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February 21, 2015

How low can you go? Doing the Petrobras Limbo! from ashwath damodarans blog

Strongly recommended to read






Tuesday, February 10, 2015

How low can you go? Doing the Petrobras Limbo!

A few months ago, I suggested that investors venture where it is darkest, the nether regions of the corporate world where country risk, commodity risk and company risk all collide to create investing quicksand. I still own the two companies that I highlighted in that post, Vale and Lukoil, and have no regrets, even though I have lost money on both. At the time of the post, I was asked why I had not picked Brazil’s other commodity colossus, Petrobras, as my company to value (and invest in) and I dodged the question. The news from the last few days provides a partial answer, but I think that the Petrobras experience, painful though it might have been for some investors, provides an illustration of the costs and benefits of political patronage.
Petrobras: A Short History

Petrobras was founded in 1953 as the Brazilian government oil company, and for the first few decades of its life, it was run as a government-owned company from its headquarters in Rio De Janeiro. Until 1997, it had a legal monopoly on oil production and distribution in Brazil, when the domestic market was opened up to foreign oil producers. Petrobras was listed as a public company in 1997 on the Sao Paulo exchange and as a depository receipt on the New York Stock Exchange soon after. The arc of fortunes for the company can be traced in the changes in its market capitalization over time, reported in US dollars in the figure below:
Market Capitalization & Enterprise Value at end of each year
In the last decade, Petrobras has seen both highs and lows, becoming the fifth largest company in the world, in terms of market capitalization, in 2011 and then seeing a precipitous drop off in market prices in the years since. To understand where Petrobras is now and to make sense of where it is going, you have to look at both its rise in the last decade and its fall in this one.

The rise of Petrobras from minor emerging market oil company to global giant between 2002 and 2010 can be traced to three factors. The first was the discovery of major new reserves in Brazil in the early part of the last decade, which catapulted the company towards the top of the list of companies with proven reserves. The fact that these reserves would be expensive to develop was mitigated by a second development, which was the sustained surge in oil prices to triple digit levels for much of the period, making them viable. The third was an overall reduction in Brazilian country risk from the stratospheric levels of 2001 (when the country default spread for Brazil reached 14.34%, just before the election of Lula Da Silva as President) to 1.43% in 2010, when Brazil looked like it had made the leap to almost-developed market status. In 2010, the company signaled that its arrival in global markets and its ambitions to be even more by raising $72.8 billion from equity markets.

The hubris that led to the public offering may have been the trigger for the subsequent fall of the company, which has been dizzying because of the magnitude of the decline, and its speed. After peaking at a market capitalization close to $244 billion in 2010, the company has managed to lose a little bit more than $200 billion in value since, putting it in rarefied company with other champion value destroyers over time. While a large portion of the blame for the decline in the last few months (especially since September 2014) can be attributed to the drop in oil prices, note that Petrobras has already managed to destroy $160 billion in value prior to that point in time.

Petrobras: Governance Structure
To understand the Petrobras story, you have to start with an assessment how the company is structured. When the government privatized the company, it did so with the objective of raising capital for its treasury but it did not want to release control of the company to the shareholders who bought shares in the company. Using "national interest" as a shield, the government devised a game where it would be able to control the company, while raising billions in capital from investors. The basis for that game, and it is not unique to Petrobras, was to create two classes of shares, one with voting rights (common shares) and one without (called preferred shares, in an Orwellian twist), and offering the latter primarily to investors. The government retains control of more than 50% of the voting shares in the company and another 11% is controlled by entities (like the Brazilian Development Bank, BNDES, and Brazil's sovereign wealth fund) over which the government has effective control. Not quite satisfied with this rigging of the game, the government also retains veto power (a golden share) over major decisions.
Shareholding as of February 2015
Using this control structure, the government has created the ultimate rubber stamp board, whose only role has been to protect the government's interests (or more precisely the politicians who comprise the government at the time) at all costs. Brazilian company law does require that the minority shareholders (anybody but the government) have board representatives, but as this story makes clear, these directors are not just ignored but face retaliation for raising basic questions about governance. To be fair to Ms. Dilma Rousseff, government interference has always been the case in Petrobras, and her predecessors have been just as guilty of treating Petrobras as a piggybank and political patronage machine, as she has. Lula, who stepped down with great fanfare, as president just a few years ago was equally interventionist, but high oil prices provided the buffer that protected him from the fallout.
A Roadmap for Value Destruction
Just as looking at companies that have created significant amounts of value over time is enlightening because of the insights you get into what companies do right, Petrobras should become a case study for the opposite reason. Put in brutally direct terms, if you were given a valuable business and given the perverse objective of destroying it completely and quickly, you should replicate what Petrobras has done in five steps.

Step 1 - Invest first, worry about returns later (perhaps never)
Invest massive amounts of money in new investments, with little heed to returns on these investments, and often with the intent of delivering political payoffs or worse. Between 2009 and 2014, Petrobras stepped up its capital expenditures and exploration costs to more than 35% of revenues, well above the 15-20% invested by other integrated oil companies, while seeing its return on capital drop to 5% (even as oil prices stayed at $100+/barrel for the bulk of the period).

Step 2 - Grow, baby, grow, and profitability be damned
Petrobras has grown its revenues from $17.4 billion in 1997 to $135.8 billion in 2014 and displaced Exxon Mobil as the largest global oil producer in the third quarter of 2014, while letting profit margins drop dramatically. The government contributes to this dysfunctional growth by putting pressure on the company to sell gasoline at subsidized prices to Brazilian car owners.

Step 3 - Pay dividends like a regulated utility (even though you are not)
Petrobras has a history of paying large dividends, partly because it had the cash flows to pay those dividends in the 1990s and partly to supports it voting share structure. The preferred (non-voting) shares that the company has used to raise capital, without giving up control, come with dividend payout requirements that are onerous, if you have growth ambitions.

