea into a business, a manager, evaluating how to make business decisions consistently or a consultant, offering advice on what a business should do differently, corporate finance is your go-to class, since it offers guiding principles for all your tasks. I start the class with a one-page summary of the entire class:

As you can see from the coverage, everything that happens in business is fair game in a corporate finance class, from whether ESG adds or detracts from value, why companies are shifting from paying dividends to buying back stock and how corporate tax changes can affect financing decisions. It is also, in every sense of the word, an applied class, with every concept applied to real companies that range the spectrum, across the life cycle, geographies and sectors.

Ìý ÌýI will be teaching this class toÌýStern MBAs, starting on January 31, 2022, meeting every Monday and Wednesday, from 10.30 am - 11.50 am, New York time, through May 9, 2022. If you are a Stern MBA, you are welcome to take the class, but if you are not, you can take the classÌýinformally,Ìýby watching the recorded sessions at this link, taking the quizzes and exam, if you are up for them, and evenÌýtracking the emails that I send the class at this link. Since the 26 sessions of the class are 80 minutes apiece, this will require a substantialÌýinvestment in time,Ìýthough no investment in money, albeit with no certification or credit. If that time investment is too much of a burden, I have created , with 15-minute sessions replacing the longer classroom sessions, and while they will cost you nothing as well, they come with no certification. If certification is your end game, and I understand that it may help augment a resume, you can take the in the fall of 2022, with a more polished interface and personal interaction, but the same content, where you will get a certification and NYU will get a portion of your savings.Ìý

b. ValuationÌý

Ìý Ìý My valuation class starts with an ambitious agenda, i.e., to give you the tools and techniques to value or price just about anything, from bitcoin to collectibles to infrastructure projects, and from any perspective, from a potential buyer to an accountant estimating fair value.Ìý

Along the way, I emphasize what I believe to be long standing truths about valuation. First, it is a craft, not an art or a science, and you get better at valuation by doing, not by reading or watching others do valuation. Second, while there are many practitioners and academics who use the words value and price interchangeably, the value and pricing processes are not only driven by different determinants, but also can yield different numbers for the same asset. Third, while valuations ultimately are collections of numbers, those numbers lose their resonance and meaning, if they are not connected to narratives that tie these numbers together.

Ìý Ìý This class will be taught to two different audiences, Stern MBAs, many of whom were in my corporate finance class last spring, and Stern undergraduates, mostly juniors. While the first group will meet every Monday and Wednesday, from 1.30 pm - 2.50 pm, from January 31, 2022, to May 9, 2022, and theÌýsecond will meet every Monday and Wednesday from 3.30 pm - 4.45 pm, from January 24, 2022, to May 9, 2022, the classes areÌýidentical in content and delivery. You areÌýwelcome to unofficially partake in either of these classes, both in recorded form, but as with corporate finance, you can take an , with twenty six shorter (15-minute) sessions, for free,Ìýwith no certification, on my site, or for a price and aÌý.

c. Investment Philosophy

Ìý Ìý This class has its origins in a seminar class that I was asked to teach more than twenty years ago, where successful investors would come in each session and talk about what they did in investing that made them successful. As we transitioned from technical analysts to value and growth investors to market timers, each of whom was successful, albeit with wildly different views of markets and divergent paths to success, I concluded that there could not be one template for investment success, and started looking at not only differences in investment philosophies, but also what personal qualities made for success, with each one. That led to , and then to a class on investment philosophies, where I cover the range of choices.

If there are two lessons that I hope that people take away from this class, it is (a) that no investment philosophy, no matter how storied and successful it has been in the past, has a monopoly on investment virtue and that (b) the right investment philosophy for you is the one that best fits your personality and strengths.Ìý

Ìý Ìý While I do not teach this course in a classroom, there are two ways you can take the class. One is , where I lead you through a journey through different investmentÌýphilosophies, weighing not just pastÌýsuccesses, but also the combination of factors that you need to have to succeed each one, over the course of 36 sessions. As with the other online classes on my site, it is free, but without certification. IfÌýyou do want certification, there is the available here, but for a price (that I do notÌýset or control... so it is not fair to argue its fairness or unfairness with me).

Game Plan

Ìý ÌýÌýWhile I hope that the descriptions of the classes will help you decide which of these courses best fits you, you may still be confused about the choices and the sequence. I hope that the flow chart below provides a little more clarity:

As you can see, if your end game is financial decision making within a business, as owner or employee, the corporate finance class will do, whereas if your intent is to learn the skills of appraising value, either for accounting/regulatory or transaction purposes, adding valuation will augment your tool kit. Finally, if you are an investor in companies, and are uninterested in the mechanics of value, you can go directly to the investment philosophies class, or make an intermediate stop, and take a look at valuation.
ConclusionÌý Ìý Each time I present theseÌýchoices, I will alwaysÌýhave a few people demand toÌýknow my investmentÌýrecord, and with respect, IÌýwill refuse, for two reasons. First, there is nothing in myÌýtrack record, whether positive or negative, that will help you assess whether what I talk about has heft, since luck is the dominant factor in any investor's track record, even over long periods. Second, this demand would make complete sense, if I were seeking to manage your money, which I am not, or promising you investment riches, which I am also not. If this absence of proof is a deal breaker for you, I understand, but if it is, trust me when I say that t.ÌýMy classes may not make you richer or wiser, but I hope that they give you a fresh perspective on finance and markets and the confidence to question what others contend to be truths. May the force be with you!

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Class List

Accounting for finance and investing (, )Foundations of FinanceÌý(, )Statistics for finance and investingÌý(, )Corporate Finance (, , )Valuation (, , , )Investment PhilosophiesÌý(, )

One of the big news stories of last week was Jack Dorsey stepping down as CEO of Twitter, and the market's response to that news was to push up Twitter's stock price by almost 10%. That reaction suggested, at least for the moment, that investors believed that Twitter would be better off without Dorsey running it, a surprise to those in the founder-worship camp. As the debate starts about whether Dorsey's hand-picked successor, Parag Agrawal, is the right person to guide Twitter through its next few years, I decided to revisit a broader question of what it is that makes for a "great CEO" and how there is no one right answer to that question, because it depends on the company, and where it stands in its life cycle. In the process, I will also look at the thorny issue of what happens when there is a mismatch between a company and its CEO, either because the board picks the wrong candidate for the job or because the company has changed over time, and the CEO has not. Finally, I will use the framework to look at the relationships between founders and their companies, and how mishandling management transitions can have damaging, perhaps even devastating, consequences for value.

The "Right" CEO: A Corporate Life Cycle Perspective

Ìý ÌýThe notion that there is a collection of characteristics that makes a person a great CEO for a company, no matter what its standing, is deeply held and fed into by both academics and practitioner. In this section, I willÌýbegin by looking at the mythology behind this push, and why it does not hold up to common sense questioning.Ìý

The Mythology of the Great CEO

Ìý Ìý Are there a set of qualities that make for a great CEO? To answer the question, I looked at two institutions, one academic and one practice-oriented, that are deeply invested in that idea, and spend considerable time advancing it.Ìý

The first is the Harvard Business School, where every student who enters the MBA program is treated as a CEO-in-waiting, notwithstanding the reality that there are too few openings to accommodate that ambition. The Harvard Business Review, over the years, has published multiple articles about the characteristics of the most successful CEOs, and Ìýfor instance, highlights four characteristics that they share in common: (a) deciding with speed and conviction, (b) engaging for impact with employees and the outside world (c) adapting proactively to changing circumstances and (d) delivering reliably.The second is McKinsey, described by some as a CEO factory, because so many of its consultants go on to become CEOs of their client companies. In ÌýMcKinsey lists the mindsets and practices of the most successful CEOs in the following picture:Ìý
Given how influential these organizations are in framing public perception, it is no surprise that most people are convinced that there is a that applies across companies, and that boards of directors in search of new CEOs should use this template.ÌýÌýÌý ÌýThat perspective also gets fed by books and movies about successful CEOs, real or imagined. Consider Warren Buffett, Jack Welch and Steve Jobs, very different men who have been mythologized in the literature, as great CEOs. Many of the books about Buffett read more like hagiographies than true biographies, given how star struck the writers of these books are about the man, but by treating him as a deity, they do him a disservice. The fall of GE has taken some of the shine from Jack Welch's star, but at his peak, just over a decade ago, he was viewed as someone that CEOs should emulate. With Steve Jobs, the picture of an innovative, risk-taking disruptor comes not just from books about the man, but from movies that gloss over his first, and rockier, stint as founder-CEO of Apple in the 1980s.Ìý Ìý The problem with the one-size-fits-all great CEO model is that it does not hold up to scrutiny. Even if you take the HBR and McKinsey criteria for CEO success at face value, there are three fundamental problems or missing pieces. First, even if all successful CEOs share the qualities listed in the HBR/McKinsey papers, not all people or even most people withÌýtheseÌýqualities become successful CEOs. So, is there a missing ingredient that allowed them to succeed? If so, what is it? Second, I find it odd that there are no questionable qualities listed on the successful CEO list, especially given the evidence that over confidence seems to be a common feature among CEOs, and that it is this over confidence that allows them to take act decisively and adopt long term perspectives. When those bets, often made in the face of long odds, pay off, the makers of those bets will be perceived as successful, but when they do not, the decision makers are consigned to the ash heap of failure. Put simply, it is possible that the quality that binds together successful CEOs the most is luck, a quality that neither Harvard Business School nor McKinsey can pass on. Third, there are clearly some successful CEOs who not only do not possess many of the listed qualities, but often have the inverse. IfÌýyou believe that Elon Musk and Marc Benioff, CEOs of Tesla and Salesforce, are great CEOs, how many of the Harvard/McKinsey criteria would they possess?

The Corporate Life Cycle

Ìý Ìý I believe that the discussion of what makes for a great CEO is flawed for a simple reason. There is no one template that works for all companies, and one way to see why is to bring in the notion that companies go through a life cycle, from start-ups (at birth) to maturity (middle age) to decline (old age). At each stage of the life cycle, the focus in the company changes, as do the qualities that top managers have to bring for success:

Early in the life cycle, as a company struggles to find traction with a business idea that meets an unmet demand, you need a visionary as a CEO, capable of thinking outside the box, and with the capacity to draw employees and investors to that vision. In converting an idea to a product or service, history suggests that pragmatism wins out over purity of vision, as compromises have to be made on design, production and marketing to convert an idea company into a business. As the products/services offered by the company scale up, the capacity to build businesses becomes front and center, as production facilities have to be built, and supply chains put in place, critical for business success, but clearly not as exciting as selling visions. Once the initial idea has become a business success, the needs to keep scaling up may require coming up with extensions of existing product lines or geographies to grow, where an opportunistic, quick-acting CEO can make a difference. As companies enter the late phases of middle age, the imperative will shift from finding new markets to defending existing market share, in what I think of the trench warfare phase of a company, where shoring up moats takes priority over new product development. The most difficult phase for a company is decline, as the company is dismantled and its sells or shuts down its constituent parts, since any one who is put in charge of this process has only pain to mete out, and bad press, to go with it. Have you ever read a book or seen a movie about a CEO who shrunk his or her company, where that person is painted as anything but a villain? In fact, I used "Larry the Liquidator" as my moniker for that CEO, to pay homage to one of my favorite movies of all time, "Other People's Money":

Ìý Ìý

As you watch the video, note that the CEO of the company, under activist attack, is played by Gregory Peck (the distinguished gray-haired gentleman who sits down at the start of the video), who presumably embodies all the qualities that Harvard and McKinsey believe embody a great CEO, and Danny DeVito plays "Larry the Liquidator". Talk about type casting, but this company needs more DeVito, less Peck!

Mismatches, Transitions and Turnover

Ìý Ìý If you buy into my structure of a corporate life cycle, and how the right CEO for a company will change as the company ages, you can already see the potential for mismatches between companies and CEOs, for three reasons.Ìý

A Hiring Mistake: The first is that the board of directors for a company seeking a new CEO hires someone who is viewed by many as a successful CEO, but whose success came at a company at a very different stage in its life cycle. I think Uber dodged the bullet in 2017, when t. Even if you had believed that Immelt was successful at his prior job as CEO for GE, and that is arguable, he would have been a horrifically bad choice as CEO at Uber, a company that is as different from GE as you can get, in every aspect, not just corporate age.ÌýA Gamble on Rebirth:ÌýThe second is when a board of director picks a mismatched CEO intentionally, with the hope that the CEO characteristics rub off on the company. This is often the case when you have a mature or declining company that thinks hiring a visionary as a CEO will lead to reincarnation as a growth company. While the impulse to become young again is understandable, the odds are against this gamble working, leaving the CEO tarnished and company worse off, in the aftermath. It was the reason that Yahoo! hired Marissa Mayer as a CEO in 2012, hoping that her success at Google would rub off on the company, would not end well for either party (and it did not).A Changing Business; The third is a more subtle problem, where a company is well matched to its CEO at a point in time, but then evolves across the life cycle, but the CEO does not. Using the Uber example again, Travis Kalatnick, a visionary and rule breaker, might have been the best match for Uber as a company, in early years, when it was disrupting a highly regulated business (taxi cabs), but even , he was ill-suited to a company that faced a monumental task of converting a model built on acquiring new riders into one that generated profits in 2017.In NY case, a CEO/company mismatch is a problem, though the consequences can range from benign to malignant.ÌýIn the most benign case, a mismatched CEO recognizes the mismatch, sets ego aside and finds a partner or co-executive with the skills needed for the company. In my view, and many of you may disagree with me, the difference between the first iteration of Steve Jobs, where he let his vision run riot and almost destroyed Apple as a company, and the second iteration, where he led one of the most impressive corporate turnarounds in history, was his choice of Tim Cook as his chief operating officer in his second go-around and his willingness to delegate operating authority. In short, Jobs was able to continue to put his visionary skills to work, while Cook made sure that the promises Jobs made were delivered as products on the ground. In the most malignant form, a badly mismatched CEO is entrenched in his or her position, perhaps because the board of directors has become a rubber stamp or by tilting voting rules (shares with different voting rights) in favor of incumbency, and continues on a pathway that takes the company to ruin. In the intermediate case, the board of directors, perhaps with a push from activist investors and large stockholders, engineers a CEO change, albeit after some or a great deal of damage has been done.

The Compressed Life Cycle: Implications for Founder CEOs

Ìý Ìý It is a testimonial to how much technology companies have changedÌýthe economy and the market that some of the best-recognized names in business are those of the founders ofÌýsuccessful technology company. I would wager that almost everyone has heard of Bill Gates, Jeff Bezos and Elon Musk, and that very fewÌýwould recognize the names of Mary Barra (CEO of GM) or Darren Woods (CEO of Exxon Mobil). While there are some who venerate these founders, in what can only be called founder worship, there are others who have a more jaundiced view of them, both as human beings and as CEOs. The corporate life cycle framework provides a usefulÌýstructure to think about how the technology companies, that dominateÌýthe twenty first century business landscape, are different from the manufacturing companies of the last century, and why these differences can create more management tensions at theseÌýcompanies.

Aging in Dog Years?

Ìý Ìý While every company goes thought the process of starting up, aging and eventually declining, the speed at which it does will vary depending on the business it is in. More specifically, the more capital it takes to enter a business and the more inertia there is among the existing players (producers, customers) are, the longer it will take for a company to get from start up to mature growth, but the same forces will play out in reverse, allowing the company to stay mature for a lot longer and decline a lot more gradual:

The great companies of the twentieth century took decades to ramp up, facing big infrastructure investments and long lags before expansion, had long stints as mature firms, milking cash flows, before embarking on long and mostly gradual declines. To illustrate, Sears and GE had century-long runs as successful companies, before time and circumstances caught up with them, and GM and Ford struggled for three decades setting up manufacturing capacity and tweaking their product offerings, before enjoying the fruits of their success. In contrast, consider Yahoo!, a company that was founded in 1994, that managed to reach a hundred billion in market capitalization by the turn of the century, enjoyed a few years of dominance, before Google's arrival and conquest of the market, before finally being acquired by Verizon in 2017. This compression of the life cycle has played out in tech company after tech company and the graph below captures the difference:
In short, tech companies age in dog years, with a 20-year tech company often resembling a hundred-year old manufacturing company, with creaky business models and facing disruption.

Implications for Founder CEOs and Management Turnover

Ìý Ìý Companies have always had founders, and while the conflict between founders and others in the company have been around for decades, the compressed life cycle has exacerbated these tensions and magnified problems. In particular, the research on founder CEOs has yielded two disparate findings. The first is that in the early stages of companies, founder CEOs either step down or are pushed out at much higher rates than in more established companies. The second is that those founder CEOs who nurse their companies to more established status, and to public offerings, are more entrenched that their counterparts at mature companies.

Ìý Ìý To understand the first phenomenon, i.e., the high displacement rateÌýamong founder CEOs of veryÌýyoung companies, I will draw on the at HarvardÌýBusiness School who has focused intensively on this topic. Using data on top management turnover at young firms, many of them non-public, he concludes that almost 30% of CEOs at these firms are replaced within a few years of inception, usually at the time of new product development or fresh financing. Much of this phenomenon can be explained by venture capitalists, with large stakes, pushing for change in these companies, but a portion of it is voluntary, and to explain why a founder CEO might willingly step down, Wasserman uses the concept of , where founders trade off full control of a much less valuable firm (with themselves in control) for lesser control of a much more valuable firm (with someone else at the helm). In the corporate life cycle structure, it is a recognition on the part of founders or capital providers that the skills needed to take a company forward require a different person at the top of the organization, especially as a firm transitions from one stage of the life cycle to the next.