Step 4 - Borrow money to cover the cash deficit
If you want to eat your cake (by investing large amounts to generate growth) and have it too (while paying large dividends), the only way to make up the deficit is to raise fresh capital. In 2010, Petrobras did raise $79 billion in fresh equity but it has been dependent upon debt as its primarily financing in every other year. As a consequence, Petrobras had total debt outstanding of $135 billion at the end of 2014, more than any other oil company in the world.

Step 5 - Destroy value (Mission accomplished)
If you over invest and grow without heeding profitability, while paying dividends you cannot afford to pay and borrowing much more than you should be, you have created the perfect storm for value destruction. In fact, the way Petrobras has been run so defies common sense and first principles in corporate finance, that if I were a conspiracy theorist, I would be almost ready to buy into the notion that this is part of a diabolical plan to destroy the company hatched by evil geniuses somewhere. I have learned through hard experience, though, that you should not attribute to malevolence what can be explained by greed, self-dealing and bad incentive systems.

It is worth noting that none of the numbers in the last section can be attributed to the drop in oil prices. In the most recent twelve month data that you see in these graphs represent the year ending September 30, 2014, and the average oil price during that year exceeded $100/barrel.The government of Brazil, working through the management that they installed at Petrobras, have pulled off the amazing feat of destroying more than $200 billion in value with no help from outside.

A Contrarian Bet?
When a company falls as fast and as far as Petrobras has, it attracts the interests of contrarian investors and the company looks attractive on the surface, at least using some conventional multiples.

Petrobras looks very cheap, at least using equity multiples (PE and Price/Book) but the results are mixed with enterprise value multiples.

All of these multiples are affected by the fact that oil prices have dropped dramatically since the most recent financial statements and that the earnings numbers, in particular, will dive in the coming quarters. Given that Petrobras was already reporting sagging profits, before the oil price drop, I am almost afraid to think of what the numbers will look like at today's oil prices (which are closer to $50)., but I will try anyway. Looking at the annual revenues over time at the company and relating them to the average oil prices each year, here is what I find:
Revenues at Petrobras = -4,619 million + 1276 (Average Oil price during year)     R squared = 92%
Thus, if you assume that the current oil price of $51.69 is close to the average for this year, the normalized revenues for Petrobras will be $61.3 billion, a drop off of about 55% from the $135.8 billion revenues in the 12 months ending September 30, 2014.
Revenues at Petrobras = -4,619 million + 1276 (51.69) = $61,337 million or $61.3 billion
If you apply the operating margin of 10.82% that Petrobras reported in the trailing 12 months to these revenues, you arrive at an operating income of $6,638 million, prior to taxes. At that level of earnings, the value that I get for the company is $62.4 billion, well below the $135.1 billion owed by the company, making its equity worth nothing. In the matrix below, I look at the value per share under different combinations of base year income (ranging from $6,638 million at the low to $28.7 billion at the high) and return on invested capital on new investments (again ranging from a low of 2.67%, with income normalized for low oil prices, to 13.36% as the high):
Assuming no high growth period, stable growth rate of 2% and cost of capital of  11.17%. Adding a high growth period reduces value in all the return on capital scenarios, except one (average over last 10 years)
The red numbers represent the dead zone, where the value of the business is less than the debt outstanding and they dominate the table.  In spite of the reckless abandon shown by its management, there remain some bright spots, if you are an optimist. The first is that the company is one of the largest oil producers in the world and if oil prices rebound, they will see a jump in revenues. The second is that the exploration and investments over the last decade have given the company the fifth largest proven oil reserves in the world, though the proportion of these reserves that will be viable at today's oil prices is open to question. The third is that if the Brazilian government stops pulling the strings and management stops its self destructive behavior, profit margins and returns will improve. In the most optimistic spin, you can assume that Petrobras will be able to keep its trailing 12-month intact at $135.8 billion, improve its operating margin to the 21.1% that it earned in 2010 and its return on capital to 13.36% (10-year average), while reducing its debt ratio to 43.5% (average over last 5 years). With those assumptions, which border on fantasy, Petrobras would be worth $8.11/share (R$ 22.55/share) well above the current stock price of $3.28/share (R$ 9.12/share).  You are welcome to try out different combinations of your assumptions in this spreadsheet and see what you get.

Unsolicited (and perhaps unwelcome) advice for a new CEO

A couple of weeks ago, Ms. Maria das Gracas Foster, Petrobras CEO since February 2012, stepped down, and the Brazilian government announced that it has chosen Mr. Aldemir Bendine, former head of Banco do Brazil, as the next CEO. The market response was almost universally negative, partly because Mr. Bendine does not have any experience in the oil business and partly because there is no trust left in the Brazilian government. I do not know Mr. Bendine and it would be unfair of me to tar him as a government stooge, just because he was appointed by the government. In fact, I am willing to not only cut him some slack but to also provide advice on what he should do in the coming weeks. Here are my suggestions:
  1. Hire a chief operating officer who knows the oil business and turn over operating responsibilities to him.
  2. Fire anyone in the top management who has any political connections. That may leave lots of empty offices in Petrobras headquarters, but less damage will be done by no one being in those offices than the current occupants.
  3. Side with directors for the minority stockholders and push for a more independent, accountable board.
  4. Refuse to go along with the cap on gasoline prices for Brazilian consumers, a subsidy that has already cost the company $20-$25 billion between 2011 and 2013. With oil prices low, the consumer backlash will be bearable.
  5. Push openly for a move to one class of shares with equal voting rights. Accompany this action by cutting dividends to zero.
  6. Clean up the investment process with less auto-pilot exploration, production that is in line with oil prices and less focus on growth, for the sake of growth.
  7. Start paying down your debt.
What is the worst that can happen to you? If the government is set on a path of self-destruction, you will be fired. If that happens, wear it as a badge of honor, since your reputation will be enhanced and you will emerge looking like a hero.  If you go along with the status quo, you will preside over the final destruction of what was Brazil’s crown jewel and face the same fate as your predecessor.  Unless the new CEO can come up with a way to remake the company,  my guess is that, at least for the next few months, here is the song that will be playing out in the market:

Final Thoughts
There are always lessons to be learned from every calamity and Petrobras qualifies as a calamity. The first is to recognize that there every reason to be skeptical when politicians claim "national interest" and meddle incessantly in public corporations. In most cases, what you have are political interests which may or may not coincide with national interests, where elected politicians and government officials use stockholder money to advance their standing. The second is that those who have labeled "value maximization" as the "dumbest idea" and pushed for stakeholder wealth maximization, a meaningless and misguided objective that only strategists and Davos organizers find attractive, as an alternative, should take a close look at Petrobras as a case study of stakeholder wealth maximization gone amok. In the last five years, Petrobras has enriched countless politicians and politically connected businesses, subsidized Brazilian car owners and provided jobs to tens of thousands of oil workers, leaving stockholders on the outside looking in. Anyone who argues that this is a net good for Brazil has clearly not grasped the damage that has been done to the country in the global market place by this fiasco.