Ìý Ìý The founders who do manage to stay at the helm of companies that make it throughÌýto early growth statusÌýare put on a pedestal, relative to CEOs of established companies. While that may be understandable, in some cases, it can take the form of founder worship, where founders are viewed as untouchable, and any challenge to their authority is viewed as bad, leading to efforts to change the rules of the game to prevent these challenges. In the United States, where prior to 2004, it was unusual to see shares with different voting rights in the same firm, it is now more the rule than the exception in many tech companies.Ìý

ÌýÌý ÌýEndowing CEOs with increased powers to fend off challenges seems like a particularly bad idea at tech companies, since their compressed life cycles are likely to create more, rather than less, mismatches between companies and their founder/CEOs, and sooner, rather than later. To see, why consider how corporate governance played out at Ford, a twentieth century corporate giant. Henry Ford, undoubtedly a visionary, but also a crank on some dimensions, was Ford's CEO from 1906 to 1945. His vision of making automobiles affordable to the masses, with the Model T, was a catalyst in Ford's success, but by the end of his tenure in 1945, his management style was already out of sync with the company. With Ford, time and mortality solved the problem, and his grandson, Henry Ford II, was a better custodian for the firms in the decades that followed. Put simply, when a company lasts for a century, the progression of time naturally takes care of mismatches and succession. In contrast, consider how quickly Blackberry, as a company, soared, how short its stay at the top was and how steep its descent was, as other companies entered the smart phone business. Mike Lazaridis, one of the co-founders of the company, and Jim Balsillie, the CEO he hired in 1992 to guide the company, presided over both its soaring success, gaining accolades for their management skills for doing so, and over its collapse, drawing jeers from the same crowd. By the time, the change in top management happened in 2012, it was viewed as too little, too late.

ÌýÌý ÌýIn my view, the next decade will bring forth more conflict, rooted in the compressed life cycle of companies. If I were a case study writer, and thank God I am not, I would not rush to write case studies or books about successful tech company CEOs, because many of those same CEOs will become case studies of failure within a few years. If I am an investor, I would worry more than ever before about giving up voting power to founder/CEOs, even if they are well regarded, because today's star CEO can become tomorrow's problem. I wonder whether the way Facebook has dealt with its privacy and related problems over the last few years would have been different, if investors had not allowed Mark Zuckerberg to effectively control 57% of the voting rights with less than 20% of the outstanding shares. It is worth noting that Twitter was one of the few social media companies that chose not to split its voting rights across shares, and that may explain the Jack Dorsey departure.

Implications for InvestorsÌý ÌýI have long argued that when investing in young tech companies, you are investing in a story about the company, not an extrapolation of numbers.ÌýÌýThe compressed corporate life cycle, and the potential for CEO/company mismatches that it creates, adds a layer of additional uncertainty to valuation. In short, when assessing the value of a young company's story, you are also assessing the capacity of the management of the company to deliver on that story. To the extent that the founder is the lead manager, and the narrative-setter, any concerns you have about the founder's capacity to convert that story into business success will translate into lower value. Let me illustrate using three examples, the first being Amazon in my early valuations of the company between 1997 and 2000, the second being Twitter, especially in the context of Jack Dorsey's departure and Paytm, the Indian online company, whose recent IPO was a dumpster fire.I have always liked Amazon, as a company, and one reason for that was Jeff Bezos. Many younger investors are surprised when I tell them that Bezos was not a household name for much of Amazon's early rise, and that it was The Washington Post acquisition in 2013 that brought him into public view. One reason that I attached lofty values to Amazon as a company, even when it was a tiny, money-losing company was that Bezos not only told , one that I described as , where if you build it (revenues), they (profits) will come. but acted consistently with that story. He built a management team that believed that story and trusted them to make big decisions for the company, thus easing the transition from small, online book retailer to one of the largest companies in the world. It is a testimonial to Bezos' success in transitioning management that Amazon's value as a company today would be close to the same, with or without him at the helm, explaining why on July 5 created almost no impact on the stock price.I , just ahead of its IPO in 2013, and built a model premised on the assumption that the company would find a way to monetize its larger user base and build a consistently money-making enterprise. In the years since, I have been frustrated by its inability to make that happen, and , I laid the blame at least partially at the feet of Twitter's management, contrasting its failure to Facebook's success. I don't know Jack Dorsey, and I wish him well, but in my view, his skill set seemed ill suited to what Twitter needed to succeed as a business, especially as he was splitting his time as Square's CEO, and talking about taking a . ÌýIn fact, eight years after going public, Twitter's strongest suit remains that it has lots of users, but its capacity to make money of these users is still questionable. One reason why the market responded so positively, j that Dorsey was leaving, is indicative of the relief that change was coming, and the reason that it has fallen back is that it is not clear that Parag Agrawal has what the company needs now. He has time to prove investors wrong, but he is on probation, as investors look to him to reframe Twitter's narrative and start delivering results.A few weeks ago, I , an online payment processing company built on the promise of a huge and growing online payment market in India. In my valuation, I told an uplifting story of a company that would not only continue to grow its user base and services, but also that it would increase its take rate (converting users to revenues) and benefit from economies of scale to become profitable over the course of the next decade.
I valued Paytm at aboutÌýâ‚�2,200, but in telling that story, I noted one big area of concern with existing management, that seemed to be more intent on adding users and services than on converting them into revenues, and pre-disposed to grandiosity in its statement of purpose and forecasts. In the months since, the company has gone public, and while the offering price, atÌýâ‚�2150, was close to my value, the stock price collapsed in the days after to less thanÌýâ‚�1400 and has languished at aboutÌýâ‚�1600-â‚�1700 since. It is always dangerous to try to explain why markets do what they do over short periods, but I do think that the company's founders and spokespeople did not do themselves any favors, ahead of the IPO. Specifically, if you were concerned about Vijay Sharma's capacity to convert the promise of Paytm into eventual profits, before the IPO, you would have been even more concerned after listening to him in the days leading into the IPO. It is still too early to conclude that there is a company/CEO mismatch, but if I were top management of the firm, I would talk less about users and gross merchandise value, and focus more on improving the abysmally low take rate at the firm.ÌýIf there is a general lessons for investors from this post, it is that when a founder CEO leaves his position, or is pushed out, the value change can be positive or negative, and that Ìýgood founders will work at making themselves less central to their company's stories over time and thus less critical to its value. It should also be a cautionary note for those investors who have looked the other way as venture capitalists, founders and insiders have fixed the corporate governance game in their favor, in young tech companies that go public, ensuring that mismatches from companies and CEOs, if they occur in the future, will persist.Ìý
Family Group Companies: The Life Cycle EffectÌý Ìý In much of the world, businesses, even if they are publicly traded, are run by family groups. To the extent that the top management of these businesses are members of the family, these companies are uniquely exposed to company/CEO mismatches, especially as second or third generations of a family enter the management ranks, and these families enter new businesses.

Family Group Companies: The Life Cycle Effect?Ìý Ìý Much of Asian and Latin American business is built around family groups, which have roots that go back decades. Using a combination of connections and capital, these family groups have lived through economic and political changes, and as many of the companies that they own have entered public markets, they have stayed in control. In some cases, this control has come from dominant shareholdings, but more often, it is exercised by using holding company structures and corporate pyramids that effectively leave the family in control, even as the public acquires a larger stake in equity.Ìý Ìý To see how the corporate life cycle structure story plays out in family groupÌýcompanies, it is worth remembering that family groups often control companies that spread across many different business, effectively resembling conglomerates in their reach, but structured as individual companies. Consequently, it is not only possible, butÌýlikely, that a family group will control companies at different stages in the corporate life cycle, ranging from young, growth companies at one end of theÌýspectrum toÌýdeclining companies at the other end of the spectrum. In fact, one of the reasons family groups survived and thrived in economiesÌýwhereÌýpublic markets were under developed was their capacity to use cash generated in their mature and declining businesses to cover capital needs in their growing businesses. This intra-group capital market becomes trickier to balance, as family group companies go public, since you need shareholder assentÌýfor these capital transfers.ÌýWith weak corporate governance, more the rule than the exception at family group companies, it is entirely possible that shareholders in the more mature and cash-generating companies in a family group are being forced to invest in younger, growth companies in that same group.Ìý
Implications for CEOs and ManagementÌý Ìý There is research on CEO turnover in family group companies, and the results are not surprising. In a , researchers looked at 4601 CEOs in companies, classifying them based on whether they were family CEO or outside CEOs, and found the forced turnover was much less frequent in the first group. In other words, family CEOs are less likely to be fired, and more likely to stay around until a successor is found, often within the family. While this is good news in terms of continuity, it is bad news if there is a company/CEO mismatch, since that mismatch will wreak havoc for far longer, before it is fixed.ÌýÌý Ìý What can family groups do about dealing with the mismatch, especially as the potential for that mismatch increases, as disruption turns some mature and growing businesses intoÌýdeclining ones and capital gets shifted to newÌýbusinesses in the green energy and technology space? First, power has to become more diffuse within the family,Ìýaway from a powerful family leader and more towards a family committee, to allow forÌýthe different perspectives needed to become successful in businesses at other stages in the life cycle. If, like me, you are a fan of , you don't want to model yourself on Logan Roy, and the Roy family, if you are a family group company. Second, there has to be a serious reassessment of where differentÌýbusinesses,Ìýwithin the family group, are in the life cycle, withÌýspecial attention to those that areÌýtransitioning from one phase to another. Third, if top management positions are restricted toÌýfamily members, the challenge for the family will be finding people with the characteristics needed to run businesses across the life cycle spectrum. As many family groups enter theÌýtechnology space, drawn by its potential growth, the limiting constraint might be finding aÌývisionary,Ìýstory teller from within the family, and if one does not exist, the question becomes whether the family will Ìýbe willing to bring someone fromÌýoutside, and give that person enough freedom to run the young, growth business. Finally, if a mismatch arises between a family member CEO and the business he or she is responsible for running, there has to be a willingness to remove that family member from power, sure to raise family tensions and create fights.
Implications for InvestorsÌý ÌýAre family group companies, in general, better or worse investments than investments in other publicly traded companies? The evidence, not surprisingly, is mixed, with some finding a positive payoff, which they attribute to a better alignment of long term investor and management interests at these companies, and others finding negative returns, largely as a result of management succession problems.ÌýÌýÌý ÌýTo address why family control can help in some cases, and hurt in others, it again helps to bring in the corporate life cycle.ÌýÌýIn the portions of the corporate life cycle, where patienceÌýand a steady hand are required, the presence of a family member CEO may increase value, since he or she will be more inclined to think about long term consequences for value, rather than short term profitÌýor pricing effects. On the other hand, if a family CEO is entrenched in a company that is transitioning from growth to mature, or from mature to declining, and is not adaptable enough to modify the way he or she manages the company, it is aÌýnegative for value. Family group companies composed primarily of companies in the former grouping will therefore trade at premiums, whereas family group companies that include a disproportionately large number of disrupted or new businesses will be handicapped.Ìý
ConclusionÌý Ìý I started this post by talking about Jack Dorsey leaving Twitter, and why the marketÌýcelebrated that news, but I would like to end on a more general note. If there is a take away fromÌýbringing a life cycle perspective to assessing CEO quality, it is that one size cannot fit all, and that a CEO who succeeds at a company at one stage in the life cycle may not have the qualities needed to succeed at another. For boards of directors, in search of new CEOs, my suggestion is that you pay less attention to past track records of nominees, in their prior stints as employees or as CEOs of otherÌýcompanies) and more attention to the qualities that they possess, to see if they match what the company needs to succeed.Ìý
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I have been writing about, and valuing, Tesla for most of its lifetime in public markets, and while it remains a company that draws strong reactions, it is also one that I truly enjoy valuing. It has been a while since my last valuation of the company, which occurred in January 2020, and given how much the landscape has changed since, partly as a result of the company's own actions and partly because of how COVID has upended its competitors in the automobile business, it is time to revisit the company and reassess its value, especially as the company’s market capitalization crosses a trillion dollars.

Tesla: The Back Story

I , as a "luxury automobile company" and ÌýI have valued almost every year since. If you are interested, you can see my valuations from , ÌýÌýandÌý. If you review those valuations, you will notice that in each valuation, my story for the company expanded, and my valuations increased, but the market price for the company jumped even more, leading me to conclude in each of them that it was not a company that I would invest in. While these valuations led me to different assessments of value, there were common themes across time:

At its core, Tesla has been an automobile company: In , I described it as the ultimate story stock, driven less by news about its most recent financial performance, and more by news that alters its story trajectory. I would be lying if I said that I have had clarity about Tesla's story over the last decade, because it has so many tangents, distractions and shifts along the way, flirting with narratives about being a battery company, an energy company and a technology company. In 2021, looking at the company, I feel more convinced than I was a few years that it is, at its core, an automobile company, and while it will continue to derive revenues from batteries and perhaps even software, its pathway to becoming a trillion dollar market cap company still runs through the "car company" story.Tesla has disrupted and reinvented the automobile business: Putting any company into the automobile business handicaps it, when it comes to value, for a simple reason. The automobile business has been in trouble for quite a while, struggling with anemic revenue growth in the aggregate, and abysmal profit margins, with even the very best in the group struggling to earn returns that match, let alone beat, their costs of capital. As I have valued Tesla over the years, I have come to the realization that it is the most 'uncar-like" automobile company in the world, and its uniqueness shows up on two dimensions. The first is on profitability, where its operating cost structure, unconventional distribution model (which bypasses dealerships), and capacity to augment revenues with related products and services, has given it an opening to deliver much higher margins than any automobile company in history. The second is on investment and capital intensity, where it has managed to take what critics pointed to as weaknesses (unwillingness to build large and expensive assembly plants ahead of time, to meet future demand) and made them into strengths. Put simply, the company has been able to scale up more quickly, while reinvesting less in capacity, than any other automobile company.Tesla positioned itself well for structural shifts in the economy: Tesla's success over the last few years has also been fed by three other external forces. The first is in theÌýgovernment and business response to climate change, and the resulting policies favoring electric cars over gas-powered, cars. It is undeniable that Tesla, especially in its early years, was a beneficiary of tax credits and other benefits meted out to electric car makers and buyers. The second is the rise of ride sharing, with a host of companies around the world upending the status quo in car service. While Tesla has not directly benefited yet from this trend, it has opened up possibilities for the future, built around self-driving cars, that have added to the company's allure. The third is the rise of ESG as an investing force, and the resulting shift away by investors from all things fossil-fuel related, has benefited Tesla, at the expense of the legacy automobile companies.Tesla is built around an outsized personality: When valuing publicly traded companies, I seldom talk about its top management explicitly, since the numbers reflect what they bring to the firm. That rule does not work with Tesla, since its founder and CEO, Elon Musk, has many qualities, but being self effacing is not one of them. Tesla and Musk are locked at the hip, and it is almost impossible to have a view on one, without having a similar view on the other. Put simply, I am still to meet an investor who loves (dislikes) Tesla as a company, and dislikes (loves) Musk. On the plus side, Musk is a visionary and out-of-the-box thinker, and an evangelist for his visions, who draws true believers to his cause. On the other side of the ledger, he is unpredictable and prone to distractions that draw attention away from the company, and his impulses have created costs for the company and its investors. While his net effect has clearly been a net positive for investors in Tesla, over the last decade, it is worth remembering that you are getting a package deal, when you invest in the company.Tesla draws extreme reactions: I have never valued a company, where there is as much divergence in views about the future, cross market players, that I have seen with Tesla and Musk. There are some who see Elon as the ultimate con man, and Tesla as a shell game, and many in this group have spent the last decade making Tesla one of the most shorted stocks in history. There are others who view him a savior, and map out pathways for Tesla to become the most successful company of all time, and many of them have bought shares in the company, and held through good and bad times.Ìý

My two most recent valuations were in June 2019 and January 2020, and I am going to go back to them, not just because they are recent, but because they led to investment decisions on my part.Ìý

In June 2019, Tesla had hit a rough spot, partly due to concerns about production bottlenecks and debt, and partly due to self inflicted wounds. Musk's tweets about going private, with funding secured, contributing to a sell off, driving the stock down to $180 ($36 in today's split adjusted terms). I , with conservative assumptions about growth and margins, and incorporating my concerns about managerial missteps, at about $190: While the buffer (between value and price) was small, I did buy shares in the company.Between June 2019 and January 2020, the stock went on a tear, as the stock price more than tripled, and I revisited my Tesla valuation. With a more expansive view of future growth and profitability, I Ìýand more than doubled my valuation, though that still left me well below the market price. I sold my shares then, and I know that many of you have pointed out how much money I have lost as a consequence of that sale, as the stock price has increased almost ten-fold since then, and I will come back and talk about my regrets, or absence thereof, towards the end of this post.

Tesla: The Numbers

Ìý Ìý It has been roughly 22 months since my lastÌývaluation of Tesla, and it is astonishing how much change there has been, not just in the company, but also in the macro environmentÌýthat it operates. In this section, I will start by chronicling the astonishing rise of Tesla in public markets in the last decade, follow by looking at the company's operating details and close by examining how the company has found a way to turn the COVID crisis into an opportunity.

Stock Prices and Market Cap

Ìý Ìý To put Tesla's explosive performance in the last two years in perspective, I will look at its market performance since its entry into public markets. The graph below contains Tesla's stock price, adjusted for stock splits, going back to 2010, and ending in November 2021:

While the graph illustrates the surge in the stock price, the table embedded in the graph conveys the rise Ìýmore vividly, by listing Tesla's market capitalization in millions of dollars. In sum, the company's market cap has risen from $2.8 billion in August 2010 to more than a trillion dollars in November 2021, and along the way, it has not only made Elon Musk into the wealthiest man in the world, but also enriched those who bought into his vision early, and stayed invested in the company.Ìý

Revenues and Earnings

ÌýÌý ÌýWhile the initial rise in Tesla's market capital was driven by the promise of the company, and detractors were quick to note Tesla's paltry revenues and big losses, the company's more recent financials reflect how it has acquired substance over time. In the graph below, I report on Tesla's quarterly revenues, gross profits and operating profits going back to 2013:

Tesla's quarterly revenues have risen from negligibly small values at the start of the last decade to almost $14 billion in the third quarter of 2021, making it the 20th largest automobile company in the world in 2020 (in revenue terms). The company spent much of the last decade losing large amounts each year, but it now not only generates an operating profit, but a healthy one at that, with a pre-tax operating margin of close to 15% in the third quarter of 2021.