Corruption update: I have been asked by many of you as to why have sidestepped the corruption stories that have been swirling around the company. I did so, not because I want to avoid controversy (which I don't mind at all) but because I thought that at least in this case, being subtle delivers the message about political game playing better than brute force. At Petrobras, I treat corruption as a really bad investment with horrible returns to stockholders, but I believe that with its management structure, the company was destined for trouble, and that the corruption just greased the skids.


  1. Petrobras valuation spreadsheet

Wednesday, February 4, 2015

Blood in the Shark Tank: Pre-money, Post-money and Play-money Valuations

My kids are inclined to binge TV-watching, especially in the winter, and this Christmas break, when they were all home, they were at it again. Having gone through all the Walking Dead episodes during the summer and  Criminal Minds multiple times, they chose Shark Tank as the show to watch in marathon format. For those of you who have never watched an episode, it involves entrepreneurs (current or wannabe) pitching business ideas to five 'sharks', who then compete (if interested) in offering capital (cash) for a share of the business.  Like some large families, we make even TV watching a competitive sport, especially when there are multiple shark offers on the table, with family members ranking the offers from best to worst. In one episode, a contestant was faced with two offers: the first shark offered $25,000 for 20% of the business and the second one jumped in with $100,000 for 50% of the business. While one family member suggested that the second offer was obviously better and everyone else in my family concurred, I was tempted to argue that it was not that obvious, but wisely chose to say nothing. A late night family gathering is almost never a good teaching moment, especially when your own children are in the audience. 
Pre-money & Post-money: The VC playbook
In public company valuation, the contrast between pre-money and post-money valuations almost never is an issue, but in venture capital valuation, it is front and center. Given the central role it plays in venture capital investing, and the consequential effects it has both on capital providers and capital seekers, I assumed that the venture capital playbook would have detailed instructions on the contrast between pre-money and post-money valuation, but I was wrong. In fact, here is what I learned from the playbook. If you pay $X for y% of a business, the post-money value is the resulting scaled-up value and netting out the cash influx yields the pre-money value:
  • Post-money value = $X/y%
  • Pre-money value = $X/y% - $X
Using the Shark Tank episode in the last paragraph, you can compare the two offers now in post-money and pre-money terms:

Thus, the two offers effectively attach the same value to the business and at least on this dimension, the entrepreneur should find them equivalent. While the VC definition is technically right, it is sterile, because if you have a pre-money value for a business, you can always extract the post-money value, or vice versa, but both estimates are only as good as your initial value estimate. It is also opaque,  because the process by which value is estimated is often unspecified and and made more so when the simple exchange of capital for a share of ownership is complicated by add ons, with options to acquire more of the business, first claims on cash flows and voting rights thrown into the mix.
While some of the opacity that accompanies pre-money and post-money valuations is related to the fact that you are dealing with young, start-ups, often without operating histories or clear business models, I believe that some of it is by design. By leaving the discussion of value vague and/or making the exchange of capital for proportion of the business complicated, venture capitalists can create enough noise around the process to confuse entrepreneurs about the values of their businesses. By the same token, the sloppiness that accompanies much of the discussion of pre-money and post-money valuations in venture capital can also lead to excesses during periods of exuberance, where the fact that too much is being paid for a share of a business is obscured by the confusion in the process.
Pre-money and Post-money in an Intrinsic Value World
I know that intrinsic valuations (and DCF valuations, a subset) are considered to be unworkable by many in the venture capital community, with the argument given that the young, start-ups that VCs have to value do not lend themselves easily to forecasting cash flows and/or adjusting for risk. I disagree but I think that even if you are of that point of view, the path to understanding pre-money and post-money values is through the intrinsic valuation of a very simple business.
The Franchise Stage
Let's assume that you are politically connected and that the government has given you a license to build a toll road. The cost of building the road is $100 million and to keep things really simple, let's assume that the government has agreed to pay you $10 million a year in perpetuity, that you live in a tax-free environment and that the long-term government bond rate is 5%. To get a measure of the value of the license, all you have to do is take the present value of the expected cash flows, net of the cost of building the road:
  • NPV of road = -100 + 10/.05 = $100
While a conventional accounting balance sheet would show no assets and no value for the business (since the road has not been built), an intrinsic value balance sheet will show this value:
Note that the $100 million value attributed to you (as the equity investor) in the intrinsic value balance sheet is based on a notional toll road, not one in existence. 
The Capital Seeking Stage
Now, let's assume that you don't have the capital on hand to build the road and approach me (a venture capitalist) for $100 million in capital that you plan to use to build the road. Assuming you convince me of the viability of the business and that I invest $100 million with you, here is what the balance sheet will look like the instant after I invest.
Note that the business value has doubled to $200 million, with half of the value coming from the cash infusion. That cash is transitory and will be used by you to invest in the toll road, and the minute that investment is made, the balance sheet will reflect it.
While the value of the business has not changed from the post-cash number, the nature of its assets has, with a physical toll road now setting value, rather than a license and cash. Thus, the value of the business after the cash infusion is $200 million and this is the post-money valuation of the company
The Negotiation Stage
The question at this point is what proportion of your business I should get as the venture capitalist. At first sight, the answer may seem obvious. The value of the business, after the capital infusion (and investment) is $200 million, and the capital I am providing is $100 million, entitling me to 50%, right? Not so fast! The actual answer will depend upon your bargaining power (as the entrepreneur) and mine (as the venture capitalist), and the easiest way to see this is in the limiting cases:

  • Case 1 - Only entrepreneur in market, Lots of capital providers: Assume that you are the only entrepreneur with a valuable franchise in the economy and there is a large supply of capital (from banks, venture capitalists, private equity investors). You (as the entrepreneur) have all the power in this negotiation and I will end up with a 50% share of the post-money valuation ($200 million).
  • Case 2 - Lots of entrepreneurs with valuable franchises, a monopolist capital provider: At the other extreme, if I (the VC) am the only game in town for capital, I will argue that without me your franchise is worth nothing, and that I should end up with all of the value (thus giving me close to 100% of the business). 
The reality will fall somewhere in the middle. In general, the value that you will use to compute your percentage ownership will be neither the pre-money, nor the post-money value. It will be the value of the business, with the next best capital provider providing the $100 million in capital. In the toll road example, assume that you can borrow $100 million from a bank at 7.5%, a rate that is much too high, given the risk of the investment (zero). The value of your equity in this toll road will now have to reflect the interest payments on this debt.
Cash flows after debt payments = $10 million - .075 (100) = $2.5 million
Value of equity = $2.5 million/.05 = $50 million
The new balance sheet of the business will reflect this expensive debt:
Note that the bank has effectively claimed $50 million of the value of the business by charging you too high a rate and netting out the bank's surplus yields a value of $150 million for the toll road, the "ownership value", since the ownership stake will be based on it. As the venture capitalist, I recognize that this is your next best option and demand two-thirds of your business for my $100 million. In summary, then the ownership percentage of your business that I will get in return for my capital provision can range from 50% to close to 100%, depending on the relative  supply of entrepreneurs and venture capital in a market.
1. A DCF valuation, done right, always yields a pre-money value for a business.
2. The value of a business, after a capital infusion, will have to incorporate the cash that comes into the business, pushing up the post-money value.
3. The "ownership value on which the ownership proportion is negotiated will move towards the post-money value, when there is an active and competitive (venture) capital market, and towards the pre-money value, when there is not one.
The Pricing World: Pre-money or Post-money?
As I noted at the start of the last section, most venture capitalists swear off DCF for many reasons, some justified and some not. Instead, they price businesses using a combination of a forecasted metric and a multiple of that metric (given what others are paying for similar businesses right now). Thus, if you were valuing a start-up money-losing technology firm with no revenues today, you would forecast out revenues three years (or five) from now and apply a multiple to those revenues (based on what the market is paying for public companies in this space) in the third year to get an exit value, which you will then proceed to discount back at a "target" rate of return to get a value today:
Pricing: Pre or post-money?
When you price companies, the question of whether the value you arrive at today is a pre-money or post-money valuation becomes murkier. The forecasted revenues that you forecast in year 3 is not (and often are) only based on the assumption that there is a capital infusion in the firm today but that there may be more capital infusions in the future, in which case it is a post-post-post money valuation and adding cash to this value will be double counting. (As an analogy, consider the toll road example that I used in the intrinsic value section. The earnings on the toll road are expected to be $10 million a year and the toll road should trade at about twenty times earnings, given its fundamentals. Using the VC approach, the value that I would get is $200 million, which is the post-money valuation). 
A pre-money pricing?
Can you modify the VC approach to deliver a pre-money pricing? Yes, and here is what you would have to do. You would have to forecast two measures of future earnings, one with the capital infusion and one without. In the extreme scenario where the start-up will cease to exist without the capital and there are no other capital providers, the expected earnings in year 3 will be zero, yielding a pre-money valuation of zero for the company. Consequently, you will demand all or almost all of the company in return for your investment.

  1. Pricing is opaque: While pricing is market-based, quick and convenient, the cost of pricing an asset rather than valuing it is that the process glosses over details and makes it difficult to figure out what exactly you are getting for your investment today and what you have already incorporated in that number. 
  2. The Target rate is Swiss Army knife of VC valuation; In the VC approach, the target rate (though called a discount rate) is like a Swiss Army knife, serving multiple purposes. First, it is a reflection of the expected return you should make, given the risk in the investment, i.e., the conventional risk-adjusted rate.  Second, it incorporates the survival risk in the company, i.e., the reality that many of the companies  that VCs invest in don't make it and that you have to lower the value of start-ups to reflect this risk. Third, it includes a component to cover the future capital needs of the business, with a higher discount rate being used for companies that will need more rounds of capital. Finally, it is a negotiating tool, with VCs pushing up the target rate, if they feel that they have a strong bargaining position. While it is impressive that so much can be piled into one number, it does make it difficult to figure whether you have counted all of these variables correctly and not double counted or miscounted it. It also implies that the actual returns generated by VCs will bear little resemblance to the target returns; the table below summarizes venture capital returns across VC funds over the last year, three years, five years and ten years and compares them to returns on growth equity mutual funds and the S&P 500.
    Through Sept 30, 2014; Source: National Venture Capital Association (NCVA)
  3. Winners and Losers: It is not clear who wins and loses in the pricing game, when sloppiness rules. In periods where entrepreneurial investments are plentiful and venture capital funding is scarce, it probably leads to venture capitalists claiming too large a stake in the businesses that they invest in, given the capital invested. During periods when entrepreneurial investments are scare and venture capitalists are plentiful, my guess it that it leads venture capitalists to overpay for businesses.

A Plea for Transparency
I am not making an argument that venture capitalists and other early stage investors shift to intrinsic valuation. While I believe that they under use and often misunderstand intrinsic valuation, I think that the attachment to pricing is too deep for them to shift. I do believe though that everyone (founders, entrepreneurs, venture capitalists) would be better served if there was more transparency in the process and we were more explicit about the basis for assessing ownership rights (and proportions). Perhaps, I will start by making myself unpopular in my household and bringing up the discussion of pre and post money valuations during Shark Tank!

Sunday, February 1, 2015

Discounted Cashflow Valuations (DCF): Academic Exercise, Sales Pitch or Investor Tool?