The COVID Effect

Ìý Ìý While Tesla's resurgence has been building for a while, its growth has clearly exploded in the last year and a half, a period where our personal and business lives have been upended by COVID. DuringÌýthis most trying of times for all businesses, and especially for those in manufacturing, Tesla has notÌýjust survived, but thrived, gaining market at the expense of its rivals and accelerating towards profitability. To understand why, I would point you to a series of posts that I did during 2020 about how COVID was playing out in markets, and the winners and losers. In particular, I noted to the following aspects that made the COVID crisis different, from prior crises:

Risk capital stayed in the game: The most striking feature of last year's crisis was how quickly markets came back from the savage sell off between February 14 and March 23 of 2020, and I . Instead of withdrawing from markets, as in prior crises, venture capital investing, initial public offerings and investment in the riskiest segments of both stock and bond markets continued, and actually increased, through 2020, and those trends have continued this year.ÌýFlexibility over Rigidity: While the overall market quickly recovered, the recovery was uneven, and the crisis left behind winners and losers. , I argued that one of the key dividing lines between the two groups was flexibility, with companies with more flexible investing, financing and dividend policies winning out over companies with more rigidity on those dimensions. To be specific, service/technology companies gained at the expense of manufacturing & natural resource firms, debt-light firms won at the expense of those with much bigger debt burdens and firms that paid large dividends lost value, relative to firms that did not.Young beat old: Another factor differentiating winners and losers during 2020 was that, unlike prior crises, (with far more of their value coming from investments in place).I summarized the transfer of wealth in a table in :
As you can see young, high growth companies, with little debt and no dividends, benefited at the expense of older companies, with more debt and dividend commitments. ÌýYou could argue that if central casting were creating the perfect COVID winner, it would look a lot like Tesla, a young, adaptable company in a sector filled with companies with expensive manufacturing facilities, large debt burdens and legacy dividend policies. In fact, many of what many (including me) considered to be Tesla's weaknesses (make-shift manufacturing, seat-of-the-pants financing) in the pre-COVID age became strengths during COVID. While conventional automobile companies shuttered and scaled down manufacturing, Tesla continued to make and sell cars through the pandemic, and it is inarguable that it has come out of this crisis, far stronger than it was going into it. The table below breaks down the Tesla's performance from the last quarter of 2019 to the third quarter of 2021:
Tesla: The COVID QuartersFocusing on the key financials of the company and looking at Tesla's performance through the COVID quarters, there are trends that stand out.ÌýThe first is that the company stumbled briefly on revenues in the second quarter of 2020, as COVID restrictions kicked in, but saw a surge in growth in the quarters since, with growth rates significantly higher than in the pre-COVID years.ÌýThe second, and more significant, is that the company seems to have turned the corner on profitability, with margins not just improving, but dramatically so, with gross margins moving towards 30% and operating margins exceeding 14% in the most recent quarter.In brief, if there Tesla's growth was lagging, leading into 2020, and there were worries about its capacity to be profitable, the COVID quarters seem to have removed both concerns.

Tesla: Updated Story and Valuation

Ìý Ìý I have long argued that the three most freeing words in investing and valuation are "I was wrong", and with Tesla, I have had to say those words repeatedly over the last decade. Through its lifetime, I have under estimated Tesla's value, and while COVID may have given the company an assist, my updated valuation will reflect what I have learned, since January 2020, about the company.

Story Components - Revisiting the Past

Ìý ÌýOver the years, I have tried, not always successfully, to navigate between the extremes on Tesla, and tell a story that reflects the company's strengths and weaknesses. Not surprisingly, that story has changed over time, as the company, the business and the world have all changed. In the table below, I list the stories that I have told, with end-year revenues, operating margins and valuations for equity, for each one, in , , and :

Over time, as you can see my story for Tesla has become bigger (in what I see both as its potential market and the revenues from it) and I have adapted my story to reflect the company's capacity to reinvest far more efficiently than the typical automobile company that I used in my very first valuation.Ìý

ÌýÌý ÌýTo see how much I was off the mark with my September 2013 valuation, I decided to compare my predicted revenues and operating income with the actual revenues and operating income from 2013-14 to 2020-21:

This may surprise you, since my 2013 valuation seems, at least in hindsight, to be hopelessly pessimistic, but I actually over estimated Tesla's revenues and profitability in the years since; the actual revenues in 2020-21 came in almost 24% below my prediction and my predicted margin of 8.52% was 0.75% higher than the actual margin posted by the company in that year. That said, I assumed in the 2013 valuation that, by 2021, Tesla's growth would be plateauing, and the company would be moving towards being a profitable, luxury car company. Instead, the company seems to be just getting started, redefining itself as a mass market company, with much bigger ambitions. I know that for some, my shifting stories and valuations are a sign of weakness, both in my analytical capabilities and in the very idea of intrinsic valuation. For me, and this may be just my delusions talking, an unwillingness to change your valuation stories and inputs, especially in a company that delivers as many twists and turns as Tesla, is a far greater sin.
Updated Story and ValuationÌý Ìý Whatever your priors were on Tesla coming into COVID, it is difficult to argue with the fact that the company has benefited from the economic changes it has wrought, and that its story has become bigger. The question of how big is what will determine value, but rather than give you my assessment at the start, I want to try an experiment. Ultimately, whatever story you tell about Tesla has to show up in five inputs that drive its value: (a) Revenue growth, or what you see as end revenues for the company in steady state, (b) Business profitability, reflecting what you see as unit economics, and captured in the pre-tax operating margin, (c) Investment efficiency, measuring how much investment will be needed to get to your estimated end revenues, (d) Operating risk, incorporated into a cost of capital for the company and (e) the chance that the company will not make it, gauged with a probability of failure. If you are willing to go along, with each input, I will lay out the choices (as objectively as I can) and I would like you to take your pick, given what you believe about the company. As you make these choices, though, please do not open the spreadsheet that I will provide at the end, to convert your choices into value, since that will create a feedback loop that can feed your biases.Revenues: I do believe that Tesla has come out COVID with the potential for far more revenues than it did, going in. In particular, as the automobile market increasingly shifts to electric cars, Tesla will hold a strong competitive advantage in that portion of the market, and have the chance to be a market leader. To get a sense of what this will mean in terms of revenues by 2032, consider the following choices:
Note that if your story draws primarily on Tesla remaining an auto company, revenues of $400 billion will translate into about ten million cars sold in that year, more than ten times the number of cars the company sold in 2020-21. If you believe that there are other businesses that Tesla will enter, you can augment your revenues with the added sales in those other businesses, keeping in mind that most of these businesses have far less revenue potential than the car business.Profitability: The biggest eye opener for me, during COVID, has been the surge in profitability at Tesla, with the operating margin nearing 15% in the third quarter of 2021. While that number is volatile and there will be ups and downs, it looks like the electric car business has far better unit economics than the conventional automobile business. Notwithstanding Tesla's first mover advantage, this margin will come under pressure not only from increased competition from electric car offerings from existing automakers and new entrants (Neo, Rivian etc.), but also from having to cut prices to increase market share in Asia, where car prices tend to be lower than in the US and Europe. Laying out the choices in terms of profitability:
As you make this choice, recognize thatÌýTesla is already approaching peak level gross margins for a manufacturing company, with its 30% gross margin in the last twelve months.Reinvestment:When I first valued Tesla in 2013, it had one plant in Fremont that produced all of the cars that it sold. At the time, one of my concerns was that the company would need massive reinvestment in assembly plants to ramp up even to luxury car revenue levels, and that this reinvestment would create significant cash burn. In the years since, Tesla has not only added capacity in lumps with assembly plants/giga factories in Storey County (Nevada), Buffalo (New York), Shanghai (China), Berlin (Germany) and Austin (Texas), but has spent far less than I originally estimated that they would have to invest. That said, if you are projecting that Tesla will sell 8, 10 or 12 million cars a year, a decade from now, it will need to reinvest in additional capacity. I use the sales to capital ratio as my proxy for investment efficiency (with higher values implying more efficiency investing), and the choices are below: To the extent that the company has the excess capacity to cover growth for the next few years, I will allow for a a higher sales to capital ratio in the early years, but move it towards a more sustainable number thereafter.ÌýRisk: When I valued Tesla last in early 2020, I used a cost of capital of 7%, reflecting a risk free rate of 1.75% and an equity risk premium of 5.2% for mature markets. In November 2021, the risk free rate is down to 1.56% and equity risk premiums have drifted to 4.62%, and the cost of capital for the median firm had drifted down to about 5.90%. The choices you have on cost of capital are structured around those market realities: The other risk measure that will affect value is the likelihood of failure, a number that has varied over Tesla's history, partly because it used to lose money and partly because of a choice it made to borrow money in 2016. In making this assessment now, recognize that Tesla now has a cash balance that exceeds its debt due and is making money, at least for the moment.Management: Taking to heart how closely Tesla and Elon Musk are connected, one of the concerns with Tesla has always been the sheer unpredictability of Mr. Musk. The Musk effect on value can be positive, neutral or negative, depending on your priors:
While Musk has been better behaved and more focused for the year and a half, with the exception of indulging in tweeting about cryptos, he seems to have reverted to bad habits in the last two weeks, from his Twitter followers on whether to sell a significant portion of his Tesla shares and indulging in a back-and-forth with senators about the billionaire tax.

I made the choices just as you did, and in the most upbeat of my forecasts, I aimed for revenues of roughly $400 billion (about ten million cars, augmented by revenues from ancillary businesses) in 2032, operating margins of 16% and a sales to capital ratio of 4.00 for the next five years (making Tesla far more profitable and investment efficient than any large manufacturing company in the world). With a cost of capital of 6% (close to the median company) and no chance of failure, it should come as no surprise that my estimated value of equity for the company has increased more than six-fold since my last valuation, to about $692 billion for equity in the aggregate, and $640 billion for equity in common stock.

There are very few companies in the world that I would value at more than half a trillion dollars, and with Tesla, I get there almost entirely based upon its potential for growth and profitability. That said, though, the value per share that I get of $571, even in this most upbeat of scenarios, is less than half the current stock price, leaving me with the conclusion that the stock is over valued. Rather than take issue with my valuation, put your inputs into the and estimate your value of equity for the firm.

What’s your story?

Ìý Ìý Given my choice to sell shares in Tesla at precisely the wrong time (in January 2020) and my history of undershooting on value for the company, I am the last person you should be relying on for your Tesla investment judgments. There are multiple caveats that go with my valuation, and it is possible that you are able to find a story that yields a valuation not just higher than mine, but also higher than the stock price. Alternatively, you might be one of those who believes that much of what we have seen as improvements in the last two years at Tesla are a mirage, and that I am being delusional in my assumptions. While I welcome debate and disagreement, I have found that, with Tesla, it is easy to get off on tangents and argue about what ultimately become distractions, and I would posit that almost any disagreement that we have about Tesla ultimately becomes one about how much revenues the company can generate from the businesses you see it operating in, and how profitable it will be as a company.Ìý

Revenues: In making my revenue estimates, I have assumed that Tesla will get a predominant portion of its revenues from selling cars, partly because of its history and partly because its alternative revenue sources (batteries, software etc.) are not big revenue items. It is possible, though, that there are new businesses with ample revenues that Tesla can enter, that can create new and substantial revenue streams. It is also possible that the electric car business will resemble technology businesses in their winner-take-all characteristics, and that Tesla will have a dominant market share of that business. In either case, you will have to find ways to get to revenues far greater than my already-daunting number of $414 billion in 2032. (Just for perspective, the total revenues of all publicly traded automobile companies, globally, in 2020-21 was $2.33 trillion and this would give Tesla roughly one sixth of the overall market.)Profitability: The other key driver of Tesla's value is its operating margin. While I think that my estimate of 16% is already at the upper end of what a manufacturing company can generate, there are a couple of ways in which Tesla might be able to get even higher margins. One is to enter a side business, perhaps software or ride sharing (with automated driving cars), that has much higher margins than the auto business. The other is to benefit from technological advantages to reap the benefits of economies of scale in production; this would require gross margins to continue to climb from less than 30% to much higher levels.Ìý

You can check this for yourself, but the other assumptions about reinvestment and risk don't have as big an impact on value, and I have computed Tesla's equity value (in common stock) as a function of targeted revenues and operating margins.

As you can see, there are pathways that exist to get to the current stock price and above, but they require that you enter rarefied territory with Tesla, assuming that it will have more revenues than any company (not just automobile) in history, while delivering operating margins similar to those delivered by the largest and most successful technology stocks, none of which have the drag of substantial manufacturing costs.Ìý

Tesla: The Pricing Game

Ìý Ìý ÌýIfÌýyou are holding or buying Tesla, finding a story to justify its current market capitalization will require a real stretch, a story that will require the company to not just be successful but a one-of-a-kind company. That said, I believe that Tesla is a "trade", not an "investment", and Ìýthat perspective provides answers to four questions that you may have about the stock.

How do you explain the current stock price? For much of the last decade, Tesla skeptics have struggled with explaining why the stock is priced at the levels that it is, by the market. Put simply, they have wondered how a company with little revenue and big losses acquires a market capitalization of hundreds of billions of dollars. I have never tried to explain what other people pay for a stock, but the answer may lie in the fact that those trading Tesla are pricing it, based on pricing variables (mood, momentum), rather than on fundamentals (earnings and cash flows). ÌýWhy does the price change so much on news stories? Tesla has always been a company, where small and sometime trivial news stories cause big price changes. Take the news story a couple of weeks that . Given that the current market cap of Tesla reflects an expectation that the company will sell 10 million cars or more in a few years, the Hertz order, by itself, will have a tiny impact on value, and certainly far less than the , after the news. However, if you view Tesla as a "story stock", the Hertz news story can be viewed as a sign that the company has made the transition from being a second car for the wealthy to a much wider market, potentially leading to a higher pricing.Does price affect value? Much as I would like to argue that intrinsic valuations are about cash flows, growth and risk, and are therefore insulated from market dynamics, the truth is more nuanced. The ten-fold surge in the stock price since last January did have an effect on my valuation, pushing me towards more upbeat and bigger stories, even though I still found the company to be over valued. If stock prices drop by 50% in the next few weeks, my assessment of value may be lower, as a consequence. In sum, it is almost impossible to value companies in a vacuum, where what the market is doing can be ignored.If I think the stock is over priced, why not sell short? To the question of why, if I believe in intrinsic value, I am not selling short on Tesla, it is because I believe that, at least in the short term, momentum beats fundamentals, and I have no desire to be caught in the whiplash effect.ÌýIf you are a Tesla trader, I wish you the best, but I do hope that you don't delude yourself, if successful, with tales of fundamentals. You were on the right side of momentum, and whether this was a function of luck or skill, I will leave it for you to decide.

Conclusion

Ìý Ìý In the last year and a half, IÌýhave heard from many of you about my decision to sell Tesla, and while I am thankful for your concern about my investment performance, there are a few of you who have asked me whether I was sorry that I had sold Tesla, just ahead of its Ìýrun-up in the last year and a half. I would be lying if I said that I did not think about the money I could have made, by holding on, when the stock crossed aÌýtrillion-dollar market cap, but those secondÌýthoughts have been fleeting and I have no regret. Like everyone else, I would rather make money on my investments, than lose money, but I would also rather leave money on the table and have an investment philosophy, flawed though it may be, than make money, andÌýend up without a core set of beliefs about markets.ÌýI can say with certainty that I will be back valuing Tesla some time in the future, either because it has crossed a new threshold or because it is in the news. This company is far too interesting to ignore!

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Spreadsheets

If you have been tracking the torturous workings of the infrastructure bills working their way through Congress, consideration is now being given to a "billionaire" tax, focused on a extraordinarily small subset of Americans, and intended to raise tens, perhaps even hundreds, of billions of dollars in revenues, to cover the costs of the bill. I am constantly amazed by the capacity of legislatures to write bad tax law, but this one takes the cake as perhaps the worst thought-through and most ineffective attempt ever, at rewriting tax code. That is a little unfair, I know, because the details are still being hashed out, and it is conceivable that the final version will be redeemable, but given that the clock is ticking, I am not hopeful!

The Billionaire Tax: History and Proposal

Ìý Ìý To get a sense of why we are discussing a billionaire tax, you have to start with a historical context, beginning with a recognition ofÌýincreasing wealth inequality and the perception (real or otherwise) that the wealthiest were not paying their fair share of taxes, continuing with promises made during Ìýthe most recent presidential campaign and culminating in the last few months of legislative slogging to get a passable bill.

The Rise of Populism

Ìý Ìý For much of this century, the big story in economics and politics has been increasing inequality, with the spread in income and wealth between the richest and the rest of society widening over time. The graph below, from theÌýPew Research Center, is a good starting point, since it highlight the shift in the share of aggregate USÌýincome flowing to upper,Ìýmiddle and lower income households.

While economists and politicians continue to debate the causes and consequences of this inequality, that income inequality is magnifiedÌýwhen you look at the wealth levels different income groups, with the lowest income householdsÌýfalling even further behind. A rising stock market hasÌýaugmented the wealth inequality, since the wealthiest hold the preponderance of equities inÌýthe market.Ìý

In conjunction with this widening inequality, the perception is building that the wealthy don't pay their fair share in taxes, even though the question ofÌýwhether they are depends upon the prism you look through. If you focus just on federal taxÌýdollars paid by each group, the wealthy are actually paying a larger share of federal taxes collected than ever before in history, undercutting the claim that they are welching on their tax responsibilities.Ìý

The pushback from progressives is that this graph misses key components, including other taxes collected by the government (payroll taxes, Medicare taxes, estate taxes etc.), and that it is the tax rate that is paid, not dollar taxes, that better measures fairness. In 2018, for instance, the federal effective tax rates paid by different income groups were as follows:

Clearly, while the richest are paying a higher percentage of income in taxes than the poorest, the argument made by some is that they are paying a lower percent of their taxes than they were 40 or 50 years ago (which is true) and that they can afford to pay more (which is debatable).

Elections andÌýInfrastructure Legislation

ÌýÌý ÌýTo understand why the billionaire tax proposal has become one of the center pieces of the revenue side of the infrastructure bill, we have to retrace the path taken during the 2020 presidential election. During the presidential campaign, President Biden , effectively locking out 98.2% of income tax payers from any proposed tax increase. In conjunction, he also argued that the the top 1.8% of the populace were not paying their fair share of taxes, and that corporations were also paying too little, and that any rewrite of the tax code would force them to pay their "fair share". In keeping with these two promises, the version of the big infrastructure bills that was initially promoted by the administration raised a significant portion of revenues from changes in tax rates for the wealthiest individuals (by raising the marginal tax rate from 37% to 39.6% for those in the $400,000 plus income range and by adding a surtax on capital gains for those making more than a million dollars in income) and by raising corporate tax rates from 21% to 28%. ÌýAfter months of back and forth between members, the House Ways and Means Committee that included many of these proposals, raising the corporate tax rate from 21% to 26.5%, while putting limits on interest tax deductions, and the individual tax rate to 39.6% (for income) and 25% (for capital gains).Ìý

Breaking the Logjam?