In my last post, I noted that I will be teaching my valuation class, starting tomorrow (February 2, 2015). While the class looks at the whole range of valuation approaches, it is built around intrinsic valuation, reflecting my biases and investment philosophy. I have already received a few emails, asking me whether this is an academic or a practical valuation class, a question that leaves me befuddled, since I am not sure what an academic value is.  As some of you who have read this blog for awhile know, I do try to value companies, but I do so not because I am intellectually curious (I don't lie awake at night wondering what Twitter is worth!) but because I need investments for my portfolio. In the context of these valuations, I have been accused of being a valuation theorist, and I cringe because I know how little theory there is in valuation or at least my version of it. In fact, my entire class is built around one simple equation:

Put in non-mathematical terms, the equation posits that the value of an asset is the value of the expected cash flows over its lifetime, adjusted for risk and the time value of money. If that sounds familiar, it should, because it is the starting point for every Finance 101 class, a rite of passage that in conjunction with buying a financial calculator sets you on the pathway to being a Financial Yoda! 
That is the only theory that you need for valuation! The rest of the class is about the practice of valuation: defining and estimating expected cash flows for different types of assets and businesses at different stages in the life cycle and estimating and adjusting the discount rate for risk and time value. Note that there is nothing in this fundamental equation that has not been known to investors and business people through the ages, i.e., the value of a business has always been a function of its cash flows, growth potential and risk and that you certainly don’t need to be mathematically inclined to be able to do valuation. So, if you don’t remember how to take first differentials or solve algebraic equations, never fear. You can still value companies.
DCF : Neither Magic Bullet nor Bogeyman
If DCF valuation is simple as its core, why does it intimidate so many? The fault lies both with its proponents and its critics. The proponents, and I would include myself on the list, have undercut the approach's usage and acceptance by:
  1. Over complicating DCF: It is undeniable that most discounted cash flow models suffer from bloat, with layers of detail that we not only don't need, but also make no difference to the ultimate value. These details and complexities are sometimes added with the best of intentions (to get better estimates of cash flows and risk) and sometimes with the worst (to intimidate and to hide the big assumptions). No matter what the intentions are, they make people on the receiving end suspicious.
  2. Over selling DCF: In the hands of bankers, analysts, consultants and managers, DCF models are less analytical devices and more sales tools, backing up a recommendation to buy, sell or change the way we do things.  While that is neither surprising nor newsworthy, it does make those who are the targets of these sales pitches cynical about the process, and who can blame them?
  3. Over sanitizing DCF: I don't know whether DCF's proponents feel that it cannot be defended on its merits or that it is too weak to stand up to scrutiny, but they seem to want to cover up the uncertainties that are embedded into every valuation and play down any hint of story telling that may underlie the numbers or uncertainty in their estimates.
Like anyone who has ever used a DCF, I have been guilty of these practices and therefore understand the motivation. At the core, it is because we are insecure both about our understanding of DCF and our capacity to explain in intuitive terms why we do what we do. If paid to do valuation, we over compensate and believe that we will be more credible if we churn out overcomplicated, number-driven models and that our clients would not pay us, if they realized how simple the process actually was.
Those who critique discounted cash flow models (and I certainly agree that there is often to disagree with), are driven by their own share of sins, where they conflate disagreements that they have with input estimation techniques, the model-builder and model output with disagreements with the DCF process itself.
  1. The Baby/Bathwater syndrome: While it is an analogy that makes me cringe each time I use it, with visions of babies flying out of bathroom windows, it is apt in its description of those who take issue with how an input is estimated in a DCF and then extrapolate to conclude that the entire process is flawed. The input that creates the most angst, of course, is the risk measure used in the valuation, with even a mention of beta generating the gag reflex among old-time value investors. 
  2. Dislike you, dislike your model: The line between a DCF model and its builder must be a gray one, since many critics seem to have trouble finding it. Not surprisingly, dislike of a user because of his or her investment philosophy, personality or style of presentation can very quickly translate into disdain about the process by which he or she values companies.
  3. Don’t like your answer: It is human nature but investors tend to like DCF models that deliver answers that they like and dislike models that do not. Even in my limited blog posting experiences, I have been lauded for using sound intrinsic value models, by Apple Bulls, when my valuations have suggested that Apple is cheap. I have also been blasted by often the same investors for using a flawed DCF model, when my valuations suggest otherwise.
As with the proponents, I think I understand where critics are coming from. After all, if you were constantly the target for sales pitches by analysts who use complicated DCF models to sell snake oil, you would be suspicious too.
A Return to Basics
The first step in spanning the divide is to strip away the layers of complexity that we have built into valuation over the decades and return to the equation that I started this post. At the risk of stating the obvious, I would like to draw on four simple and self-evident propositions that get overlooked or ignored frequently in the discussion of discounted cashflow valuation (DCF).
  1. The Duh Proposition: For an asset to have value, its expected cash flows have to be positive at some point in time, but that does not imply that the cash flow has to be positive every single year and it is quite clear that you can have a valuable business (asset) with negative cash flows in the first year, the first three years or even the first seven or eight, if it can deliver disproportionately large positive cash flows later in their lives. It is true that those whose DCF toolbox has only one model in it, usually the Gordon Growth Model (a stable growth dividend discount model), have trouble with such companies, but using the Gordon Growth Model to value most equities is the equivalent of doing surgery with a  hammer: painful, ineffective and designed to come to a bloody end.
  2. You can hate beta (or modern portfolio theory or all of academic finance), but still love DCF: This may come as news to its worst critics but the DCF model does not come prepackaged with modern portfolio theory and its most famous handmaiden, the beta. In fact, while the discount rate in the discounted cash flow model is usually risk-adjusted and reflects the time value of money, the model itself is completely agnostic about how you adjust for risk (you can come up with your own creative ways of making the adjustment) or even whether you adjust for risk. The DCF model is a descriptive equation of a cash-flow generating asset or business, not a theory or a hypothesis.
  3. It is the asset's life, not your time horizon: A DCF model is designed to value an asset over it's life, and is really not malleable to what you (as the investor looking at the asset) believe your time horizon to be. If the value of an asset is the present value of cash flows over its life, what is that life? It clearly depends on the asset. If you are valuing a machine whose functioning life is only one year, all you need is one year's cash flows, but if estimating a value for a rental building with a 20-year life, it would be twenty years. With public companies that at least in theory can last forever, we do stop estimating cash flows at a point in time and assume that cash flows beyond that point continue in perpetuity, but this is an assumption of convenience, not necessity. In fact, there is nothing that stops you from replacing that perpetuity assumption with one that assumes that cash flows will continue for only 20 or 30 years after your closure year.
  4. You will be wrong, and it is not your fault: If you take expected cash flows (where the expectations are across a wide spectrum of outcomes) and discount those expected cash flows at a risk-adjusted discount rate, it should go without saying (but I am going to say it anyway) that the present value that you get is an estimate of value. Thus, you are almost guaranteed to be wrong when valuing assets with any uncertainty about the future, and more wrong when there is more uncertainty. So what? The market price is just as affected by uncertainty, and you are judged not by how wrong you are in absolute terms but how wrong you are, relative to other people valuing the stock.
Ten Myths about the DCF Model
While the architecture of the DCF model is simple and the truths that emerge from it are universal, there is a great deal of mythology around DCF valuation, some of it promoted by model-users and some by model-haters.
  • Myth 1: If you have a D(discount rate) and a CF (cash flow), you have a DCF. As a DCF-observer, I see a lot of pseudo DCF, DCFs in drag and other fake DCFs being pushed as discounted cash flow valuations. 
  • Myth 2: A DCF is an exercise in modeling & number crunching. There is no room for creativity or qualitative factors.
  • Myth 3: You cannot do a DCF when there is too much uncertainty, thus making it useless as a tool in valuing start-ups, companies in emerging markets or during macroeconomic crises.
  • Myth 4: The most critical input in a DCF is the discount rate and if you don’t believe in modern portfolio theory (or beta), you cannot use a DCF.
  • Myth 5: If most of your value in a DCF comes from the terminal value, there is something wrong with your DCF, since the value rests almost entirely on what you assume in that terminal value.
  • Myth 6: A DCF requires too many assumptions and can be manipulated to yield any value you want.
  • Myth 7: A DCF cannot value brand name or other intangibles. 
  • Myth 8: A DCF yields a conservative estimate of value. It is better to under estimate value than over estimate it.
  • Myth 9: If your DCF value changes significantly over time, there is either something wrong with your valuation (since intrinsic value should not change over time) or it is pointless (since you cannot make money on a shifting value)
  • Myth 10: A DCF is an academic exercise, making it useless for investors, managers or others who inhabit the real world.
Each of these myths deserves its own post and I plan to cover all of them in the next year (one myth a month). Stay tuned!
A Trial Run
I know that some of you are skeptical about my pitch but if you are, at least give the process a try. If you feel a little rusty on the basics or have questions about details, you are welcome to take my class in real time or the online version of it (which is less trying and has shorter webcasts).

Wednesday, January 28, 2015

The Dance of the Disrupted: Observations from the front lines

Teaching is my passion, writing gives me joy and finance is my playground. While I am blessed in being able to immerse myself in all three, my activities put me in three businesses, education, publishing and financial services, that are begging to be disrupted. In fact, as disruption starts to challenge the status quo in all three businesses, I have a front row seat to observe how they react to these changes and perhaps add to their discomfort. 

The targets of disruption

As technology and globalization disrupt one business after another, it is useful to start with a simple question. Why do some businesses get targeted for disruption and others left alone? As I see it, there are three characteristics that businesses that get disrupted seem to share:
  1. Sizable economic footprint: The probability of a business being disrupted increases proportionately with the amount of money that is spent on that business. Using this template, it is easy to see why financial services (active money management, financial advisory services, corporate finance) and education are attracting so many disruptors and why publishing offers a smaller target.
  2. Inefficient production and delivery mechanisms: A common characteristic that disrupted businesses share is that they are inefficiently run, and neither producers nor consumers seem happy. Consumers are unhappy because producers are non-responsive to their needs and deliver sub-standard products at premium prices, but producers seem to have little to show in surplus. In education, for instance, students (especially under graduates at research universities) complain that they get a bad deal for the money they spend but colleges collectively seem to have trouble balancing their budgets, as is evidenced by their frequent and frantic attempts to raise money from alumni to cover their unmet needs. Publishers claim that their business models are being threatened by Amazon, while textbooks still cost outlandish amounts of money. Even in finance, where there are a few big winners every period, it is becoming increasingly difficult to find entities that win big consistently, and consumers of financial services are not exactly happy campers.
  3. Outdated competitive barriers and inertia: If these businesses are so big and inefficiently run, you may wonder what has allowed them to continue in existence for as long they have. The strongest force that they have going for them is inertia, where consumers have been programmed to accept the status quo: that it should take four years to get an undergraduate degree, that you need professional (paid) help to invest and that it makes sense to pay outlandish amounts for new editions of textbooks (on accounting, economics or mathematics) that are little changed from the old editions. Adding to the protections are regulatory or licensing requirements that have long outlived their original purpose and serve to protect incumbents from insurgencies. I have posted previously on how universities have bundled together screening, classes, networking and entertainment into packages that students have to take whole or leave and publishers and financial service companies have their own bundling variants.
The Dance of the Disrupted: The Five Stages
One of the enduring challenges that we face is explaining why disrupted businesses take so long to respond to disruption. Why did retailers not react faster to online retailing, in general, and Amazon, in particular? In a more updated version, what is it that is stopping traditional cab service companies from responding better to the car-sharing services like Uber and Lyft? I will let corporate strategists hash out the answers to those questions, but watching the education business respond to disruption has given me some perspective. With apologies to Elizabeth Kubler-Ross, I see disruption working its way through disrupted businesses in five stages, starting with denial and ending with acceptance.