ÌýÌý ÌýThe proposals to raise revenues, from the While House and the House committee ran aground, because of last week, leading to a rethink of the revenue side. ÌýAs higher tax rates were taken off the table, the congressional committees had to look elsewhere, and the billionaire tax proposal seems to be gaining traction, as the replacement. Since almost everything we know about the proposals comes from unofficial sources or news leaks, and talks are still continuing, everything could change in the next couple of days, but here is :

Targeted Taxpayers: The tax will be targeted at individuals who own more than $1 billion in assets or have had income of more than $100 million for three consecutive years. That is pretty elite company, and it is estimated that less than 1000 taxpayers in the United States would be affected.Taxable Items: The tax would apply to a wide array of assets, including stocks, bonds, real estate and art. I am assuming that closely held businesses are not covered by the tax, or if they are, they will be dealt with differently, but since the proposal is still in the process of being written, we just don't know.The Proposal: The changes in values of these assets will be subject to tax, even though the individuals continue to hold them, making this a tax on "unrealized" capital gains. There is talk that taxpayers will be allowed to deduct "unrealized" capital losses as well, though the details remain fuzzy.ÌýThe Tax Rate: It is not clear what tax rate would apply on these changes in value, i.e., whether it would be an extension of the capital gains tax rate to these unrealized capital gains, or some other rate, and also whether the tax rate will be the same for all assets, irrespective of liquidity.In conjunction, corporations will also face a corporate minimum tax rate, putting a floor (at least in theory) on how low they can make their effective tax rates. I will leave it others to discuss that aspect of the tax code, which at least has a defensible basis, but I find the billionaire tax to be problematic at multiple levels.
The Worst Tax Code Change EverAs I noted earlier, there may be changes that happen between now and when this gets voted on that help make it better, but as it stands, this is an extraordinarily bad tax proposal, and for many reasons:Micro targeting: Since very few of us to like paying more in taxes, but don't seem to mind seeing others paying more, the political payoff from targeting very few taxpayers is that you minimize the backlash. I know that each of us probably has a billionaire that we hate, and may take secret pleasure in watching that billionaire pay more, but if you view the prime role of taxes as generating revenues for governments, it is dangerous to focus raising tax revenues from this small a number. As a general rule, taxes that are broad based and affect most people are more likely to deliver predicted revenues than those that affect a narrow subset of the population, and the billionaire tax is about as narrowly focused as tax law gets. You may have little sympathy for the seven hundred or so billionaires affected by these taxes, but you should also recognized that these individuals also have the most resources to find ways to minimize the impact of these laws. In fact, not only is an army of tax lawyers, accountants and investment vehicles being created while the law in being written, but I would not be surprised if they are providing input on its actual form.Taxing capital gains (and losses): The basis used for computing taxes can have implications for revenues from the tax code, and that basis can range from sales (with value added and sales taxes) to salary/wage income, to capital gains. Rather than get into moralistic arguments about whether salary income is more virtuous than capital gains income (or unearned income, as its critics like to call it), I will focus on tax revenue reality. Taxes based upon revenues/sales will yield more predictable revenue for the government than taxes based upon salary income, and taxes based upon salary income will yield more stable revenues than taxes based upon capital gains.ÌýCapital gains come from stock price changes, which are far more volatile, than income earned by taxpayers, and that income, in turn, changes more on a year-to-year basis than the value of the assets they own. Without passing any judgment on which approach is better, consider tax revenues collected by California, a state that not only taxes all capital gains as ordinary income, but is also more dependent on capital gains than almost any other state, with tax revenues collected by Florida, a state without taxes on individual income:
California's tax revenues are significantly more volatile than Florida's tax revenues, and capital gains are a big reason why that is the case. ÌýIf you are in finance, and you were measuring the risk of different tax revenue sources, capital gains tax revenue would have a "higher beta" than "income tax revenues or sales tax revenues. It is true that prudent governments can find ways to put aside big portions of the capital gains tax revenues, in years of plenty, to cover shortfalls in years where capital gains tax collections are low, but when was the last time you saw prudent governance?Including "unrealized" gains: The new feature of this law is its attempt to tax unrealized capital gains on assets. The problem with taxing "unrealized" gains or income is that since they are unrealized, and taxes have to be paid with cash, the question of how to come up with the cash becomes an issue, making it a central challenge for any plan, built around it. In fact, there are two practical problems with the proposal, at least as described in the press.ÌýLiquidity questions: If the billionaire is going to apply on assets like real estate and fine art, and not just on stocks and bonds, the idea that you can sell some your holdings in the open market and get the cash you need to pay taxes does not apply as easily, since these non-traded assets are often illiquid and cannot be sold off in small parts. It will also mean that taxpayers who own non-traded assets will need appraisers to revalue these assets every year, great for the appraisal business, but almost guaranteed to create a hotbed of litigation around the appraised values.Losses and Gains: After a decade of rising stock and bond prices, I guess that many have forgotten that not only can what goes up come down, but also that you can have extended periods where assets stagnate or drop in value. While there is airy talk of being allowed to claim unrealized losses as deductions, how exactly would this work? Put simply, if stocks are up 20% in 2021 and down in 2022, would taxpayers get refunds on their taxes paid in 2021? It is also not clear what the tax code writers are assuming about what the market will do over the next decade, when they estimate that this tax will deliver about $200 billion in revenues, but are they assuming that the good times will continue? Stock and bonds have a really good run, but history suggests that there will be not just bad times, but extended bad times for markets:
There may be no revenues at all from this tax code change, if the market has a decade like the 1970-1979 or 2000-2009, and if that happens, what are the contingency plans for the expenditure that is being funded by these revenues?ÌýWith side effects for other tax revenues: There is another point that I still not seen a response to, and that is the effect that this billionaire tax will have on revenues from other parts of the tax code, particularly estate taxes. If paying the billionaire tax changes the tax basis for assets, as it should since they are being marked to market, and taxed, that will also mean that when these stocks are inherited, and ultimately sold, there will be less capital gains taxes collected. If all that the billionaire tax code change is doing is moving forward the collection of taxes to earlier, rather than later, there is a time value benefit to the government, but it has to be a net benefit. In other words, the lost future taxes will have to be netted out against the $200 billion that it is expected to bring in revenues over the next decade.It is a wealth tax, albeit on incremental, not total wealth: For a few years, progressives led by Senator Warren have argued for a wealth tax, and its pluses and minuses have been debated widely.ÌýThe administration is trying hard to avoid using the words "wealth taxes" to describe this proposal, but that is sophistry. Janet Yellen's claims notwithstanding, this is a wealth tax, albeit on incremental wealth, rather than total wealth. Put simply, this proposal is biased towards people with inherited wealth, invested in non-traded assets and mature businesses, and against people invested in publicly traded equities in growth companies, many of which they have started and built up. If that is the message that the tax law writers want to send, they should at least have the decency to be up front about that message, and to defend it.Side CostsIf the history of tax law is that there are always unintended consequences, the problem with this law is that the consequences are entirely predictable and mostly bad, and you and I, even though we are not in the billionaire club, will face them.ÌýPrice Effects: If there is a billionaire tax on unrealized gains, some or even many of these billionaires will have to sell portions of their asset holdings to pay taxes dues. There is no way that an Elon Musk would have been able to pay taxes on the unrealized gains on his Tesla holdings in 2020, without selling a portion of his holding. While there may be enough liquidity in a stock like Tesla to absorb that selling, there are other assets where the liquidity effect is going to be larger and more permanent.ÌýFounder/Managers: One reason that investors prefer companies that have founders with substantial stock holdings running them is because they believe that there is less of a conflict of interest in these firms, than it those run by professional managers with little or now shareholdings. If this proposal is pushed through, and especially if the tax rate is set at capital gains levels, founders will have no choice but to reduce holdings over time, both to pay taxes and to shift to less traded assets.Public to Private: As I said earlier, I am not sure how privately held businesses will be treated, for computing the billionaire tax, but if there is indeed a carve out for these businesses, I will predict that there will be more companies where rich founders will choose to take the company private again.For those who view the tax code as an instrument to deliver pain, the only consolation prize will be that punishment is being meted out to those who "deserve" it the most, but I am afraid that it is a booby prize. With the billionaire tax, the intended targets will pay far less in taxes than you think they should and now that the door to unrealized profits being taxed has been opened, how do you know that you are not next on the target list?
ConclusionI understand that those working on these tax code changes face a tough task, given the constraints that they have on them (not raising tax rates, not taxing people who make less than $400,000), but these are constraints that they imposed on themselves, either because too much was promised on campaign trails or because they are working with paper-thin majorities, where one hold out can stop the process. The problem with the billionaire taxes is that it will be ineffective at collecting tax revenues, and I am willing to wager that a decade from now, we will find that it collected only a small fraction of its promised revenues. Good intentions about creating a better social safety net cannot excuse the writing of tax laws that are inefficient at collecting revenues, ineffective even in their punitive intent and potentially dangerous for the rest of us, in terms side costs.Ìý
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In , I argued that the disclosure process had lost its moorings, as corporate disclosures (annual filings, prospectuses for IPOs) have become more bulky, while also become less informative. I argued that some of this disclosure complexity could be attributed to the law of unintended consequences, with good intentions driving bad disclosure rules, and that some of it is deliberate, as companies use disclosures to confuse and confound, rather than to inform. For those of you who agreed with my thesis, the end game looks depressing, as new interest groups push for even more disclosures on their preferred fronts, with the strongest pressure coming from the environmental, social and governance (ESG) contingent. In this post, I propose one way out of the disclosure dilemma, albeit one with little chance of being adopted by the SEC or any other regulatory group, where you can have your cake (more disclosure on relevant items) and eat it too (without drowning in disclosure).Ìý

The Disclosure Dilemma: DiseaseÌýand Diagnosis

Ìý ÌýÌýFor those of you who did not read my first post on disclosures, let me summarize its key points. The first is that company disclosures have become more bulky over time, whether it be in the form on required filings (like annual reports or 10K/10Q filings in the US) or prospectuses for initial public offerings. ÌýThe second is that these disclosures have become less readable and more difficult to navigate, partly because they are so bulky, and partly because disclosures with big consequences are mingled with disclosure with small or even no consequences, often leaving it up to investors to determine which ones matter. The net effect is that investors feel more confused now, when investing in companies, than ever before, even though the push towards more disclosures hasÌýostensibly been for their benefit.

ÌýÌý ÌýAs we look at the explosion of disclosures around the world, there are many obvious culprits. The first is that technology has made it possible to collect more granular data, and on more dimensions of business, than ever before in history, and to report that data. The second is that interest groups have become much more savvy about lobbying regulatory groups and accounting rule writers to get their required data items on the required list. The third is that companies have learned that converting disclosures into data dumps has the perverse effect of making it less likely that they will held accountable, rather than more. That said, there are three other reasons for the disclosure bloat:Ìý

The first is the prevailing orthodoxy in disclosure is tilted towards " one size fits all ", where all companies are covered by disclosure requirements, even if they are only tangentially exposed. Though that practice is defended as fair and even handed, it is adding to the bloat, since disclosures that are useful for assessing some firms will be required even for firms where they have little informative value.ÌýThe second is the notion of materiality , a key component of how accountants and regulators think about what needs to be disclosed. ÌýUsing the words of IFRS (1.7), â€�Information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of general purpose financial statements make on the basis of those financial statements, which provide financial information about a specific reporting entityâ€�. As we will argue in the next section, this definition of materiality may be leading to too much disclosure for backward looking items and too little for forward looking items.The third is that the disclosure rule writers happen to be in the disclosure business , and since more disclosure is good for business, the conflict of interest will always tilt toward more rather than less disclosure. No matter how many complaints you hear from accountants and data services about disclosure bloat, it has been undeniable that it has created more work for accountants, appraisers and others in the disclosure ecosystem.It is quite clear, though, that unless we break this cycle, where each corporate shortcoming or market upheaval is followed by a fresh round of new disclosures, we are destined to make this disclosure problem worse. In fact, there may come a point where only computers can read disclosures, because they are so voluminous and complicated, perhaps opening the door for artificial intelligence or matching learning into investing, but for all the wrong reasons.

Escaping the Disclosure Trap

Ìý Ìý There is a way out of this disclosure trap, but it will require a rethink of the status quo in disclosures. It starts first by moving away from "one size fits all" disclosure rules to disclosures tailored to companies, a "triggered" disclosure process, where a company's value story (big market, lots of subscribers) triggers disclosures on the parameters of that story. It extends into materiality, by reframing that concept in terms of value, rather than profits, and connecting it to disclosure, with disclosure requirements increasing proportionately with the value effect. Finally, it requires creating a separation between those who write the disclosure rules and those who make money from the disclosure business.

One size (does not) fit all!

When disclosure laws were first written in the aftermath of the great depression, they were focused on the publicly traded firms of the time, a mix of utilities, manufacturing and retail firms. At the time, the view that disclosure requirements should be general, and apply to all companies, was rooted in the idea of fairness. In the decades since, there have been exceptions to this general rule, but they have been narrowly carved out for segments of firms. For instance, oil companies are required to disclose their ownership of "proven undeveloped reserves", in addition to details about quantity, new investments and progress made during the year in converting those reserves. The disclosure rules for banks and insurance companies require them to reveal the credit standing of their loan portfolios and their regulatory capital levels to investors and the public. These exceptions notwithstanding, disclosure laws written to cover concerns in one sector (such as the use of management options at technology firm or lease commitments at retail and restaurant companies) have been applied broadly to all companies. It is time to rethink this principle and allow for a more variegated disclosure policy, with some disclosures required only fir subsets of companies. Since the next big bout of disclosures that are coming down the pike will be related to ESG, this discussion will play out in a wide range of ESG data items. For instance, while it makes sense to require that fossil fuel and airline companies report on their carbon footprints and greenhouse gas emissions, it may just be a time consuming and wasteful exercise to require it of technology companies.

From earnings-based to value-based materiality

I do not think that you will find many who disagree with the premise that any information that has a material effect should be disclosed, but there is disagreement on what comprises materiality.ÌýI believe that the "materiality principle", as defined by accountants, is diluted by measuring it in terms of impact on net income and the fact that accountants tend to be naturally conservative in measuring that impact. Simply put, it is safer for an accounting or audit firm to assume that a disclosure is material, and include it in reports, even if it turns out to be immaterial, than it is to assume that it is immaterial, and be found wrong subsequently. ÌýOne solution to this problem is to redefine materiality in terms of effects on value, rather than earnings, thusÌýaccomplishing two objectives. First, it will reduce theÌýnumber of noise disclosures, i.e., those that passÌýthe materiality threshold for earnings, but don't have a significant impact on value. Second, since value is driven by expected cash flows in the future and not in the past, it will shift the focus onÌýdisclosures to itemsÌýthat will have an impact on future earnings and cash flows, rather than on past earnings or book value.

Triggered Disclosures

At first sight, the requirements to make disclosures slimmer and more informative may seem at war with each other, since disclosure bloat has largely come from well-intentioned attempts to make companies reveal more about themselves. Triggered disclosures, where disclosures are tailored to a company's make-up and stories, are one solution, where contentions made by a company trigger additional disclosures related to that contention. Thus, a company that claims that brand name is its supreme competitive advantage would then have to provide information to not only back up that claim, but also to allow others to value that brand name.Ìý
Disclosure Illustration: Initial Public OfferingsÌý ÌýÌý
It is difficult to grapple with disclosure questions in the abstract, and to illustrate how my proposed solutions will play out in practice, I will focus on initial public offerings, where there is a sense that the disclosure rules are not having their desired effect. In my last post, I noted that prospectuses, the primary disclosure documents for a companies going public, have bulked up, contrasting the Microsoft and Apple prospectuses that came in at less than a 100 pages in the 1980s to the 400+ page prospectuses that we have seen with Airbnb and Doordash in more recent years. At the same time, applying a disclosure template largely designed for mature public companies to young companies, often with big losses and unformed business models, has resulted in prospectuses that are focused in large parts on details that are of little consequence to value, while ignoring the details that matter. ÌýSince companies going public often do so on the basis of stories that they tell about their futures, and these stories vary widely across companies, this segment lends itself well to the triggered disclosure approach. To do so, I will drawÌý with Dan McCarthy and Maxime Cohen, to provide details. In that paper, we argue that a going-public company that wants to build its story around certain dimensions (a large total addressable market or a large user base) will trigger disclosure of a more systematic, business type-specific, collection of “base disclosuresâ€� that are required to understand the economics of businesses of that type, whatever type that might be.
Total Addressable Market (TAM)
Companies going public have increasingly supported high valuations by pointing to market potential, using large TAMs as one of the justifications. These TAMs are often not only aspirational, but also come with very little justification and no timeline for how long it will take for the existing market sizes to grow into those TAMs. For instance, the graph below shows the TAMs that Uber and Airbnb claimed in their prospectuses at the time of their initial public offerings.Uber and Airbnb ProspectusesIs Uber’s total addressable market really $5.2 trillion? I don’t think so, but you can see why the company was tempted to go with that inflated number to push a “big market� narrative. To prevent the misuse of TAM as little more than a marketing ploy, companies that specify a TAM should also have to provide the following:

a. TAM, SAM and bridges: Companies that specify a TAM should also specify the existing market size (i.e., the serviceable addressable market or SAM), as well as additional “bridgesâ€� so that investors can understand the evolution from SAM to TAM (e.g., an estimate of how many individuals would be interested in the company’s product before considering price). Investors who may be skeptical of a lofty TAM could still look to SAM as a more achievable intermediate metric.b. Market share estimates: As long as companies do not have to twin TAM with expectations of market share, there is little incentive for them to restrain themselves when estimating TAM. We would recommend requiring that companies that disclose TAM figures couple them with forecasts of their market share of those TAM figures. For companies that are tempted to significantly inflate their TAMs, the worry that they will be held accountable if their revenues do not measure up to their promises, will act as a check.c. Ongoing metrics or measures: Companies usually provide TAM, SAM, and variants thereof on a one-shot basis, disclosing these figures in their pre-IPO prospectuses and then never again. We believe that investors should be given these measures on an ongoing basis. This will help on two levels. First, it will allow investors to see how well the company is adhering to its prior disclosures and forecasts and provide investors with updates if conditions have changed. Second, companies that know they will be held accountable to their IPO disclosures after they go public will be more incentivized to make those disclosures realistic and achievable.Ìý

To the extent that investors will continue to assess premiums for companies that have bigger markets, the bias on the part of companies will still be to overestimate TAM. That said, these recommendations should help rein in some of those biases.
Subscription-Based Companies A subscription-based company derives its value from a combination of its subscriber base (and additions to it) and the subscription fees its charges these subscribers. ÌýConsequently, the value of an existing subscriber can be written as the present value of the expected marginal profit (subscription fee net of the costs of servicing that subscription) from the subscription each year, over the expected life of the subscriber (based upon renewal/churn rates in subscribers), and the value of a new subscriber will be driven all of the same factors, net of the cost of acquiring that subscriber. The overall value of the company can be written in terms of its existing and new subscribers:

Companies that sell a “subscriberâ€� story have the obligation, then, to provide the information needed to derive this value:Existing subscriber count: Observing the total number of subscribers in each period (e.g., month or quarter) allows us to track overall growth trends in the number of subscribers, and to understand how revenue per subscriber evolves over time, because revenue is disclosed.Subscriber churn: To value a subscriber, a key input is the renewal rate or its converse, the churn rate. Holding all else constant, a subscription business with a higher renewal rate should have more valuable subscribers than one with a lower renewal rate. It would stand to reason that any subscription-based company should report this number, but it is striking just how many do not disclose these measures or disclose them opaquely. For example, while the telecom industry regularly discloses churn figures, Netflix has not disclosed its churn rate in recent years.ÌýContribution profitability: For subscribers to be valuable, they need to generate incremental profits, and to estimate these profits, you need to know not just the subscription fees that they pay, but also the cost of servicing a subscription; the net figure (subscription fee minus cost of service) is called the contribution margin. Many subscription companies explicitly disclose contribution profits (e.g., Blue Apron, HelloFresh, and Rent the Runway), but many others do not (e.g., StitchFix). In the absence of explicit contribution profit data, investors often resort to simple proxies for it, such as gross profit, but these proxies are imperfect and noisy.Subscriber acquisitions & drop offs: To move from the value of a single subscriber to the value of the entire subscriber base, we must also know how many subscribers are acquired over time, not just the net subscriber count. Put differently, if a company grew the overall size of its subscriber base from 10 million to 12 million subscribers in a year, it is quite different if that net growth came about because the company acquired 10 million customers that year but then lost 8 million of them, versus if the company acquired 2 million customers and lost none of them. Acquisition (or equivalently, churn) disclosures are what allow us to piece this apart.Cost of acquiring subscribers (CAC): Subscription-based companies attract new subscribers by offering special deals or discounts, or through paid advertising. While the cost of acquiring subscribers can sometimes be backed out of other disclosures at subscription-based companies (such as subscribers numbers, churn and marketing costs), it would make sense to require that it be explicitly estimated and reported by the company.Cohort data: While many subscriber companies are quick to report total numbers, only a provide a breakdown of subscribers, based upon subscription age. This breakdown, called a cohort table, can be informative to observe retention and/or monetization patterns across cohorts, as noted by Fader and McCarthy in . Many subscription-based firms, including Slack, Dropbox, and Atlassian, now disclose cohort data, and the figure below shows one such chart for Slack Technologies:Source: Slack Technologies Form S1

By breaking down cohort-specific retention and monetization trends, a cohort chart offers investors visibility into retention and development patterns as a function of subscriber tenure (e.g., does the retention rate get better or worse as subscribers get older), and trends across time, as subscribers stay on the platform.Ìý

Transaction-Based Companies The guiding principles driving our disclosure recommendations for subscription-based businesses largely extend to transaction-based businesses, with the primary difference being that subscription revenues are replaced with transaction revenues, a number that is not only more difficult to estimate, but one that can vary more widely across customers. The value of the customer base at transaction-based businesses is driven off the activity of these customers, translating into transaction revenues and profits.Ìý

As with subscriber-based businesses, this framework can only be used if the company provides sufficient data from which one can estimate the inputs. Deconstructing this picture, many of the key disclosures track those listed for subscription based companies, including contribution profitability, customer acquisition costs and cohort data. In addition, there are three key additional pieces of information that can be useful in valuing these companies:Active customer count: We replace the notion of a subscriber with that of an “activeâ€� customer, which is more suitable for transaction-based businesses. After all, a customer in your platform who never transacts is not affecting value, and one issue that transaction-based companies have struggled with is defining "activity". Wayfair, Amazon, and Airbnb, for example, define an active customer to be one who has placed at least one order over the past 12 months. In contrast, Lyft, Overstock, and many other companies define a customer as active if they placed an order in the past 3 months.ÌýTotal orders: In transaction-based companies, the average purchase frequency of active customers can change, often significantly, over time. We need to know the total orders because this further allows us to decompose changes in revenue per active customer into changes in order frequency per active customer and changes in average order value. While some transaction-based businesses disclose this information, including Wayfair, Overstock, Airbnb, and Lyft, this data is notably absent for many others, such as Amazon.Promotional activity: It can be easy to significantly increase purchase activity through enticing targeted promotions, creating the illusion of rapid growth that may not be sustainable over the long run, due to their substantial cost. Since these promotions are often reported as revenue reductions, rather than expenses, the cost of these campaigns are often opaque, to investors. For example, DoorDash did not disclose their total promotional expense during the most recent 6 months in their IPO prospectus, creating substantial uncertainty for investors as to how this may have influenced gross food sales).Ìý Fintech Companies In the last decade, we have seen banks, insurance companies and investment firms face disruption from firms in the "fin-tech" space, covering a diverse array of companies in the space. With all of these companies, though, there is (or should be) a lingering concern that part of their value proposition comes from "regulatory arbitrage", i.e., that these disruptions can operate as financial service companies, without the regulatory overlay that constrains these companies, at least in their nascent years. Since this regulatory arbitrage is a mirage, that will be exposed and closed as these fin-tech companies scale up, investors in these companies need more information on:Quality/Risk metrics on operating activity: In the aftermath of the 2008 crisis, banks, insurance companies and investment banks have all seen their disclosure requirements increase, but ironically, the young, technology-based companies that have entered this space seem to have escaped this scrutiny. In fact, the absence of a regulatory overlay at these companies makes this oversight even more dangerous, since an online lender that uses a growing loan base as its basis for a higher valuation, but does not report on the default risk in that loan base, is a problem waiting to blow up.ÌýIt is highly informative for investors to observe the evolution of these measures in the years and quarters leading up to the IPO. Indeed, lenders can be tempted to strategically lower their credit standards to issue more loans (and hence significantly increase revenue through loan-related fees, which are often assessed upfront) to create the illusion of growth at the expense of long-term profitability and trust (since many of these risky loans are likely to default in the future).Capital Buffer: It is worth remembering that banks existed prior to the Basel accords, and that the more prudent and long-standing ones learned early on that they needed to set aside a capital buffer to cover unexpected loan losses or other financial shortfalls. In the last century, regulators have replaced these voluntary capital set asides, at banks and insurance companies, with regulatory capital needs, tied (sometimes imperfectly) to the risk in their business portfolios. Many fintech companies have been able to avoid that regulatory burden, largely because they are too small for regulatory concern, but since they are not immune from shocks, they too should be building capital buffers and reporting on the magnitude of these buffers to investors.ÌýConclusionAs data becomes easier to collect and access, the demands for data disclosure from different interest groups will only increase over time, as investors, regulators, environmentalists and others continue to add to the list of items that they want disclosed.ÌýThat will make already bulky disclosures even bulkier, and in our view, less informative.ÌýThere are three ways to have your cake and eat it too. The first is to allow for increasing customization of disclosure requirements to the firms in question, since requiring all firms to report everything not only results in disclosures becoming data dumps, but also in the obscuring of the disclosures that truly matter. The second is to shift the materiality definition from impact on earnings to impact on value, thus moving the focus from the past to the future. Finally, tying disclosures to a company's characteristics and value stories will limit those stories and create more accountability.
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PapersÌý(with Dan McCarthy and Maxime Cohen)Blog Posts

A few weeks ago, I valued Zomato, the Indian online food delivery company, just prior to its IPO, and argued that the excitement about its potential was tied to the potential for growth in India and the shifting habits of Indian consumers. Since its public offering, Zomato's stock price has reflected that excitement, more than doubling from its offering price of 74 rupees per share. Waiting in the wings for its public debut, is Paytm, a company that in many ways is even more closely tied to India's macro story, drawing on the growth of online commerce in India and a willingness of Indian consumers to use mobile payment mechanisms. In this post, I will look at the levers that drive Paytm's value, and you can make your judgments on where you think this offering will lead in terms of valuation and pricing.Ìý

Setting the Table

As the Paytm IPO speeds to offering date, it is worth looking back at its relatively short history as a company, and how much change has been packed into that period. Since so much of Paytm’s success has been driven by the rise if smart phone usage among Indian consumers, and the concurrent rise in mobile payments for goods and services, I will start with a review of that rise, before looking at how Paytm has put itself in position to take advantage of that market shift.

The Rise of the Indian Smartphone User

India was late to join the smart phone party, held back both by the relative expensiveness of these devices, as well as the absence of affordable and reliable cell service in much of the country. In 2010, fewer than 2% of Indians had smart phones, with most of them being well off and living in urban areas. In the decade since, that has changed, as the smart phone market has exploded to reach hundreds of millions of Indians in 2020.Ìý

Source: World Bank Database

Entering 2021, more than 500 million Indians had smart phones, making it the second largest smartphone market in the world (after China), but its penetration rate of less than 50% of the market gave it more room to grow. There are multiple forces that have contributed to this shift, but two stand out.Ìý

The first is that the costs of smartphones have decreased, and especially so in India, as technology and competition have worked their magic. In particular, the entry of Chinese brands, with Xiaomi and Vivo leading the charge, played a major role in making smartphones more affordable to Indians.The second is that cell service costs have also dropped, and in India, the drop in costs has been precipitous, after Reliance Jio entered the game in 2016, and quickly acquired 100 million subscribers by offering free voice and data calls over its 4G network. Today, Jio has more than 400 million subscribers, and while it remains a lightning rod for criticism, it is undeniable that it has played a major role in the evolution of the market.ÌýAs smart phones have become ubiquitous in India, their usage has soared, partly because they are the only digital devices that many Indians have available to them to get online, and thus use to access social media, entertainment and shopping. By 2020, Indians ranked third in the world in how much time they were spending per day on their phones, with COVID contributing to a surge in that year:

Access to these smartphones, in conjunction with poor banking outreach in India, has created the perfect storm for a surge in mobile payments in India, and this graph bears out this trend:

Within the mobile payment space, there was also an external development that added to its acceleration, and that was the advent, in 2016, of United Payments Interface (UPI), a real-time payment interface devised by the National Payments Corporation of India, and regulated by the Reserve Bank of India, facilitating and speeding up inter-bank, person to person and person to merchant transactions.Ìý

Paytm: Operating HistoryÌý

The rise of Paytm (Pay through Mobile) as a company parallels the rise of mobile phones in India. When it was founded in in 2010 by by Vijay Sharma, it operated as a pre-paid mobile platform, but its market then was small both in terms of numbers and services offered. As mobile access improved, Paytm has relentlessly added to its suite of products. In 2014, it introduced Paytm Wallet, a digital wallet that was accepted as a payment option by leading service providers and retailers. In 2016, it added ticket booking to movies, events and amusement parks, with flight bookings soon after, and started Paytm Mall, a consumer shopping app, based upon Alibaba's Taobao Mall model. In 2017 it added Paytm Gold, allowing users to buy gold in quantities as little as 1 rupee, and Paytm Payments Bank, a messaging platform with in-Chat payments. In 2018, it added a Paytm Money, for investment and wealth management, and in 2019, it launched a Paytm for Business app for merchants to track payments. In short, over time, it has used its platform of users to launch itself into almost every online activity. As Paytm's product suite has expanded, its numbers reflect both its strengths and weaknesses, with four key statistics tracking its expansion.Ìý

The first is the number of users on its platform, using one or more of its many services.ÌýThe transactions that these users make on the platform plays out Ìýin theÌýgross merchandise value of all the products and services bought.ÌýThe third is the take rate, i.e., the percentage of this gross merchandise value that Paytm records as its revenues.ÌýThe last is the operating margin, it operating income (or loss) as a percent of operating income each year.The table below is my attempt to recreate how Paytm has performed on these key measures in recent years, with the caveat that some of the information (on users and GMV, especially prior to 2019) is cobbled together from claims by corporate executives, press reports and opaque disclosures from the firm.

Take Rate = Revenues/ GMV

Looking at the numbers, we start to get a picture of Paytm, warts and all, over its lifetime. First, it is a growth company, if you define growth as growth in user count and number of transactions done on its platform, and perhaps in gross merchandise value. However, its growth in revenues has not kept track with those larger statistics, leading to a cynical conclusion that the company is adding new services and giving them away for nothing (or close to it) to pad its user/transaction numbers. Second, this is a company that seems to run on hyperbolic forecasts from its founders and top management, that are not just consistently higher than what the company deliver, but often by a factor of three or four. For instance, just to pick on one of many examples, Vijay Sharma claimed in with Business Standard that the company's GMV would be $ 100 billion (7500 billion rupees) by the end of the year, more than double what the company reported as GMV for that year or the next. Third, access to capital from its deep pocketed investors, especially Alibaba, seems to have made this company casual about its business model and profitability, even by young, tech company standards. In fact, there is almost never even a mention of profitability (or aspirations towards profitability) in any of the corporate soundbites that I was able to read. ÌýThe picture that emerges of Paytm is that of a Ìýmanagement that is too focused on racking up user numbers, and too distracted to care about converting those into revenues and profits, while making grandiose statements about its future. Using the corporate life cycle framework to assess Paytm, it resembles an adolescent with attention deficit issues, in its scattershot approach to growth and absence of attention to business details, and if you are an investor, you have to hope that going public will cause it to grow up quickly.

Paytm: Funding and Ownership

Paytm's ambitious growth plans have made it one of India's premier cash burning machines, and it has been able to pull these plans off, because it has found ample sources of capital to feed them. In the table below, I list Paytm's big capital infusions over its lifetime:

Along the way, there have been others who have provided capital to the firm (Reliance, Ratan Tata) who have exited as foreign investors, led by Alibaba and SoftBank, have muscled their way into the firm. Those capital infusions have naturally led to a diminution of the share of the company held by its founder, and the pie chart below lists the owners of Paytm, ahead of its IPO:

Note that while the company's origins and business are in India, it is primarily a Chinese-owned company ahead of its IP0, with Ant Group, Alibaba and SAIF Partners (a Hong-Kong based private equity firm) collectively owning more than 50% of the shares, with the Softbank Vision fund as the next largest investor with 18%. Vijay Sharma's holdings in the company have dwindled to 15% of the company, and his tenure as CEO depends on whether he can keep his foreign shareholder base happy.Ìý

Paytm: Story and Valuation

Ìý Ìý With that lead in, the pieces are in place to value Paytm and I will start by laying out the value drivers for the company and follow with my valuation. In making this assessment, I will draw on the company's stated plans to raise money from the offering, though they may be altered as the company gets to its offering date.

The Story

Ìý Ìý The company's history provides some insight into the Paytm's value drivers, starting with a large and growing mobile payment market in India, and working down to the company's operating metrics.Ìý

The value story for Paytm starts with a large and growing digital payment market in India, one that has surged over the last four years, and is expected to increase five-fold over the next five years, as the smart phone penetration rate rises for India and more merchants accept mobile payments. While Paytm has the advantage of having been in the Indian mobile payment market the longest, and having the largest user base, PhonePe and Google Pay have outmaneuvered Paytm in the UPI app ecosystem, claiming the lion's share of that market, though the bulk of the transaction in that ecosystem are person-to-person. Paytm's large user base, close to 350 million, and the wide acceptance of its wallets allow it to dominate the person to merchant (P2M) market in India, giving it a market share of close to 50% in early 2021.

The growth in the Indian mobile payment market will provide enough of a tailwind for Paytm to continue to grow its user base and transactions, but the bigger challenges for Paytm will be on the business dimensions where it has lagged in the past.Ìý

The first is in the take rate, where Paytm has seen its revenue share of GMV drop from 2.18% in 2016-17 to 0.79% in 2020-21, as the company has prioritized acquiring users and user transactions over actually generating revenues from these transactions. To get a measure of a reasonable take rate that the company can aspire to reach in the long term, I looked at larger, more established players in the payment processing space:

From company 10Ks. Removed net interest income from Amex revenues and subscription/bitcoin/hardware revenues from Square revenues

Visa and Mastercard, the status quo players, still retain considerable market share, though Mastercard has a higher take rate (1.83%) than Visa does (1.11%); American Express has a higher take rate than the two larger players, because it gets a higher percent of its revenue from annual card fees. Paypal Shopify and Square, all of which derive their revenues from merchandising value, have take rates between 2% and 3%, though Square gets substantial additional revenues from bitcoin transactions (not counted in GMV or revenues in this table). Ant Financials, perhaps the company that Paytm has most closely modeled itself around, has a low take rate (1.37%), but makes up for it with huge transaction volumes. In modeling Paytm's take rate over time, I will begin by assuming that the company will spend the next few years putting user growth first, at the expense of generating revenues, and that the take rate will stay low over the next five years, rising slowly to 1% in 2026. In the years following, though, I expect the take rate to double (to 2%), as the focus shifts from users to revenues, and its business model approaches that of a more conventional payment processing company.

The second big challenge that Paytm faces is generating profits, a feat the company has been unable to accomplish over its lifetime. While the operating margins posted by Visa and Mastercard may be unreachable, note that Paypal's operating margin has been trending up, as the company has become bigger. As Paytm increases its revenues, and user growth starts to level off, Paytm's marketing and personnel expenses should start to decrease, and I expect operating profits to turn positive and the operating margin to reach 5% in 2026, and for that improvement to accelerate in the following five years, as growth rates decrease, allowing for an operating margin of 30% in stable growth.As a technology company, whose most valuable asset is the platform that it offers and products and services on, Paytm's reinvestments have been mostly in the form of acquisitions and technology investments, and we assume that it will continue to follow this path, generatingÌýâ‚�3 Ìýin revenues for every rupee of capital invested in the near term, butÌýâ‚�2.45 per dollar invested in the long term, converging on an industry average (for business and consumer services). Within the online payment space, this number has wide variance, with Paypal, perhaps the most mature of the companies, having a sales to invested capital of 2.54 over the last five years and Square, a younger and faster growing player, reporting a sales to invested capital of 5.68.On the risk front, there is little reason to reinvent the wheel. Paytm's cost of capital, in rupee terms, is 10.43%, reflecting its business risk, and puts the company just below the median Indian company, in risk terms. The company's capacity to burn cash will continue to expose it to risk, but with deep pocketed investors (Alibaba and Softbank), and a large cash balance (post IPO), the risk of failure is low (5%).To get from these numbers to a value per share, I use the existing share count, in conjunction with the information in the prospectus that the company plans to raiseÌýâ‚�16,600 million at the offering, with half of these proceeds staying in the firm to cover future investment needs and the other half going to existing shareholders, cashing out.