Stage 1: Denial and Delusion
The first reaction to a disruptive challenge at most established businesses is delusion and denial, the delusion coming from the belief on the part of the existing players that the established way of doing business is the only (and best) way, notwithstanding widespread dissatisfaction on the part of both producers and consumers, followed by denial that others can do it better. I see this clearly in the education business, where I hear university overseers, administrators and faculty all express shock that anyone would question the Rube Goldberg contraption that forms the modern university education and conviction that no one outside the hierarchy understands education like they do.

Stage 2: Failure and False Hope
In most businesses, the initial wave of disruption usually fails, both because the disruptors do not understand the businesses that they are trying to disrupt and/or ran foul of the rules of the game (written by the establishment). Thus, Napster’s initial foray into the music business ended in it being shut down and the online retailing challenge was derailed (at least temporarily) by the tech market collapse in 2000. In the education business, the MOOC phenomenon was the shooting star that challenged the education establishment five years ago but it looks like it has fizzled out, partly because its providers mistook a university degree for a collection of courses. That initial failure was a moment of relief for the education establishment, since it reinforced its sense of superiority, and has created the hope among some in it that the disruption has passed.

Stage 3: Imitation and Institutional Inertia
The threat of disruption scares the establishment, though it moves in conventional ways to counter the disruption: by mapping out long-term plans and trying to borrow ideas from the disruptors. Those moves, while initiated with fanfare and backed up by resources, are generally undermined by an unwillingness on the part of those who benefit from the status quo to give up or compromise any of their existing privileges. In the education business, this “me too” phase is in full force, as universities create online course and some even offer online degrees, with a few faculty contributing willingly and a large majority going along either grudgingly, or not at all. If the only way that traditional colleges can compete with online education is by forcing professors to be accountable for the classes they teach (tying hiring, pay and tenure to teaching quality more than to research output) and firing those who do not measure up (no matter how productive they have been in their research), do you think that proposal has any chance of succeeding at a modern research university? I do not!

Stage 4: Regulation and Rule Rigging
The initial disruption may fail but it exposes both the weaknesses of the existing system and ways of getting around its defenses. Just as Napster softened up the music business for the assault of Apple’s iTunes store, the failure of MOOCs has offered valuable clues to disruptors as to what they need to do differently to beat universities at their game. In this post from September 2014, I laid out what I think will characterize the first successful online university: a combination of student screening, top-notch classes, discussion and interaction forums and networking opportunities , and I remain convinced that it will happen sooner rather than later. I predict that the education status quo will respond as other disrupted businesses have in the past, with a combination of complaints about unfairness and bad quality of the disruptors and a demand for protection from regulatory and licensing authorities from competition. Anecdotal evidence about the poor quality of education at some online education portals will be used to tar all online education, as if traditional colleges do not churn out their own share of substandard graduates.

Stage 5: Acceptance and Adjustment
The end game in disruption is painful. There will be jobs lost not only at the disrupted institutions and there will be ripple effects in the communities that serve them. With universities that have tenure-protected older faculty, the pain will be borne disproportionately by younger faculty and doctoral students entering the academic job market, and even tenure-protected faculty will find out that a guaranteed job does not come with guaranteed pay or research support. I am not predicting that universities will cease to exist, but there will be fewer of them, and the ones that survive will do so because they have carved out niches for themselves. IT is unfair, but it will be easier for a Harvard, MIT or Oxford to make it than lesser schools, with less illustrious histories, smaller endowments and less connected alumni.

My Disruption Plans
As I watch the businesses that I am in face the threat of disruption and respond badly, I plan to contribute to the disruption with small (and perhaps futile) acts of my own.
  1. In the publishing business, there is nothing more perverse and irrational than the textbook game, where books are obscenely over priced (even in their e-book versions) and old editions are made obsolete with a few selected edits. Of my ten books, four are textbooks and the way they are priced is the reason that I don’t require them in my own classes. The first editions of these books were written more than 15 years ago, and I had no choice but to use a publisher, but if I were writing these books today, I would do things differently. Then again, I am not done writing and will perhaps get a chance to make amends to those who have read my books.
  2. The finance business is too big for me to even cause a ripple, but I will continue to make the case that investors need to stop paying financial advisors for useless (and often counter productive) investment advice, that businesses should be able to make fundamental corporate finance decisions without calling in consultants and that the valuations that you get from bankers in IPOs and acquisitions are more pricing than value. One reason that Anant Sundaram and I co-developed uValue, a (free) valuation app for the iPhone/iPad is to make it easier for investors/companies to do valuations on their own.
  3. On the education front, anyone who has been reading my blog for a while knows that I put my regular classes online, class webcasts, lectures and exams included. I will be teaching corporate finance and valuation to MBAs at Stern in the spring, with classes starting on February 2, 2015 and continuing through May 11, 2015. The corporate finance class is the first one in the sequence, offered to first year MBAs, and valuation is an elective. You have four forums where you can take these classes:

Corporate Finance
My site (Stern NYU)
Apple iTunes U

Each option has its pluses and minuses. My site will include everything I offer my regular class, including emails and announcements but it is an online site without any bells and whistles. The iTunes U site is the most polished in terms of offerings, but there is no forum for interaction and requires more work if you don't have an Apple device. Yellowdig is a new add-on to my menu and it is a site where you will be able to access the classes and material and hopefully interact with others in the class. (You will have to register on Yellowdig and it is restrictive on what email addresses it will accept.) YouTube is the least broadband-intensive forum, since the file size adjusts to your device, but you will be able to get only the class videos (and not the material).
If you are wondering why I would disrupt businesses that I am part of, I have three responses. The first is that, with four children, I am a consumer of the products/services of these businesses and I am sick and tired of paying what I do for textbooks, college tuition and minor financial services. The second is that it is so much more fun being a disruptor than the disrupted and being in a defensive posture for the rest of my life does not appeal to me. The third is that with Asia's awakening, we face a challenge of huge numbers and the systems (education, public and financial services) as we know them don't measure up.