There are other Paytm businesses that may augment revenues in future years, but each one comes with caveats. The money deposited in Paytm wallets by users can potentially earn interest for the company, but restrictions that this money be kept in escrow accounts at banks, not always paying close to market interest rates, can crimp that income stream. Paytm Bank could expand from its very limited presence now to more traditional banking (taking deposits, making loans), but that is a capital and regulation intensive business. I believe that Paytm's core value comes from being an intermediary, in the payments business, and the story reflects that belief.

The Valuation

If you buy into my story of Paytm continuing to maintain a dominant market share of the mobile payment market in India, while also increasing its take rate over time and improving operating margins to those of an intermediary business, you have the pieces in place for a valuation of Paytm, captured in the picture below:

; Price per share ofÌýâ‚�2950 is for unlisted shares.

I know that there are many on both sides of the value divide who will disagree with me on my story and valuation, and that is par for the course. On one side, there will be some Ìýwho view a value of close to $20 billion (â‚�1500 billion) for a company with a pittance in revenues, a history of operating losses and distracted management as insanity. On the other side, there will be some who feel that I am not giving the company credit for all of the new businesses it can enter, using its vast platform of users, and thus under valuing the company. To both sides, my defense is that this is my story and valuation, and it will drive my investment, but that you are welcome to , change the inputs that you disagree with and come up with your own valuations.Ìý

In making my assessment, I fully understand that there is substantial operating and execution risk in this story, since this value presupposes that Paytm will remain a dominant player in the Indian mobile payment space, as it grows, and that Paytm's management will pivot from growing users to growing revenues and from growing revenues to growing profits, over time, with nothing in their history to back that up. Needless to say, if I invested in Paytm, it would not only have to be at the right price, i.e., trading at less thanÌýâ‚�1500 billion, but also with the acceptance that this cannot be a passive (buy and hold) investment, but one that will require active engagement and monitoring of the company's actions and performance. To assess how this uncertainty will play out in my estimates of overall equity value, I did a Monte Carlo simulation, with my point estimates on total GMV, take rate, operating margin and sales to invested capital replaced with distributions:

Crystal Ball used for simulation

There are lessons, albeit some obvious, that emerge from this simulation. First, given that almost all of the value of Paytm comes from expectations of the future, and there is significant uncertainty on every single dimension, it should come as no surprise that the range on estimated value is immense, with a 3%chance that the company's equity is worth nothing to more thanÌýâ‚�2000ÌýbillionÌýat the 90th percentile. Second, with this range in value, the potential for your priors and biases to play out on your final valuation are strong. Put simply, if you like the company so much that you want to buy the stock, you can find a way to make the assumptions that get to that value. Third, even if you strongly favor the company and find it under valued, it would be hubris to concentrate your portfolio, around this stock. In other words, this is the type of stock that you would put 5% or perhaps 10% of your portfolio in, not 25% or 40%.

Closing Thoughts

As human beings, it is natural for us to categorize choices we face into broad groupings, because those groupings then allow us to generalize. In the 1980s, when technology companies first entered the market in big numbers, we classified them all as high growth, high risk investments. While that categorization would have worked at the time, it is quite clear that the technology sector today is not only a dominant segment of the market (accounting for the largest slice of the S&P 500 market capitalization pie), but is also home to a wide array of companies. In fact, at one end of the spectrum, there are many older tech companies that are now mature, and perhaps even in decline, and several are stable, cash earning machines, akin to the consumer product companies of the 1980. At the other end, you see new sub-segments of technology-based companies that have emerged to claim the "high growth, high risk" mantle, deriving more of their value from the number of users on their platforms, than from conventional financial metrics. ÌýA few weeks ago, when I valued Zomato, I argued that it was a joint bet on the company's continued dominance of the food delivery market and the growth in the Indian restaurant/food delivery business. Paytm is also a joint bet on an early entrant into the Indian mobile payment market, continuing to maintain market share, in a growing digital payment market in India. That said, the companies have very different business models, with Zomato's 20% plus take of every dollar spent on its platform vastly exceeding Paytm's less than 1% take of every dollar spent on its platform. They are both big market bets, but the Paytm bet is much more dependent on management figuring out a way to grow, while improving take rates at the same time.Ìý

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Spreadsheets to download

Last year, I and explained why I was skeptical about the claims made by advocates about the benefits it would bring to companies, investors and society. In the year since, I have heard from many on the topic, and while there are some who agreed with me on the internal inconsistencies in its arguments, there were quite a few who disagreed with me. In keeping with my belief that you learn more by engaging with those who disagree with you, than those who do, I have tried my best to see things through the eyes of ESG true believers, and I must confess that the more I look at ESG, the more convinced I become that "there is no there there". More than ever, I believe that ESG is not just a mistake that will cost companies and investors money, while making the world worse off, but that it create more harm than good for society.

ESG: Value and Pricing Implications

Rather than repeat in detail the points I made in , I will summarize my key conclusions, with addendums and modifications, based upon the feedback (positive and negative) that I have received.Ìý

1. Goodness is difficult to measure, and the task will not get easier!

The starting point for the ESG argument is the premise that we can come up with measures of goodness that can then be targeted by corporate managers and used by investors. To meet this demand, services have popped up around the world, claiming to measure ESG with scores and ratings. As I noted in my last post, there seems to be little consensus across services on how to measure goodness, and the low correlation across service measures of ESG has been . The counter from the ESG services and ESG advocates is that these differences reflect growing pains, and just as bond ratings agencies found convergence on measuring default risk, services will also find commonalities. I think that view misses a key difference between default risk and goodness, insofar as default is an observable event and services were able to learn from corporate defaults and fine tune their ratings. Goodness is in the eyes of the beholder, and what you perceive to be a grevious corporate sin may not even register on my list, as a problem. To illustrate how investors can differ on core values, consider the chart below, where investors were asked to assess which issues should rank highest, when considering corporate goodness:

Based on this survey, younger investors want the focus to be on global warming and plastics, whereas older investors seem to focus on data fraud and gun control. If you expand these factors to include other social and religious issues, I would wager that the differences will only widen. As ESG scores and ratings get more traction, researchers are also looking at the factors that allow companies to get high scores and good rankings, and improve them over time. Studies of ESG scores find that they were influenced by company size and location, with larger companies getting higher ESG scores/rankings than smaller companies, and developed market companies getting higher scores and rankings than emerging market companies:

It is entirely possible that big companies are better corporate citizens than smaller ones, but it is also just as plausible that big companies have the resources to play the ESG scoring game, and that more disclosure is a tactic used by these companies that want to bury skeletons in their current or past lives, rather than expose them. In fact, a JP Morgan study of ESG Ratings and disclosures also points to a larger danger from enhanced ESG disclosure requirements, which is that the ESG ratings seems to increase across companies, as disclosure increase.Ìý

Chen et al, JP Morgan

While I am sure that there will be some in the ESG community who will view this as vindication that disclosure is inducing better corporate behavior, the cynic in me sees companies learning to play the ESG game, at least as designed by services, and using the disclosure process to check boxes and up their scores. To me, the parallels to the corporate governance movement from two decades ago are uncanny, where services rushed to estimate corporate governance scores for companies, accountants and rule writers added hundreds of pages of disclosure on corporate governance, and promises were made of a "golden age" for shareholder power. The fact that the corporate governance movement enriched services, consultants and bankers, and left shareholders more powerless than they were before the movement started, holding shares in companies with dual class shares or worse, should act as a warning for ESG disclosure/measurement advocates, but I have a feeling that it will not.

2. Being “good� will add to value some companies, hurt others, and leave the rest unaffected!

If the ESG sales pitch to companies, which is that if you are a "good" company, you will be worth more, is right, why do we need ESG? In fact, Milton Friedman, theÌýbête noireÌýof ESG advocates, would stand vindicated, and companies would do good, because it made them more profitable and valuable, and not because of lectures about morality and goodness. This may be cynical, on my party, but the very fact that ESG advocates keep insisting that being "good" increases value must be because they are themselves unsure why or whether this is true. The framework for tracing out the effect of ESG on value is a simple one, since ESG, if it affects value, has to affect one of four variables: revenue growth (by increasing or decreasing growth), operating profit margins, reinvestment efficiency (the payoff to investing in new capacity) Ìýor risk (through the cost of funding/capital and failure risk). In last year's post, I noted that the empirical evidence that ESG has a positive payoff is weak, at best, and inconclusive, for the most part:The strongest evidence that is supportive of ESG comes on the risk front, with evidence that it does not pay to be a "bad" company, with some Ìýa higher cost of funding and greater risk of catastrophes, but much of that evidence comes from fossil fuel companies. The weakest evidence in ESG's favor is on profitability and cash flows, since almost every study that purports to find positive correlation between profitability and ESG scores trips up on the causality question, i.e., are "good" companies more profitable or are companies that are more profitable able to take the actions that make them look good? An objective look at the data would lead us to conclude that while one can make a reasonable case that companies should work at "not being bad", there is very little evidence that there is a payoff to Ìýspending more money to be "good".

3. The ESG sales pitch to investors is internally inconsistent and fundamentally incoherent

If the argument that ESG translates into higher value is weak, the argument that incorporating ESG into your investing is going to increase your returns fails a very simple investment test. For any variable, no matter how intuitive and obvious its connection to value might be, to generate "excess" returns, you have to consider whether it has been priced in already. That is why investing in a well managed company or one that has high growth does not translate into excess returns, if the market already is pricing in the management and growth. Applying this principle to ESG investing, the question of whether ESG-based investing pays off or not depends on not only whether you think ESG increases or decreases firm value, but also on whether the market has already priced in the impact.

If the market has fully priced in the ESG effect on value, positive or negative, investing in 'good' companies or avoiding 'bad' companies will have no effect on excess returns. In fact, if being good makes companies less risky, investors in good companies will earn lower returns than investors in bad companies, before adjusting for risk, and equivalent returns after adjusting for risk.If the market is over enthused with ESG and is overpricing how much being "good" will add to a company's profitability or reduce risk, investing in 'good' companies will generate lower risk-adjusted returns than investing in 'bad' companies.If the market is underestimating the benefits of being good on growth, margins and risk, investing in 'good' companies will generate higher returns for investors, even after adjusting for risk.In the latter two cases, the excess returns (negative in the "markets are over estimating" case and positive in the "markets are under estimating") will manifest only when the market corrects its mistakes. Ìý Bringing in market pricing into the discussion is important for two reasons.ÌýThe first is that it suggests that much of the research on the relationship between ESG and returns yields murky findings. Put simply, there is very little that we learn from these studies, whether they find positive or negative relationships between ESG and investor returns, since that relationship is compatible with a number of competing hypotheses about ESG, value and price.ÌýThe second is that bringing in market pricing does shed some light on perhaps the only aspect of ESG investing that seems to deliver a payoff for investors, which is investing ahead or during market transitions. In , I pointed to that find that activist investors who take stakes in "bad" companies and try to get them to change their ways generate significant excess returns from doing so. contends that investing in companies that improve their ESG can generate excess returns of about 3% a year, but skepticism is in order because it is based upon a proprietary ESG improvement score (REIS), and was generated by an asset management firm that invests based upon that score.ÌýIf you are interested in making market transitions on ESG work in your favor, you also have to be clear about the strengths you will need to get the payoffs, including skills in divining not only what social values are gaining and losing ground and which changes have staying power.

4. Outsourcing your conscience is a salve, not a solution!

ÌýÌý ÌýEven if being “goodâ€� does not increase value or make investors better off, could it still help, by making the world a better place? After all, what harm can there be in asking and putting pressure on companies to behave well, even if costs them? In the short term, the answer may be no, but in the long term, I believe that this will cost us all (as society). The ESG movement has given each of us an easy way out of having to make choices, by outsourcing these choices to corporate CEOs and investment fund managers, asking them to be “goodâ€� for us, while not charging us more for their products and services (as consumers) and delivering above-average returns (as investors). Implicit in the ESG push is the presumption that unless companies that are explicitly committed to ESG, they cannot contribute to society, but that is not true. Consider Bill Gates and Warren Buffett, two men who built extraordinarily valuable companies, with goodness a factor in decision making only if it was good for business. Both men have not only made , promising to give away most of their wealth to their favorite causes in their lifetimes, and living up to that promise, but they have also made their shareholders wealthy, and . As I see it, the difference between this “oldâ€� model of business and the proposed “new ESGâ€� version is in who does the giving to society, with corporate CEOs and management taking over that responsibility from shareholders. I am willing to listen to arguments for why this new model is better, but I am certainly not willing to concede, without challenge, that a corporate CEO knows my value system better than I do, as a shareholder, and is better positioned to make judgments on how much to give back to society, and to whom, than I am.

Ìý Ìý For a perspective more informed and eloquent than mine, I would strongly recommend , whose stint at BlackRock, as chief investment officer for sustainable investing, put him at the heart of the ESG investing movement. He argues that trusting companies and investment fund managers to make the right judgments for society will fail, because their views (and actions) will be driven by profits, for companies, and investment returns, for fund managers. He also believes that governments and regulators have been derelict in writing rules and laws, allowing companies to step into the void. While I don’t share his faith that government actions are the solution, I share his view that entities whose prime reasons for existence are to generate profits for shareholders (companies) or returns for investors (investment funds) all ill suited to be custodians of public good.

Cui Bono? The ESG Gravy Train (or Circle)!

Ìý Ìý If ESG is a flawed concept, perhaps fatally so, and if the flaws are visible for everyone to see, how do we explain the immense push in both corporate and investment settings? I think the answer always lies in asking the question "Cui Bono, or who benefits?". With ESG, the answer seems to be everyone, but those it is purported to help, i.e. corporate stakeholders, investors and society. The picture below captures the groups that have primarily benefited from the ESG boom, and how they feed off each other.

Given how much ESG disclosure advocates, measurement services, investment funds and consultants feed off each other, it is no wonder that they have an incentive to sell you on its unstoppable growth and inevitable success. Given that shareholders in companies and investors in funds are paying for this gravy, you may wonder why corporate CEOs not only go along with this charade, but also actively encourage it, and the answer lies in the power it gives them to bypass shareholders and to evade accountability. After all, these are the same CEOs who, in 2019, put forth the that it is a company’s responsibility to maximize stakeholder wealth, rather than cater to shareholders, which I then that being accountable to everyone effectively meant that CEOs were accountable to no one. ÌýIn some cases, flaunting goodness has become a way that founders and CEOs use to cover business model weaknesses and overreach. It is a point that I made in my posts on , and on , noting that Elizabeth Holmes and Adam Neumann used their “noble purposeâ€� credentials to cover up fraud and narcissism.Ìý

I should add that, notwithstanding my negative views about ESG, I do not think that ESG consultants, fund managers and analysts are venal, but I do think that they, like everyone else, are driven by self interest. I also believe that many in the ESG ecosystem are driven by good motives, a desire to do good for society and make the world a better place, but that are being used by a few at the top of the ESG pyramid, whose commitment to the cause is skin deep. If you are someone working inÌýthe ESGÌýspace or a true believer, please do look to the highest profile spokespersons for your cause, mostly corporate CEOs and investment fund titans, and remember the adage about waking up with fleas, ifÌýyou lie down with dogs.

A Roadmap for being and doing Good

Ìý Ìý My skepticism about ESG notwithstanding, I understand its draw, especially on the young. As individuals, each of us has a moral code, sometimes coming from religion, sometimes from family and sometimes from culture, but whatever its source, our actions should be consistent with that code. Since those actions involve what we do at work, and in investing, it stands to reason that there are some investments you will and should not make, because it violates your sense of right and wrong, and other investments that you will make, because they advance your view of goodness. It is for this reason that I would suggest a more nuanced and personalized version of ESG, built around the following principles:

Start with a personalized measure of goodness, and don’t overreach: The key with moral codes is that they are personal, and for goodness to be incorporated into your investment and business decisions, you have to bring in your value judgments, rather than leave it to ESG measurement services or to portfolio managers. I would also recommend that you focus on core values, rather than try to find a match on every one, not only because adding too restrictions will constrain you in your choices, perhaps to the point of paralysis, but also because you may find yourself accepting major compromises on your key values in order to meet secondary values.ÌýAs a business person, be clear on how being good will affect business models and value: If you own a business, you are absolutely within your rights to bring your personal views on morality into your business decisions, but if you do so, you should work through the effects on growth, margins and risk, and be at peace with the fact that staying true to your values may, and probably will, cost you money. If you are making decisions at a publicly traded company, as an employee, manager or even CEO, you are investing other people’s money and if you choose to make decisions based upon your personalized moral code, you cannot justify these decisions with hand waving and double talk. In fact, you have an obligation to be open about what your conscience will cost your shareholders, a twist on disclosure that ESG advocates will not like.As an investor, understand how much goodness has been priced in: If you are an investor, you don’t have to compromise on your values, as long as you start with the recognition that, at least in the long term, you will have to accept lower returns than you would have earned without that constraint. If you are tempted to have your cake and eat it too, and who isn’t, you may be able to do so by getting ahead of the market in detecting shifts in social mores and pushing for change in the companies you invest in, to change.ÌýAs a consumer and citizen, make choices that are consistent with your moral code: If you believe that owning a portfolio of “goodâ€� stocks or running a “goodâ€� business is all you have to do to fulfill your moral or societal obligations, you are wrong. Your consumption decisions (on which products and services you buy) and your citizenship decisions (on voting and community participation) have as big, if not greater, an effect. Put simply, if your key societal issue is climate change, your refusal to own fossil fuel stocks in your portfolio is of little consequence, if you still drive a gas guzzler, air condition your house to feel like an ice box all summer and take private corporate jets to Davos every year.On a personal note, I have always found that the people that I've known who do good, spend very little time talking about being good or lecturing other people on goodness. I would extend that perspective to companies and investment funds as well, and I reserve my skepticism for those companies that spend hundreds of pages of their annual filings telling me how much "good" they do.
In conclusionÌýÌý ÌýThe ESG movement’s biggest disservice is the message that it has given those who are torn between morality and money, that they can have it all. Telling companies that being good will always make them more valuable, investors that they can add morality constraints to their investments and earn higher returns at the same time, and young job seekers that they can be paid like bankers, while doing peace corps work, is delusional. In the long term, as the truth emerges, it will breed cynicism in everyone involved, and if you care about the social good, it will do more damage than good. The truth is that, most of the time, being good will cost you and/or inconvenience you (as businesses, investors or employees), and that you choose to be good, in spite of that concern.Ìý

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For the last two decades, China has been the dominant story for both the global economy and capital markets, as the country's immense growth and infrastructure investments have sustained commodity prices, and altered the balance of world economic power. That growth has come (or should have come) with the recognition that in almost every venture in China, public or private, the Chinese government is not just a player, but often the key player determining the venture's success and failure. Afraid of being shut out of the biggest, growth market in the world, companies operating in China have accepted limits and constraints that they would fight in almost every other part of the world, including in their own domestic markets. That includes not just foreign companies, seeking to operate in China, but domestic companies, who, while benefiting from Beijing's backing, knew how quickly the iron fist could replace the velvet glove, in their dealings with the government. In the last year or so, Chinese tech companies, including shining stars like Alibaba, Tencent and Didi have also woken up to this recognition, and investors have had to readjust their expectations for these companies. In this post, I will begin by tracing out the rise of China to global economic power, and then focus on Chinese tech companies, with the intent of examining how government actions and inactions can affect value and pricing.The Rise of ChinaWhile China's rise in the last two decades has been meteoric, it is worth remembering that China was a dominant part of the global economy centuries ago. The graph below draws on one of the most fascinating (and fun) datasets in the world, maintained at the University of Groningen which estimates (or at least tries to estimate) the GDP regionally going back to 1 AD.In 1500, China had the largest GDP of any country in the world, followed by India, not surprising since output and population were tied together strongly at the time, when human labor was the key driver of economic output. With the advent of the Industrial Age, both India and China fell off the pace, and by the start of the twentieth century were punching well below their (population) weight.
I am not an historian or political scientist, and will not probe the reasons, but China spent much of the twentieth century with a stalled economy, and in 1970, China's GDP accounted for 4.63% of global GDP, down from more 30% in 1820. The turn around that occurred in China's economic growth occurred is one for the history books, and you can see the rise in the graph below, where I look at China's GDP, relative to the United States (which had the dominant share of global GDP) and to the rest of the world between 1960 and 2020:
The United States, which used to account for close to half of global GDP in 1960 has seen its share drop go global GDP drop to 25%, while China's share has climbed close to 20% in 2020. ÌýTo get a sense of how dependent the world economy has become on China for its growth, take a look at the table below, where I report World GDP growth, by decade, with and without China:World BankPut bluntly, without China, the world economy would have tread water for the last decade, since China accounted for close to two thirds of global GPD added on during the decade. As China's economy has grown, its financial markets have also found their footing, albeit at a slower pace. In the graph below, I plot the market capitalization of Chinese listed companies, in dollar terms, and as a percent of market capitalization of all global companies:Ìý
Chinese equities have risen from a negligible share of global market capitalization, in 2000, to more than 10% of global market capitalization, in 2020. It is beyond debate that China's economy and markets have had a renaissance, cementing the country’s place as a leading economic power.Ìý
While many of the companies listed initially on the Chinese markets represented infrastructure and financial service companies, the last decade has seen the rise of the Chinese tech behemoth. That transition can be seen when you compare the fifteen largest Chinese companies, in market capitalization terms, at the end of Ìý2010 to the fifteen largest Chinese companies, again in market capitalization terms, at the end of 2020.ÌýS&P Capital IQAt the end of 2010, of the fifteen largest market cap companies in China, only two were tech companies (Tencent and Baidu), and they were towards the bottom of the rankings; banks and insurance companies dominated the list. By the end of 2020, six of the top fifteen were technology companies, and Tencent and Alibaba topped the rankings.The Chinese Tech DecadeThe rise of technology as an economic force and Ìýmarket driver is not unique to China. After all, the FANGAM stocks (Facebook, Amazon, Netflix, Google, Apple and Microsoft) were the engine that drove market capitalization up in the US, for the last decade, with COVID super charging their rise in 2020. In this section, I will focus on the Chinese tech market, by looking at some its biggest success stores, and using them to gain an understanding of both the promise and peril in this business.ÌýChinese Tech Plays - The Lead InIn this day and age, every business brands itself, at least in part, as a technology company, and it is always tricky to try to crystallize the diverse mix of technology into a tech sector. That said, there is an advantage to taking a deeper look at some of the biggest winners in the tech business, not only to understand why they succeeded, but also to get insights into whether they can sustain that success in the future. It is for that reason that I will focus onÌýfour Chinese tech companies (Tencent, Alibaba, JD.com and Didi) for the rest of this post, the first three because they make the top fifteen list of market cap companies in China, and Didi because of its high profile IPO, just a few weeks ago.Ìý
I am not a fan of extensive corporate write ups, with long treatises about corporate history and developments, since they often operate more as distractions than as sources of information. Instead, I will try to compress what I know (which is not much) about the evolution and operations of each of the four companies. I will start with Tencent, in deference to its age (it is the oldest of the four) as well as its standing as the largest market cap company on the list.Ìý
Tencent is the most versatile of the four companies, in terms of its business mix, and while it has been in existence for 20 years as a publicly traded company, its growth in the last decade has converted it from a minnow to a whale. ÌýMoving to Alibaba, the second largest Chinese tech company in 2020, I drew on that I wrote ahead of its IPO in 2014, where I described it as “the Real China Storyâ€�, because so much of Chinese retail traffic travels through its platforms (Taobao and TMall), with the company collecting a slice of the transaction revenues, in return for its intermediation services.


While Alibaba is sometimes characterized as China's Amazon, it is closer to Google in its business model, collecting most of its revenues from customers using its platforms to buy goods and services. Staying in the online retail space, I look at JD.com, which operates more as a retailer, selling goods and services through its platforms.
Note that JD.com, while posting strong revenue growth rates for much of the last decade, has had trouble generating significant operating profits. That, in my view, is not accidental, since the company has been open about its focus on increasing market share, at the expense of profitability, following the (If we build it, they will come)... The final company in my list is Didi, a company that I had tracked in the process of valuing Uber and Lyft, and it followed them into public markets in 2021:
Didi's acquisition of Uber China has given it dominance over the Chinese ride sharing market, but it is difficult to see the payoff in the numbers. Revenues have stagnated between 2018 and 2020, and the easy excuse of COVID does not explain the stagnation, since growth was tepid even in 2019. The company has also shown an almost unparalleled capacity to lose money and burn through cash, even by ride sharing company standards.Chinese Tech Plays - Valuation StoriesTo value the Chinese tech companies, I have to construct valuation stories that fit them, and as you can see there are big differences across the four companies (Tencent, Alibaba, JD.com and Didi) not only in where they are in terms of growth potential, but also in terms of profitability and business models. That said. there are some commonalities across these companies that I will explore in this section.
Big Markets (Squared)There are many aspects that make Chinese tech companies attractive to investors, but the one overriding attraction of these companies is their access to the Chinese market. As I noted in the first section, China was the engine that drove global growth over the last decade, and with that growth has come a surge in buying power for Chinese consumers. Companies that are positioned to take advantage of this growth, whether domestic or foreign, have been rewarded by investors with higher market capitalizations, even if the promise has not translated into profitability (yet). ÌýWith tech companies that are disrupting conventional businesses, there is an added allure of growth occurring at the expense of the status quo. Tencent in the gaming business, Alibaba and JD.com, with retailing, and Didi, with logistics, are all disruptors of the status quo, in the businesses that they operate in. You could argue that this combination of China and disruption creates growth stories on steroids, as investors load on dreams of one big market (from disruption) on top of another (China).Ìý
As with any steroid-driven story, there are downsides. First, I have had , where I argue that investors often over estimate the likelihood and payoffs of success in big markets, because they fail to factor in new entrants, and changing technology fully. This argument applies to Chinese companies, generally, and to Chinese tech companies, specifically, as "the market is huge, the company's value has to be immense" argument often wins the day. Second, the size of the Chinese market, in conjunction with local dominance, has also meant that Chinese tech companies prioritize domestic market growth, simply because it is easier and often more profitable. Of the four companies that I am analyzing, Tencent is the only one where foreign market revenues are substantial enough to make a difference to its valuation. Alibaba has aspirations to grow in foreign markets but has little to show yet in terms of profits, and Didi and JD.com are almost entirely China-focused.ÌýClearly, their global ambitions notwithstanding, Chinese tech companies have remained overwhelmingly Chinese. There are benefits to getting growth from domestic markets, but that dependence also makes these companies extraordinarily exposed to government regulations and restrictions in these markets.
Attuned to the Chinese MarketThe argument that the big (and growing) Chinese tech market explains the success of the winners (like Alibaba, Tencent, JD.com and Didi) short changes these companies, by underplaying what each of them brought to the game that allowed them to succeed. Note that these companies were very much part of the pack, competing with foreign and Ìýdomestic players, just a decade or two ago, but have managed to separate themselves from their competitors, in the years since. ÌýWhile there are many factors that may have contributed, one in particular stands out. Rather than copying what successful US tech companies were doing to gain market share and profitability, these companies tailored their business models and product offerings to the Chinese market, adapting to what Chinese consumers cared about and wanted. In my IPO post on Alibaba, I argued that the reason it was able to vanquish eBay and more established competitors was because it created what the Economist called and a payment mechanism that Chinese consumers felt comfortable using online. Tencent not only built a gaming platform specifically focused on Chinese consumers, but was well ahead of its US tech competitors in building the world's leading social media platform in WeChat. Didi was conceived as a cab-hailing company in 2012, but it too tailored its services to the local characteristics of the Chinese market, acquiring its main domestic rival in Kuadi Dache in 2015, and forcing Uber to capitulate and sell its Chinese segment in 2017.
Corporate Governance NightmaresThere is another feature that Chinese tech companies share, and it is not a favorable one. While Alibaba, Tencent, JD.com and Didi are undeniably Chinese companies (both in terms of operations and where they get their revenues), three of these companies (Alibaba, JD and Didi) made their public market debuts in New York, with NASDAQ listings. In fact, these three companies are also incorporated in the Cayman Islands, and Tencent began its corporate life as a Cayman Island listing. In fact, the structure (called a variable interest entity or VIE) used by Alibaba, HD and Didi essentially means that shareholders are technically owners of shell companies (in the Cayman Islands) rather than the Chinese enterprises that they they think they are buying.ÌýWhy do Chinese tech companies favor this convoluted structure? The answer lies in Chinese laws and regulations that restrict the types of business that foreign investors are allowed to own shares in, and technology is one of those restricted businesses. Variable interest entities are a technicality that allows Chinese tech companies to get around the law, but they hold up only because the Chinese government has looked the other way, perhaps because the benefits to China (of tapping into foreign capital) exceed the costs. The legality of variable interest entities is still much debates, but if its gets litigated, stockholders in these companies may find themselves with limited standing. As an added complication, each of these companies has elaborate subsidiary structures, including wholly owned, majority owned and minority owned subsidiaries that are, at best, opaquely reported upon, and at worst, a blank slate.Beijing: A Silent (or not-so-silent) Partner!The discussion of variable interest entities (VIE) its a good lead in to the third component that Chinese tech companies share in common, which is that the Chinese government is a player in the game, no matter what business you enter into in China. Note, though, that the notion that governments are neutral arbiters who don't affect company value is utopian, since governments in every market affect almost every dimension of value, sometimes positively and sometimes negatively. In the figure below, I have used my value drivers framework, where I connect the value of a company to key drivers of value (revenue growth, operating margins, capital intensity and risk), to examine how government action (or inaction) can affect each driver.

There are a myriad of ways in which governments can add or detract from value, and the net effect will depend on the company and government in question. I have found this framework useful in dealing with a effect on value of everything from crony capitalism and political connections to regulation.
If this is true for all companies, why make this an issue with just Chinese tech companies? There are two reasons.ÌýFirst, the Chinese government can not only change the competitive balance and business more decisively than democratic counterparts, where making laws involves trade offs and bargains, but also make the changes more permanent, since a change in government is not in the cards.ÌýSecond, in most countries, government rules and regulations have to run a gauntlet of legal challenges, before becoming law, since a judiciary can over ride, delay or even set aside government actions. This may reflect my ignorance, but I have never heard of a Chinese government law or regulation that had to be withdrawn or suspended, because a Chinese court ruled it illegal.ÌýPut simply, the Chinese government has more power to give and to take away from its companies than any other government of consequence in the world. Sensible investors have always understood this power, and tried to price them in, but for much of the last decade that has led them to bid up Chinese companies, on the assumption that Beijing would tilt the playing field in favor of domestic companies, at the expense of foreign competitors, and that the governments' push for more economic growth would make it more likely to be an ally, rather than an adversary, to companies.Ìý
That calculation, though, does miss the other quality that the Chinese government has always valued, which is control, and the tussle between the two (growth and control), in Ìýmy view, explains much of the crackdown on Chinese tech. As Chinese tech companies have become larger and more valuable, they have also become repositories for data on their customers, and that data is what Beijing not only fears, but covets. While the government may frame its crackdown on big tech as designed to protect Chinese consumersâ€� privacy or to prevent market domination, the truth is that Ìýthis is mostly about the Chinese government increasing its control of data and markets. Just as a thought experiment, if the Chinese government had the information that Tencent and Alibaba have about their customers, do you believe that they would not keep it? Whatever the reasons for the Chinese government’s actions, it is undeniable that they have changed the calculus, at least for the moment, of how the Chinese government affects Chinese tech company valuations. As investors bring in the downside of the government effects on value, markets have reassessed the pricing of all four of the companies that I am valuing, dropping market capitalization by 17% for Tencent, 46% for Alibaba and 7% for JD.com in 2021, over the most recent year, and providing a frosty reception to Didi’s IPO, with the stock price dropping 42% from its offer price of $14 a share , just a few weeks ago. The question is not whether the mark down on price has a good reason (it does), but whether the market is over or under reacting to the new relationship between Chinese tech and the Chinese government.Investing in China TechWith that long lead in, I think that we are positioned to not only value Tencent, Alibaba, JD.com and Didi, but also to bring in the effect of activist government on their value drivers in the future. In the process, the question of whether these companies are cheap, given their recent mark downs, or expensive, will be answered.Ìý
Valuing Chinese Tech Companies As I noted in the last section, investors have priced Chinese tech companies for much of the last decade, on the presumption that the Chinese government would be a net plus for these companies, stifling competition from foreign companies and easing the pathway to growth to profitability. It is for that reason that investors have been shocked by the realization that what governments can give, they can take away. Rather than bury you in details of each company's valuation, I have summarized the key inputs and valuations of each company, under three scenarios, built around views of the government - the government as benefactor, the government as a net-negative (more likely to hurt the company than help it, reflecting my current view on the Chinese government's relationship with these companies) and the government as adversary - in the table below:Tencent: Government asÌý,ÌýÌýandÌý
Alibaba: Government asÌý,ÌýÌýandÌý
JD.com: Government asÌýÌý,ÌýÌýandÌý
Didi: Government asÌýÌý,ÌýÌýandÌýThe effects of the Chinese government on the valuations of these technology companies can be seen in the range of values per share that you get for each company. In making my assessments of how government affects value, I believe that almost all of the effect will be in the cash flows for the companies, since most of the restrictions are on growth (constraints rising from anti-trust moves) or on margins (costs associated with meeting privacy needs). While there is talk of banning tech companies from listing on foreign markets, using shell structures, I don't believe it will be retroactive, and the companies on my list are big enough to transition. With Didi, I do believe that a strong push by the government to restrict how it does business will increase the chance that the company will not make it as a going concern, since its business model is still a work in process.
Based upon my assessments, the quick takeaway is that at current stock prices, all four of the companies are under valued, with what I believe are reasonable constraints brought in by government actions. Alibaba is the most undervalued (by 12.7%), followed by Tencent (by 8%), but Didi and JD.com are close to being fairly valued (undervalued by 3.65% and 2.07%). Digging deeper, there is substantial downside if the government becomes openly and actively adversarial, with Didi dropping to becoming almost worthless, if that happens. On the upside, if any of these companies finds a way into the government's good graces, the benefits that flow from it can increase the upside at each of these companies, but most at Didi. Didi is clearly more exposed to government actions than the other three, suggesting a broader principle at play, which is that young companies are more affected in terms of both upside and downside, by government actions and regulations, than older companies.
Investing in Chinese Tech Companies Valuation is a pragmatic, rather than a theoretic, exercise, where the end game is not just understanding and estimating the value of a company, but acting on that valuation. If you are an investor, you should be willing to buy under valued companies and sell short on over valued companies, with the caveat that you need a market correction to make money, and that correction may take time. Since I find all four of the Chinese tech companies under valued, what would I do next? First, I would remove Didi and JD.com from the mix, largely because they are closer to fairly valued, than under valued. In fact, I would argue that looking at Didi's still unformed business model, and the huge consequences of government action or inaction, it is closer to being an option than a conventional going-concern valuation. Second, with Alibaba and Tencent, both of which are under valued in my base case (government as a net negative), I have three choices:Buy both Alibaba and Tencent, and hope that the "government as adversary" scenario does not play out for either.ÌýBuy one of the two, based upon not just the valuation but also the rest of the company, including corporate governance and structure.Buy neither, because you believe that the "government as adversary" scenario is more likely than the "government as benefactor".I am not inclined to double down (buying both companies) on betting on how the Chinese government will behave in the future, and if I had to pick one, I would pick Tencent over Alibaba for three reasons. The first is that Tencent is a more rounded company in terms of being in business mix, and I think that the WeChat platform, like the Facebook platform, adds a premium to their valuation. The second is that I prefer buying Tencent on the Hong Kong stock exchange to buying Alibaba's Cayman Islands shell company on the New York Stock Exchange. The third is that while I admire Jack Ma as an entrepreneur, I am believe that personality-driven companies have an added layer of risk, since that personality can draw attention and fire. In fact, there are some who believe that the increased regulation of Chinese technology can be traced to Ìýin 2020.Ìý
With my Tencent investment, I faced a secondary choice of investing directly in Tencent or indirectly buying shares in Naspers, a South African holding company. If you are puzzled about why Naspers enters the Ìýequation, the company acquired 46.5% of Tencent in return for a $32 million VC investment in 2001, and as Tencent surged in market capitalization, , with 80% or more of its value coming from its Tencent holdings. The one difference is that the market is discounting the holding by 20-30%, in Naspers hands, reflecting concerns about taxes due and corporate governance at Naspers. That discount seems immune to almost every attempt by Naspers to make it disappear; for instance, Naspers spun off a Dutch entity, Prosus, and endowed it with a portion of the holding, in an attempt to eliminate the discount, but the discount persists in Prosus as well, albeit a little smaller. I decided that the potential upside of hoping that the discount narrows over time is exceeded by the downside of creating an extra layer between me and my Tencent investment. (For those of you who want to track my Tencent investment, and perhaps taunt me if (or when) I get wrong, I bought the ADR on August 31.)
ConclusionIn valuation, we seldom consider the explicit effects of government policy and regulations on company value. The rationale that is usually offered for this practice is either that the government's capacities to add and detract from value offset each other or that the current numbers for the company (growth, margin etc.) already incorporate the government effect. While ignoring governments may be defensible, when government policy is stable, it breaks down when governments deviate from the script, and behave differently that they have in the past. With Chinese tech companies, long used to the Chinese government being an ally in their search for growth and profits, the last year has been a rude awakening to a new reality of a more activist and punitive version. That said, I don't for a moment believe that the Chinese government cares about either consumers or competition, the stated reasons for the crackdown, and am convinced that this is more about the it exercising control over both companies and data. I also believe that the adjustment in market prices that we have seen in Chinese tech companies is reflecting the fear that investors have now that the government will act as a constraint rather than an accelerator on future growth and profitability. As markets recalibrate prices to reflect the new reality, there are opportunities for solid returns in this space, and I hope to one of the beneficiaries!Ìý
YouTube Video
ValuationsTencent: Government as , and Alibaba: Government asÌý,ÌýÌýandÌýJD.com: Government asÌýÌý,ÌýÌýandÌýDidi: Government asÌýÌý,ÌýÌýandÌý