Monday, January 19, 2015

The X Factor in Value: Excess Returns in Theory and Practice

There are lots of reasons why we try to start and run businesses. Some of them are emotional but the financial rationale for starting and staying in business is a simple one. It is to not just to make money, but to make more than what you would have made elsewhere with the capital (human and financial) invested in the business. Of course, your competitors, the government and sometimes the entire world seems to conspire against you (or at least it seems that way) to prevent you from making these “excess” returns. 
The Search for and Scarcity of Excess Returns
In corporate finance, decision-making tools are constructed with the objective of earning and maximizing excess returns. Thus, the notion of net present value in capital budgeting is built on the presumption that an investment should earn more than what you would have generated as a return on an investment of equivalent risk.  In investing, the search for excess returns or alpha is just as intense, with traders, value investors and growth investors playing their own versions of the game.
While you can plan, hope and pray for excess returns, to earn them consistently, you have to bring something unique that cannot be easily replicated to the game. In the case of businesses, that something is a competitive advantage or a barrier to entry that allows them to continue generating returns that exceed their costs of capital, without competition driving down profitability to more "normal" levels. These competitive advantages can range from economies of scale (Walmart), to brand name (Coca Cola) to patents (Amgen), and while they are have to be earned, they are not uncommon. In the case of investors, those competitive advantages are not only rarer but also more difficult to defend, perhaps explaining why so few active investors beat index funds or the market.
The Measurement of Excess Returns
Assume that you have been given the task of measuring whether a company’s past investments have generated returns for that exceed their cost, i.e. excess returns. To measure excess returns generated by companies on their investments collectively, you need two numbers, the expected return on the investments, given their risk and alternative investment choices today, and the actual return earned on those investments.
  1. The first number is the expected return on the investment, given its risk. As I noted in my last post, the cost of capital, computed right, should be an opportunity cost that reflects the expected return that investors in the company can generate by investing elsewhere in investments of equivalent risk. 
  2. The second number is easy to compute for investors in publicly traded securities, since it a function of how much cash the investments returned (in dividends or other forms) and the price change over the year. Measuring the return earned by companies is more problematic, especially for ongoing and evolving investments. The most logical place to start is with the earnings generated by the company on these investments, but that number,  is volatile and may not reflect the true quality of investments.  The actual earnings (and returns) for a company will move a lot from year to year, sometimes because of actions taken by the firm and sometimes because of macroeconomic shifts. In addition, a company’s earnings and investing history is framed by accounting statements. Thus, accounting profits (net income, operating income) become a proxy for true earnings and the book value of capital invested (book value of equity, invested capital) stand in for earnings and investments, and we get two of the most widely used accounting returns: the return on (invested) capital and the return on equity.
While I have no qualms about using either return measure, the dependence on accounting statements for both the numerator and denominator trouble me.  It is not my objective in this post to belabor the definition of return on equity and capital. If you are interested, I have an extended discourse on the technical issues that you may face in computing accounting returns in this paper.
In my last post, I looked at the simplifying assumptions that I made to compute the costs of capital for industries and for individual companies. To measure the excess returns, I do need to compute the return on invested capital, and I do make simplifying assumptions again to prevent getting bogged down.
Note that I am using the effective tax rate to compute after-tax operating income, both at the industry and company level. For return on equity, I use a similar adjustment process:

I am well aware of the weaknesses in these measures. The first is the use of the most recent year's operating income in the numerator. Earnings at companies can vary over time and the most recent year may yield a number that is not representative of the company. (I did also use a ten-year average income to generate returns to try to counter this problem). The second is that the book value of equity is an accounting number and as such, is affected by accounting decisions on capitalization/expensing, depreciation and write offs. The third is that netting out the most recent period's cash balance, especially at technology or growth companies, can result in a negative invested capital. Finally, this measure, even if the earnings and invested capital are measured right, will be biased against young companies and companies investing in long-gestation period investments (infrastructure, toll roads etc.), since it will be low in the early years.
The Evidence on Excess Returns
Notwithstanding the many limitations of the excess return measure that I have described, I do think that there is value in looking at how firms measure up on it, across sectors and across the globe.

a. Across Sectors
To compute the return on capital for a sector, I used aggregated values for the operating income and invested capital across companies in the sector, rather than a simple average of the returns on capital of individual companies. I did this for two reasons. The first is that it allows me to keep all of the firms in my sample, rather than only the ones for which I can measure excess returns. The second is that it prevents outliers (hugely positive or negative excess returns that I may estimate for a firm, usually because of quirky accounting) from affecting the average. The third is to get a measure of weighted performance, where larger firms in a sector count for more than smaller firms.

I report the industry averages in this data in this dataset. In the table below, I report on the five industries, in the US and globally, that report the highest return spreads (a return on capital that most exceeds the cost of capital) and the five that had the lowest return spreads.
Return spreads based on trailing 12 month returns: January 2015
As with any measure, the rankings reveal as much about the quality of the measure as they do about the quality of the sectors. Tobacco companies are at the top of the list partly because repeated stock buybacks have depleted the book values of equity and invested capital, at last in the United States. Aerospace and defense is a volatile business and the high positive excess returns in 2014 can turn negative, if the airline business is troubled. 
b. Across Countries
To look at excess returns across countries, I consolidated companies into five groups: US, emerging markets, Europe, Japan and Australia/NZ/Canada. I then looked at the individual companies within each group and how much they earned, relative to their costs of capital. The table below summarizes the distribution of companies, in terms of excess returns, in each region:

The most striking feature of the data, to me, is that the proportion of companies that earn less than their cost of capital, 65.36% of all companies and 53.99% of companies with market capitalizations that exceed $50 billion. That indicates either that competition is a lot more intense in more businesses than we think and/or that management at many of these companies are either unaware or indifferent that their businesses are not generating sufficient profits, given the risk. 

What next?
This may reflect my biases but everyone should care about these excess returns. Investors should be valuing companies, based on their expectations of future expected returns, and pushing for change in companies that don't deliver them. Anti-trust regulators can use them as proxies for determining whether competition is adequate in markets and lawmakers should consider excess returns rather than absolute profits, in making public policy.

Dataset attachments
  1. Excess Returns by sector (USEmerging MarketsEuropeJapan, Australia/CanadaGlobal)


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