Just over a week ago, I valued Zomato ahead of its market debut, and as with almost every valuation that I do on this forum, I heard from many of you. Some of you felt that I was being far too generous in my assumptions about market share and profitability, for a company with no history of making money, and that I was over valuing the company. Many others argued that I was understating the growth in the Indian food market and the company's potential to enter new markets, and thus undervaluing the company, a point that the market made even more emphatically by pricing the stock at about three times my estimated value. A few of you posited that I was missing the point entirely, and that Zomato is a trader's game, and that there are plenty of reasons for traders to be optimistic about its future prospects. ÌýIn this post, rather than impose my story (and value) on you, I offer a template for telling your own story about Zomato, and arriving at your own estimate of value.

The Prelude

After I posted my valuation last week, I did find some of the portrayals of my post to be a little unsettling. Some started by describing me as some kind of valuation luminary, and then proceeding to describe what I did to arrive at value as the result of deeply insightful research. Let me dispel both delusions. First, there is nothing in valuation that merits the use of “expertâ€� or “guruâ€� as a descriptor, since it is for the most part, common sense, layered with a few valuation basics. Second, while valuation practitioners have created their own buzzwords to create an aura of mystery, and added complexities, often with no reason other than to intimidate outsiders, I believe that anyone should be able to value a company, as I hope to show later in this post. ÌýThere was also some who misread my post to imply that I disliked Zomato as a company, or that I was trying to talk others out of investing in the company. Neither assertion is true, and since they relate to what I view as fundamental truths about investing, let me elaborate:

Good Company versus Good Investment: While it is true that, at least in my assessment, Zomato is over priced, making it a bad investment, it does not follow that it is a bad company. I have written about the contrast between good investments and good companies before, but the picture below captures the essence:
In short, your assessment of whether a company is good, average or bad is based upon how you see their business model playing out in future earnings and cash flows, but your assessment of whether it is a good investment depends upon whether your expectations for the company are more positive or negative than the market expectations for that company. My story for Zomato is a very positive one, where the company not only maintains its market share of a growing Indian market, but preserves its profitability, in the face of competition. That is one reason that I emphasized that unlike some, who have concluded that its money-losing status and big ambitions make it a "bad" company, my conclusion is that it is a good company. That said, the market seems to be pricing in the expectation that it will be a great company, and in my view, that judgment is premature.Taking ownership of investment decisions: I value companies for an audience of one, and that audience member is forgiving and understanding, because I see him in the mirror every day. It has always been my belief that as investors, each of us needs to take ownership of our investment decisions, and that buying or selling a company because someone else is doing so, even if that person has legendary investment credentials, is a dereliction of investment due diligence. Thus, if you find Zomato to be cheap and buy it, I have no desire to talk you out of your decision, since it is your money that you are investing, and that decision should be based upon your assessment of the company's prospects, not mine.If investing is all about market price and how it relates to your assessment of value, it follows that there will never be consensus, and that disagreement is not only part and parcel of the process, but a healthy component in good valuation.

Valuation Storytelling: The Feedback Loop

In my valuation of Zomato, I laid out the story that I was telling about the company and how it played out in valuation numbers. It is part of a broader theme that I have harped on for years, which is that a good valuation is a bridge between story and numbers, and in my book on how to build that bridge, I talked about a five-step process:

In my last post on Zomato, you saw much of this process play out, but I want to focus on the fifth step, i.e., keeping the feedback loop open, and what it requires:Talk to a diverse audience: We live in a world of specialization, in almost every aspect of life, and that trend comes with mixed blessings. On the plus side, we now have experts who have spent their entire lives delving into an extraordinarily narrow slice of a discipline, often at the expense of the rest of that discipline. On the minus side, this expertise creates tunnel vision, where these experts often lose the forest for the trees. To make things worse, we have created workplaces, where these specialists often interact only with each other, making their isolation almost complete. I am lucky that I am able to interact with people with very different backgrounds (bankers, VCs, founders, CFOs, regulators), from different geographies and with very different perspectives, through my teaching and writing, and my suggestion is that you hang out less with people who think just like you do (often because they have the same training and credentials) and more with people who do not.Transparency over opacity: You have all heard the old saying about economists (and market gurus) needing three hands, because they constantly seem to have two of them busy, with their "on the one hand, and the other" prevarications about the future, that leave listeners confused about what they are predicting. I start with my valuation classes with the motto that I would rather be transparently wrong than opaquely right. Consequently, when I value companies, I try to take a stand on value, and be open about process, data and mechanics, so that anyone can not only replicate what I did, but Ìýalso find their own points of disagreement, and reflect those changes in their own assessed values. I am also well aware of the risk that by putting out valuation details, I will be proven wrong in the future, but I like the accountability that comes with disclosure. In commenting on my Zomato valuation, some of you pointed to how wrong I have been in valuing Uber and Tesla in the past, and while that is fair game, I have made peace (really) with my mistakes.Listen to those who disagree with you: I try to listen to those who disagree with me on any forum, whether it be social media or snail mail, for a very selfish reason. On every company that I value, I know that there are people out there who know more than I do about some aspect of the company (its products, market or competition) that I am valuing, and I can learn from them. With Zomato, for instance,ÌýI have learned about online food delivery and restaurants in India in the two weeks since I posted my Zomato valuation. I have some understanding of why Zomato Pro has not caught on as quickly as the company thought it would, why some of you prefer Swiggy, and even what you like to order from restaurants.Ìý(Biryani seems to a much bigger draw, for Indian diners, than it was in the days that I was growing up in India.)Be willing to change: The three most freeing words in investing and valuation are “I was wrongâ€�, and I would be lying if I said they comes easily to me. That said, I find it easier to say those words now that I have had practice, and while some view this as an admission of weakness, saying it releases you to tell a better, and sometimes different, story. Bill Gurley’s critique of my narrow definitions of total market in my first Uber valuation significantly changed not only my valuation of that company, but has played a role in how I estimate total market size and value sharing economy companies.The feedback that I have received on Zomato has already had tangible effects on my valuation. For instance, some of you noted that the corporate tax rate in India is 25%, not 30%, and while the Indian tax code with its predilection to add in surcharges that seem to last forever, and exceptions, still leaves me confused, I will concede on this point (pushing up my value per share marginally from 41 INR/share to about 43 INR/share). I have had pushback on my story’s focus on Indian food delivery, with some pointing to the potential for Zomato to expand its market globally, and others to the expansion possibilities in Indian grocery deliveries and from cloud kitchens. While I believe that the networking advantage that works to Zomato’s benefits will stymie them if they try to expand to large foreign markets and that the grocery delivery market, at least for the moment, offers too small a slice of revenues to be a game changer for the company, those are legitimate points.

A DIY Valuation of Zomato

ÌýIf, as you read my Zomato valuation, you found yourself disagreeing with me, I would like to offer you a way of valuing the company, with your disagreements incorporated into the value. Put simply, I will take care of the background work and the valuation mechanics, if you can supply the story. So, if you are ready, let’s go!

1. Total Addressable Market & Scaling Growth

The first and biggest part of the Zomato story is the total market that it can go after, since it defines how big a story you can tell, and by extension, how big your value can be. In my valuation, I assumed that Zomato’s primary revenues would continue to come from customers ordering food from restaurants for pickup and delivery, and that notwithstanding its global ambitions, India will remain its main market. That assumption led to my base case estimate of about 2,000 billion rupees (just over $25 billion) for the total market.ÌýThis was the assumption that got the most pushback, on two fronts, first that I was ignoring the possibility that Zomato’s global reach could expand that market and second that adding grocery deliveries could make the market bigger. Some also mentioned the potential for growth from cloud kitchens, i.e., restaurants (small and large) that offer food only for delivery. So, with no further ado, here are your choices:

For pessimists about Indian growth and eating habits, I offer the possibility that the total market will grow to only 1,125 billion ($15 billion) in ten years. For optimists, allowing for more growth in the Indian market or adding global growth makes the market bigger, and adding grocery deliveries to the total market more than doubles the market. In addition, you can make a judgment on whether the growth will be front ended (more growth in the early years) or spread evenly over time:

This choice will be tied to how quickly you think that the Indian economy and food delivery market will develop over time.

2. Market Share

Zomato is currently one of the two largest companies in the Indian food delivery market, with a market share that is just above the the 40%. In my valuation, I assume that the food delivery market, following a pattern that seems to be forming globally, will remain dominated by a couple of players, and leave the market share at 40%. Many of you suggested that the Indian market’s diversity, across regions and income classes, would result in a more splintered market, with lower market share, but a few argued that Zomato’s capital raise would allow it to dominate the market, earning an even higher market share:

In making this judgment, keep in mind that the more expansively you define the total market, the more you may have to pull back on market share. Also, if you do choose a dominant market share (60% or higher), consider the potential for legal and regulatory pushback.Ìý

3. Revenue Slice

The driver for the online food delivery business remains the slice of the total food order that accrues to them as base revenues, and this slice is what has to use to pay delivery personnel, cover operating costs and be used to acquire new customers. In my base case valuation, I assumed that Zomato would get to keep the 22% of gross order value in the future, a little higher than its COVID-affected FY 2021 numbers and a little lower than its FY 2020 numbers. As Zomato tries to maintain its leading market share of the Indian market, this number will be the one that will come under the most pressure, since an aggressive competitor (like Amazon Food) may be willing to settle for a lower percentage. Note that there is also the possibility that the Indian food delivery market will end up dominated by two or three companies, and that these companies could come to an implicit agreement to leave the GOV slice untouched. That would be unfair to restaurants, but will improve the bottom line for the online delivery companies:

In making a choice on revenue slice, recognize that it will be affected by your choices on market size and market share. Thus, if your total market is much bigger, because you have added in grocery deliveries, you should also be using a lower revenue slice, since grocery stores, with their lower profit margins, are reluctant to let delivery companies keep more than 10% of the order. In the US, for instance, large grocers have pushed back against Instacart’s cut (about 9%) of gross order value, and have started their own delivery services.

4. Operating Margins & Pathway to Profitability

In my valuation of Zomato, I noted that one of the advantages of being an intermediary is that the gross and operating margins tend to be high, once growth subsides that the expenses (selling and advertising costs) associated with Ìýdelivering that growth scale down. In my base case, I assumed a pre-tax target operating margin of 35%, but that margin will depend on how the competitive landscape evolves. If you have only two or three players, with a live-and-let-live attitude, margins will be high for all of the competitors, but if they continue to try to aggressively claw back from market share, through advertising and discounting, they will decline for all of the players.

In my Zomato valuation, I also assumed that the company would continue to lose money in the near term, but that operating margins would converge on the target value in year 7. This assumption implicitly stands in for your views on how smooth the pathway to profitability will be for Zomato, with rockier pathways leading to a longer time period before you reach the target margin:

Here again, the assumptions about margins will depend on the businesses that you believe that Zomato can enter, using its platform capabilities. In the last week, I have heard arguments that Zomato can go beyond food delivery into running cloud kitchens, enter the health/fitness market and even be a lender to restaurants. While all of these are possible, these are businesses with very different profitability profiles, and are unlikely to earn operating margins even remotely close to the margins that can be earned in the online food delivery business.

5. Reinvestment

The key ingredient connecting value to growth is the reinvestment needed to sustain that growth. Put simply, a company that has to reinvest large amounts to deliver a specific growth rate will have lower cash flows and be worth less than an another company with the same growth rate, but lower reinvestment needs. The input that I used in the Zomato valuation to bring in reinvestment is the sales to Ìýcapital ratio, a metric measuring how much revenue is generated for each dollar of capital invested, with reinvestment defined broadly to include net capital expenditures (capital expenditures minus depreciation), working capital needs, technology investments in the platform and acquisitions, with a higher number reflecting more efficient reinvestment. In my story, I see a continuation of their historical pattern of reinvesting in acquisitions and technology, albeit with more efficient growth in the near term, as the company bounces back from the COVID effect; my sales to capital ratio for next year is 5.00, dropping to 3.00 in years 2-5, before settling into 2.50 in steady state. Here again, there is room for debate, since you could argue for less reinvestment in the future (than I am assuming), based upon past acquisitions paying off, or for more reinvestment, if the company tries to buy its way into new markets and businesses.

Since the sales to capital ratio is not one that is widely reported, you may find yourself lacking perspective on what comprises a high, low or typical number.

6. RiskÌý

There are two risk parameters in intrinsic valuation, the cost of capital accounting for the risk or variability in expected cash flows and the failure probability incorporating the risk that your company will not make it as a going concern. In the Zomato valuation, I attached a 10% chance of failure, with the large cash balance (especially after the IPO) offsetting concerns from the company's money losing, cash burning status. For the cost of capital, I followed the traditional route of estimating the company's costs of equity (based upon its exposure to market risk) and after-tax cost of debt, to arrive at an initial cost of capital of 10.25%, which I lowered over time to 8.97%, with both numbers in Indian rupees. For those of you who may disagree with my estimates on these numbers, I will make the confession that in this valuation, this input is not on my top ten list of key inputs. To see why, consider this histogram of costs of capital (that I computed) for publicly traded Indian companies in July 2021:

Note that 80% of Indian companies have costs of capital between 8.01% and 13.16%, and that half have costs of capital between 9.50% and 12.06%. To estimate a cost of capital for Zomato, consider this simplistic (but effective) approach, based on these estimates: Thus, if you feel that I have underestimated Zomato's risk in my valuation, consider going with an initial cost of capital of 12.06% (the third quartile), whereas if you believe that I have overestimated the risk, go with 9.50% (the first quartile). Then, move on to the inputs that really matter, since, in my view, this is not one of them.

Possible, Plausible and Probable

A common pushback against story telling is that it allows investors, analysts and appraisers to let their imaginations run riot, creating fairy tale valuations. It is to counter that possibility that I argue that every valuation story has to go through a three part test:

As you navigate your way through the choices, you may be tempted as an optimist to go with the most positive (for Zomato's value) choices on each variable (biggest market, highest market share, highest margin, lowest cost of capital) or the most negative (smallest market, lowest market share, lowest margin, highest cost of capital). In fact, the former if often labeled a "best case" and the latter a "worst case" valuation, when in fact, neither passes the possible/plausible/probable test, since assuming that you will go after the biggest market will mean accepting lower margins and higher reinvestment. Thus, I could tell you that the best case value isÌýâ‚�423 and that my worst case value isÌýâ‚�0, but that would be both useless and misleading. That said, you can already see, no matter what your priors, that there is a whole range of stories for Zomato that pass the test, and that they can yield values per share that are very different:

No failure risk in juggernaut stories, 10% risk in others

The most upbeat story that passes the plausibility test, albeit barely, is the one where Zomato targets the food and grocery delivery markets, while maintaining its revenue slice at 25% and margins at 45% (duopoly levels) and a low risk profile, and even with that unlikely combination of assumptions, the value per share is �150, about 10% higher than its stock price of �140, on August 2nd. Most of the plausible stories fall between �30 and �60, with your views about growth in the Indian economy & delivery market, revenue slice, margins and risk determining where you fall in the spectrum. This table contains only a small subset of the stories that can be told about Zomato, and I would encourage you to try your hand . Once you are done, please go to thisand stake out your value. In a world where we trust crowds to get things right on every aspect of our lives from what restaurant to eat at to what movies to watch, let's get a crowd valuation of Zomato going.

Playing the Zomato Game

I am sure that there are some of you are wondering whether any of this discussion matters, if the market pricing is based upon mood and momentum. After all, if enough buyers line up to buy Zomato shares, perhaps drawn to it by the success of others, there is no reason why the price cannot continue to rise, no matter what the value. I don't disagree with that sentiment, and it goes back to the contrast I draw not just between value and price, but between investing and trading. As an investor, I am having trouble finding a pathway to justify paying 140 INR per share, for Zomato, even with the most upbeat stories that I come up with, for the company. That may of course reflect a failure of imagination on my part, and you may be able to find a narrative for the company that allows you to invest in the company. As a trader, the question of whether you should buy Zomato comes down squarely to how good you are at playing the momentum game, knowing when to get on, and more importantly, when to get off. For you, the value of Zomato may be irrelevant, and you will need a different set of metrics (charts, price and volume indicators) to make your decisions. I wish I could help you on that front, but trading is not my game, and I have neither the tools nor the inclination to play it. I wish you the best!

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